Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 7 of our Annual Report on Form 10-K generally discusses year-to-year comparisons between the years ended December 31, 2020 and 2019. Discussions of comparisons between 2019 and 2018 are not included in this Form10-K but can be found in “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form10-K for the year ended December 31, 2019.
Management’s discussion and analysis is presented to aid the reader in understanding and evaluating the financial condition and results of operations of Southern National. This discussion and analysis should be read with the consolidated financial statements, the footnotes thereto, and the other financial data included in this report.
COVID-19 PANDEMIC
In March 2020, the World Health Organization declared COVID-19 as a global pandemic. This public health crisis has resulted in unprecedented uncertainty, volatility and disruption in financial markets and in governmental, commercial and consumer activity in the United States and globally, including the markets that we serve. In response to the crisis, the Board of Governors of the Federal Reserve reduced benchmark federal fund interest rates to near zero. In addition, in March 2020, the CARES Act was enacted. The CARES Act contains substantial tax and spending provisions intended to address the financial impact of the COVID-19 pandemic.
The COVID-19 pandemic has resulted in significant health, economic and other major consequences throughout the communities the Company serves, as well as nationally and globally. The Company has implemented a number of procedures in response to the pandemic to support the safety and well-being of our employees, customers and shareholders that continue through the date of this report:
The Company continues to closely monitor the pandemic and expects to make future changes to respond to the pandemic as it evolves.
CRITICAL ACCOUNTING POLICIES
Our accounting policies are in accordance with U.S. GAAP and with general practices within the banking industry. Management makes a number of estimates and assumptions relating to reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during periods presented. Different assumptions in the application of these methods or policies could result in material changes in our financial statements. As such, the following policies are considered “critical accounting policies” for us.
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Allowance for Credit Losses (“ACL”)
The allowance for credit losses on loans is a contra-asset valuation account, calculated in accordance with ASC 326 that is deducted from the amortized cost basis of loans to present the net amount expected to be collected. The amount of the allowance represents management's best estimate of current expected credit losses on loans considering available information, from internal and external sources, relevant to assessing collectability over the loans' contractual terms, adjusted for expected prepayments when appropriate. The contractual term excludes expected extensions, renewals and modifications unless (i) management has a reasonable expectation that a trouble debt restructuring will be executed with an individual borrower or (ii) such extension or renewal options are not unconditionally cancellable by us and, in such cases, the borrower is likely to meet applicable conditions and likely to request extension or renewal. Relevant available information includes historical credit loss experience, current conditions and reasonable and supportable forecasts. While historical credit loss experience provides the basis for the estimation of expected credit losses, adjustments to historical loss information may be made for differences in current portfolio-specific risk characteristics, environmental conditions or other relevant factors. The allowance for credit losses is measured on a collective basis for portfolios of loans when similar risk characteristics exist. Loans that do not share risk characteristics are evaluated for expected credit losses on an individual basis and excluded from the collective evaluation. Expected credit losses for collateral dependent loans, including loans where the borrower is experiencing financial difficulty but foreclosure is not probable, are based on the fair value of the collateral at the reporting date, adjusted for selling costs as appropriate.
Credit loss expense related to loans reflects the totality of actions taken on all loans for a particular period including any necessary increases or decreases in the allowance related to changes in credit loss expectations associated with specific loans or pools of loans. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate appropriateness of the allowance is dependent upon a variety of factors beyond our control, including the performance of our loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications.
In calculating the allowance for credit losses, most loans are segmented into pools based upon similar characteristics and risk profiles. Common characteristics and risk profiles include the type/purpose of loan, underlying collateral, geographical similarity and historical/expected credit loss patterns. In developing these loan pools for the purposes of modeling expected credit losses, we also analyzed the degree of correlation in how loans within each portfolio respond when subjected to varying economic conditions and scenarios as well as other portfolio stress factors. For allowance modeling purposes, our loan pools include (i) commercial real estate - owner occupied, (ii) commercial real estate - non-owner occupied, (iii) construction and land development, (iv) commercial, (v) agricultural loans, (vi) residential 1-4 family and (vii) consumer loans. We periodically reassess each pool to ensure the loans within the pool continue to share similar characteristics and risk profiles and to determine whether further segmentation is necessary.
For each loan pool, we measure expected credit losses over the life of each loan utilizing a combination of inputs: (i) probability of default (“PD”), which is the likelihood that loan will stop performing/default, (ii) probability of attrition (“PA”), which is the likelihood that a loan will pay-off prior to maturity, (iii) loss given default (“LGD”), which is the expected loss rate for loans in default and (iv) exposure at default (“EAD”), which is the estimated outstanding principal balance of the loans upon default, including the expected funding of unfunded commitments outstanding as of the measurement date. Inputs are pool-specific, though not necessarily solely reliant on internally-sourced data. Internal data is supplemented by, but not replaced by, peer data when required, primarily to determine the PD input. The various pool-specific inputs may be adjusted for current macroeconomic assumptions, as further discussed below, and other factors such as differences in underwriting standards, portfolio mix, or when historical asset terms do not reflect the contractual terms of the financial assets being evaluated as of the measurement date. Each time we measure expected credit losses, we assess the relevancy of historical information and consider any necessary adjustments to address any differences in current asset-specific characteristics.
