Item 1A. Risk Factors.
Economy and Our Markets
Adverse economic conditions in market areas we serve could adversely impact our earnings and could increase the credit risk associated with our loan portfolio.
A significant portion of our loans are to businesses and individuals in the state of Washington. An economic decline affecting our region could have a material adverse effect on our business, financial condition, results of operations, and prospects. Weakness in the global economy has adversely affected many businesses operating in our markets that are dependent on international trade. Other businesses in our market area and around the world were impacted in a significant way by the COVID-19 pandemic.
While real estate values and unemployment rates have recently improved, deterioration in economic conditions in the market areas we serve, in particular the North Olympic Peninsula and Puget Sound area of Washington State, could result in the following consequences, any of which could have a materially adverse impact on our business, financial condition and results of operations:
• loan delinquencies, problem assets and foreclosures may increase;
A decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose real estate loan portfolios are geographically diverse. If we are required to liquidate a significant amount of collateral during a period of reduced real estate values, our financial condition and profitability could be adversely affected. Adverse changes in the regional and general economy could reduce our growth rate, impair our ability to collect loans, and generally have a negative effect on our financial condition and results of operations.
Public health crises,geopolitical developments, acts of terrorism, natural disasters, climate change and other external factors could harm our business.
Public health crises, such as the global outbreak of COVID-19, domestic or geopolitical crises, such as the recent invasion of Ukraine by Russia, political instability or civil unrest, terrorism, human error or other events outside of our control, could cause disruptions to our business or the United States economy, and our business and operating results could suffer. Natural disasters may disrupt our operations, result in damage to our properties, reduce or destroy the value of the collateral for our loans and negatively affect the economies in which we operate. Climate change may worsen the severity and impact of future natural disasters and other extreme weather-related events that could cause disruption to our business and operations. Chronic results of climate change such as shifting weather patterns could also cause disruption to the business and operations of our customers, with potential negative effects on our loan portfolio and growth opportunities. A significant natural disaster, such as a tsunami, earthquake, fire or flood, where we or our customers live and do business, could have a material adverse impact on our local market areas and ability to conduct business, and our insurance coverage may be insufficient to compensate for losses that may occur. The effects of any of the foregoing factors could have a material adverse effect on our business, operations and financial condition.
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Conditions in the financial markets may limit our access to additional funding to meet our liquidity needs, which could adversely affect our earnings and capital levels.
Liquidity is essential to our business. We rely on a variety of sources in order to meet our potential liquidity demands. We require enough liquidity to meet customer loan requests, customer deposit maturities and withdrawals, payments on our debt obligations as they come due and other cash commitments under both normal operating conditions and other unpredictable circumstances, including events causing industry or general financial market stress. A tightening of the credit markets and the inability to obtain adequate funding may negatively affect our liquidity, asset growth and, consequently, our earnings capability and capital levels. In addition to any deposit growth, and the sale of loans or investment securities, maturity of investment securities and loan payments, we rely from time to time on advances from the FHLB and certain other wholesale funding sources to meet liquidity demands. Our liquidity position could be significantly constrained if we were unable to access funds from the FHLB or other wholesale funding sources.
Factors that could detrimentally impact our access to liquidity sources include a decrease in the level of our business activity as a result of a downturn in the markets in which our loans are concentrated, negative operating results, or adverse regulatory action against us. Our ability to borrow could also be impaired by factors that are not specific to us, such as a disruption in the financial markets or negative views and expectations about the prospects for the financial services industry or deterioration in credit markets. Any decline in available funding could adversely impact our ability to originate loans, invest in securities, meet our expenses, or fulfill obligations such as repaying our borrowings or meeting deposit withdrawal demands, any of which could, in turn, have a material adverse effect on our business, financial condition and results of operations.
Additionally, collateralized public funds are bank deposits of state and local municipalities. These deposits are required to be secured by certain investment grade securities or other collateral to ensure repayment, which on the one hand tends to reduce our contingent liquidity risk by making these funds somewhat less credit sensitive, but on the other hand reduces standby liquidity by restricting the potential liquidity of the pledged collateral. Although these funds historically have been a relatively stable source of funds for us, availability depends on the individual municipality's fiscal policies and cash flow needs.
The COVID-19 pandemic has adversely impacted our ability to conduct business and may adversely impact our financial results and those of our customers. The ultimate impact will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic.
The COVID-19 pandemic has significantly affected our operations and the way we provide banking services to businesses and individuals. As an essential business, we provided banking and financial services to our customers throughout the pandemic. We returned to regular lobby and drive-thru access at our branch locations in May 2021. In addition, we continue to provide access to banking and financial services through online banking, Interactive Teller Machines ("ITMs"), Automated Teller Machines ("ATMs"), and by telephone. If the COVID-19 pandemic worsens it could limit or disrupt our ability to provide banking and financial services to our customers.
A number of our employees currently are working remotely to enable us to continue to provide banking services to our customers. Heightened cybersecurity, information security and operational risks may result from these remote work-from-home arrangements. We also could be adversely affected if key personnel or a significant number of employees were to become unavailable due to the effects and restrictions of the COVID-19 pandemic. We also rely upon our third-party vendors to conduct business and to process, record and monitor transactions. If any of these vendors are unable to continue to provide us with these services, it could negatively impact our ability to serve our customers. Although we have business continuity plans and other safeguards in place, there is no assurance that such plans and safeguards will be effective.
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There is pervasive uncertainty surrounding the future economic conditions that will emerge in the years following the start of the pandemic. As a result, management is confronted with a significant and unfamiliar degree of uncertainty in estimating the impact of the pandemic on credit quality, revenues and asset values. To date, the COVID-19 pandemic has resulted in changes in the demand for certain loan types, including government sponsored programs such as the Paycheck Protection Program, deposit availability, and market interest rates. Because the length of the pandemic and the efficacy of the extraordinary measures being put in place to address its economic consequences are unknown, our net interest income and net interest margin may continue to be adversely affected.
Although the Company makes estimates of loan losses related to the pandemic as part of its evaluation of the allowance for loan losses, such estimates involve significant judgment and are made in the context of substantial uncertainty as to the impact the pandemic will have on the credit quality of our loan portfolio. Consistent with guidance provided by banking regulators, we modified loans by providing various loan payment deferral options to our borrowers affected by the COVID-19 pandemic. Notwithstanding these modifications, not every borrower may be able to make full payments on their loans once the COVID-19 pandemic is resolved. Any increases in the allowance for credit losses will result in a decrease in net income and, most likely, capital, and may have a material negative effect on our financial condition and results of operations.
SBA PPP loans are subject to the provisions of the CARES Act and to complex and evolving rules and guidance issued by the SBA and other government agencies. The great majority of our SBA PPP borrowers have received full or partial forgiveness of their loan obligations. We have credit risk on SBA PPP loans if the SBA determines that there is a deficiency in the manner in which we originated, funded or serviced loans, including any issue with the eligibility of a borrower to receive an SBA PPP loan. As of December 31, 2021, we hold and service SBA PPP loans with an aggregate balance of $14.6 million.
Even after the COVID-19 pandemic subsides, the U.S. economy will likely require some time to recover from its effects, the length of which is unknown, and during which we may experience a recession. As a result, we anticipate our business may be materially and adversely affected during this recovery. To the extent the effects of the COVID-19 pandemic adversely impact our business, financial condition, liquidity or results of operations, it may also have the effect of heightening many of the other risks described in this section.
Credit and Asset Quality
Our increased emphasis on commercial real estate lending subjects us to various risks that could adversely impact our results of operations and financial condition.
We have increased the amount of our commercial real estate and multi-family loans to $535.7 million, or 39.5% of our total loan portfolio, at December 31, 2021, from $459.0 million, or 39.8%, of our total loan portfolio at December 31, 2020. We intend to continue to increase, subject to market demand, our origination and purchase of commercial real estate loans. As an institution’s concentration in commercial real estate lending increases, it becomes subject to more scrutiny by the FDIC under its policies applicable to management of its portfolio of commercial loans.
Our increased focus on this type of lending has increased our risk profile. Commercial real estate loans are intended to enhance the average yield of our earning assets; however, they do involve a different level of risk of delinquency or collection than one- to four-family loans. The repayment of commercial real estate loans typically is dependent on the successful operation and income stream of the borrowers’ business, or the ability to lease the property at sufficient rates, and the value of the real estate securing the loan as collateral, which can be significantly affected by economic conditions. These loans also involve larger balances to a single borrower or groups of related borrowers. Some of our commercial borrowers have more than one loan outstanding with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss compared to an adverse development with respect to a single one- to four-family residential mortgage loan.
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Since commercial real estate loans generally have large balances, deterioration in the quality of commercial loans may result in the need to significantly increase our provision for loan losses and charge-offs will likely be larger on a per loan basis compared to consumer loans. As a result, deterioration of this portfolio could materially adversely affect our future earnings. Collateral evaluation and financial statement analysis in these types of loans also requires a more detailed analysis at the time of loan underwriting and on an ongoing basis. Finally, if we foreclose on a commercial real estate loan, our holding period for the collateral is typically longer than for a one- to four-family residence because the market for most types of commercial real estate is not readily liquid, which results in less opportunity to mitigate credit risk by selling part or all of our interest in these assets. At December 31, 2021, we had $71,000 of nonperforming commercial real estate loans and $0 of nonperforming multi-family loans in our portfolio.
The significant growth in our loan portfolio and expansion into new markets may increase our credit risk.
Since the completion of our initial public offering in January 2015, we have grown substantially in terms of total assets, total loans, total deposits, employees, and locations, expanding our business activities throughout the Puget Sound region. Our commercial loan portfolio, which includes loans secured by commercial and multi-family real estate as well as business assets, has increased to $615.6 million, or 45.4% of total loans, at December 31, 2021, from $559.2 million, or 48.5% of total loans, at December 31, 2020. Construction and land loans have increased to $224.7 million, or 16.5% of total loans, at December 31, 2021, from $123.6 million, or 10.7% of total loans, at December 31, 2020. Rapidly growing loan portfolios are, by their nature, less seasoned and our experience with these loans may not provide us with a significant payment history pattern. Rapid growth combined with the geographic expansion of our lending area may make estimating loan loss allowances more difficult and more susceptible to changes in estimates, and to losses exceeding estimates, than our more seasoned portfolio of loans in our traditional lending area. As a result, it is difficult to predict the future performance of these parts of our loan portfolio. These loans may develop delinquency or charge-off levels above our historical experience, which could adversely affect our future performance.
We plan to continue both strategic and opportunistic growth, understanding that we may see a slowing of growth as we mature and manage capital down to more efficient levels. Continued growth can present substantial demands on management personnel, line employees, and other aspects of our operations, especially if our growth occurs rapidly. We may face difficulties in managing that growth effectively, which could damage our reputation, limit our growth, and negatively affect our operating results. Also see "Our expansion strategy will cause our expenses to increase and may negatively affect our earnings."
We have a concentration of large loans outstanding to a limited number of borrowers that increases our risk of loss.
First Fed has extended significant amounts of credit to a limited number of borrowers, largely in connection with high-end residential real estate and commercial and multi-family real estate loans. At December 31, 2021, the aggregate amount of loans, including unused commitments, to First Fed's five largest borrowers (including related entities) amounted to approximately $116.5 million. Outstanding loan balances for the ten largest borrowing relationships at December 31, 2021, totaled $146.6 million, or 10.8% of total loans. Although none of the loans to First Fed's 20 largest borrowers were nonperforming loans as of December 31, 2021, concentration of credit to a limited number of borrowers increases the risk in First Fed's loan portfolio. If one or more of these borrowers is not able to service the contractual repayment, the potential loss to First Fed is more likely to have a material adverse impact on our business, financial condition and results of operations.
Our construction and land loans are based upon estimates of costs and the value of the completed project.
During the year ended December 31, 2021, our construction and land loans increased $101.1 million, or 81.8%, to $224.7 million, or 16.5%, of the total loan portfolio at December 31, 2021 and consisted of properties secured by one- to four-family residential of $39.7 million, multi-family of $89.7 million, commercial acquisition-renovation of $51.1 million, commercial real estate of $35.7 million, and land of $8.6 million. Land loans include raw land and land acquisition and development loans.
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Construction and land development lending generally involves additional risks when compared with permanent residential lending because funds are advanced upon estimates of costs in relation to values associated with the completed project that will produce a future value at completion. Because of the uncertainties inherent in estimating construction costs, the market value of the completed project, the effects of governmental regulation on real property, and changes in demand, it is relatively difficult to evaluate accurately the total funds required to complete a project and the completed project loan-to-value ratio, which may cause actual results to vary significantly from those estimated. For these reasons, this type of lending also typically involves higher loan principal amounts and is often concentrated with a small number of builders.
A downturn in housing, or the real estate market, could increase loan delinquencies, defaults and foreclosures, and significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. Some of our builders have more than one loan outstanding with us, and an adverse development with respect to one loan or one credit relationship may expose us to a significantly greater risk of loss.
