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. Deterioration in the national economy may also have an adverse effect on the region.
Any future 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, domestic or geopolitical crises, such as the current wars in Ukraine and the Middle East, 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, resulting in potentially adverse operating results. 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 potentially negative effects on our loan portfolio and growth opportunities. A significant natural disaster, such as a tsunami, earthquake, drought, fire or flood, where we or our customers live and do business, could have a material adverse impact on our local market areas and our ability to conduct business, especially if our insurance coverage is 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.
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.
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Factors that could detrimentally impact our access to liquidity sources include actions by the FRB, 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 consumer and business behavior utilizing funds on deposit to pay down higher cost debt or to seek higher yielding investments, 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.
Competition for deposits may limit our ability to grow.
Our loan growth is primarily dependent on retaining and attracting additional customer deposits. While we emphasize the generation of low-cost core deposits as a source of funding, there is strong competition for such deposits in our market area, including from internet-based banking institutions, which have grown rapidly in recent years.
Deposit flows are influenced by various factors, including customer relationships, sales and marketing efforts, interest rates paid by competitors, alternative investments such as money market mutual funds, equities and bonds, government stimulus programs, and the overall levels of business and personal income and savings. The current elevated interest rate environment has increased competition for deposits across the banking industry, and deposit balances may decrease if customers perceive alternative investments as providing a better risk/return tradeoff.
Our failure to grow or retain deposits may result in a loss of market share and slower or negative loan growth, which likely would have an adverse effect on our financial condition and results of operations.
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 $721.1 million, or 43.4%, of our total loan portfolio, at December 31, 2023, from $641.6 million, or 41.5%, of our total loan portfolio at December 31, 2022. 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 under the FDIC's policies for management of its commercial real estate loan portfolio.
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 compared to one-to-four family loans. The repayment of commercial real estate loans typically depends on the successful operation and income stream of the borrowers’ operating business, or their ability to lease the commercial property at sufficient rates. The value of the commercial real estate securing the loan as collateral is a secondary source of repayment in case of default, which can be significantly affected by economic conditions. The FDIC has issued pronouncements alerting banks of its concerns about banks with a heavy concentration of commercial real estate loans. Moreover, federal bank regulators have highlighted the increased risk associated with commercial real estate loans, including with respect to the higher vulnerability of these credits to pressure as interest rates remain elevated and market conditions in many metropolitan areas continue to show signs of stress. 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 on 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 credit losses on loans and charge-offs will likely be larger on a per loan basis compared to consumer loans. As a result, deterioration of this portfolio could have a materially adverse effect on our future earnings. Collateral evaluation and financial statement analysis for commercial loans also requires a more detailed review at origination 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, resulting in less opportunity to mitigate credit risk by selling part or all of our interest in these assets. At December 31, 2023, we had $28,000 of nonperforming commercial real estate loans and $0 of nonperforming multi-family loans in our portfolio.
An increase in unsecured lending exposes us to an increase in loan losses.
We have increased our commercial business loan portfolio by purchasing unsecured loans to small businesses and professionals and our consumer loan portfolio through purchases from Splash Financial. Our exposure on these purchased loan portfolios was $21.1 million and $7.3 million, respectively, at December 31, 2023. Unsecured loans present additional risks to us because if a borrower defaults on an unsecured loan, there is no collateral to repossess and liquidate in order to satisfy the outstanding loan balance. Also, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount that can be recovered on an unsecured loan in default. Our efforts to mitigate this risk include carefully assessing a borrower’s creditworthiness, including their income, employment history, and debt-to-income ratio.
In 2022, we began purchasing unsecured consumer loans through a partnership with Splash Financial, a private lender that underwrites and funds personal loans. First Fed has experienced losses of $3.4 million on the Splash Financial loans to date. We made changes to the program participation criteria for these loans in 2023 with the goal of reducing additional losses. Additional losses in our unsecured lending portfolio would negatively affect our profitability and capital.
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 for commercial and multi-family real estate as well as other business loans, has increased to $833.4 million, or 50.2% of total loans, at December 31, 2023, from $718.6 million, or 46.4% of total loans, at December 31, 2022. One-to-four family loans have increased to $378.4 million, or 22.8% of total loans, at December 31, 2023, from $343.6 million, or 22.2% of total loans, at December 31, 2022. Total consumer loans have increased to $318.5 million, or 19.2% of total loans, at December 31, 2023, from $291.8 million, or 18.8% of total loans, at December 31, 2022. Rapidly growing loan portfolios are, by their nature, less seasoned and our experience with these loans may not provide us with a useful 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 certain borrowers, largely in connection with high-end residential real estate and commercial and multi-family real estate loans. At December 31, 2023, the aggregate amount of loans, including unused commitments, to First Fed's five largest borrowers (including related entities) amounted to approximately $95.8 million. Outstanding loan balances for the ten largest borrowing relationships at December 31, 2023, totaled $171.2 million, or 10.3% of total loans. Although only one of the loans to First Fed's 20 largest borrowers was nonperforming as of December 31, 2023, 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.
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Our construction and land loans are based upon estimates of costs and the value of the completed project.
During the year ended December 31, 2023, our construction and land loans decreased $64.0 million, or 33.0%, to $129.7 million, or 7.8%, of the total loan portfolio at December 31, 2023 and consisted of properties secured by multi-family of $66.7 million, one-to-four family residential of $43.7 million, commercial real estate of $11.8 million, and land of $7.5 million. Land loans include raw land and land acquisition and development loans.
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, 2023, $447.8 million, or 27.0% 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 loans in a subordinate lien position to a first lienholder.
For 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 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, 2023, we had $112.3 million, or 6.8% 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 the value of the collateral and predetermined loan to collateral ratios; liquidation of the underlying real estate collateral is the primary source of repayment in the event of borrower default. Our commercial business loans are primarily supported by the cash flow of the borrower and secondarily by the underlying collateral provided by the borrower. The borrowers' cash flows may be unpredictable, and the 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. Factors affecting the value of this type of collateral include uncollectable accounts receivable and obsolete or limited use inventory, among others.
Our allowance for credit losses on loans 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 allowance for credit losses on loans, we review our loan portfolios, loss and delinquency trends, and economic conditions. If our assumptions are incorrect, our allowance for credit losses on loans may not be sufficient to cover incurred losses, resulting in additions to our allowance for credit losses on loans through the provision for credit 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 credit losses on loans 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 credit losses on loans, we will need additional provisions to replenish the allowance for credit losses on loans. 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.
If our nonperforming assets increase, our earnings will be adversely affected.
At December 31, 2023, our nonperforming assets, which consist of nonaccrual loans, real estate owned and repossessed assets, were $18.6 million, or 0.8% of total assets. Our nonperforming assets adversely affect our net income in various ways.
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 current wars in Ukraine and the Middle East, terrorism, or other geopolitical events. A need for additional liquidity may also require us to sell investment securities at depressed prices. These factors, among others, could result in an allowance for credit losses on investment securities, 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 an allowance for credit losses on investment securities 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.