Significant macroeconomic variables utilized in our allowance models include, among other things, (i) VA Gross Domestic Product, (ii) VA House Price Index, and (iii) VA unemployment rates. The macroeconomic variables utilized as inputs in forecast modeling were subjected to a variety of analysis procedures and were selected primarily based on
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statistical relevancy and correlation to historical credit losses, where historical credit losses may be fully internally-sourced or supplemented with peer data.
PDs were estimated by analyzing the relationship between the historical performance of each loan pool and historical economic trends over a complete economic cycle. Again, historical performance data is either fully internally-sourced or supplemented with peer data where necessary. PDs are adjusted to reflect the current impact of certain macroeconomic variables as well as their expected changes over a reasonable and supportable forecast period. We have determined that we are reasonably able to forecast the macroeconomic variables used in our forecast modeling processes with an acceptable degree of confidence for a total of four quarters. This forecast period is followed by an additional eight quarter reversion process whereby the forecasted macroeconomic variables are reverted to their historical mean on a straight-line basis. By reverting these economic inputs to their historical mean and considering loan/borrower specific attributes, our allowance models are intended to yield a measurement of expected credit losses that reflects average historical loss rates (which may be supplemented by peer data) for periods subsequent to the initial twelve-quarters consisting of the forecast and reversion periods. The LGD is linked to PD based on benchmark historical loss averages for each loan pool. That is, LGD is dynamic with PD; as PD increases, so will LGD, and vice versa. In this context, “benchmark” refers to the use of third-party data, and “historical loss averages” refers to the fraction of defaulted balance that tends to be lost. By nature of its connection to PD, LGD is by extension adjusted to reflect the current impact of certain macroeconomic variables as well as their expected changes over the four-quarter forecast period and eight-quarter reversion process, which management considers to be both reasonable and supportable. This same forecast/reversion period is used for all macroeconomic variables used in all of our economic forecast models. PA and EAD are estimated using either a Discounted Cash Flow or Remaining Life model, both of which use various timing inputs to estimate the loan balance that remains at various future points in time, and thus also at the time of a default event.
Management qualitatively adjusts allowance model results for risk factors that are not considered within our quantitative modeling processes but are nonetheless relevant in assessing the expected credit losses within our loan pools. These qualitative factor (“Q-Factor”) adjustments may increase or decrease management's estimate of expected credit losses by a calculated percentage or amount based upon the estimated level of risk. The various risks that may be considered in making Q-Factor adjustments include, among other things, the impact of (i) changes in lending policies and procedures, including changes in underwriting standards and practices for collections, write-offs, and recoveries, (ii) actual and expected changes in international, national, regional, and local economic and business conditions and developments that affect the collectability of the loan pools, (iii) changes in the nature and volume of the loan pools and in the terms of the underlying loans, (iv) changes in the experience, ability, and depth of our lending management and staff, (v) changes in volume and severity of past due financial assets, the volume of non-accrual assets, and the volume and severity of adversely classified or graded assets, (vi) changes in the quality of our credit review function, (vii) changes in the value of the underlying collateral for loans that are non-collateral dependent, (viii) the existence, growth, and effect of any concentrations of credit and (ix) other factors such as the regulatory, legal and technological environments; competition; and events such as natural disasters or health pandemics.
In some cases, management may determine that an individual loan exhibits unique risk characteristics which differentiate the loan from other loans within our loan pools. In such cases, the loans are evaluated for expected credit losses on an individual basis and excluded from the collective evaluation. Specific allocations of the allowance for credit losses are determined by analyzing the borrower’s ability to repay amounts owed, collateral deficiencies, the relative risk grade of the loan and economic conditions affecting the borrower’s industry, among other things. A loan is considered to be collateral dependent when, based upon management's assessment, the borrower is experiencing financial difficulty and repayment is expected to be provided substantially through the operation or sale of the collateral. In such cases, expected credit losses are based on the fair value of the collateral at the measurement date, adjusted for estimated selling costs if satisfaction of the loan depends on the sale of the collateral. We reevaluate the fair value of collateral supporting collateral dependent loans on a quarterly basis. The fair value of real estate collateral supporting collateral dependent loans is evaluated by our internal appraisal services using a methodology that is consistent with the Uniform Standards of Professional Appraisal Practice. The fair value of collateral supporting collateral dependent construction loans is based on an “as is” valuation.
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Accounting for Acquired Loans
Southern National has purchased, primarily through acquisitions, individual loans and groups of loans, some of which have shown evidence of credit deterioration since origination. These purchased loans are recorded at fair value such that there is no carryover of the seller’s allowance for credit losses. We adopted ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, on January 1, 2020 which now requires us to record purchased financial assets with credit deterioration (PCD assets), defined as a more-than-insignificant deterioration in credit quality since origination or issuance, at the purchase price plus the allowance for credit losses expected at the time of acquisition. Under this method, there is no credit loss expense affecting net income on acquisition of PCD assets. Changes in estimates of expected credit losses after acquisition are recognized as credit loss expense (or reversal of credit loss expense) in subsequent periods as they arise. Any non-credit discount or premium resulting from acquiring a pool of purchased financial assets with credit deterioration shall be allocated to each individual asset. At the acquisition date, the initial allowance for credit losses determined on a collective basis shall be allocated to individual assets to appropriately allocate any non-credit discount or premium. The non-credit discount or premium, after the adjustment for the allowance for credit losses, shall be accreted to interest income using the interest method based on the effective interest rate determined after the adjustment for credit losses at the adoption date.