In addition, during the term of most of our construction loans, no payment from the borrower is required since the accumulated interest is added to the principal of the loan through an interest reserve. As a result, these loans often involve the disbursement of funds with repayment substantially dependent on the successful outcome of the project and the ability of the borrower to sell or lease the property or obtain permanent take-out financing, rather than the ability of the borrower or guarantor to repay principal and interest. If our appraisal of the value of a completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project and may incur a loss. Because construction loans require active monitoring of the building process, including cost comparisons and on-site inspections, these loans are more difficult and costly to monitor. Increases in market rates of interest may have a more pronounced effect on construction loans by rapidly increasing the end-purchasers' borrowing costs, thereby reducing the overall demand for the project. Properties under construction are often difficult to sell and typically must be completed in order to be successfully sold, which also complicates the process of working out problem construction loans. This may require us to advance additional funds and/or contract with another builder to complete construction and assume the market risk of selling the project at a future market price, which may or may not enable us to fully recover unpaid loan funds and associated construction and liquidation costs.
Our business may be adversely affected by credit risk associated with residential real estate.
At December 31, 2021, $334.1 million, or 24.6% of our total loan portfolio, consisted of one- to four-family mortgage loans and home equity loans secured by residential properties. Lending on residential property is sensitive to regional and local economic conditions that significantly impact the ability of borrowers to meet their loan payment obligations, making loss levels difficult to predict. Declines in residential real estate values securing these types of loans may increase the level of borrower defaults and losses above the recent charge-off experience on these loans. Jumbo one- to four-family residential loans that do not conform to secondary market mortgage requirements for our market areas would not be immediately saleable to Freddie Mac or other investors and may expose us to increased risk because of their larger balances. Further, a significant amount of our home equity lines of credit consist of second mortgage loans.
For those home equity lines secured by a second mortgage, it is unlikely that we will be successful in recovering all or a portion of our loan balances in the event of default unless we are prepared to repay the first mortgage loan and such repayment and the costs associated with a foreclosure are justified by the value of the property. For these reasons we may experience higher rates of delinquencies, default and losses on loans secured by junior liens.
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Repayment of our commercial business loans is often dependent on the cash flows of the borrower, which may be unpredictable, and the collateral securing these loans may fluctuate in value.
At December 31, 2021, we had $79.8 million, or 5.9% of total loans, in commercial business loans. Commercial business lending involves risks that are different from those associated with residential and commercial real estate lending. Real estate lending is generally considered to be collateral based lending with loan amounts based on predetermined loan to collateral values, with liquidation of the underlying real estate collateral being viewed as the primary source of repayment in the event of borrower default. Our commercial business loans are primarily made based on the cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. These borrowers' cash flows may be unpredictable, and collateral securing these loans may fluctuate in value. Although commercial business loans are often collateralized by equipment, inventory, accounts receivable, or other business assets, the liquidation of collateral in the event of default is often an insufficient source of repayment because accounts receivable may be uncollectible and inventories may be obsolete or of limited use, among other things. SBA PPP loans totaling $14.6 million are included in commercial business loans.
Our allowance for loan losses may prove to be insufficient to absorb losses in our loan portfolio.
We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. In determining the amount of the allowance for loan losses, we review our loans and our loss and delinquency experience, and we evaluate economic conditions. If our assumptions are incorrect, our allowance for loan losses may not be sufficient to cover probable incurred losses in our loan portfolio, resulting in additions to our allowance for loan losses through the provision for losses on loans which is charged against income.
Additionally, pursuant to our growth strategy, management recognizes that significant new loan growth, new loan products, new market areas, and the refinancing of existing loans, resulting in portfolios composed of unseasoned loans that may not perform in a historical or projected manner, may increase the risk that our allowance may be insufficient to absorb losses without significant additional provisions. Significant provisions to our allowance could materially decrease our net income. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on judgments different than those of management.
In addition, if charge-offs in future periods exceed the allowance for loan losses, we will need additional provisions to replenish the allowance for loan losses. Any additional provisions will result in a decrease in net income, and possibly capital, and may have a material adverse effect on our financial condition and results of operations.
In addition, the Financial Accounting Standards Board has adopted a new accounting standard update ("ASU") 2016-13 that will be effective on January 1, 2023. This standard, referred to as Current Expected Credit Loss, or CECL, will require financial institutions to determine periodic estimates of lifetime expected credit losses on loans, and recognize the expected credit losses as allowances for credit losses. This will change the current method of providing allowances for credit losses that are probable, which may require us to increase our allowance for loan losses, and may greatly increase the types of data we would need to collect and review to determine the appropriate level of the allowance for credit losses. For more on this ASU, see Note 1 of the Notes to Consolidated Financial Statements - Recently Issued Accounting Pronouncements contained in Item 8 of this report.
If our nonperforming assets increase, our earnings will be adversely affected.
At December 31, 2021, our nonperforming assets, which consist of nonaccrual loans, real estate owned and repossessed assets, were $1.4 million, or 0.1% of total assets. Our nonperforming assets adversely affect our net income in various ways.
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If additional borrowers become delinquent and do not pay their loans and we are unable to successfully manage our nonperforming assets, our losses and troubled assets could increase significantly, which could have a material adverse effect on our financial condition and results of operations.
Our securities portfolio may be negatively impacted by fluctuations in market value and interest rates.
Factors beyond our control can significantly influence the fair value of securities in our portfolio and can cause potential adverse changes to the fair value of these securities. These factors include, but are not limited to, ratings agency actions, defaults or other adverse events affecting the issuer or the underlying collateral, if any, of the security, changes in market interest rates, and continued instability in the capital markets. Additionally, financial markets may be adversely affected by the current or anticipated impact of military conflict, including the recent invasion by Russia of Ukraine, terrorism, or other geopolitical events. These factors, among others, could cause other-than-temporary-impairment ("OTTI"), realized and/or unrealized losses in future periods, and declines in other comprehensive income, which could materially affect our business, financial condition, and results of operations. Determining OTTI requires complex, subjective judgments about the future financial performance and liquidity of the security's issuer and underlying collateral, if any, to assess the probability of receiving all contractual principal and interest payments due, and these estimates may differ significantly from actual future performance of the security.
If our real estate owned is not properly valued or declines further in value, our earnings could be reduced.
We obtain updated valuations in the form of appraisals and tax assessed values when a loan has been foreclosed and the property taken in as real estate owned and at certain other times during the asset’s holding period. Our net book value of the loan at the time of foreclosure and thereafter is compared to the updated market value of the foreclosed property less estimated selling costs (fair value). A charge-off is recorded for any excess in the asset’s net book value over its fair value. If our valuation process is incorrect, or if property values decline, the fair value of our real estate owned may not be sufficient to recover our carrying value in such assets, resulting in the need for additional charge-offs. In addition, bank regulators periodically review our real estate owned and may require us to recognize further charge-offs. Significant charge-offs to our real estate owned could have a material adverse effect on our financial condition and results of operations.
We operate in a highly competitive industry.
We face substantial competition in all areas of our operations from a variety of different competitors, many of which are larger and may have more financial resources. These competitors primarily include national, regional and digital banks within the various markets in which we operate. We also face competition from many other types of financial institutions, including savings and loans, credit unions, mortgage banking finance companies, brokerage firms, insurance companies and other financial intermediaries. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Also, technology has lowered barriers to entry and made it possible for nonbanks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Competitors in these nonbank sectors may have fewer regulatory constraints, as well as lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than we can.
Failure to perform in any of these areas could significantly weaken our competitive position, which could adversely affect our growth and profitability and result in a material adverse effect on our financial condition and results of operations.
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We are subject to certain risks in connection with our use of networks and technology systems.
Our security measures may not be sufficient to mitigate the risk of a cyber-attack. Communications and information systems are essential to the conduct of our business, as we use such systems to manage our customer relationships, our general ledger and virtually all other aspects of our business. Our operations rely on the secure processing, storage, and transmission of confidential and other information in our computer systems and networks. Although we take protective measures and endeavor to modify them as circumstances warrant, the security of our computer systems, software, and networks may be vulnerable to breaches, unauthorized access, misuse, computer viruses, or other malicious code and cyber-attacks that could have a security impact. If one or more of these events occur, this could jeopardize our or our customers’ confidential and other information processed and stored in, and transmitted through, our computer systems and networks, or otherwise cause interruptions or malfunctions in our operations or the operations of our customers or counterparties. We may be required to expend significant additional resources to modify our protective measures or to investigate and remediate vulnerabilities or other exposures, and we may be subject to litigation and financial losses that are either not insured against or not fully covered through any insurance maintained by us. We could also suffer significant reputational damage.
We support the ability of our customers to transact business through multiple automated methods. As such, we may be susceptible to fraud performed through these technologies.
Security breaches in our Internet banking activities could further expose us to possible liability and damage our reputation. Any compromise of our security also could deter customers from using our Internet banking services that involve the transmission of confidential information. We rely on standard Internet security systems to provide the security and authentication necessary to effect secure transmission of data. These precautions may not protect our systems from compromises or breaches of our security measures, which could result in significant legal liability, heightened regulatory scrutiny or fines, violations of consumer protection and privacy laws, and significant damage to our reputation and our business.
Our security measures may not protect us from systems failures or interruptions. While we have established policies and procedures to prevent or limit the impact of systems failures and interruptions, there can be no assurance that such events will not occur or that they will be adequately addressed if they do. In addition, we outsource certain aspects of our data processing and other operational functions to certain third-party providers. If our third-party providers encounter difficulties, or if we have difficulty in communicating with them, our ability to adequately process and account for transactions could be affected, and our business operations could be adversely impacted. Threats to information security also exist in the processing of customer and consumer information through various other vendors and their personnel.
The occurrence of any failures or interruptions may require us to identify alternative sources of such services, and we cannot assure that we would be able to negotiate terms that are as favorable to us or obtain services with similar functionality as found in our existing systems without the need to expend substantial resources, if at all. Further, the occurrence of any systems failure or interruption could damage our reputation and result in a loss of customers and business, could subject us to additional regulatory scrutiny, or could expose us to legal liability. Any of these occurrences could have a material adverse effect on our financial condition and results of operations.
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Interest Rates, Operations and Risk Management
We are subject to interest rate risk.
Our earnings and cash flows are largely dependent on our net interest income. Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies, particularly the Federal Reserve. When the Federal Reserve Board increases the Fed Funds rate, overall interest rates will likely rise, which may negatively impact housing markets by reducing refinancing activity and new home purchases, and may also adversely affect the U.S. economy and, as a result, our business as a whole. Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and investments and the amount of interest we pay on deposits and borrowings, but these changes could also affect (i) our ability to originate and/or sell loans (ii) the fair value of our financial assets and liabilities, which could negatively impact shareholders' equity, and our ability to realize gains from sales of such assets; (iii) our ability to obtain and retain deposits in competition with other available investment alternatives; (iv) the ability of our borrowers to repay adjustable or variable rate loans; and (v) the average duration of our mortgage-backed securities portfolio and other interest-earning assets. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, our net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings.
Changes in interest rates could also have a negative impact on our results of operations by reducing the ability of borrowers to repay their current loan obligations or by reducing our margins and profitability. Our net interest margin is the net interest income divided by average interest-earning assets. Changes in interest rates-up or down-could adversely affect our net interest margin and, as a result, our net interest income. Although the yield we earn on our assets and our funding costs tend to move in the same direction in response to changes in interest rates, one can rise or fall faster than the other, causing our net interest margin to expand or contract. Our liabilities tend to be shorter in duration than our assets, so they may adjust faster in response to changes in interest rates. As a result, when interest rates rise, our funding costs may rise faster than the yield we earn on our assets, causing our net interest margin to contract until the yields on interest-earning assets catch up. Changes in the slope of the "yield curve", or the spread between short-term and long-term interest rates, could also reduce our net interest margin. Normally, the yield curve is upward sloping, meaning short-term rates are lower than long-term rates. Because our liabilities tend to be shorter in duration than our assets, when the yield curve flattens or even inverts, we could experience pressure on our net interest margin as our cost of funds increases relative to the yield we can earn on our assets.
A sustained increase in market interest rates could adversely affect our earnings. As a result of the exceptionally low interest rate environment for the past few years, an increasing percentage of our deposits have been composed of deposits bearing no or a relatively low rate of interest and having a shorter duration than our assets. We would incur a higher cost of funds to retain these deposits in a rising interest rate environment. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, our net interest income, and therefore earnings, would be adversely affected.
Changes in interest rates also affect the value of our interest-earning assets, including our securities portfolio. Generally, the fair value of fixed-rate securities fluctuates inversely with changes in interest rates. Unrealized gains and losses on securities available for sale are reported as a separate component of equity, net of tax. Decreases in the fair value of securities available for sale resulting from increases in interest rates could have an adverse effect on our shareholders’ equity.