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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. Further, clients may choose to conduct business with other market participants who engage in business or offer products in areas we deem speculative or risky, such as cryptocurrencies, non-fungible tokens, and other digital assets. Additionally, 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.
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.
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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 third-party 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.
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 beyond our control, including general economic conditions and policies of various governmental and regulatory agencies, particularly the Federal Reserve. The Federal Reserve slowed its increases to the federal funds target rate in 2023, with the most recent increase occurring in July 2023. 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. A rising or elevated interest rate environment may also adversely affect the U.S. economy and, as a result, our business as a whole. The Federal Reserve has communicated that the economic outlook continues to be uncertain, and while it has stated that rates may decrease later in 2024, there can be no assurance of the timing or amount of any future rate adjustments. Further, there can be no assurance regarding any forecasts or predictions about the effect that any future rate adjustment may have on our results of operations.
Further 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 mortgage and SBA 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.
Additional 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. Further 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 in the years prior to 2022, a high percentage of our deposits were composed of deposits bearing no or a relatively low rate of interest and having a shorter duration than our assets. We will likely incur a higher cost of funds to retain these deposits in the current elevated 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.
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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.
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," in this Form 10-K for additional information.
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.
A portion of our loan portfolio is serviced by third parties, which may limit our ability to foreclose on or repossess such loans.
At December 31, 2023, $105.4 million of our consumer, $38.1 million of our commercial real estate, and $19.2 million of our one-to-four family 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 $46.0 million at December 31, 2023. 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 $34.5 million at December 31, 2023, 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.
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We operate in a highly regulated environment and may be adversely affected by changes in laws and regulations and the impact of consent orders to which we are subject.
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 financial 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 credit losses on loans 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.
On November 21, 2023, the Bank entered into a consent order ("Order") with the FDIC, the Bank's primary regulator. The Order, which will remain effective until modified, suspended or terminated by the FDIC, requires the Board and senior management to:
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.
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.
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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:
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 may also 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.
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Item 1C. Cybersecurity
The Company recognizes cybersecurity as a critical risk to its operations and the management of this risk is a top priority. We are committed to protecting the confidentiality, integrity, and availability of our customer information, information systems, data, and assets from unauthorized access, use, disclosure, disruption, modification, or destruction. The Company adheres to cybersecurity industry best practices such as the National Institute of Standards and Technology cybersecurity framework and Federal Financial Institutions Examinations Council ("FFIEC") guidance. FNWB management has integrated its processes for assessing, identifying, and managing material risks from cybersecurity threats into the Company’s overall risk management program, including regularly conducting risk assessments and gap analyses in order to identify and prioritize cybersecurity threats and vulnerabilities across our entire digital estate which is comprised of our IT infrastructure as well cloud-based applications and storage. These assessments consider industry best practices, evolving threats, and the specific needs of our business.
The Company implements a defense in depth, or layered, approach to security controls, including network security, intrusion detection and prevention, anomaly detection, endpoint security, data encryption, identity and access management, and security awareness training. Staff evaluate and update our controls on an ongoing basis to address emerging threats. We have a documented incident response plan in place to identify, contain, and remediate cybersecurity incidents. The plan includes roles and responsibilities for key personnel, communication protocols, and procedures for recovery and notification. We also maintain business continuity, crisis management, and disaster recovery plans to ensure the continued operation of critical business functions in the event of a major disruption, including a cyberattack, which are tested regularly through tabletop exercises, simulations, parallel testing, and functional testing.
The Company adheres to a continuous improvement philosophy in regard to cybersecurity and leverages external experts, consultants, auditors, and assessors on a regular basis to complement the internal staff in identifying and remediating any gaps in the Company’s cybersecurity program.
The Company has a well-defined and mature vendor management program that includes controls to address third-party cybersecurity risks throughout the vendor management lifecycle.
The FNWB Board of Directors has oversight responsibility for enterprise-wide risks, including cybersecurity risks. The Board recently welcomed a cybersecurity expert as a director to help further understand and anticipate risks in this area. A designated committee of the Board, the Audit Committee, is responsible for overseeing the Company's cybersecurity risk management program and reviewing its effectiveness. The Chief Information Officer and Security Officer ("CIO/SO") is responsible for assessing and managing material risks from cybersecurity threats, with a dedicated staff of information security professionals. The CIO/SO has over 25 years of education, training, and experience managing technology and cybersecurity risks, and over 12 years of experience in the banking industry specifically. The CIO/SO regularly updates executive and senior management, including the Enterprise Risk Management Committee, as well as the Board Audit Committee on cybersecurity risks and mitigation strategies. The Company has implemented internal controls to address the effectiveness of our cybersecurity program. These controls include risk assessments, vulnerability assessments and scans, periodic audits, and periodic penetration testing.
We are committed to disclosing material cybersecurity incidents to investors and other stakeholders in a timely and transparent manner in compliance with applicable regulations and in keeping with market practices. Management will assess the materiality of a cybersecurity incident based on its potential impact on our financial condition, results of operations, reputation, or ability to meet our business objectives. The Company is not aware of any current cybersecurity threats that are reasonably likely to affect the Company’s business strategy, results of operations or financial condition.
See "We are subject to certain risks in connection with our use of networks and technology systems"in Item 1A. Risk Factors of this Form 10-K for additional information regarding the risks we face from cybersecurity threats.
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Item 2. Properties
The Company's main administrative office is located at 105 West Eighth Street, Port Angeles, WA 98362. As of December 31, 2023, we conducted our business through twelve branch offices located in Clallam, Jefferson, King, Kitsap, and Whatcom Counties, Washington; two business centers and a support service center located in King County, Washington; one business center in Whatcom County, Washington; and our main administrative office and a support service center located in Clallam County, Washington. The Company currently owns seven branch offices, the main administrative office and the Clallam County support services center. The remaining five branch offices, three business centers and King County support service center are leased. The net book value of the Company’s properties totaled $16.0 million at December 31, 2023. Additional information is presented in Note 5 - Premises and Equipment, Note 6 - Leases, and Note 20 - Subsequent Event (relating to a potential sale and leaseback of six of the Company's owned properties) 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 8, 2024, there were 9,443,271 shares of common stock issued and outstanding and we had approximately 511 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, 2023.
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 and a financial holding company and is engaged in banking activities through its wholly owned subsidiary, First Fed Bank, as well as certain non-banking financial activities. Non-banking investments include several limited partnership investments, including a 33% interest in The Meriwether Group, LLC ("MWG"). The Company's business activities are generally focused on passive investment activities and oversight of the activities of First Fed. The Company has also entered into partnerships to strategically invest in fintech-related businesses, which may result in the development of additional investment opportunities.