A purchased financial asset that does not qualify as a PCD asset is accounted for similar to an originated financial asset. Generally, this means that an entity recognizes the allowance for credit losses for non-PCD assets through net income at the time of acquisition. In addition, both the credit discount and non-credit discount or premium resulting from acquiring a pool of purchased financial assets that do not qualify as PCD assets shall be allocated to each individual asset. This combined discount or premium shall be accreted to interest income using the effective yield method.
Goodwill
Under FASB ASC 350, Intangibles – Goodwill and Other, goodwill is not amortized, but rather tested annually for impairment. Southern National evaluates goodwill for impairment on an annual basis or more frequently if events or circumstances warrant. Our annual assessment occurs during the third calendar quarter. Goodwill totaled $101.9 million at December 31, 2020. There was no impairment recorded for the years ended December 31, 2020, 2019 and 2018.
Valuation of Deferred Tax Asset
The provision for income taxes reflects the tax effects of the transactions reported in the consolidated financial statements, including taxes currently due as well as changes in deferred taxes. Deferred tax assets and liabilities represent estimates of the future tax return consequences of temporary differences between carrying amounts and tax bases of assets and liabilities. Deferred tax assets and liabilities are computed by using currently enacted income tax rates and applying those rates to the periods in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. As of December 31, 2020 and 2019, management concluded that it is more likely than not that Southern National will generate sufficient taxable income to fully utilize our deferred tax assets.
OVERVIEW
Southern National is a corporation that was formed on July 28, 2004 under the laws of the Commonwealth of Virginia and is the holding company for Sonabank, a Virginia state-chartered bank which commenced operations on April 14, 2005. Sonabank provides a range of financial services to individuals and small and medium sized businesses.
At December 31, 2020, Sonabank had forty-two full-service branches in Virginia and Maryland and also provides services to customers through certain internet and mobile applications. Thirty-seven full-service retail branches are in Virginia (Ashland, Burgess, Callao, Central Garage, Charlottesville, Chester, Clifton Forge, Colonial Heights, Courtland, Deltaville, Fairfax, Front Royal, Gloucester, Gloucester Point, Hampton, Hartfield, Heathsville, Kilmarnock, Leesburg, McLean, Mechanicsville (2), Middleburg, Midlothian, New Market, Newport News, Quinton, Reston, Richmond, South Riding, Surry, Tappahannock (2), Urbanna, Warrenton, Waverly, and Williamsburg) and five full-service retail branches are in Maryland (Bethesda, Brandywine, Owings, Rockville, and Upper Marlboro). We have
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administrative offices in Warrenton and Glen Allen, Virginia. Our South Riding branch will be closing effective April 15, 2021.
While we offer a wide range of commercial banking services, we focus on making loans secured primarily by commercial real estate and other types of secured and unsecured commercial loans to small and medium-sized businesses in a number of industries, as well as loans to individuals for a variety of purposes. We are a leading SBA lender among Virginia community banks. We also invest in real estate-related investment securities, including collateralized mortgage obligations and agency mortgage backed securities. Our principal sources of funds for loans and investing in securities are deposits and, to a lesser extent, borrowings. We offer a broad range of deposit products, including checking, NOW, savings, and money market accounts and certificates of deposit. We actively pursue business relationships by utilizing the business contacts of our senior management, other bank officers and our directors, thereby capitalizing on our knowledge of our local market areas.
FINANCIAL HIGHLIGHTS
● Total assets as of December 31, 2020 were $3.09 billion.
● Total deposits increased $307.9 million from the prior year.
RESULTS OF OPERATIONS
Net Income
Net income for the year ended December 31, 2020 was $23.3 million, compared to $33.2 million for the year ended December 31, 2019. The 29.8% decrease in the net income during the year ended December 31, 2020 compared to the year ended December 31, 2019 was primarily driven by higher provision for credit losses in 2020. The decline in net income was also driven by a charge of $4.4 million, net of taxes of salary and benefits expense related to the restructuring of executive management in 2020 and increased staffing in the commercial lending and Panacea Financial divisions along with the modified incentive and bonus plans and increased costs associated with recruitment in 2020. These decreases were partially offset by an increase in equity gain from the Company’s mortgage affiliate driven by higher margins on closed loans and materially higher volumes from refinance activity as well as production from new hires and teams that were on-boarded in 2019. The decline in net income was also offset by a decline in cost of deposits and an increase in recoveries related to acquired charged-off loans and investment securities in the current year.
Net Interest Income
Our operating results depend primarily on our net interest income, which is the difference between interest and dividend income on interest-earning assets such as loans and investments, and interest expense on interest-bearing liabilities such as deposits and borrowings.