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Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on our results of operations, any substantial, unexpected or prolonged change in market interest rates could have a material adverse effect on our financial condition and results of operations. Also, our interest rate risk modeling techniques and assumptions likely will not fully predict or capture the impact of actual interest rate changes on our balance sheet. See Item 7. "Management’s Discussion and Analysis of Financial Condition and Results of Operations – Asset and Liability Management and Market Risk," of this Form 10-K for additional information.
Changes in the method of determining the LIBOR or other reference rates may adversely impact the value of loans receivable and other financial instruments we hold that are linked to LIBOR or other reference rates in ways that are difficult to predict and could adversely impact our financial condition or results of operations.
In July 2017, the United Kingdom Financial Conduct Authority announced the potential replacement of the London Interbank Offered Rate ("LIBOR") at the end of 2021. LIBOR is used extensively in the U.S. and globally as a "benchmark" or "reference rate" for various commercial and financial contracts. In response, the Alternative Reference Rates Committee (“ARRC”), made up of financial and capital market institutions, was convened to address the replacement of LIBOR in the U.S. The ARRC identified a potential successor to LIBOR in the Secured Overnight Financing Rate (“SOFR”) and has crafted a plan to facilitate the transition. Our subordinated debt issued in March 2021 provides for application the SOFR rate to determine the interest that will be payable on the Notes beginning in March 2026. There are significant conceptual and technical differences between LIBOR and SOFR. At this time, no consensus exists as to what rate or rates may become acceptable alternatives to LIBOR and it is impossible to predict the effect of any such alternatives on the value of LIBOR-based securities, variable rate loans, and other securities or financial arrangements. ICE Benchmark Administration (“IBA”), the authorized and regulated administrator of LIBOR, recently announced it would consult on its plans for discontinuation of LIBOR. IBA ended publication of some LIBOR tenors on December 31, 2021, and intends to end publication of the remaining LIBOR tenors in June 2023. Financial services regulators and industry groups are seeking to develop alternate reference rate indices or reference rates. The transition to a new reference rate requires changes to contracts, risk and pricing models, valuation tools, systems, product design and hedging strategies. It is not currently possible to determine whether, or to what extent, the replacement of LIBOR will impact the value of any loans and other financial obligations or extensions of credit we hold or that are due to us, that are linked to LIBOR or other reference rates, or whether, or to what extent, such changes may impact our financial condition or results of operations.
Decreased volumes and lower gains on sales of loans could adversely impact our noninterest income.
We originate and sell one- to four-family mortgage loans. Our mortgage banking income is a significant portion of our noninterest income. We generate gains on the sale of one- to four-family mortgage loans pursuant to programs currently offered by Freddie Mac and other secondary market investors. Any future changes in their purchase programs, our eligibility to participate in such programs, the criteria for loans to be accepted or laws that significantly affect the activity of such entities could, in turn, materially adversely affect our results of operations.
Further, in a rising or higher interest rate environment, our originations of mortgage loans may decrease, resulting in fewer loans that are available to be sold to investors. This would result in a decrease in mortgage banking revenues and a corresponding decrease in noninterest income. In addition, our results of operations are affected by the amount of noninterest expense associated with mortgage banking activities, such as salaries and employee benefits, occupancy, equipment and data processing expense and other operating costs. During periods of reduced loan demand, our results of operations may be adversely affected to the extent that we are unable to reduce expenses commensurate with the decline in loan originations. In addition, although we sell loans into the secondary market without recourse, we are required to give customary representations and warranties about the loans to the buyers. If we breach those representations and warranties, the buyers may require us to repurchase the loans and we may incur a loss on the repurchase.
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A portion of our loan portfolio is serviced by third parties, which may limit our ability to foreclose on such loans.
At December 31, 2021, $33.8 million of our one- to four-family, $64.0 million of our consumer, and $18.1 million of our commercial real estate loan portfolios were serviced by third parties. When a loan goes into default, it is the responsibility of the third-party servicer to enforce the borrower’s obligation to repay the outstanding indebtedness. We are reliant on the servicer to bring the loan current, enter into a satisfactory loan modification or foreclose on the property on behalf of First Fed. We must comply with any loan modification entered into by the servicer even if we would not otherwise agree to the modified terms, which may result in a reduction in our interest income due to the loan modification. Delays in foreclosing on property, whether caused by restrictions under state or federal law or the failure of a third-party servicer to timely pursue foreclosure action, may increase our potential loss on such property, due to factors such as lack of maintenance, unpaid property taxes and adverse changes in market conditions. These delays may adversely affect our ability to limit our credit losses.
Regulatory Matters
Our lending limit may restrict our growth.
Washington law provides that Washington chartered commercial banks are subject to loans-to-one-borrower restrictions, which generally restrict total loans and extensions of credit by a bank to 20% of its unimpaired capital and surplus. As a result, under Washington law, First Fed would be limited to loans to one borrower of $42.4 million at December 31, 2021. Under its current policy, First Fed has elected to restrict its loans to one borrower to no more than 60% of the Bank's lending limit, which is adjusted quarterly and was $31.8 million at December 31, 2021, unless specifically approved by the Senior Loan Committee as an exception to policy. This amount is significantly less than that of many of our competitors and may discourage potential commercial borrowers who have credit needs in excess of our loans to one borrower lending limit from doing business with us. Our loans to one borrower restriction also impacts the efficiency of our commercial lending operation because it lowers our average loan size, which means we have to generate a higher number of transactions to achieve the same portfolio volume. We can accommodate larger loans by selling participations in those loans to other financial partners, but this strategy is not the most efficient or always available. We may not be able to attract or maintain clients seeking larger loans or may not be able to sell participations in these loans on terms we consider favorable.
We operate in a highly regulated environment and may be adversely affected by changes in laws and regulations.
We are subject to extensive examination, supervision and comprehensive regulation by the Federal Reserve, the FDIC as insurer of our deposits, and by the DFI. First Northwest Bancorp is subject to regulation and supervision by the Federal Reserve (as a bank holding company) and regulation by the State of Washington (as a Washington corporation). The Bank is subject to regulation and supervision by the FDIC and the DFI. Such regulation and supervision govern the activities in which we may engage, primarily for the protection of depositors and the Deposit Insurance Fund. These regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the ability to impose restrictions on an institution’s operations, require additional capital, reclassify assets, determine the adequacy of an institution’s allowance for loan losses and determine the level of deposit insurance premiums assessed. Any future changes to the laws, rules and regulations applicable to us could make compliance more difficult and expensive, or otherwise adversely affect our business, financial condition or prospects.
We are also subject to tax, accounting, securities, insurance, monetary laws and regulations, rules, standards, policies, and interpretations that control the methods by which financial institutions conduct business. These may change significantly over time, which could materially impact our business and have a significant adverse effect on our cost of regulatory compliance and results of operations. Further, changes in accounting standards and their interpretation may materially impact how we report, potentially retroactively, our financial condition and results of operations.
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Changes in federal policy and at regulatory agencies are expected to occur over time through policy and personnel changes, which could lead to changes involving the level of oversight and focus on the financial services industry. The nature, timing, and economic and political effects of potential changes to the current legal and regulatory framework affecting financial institutions remain highly uncertain. If changes to laws, rules and/or regulations applicable to us are made, such changes could offset the otherwise anticipated increase in operating and compliance costs (included in noninterest expense); however, no assurance can be given as to whether such changes will occur or what may result from such changes.
The CFPB, which was created under the Dodd-Frank Act, has issued, and continues to issue, rules related to consumer protection, including The Truth in Lending Act and the Real Estate Settlement Procedures Act Integrated Disclosure (TRID), which combines certain disclosures that consumers receive in connection with applying for and closing a mortgage loan. These CFPB rules, including rules generally prohibiting creditors from extending mortgage loans without regard for the consumer's ability to repay, may adversely affect the volume of mortgage loans that we underwrite and subject us to increased potential liabilities related to such residential loan origination activities. The CFPB has adopted a number of additional requirements and issued additional guidance, including with respect to indirect auto lending, appraisals, escrow accounts and servicing, each of which may entail increased compliance costs.
General Risk Factors
We are dependent on key personnel and the loss of one or more of those key persons may materially and adversely affect our prospects.
We rely heavily on the efforts and abilities of our executive officers, and certain other key management personnel, which make up our management team. The loss of the services of any of our current management team could have a material adverse impact on our operations. The ability to attract, retain and season replacements to our management team presents risks to executing our business plan. Changes in our current management team and their responsibilities may be disruptive to our business and operations and could have a material adverse effect on our business, financial condition, and results of operations. While we believe that our relationship with our management team is good, we cannot guarantee that all members of our management team will remain with our organization.
Our consideration of whole bank, branch acquisitions, or fintech partnerships in the future may expose us to financial, execution and operational risks that could adversely affect us.
We may evaluate supplementing organic growth by acquiring other financial institutions or their businesses that we believe will help us fulfill our strategic objectives and enhance our earnings. There are risks associated with this strategy, however, including the following:
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Our expansion strategy will cause our expenses to increase and may negatively affect our earnings.
Over the past seven years, we have opened four new full-service branches and two business centers. We also acquired a branch from another financial institution in 2021. We may continue to open or purchase new branches and lending centers, and the success of our expansion strategy into new markets is contingent upon numerous factors, such as our ability to select suitable locations, assess each market's competitive environment, secure managerial resources, hire and retain qualified personnel and implement effective marketing strategies. The opening of new offices may not increase the volume of our loans and deposits as quickly or to the degree that we projected and opening new offices will increase our operating expenses. The cost of opening additional de novo branches and lending centers is uncertain, and projected timelines and estimated dollar amounts involved in opening new offices could differ significantly from actual results. In addition, we may not successfully manage the costs and implementation risks associated with our branching strategy. Accordingly, any new branch or lending center may negatively impact our earnings for some period of time until the office reaches certain economies of scale, and there is a risk that our new offices will not be successful even after they have been established.
We also plan to expand our digital footprint through partnerships with and investments in fintech companies. The new technology and start-up companies we invest in may not be as successful as anticipated or may fail, resulting a total loss of our related investment.
Item 1B. Unresolved Staff Comments
None.
Item 2. Properties
The Company's main administrative office is located at 105 West Eighth Street, Port Angeles, WA 98362. As of December 31, 2021, we conducted our business through twelve branch offices located in Clallam, Jefferson, King, Kitsap, and Whatcom Counties, Washington; two business centers located in King and Whatcom Counties, Washington; and our main administrative office and a support service center located in Clallam County, Washington. The Company owns seven branch offices, the main administrative office and the support services center. The remaining five branch offices and two business centers are leased. The net book value of the Company’s properties totaled $14.7 million at December 31, 2021. Additional information is presented in Note 4 - Premises and Equipment and Note 5 - Leases of the Notes to the Consolidated Financial Statements included in "Item 8. Financial Statements and Supplementary Data."
Item 3. Legal Proceedings
The Company and First Fed are involved from time to time in various claims and legal actions arising in the ordinary course of business. There are currently no matters that, in the opinion of management, would have a material adverse effect on our consolidated financial position, results of operation, or liquidity.
Item 4. Mine Safety Disclosures
Not applicable
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PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market and Holder Information. Our common stock is listed on The Nasdaq Stock Market LLC’s Global Market, under the symbol "FNWB." As of the close of business on March 10, 2022, there were 10,006,022 shares of common stock issued and outstanding and we had approximately 539 shareholders of record, excluding persons or entities who hold stock in nominee or "street name" accounts with brokers.
Stock Repurchases. The Company's repurchase programs permit shares to be repurchased in the open market or private transactions, through block trades, and pursuant to any trading plan that may be adopted in accordance with the SEC's Rule 10b5-1. On October 28, 2020, the Company announced that its Board of Directors had authorized the repurchase and retirement of up to an additional 1,023,420 shares of its common stock.
The following table provides information regarding repurchases of the Company's common stock during the quarter ended December 31, 2021.
Item 6. [Reserved]
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
General
First Northwest is a bank holding company primarily engaged in the business activity of its subsidiary, First Fed. First Fed is a community-oriented financial institution serving Clallam, Jefferson, King, Kitsap, and Whatcom counties in Washington State, through its twelve full-service branches and two business centers. We offer a wide range of products and services focused on the financial security and payment needs of the communities we serve. While we have a concentration of first lien one- to four-family mortgage loans, in order to diversify our portfolio and increase interest income, we have increased our origination of commercial real estate, multi-family real estate, construction, and commercial business loans, and have increased our auto and consumer loans through originations, indirect auto lending, and purchased auto loan programs. We continue to originate one- to four-family residential mortgage loans and regularly sell conforming loans into the secondary market to increase noninterest income and manage interest rate risk or retain select loans in our portfolio to enhance interest income. We offer traditional consumer and business deposit products, including transaction accounts, savings and money market accounts and certificates of deposit for individuals, businesses and nonprofit organizations. Deposits are our primary source of funding for our lending and investing activities.