First Fed is a community-oriented commercial bank serving Clallam, Jefferson, King, Kitsap, and Whatcom counties in Washington State, through its twelve full-service branches, three business centers and three administration centers. We offer a wide range of products and services focused on the lending, deposit and money movement needs of the communities we serve. To diversify our portfolio and increase interest income, we increased our origination of commercial real estate, multi-family real estate, and commercial business loans. We also increased our auto and consumer loans through originations, purchased auto loan programs, and purchased manufactured homes. We continue to originate one-to-four family residential mortgage loans, primarily for sale into the secondary market to generate noninterest gain on sale and servicing fee revenue and manage interest rate risk, or retain select loans in our portfolio to enhance interest income. Home equity, residential construction and commercial construction loans are also originated primarily in Western Washington. 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 policy, including fiscal stimulus, interest rate policy and open market operations, housing, and consumer protection. Deposit flows are influenced by various factors, including changes in market rates; sales and marketing efforts; interest rates paid by competitors; available alternative investments such as money market mutual funds, the stock and bond markets; 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 both regional and national 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 impact 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, earnings from equity and partnership investments, and gains and losses from the sale of loans and securities.
An offset to net interest income is the provision for credit losses, which represents the periodic charge to operations required to adequately provide for probable losses inherent in our loan, unfunded commitments and investment portfolios through our allowance for credit losses. A recapture of previously recognized provision for credit losses may be added to net interest income if forecasted macroeconomic factors improve, underlying balances decrease, or recoveries of amounts previously charged off are received.
The noninterest expenses incurred in operating our business consist of salaries and employee benefit costs, occupancy and equipment expenses, professional fees, 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 growing and diversifying our loan portfolio, expanding our deposit product offerings, and enhancing our digital 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. Below are strategies we have implemented, or intend to implement, 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.
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The following represent our critical accounting policies:
Allowance for Credit Losses on Loans. The allowance for credit losses on loans ("ACLL") is a valuation account that is deducted from the amortized cost of loans receivable to present the net amount expected to be collected. The allowance is established through the provision for credit losses on loans, which is charged to income. Determining the amount of the ACLL necessarily involves a high degree of judgment. Management has adopted a discounted cash flow ("DCF") methodology for most of its segments to calculate the ACLL. For certain segments with smaller portfolios or where data is prohibitive to running a DCF calculation, management has elected to use a remaining life methodology. The Company also uses established metrics to estimate qualitative risk factors by segment based on the identified risk. The Company evaluates individual loans for expected credit losses when those loans do not share similar risk characteristics with loans evaluated using a collective (pooled) basis using either a collateral value or cash flow method. All of the factors used in these methodologies are susceptible to significant change. Management reviews and approves, at least quarterly, the level of the allowance and the provision for credit losses on loans based on anticipated future 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 credit losses on loans, future economic or other conditions may differ substantially from the assumptions used in making the evaluation. The FDIC and the DFI, as an integral part of their examination process, periodically review our ACLL 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 credit losses on loans to replenish the allowance, which would adversely affect earnings. Management considers the ACLL to be a critical accounting estimate. Our accounting policies are discussed in detail in Notes 1 and 4 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 servicing rights on loans originated and subsequently sold into the secondary market. We stratify our capitalized servicing rights based on the type, term and interest rates of the underlying loans. Servicing rights are measured at fair value at each reporting date with the change reported in earnings. 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, 7 and 15 to the Notes to Consolidated Financial Statements included in Item 8, "Financial Statements and Supplementary Data" of this Form 10-K.
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. In the absence of quoted market prices, management determines the fair value of the Company’s assets and liabilities using valuation models or third-party pricing services.
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.
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Comparison of Financial Condition at December 31, 2023 and December 31, 2022
Assets. Total assets increased $159.7 million, or 7.8%, to $2.2 billion at December 31, 2023, from $2.04 billion at December 31, 2022.
Total loans, excluding loans held for sale, increased $112.5 million, or 7.3%, during the year ended December 31, 2023. Multi-family and commercial real estate loans increased $79.5 million, or 12.4%, consisting mainly of an increase in multi-family real estate loans of $80.4 million as a result of new originations and $38.4 million of construction loans converting into permanent amortizing loans. Commercial real estate loans decreased $901,000 as payment activity exceeded new loan originations of $39.7 million and $10.1 million from construction loans converting into permanent amortizing loans. Auto and other consumer loans increased $10.2 million, or 4.3%, 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 increased $35.4 million primarily due to an increase in the Northpointe Bank Mortgage Participation Program of $9.5 million and purchases of $15.9 million of unsecured Bankers Healthcare Group loans in addition to advances on new and existing lines of credit and originations of amortizing commercial loans.
One-to-four family residential loans increased $34.9 million, or 10.2%, with $64.7 million in construction loans converting to permanent amortizing loans during the year. We continue to focus on the origination of one-to-four family mortgage loans with the intention of retaining certain adjustable-rate 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 decreased $64.0 million, or 33.0%, with $118.2 million converting into fully amortizing loans partially offset by draws on new and existing commitments. Undisbursed construction commitments totaled $55.4 million at December 31, 2023 compared to $120.7 million at December 31, 2022. Undisbursed construction commitments at December 31, 2023 included $27.9 million of mainly custom one-to-four family residential construction, $22.1 million of multi-family construction, and $5.5 million of commercial real estate construction. Our construction loans are geographically disbursed throughout the state of Washington with one commitment for a property in Oregon. We manage our construction lending primarily 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.
During the year ended December 31, 2023, the Company originated $221.9 million of loans, of which $156.9 million, or 70.80%, were originated in the Puget Sound region; $55.9 million, or 25.20%, in the Olympic Peninsula region; $5.7 million, or 2.60%, in other areas in Washington; and $3.5 million, or 1.60%, in other states. The Company also purchased loans totaling $83.1 million with the largest concentration of these loans located in California.
Loans receivable, excluding loans held for sale, consisted of the following at the dates indicated:
(In thousands)
Real Estate:
Consumer:
Less:
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Our allowance for credit losses on loans increased $1.4 million, or 8.6%, during the year ended December 31, 2023, as a result of our transition from the incurred loss model to CECL and loan growth. Asset quality declined with increases in past due, nonaccrual and classified assets compared to the total loan portfolio. Management continues to closely monitor economic conditions for potential weaknesses that could expose the loan portfolio to losses. The allowance for credit losses on loans as a percentage of total loans was 1.05% at December 31, 2023 and 1.04% at December 31, 2022. We believe our allowance for credit losses on loans is adequate to cover inherent losses in the loan portfolio.
Nonperforming loans increased $16.9 million, or 939.8%, during the year ended December 31, 2023 to $18.6 million. This increase was mainly the result of increases in nonperforming commercial construction of $15.0 million, one-to-four family of $890,000, commercial business of $877,000 and auto and other consumer of $211,000, partially offset by decreases in home equity loans of $73,000 and commercial real estate of $25,000. Nonperforming loans to total loans was 1.12% at December 31, 2023, an increase from 0.12% at December 31, 2022.
At December 31, 2023, 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 $18.2 million, or 107.7%, to $35.1 million at December 31, 2023, from $16.9 million at December 31, 2022. The change in classified loans was mainly the result of a downgrade of a commercial loan relationship totaling $9.3 million involving several commercial real estate and business loans along with downgrades of a $3.6 million SBA loan and a $104,000 commercial business loan during the fourth quarter of 2023. A $15.0 million construction loan, which became a classified loan in the fourth quarter of 2022, and the $9.3 million commercial loan relationship account for 69% of the classified loan balance at December 31, 2023. The Bank continues to work with its borrowers to facilitate satisfactory repayment.