Net interest income was $91.6 million for the year ended December 31, 2020, compared to $83.6 million for the year ended December 31, 2019. The increase in net interest income was due to higher levels of average earning assets and as a result of lower costs of funds including deposits and borrowings in 2020. Southern National’s net interest margin for the year ended December 31, 2020 was 3.35%, compared to 3.39% for the year ended December 31, 2019. Net interest margin was impacted heavily by the origination of PPP loans in 2020. Total income on interest-earning assets was
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$117.8 million and $120.5 million for the year ended December 31, 2020 and 2019, respectively. The yield on average interest-earning assets was 4.31% and 4.88% for the year ended December 31, 2020 and 2019, respectively. The decrease was primarily driven by market conditions. Interest and fees on loans totaled $111.6 million and $112.1 million for the year ended December 31, 2020 and 2019, respectively. The accretion of the discount on loans acquired in the acquisitions contributed $4.3 million to net interest income during the year ended December 31, 2020, compared to $3.9 million during the year ended December 31, 2019. The increase in accretion was due to increased acquired loan paydowns and payoffs. Average loans during the year ended December 31, 2020 were $2.40 billion compared to $2.16 billion during the year ended December 31, 2019.
The following table details average balances of interest-earning assets and interest-bearing liabilities, the amount of interest earned/paid on such assets and liabilities, and the yield/rate for the periods indicated:
Average Balance Sheets and Net Interest
Analysis For the Year Ended
Interest Interest Interest
Balance Expense Rate Balance Expense Rate Balance Expense Rate
(Dollar amounts in thousands)
Assets
Interest-earning assets:
Liabilities and stockholders' equity
Interest-bearing liabilities:
Noninterest-bearing liabilities:
Net interest income $ 91,640 $ 83,600 $ 91,066
Interest rate spread 3.10 % 3.04 % 3.47 %
Net interest margin 3.35 % 3.39 % 3.72 %
(2) Calculations include non-accruing loans in average loan amounts outstanding.
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The following table summarizes changes in net interest income attributable to changes in the volume of interest-earning assets and interest-bearing liabilities compared to changes in interest rates. The change in interest, due to both rate and volume, has been proportionately allocated between rate and volume.
Year Ended Year Ended
Increase (Decrease) Increase (Decrease)
Due to Change in: Due to Change in:
Net Net
Volume Rate Change Volume Rate Change
(in thousands)
Interest-earning assets:
Interest-bearing liabilities:
Savings accounts 62 (33) 29 (50) — (50)
Provision for Credit Losses
The provision for credit losses is a current charge to earnings made in order to adjust the allowance for credit losses to an appropriate level for inherent probable losses in the loan portfolio based on an evaluation of the loan portfolio, current economic conditions, changes in the nature and volume of lending, historical loan experience and other known internal and external factors affecting loan collectability. Our allowance for credit losses is calculated by segmenting the loan portfolio by loan type and applying risk factors to each segment. The risk factors are determined by considering historical loss data, peer data, as well as applying management’s judgment.
The Company elected to defer adoption of CECL until the earlier of the termination date of the current national emergency, declared on March 31, 2020, under the National Emergencies Act in connection with the COVID-19 outbreak, or December 31, 2020. The Company adopted ASU 2016-13 effective January 1, 2020 and implemented as of December 31, 2020, resulting in a gross cumulative effect adjustment of $8.3 million. The provision for credit losses for the years ended December 31, 2020, 2019 and 2018 was $19.5 million, $350 thousand and $4.2 million, respectively. We had charge-offs totaling $2.3 million during 2020, $3.3 million during 2019 and $3.1 million during 2018. There were recoveries totaling $685 thousand during 2020, $906 thousand during 2019 and $1.8 million during 2018.
The Financial Condition Section of Management’s Discussion and Analysis provides information on our loan portfolio, past due loans, nonperforming assets and the allowance for credit losses.
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Noninterest Income
The following tables present the major categories of noninterest income for the years ended December 31, 2020, 2019 and 2018 (in thousands):
For the Year Ended
December 31,
Account maintenance and deposit service fees $ 6,520 $ 7,159 $ (639)
Income from bank-owned life insurance 1,559 1,699 (140)
Account maintenance and deposit service fees $ 7,159 $ 5,959 $ 1,200
Income from bank-owned life insurance 1,699 1,983 (284)
Equity loss from mortgage affiliate 1,191 (894) 2,085
Gain on sales of investment securities — — —
Noninterest income increased 102% to $25.5 million for the year ended December 31, 2020, compared to $12.6 million for the year ended December 31, 2019. The $12.9 million increase was primarily driven by a $9.6 million increase in equity gain from the Company’s mortgage affiliate and $5.0 million increase in recoveries related to acquired charged-off loans and investment securities. Equity gain from the Company’s mortgage affiliate increased $9.6 million driven by higher margins on closed loans and materially higher volumes from refinance activity as well as production from new hires and teams that were on-boarded in 2019. The increase was also attributable to a recovery related to a previously charged-off acquired loan of approximately $2.0 million during 2020. These increases were partially offset by a decrease of $639 thousand in account maintenance and deposit service fees primarily in account service charges and non-sufficient funds fee. Income from bank-owned life insurance decreased $140 thousand due to death benefits paid in 2019.