First Fed is impacted by prevailing economic conditions as well as government policies and regulations concerning, among other things, monetary and fiscal affairs, including fiscal stimulus, interest rate policy and open market operations, housing and financial institutions. Deposit flows are influenced by various factors, including sales and marketing efforts, interest rates paid on competing deposits, available alternative investments such as the stock market, account maturities, government stimulus and unemployment programs, and the overall level of personal income and savings. Lending activities are influenced by prevailing interest rates and property values in our markets, the demand for funds, the number and quality of lenders employed by First Fed, and regional economic cycles.
Our primary source of pre-tax income is net interest income. Net interest income is the difference between interest income earned on our loans and investments and interest expense paid on our deposits and borrowings. Changes in levels of interest rates can affect our net interest income. A secondary source of income is noninterest income, which includes revenue we receive from providing products and services, including service charges on deposit accounts, debit card interchange income, mortgage banking income, treasury and other commercial banking related fees, earnings from bank-owned life insurance, loan servicing income, and gains and losses from sales of securities.
An offset to net interest income is the provision for loan losses, which represents the periodic charge to operations required to adequately provide for probable losses inherent in our loan portfolio through our allowance for loan losses. As a loan's risk rating improves, property values increase, or recoveries of amounts previously charged off are received, a recapture of previously recognized provision for loan losses may be added to net interest income.
The noninterest expenses we incur in operating our business consist of salaries and employee benefit costs, occupancy and equipment expenses, federal deposit insurance premiums and regulatory assessments, digital delivery and data processing expenses, advertising and promotion expenses, expenses related to real estate and personal property owned, state and local taxes, federal income tax, and other miscellaneous expenses.
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Our Business and Operating Strategy
Our operating strategy is focused on diversifying our loan portfolio, expanding our deposit product offerings, and enhancing our infrastructure. Certain highlights of our operations in the last three years include:
Our objective is to be an independent, high performing bank focused on meeting the needs of individuals, small businesses and community organizations throughout our market areas with exceptional service and competitive products. We intend to implement these strategies to achieve our objectives:
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Critical Accounting Policies
We have certain accounting policies that are important to the assessment of our financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Facts and circumstances which could affect these judgments include, but are not limited to, changes in interest rates, changes in the performance of the economy and changes in the financial condition of borrowers. Our accounting policies are discussed in detail in Note 1 of the Notes to Consolidated Financial Statements included in Item 8, "Financial Statements and Supplementary Data" of this Form 10-K.
The following represent our critical accounting policies:
Allowance for Loan Losses. The allowance for loan losses is the amount estimated by management as necessary to cover losses inherent in the loan portfolio as of the balance sheet date. The allowance is established through the provision for loan losses, which is charged to income. Determining the amount of the allowance for loan losses necessarily involves a high degree of judgment. Among the material estimates required to establish the allowance are: the likelihood of default; the loss exposure at default; the amount and timing of future cash flows on impaired loans; the value of collateral; and the determination of loss factors to be applied to the various elements of the portfolio. All of these estimates are susceptible to significant change. Management reviews, and the Board of Directors approves, at least quarterly, the level of the allowance and the provision for loan losses based on past loss experience, current economic conditions and other factors related to the collectability of the loan portfolio. Although we believe that we use the best information available to establish the allowance for loan losses, future adjustments to the allowance may be necessary if economic or other conditions differ substantially from the assumptions used in making the evaluation. In addition, the FDIC and the DFI, as an integral part of their examination process, periodically review our allowance for loan losses and may require us to recognize adjustments to the allowance based on their judgment about information available at the time of their examination. A large loss could deplete the allowance and require increased provisions for loan losses to replenish the allowance, which would adversely affect earnings. See Note 3 of the Notes to Consolidated Financial Statements included in Item 8, "Financial Statements and Supplementary Data" of this Form 10-K.
Mortgage Servicing Rights. We record mortgage servicing rights on loans originated and subsequently sold into the secondary market. We stratify our capitalized mortgage servicing rights based on the type, term and interest rates of the underlying loans. Mortgage servicing rights are initially recognized at fair value. The value is determined through a discounted cash flow analysis, which uses interest rates, prepayment speeds and delinquency rate assumptions as inputs. All of these assumptions require a significant degree of management judgment. If our assumptions prove to be incorrect, the value of our mortgage servicing rights could be negatively affected. See Notes 1 and 6 to the Notes to Consolidated Financial Statements included in Item 8, "Financial Statements and Supplementary Data" of this Form 10-K.
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Income Taxes. Management makes estimates and judgments to calculate certain tax liabilities and to determine the recoverability of certain deferred tax assets, which arise from temporary differences between the tax and financial statement recognition of revenues and expenses. We also estimate a valuation allowance for deferred tax assets if, based on the available evidence, it is more likely than not that some portion or all of the recorded deferred tax assets will not be realized in future periods. These estimates and judgments are inherently subjective. In evaluating the recoverability of deferred tax assets, management considers all available positive and negative evidence, including past operating results, recent cumulative losses - both capital and operating - and the forecast of future taxable income, both capital gains and operating. In determining future taxable income, management makes assumptions for the amount of taxable income, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require judgments about future taxable income and are consistent with the plans and estimates to manage our business. Any reduction in estimated future taxable income may require us to record a valuation allowance against deferred tax assets. An increase in the valuation allowance would result in additional income tax expense in the period and could have a significant impact on future earnings.
Fair Value. Fair values of financial instruments are estimated using relevant market information and other assumptions. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect these estimates.
New Accounting Pronouncements
For a discussion of new accounting pronouncements and their impact on the Company, see Note 1 of the Notes to Consolidated Financial Statements included in Item 8, "Financial Statements and Supplementary Data" of this Form 10-K.
Comparison of Financial Condition at December 31, 2021 and December 31, 2020
Assets. Total assets increased $266.7 million, or 16.1%, to $1.92 billion at December 31, 2021, from $1.65 billion at December 31, 2020, primarily due to an increase in new deposits.
Total loans, excluding loans held for sale, increased $203.1 million, or 17.6%, during the year ended December 31, 2021. Multi-family and commercial real estate loans increased $76.7 million, or 16.7%, consisting mainly of an increase in multi-family real estate loans of $66.7 million. Auto and other consumer loans increased $54.5 million, or 42.5%, with the purchase of a pool of manufactured home loans as well as purchases of individual manufactured home loans and specialty auto loans. Commercial business loans decreased $20.4 million due to a decrease in the Northpointe Bank Mortgage Participation Program and payoffs of SBA Paycheck Protection Program loans.
One- to four-family residential loans decreased $14.9 million, or 4.8%, as payoffs outpaced new loan production during the year. We continue to focus on the origination of one- to four-family mortgage loans with the intention of retaining certain loans that may not be readily sold in the secondary market, while selling the majority of our saleable production to the Federal Home Loan Mortgage Corporation ("Freddie Mac") and other investors.
Construction and land loans increased $101.1 million, or 81.8%. There was $194.3 million in undisbursed construction commitments at December 31, 2021 compared to $155.1 million at December 31, 2020. Undisbursed construction commitments at December 31, 2021 included $54.5 million of mainly custom one- to four-family residential construction, $105.0 million of multi-family construction, $29.7 million of commercial real estate construction, and $5.0 million of commercial acquisition-renovation construction. Our construction loans are geographically disbursed throughout the state of Washington with two commitments for properties in Oregon. We manage our construction lending by utilizing a licensed third-party vendor to assist us in monitoring our construction projects. Internal staff monitor certain projects, which enhances fee income related to these loans.
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During the year ended December 31, 2021, the Company originated $780.5 million of loans, of which $226.4 million, or 29.0%, were originated in the Olympic Peninsula region; $479.7 million, or 61.5%, in the Puget Sound region; $42.7 million, or 5.5%, in other areas in Washington; and $31.6 million, or 4.1%, in other states. The Company also purchased loans totaling $115.5 million with the largest concentration of property located in California.
Loans receivable, excluding loans held for sale, consisted of the following at the dates indicated:
(In thousands)
Real Estate:
Consumer:
Less:
Premium on purchased loans, net (12,995 ) (6,129 )
Our allowance for loan losses increased $1.3 million, or 9.2%, during the year ended December 31, 2021, as the result of loan growth. Asset quality has remained stable year over year despite the uncertain economic conditions due to the pandemic. As a result, a negative provision of $150,000 was taken during 2021. Management continues to closely monitor these conditions. The allowance for loan losses as a percentage of total loans was 1.1% at December 31, 2021 and 1.2% at December 31, 2020. There was no material change in our allowance for loan losses as a percentage of total loans during the year ended December 31, 2021 compared to 2020. We believe our allowance for loan losses is adequate to cover inherent losses in the loan portfolio.
Nonperforming loans decreased $892,000, or 39.2%, during the year ended December 31, 2021 to $1.4 million. This decrease was mainly the result of decreases in nonperforming one- to four-family of $418,000, auto and other consumer of $309,000, and multi-family loans of $284,000, partially offset by an increase in home equity loans of $209,000. Nonperforming loans to total loans was 0.1% at December 31, 2021, a decline from 0.2% at December 31, 2020. Real estate owned and repossessed assets decreased $2,000, or 100.0%, as defaulted auto loans were sold. The allowance for loan losses as a percentage of nonperforming loans increased to 1095.1% at December 31, 2021 from 609.2% at December 31, 2020 as result of the decrease in nonperforming loans.
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At December 31, 2021, substantially all restructured loans were performing in accordance with their modified payment terms and returned to accrual status. Classified loans, consisting solely of substandard loans, increased by $5.1 million, or 67.3%, to $12.6 million at December 31, 2021, from $7.5 million at December 31, 2020. The change in classified loans was mainly the result of an increase in substandard commercial real estate during the year. The Bank continued to work with its borrowers to facilitate satisfactory repayment.
In late March 2020, the Bank announced loan modification programs to support and provide relief for its borrowers during the COVID-19 pandemic. Loans subject to payment forbearance under the Bank's COVID-19 loan modification program are not reported as delinquent during the forbearance time period. For additional information, see "COVID-19 Loan Modifications" in Item 1.
Total investment securities decreased $20.1 million, or 5.5%, to $344.2 million at December 31, 2021, from $364.3 million at December 31, 2020. The year-over-year decrease was the result of sales, prepayment activity, and normal amortization during the year, partially offset by purchases. During 2021, we purchased $148.4 million of available-for-sale securities as a source of additional interest income. We also took advantage of market opportunities to improve long-term yields, reduce our LIBOR risk, and manage duration by selling $107.8 million of available-for-sale securities for a total gain of $2.4 million during the same period. The estimated average life of the total investment securities portfolio was 5.7 years, and the average repricing term was approximately 7.3 years as of December 31, 2021, based on the interest rate environment at that time. We anticipate the investment portfolio will continue to provide additional interest income, act as a source of liquidity to fund loan growth and give us the ability to manage interest rate risk.
Mortgage-backed securities represent the largest portion of our investment portfolio and totaled $140.0 million at December 31, 2021, an increase of $50.7 million, or 56.8% from $89.3 million at December 31, 2020. Municipal bonds are the second largest segment, totaling $113.4 million at December 31, 2021, a decrease of $14.5 million, or 11.3%, from $127.9 million at December 31, 2020. Other investment securities, including U.S. government agencies, corporate and asset-backed securities, were $90.9 million at December 31, 2021, an increase of $56.3 million, or 38.3% from $147.2 million at December 31, 2020.At December 31, 2021, the investment portfolio contained 43.0% of amortizing securities, compared to 48.0% at December 31, 2020. The projected average life of our securities may vary due to prepayment activity, which, particularly in the mortgage-backed securities portfolio, is generally affected by changing interest rates. We continue to focus on growing our loan portfolio and improving our earning asset mix over the long term, as evidenced by net loan growth exceeding the rate of investments during the year. We may purchase investment securities as a source of additional interest income and in lieu of carrying higher cash balances at nominal interest rates. For additional information, see Note 2 of the Notes to Consolidated Financial Statements included in Item 8, "Financial Statements and Supplementary Data," of this Form 10-K.
Liabilities. Total liabilities increased $262.6 million, or 17.9%, to $1.73 billion at December 31, 2021, from $1.47 billion at December 31, 2020, mainly due to deposit account balances increasing $247.1 million, or 18.5%, to $1.58 billion at December 31, 2021 from $1.33 billion at December 31, 2020. Money market accounts increased $168.7 million, transaction accounts increased $69.0 million, and savings accounts increased $30.2 million as customers significantly increased their liquidity during the year. Certificates of deposit decreased $61.5 million, or 19.9%, to $247.2 million at December 31, 2021. Included in certificates of deposit balances at year end were $65.7 million in brokered certificates of deposit. Our focus will continue to be on increasing our customer deposits and maintaining a stable source of funding for our continued growth.
FHLB borrowings decreased $30.0 million, or 27.3%, to $80.0 million at December 31, 2021, from $110.0 million at December 31, 2020, as lower-cost deposit balances increased. Overnight variable-rate advances were repaid, helping to manage our cost of funds and interest rate risk.