Cash and cash equivalents increased by $77.6 million, or 170.1%, to $123.2 million as of December 31, 2023, compared to $45.6 million at December 31, 2022, as a portion of the proceeds from the sale of investment securities in the fourth quarter of 2023 were held in interest-bearing cash.
Total investment securities decreased $31.0 million, or 9.5%, to $295.6 million at December 31, 2023, from $326.6 million at December 31, 2022. The year-over-year decrease was the result of sales and normal amortization during the year, partially offset by purchases and an improved portfolio market value. During 2023, we repositioned the investment portfolio by selling $44.8 million of available-for-sale securities yielding 2.4% for a total loss of $5.4 million during the period, and purchased $21.1 million of available-for-sale securities yielding 6.7%. The decrease in unrealized loss of $10.3 million relates mainly to a $5.4 million improvement in unrealized losses driven by a decrease in long-term interest rates and $4.9 million of realized losses related to the securities sale.
The estimated average life of the total investment securities portfolio was 7.7 years as of December 31, 2023, compared to 8.2 years as of December 31, 2022, and the average repricing term was approximately 6.3 years as of December 31, 2023, compared to 7.1 years as of December 31, 2022, based on the interest rate environments at those times. Expected duration of the portfolio has decreased to 4.8 years as of December 31, 2023, compared to 5.1 years as of December 31, 2022. We anticipate the investment portfolio will continue to provide additional interest income and act as a source of liquidity.
Mortgage-backed securities represent the largest portion of our investment portfolio and totaled $139.3 million at December 31, 2023, a decrease of $29.6 million, or 17.5% from $169.0 million at December 31, 2022. Municipal bonds are the second largest segment, totaling $87.8 million at December 31, 2023, a decrease of $10.3 million, or 10.5%, from $98.1 million at December 31, 2022. The sale of investment securities during the fourth quarter of 2023 resulted in a shift in the investment mix from mortgage-backed securities, municipal bonds and U.S. Treasury notes toward more U.S. agency and corporate asset-backed securities. Other investment securities totaled $68.5 million at December 31, 2023, an increase of $9.0 million, or 15.0% from $59.6 million at December 31, 2022.At December 31, 2023, the investment portfolio contained 52.0% of amortizing securities, compared to 50.8% at December 31, 2022. 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 may purchase investment securities as a source of additional interest income and in lieu of carrying higher cash balances. 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.
Equity and partnership investments increased to $14.8 million at December 31, 2023, compared to $14.3 million at December 31, 2022, from contributions to existing commitments totaling $608,000 during 2023. Prepaid expenses and other assets decreased $1.5 million to $26.9 million at December 31, 2023, compared to $28.3 million one year ago. The decrease was mainly due to the $1.5 million write-off of the Quil commitment receivable in the fourth quarter of 2023, when the Company determined that Quil was no longer a going concern. Net deferred tax assets decreased $1.0 million from the prior year end as a result of an increase in the fair market value of the investment portfolio.
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Liabilities. Total liabilities increased $154.7 million, or 8.2%, to $2.04 billion at December 31, 2023, from $1.88 billion at December 31, 2022, with increases in deposits and borrowings used mainly to fund loan growth.
Deposit account balances increased $112.6 million, or 7.2%, to $1.68 billion at December 31, 2023 from $1.56 billion at December 31, 2022. Money market accounts decreased $110.8 million and transaction accounts decreased $87.1 million, while savings accounts increased $41.2 million. Retail CDs increased $195.6 million, or 78.9%, to $443.4 million and Brokered CDs increased $73.8 million, or 55.1%, to $207.6 million at December 31, 2023. We believe the current rate environment contributed to greater competition for deposits across the industry during 2023. Our focus continues to be on increasing core customer deposits, with an emphasis on small-to-medium sized business deposits, and maintaining a stable source of funding to reduce interest expense as a percentage of liabilities.
Borrowings increased $35.6 million, or 12.5%, to $320.9 million at December 31, 2023, from $285.4 million at December 31, 2022, as the Bank utilized FHLB overnight funds to maintain on balance sheet liquidity.
Equity. Total shareholders' equity increased $1.8 million, or 1.1%, to $163.3 million at December 31, 2023, from $161.6 million at December 31, 2022. The increase during the year resulted from a $7.9 million reduction in accumulated other comprehensive loss related to an improved unrealized market value of available for sale securities, net of tax, net income of $2.3 million, and an increase of $2.1 million related to share-based compensation plans. These increases were partially offset by a one-time decrease of $3.0 million upon the adoption of CECL, $2.7 million in dividends paid in 2023 and share repurchases of $1.1 million. During the year ended December 31, 2023, we repurchased 87,895 shares of common stock at an average cost of $12.95 per share, pursuant to the Company's 2020 stock repurchase plan.
Comparison of Results of Operations for the Years Ended December 31, 2023 and 2022
General. The Company generated a return on average assets of 0.11%, and a return on average equity of 1.43%, for the year ended December 31, 2023, compared to 0.79% and 9.09%, respectively, for the year ended December 31, 2022. Net income decreased $13.4 million, or 85.4%, compared to 2022. Net interest income declined as increases to interest expense outpaced increases to interest income. Noninterest income was down due to a loss on sale of securities of $5.4 million as well as lower loan and deposit fee, servicing rights and loan sale income. Noninterest expense was lower due to decreased compensation, advertising, data processing, and occupancy expenses. We earned $0.26 per common and diluted share for the year ended December 31, 2023, compared to $1.71 per common and diluted share for the year ended December 31, 2022. The decrease in earnings per share was the result of the decrease in net income as the Bank recognized a loss on sale of securities to reposition the portfolio by paying down higher cost funding and investing in higher yielding loans and securities.
Net Interest Income. Net interest income decreased $8.4 million, or 12.1%, to $61.4 million for the year ended December 31, 2023, from $69.9 million for the year ended December 31, 2022, mainly as the result of additional interest expense related to higher costs on both deposit and advance balances as well as an increase in the average balances of CDs and advances.
The increase in interest income was largely attributable to changes in loans receivable with an average balance increase of $145.5 million, at an average yield of 5.31%, for the year ended December 31, 2023 compared to an average yield of 4.74%, for the year ended December 31, 2022. The interest income earned from higher yields was offset by higher interest-bearing liability costs which increased to 2.42% for the year ended December 31, 2023 compared to 0.73% for the year ended December 31, 2022. This resulted in a 66 basis point decrease in our net interest margin to 3.13% for the year ended December 31, 2023, from 3.79% for the year ended December 31, 2022.
The $1.8 million net increase in interest income from the volume of interest earning assets was offset by the net increase in interest costs of $10.3 million as changes in rates outpaced increases in yields. As noted above, loans receivable was the main contributor to the increase in interest income with $6.9 million due to an increase in average volume and $9.1 million due higher rates. The increase to the cost of average interest-bearing liabilities for the year ended December 31, 2023 was due primarily to costs from higher rates paid of $24.6 million and increased average balances of $4.3 million on advances, certificates of deposit and money market accounts.