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Noninterest Expense
The following tables present the major categories of noninterest expense for the years ended December 31, 2020, 2019 and 2018 (in thousands):
For the Year Ended
December 31,
Furniture and equipment expenses 2,725 2,719 6
Amortization of core deposit intangible 1,364 1,418 (54)
Telephone and communication expense 1,497 1,615 (118)
Net (gain) loss on other real estate owned 960 (38) 998
Furniture and equipment expenses 2,719 2,795 (76)
Amortization of core deposit intangible 1,418 1,445 (27)
FDIC assessment — — —
Telephone and communication expense 1,615 2,035 (420)
Amortization of FDIC indemnification asset —
Net (gain) loss on other real estate owned (38) 360 (398)
Noninterest expenses were $67.7 million during the year ended December 31, 2020, compared to $56.6 million during the year ended December 31, 2019. The 19.7% increase in noninterest expenses was primarily due to an increase in employee compensation and benefits expense, higher legal and professional fees and higher data processing expense, partially offset by lower other operating expenses. Employee compensation and benefits expense totaled $36.7 million and $26.3 million for the year ended December 31, 2020 and 2019, respectively. The increase was associated with a pre-tax management restructuring expense of $5.6 million in 2020 and increased staffing in the commercial lending and Panacea Financial divisions along with the modified incentive and bonus plans and increased costs associated with recruitment in 2020. The increase in noninterest expense during the year ended December 31, 2020 was also attributable to a $1.1 million increase in professional fees driven by higher consulting and legal services and a $797 thousand increase in data processing expense. We also recorded net loss of $960 thousand on other real estate owned for the year ended December 31, 2020 compared to a net gain of $38 thousand for the year ended December 31, 2019. The decrease in other operating expenses was driven by a pre-tax nonrecurring loss of $3.2 million with related legal expense of $502 thousand during 2019 that did not recur, partially offset by increased expenses associated with our pending name change and rebranding efforts.
FINANCIAL CONDITION
Balance Sheet Overview
Total assets were $3.09 billion as of December 31, 2020 and $2.72 billion as of December 31, 2019. Total loans increased 11.6%, from $2.19 billion at December 31, 2019 to $2.44 billion at December 31, 2020, with loan growth in
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2020 primarily due to PPP loan originations. Excluding PPP loans, loans outstanding decreased $65.0 million, or 3.0%, since December 31, 2019. Total deposits were $2.43 billion at December 31, 2020 compared to $2.12 billion at December 31, 2019 and total equity was $390.6 million and $377.2 million at December 31, 2020 and December 31, 2019, respectively.
Loans
Total loans, net of deferred fees were $2.44 billion and $2.19 billion at December 31, 2020 and 2019, respectively. Loan growth in 2020 was primarily due to PPP loan originations, which totaled $319.4 million at December 31, 2020. Excluding PPP loans, loans outstanding decreased $65.0 million, or 3.0%, since December 31, 2019. As of December 31, 2020, we had $122.0 million of loans on deferral, or 5.75% of total loans excluding PPP loans. Hotel loans account for 58.9% of all deferrals with 27.1% of the hotel portfolio deferred at December 31, 2020.
As of December 31, 2020 and 2019, substantially all of our loans were to customers located in Virginia and Maryland. We are not dependent on any single customer or group of customers whose insolvency would have a material adverse effect on operations.
The following table summarizes the composition of our loans, net of unearned income, at December 31 for the years indicated (in thousands):
Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent
Loans secured by real estate:
PCD loans 8,908 0.4 %
Total loans 2,444,526 100.0 %
The following table sets forth the contractual maturity ranges of the construction and land development and commercial loan portfolios and the amount of those loans with fixed and floating interest rates in each maturity range as of December 31, 2020 (in thousands):
After 1 Year
Through 5 Years After 5 Years
One Year Fixed Floating Fixed Floating
or Less Rate Rate Rate Rate Total
Asset Quality; Past Due Loans and Nonperforming Assets
Asset quality remained solid during 2020. The outbreak of COVID-19 and resulting economic instability has had and will likely continue to have an impact on our asset quality, but it is currently unknown to what extent. We will generally place a loan on nonaccrual status when it becomes 90 days past due. Loans will also be placed on nonaccrual status in
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cases where we are uncertain whether the borrower can satisfy the contractual terms of the loan agreement. Cash payments received while a loan is categorized as nonaccrual will be recorded as a reduction of principal as long as doubt exists as to future collections. We defer COVID-impacted loans to end of the deferral date and track delinquency from end of that new deferral date. During the third and fourth quarter of 2020, the Company saw a substantial amount of deferred loans return to traditional loan terms.
We maintain appraisals on loans secured by real estate, particularly those categorized as nonperforming loans and potential problem loans. In instances where appraisals reflect reduced collateral values, we make an evaluation of the borrower’s overall financial condition to determine the need, if any, for impairment or write-down to their fair values. If foreclosure occurs, we record OREO at the lower of our recorded investment in the loan or fair value less our estimated costs to sell.
Our loss and delinquency experience on our loan portfolio has been limited by a number of factors, including our underwriting standards and the relatively short period of time since the loans were originated. Whether losses and delinquencies in our portfolio will increase significantly depends upon the value of the real estate securing the loans and economic factors, such as the overall economy in our market area, including as a result of the impact of COVID-19.