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On March 25, 2021, the Company completed a private placement of $40.0 million of 3.75% fixed-to-floating rate subordinated notes due 2031 (the “Notes”) to certain qualified institutional buyers and institutional accredited investors. The net proceeds to the Company from the sale of the Notes were approximately $39.3 million after deducting placement agent fees and other offering expenses. The Notes are structured to qualify as Tier 2 capital for the Company for regulatory capital purposes. The Company intends to use the net proceeds of the offering for general corporate purposes and provided $20.0 million to the Bank as Tier 1 capital. The remaining balance at December 31, 2021 was $39.3 million.
Equity. Total shareholders' equity increased $4.6 million, or 2.5%, to $191.0 million at December 31, 2021, from $186.4 million at December 31, 2020. This increase during the year resulted from net income of $15.4 million and an increase of $2.4 million related to our stock-based compensation plans. These increases were partially offset by a decrease of $6.0 million related to our repurchase of shares, a decrease of $5.2 million due to the change in accumulated other comprehensive loss related to the change in unrealized market value of available for sale securities, net of tax, and $2.5 million in dividends paid in 2021. During the year ended December 31, 2021, we repurchased 349,497 shares of common stock at an average cost of $17.07 per share, pursuant to the Company's 2020 stock repurchase plans.
Comparison of Results of Operations for the Years Ended December 31, 2021 and 2020
General. The Company had net income for the year ended December 31, 2021 of $15.4 million, compared to net income of $10.3 million for the year ended December 31, 2020, an increase of $5.1 million, or 49.1%. The increase in net income was due to increases in net interest income and noninterest income. We earned $1.63 per common and diluted share for the year ended December 31, 2021, compared to $1.07 per common and diluted share for the year ended December 31, 2020. The increase in earnings per share year-over-year was the result of an increase in net income combined with lower weighted-average common shares outstanding of 9,133,953 basic and 9,228,740 diluted shares in 2021, compared to 9,370,778 basic and 9,402,198 diluted shares for the same period in 2020. The decrease in average shares year-over-year is due to our share repurchase program and restricted stock award forfeitures offset by restricted stock award grants.
Net Interest Income. Net interest income increased $14.3 million, or 32.6%, to $58.3 million for the year ended December 31, 2021, from $44.0 million for the year ended December 31, 2020, mainly as the result of additional interest income related to the increase in the average balances of loans receivable and investment securities.
The average balance of loans receivable increased $270.0 million, at an average yield of 4.44%, for the year ended December 31, 2021 compared to an average yield of 4.44%, for the year ended December 31, 2020. The cost of interest-bearing liabilities decreased to 0.43% for the year ended December 31, 2021 compared to 0.75% for the year ended December 31, 2020. The combination of increased loan receivable balances and lower cost of funds resulted in a 24 basis point increase in our net interest margin to 3.51% at December 31, 2021, from 3.27% at December 31, 2020.
Net interest income increased $14.3 million during the year ended December 31, 2021 compared to the year ended December 31, 2020, of which $12.5 million was the result of an increase in volume and $1.8 million due to changes in yields. As noted above, loans receivable was the main contributor to the increase in net interest income with $12.0 million due to an increase in average volumes. The decrease to the cost of average interest-bearing liabilities for the year ended December 31, 2021 was due primarily to lower rates paid on deposit accounts, partially offset by an increase from the subordinated debt issued in 2021.
Interest Income. Interest income increased $12.0 million, or 23.2%, to $63.7 million for the year ended December 31, 2021 from $51.7 million for the comparable period in 2020, primarily due to an increase in the average balance of loans receivable. Interest and fees on loans receivable increased $12.0 million as a result.
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Interest income on investment securities increased $250,000 to $5.8 million for the year ended December 31, 2021 compared to $5.6 million for the year ended December 31, 2020. The increase in interest income on investment securities was driven by a $17.1 million increase in the average balance during the year to $244.4 million for the year ended December 31, 2021 compared to $227.3 million for the year ended December 31, 2020. The average yield decreased 7 basis points. The change in average yields on investment securities does not include the benefit of nontaxable income from municipal bonds. Interest income on mortgage-backed and related securities decreased $151,000 to $2.6 million for the year ended December 31, 2021 from $2.7 million for the year ended December 31, 2020, commensurate with a decline in the average balance of $3.2 million and a decrease in average yield of 7 basis points.
The following table compares average earning asset balances, associated yields, and resulting changes in interest income for the periods shown:
Year Ended December 31,
(Dollars in thousands)
Interest Expense. Total interest expense decreased $2.4 million, or 30.4%, for the year ended December 31, 2021, compared to the prior year, with decreases in deposit costs of $3.3 million, partially offset by increases in borrowing costs of $916,000. Deposit costs decreased due to the decrease in the interest rates combined with growth in lower-rate non-maturity deposits. The average balance of interest-bearing deposits increased $197.1 million, or 20.6%, to $1.15 billion for the year ended December 31, 2021 from $957.3 million for the year ended December 31, 2020, as we continued to target growth in deposits in new and existing market areas. Additionally, the bank experienced deposit growth due the significant inflow of deposits into the banking system during the pandemic due to government stimulus payments and changes to consumer and business savings and spending habits. During the year ended December 31, 2021, the cost of certificates of deposit decreased $2.3 million due to a decrease in the average rate paid of 59 basis points. The average rate paid on savings accounts decreased 43 basis points and the cost of money market accounts decreased 21 basis points even though the average balance of all deposit accounts increased $300.6 million. The average cost of all interest-bearing deposit products decreased 41 basis points to 0.29% for the year ended December 31, 2021 from 0.70% for the year ended December 31, 2020. Borrowing rates decreased 42.7%, or 32 basis points, mainly due to lower rates paid on overnight and long-term borrowings, partially offset by the subordinated debt issued in March 2021.
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The following table details average balances, cost of funds and the change in interest expense for the periods shown:
Year Ended December 31,
(Dollars in thousands)
Provision for Loan Losses. The provision for loan losses decreased during the year ended December 31, 2021 compared to 2020. The lower provision reflects improvement in economic conditions, less uncertainty regarding the impact of COVID-19, and stable credit quality compared to the prior year. Management took a negative provision of $150,000 during 2021.
The following table details activity and information related to the allowance for loan losses for the periods shown:
Year Ended December 31,
(Dollars in thousands)
Provision for loan losses $ 1,350 $ 5,046
Charge offs net of recoveries (73 ) (827 )
Noninterest Income. Noninterest income decreased 1.3% to $15.6 million for the year ended December 31, 2021, compared to $15.9 million for the year ended December 31, 2020, reflecting a lower gain on sale of mortgage loans, lower gain on sale of securities, and a decrease in the cash surrender value of bank owned life insurance (BOLI) due to a one-time increase recorded in the third quarter of 2020 from a restructure of the BOLI policies in 2020. Decreases were partially offset by increases in the gain on sale of commercial loans and related servicing asset, SBA and adjustable-rate conversion program participation fees, and a gain on our investment in Canapi Ventures Fund LP.
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The following table provides a detailed analysis of the changes in the components of noninterest income for the periods shown:
Year Ended December 31, Increase (Decrease)
(Dollars in thousands)
Noninterest Expense. Noninterest expense increased to $54.4 million for the year ended December 31, 2021, from $41.5 million for the year ended December 31, 2020. The year-over-year increase reflects higher compensation expense, including salaries, production-related commissions, incentives and benefits, as well as costs associated with expanding our footprint with two new locations and the relocation of our Fairhaven branch, and technology enhancements for digital and mobile banking products.
The following table provides an analysis of the changes in the components of noninterest expense for the periods shown:
Year Ended December 31, Increase (Decrease)
(Dollars in thousands)
Provision for Income Tax. The provision for income tax for the year ended December 31, 2021, was $3.2 million compared to $3.0 million for the year ended December 31, 2020, reflecting higher net income before provision for income tax in the current year, while the prior year included a penalty recorded related to the surrender of a bank-owned life insurance policy in the third quarter of 2020 which resulted in a higher tax provision as well as a higher effective tax rate for the related period.
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Average Balances, Interest and Average Yields/Cost
The following tables set forth, for the periods indicated, information regarding average balances of assets and liabilities as well as the total dollar amounts of interest income from average interest-earning assets and interest expense on average interest-bearing liabilities, resultant yields, interest rate spread, net interest margin (otherwise known as net yield on interest-earning assets), and the ratio of average interest-earning assets to average interest-bearing liabilities. Also presented is the weighted average yield on interest-earning assets, rates paid on interest-bearing liabilities and the resultant spread at December 31, 2021 and 2020. Income and all average balances are monthly average balances, which management deems to be not materially different than daily averages. Nonaccrual loans have been included in the table as loans carrying a zero yield.
At December 31, Year Ended December 31,
Interest-earning assets: (Dollars in thousands)
Interest-bearing liabilities:
(1) The average loans receivable, net balances include nonaccrual loans.
(2) Includes interest-bearing deposits (cash) at other financial institutions.
(3) Net interest income divided by average interest-earning assets.
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Rate/Volume Analysis
The following tables present the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. The presentation distinguishes between the changes related to outstanding balances and the changes in interest rates. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (i.e., changes in volume multiplied by old rate) and (ii) changes in rate (i.e., changes in rate multiplied by old volume). For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the change due to volume and the change due to rate.
Year Ended
Increase (Decrease) Due to Total Increase
Volume Rate (Decrease)
(In thousands)
Interest-earning assets:
Investment and mortgage-backed securities 349 (250 ) 99
Interest-bearing liabilities:
Interest-bearing demand deposits $ 18 $ (12 ) $ 6
Total interest-bearing liabilities $ (53 ) $ (2,298 ) $ (2,351 )
(1) Includes interest-bearing deposits (cash) at other financial institutions.
Asset and Liability Management and Market Risk
Risk Management Overview. Managing risk is an essential part of successfully managing a financial institution. Our Enterprise Risk Management Committee reports key risk indicators to the Board of Directors through the Audit Committee. The most prominent risk exposures management monitors are strategic, credit, interest rate, liquidity, operational, compliance, reputational, cybersecurity, and legal risk. We utilize the services of outside firms to assist us in our asset and liability management and our analysis of market risk.
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Interest Rate Risk Management. We manage the interest rate sensitivity of interest-earning assets and interest-bearing liabilities in an effort to minimize the adverse effects of changes in the interest rate environment. Deposit accounts may reprice more quickly in response to changes in market interest rates because of their shorter maturities. Certain adjustable-rate investment securities, home equity lines of credit, and commercial real estate loans that are tied to the prime rate, the twelve-month constant maturity treasury, the London Interbank Offered Rate ("LIBOR"), or the Secured Overnight Financing Rate ("SOFR") will also reprice higher when market interest rates increase. Increases in interest rates should beneficially affect our earnings when variable or adjustable interest-earning assets reprice at higher interest rates faster than it takes for deposit and borrowing costs to reprice higher. Decreases in interest rates may adversely affect earnings as variable and adjustable assets will reprice lower which will reduce interest income. Given the current low cost of funding there is little ability to reduce funding costs to offset the decrease in interest income. Additionally, lower rates may result in increased prepayments and refinancing associated with loans and investment securities, particularly consumer and one- to four-family residential loans and MBS securities with no prepayment restrictions, which are then reinvested into lower yielding assets, further reducing interest income.
We currently do not participate in hedging programs, interest rate swaps or other activities involving the use of derivative financial instruments to manage interest rate risk.
Interest Rate Sensitivity Analysis. Management uses an interest rate sensitivity analysis to review our level of interest rate risk. This analysis measures interest rate risk by computing changes in the present value of our cash flows from assets, liabilities and off-balance sheet items in the event of a range of assumed changes in market interest rates. The present value of equity is equal to the market value of assets minus the market value of liabilities, with adjustments made for off-balance sheet items. This analysis assesses the risk of loss in market risk sensitive instruments in the event of a sudden and sustained 100 to 300 basis point increase or a 100 basis point decrease in market interest rates with no effect given to any future steps that management might take to counter the impact of that interest rate movement. The following table presents the change in the present value of First Fed’s equity at December 31, 2021, that would occur in the event of an immediate change in interest rates based on management's assumptions.
Economic Value of Equity
Basis Point Change in Interest Rates $ Amount $ Change % Change EVE Ratio %
(Dollars in thousands)
Using the same assumptions as above, the sensitivity of our projected net interest income over a one-year period for the year ended December 31, 2021, is as follows:
Basis Point Change Projected Net Interest Income
in Interest Rates $ Amount $ Change % Change
(Dollars in thousands)
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Assumptions made by management relate to interest rates, loan prepayment rates, deposit decay rates, and the market values of certain assets under differing interest rate scenarios, among others. As with any method of measuring interest rate risk, certain shortcomings are inherent in the method of analysis presented in the foregoing tables. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, 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 may take longer to adjust to changes in market rates. Additionally, certain assets have features, such as rate caps or floors, which restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, expected rates of prepayments on loans and early withdrawals from certificates could deviate significantly from those assumed in calculating the table.