Interest Income. Interest income increased $20.5 million, or 25.5%, to $100.9 million for the year ended December 31, 2023 from $80.4 million for the comparable period in 2022, primarily due to an increase in the average balance of and higher yields on loans receivable. Interest and fees on loans receivable increased $16.0 million during the year, in part, as the Bank grew the loan portfolio through single-family, multi-family and commercial real estate lending as well as purchased auto and manufactured home loans. Loan yields also increased due to higher rates on new originations as well as the repricing of variable rate loans tied to the Prime Rate or other indices.
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Interest income on investment securities increased $2.4 million to $13.3 million for the year ended December 31, 2023, compared to $10.9 million for the year ended December 31, 2022. The increase in interest income on investment securities was driven by an increase in the average yield during the year of 108 basis points due to the repricing of variable rate securities and slower prepayment activity reducing the amount of premium amortization during the period.
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 increased $29.0 million, or 275.3%, for the year ended December 31, 2023, compared to the prior year, with increases in borrowing costs and deposit costs of $7.1 million and $21.8 million, respectively. Borrowing costs increased 207 basis points, mainly due to higher rates paid on overnight and short-term borrowings, combined with an increase of $86.0 million in the average balance outstanding. Deposit costs increased due to higher funding costs and an increase of $116.8 million in the average balance of interest-bearing deposits, as we utilized brokered certificates of deposits. The average cost of all interest-bearing deposit products increased 159 basis points to 2.01% for the year ended December 31, 2023 from 0.42% for the year ended December 31, 2022. The average balances of savings and CD accounts increased year-over-year, while lower cost transaction and money market average account balances declined.
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 Credit Losses. The total provision for credit losses decreased $212,000 to $1.3 million during the year ended December 31, 2023, compared to $1.5 million for 2022. A recapture of provision for credit losses on unfunded commitments due to the significant decrease in unfunded construction loan commitments from the initial balance recorded upon the adoption of CECL on January 1, 2023, was recorded during 2023. A higher provision for credit losses on loans compared to 2022 is reflective of loan growth, a change to the life-of-loan loss methodology and an increase in net charge-offs during 2023, which partially offset the unfunded commitments recapture.
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The following table details activity and information related to the allowance for credit losses on loans and reserve for unfunded commitments for the periods shown:
Year Ended December 31,
(Dollars in thousands)
Provision for credit losses on loans $ 2,357 $ 1,535
Charge offs net of recoveries (3,172 ) (543 )
Recapture of provision for credit losses on unfunded commitments $ (1,034 ) $ —
Reserve for unfunded commitments 817 325
Noninterest Income. Noninterest income decreased 61.1% to $4.0 million for the year ended December 31, 2023, from $10.3 million for the year ended December 31, 2022. The decrease compared to the prior year was primarily due to a $5.4 million loss on sale of investment securities during 2023. One-time increases to other income include a gain on sale of Visa, Inc. Class B common stock of $470,000 and $950,000 received from the Splash loan program as a partial reimbursement of program losses incurred by the Bank during 2023. Saleable mortgage loan production and related gains continued to be impacted by higher market rates on mortgage loans compared to the prior year. Fee income in 2023 was impacted by a decrease in late fees on commercial loans. In 2022, a one-time increase was recorded for a BOLI death benefit payment of $1.5 million.
The following table provides an 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 decreased to $61.5 million for the year ended December 31, 2023, from $62.3 million for the year ended December 31, 2022. The year-over-year decrease reflects lower compensation expense, primarily due to lower Bank commissions, payroll taxes, and medical insurance expenses along with a $1.5 million reduction related to Quin Ventures compensation. Other one-time noninterest expenses recorded during 2023 included the Quil commitment receivable write-off of $1.5 million, a write-off of Fannie Mae and Freddie Mac investor accounting related items totaling $725,000, and an accrual for a civil money penalty proposed by the FDIC of $718,000. The FDIC proposed assessing a civil money penalty in connection with the concerns detailed in a consent order entered into by the Bank during 2023.
Quin Ventures non-compensation expenses included for the year ended December 31, 2023, totaled $320,000 compared to $2.7 million in the year ended December 31, 2022, as a result of decreases in advertising, depreciation and data processing expenses. The full amount of Quin Ventures activity was reported in noninterest income and noninterest expense under the controlling interest method of accounting. The proportional noncontrolling interest amount was then subtracted from net income. This resulted in noncontrolling interest net losses of $160,000 and $2.1 million being added back to net income for the years ended December 31, 2023 and 2022, respectively.
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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, 2023, was $549,000 compared to $2.9 million for the year ended December 31, 2022, reflecting differences in pre-tax income. The effective tax rate increased over the prior year as a result of the permanent tax exclusion of BOLI noninterest income, including the BOLI death benefit, in 2022.
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Average Balances, Interest and Average Yields/Cost
The following table sets 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, 2023 and 2022. Income and all average balances are daily average balances. Nonaccrual loans have been included in the table as loans carrying a zero yield.
Year Ended December 31,
Interest-earning assets: (Dollars in thousands)
Interest-bearing liabilities:
Other noninterest-bearing liabilities 37,967 36,666
Net interest rate spread 2.71 3.63
(1) The average loans receivable, net balances include nonaccrual loans.
(2) Interest earned on loans receivable includes net deferred costs of $561,000 for the year ended December 31, 2023, and net deferred fees of $1.7 million, including $377,000 of deferred fee income from SBA Paycheck Protection Plan loans, for the year ended December 31, 2022.
(3) Includes interest-bearing deposits at other financial institutions.
(4) Cost of all deposits, including noninterest-bearing demand deposits, was 1.66% and 0.33% for the years ended December 31, 2023 and 2022.
(5) Net interest income divided by average interest-earning assets.
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Rate/Volume Analysis
The following table presents 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 component, 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.
Increase (Decrease) Due to Total Increase
Volume Rate (Decrease)
(In thousands)
Interest-earning assets:
Interest-bearing liabilities:
Interest-bearing demand deposits $ (15 ) $ 674 $ 659
Subordinated debt, net 1 — 1
(1) Includes net deferred fee income.
(2) Includes interest-bearing deposits 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.
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, or the Term Secured Overnight Financing Rate ("TSOFR") 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.
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.
The Bank employs 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 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 400 basis point increase or a 100 to 400 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 Bank's balance sheet became more liability sensitive in 2023 due to slower loan prepayment speeds, driven by higher interest rates and deposit migration from non-maturity deposits to certificates of deposits with shorter average lives.
The following table presents the change in the present value of First Fed’s equity at December 31, 2023, 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, 2023, is as follows:
Basis Point Change Projected Net Interest Income
in Interest Rates $ Amount $ Change % Change
(Dollars in thousands)
Management makes assumptions about 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 our analysis. 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 forgoing the table.