The following table presents a comparison of nonperforming assets as of December 31, for the years indicated (in thousands):
December 31, December 31, December 31, December 31, December 31,
Loans past due 90 days and accruing interest — — — — —
Allowance for credit losses to total loans 1.52 % 0.47 % 0.57 % 0.46 % 0.95 %
(2) Included non-covered loans and non-covered assets.
Not included in the table above are $122.0 million of loans that were subject to COVID-related deferrals at December31, 2020. Some of these loans may become potential problem loans in 2021.
OREO at December 31, 2020 was $3.1 million, compared to $6.2 million at December 31, 2019. The decrease was primarily driven by sale of properties and write-downs on OREO during 2020.
Loans acquired in a transaction covered under an FDIC loss-share agreement expired on December 31, 2019 and therefore any references to “non-covered” loans do not apply to any periods after December 31, 2019. Nonaccrual loans were $14.5 million (excluding $3.1 million of loans fully covered by SBA guarantees) at December 31, 2020, compared to $4.8 million (non-covered and excluding $4.1 million of loans fully covered by SBA guarantees) at December 31, 2019, an increase of 202%. The ratio of non-covered nonperforming assets (excluding the SBA guaranteed loans) to total non-covered assets was 0.41% at December 31, 2019 and the ratio of nonperforming assets (excluding the SBA guaranteed loans) to total assets was 0.47% at December 31, 2020, an increase of 6 basis points.
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At December 31, 2020, our total substandard loans totaled $44.6 million. Included in the total substandard loans were SBA guarantees of $2.3 million. Special mention loans totaled $30.0 million at December 31, 2020.
As of December 31, 2020, there were seven TDR loans in the amount of $987 thousand primarily due to the economic impact of COVID-19. There have been no defaults of TDRs modified during the past twelve months.
We identify potential problem loans based on loan portfolio credit quality. We define our potential problem loans as our classified/criticized loans less total nonperforming loans noted above. At December 31, 2020, our potential problem loans totaled $30.2 million.
Allowance for Credit Losses
We are very focused on the asset quality of our loan portfolio, both before and after the loan is made. We have established underwriting standards that we believe are effective in maintaining high credit quality in our loan portfolio. We have experienced loan officers who take personal responsibility for the loans they underwrite, a standing credit committee that reviews each loan application carefully, and a requirement that loans over $1.5 million must be approved by the Executive Credit Committee consisting of the President and CEO, Chief Credit Officer, Chief Credit Risk Officer, Chief SBA Lending Officer, Director of Small Business and Consumer Lending, and the Commercial Credit Risk Officer. Loans in the amount of $20.0 million to legal lending limit are approved by the full Board of Directors or two outside directors. Loans up to $500 thousand must be approved by one regular and one Senior member of our standing Credit Committee, loans in the amount of $500 thousand to $1.5 million must be approved by one regular, one Senior and one executive member (President and CEO or Chief Credit officer) of our standing Credit Committee.
Our allowance for credit losses is established through charges to earnings in the form of a provision for credit losses. Management evaluates the allowance at least quarterly. In addition, on a quarterly basis our board of directors reviews our loan portfolio, evaluates credit quality, reviews the loan loss provision and the allowance for credit losses and makes changes as may be required. In evaluating the allowance, management and the board of directors consider the growth, composition and industry diversification of the loan portfolio, historical loan loss experience, current delinquency levels and all other known factors affecting loan collectability.
The allowance for credit losses is based on the CECL methodology and represents management’s estimate of an amount appropriate to provide for expected credit losses in the loan portfolio in the normal course of business. This estimate is based on historical credit loss information adjusted for current conditions and reasonable and supportable forecasts applied to various loan types that compose our portfolio, including the effects of known factors such as the economic environment within our market area will have on net losses. The allowance is also subject to regulatory examinations and determination by the regulatory agencies as to the appropriate level of the allowance.
Our loan review program is administrated by the Chief Credit Risk Officer who reports the results directly to the Audit Committee of the Board of Directors. The Bank’s credit policy specifies that “Internal Loan review is responsible for performing a full scope review and written report of loans with a total dollar commitment amount equal to 30% of commercial loans outstanding at the previous year-end including Construction and Development, Nonfarm nonresidential (CRE) and commercial and Industrial. External loan review is responsible for reviewing 50% of the same portfolio at previous year end based on a judgmental sample including loans internally reviewed, and classified and criticized loans. On a combined basis loan reviews on at least 80% of the specified portfolio of loans outstanding at prior year end.” In 2020, internal loan review performed loan reviews on loans and commitments totaling 12.8% of this loan portfolio outstanding as of December 31, 2019. An independent third party consultant performed loan reviews on 68.74% of this portfolio. In 2020, internal and external loan reviews were performed on 81.54% of the specified portfolio of loans. In 2020 we plan to have the independent third-party consultant review loans and commitments totaling at least 50% of the loan portfolio outstanding as of December 31, 2020, and another 30% reviewed internally. Loan reviews totaling at least 80% of the specified commercial loan portfolio outstanding at December 31, 2020 will be performed. The purpose of loan review by a third-party is to validate management’s assessment of risk of the individual loans in the portfolio and to determine whether the loan was approved, underwritten and is being monitored in accordance with the Bank’s credit policy and regulatory guidance. Management’s risk assessment of individual loans
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takes into consideration among other factors, the estimated value of the underlying collateral, the borrower’s ability to repay, the borrower’s payment history and current payment status.