Liquidity Management
Liquidity is the ability to meet current and future financial obligations of a short-term and long-term nature. Our primary sources of funds consist of deposit inflows, loan repayments, maturities and sales of securities and borrowings from the FHLB. While maturities and scheduled amortization of loans and securities are usually predictable sources of funds, deposit flows, calls of investment securities and borrowed funds, and prepayments on loans and investment securities are greatly influenced by general interest rates, economic conditions and competition, which can cause those sources of funds to fluctuate.
Management regularly adjusts our investments in liquid assets based upon an assessment of expected loan demand, expected deposit flows, yields available on interest-earning deposits and securities, and objectives of our interest-rate risk and investment policies.
Our most liquid assets are cash and cash equivalents followed by available for sale securities. The levels of these assets depend on our operating, financing, lending and investing activities during any given period. At December 31, 2021, cash and cash equivalents totaled $126.0 million, and securities classified as available-for-sale, which provide additional potential sources of liquidity, had a market value of $344.2 million. We have pledged collateral to support borrowings from the FHLB of $80.0 million. We have also pledged collateral to the Federal Reserve Bank of San Francisco to secure discount window advances; however, no funds were borrowed as of December 31, 2021.
At December 31, 2021, we had $2.7 million in loan commitments outstanding and an additional $270.5 million in undisbursed loans, including undisbursed construction commitments, and standby letters of credit.
Certificates of deposit due within one year of December 31, 2021 totaled $153.5 million, or 62.1% of certificates of deposit. The large percentage of certificates of deposit that mature within one year reflects customers' hesitancy to invest their funds for longer periods in this low-rate environment. Management believes, based on past experience, that a significant portion of our certificates of deposit will be renewed or rolled into new certificates of deposit given the current rate environment; however, should rates continue to stay at lower levels, balances could continue to shift into more liquid money market accounts over time. If these maturing deposits are not renewed or rolled into other deposit products, however, we will be required to seek other sources of funds, which may include borrowings and brokered deposits. We also can attract and retain deposits by adjusting the interest rates offered, including the offering of promotional rates on certificates of deposit to encourage the renewal or rollover of maturing certificates of deposit and mitigate the risk of loss of these deposits to our competitors. Depending on market conditions, we may also be required to pay higher rates on borrowings or brokered deposits than we currently pay on standard certificates of deposit or promotional rate offerings. We believe that business developed by our sales teams, including our commercial relationship managers, branch managers and members of our branch network, and the general cash flows from our existing lending and investment activities, will afford us enough long-term liquidity. For additional information, see the Consolidated Statements of Cash Flows included in Item 8, "Financial Statements and Supplementary Data," of this Form 10-K.
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The Company is a separate legal entity from the Bank and relies on dividends from its subsidiary, First Fed, and cash received from the issuance of subordinated debt for liquidity to pay its operating expenses and other financial obligations. At December 31, 2021, the Company (on an unconsolidated basis) had liquid assets of $14.1 million.
Off-Balance Sheet Activities
In the normal course of operations, First Fed engages in a variety of financial transactions that are not recorded in the financial statements. These transactions involve varying degrees of off-balance sheet credit, interest rate and liquidity risks. These transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments and lines of credit. For the year ended December 31, 2021, we engaged in no off-balance sheet transactions likely to have a material effect on our financial condition, results of operations or cash flows.
Commitments and Off-Balance Sheet Arrangements
The following table summarizes our commitments and contingent liabilities with off-balance sheet risks as of December 31, 2021:
Amount of Commitment Expiration - Per Period
Total Amounts Committed Due in One Year
(In thousands)
Commitments to originate loans:
Unfunded commitments under lines of credit 75,977 75,977
Unfunded commitments under existing construction loans 194,296 194,296
Standby letters of credit 212 212
Capital Resources
First Northwest Bancorp is a bank holding company subject to regulation by the Federal Reserve. As a bank holding company, we are subject to capital adequacy requirements of the Federal Reserve under the Bank Holding Company Act of 1956, as amended, and the regulations of the Federal Reserve. Our subsidiary, First Fed, is subject to minimum capital requirements imposed by the FDIC. Capital adequacy requirements are quantitative measures established by regulation that require us to maintain minimum amounts and ratios of capital.
First Fed is subject to meeting minimum capital adequacy requirements for common equity Tier 1 ("CET1") capital, Tier 1 risk-based capital, total risk-based capital, and tier 1 capital ("leverage"). Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by bank regulators that, if undertaken, could have a direct material effect on the Company’s financial statements.
First Fed is subject to capital requirements adopted by the Federal Reserve and the FDIC. See Item 1, "Business-How We Are Regulated," and Note 11 of the Notes to Consolidated Financial Statements included in Item 8, "Financial Statements and Supplementary Data," of this Form 10-K for additional information regarding First Northwest Bancorp and First Fed’s regulatory capital requirements.
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In order to avoid limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses based on percentages of eligible retained income that could be utilized for such actions, First Northwest Bancorp and First Fed must maintain CET1 capital at an amount greater than the required minimum levels plus a capital conservation buffer. This new capital conservation buffer requirement was phased in starting in January 2016 until fully implemented in the amount of 2.5% of risk-weighted assets in January 2019. As of December 31, 2021, the conservation buffer was 2.5%.
Consistent with our goals to operate a sound and profitable organization, our policy for First Fed is to maintain its "well-capitalized" status in accordance with regulatory standards. At December 31, 2021, the Bank and consolidated Company exceeded all regulatory capital requirements, and the Bank was considered "well capitalized" under FDIC regulatory capital guidelines.
The following table provides the capital requirements and actual results at December 31, 2021.
Actual Minimum Capital Requirements Minimum Required to be Well-Capitalized
Amount Ratio Amount Ratio Amount Ratio
(Dollars in thousands)
Tier I leverage capital (to average assets)
Common equity tier I (to risk-weighted assets)
Tier I risk-based capital (to risk-weighted assets)
Total risk-based capital (to risk-weighted assets)
Effect of Inflation and Changing Prices
The consolidated financial statements and related financial data presented in this report have been prepared according to generally accepted accounting principles in the United States, which require the measurement of financial and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time due to inflation. The primary impact of inflation on our operations is reflected in increased operating costs and the effect that general inflation may have on both short-term and long-term interest rates. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant impact on a financial institution's performance than do general levels of inflation. Although inflation expectations do affect interest rates, interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.
Recent Accounting Pronouncements
See Note 1 of the Notes to Consolidated Financial Statements contained in Item 8, "Financial Statements and Supplementary Data," of this Form 10-K.
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Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The information contained under "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Market Risk and Asset and Liability Management" of this Form 10-K is incorporated herein by reference.
Item 8. Financial Statements and Supplementary Data
Index to Consolidated Financial Statements Page
Notes to Consolidated Financial Statements 96
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Report of Independent Registered Public Accounting Firm
To the Shareholders and Board of Directors of
First Northwest Bancorp and Subsidiary
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of First Northwest Bancorp and Subsidiary (the “Company”) as of December 31, 2021 and 2020, the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for the years then ended, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2021 and 2020, and the consolidated results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
Basis for Opinion
These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting in accordance with the standards of the PCAOB. As part of our audit we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting in accordance with the standards of the PCAOB. Accordingly, we express no such opinion.
Our audit included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures to respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audit also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audit provides a reasonable basis for our opinion.
Critical Audit Matter
The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that (1) relates to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.
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Allowance for Loan Losses
As described in Notes 1 and 3 to the consolidated financial statements, the Company’s consolidated allowance for loan losses balance was $15.1 million at December 31, 2021. The allowance for loan losses is maintained to provide for estimated inherent losses based on evaluating known and inherent risks in the loan portfolio, and is based upon the Company’s analysis of the factors underlying the quality of the loan portfolio. These factors include, among others, changes in the size and composition of the loan portfolio, actual loan loss experience, current economic conditions, analysis of individual loans for which full collectability may not be assured, and determination of the discounted cash flows or determination of the existence and realizable value of the collateral and guarantees securing the loans.
We identified management’s estimation of the qualitative factor adjustment, which is used in the allowance for loan losses calculation, as a critical audit matter. The qualitative factors are comprised of subjective factors used to estimate losses related to factors that are not captured in the historical loss rates, and are based on management’s evaluation of available internal and external data and involves significant management judgment. The qualitative factor adjustment is added to the historical loss rate to calculate the allowance for loan losses. Auditing management’s judgments regarding the determination of the qualitative factor adjustment applied to the allowance for loan losses involved a high degree of subjectivity.
The primary procedures we performed to address this critical audit matter include:
/s/ Moss Adams LLP
Everett, Washington
March 18, 2022
We have served as the Company’s auditor since 2002.
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FIRST NORTHWEST BANCORP AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
ASSETS
Investment securities available for sale, at fair value 344,212 364,296
Federal Home Loan Bank (FHLB) stock, at cost 5,196 5,977
Servicing rights on sold loans, net 3,282 2,120
Goodwill and other intangible assets 1,183 —
LIABILITIES AND SHAREHOLDERS' EQUITY
Subordinated debt, net 39,280 —
Accrued interest payable 393 53
Accrued expenses and other liabilities 29,240 23,303
Advances from borrowers for taxes and insurance 1,108 1,116
Commitments and Contingencies (Note 13)
Shareholders' Equity
Accumulated other comprehensive income, net of tax 288 5,442
Unearned employee stock ownership plan (ESOP) shares (8,572 ) (9,230 )
Noncontrolling interest in Quin Ventures, Inc. (481 ) —
See accompanying notes to the consolidated financial statements.
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CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)
For the Year Ended December 31,
INTEREST INCOME
Interest and fees on loans receivable $ 55,029 $ 43,063
Interest on mortgage-backed and related securities 2,550 2,701
Interest on investment securities 5,819 5,569
Interest-bearing deposits and other 83 94
INTEREST EXPENSE
Subordinated debt 1,203 —
Net interest income after provision for loan losses 56,948 38,912
NONINTEREST INCOME
Loan and deposit service fees 3,860 3,454
Sold loan servicing fees, net of amortization 946 137
Net gain on sale of investment securities 2,410 3,147
Increase in cash surrender value of bank-owned life insurance, net 965 1,826
NONINTEREST EXPENSE
Supplies, postage, and telephone 1,189 985
Regulatory assessments and state taxes 1,213 930
FHLB prepayment penalty — 210
INCOME BEFORE PROVISION FOR INCOME TAXES 18,173 13,294
Net loss attributable to noncontrolling interest in Quin Ventures, Inc. 439 —
NET INCOME ATTRIBUTABLE TO PARENT $ 15,418 $ 10,340
Basic and diluted earnings per common share $ 1.63 $ 1.07
See accompanying notes to the consolidated financial statements.
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CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In thousands)
For the Year Ended December 31,
Other comprehensive income:
Other comprehensive (loss) income, net of tax (5,154 ) 6,981
Comprehensive (loss) income attributable to noncontrolling interest (439 ) —
COMPREHENSIVE INCOME ATTRIBUTABLE TO PARENT $ 10,264 $ 17,321
See accompanying notes to the consolidated financial statements.
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CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(In thousands, except share data)
Shares Amount Capital Earnings Shares Net of Tax Interest Equity
Restricted stock awards granted net of forfeitures 105,124 1 (1 ) —
Restricted stock awards canceled (13,719 ) — (178 ) — (178 )
Other comprehensive income, net of tax 6,981 6,981
Cash dividends declared and paid ($0.21 per share) (2,185 ) (2,185 )
Restricted stock awards granted net of forfeitures 64,839 1 (1 ) —
Restricted stock awards canceled (19,548 ) — (352 ) — (352 )
Other comprehensive loss, net of tax (5,154 ) (5,154 )
Cash dividends declared and paid ($0.25 per share) (2,533 ) (2,533 )
See accompanying notes to the consolidated financial statements.
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CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
For the Year Ended December 31,
CASH FLOWS FROM OPERATING ACTIVITIES
Net income before noncontrolling interest $ 14,979 $ 10,340
Adjustments to reconcile net income to net cash from operating activities:
Depreciation and amortization 1,432 1,375
Amortization of core deposit intangible 5 —
Accretion (amortization) of deferred loan fees, net 1,260 (1,113 )
Amortization of debt issuance costs 57 —
Amortization of servicing rights on sold loans 108 278
Additions to servicing rights on sold loans (1,233 ) (1,564 )
Deferred federal income taxes, net 63 (1,131 )
Allocation of ESOP shares 675 475
Gain on sale of loans, net (5,278 ) (6,433 )
Gain on sale of securities available for sale, net (2,410 ) (3,147 )
Increase in cash surrender value of life insurance, net (965 ) (1,826 )
Change in assets and liabilities:
Decrease (increase) in accrued interest receivable 1,677 (3,035 )
(Increase) decrease in prepaid expenses and other assets (15,404 ) 781
Increase (decrease) in accrued interest payable 340 (319 )
Increase in accrued expenses and other liabilities 6,218 7,463
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of securities available for sale (152,930 ) (305,713 )
Proceeds from sales of securities available for sale 109,829 210,264
Redemption of FHLB stock 781 57
Purchase of bank-owned life insurance policy — (6,500 )
Purchase of premises and equipment, net (6,019 ) (1,818 )
Capital contributions to equity investments (584 ) (1,416 )
Capital contributions to low-income housing tax credit partnerships (248 ) —
Net cash acquired from branch acquisition 63,545 —
See accompanying notes to the consolidated financial statements.