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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 investment security principal and interest payments, deposit inflows, brokered deposits, loan repayments, maturities, 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 holdings of 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, 2023, cash and cash equivalents totaled $123.2 million and securities classified as available-for-sale had a market value of $295.6 million. We have pledged loan collateral with principal balances totaling $896.2 million to support borrowings from the FHLB of $275.0 million, with a remaining borrowing capacity of $589.5 million. We have also pledged collateral of $6.6 million and $15.2 million, respectively, to the Federal Reserve Bank of San Francisco to secure discount window and Bank Term Funding Program advances; the Company has performed periodic borrowing tests on these lines with the Federal Reserve; however, no such funds were borrowed as of December 31, 2023. First Northwest maintains a $20.0 million line of credit with NexBank, with an available borrowing capacity of $13.5 million at year end, which is secured by First Northwest's personal property assets (with certain exclusions), including all the outstanding shares of First Fed, cash, loans receivable, and limited partnership investments.
At December 31, 2023, we had $220,000 in loan commitments outstanding and an additional $148.2 million in undisbursed loans, including undisbursed construction commitments, and standby letters of credit. The Company also had unfunded partnership commitments totaling $3.7 million.
Customer CDs due within one year as of December 31, 2023, totaled $349.4 million, or 53.7% of total CDs. Brokered CDs due within one year as of December 31, 2023, totaled $146.2 million, or 22.5% of total CDs. Management believes a significant portion of our customer CDs will be renewed or rolled into new certificates of deposit given the current rate environment. If these maturing deposits are not renewed or rolled into other deposit products, we will seek other sources of funds, which may include borrowings and brokered deposits. We also 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. Depending on market conditions, we may pay higher rates on borrowings or brokered deposits than we currently pay on standard certificates of deposit or promotional rate offerings. However, rates on these sources of funds may also be less than what the market demands for customer deposits. We believe relationships 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 sufficient short- and 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.
First Fed has a diversified deposit base with approximately 60% of deposit account balances held by consumers, 28% held by business and public fund depositors, and 12% in brokered deposits. The average deposit account balance, excluding brokered and public fund accounts, was $27,000 at December 31, 2023. We estimate that 20-25% of our retail customer deposit balances are over the $250,000 FDIC insurance limit, representing less than 5% of deposit customers. Management believes that maintaining a diversified deposit base is an important factor in managing liquidity.
The Company is a separate legal entity from the Bank and relies on dividends from its subsidiary, First Fed Bank, the NexBank line of credit and future investment redemptions for liquidity to pay its operating expenses and other financial obligations. At December 31, 2023, the Company (on an unconsolidated basis) had liquid assets of $500,000.
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, 2023, we engaged in no off-balance sheet transactions likely to have a material effect on our financial condition, results of operations or cash flows.
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Commitments and Off-Balance Sheet Arrangements
The following table summarizes our commitments and contingent liabilities with off-balance sheet risks as of December 31, 2023:
Amount of Commitment Expiration
(In thousands)
Commitments to originate loans:
Fixed-rate loans $ 220 $ — $ — $ — $ 220
Unfunded commitments under existing maritime loans — — — 1,650 1,650
Standby letters of credit — — — 200 200
Unfunded commitments under partnership agreements 3,659 — — — 3,659
Capital Resources
First Northwest Bancorp is a financial holding company (a type of 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 12 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.
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, 2023, 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, 2023, the Bank and consolidated Company exceeded all regulatory capital requirements, and the Bank was considered "well capitalized" under FDIC regulatory capital guidelines.
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The following table provides the capital requirements and actual results at December 31, 2023.
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.
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 88
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Report of Independent Registered Public Accounting Firm
The Shareholders and Board of Directors
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, 2023 and 2022, 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, 2023 and 2022, and the consolidatedresults 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.
Change in Accounting Principle
As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for credit losses effective January 1, 2023, due to the adoption of Accounting Standards Codification Topic 326, Financial Instruments - Credit Losses (Topic 326). The Company adopted the new credit loss standard using the modified retrospective approach such that prior period amounts are not adjusted and continue to be reported in accordance with previously applicable generally accepted accounting principles. The new credit loss standard is also communicated a a critical audit matter below.
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 audits, we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting in accordance with the standards of the PCAOB. Accordingly, we express no such opinion.
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Our audits included performing procedures to assess the risks of material misstatement of the consolidatedfinancial 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 audits 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 audits provide 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.
Allowance for Credit Losses on Loans
As described in Notes 1 and 4 to the consolidated financial statements, the Company's consolidated allowance for credit losses on loans (ACLL) balance was $17.5 million at December 31, 2023. The ACLL is a valuation account that is deducted from the amortized cost of loans receivable to present the net amount expected to be collected. Management's estimate of the ACLL uses relevant available information, from internal and external sources, relating to past events, current conditions, and reasonable and supportable forecasts.
We identified management’s application of historical losses including reasonable and supportable forecasts of future economic conditions in the discounted cash flow model, and management’s estimation of qualitative risk factors, which are both components of the ACLL calculation, as a critical audit matter. Baseline loss rates are calculated using peer institution data related to historical losses. Historical losses are adjusted for management’s consideration of the forecasted direction of the economic and business environment. The Company also considers other qualitative risk factors to adjust the estimated ACLL.
The primary procedures we performed to address this critical audit matter included:
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/s/ Moss Adams LLP
Everett, Washington
March 15, 2024
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 295,623 326,569
Federal Home Loan Bank (FHLB) stock, at cost 13,664 11,681
Servicing rights on sold loans, at fair value 3,793 3,887
Goodwill and other intangible assets 1,086 1,089
LIABILITIES AND SHAREHOLDERS' EQUITY
Accrued expenses and other liabilities 35,973 32,344
Advances from borrowers for taxes and insurance 1,260 1,376
Commitments and Contingencies (Note 14)
Shareholders' Equity
Accumulated other comprehensive loss, net of tax (32,636 ) (40,543 )
Unearned employee stock ownership plan (ESOP) shares (7,253 ) (7,913 )
Noncontrolling interest in Quin Ventures, Inc. — (3,291 )
See accompanying notes to the consolidated financial statements.
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FIRST NORTHWEST BANCORP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)
For the Year Ended December 31,
INTEREST INCOME
Interest and fees on loans receivable $ 84,614 $ 68,635
Interest-bearing deposits and other 2,126 375
INTEREST EXPENSE
PROVISION FOR CREDIT LOSSES
Provision for credit losses on loans 2,357 1,535
Recapture of provision for credit losses on unfunded commitments (1,034 ) —
Net interest income after provision for credit losses 60,109 68,328
NONINTEREST INCOME
Sold loan servicing fees and servicing rights mark-to-market 676 867
Net gain on sale of loans 438 824
Net (loss) gain on sale of investment securities (5,397 ) 118
Increase in cash surrender value of bank-owned life insurance, net 928 916
Income from death benefit on bank-owned life insurance, net — 1,489
NONINTEREST EXPENSE
Supplies, postage, and telephone 1,433 1,376
Regulatory assessments and state taxes 1,635 1,539
Income before provision for income taxes 2,675 16,343
Provision for income taxes 549 2,847
Net income attributable to parent $ 2,286 $ 15,645
Basic and diluted earnings per common share $ 0.26 $ 1.71
See accompanying notes to the consolidated financial statements.