The following table sets forth the allowance for credit/loan losses allocated by loan category and the percent of loans in each category to total loans at the dates indicated (in thousands):
As of December 31,
PCD loans 2,394 0.4 % — — % — — % — — % — — %
Unallocated allowance — 174 564 — 746
(2) Includes home equity lines of credit.
The following table presents an analysis of the allowance for credit losses for the periods indicated (in thousands):
For the Years Ended December 31,
Provision charged to operations:
Adoption of ASC 326 8,292 — — — —
Recoveries credited to allowance:
Real estate - construction, land and other — — — 1 121
Loans charged off:
Real estate - construction, land and other — — — — 449
(2) Includes home equity lines of credit.
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In 2020, we had loan charge-offs totaling $2.3 million, compared to $3.3 million in 2019.
We believe that the allowance for credit losses at December 31, 2020 is sufficient to absorb probable incurred credit losses in our loan portfolio based on our assessment of all known factors affecting the collectability of our loan portfolio. Our assessment involves uncertainty and judgment; therefore, the adequacy of the allowance for credit losses cannot be determined with precision and may be subject to change in future periods. In addition, bank regulatory authorities, as part of their periodic examination, may require additional charges to the provision for credit losses in future periods if the results of their reviews warrant additions to the allowance for credit losses.
Investment Securities
Our investment securities portfolio provides us with required liquidity and investment securities to pledge as collateral to secure public deposits, certain other deposits, a line of credit for advances from the FHLB of Atlanta, and repurchase agreements.
Our investment securities portfolio is managed by our executive vice chairman and our treasurer, both of whom have significant experience in this area, with the concurrence of our Asset/Liability Committee. In addition to our executive vice chairman (who is the chairman of the Asset/Liability Committee) and our Controller, this committee is comprised of outside directors and other senior officers of the Bank, including but not limited to our executive chairman, our chief executive officer and our chief financial officer. Investment management is performed in accordance with our investment policy, which is approved annually by the Asset/Liability Committee and the Board of Directors. Our investment policy addresses our investment strategies, approval process, approved securities dealers and authorized investments. Our investment policy authorizes us to invest in:
● Collateralized mortgage obligations
● U.S. Treasury securities
● SBA guaranteed loan pools
● Agency securities
● Obligations of states and political subdivisions
● Other corporate debt securities rated Aa3/AA- or better at purchase
MBS are securities that have been developed by pooling a number of real estate mortgages and which are principally issued by agency/government-sponsored entities (“GSEs”) such as the GNMA, FNMA and FHLMC. These securities are deemed to have high credit ratings, and minimum regular monthly cash flows of principal and interest are guaranteed by the issuing agencies.
Unlike U.S. Treasury and U.S. government agency securities, which have a lump sum payment at maturity, MBS provide cash flows from regular principal and interest payments and principal prepayments throughout the lives of the securities. MBS which are purchased at a premium will generally suffer decreasing net yields as interest rates drop because homeowners tend to refinance their mortgages. Thus, the premium paid must be amortized over a shorter period. Conversely, MBS purchased at a discount will obtain higher net yields in a decreasing interest rate environment. As interest rates rise, the opposite will generally be true. During a period of increasing interest rates, fixed rate MBS do not tend to experience heavy prepayments of principal, and consequently the average life of these securities will be lengthened. If interest rates begin to fall, prepayments will generally increase.
Collateralized mortgage obligations (“CMOs”) are bonds that are backed by pools of mortgages. The pools can be GNMA, FNMA or FHLMC pools or they can be private-label pools. The CMOs are designed so that the mortgage collateral will generate a cash flow sufficient to provide for the timely repayment of the bonds. The mortgage collateral
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pool can be structured to accommodate various desired bond repayment schedules, provided that the collateral cash flow is adequate to meet scheduled bond payments. This is accomplished by dividing the bonds into classes to which payments on the underlying mortgage pools are allocated. The bond’s cash flow, for example, can be dedicated to one class of bondholders at a time, thereby increasing call protection to bondholders. In private-label CMOs, losses on underlying mortgages are directed to the most junior of all classes and then to the classes above in order of increasing seniority, which means that the senior classes have enough credit protection to be given the highest credit rating by the rating agencies.
Obligations of states and political subdivisions (municipal securities) are purchased with consideration of the current tax position of the Bank. In-state (Virginia) municipal bonds will be favored when they present better relative value than comparable out-of-state municipal bonds. Both taxable and tax-exempt municipal bonds may be purchased, but only after careful assessment of the market risk of the security. Appropriate credit evaluation must be performed prior to purchasing municipal bonds.