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CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
For the Year Ended December 31,
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from long-term FHLB advances 40,000 30,000
Repayment of long-term FHLB advances (10,000 ) (30,000 )
Net decrease in short-term FHLB advances (59,977 ) (2,953 )
Proceeds from issuance of subordinated debt, net 39,223 —
Net decrease in advances from borrowers for taxes and insurance (8 ) (29 )
Net share settlement of stock awards (352 ) (178 )
Repurchase of common stock (5,979 ) (7,413 )
NET INCREASE IN CASH AND CASH EQUIVALENTS 60,861 16,416
CASH AND CASH EQUIVALENTS, beginning of period 65,155 48,739
CASH AND CASH EQUIVALENTS, end of period $ 126,016 $ 65,155
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for:
Interest on deposits and borrowings $ 4,550 $ 8,043
NONCASH INVESTING ACTIVITIES
Unrealized (loss) gain on securities available for sale $ (4,181 ) $ 8,837
Lease liabilities arising from obtaining right-of-use assets $ 4,402 $ 1,047
BUSINESS COMBINATION (See Note 17)
Fair value of assets acquired $ 1,340 $ —
Fair value of liabilities assumed $ 65,947 $ —
See accompanying notes to the consolidated financial statements.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 - Summary of Significant Accounting Policies
Nature of operations - First Northwest Bancorp, a Washington corporation ("First Northwest"), became the holding company of First Fed Bank ("First Fed" or the "Bank") on January 29,2015, upon completion of the Bank's conversion from a mutual to stock form of organization (the "Conversion").
In connection with the Conversion, the Company issued an aggregate of 12,167,000 shares of common stock at an offering price of $10.00 per share for gross proceeds of $121.7 million. An additional 933,360 shares of Company common stock and $400,000 in cash were contributed to the First Federal Community Foundation ("Foundation"), a charitable foundation that was established in connection with the Conversion, resulting in the issuance of a total of 13,100,360 shares. The Company received $117.6 million in net proceeds from the stock offering of which $58.4 million were contributed to the Bank upon Conversion.
At the time of Conversion, the Bank established a liquidation account in an amount equal to its total net worth, approximately $79.7 million, as of June 30,2014, the latest statement of financial condition appearing in First Northwest's prospectus. The liquidation account is maintained for the benefit of eligible depositors who continue to maintain their accounts at the Bank after the Conversion. The liquidation account is reduced annually to the extent that eligible depositors have reduced their qualifying deposits. Subsequent increases will not restore an eligible holder’s interest in the liquidation account. In the event of a complete liquidation, each eligible depositor will be entitled to receive a distribution from the liquidation account in an amount proportionate to the current adjusted qualifying balances for accounts then held. The liquidation account balance is not available for payment of dividends, and the Bank may not pay dividends if those dividends would reduce equity capital below the required liquidation account amount.
Pursuant to the Conversion, the Bank’s Board of Directors adopted an ESOP which purchased in the open market 8% of the common stock originally issued for a total of 1,048,029 shares. As of December 15,2015,1,048,029 shares, or 100.0% of the total, had been purchased. As of December 31, 2021, First Northwest had allocated 333,396 shares from the total shares purchased to participants.
In April 2021, First Northwest entered into an Amended and Restated Joint Venture Agreement (the "Joint Venture Agreement") with the Bank, POM Peace of Mind, Inc. ("POM"), and Quin Ventures, Inc. ("Quin" or "Quin Ventures"). First Northwest has partially fulfilled its commitment to extend $15.0 million to Quin Ventures under a capital financing agreement and related promissory note and issued 29,719 shares of the Company's common stock to POM with a value of $500,000.
On October 31, 2021, the Bank converted from a State Savings Bank Charter to a State Commercial Bank Charter and was simultaneously renamed First Fed Bank from First Federal Savings and Loan Association of Port Angeles.
First Northwest, the Bank, and Quin Ventures are collectively referred to as the "Company."
First Northwest's business activities generally are limited to passive investment activities and oversight of its investments in First Fed and Quin Ventures. Accordingly, the information set forth in this report, including the consolidated financial statements and related data, relates primarily to the Bank.
The Bank is a community-oriented financial institution providing commercial and consumer banking services to individuals and businesses in Western Washington State with offices in Clallam, Jefferson, Kitsap, King, and Whatcom counties. These services include deposit and lending transactions that are supplemented with borrowing and investing activities.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Use of estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make assumptions. These assumptions result in estimates that affect the reported amounts of assets and liabilities, revenues and expenses, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expense during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to a determination of the allowance for loan losses, fair value of financial instruments, deferred tax assets and liabilities, and the valuation of impaired loans.
Principles of consolidation - The accompanying consolidated financial statements include the accounts of First Northwest Bancorp and its wholly owned subsidiary, First Fed, and its controlling interest in Quin Ventures, Inc. All material intercompany accounts and transactions have been eliminated in consolidation. While First Northwest and POM share equal ownership in Quin Ventures, it has been determined that First Northwest has a controlling interest for financial reporting purposes under Accounting Standards Codification 810. The Quin Ventures net loss allocable to POM is shown on the financial statements where applicable thorough a noncontrolling interest adjustment.
Subsequent events - The Company has evaluated subsequent events for potential recognition and disclosure and determined there are no such events or transactions requiring recognition or disclosure.
Cash and cash equivalents - Cash and cash equivalents consist of currency on hand, due from banks, and interest-bearing deposits with financial institutions with an original maturity of three months or less. The amounts on deposit fluctuate and, at times, exceed the insured limit by the FDIC, which potentially subjects First Fed to credit risk. First Fed has not experienced any losses due to balances exceeding FDIC insurance limits.
Restricted assets - Federal Reserve Board regulations require maintenance of certain minimum reserve balances on deposit with the Federal Reserve Bank of San Francisco. The deposit requirement was zero at both December 31, 2021 and 2020. First Fed was in compliance with its reserve requirements at December 31, 2021 and 2020.
Equity securities - Equity securities, except those accounted for under the equity method of accounting or those that result in consolidation of the investee, are carried at fair value. Changes in the fair value of investments in equity securities are recorded in other non-interest income.
Investment securities - Investment securities are classified into one of three categories: (1) held-to-maturity, (2) available-for-sale, or (3) trading. First Fed had no trading securities at December 31, 2021 and 2020. Investment securities are categorized as held-to-maturity when First Fed has the positive intent and ability to hold those securities to maturity. First Fed had no held-to-maturity securities at December 31, 2021 and 2020.
Securities that are held-to-maturity are stated at cost and adjusted for amortization of premiums and accretion of discounts, which are recognized as adjustments to interest income.
Investment securities categorized as available for sale are generally held for investment purposes (to maturity), although unanticipated future events may result in the sale of some securities. Available-for-sale securities are recorded at fair value, with the unrealized holding gain or loss reported in other comprehensive income (OCI), net of tax, as a separate component of shareholders' equity. Realized gains or losses are determined using the amortized cost basis of securities sold using the specific identification method and are included in earnings. Dividend and interest income on investments are recognized when earned. Premiums and discounts on securities without call features are recognized in interest income using the level yield method over the period to maturity. Premiums on securities with call features are amortized to the earliest call date.
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The Company reviews investment securities for other-than-temporary impairment (OTTI) on a quarterly basis. For debt securities, the Company considers whether management intends to sell a security or if it is likely that the Company will be required to sell the security before recovery of the amortized cost basis of the investment, which may be maturity. For debt securities, if management intends to sell the security or it is likely that the Company will be required to sell the security before recovering its cost basis, the entire impairment loss would be recognized as OTTI and charged against earnings. If management does not intend to sell the security and it is not likely that the Company will be required to sell the security, but management does not expect to recover the entire amortized cost basis of the security, only the portion of the impairment loss representing credit losses would be recognized in earnings. The credit loss on a security is measured as the difference between the amortized cost basis and the present value of the cash flows expected to be collected. Projected cash flows are discounted by the original or current effective interest rate depending on the nature of the security being measured for potential OTTI. The remaining impairment related to all other factors, i.e., the difference between the present value of the cash flows expected to be collected and fair value, is recognized as a charge to OCI. Impairment losses related to all other factors are presented as separate categories within OCI. If there is an indication of additional credit losses, the security is re-evaluated according to the procedures described above.
Federal Home Loan Bank stock - First Fed’s investment in Federal Home Loan Bank of Des Moines (FHLB) stock is carried at cost, which approximates fair value. As a member of the FHLB system, First Fed is required to maintain a minimum investment in FHLB stock based on specific percentages of its outstanding mortgages, total assets, or FHLB advances. At December 31, 2021 and 2020, First Fed’s minimum investment requirement was approximately $5.2 million and $5.9 million, respectively. First Fed was in compliance with the FHLB minimum investment requirement at December 31, 2021 and 2020. First Fed may request redemption at par value of any stock in excess of the amount First Fed is required to hold. Stock redemptions are granted at the discretion of the FHLB.
Management evaluates FHLB stock for impairment based on its assessment of the ultimate recoverability of cost rather than by recognizing temporary declines in value. The determination of whether a decline affects the ultimate recoverability of cost is influenced by criteria such as (1) the significance of any decline in net assets of the FHLB compared with the capital stock amount for the FHLB and the length of time this situation has persisted, (2) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLB, (3) the impact of legislative and regulatory changes on institutions and, accordingly, the customer base of the FHLB, and (4) the liquidity position of the FHLB. Based on its evaluation, First Fed did not recognize an OTTI loss on its FHLB stock at December 31, 2021 and 2020.
Loans held for sale - Mortgage loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or fair value. Fair value is determined based upon market prices from third-party purchasers and brokers. Net unrealized losses, if any, are recognized through a valuation allowance by charges to earnings. Gains or losses on the sale of loans are recognized at the time of sale and determined by the difference between net sale proceeds and the net book value of the loan less the estimated fair value of any retained mortgage servicing rights.
Loans receivable - Loans are stated at the amount of unpaid principal, net of charge-offs, unearned income, allowance for loan loss (ALLL) and any deferred fees or costs. Interest on loans is calculated using the simple interest method based on the month end balance of the principal amount outstanding and is credited to income as earned. The estimated life is adjusted for prepayments.
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Each loan segment and class inherently contains differing credit risk profiles depending on the unique aspects of that segment or class of loans. For example, borrowers tend to consider their primary residence and access to transportation for employment-related purposes as basic requirements; accordingly, many consumers prioritize making payments on real estate first-mortgage loans and vehicle loans. Conversely, second-mortgage real estate loans or unsecured loans may not be supported by sufficient collateral; thus, in the event of financial hardship, borrowers may tend to place less importance on maintaining these loans as current and the Bank may not have adequate collateral to provide a secondary source of repayment in the event of default. Notwithstanding the various risk profiles unique to each class of loan, management believes that the credit risk for all loans is similarly dependent on essentially the same factors, including the financial strength of the borrower, the cash flow available to service maturing debt obligations, the condition and value of underlying collateral, the financial strength of any guarantors, and other factors.
Loans are classified as impaired when, based on current information and events, it is probable that First Fed will be unable to collect the scheduled payments of principal and interest when due, in accordance with the terms of the original loan agreement. The carrying value of impaired loans is based on the present value of expected future cash flows discounted at each loan’s effective interest rate or, for collateral dependent loans, at fair value of the collateral, less selling costs. If the measurement of each impaired loan’s value is less than the recorded investment in the loan, First Fed recognizes this impairment and adjusts the carrying value of the loan to fair value through the allowance for loan losses. This can be accomplished by charging off the impaired portion of the loan or establishing a specific component to be provided for in the allowance for loan losses.
The accrual of interest on loans is discontinued at the time the loan is 90 days delinquent, unless the credit is well secured and in process of collection. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful.
All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash basis or cost recovery method until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. For those loans placed on non-accrual status due to payment delinquency, return to accrual status will generally not occur until the borrower demonstrates repayment ability over a period of not less than six months.
Loan fees and purchased premiums - Loan origination fees and certain direct origination costs are deferred and amortized as an adjustment to the yield of the loan over the contractual life using the effective interest method. In the event a loan is sold, the remaining deferred loan origination fees and/or costs are recognized as a component of gains or losses on the sale of loans. We may pay a purchase premium or receive a purchase discount on fully originated loans that we purchase. Premiums and discounts are capitalized at the time of purchase and amortized as an adjustment to the yield over the contractual life using the effective interest method.