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FIRST NORTHWEST BANCORP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In thousands)
For the Year Ended December 31,
Other comprehensive income (loss):
Net actuarial gains (losses) on defined benefit ("DB") plan assets 397 (509 )
Amortization of unrecognized DB plan prior service cost 150 147
Unrealized holding losses on derivatives (1,054 ) —
Income tax benefit related to unrealized holding losses on derivatives 226 —
Other comprehensive income (loss), net of tax 7,907 (40,831 )
Comprehensive income (loss) attributable to parent $ 10,193 $ (25,186 )
See accompanying notes to the consolidated financial statements.
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FIRST NORTHWEST BANCORP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(In thousands, except share data)
Shares Amount Capital Earnings Shares Net of Tax Interest Equity
Restricted stock award grants net of forfeitures 22,470 — — —
Restricted stock awards canceled (21,302 ) — (392 ) — (392 )
Other comprehensive loss, net of tax (40,831 ) (40,831 )
Reclassification resulting from change in accounting method, net of tax 425 425
Quin Ventures asset sale in-substance distribution — — — — (661 ) (661 )
ESOP shares committed to be released 293 659 952
Cash dividends declared and paid ($0.28 per share) (2,787 ) (2,787 )
Restricted stock award grants net of forfeitures 16,856 — — —
Restricted stock awards canceled (20,666 ) — (280 ) (280 )
Other comprehensive income, net of tax 7,907 7,907
Close out investment in Quin Ventures (3,451 ) 3,451 —
ESOP shares committed to be released 32 660 692
Cash dividends declared and paid ($0.28 per share) (2,700 ) (2,700 )
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 $ 2,126 $ 13,496
Adjustments to reconcile net income to net cash from operating activities:
Depreciation and amortization 1,612 1,960
Amortization of core deposit intangible 3 94
Amortization of debt issuance costs 78 78
Change in fair value of sold loan servicing rights 243 (13 )
Additions to servicing rights on sold loans, net (149 ) (54 )
Provision for credit losses on loans 2,357 1,535
Recapture of provision for credit losses on unfunded commitments (1,034 ) —
Deferred federal income taxes, net 134 (1,529 )
Allocation of ESOP shares 692 673
Share-based compensation expense 1,413 1,601
Gain on sale of loans, net (438 ) (824 )
Loss (gain) on sale of securities available for sale, net 5,397 (118 )
Increase in cash surrender value of life insurance, net (928 ) (916 )
Income from death benefit on bank-owned life insurance, net — (1,489 )
Origination of loans held for sale (25,612 ) (25,926 )
Change in assets and liabilities:
Increase in accrued interest receivable (1,151 ) (1,454 )
Decrease (increase) in prepaid expenses and other assets 1,293 (3,938 )
Increase in accrued interest payable 2,941 62
Increase in accrued expenses and other liabilities 2,270 3,104
Net cash provided by operating activities 17,875 15,902
Cash flows from investing activities:
Purchase of securities available for sale (20,330 ) (78,409 )
Proceeds from sales of securities available for sale 40,619 12,685
Early surrender of bank-owned life insurance policy 15 —
Purchase of premises and equipment, net (1,571 ) (2,914 )
Capital contributions to equity investments (608 ) (7,364 )
Capital disbursements from equity and partnership agreements 759 —
Capital contributions to historic tax credit partnerships — (1,829 )
Net cash used by investing activities (84,194 ) (237,647 )
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:
Net increase (decrease) in deposits $ 112,637 $ (16,325 )
Proceeds from long-term FHLB advances 15,000 —
Repayment of long-term FHLB advances (15,000 ) —
Net (decrease) increase in line of credit (5,500 ) 12,000
Restricted stock awards canceled (280 ) (392 )
Repurchase of common stock (1,149 ) (5,439 )
Net increase (decrease) in cash and cash equivalents 77,573 (80,420 )
Cash and cash equivalents at beginning of period 45,596 126,016
Cash and cash equivalents at end of period $ 123,169 $ 45,596
Supplemental disclosures of cash flow information:
Cash paid for interest on deposits and borrowings $ 36,526 $ 10,453
Supplemental disclosures of noncash investing activities:
Change in unrealized loss on securities available for sale $ 10,287 $ (51,322 )
Change in unrealized loss on fair value hedge (1,054 ) —
Lease liabilities arising from obtaining right-of-use assets 152 —
Investment in Meriwether Group, LLC acquired through issuance of shares — 1,869
See accompanying notes to the consolidated financial statements.
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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, 2023, First Northwest had allocated 439,174 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, Peace of Mind, Inc. ("POM"), and Quin Ventures, Inc. ("Quin" or "Quin Ventures"). First Northwest extended $8.0 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. Quin Ventures sold substantially all of its assets in December 2022 to Quil Ventures, Inc. ("Quil"), at which time POM returned the 29,719 shares previously issued and the joint venture agreement was terminated. As part of the sale transaction, the Company received a 5% ownership stake in Quil valued at $225,000 and recorded a $1.5 million commitment receivable. In June 2023, First Northwest determined that Quin Ventures was no longer a going concern. The Company wrote off the remaining investment in Quin Ventures through retained earnings in accordance with applicable non-controlling interest accounting methods. The noncontrolling interest in Quin Ventures balance was moved to retained earnings, with no change to total shareholders' equity as a result of the transaction. In December 2023, the Company determined that Quil was no longer a going concern, making the collectability of the receivable from and investment in Quil unlikely. As result, the related investment of $225,000 and commitment receivable of $1.5 million were written off during the fourth quarter of 2023, impacting other noninterest income and other noninterest expense, respectively.
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.
On August 5, 2022, First Northwest's election to be treated as a financial holding company became effective, allowing the Company to engage in non-banking activities that are financial in nature or incidental to financial activities.
First Northwest and the Bank are collectively referred to as the "Company." For periods prior to June 30, 2023, Company references also include Quin Ventures.
First Northwest's business activities generally are limited to passive investment activities and oversight of its investments in First Fed and former controlling interest in Quin Ventures. Accordingly, the information set forth in this report, including the consolidated financial statements and related data, relates primarily to the Bank for balance sheet related disclosures and the Bank and Quin Ventures for income statement related disclosures.
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The Bank is a community-oriented financial institution providing commercial and consumer banking services to individuals and businesses primarily 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.
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 credit losses, fair value of financial instruments, deferred tax assets and liabilities, and the valuation of collateral dependent 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 former controlling interest in Quin Ventures, Inc. All material intercompany accounts and transactions have been eliminated in consolidation. Through June 2023, First Northwest and POM shared equal ownership in Quin Ventures; however, it was previously determined that First Northwest had a controlling interest for financial reporting purposes under Accounting Standards Codification 810. As a result, 100% of Quin Ventures balances, excluding intercompany activity, are reported in the consolidated financial statements presented. The Quin Ventures net loss allocable to POM is shown on the financial statements thorough a noncontrolling interest adjustment where applicable.