Allowance for loan losses - First Fed maintains a general allowance for loan losses based on evaluating known and inherent risks in the loan portfolio, including management’s continuing analysis of the factors underlying the quality of the loan portfolio. These factors include changes in the size and composition of the loan portfolio, actual loan loss experience, and current and anticipated economic conditions. When determining the appropriate historical loss and qualitative factors, management took into consideration the impact of the COVID-19 pandemic on such factors as the national and state unemployment rates and related trends, the amount of and timing of financial assistance provided by the government, consumer spending levels and trends, industries significantly impacted by the COVID-19 pandemic, and the Company's COVID-19 loan modification program. Qualitative factors such as economic, market, industry, and political changes are also considered for calculation of the allowance. The appropriateness of the allowance for loan losses is estimated based upon these factors and trends identified by management at the time the consolidated financial statements are prepared. The reserve is an estimate based upon factors and trends identified by management at the time the financial statements are prepared.
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The ultimate recovery of loans is susceptible to future market factors beyond First Fed’s control, which may result in losses or recoveries differing significantly from those provided in the consolidated financial statements. In addition, various regulatory agencies, as an integral part of their examination processes, periodically review First Fed’s allowance for loan losses. Such agencies may require First Fed to recognize additional provisions for loan losses based on their judgment using information available to them at the time of their examination.
Allowances for losses on specific problem loans are charged to income when it is determined that the value of these loans and properties, in the judgment of management, is impaired. First Fed accounts for impaired loans in accordance with Accounting Standards Codification (ASC) 310-10-35,Receivables—Overall—Subsequent Measurement. A loan is considered impaired when, based on current information and events, it is probable that First Fed will be unable to collect all amounts due according to the contractual terms of the loan agreement.
When a loan has been identified as being impaired, the amount of the impairment is measured by using discounted cash flows, except when it is determined that the sole source of repayment for the loan is the operation or liquidation of the underlying collateral. In such cases, impairment is measured at current fair value generally based on a current appraisal of the collateral, reduced by estimated selling costs. When the measurement of the impaired loan is less than the recorded investment in the loan (including collected interest that has been applied to principal, net deferred loan fees or costs, and unamortized premiums or discounts), loan impairment is recognized by establishing or adjusting an allocation of the allowance for loan losses. Uncollected accrued interest is reversed against interest income.
If ultimate collection of principal is in doubt, all cash receipts on impaired loans are applied to reduce the principal balance. The impairment amount for small balance homogeneous loans is calculated using the adjusted historical loss rate for the class and risk category related to each loan, unless the loan is subject to a troubled debt restructuring ("TDR").
A TDR is a loan for which First Fed, for reasons related to the borrower’s financial difficulties, grants a concession to the borrower that First Fed would not otherwise consider. The loan terms that have been modified or restructured due to the borrower’s financial difficulty include, but are not limited to, a reduction in the stated interest rate; an extension of the maturity; an interest rate below market; a reduction in the face amount of the debt; a reduction in the accrued interest; or extension, deferral, renewal, or rewrite of the original loan terms.
The restructured loans may be classified "special mention" or "substandard" depending on the severity of the modification. Loans that were paid current at the time of modification may be upgraded in their classification after a sustained period of repayment performance, usually six months or longer, and there is reasonable assurance that repayment will continue. Loans that are past due at the time of modification are classified "substandard" and placed on nonaccrual status.
TDR loans may be upgraded in their classification and placed on accrual status once there is a sustained period of repayment performance, usually six months or longer, and there is a reasonable assurance that repayment will continue. First Fed allows reclassification of a troubled debt restructuring back into the general loan pool (as a non-troubled debt restructuring) if the borrower is able to refinance the loan at then-current market rates and meet all of the underwriting criteria of First Fed required of other borrowers. The refinance must be based on the borrower’s ability to repay the debt and no special concessions of rate and/or term are granted to the borrower.
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In March 2020, the Company announced loan modification programs to support and provide relief for its borrowers during the novel coronavirus of 2019 ("COVID-19") pandemic. The Company has followed the loan modification criteria within the Coronavirus Aid, Relief, and Economic Security Act of 2020 ("CARES Act"), which was signed into law on March 27, 2020, and interagency guidance from the federal banking agencies when determining if a borrower's modification is subject to a TDR classification. On December 27, 2020, the Consolidated Appropriations Act, 2021 (the “Relief Act”) was signed into law, which further extended the relief to the earlier of January 1, 2022 or 60 days after the date of termination of the national emergency. If it is determined that the modification does not meet the criteria under the CARES Act or interagency guidance to be excluded from TDR classification, the Company evaluates the loan modifications under its existing TDR framework. Loans subject to forbearance under the COVID-19 loan modification program are not reported as past due or placed on non-accrual status during the forbearance time period, and interest income continues to be recognized over the contractual life of the loans.
Reserve for unfunded commitments - Management maintains a reserve for unfunded commitments to absorb probable losses associated with off-balance sheet commitments to lend funds such as unused lines of credit and the undisbursed portion of construction loans. Management determines the adequacy of the reserve based on reviews of individual exposures, current economic conditions, and other relevant factors. The reserve is based on estimates and ultimate losses may vary from the current estimates. The reserve is evaluated on a regular basis and necessary adjustments are reported in earnings during the period in which they become known. The reserve for unfunded commitments is included in "Accrued expenses and other liabilities" on the consolidated balance sheets.
Real estate owned and repossessed assets - Real estate owned and repossessed assets include real estate and personal property acquired through foreclosure or repossession and may include in-substance foreclosed properties. These properties are initially recorded at the fair market value of the property less selling costs. Properties are subsequently evaluated for impairment. In-substance foreclosed properties are those properties for which the Bank has taken physical possession, regardless of whether formal foreclosure proceedings have taken place.
Loan servicing rights - Originated servicing rights are recorded when loans are originated and subsequently sold with the servicing rights retained. Servicing assets are initially capitalized at fair value with the income statement effect recorded in gains on sales of loans. Management uses a valuation model that calculates the present value of future cash flows to determine the fair value of servicing rights. Assumptions used in the valuation model include market discount rates and anticipated prepayment speeds. In addition, estimates of the cost of servicing per loan, an inflation rate, ancillary income per loan, and default rates are used. The fair value of the servicing asset is amortized into noninterest income in proportion to, and over the period of, estimated future net servicing income.
Management assesses impairment of the loan servicing rights based on recalculations of the present value of remaining future cash flows using updated market discount rates and prepayment speeds. Subsequent loan prepayments and changes in prepayment assumptions in excess of those forecasted can adversely impact the carrying value of the servicing rights. Impairment is assessed on a stratified basis with any impairment recognized through a valuation allowance for each impaired stratum. The servicing rights are stratified based on the predominant risk characteristics of the underlying loans: fixed-rate loans and adjustable-rate loans. The effect of changes in market interest rates on estimated rates of loan prepayments is the predominant risk characteristic for loan servicing rights. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds, and default rates and losses.
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Sold loan servicing income represents fees earned for servicing loans. Fees for servicing sold loans are generally based upon a percentage of the principal balance of the loans serviced, as well as related ancillary income such as late charges. Servicing income is recognized as earned unless collection is doubtful. The caption in the consolidated statement of income "Sold loan servicing fees, net of amortization" includes sold loan servicing income, amortization of loan servicing rights, the effects of sold loan servicing run-off, and impairment, if applicable.
Income taxes - First Fed accounts for income taxes in accordance with the provisions of ASC 740-10,Income Taxes, which requires the use of the asset and liability method of accounting for income taxes. Deferred tax assets and liabilities are recognized for their future tax consequences, attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.
Premises and equipment - Premises and equipment are stated at cost less accumulated depreciation. Depreciation is recognized and computed on the straight-line method over the estimated useful lives as follows:
Years
Furniture, fixtures, and equipment 3 - 10
Software 3
Automobiles 5
Goodwill - Goodwill is recorded from a business combination as the difference in the purchase price and fair value of assets acquired and liabilities assumed. Goodwill has an indefinite useful life, and as such, is not amortized. The Company will perform a goodwill impairment on an annual basis. Additionally, the Company will perform an impairment analysis as needed when circumstances indicate impairment potentially exists. Any impairment will be recorded as noninterest expense and corresponding reduction in intangible asset on the consolidated financial statements.
Core deposit intangible - A core deposit intangible ("CDI") asset is recognized from the assumption of core deposit liabilities in connection with the acquisition of one branch from Sterling Bank and Trust of Southfield, Michigan (the "Branch Acquisition"). The asset was valued by a third party and is amortized into noninterest expense over ten years. The CDI is evaluated for impairment annually with any additional decline recorded as noninterest expense on the Consolidated Income Statement.
Leases - Operating lease right-of-use ("ROU") assets represent the Company's right to use the underlying asset during the lease term and operating lease liabilities represent the Company's obligation to make lease payments arising from the lease. ROU assets and operating lease liabilities are recognized at lease commencement based on the present value of the future lease payments using the Company's incremental borrowing rate. The Company does not capitalize short-term leases, which are leases with terms of twelve months or less. ROU assets and related operating lease liabilities are remeasured when lease terms are amended, extended, or when management intends to exercise available extension options.
Low Income Housing Tax Credit Investment - The Company has an equity investment in a Low Income Housing Tax Credit Investment ("LIHTC") partnership which is an indirect federal subsidy that finances low-income housing projects. As a limited liability investor in this partnership, the Company receives a tax benefit in the form of a tax deduction from partnership operating losses and a federal income tax credit. The federal income tax credit is earned over a 10-year period as a result of the investment properties meeting certain criteria and is subject to recapture for noncompliance with such criteria over a 15-year period.
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The Company accounts for the LIHTC under the proportional amortization method and amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance on the Consolidated Statements of Income as a component of income tax expense. The Company reports the carrying value of the equity investment in the unconsolidated LIHTC in Prepaid expenses and other assets on the Company’s Consolidated Balance Sheets.
The maximum exposure to loss in the LIHTC is the amount of equity invested and credit extended by the Company. The Company has evaluated the variable interests held by the Company in the LIHTC investment and determined that the Company does not have controlling financial interests in such investment and is not the primary beneficiary.
Transfers of financial assets - Transfers of an entire financial asset, a group of financial assets, or a participating interest in an entire financial asset are accounted for as sales when control over the assets has been relinquished. Control over transferred assets is deemed to be surrendered when: (1) the assets have been isolated from First Fed, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) First Fed does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. The mortgage loans that are sold with recourse provisions are accounted for as sales until such time as the loan defaults.
Periodically, First Fed sells mortgage loans with "life of the loan" recourse provisions, requiring First Fed to repurchase the loan at any time if it defaults. The remaining balance of such loans at December 31, 2021 and 2020, was approximately $2.0 million and $2.7 million, respectively. Of these loans, no loans were repurchased during the years ended December 31, 2021 or 2020. There is an associated allowance of $11,000 and $11,000 at December 31, 2021 and 2020, respectively, included in "accrued expenses and other liabilities" on the consolidated balance sheets related to these loans.
Bank-owned life insurance - The carrying amount of life insurance approximates fair value. Fair value of life insurance is estimated using the cash surrender value, less applicable surrender charges. The change in cash surrender value is included in noninterest income.
Off-balance-sheet credit-related financial instruments - In the ordinary course of business, First Fed has entered into commitments to extend credit, including commitments under lines of credit, commercial letters of credit, and standby letters of credit. Such financial instruments are recorded when they are funded.
Advertising costs - First Fed expenses advertising costs as they are incurred.
Comprehensive income (loss) - Accounting principles generally require that recognized revenue, expenses, and gains and losses be included in net income (loss). Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the consolidated balance sheets, such items, along with net income (loss), are components of comprehensive income (loss).
Dividend restriction - Banking regulations require maintaining certain capital levels and may limit the dividends paid by the Bank to the Company or by the Company to shareholders.
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Components of noninterest income evaluated under Topic 606 - The Company recognizes revenue as it is earned and noted no impact to its revenue recognition policies as a result of the adoption of ASU 2014-09. The following is a discussion of key revenues within the scope of the new revenue guidance.
Deposit fees - The Company earns fees from its deposit customers for account maintenance, transaction-based activity and overdraft services. Account maintenance fees consist primarily of account fees and analyzed account fees charged on deposit accounts on a monthly basis. The performance obligation is satisfied and the fees are recognized on a monthly basis as the service period is completed. Transaction-based fees on deposit accounts are charged to deposit customers for specific services provided to the customer, such as non-sufficient funds fees, overdraft fees, and wire fees. The performance obligation is completed as the transaction occurs and the fees are recognized at the time each specific service is provided to the customer. Deposit fees are included in Service Fees on the Consolidated Statements of Income.
Debit card interchange income - Debit and Automated Teller Machine ("ATM") interchange income represent fees earned when a debit card issued by the Company is used. The Company earns interchange fees from debit cardholder transactions through card networks. In addition, the Company earns interchange fees for use of its ATMs by customers of other banking institutions. Interchange fees are based on purchase volumes and other factors and are recognized as transactions occur. The performance obligation is satisfied and the fees are earned when the cost of the transaction is charged to the cardholder's debit card. Certain expenses directly associated with the credit and debit card are netted against interchange income. Debit card interchange income is included in Service Fees on the Consolidated Statements of Income.