Subsequent events - The Company has evaluated subsequent events for potential recognition and 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, 2023 and 2022. First Fed was in compliance with its reserve requirements at December 31, 2023 and 2022.
Investment securities - Investments in debt 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, 2023 and 2022. 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, 2023 and 2022.
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 the need for an allowance for credit losses on investment securities ("ACLI") on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For investment securities available for sale in an unrealized loss position, the Company first assesses whether it intends to sell, or it is more likely than not that it will be required to sell the security before the recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the security’s amortized cost basis is written down to fair value through income. For investment securities available for sale that do not meet the aforementioned criteria, the Company evaluates whether the decline in fair value has resulted from credit losses or other factors. In making this assessment, management considers the extent to which fair value is less than amortized cost, any changes to the rating of the security by a rating agency and adverse conditions specifically related to the security, among other factors. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an ACLI is recorded for the credit loss, limited by the amount that the fair value is less than the amortized cost basis. Any decline in fair value that has not been recorded through an ACLI is recognized in other comprehensive income (loss). Changes in the ACLI are recorded as provision, or recapture of provision, for credit losses expense. Losses are charged against the allowance when management believes the uncollectibility of an investment security available for sale is confirmed or when either of the criteria regarding intent or requirement to sell is met. Accrued interest receivable on investment securities available for sale is excluded from the estimate of credit losses as interest accrued, but not received, is reversed timely in accordance with the policy for investment securities 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, 2023 and 2022, First Fed’s minimum investment requirement was approximately $13.7 million and $11.7 million, respectively. First Fed was in compliance with the FHLB minimum investment requirement at December 31, 2023 and 2022. 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 a loss on its FHLB stock at December 31, 2023 and 2022.
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 credit losses on loans (ACLL) 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.
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.
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Problem loans are monitored and a portion or all of the balance is charged off when collectability is sufficiently questionable that the Bank can no longer justify showing the loan as an asset on the balance sheet. To determine if a loan should be charged off, all possible sources of repayment are analyzed. Possible sources of repayment include the potential for future cash flow, the value of the Bank’s collateral, and the strength of co-makers or guarantors. When these sources do not add up to a reasonable probability that the loan can be collected, charge off is processed.
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 credit losses (applicable to 2023) - On January 1, 2023, the Company adopted Financial Accounting Standards Board ("FASB") ASU 2016-13 Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, as amended, which replaces the incurred loss methodology with a current expected credit loss ("CECL") methodology. The allowance for credit losses on loans ("ACLL") is a valuation account that is deducted from the amortized cost of loans receivable to present the net amount expected to be collected. Loans are charged against the allowance when management believes the collectability of a loan balance is unlikely. Subsequent recoveries, if any, are credited to the allowance. The Bank records the changes in the ACLL through earnings, as a provision for credit losses on the Consolidated Statements of Income. Accrued interest receivable on loans receivable is excluded from the estimate of credit losses. Instead, interest accrued, but not received, is reversed timely in accordance with the policy for loans receivable above.
The Company has identified segments of loans with similar risk characteristics for which it then applies one of two loss methodologies. Management has adopted a discounted cash flow ("DCF") methodology for most of its segments to calculate the ACLL. For certain segments with smaller portfolios or where data is prohibitive to running a DCF calculation, management has elected to use a remaining life methodology. The Company will evaluate individual loans for expected credit losses when those loans do not share similar risk characteristics with loans evaluated using a collective (pooled) basis. The allowance for individually evaluated loans is calculated using the collateral value method, which considers the likely source of repayment as the value of the collateral, less estimated costs to sell, or another method such as the cash flow method, which considers the contractual principal and interest terms and estimated cash flows available from the borrower to satisfy the debt. When the cash flow method is used, cash flows are discounted back by the effective interest rate and compared to the total recorded investment. If the present value of cash flows is less than the total recorded investment, a reserve is calculated.
For each loan segment collectively measured, the baseline loss rates are calculated using peer institution data from FFIEC Call Report filings. The Bank evaluates the historical period on a quarterly basis. The baseline loss rates are applied to each loan's estimated cash flows over the life of the loan to determine the baseline loss estimate for each loan. Estimated cashflows consider the principal and interest in accordance with the contractual term of the loan and estimated prepayments. Contractual cashflows are based on the amortized cost, as adjusted for balances guaranteed by governmental entities, such as the Small Business Administration ("SBA") or the United States Department of Agriculture ("USDA"), or the unguaranteed amortized cost. The contractual term excludes expected extensions, renewals, and modifications unless either of the following applies: 1) management has a reasonable expectation at the reporting date that a modification agreement will be executed with an individual borrower or 2) the extension or renewal options are included in the original or modified contract at the reporting date and are not unconditionally cancellable by the Company. Prepayments are established for each segment based on historical averages for the segments, which management believes is an accurate representation of future prepayment activity. Management reviews the adequacy of the prepayment period assumption on a quarterly basis.
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The CECL methodology includes consideration of the forecasted direction of the economic and business environment and its likely impact to the estimated allowance as compared to the historical losses over the reasonable and supportable time frame. Economic forecast models for the current period are uploaded to the model, which targets two forecasted macroeconomic factors, which are national gross domestic product ("GDP") and unemployment figures. Each of the forecasted DCF segments is impacted by these macroeconomic factors. Further, each of the macroeconomic factors is utilized differently by segment, including the application of lagged factors and various transformations such as percent change year over year.
The Bank uses the Federal Open Market Committee ("FOMC") forecast via an application programming interface with our CECL software. FOMC provides various forecast scenarios used to determine the loan portfolio’s expected credit loss. Based on known/knowable information at the measurement date, management has determined that the FOMC scenarios and the underlying assumptions most closely align with current and expected conditions. The Bank has elected to forecast the firstfour quarters of the credit loss estimate and revert on a straight-line basis as permitted in ASC 326-20-30-9. The Bank also considers other qualitative risk factors to adjust the estimated ACLL calculated by the above-mentioned model. While there are many factors available to incorporate into the quantitative model, the Bank has selected to use the most critical factors. Additional metrics will be included only if internal or external factors outside those considered in its historical losses or macroeconomic forecast indicate otherwise. The Bank has established metrics to estimate the qualitative risk factor by segment based on the identified risk.
In general, management's estimate of the ACLL uses relevant available information, from internal and external sources, relating to past events, current conditions, and reasonable and supportable forecasts. The allowance for credit losses on loans evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. While management utilizes its best judgment and information available to recognize losses on loans, future additions to the allowance may be necessary based on further declines in local and national economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s ACLL. Such agencies may require the Bank to make adjustments to the allowance based on their judgments about information available to them at the time of their examinations. The Company believes the ACLL at December 31, 2023, is appropriate given the above considerations.
Allowance for loan losses (applicable to 2022 and prior years) - Prior to the implementation of CECL, First Fed maintained 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 included 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 were also considered for calculation of the allowance. The appropriateness of the allowance for loan losses was estimated based upon these factors and trends identified by management at the time the consolidated financial statements were prepared.
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.
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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.