Southern National’s corporate bonds consist of pooled trust preferred securities issued by banks, thrifts and insurance companies as well as senior subordinated notes issued by banks. The collateral pools of these trust preferred securities must be at least 80% banks or thrifts, if the rating at the time of purchase is A3/A- or better. If the rating is Aaa/AAA, the collateral pool must be at least 60% banks or thrifts. These securities generally have a long term (25 years or more), allow early redemption by the issuers, make periodic variable interest payments and mature at face value. Trust preferred securities allow the deferral of interest payments for up to five years.
We classify our investment securities as either held to maturity or available for sale. Debt investment securities that Southern National has the positive intent and ability to hold to maturity are classified as held to maturity and carried at amortized cost. Investment securities classified as available for sale are those debt securities that may be sold in response to changes in interest rates, liquidity needs or other similar factors. Investment securities available for sale are carried at fair value, with unrealized gains or losses net of deferred taxes, included in accumulated other comprehensive income (loss) in stockholders’ equity. Investment securities totaling $40.7 million were in the held to maturity portfolio at December 31, 2020, compared to $72.5 million at December 31, 2019. Investment securities totaling $153.2 million were in the available for sale portfolio at December 31, 2020, compared to $164.8 million at December 31, 2019. During 2020 and 2019, $38.9 million and $45.1 million, respectively, of available for sale investment securities and $15.2 million and $15.3 million, respectively, of held to maturity investment securities were purchased. During 2020, $1.9 million and $1.7 million, respectively, of available for sale investment securities and held to maturity investment securities were sold. No investment securities were sold during 2019.
During 2020, we sold all the pooled trust preferred investment securities.
We recognized no credit impairment charges related to credit losses during 2020 or 2019.
Investment securities in our portfolio as of December 31, 2020 were as follows:
● corporate bonds in the amount of $15.1 million;
● commercial mortgage-backed securities in the amount of $30.2 million;
● SBA loan pool securities in the amount of $11.4 million;
● callable agency securities in the amount of $11.1 million;
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Moody's Amount Standard & Poor's Amount
Rating (in thousands) Rating (in thousands)
Baa1 — BBB+ —
For additional information regarding investment securities refer to “Item 8. Financial Statements and Supplementary Data, Note 2-Investment Securities.”
The following table sets forth a summary of the investment securities portfolio as of the dates indicated. Available for sale investment securities are reported at fair value, and held to maturity investment securities are reported at amortized cost (in thousands).
December 31,
Available for sale securities:
Trust preferred securities — 2,568 2,641
Held to maturity investment securities:
Obligations of states and political subdivisions 9,594 15,071 21,496
Trust preferred securities — 1,938 2,610
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The following table sets forth the amortized cost, fair value, and weighted average yield of our investment securities by contractual maturity at December 31, 2020. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties (in thousands).
Investment Securities Available for Sale
Weighted
Amortized Average
Cost Fair Value Yield
Obligations of states and political subdivisions
Due after one year through five years $ 2,341 $ 2,486 2.70 %
Due after five years through ten years 8,253 8,631 2.84 %
Corporate securities
Due after one year through five years 2,000 2,004 5.77 %
Due after five years through ten years 11,000 11,065 4.67 %
Government-sponsored agency securities
Due after one year through five years 1,500 1,566 2.00 %
Residential government-sponsored mortgage-backed securities
Due after one year through five years 6,334 6,731 2.46 %
Due after five years through ten years 1,453 1,509 2.06 %
Residential government-sponsored collateralized mortgage obligations
Due after five years through ten years 8,229 8,451 1.40 %
Agency commercial mortgage-backed securities
Due after five years through ten years 4,197 4,368 1.74 %
SBA pool securities
Due after one year through five years 234 233 2.61 %
Due after five years through ten years 4,622 4,697 2.30 %
Investment Securities Held to Maturity
Weighted
Amortized Average
Cost Fair Value Yield
Obligations of states and political subdivisions
Due after one year through five years 1,963 2,052 2.46 %
Due after five years through ten years 2,183 2,231 3.03 %
Government-sponsored agency securities
Residential government-sponsored mortgage-backed securities
Due after five years through ten years 1,503 1,556 2.01 %
Residential government-sponsored collateralized mortgage obligations
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Deposits and Other Borrowings
The market for deposits is competitive. We offer a line of traditional deposit products that currently include noninterest-bearing and interest-bearing checking (or NOW accounts), commercial checking, money market accounts, savings accounts and certificates of deposit. We compete for deposits through our banking branches with competitive pricing, advertising and online banking. We use deposits as a principal source of funding for our lending, purchasing of investment securities and for other business purposes.
Total deposits increased 14.5% to $2.43 billion at December 31, 2020 from $2.12 billion at December 31, 2019. Noninterest-bearing demand deposits increased from a year-end 2019 level of $339.2 million to $440.7 million as of December 31, 2020. Time deposits decreased from $783.0 million to $490.0 million and savings accounts increased from $144.5 million to $183.8 million over the same period. As of December 31, 2020, we had brokered certificates of deposit in the amount of $270 thousand and brokered money market deposits of $55.2 million. At December 31, 2019, we had brokered certificates of deposit in the amount of $114.1 million, and we had brokered money market deposits of $24.4 million.
The following table sets forth the average balance and average rate paid on each of the deposit categories for the years ended December 31, 2020, 2019 and 2018:
Average Average Average Average Average Average
Balance Rate Balance Rate Balance Rate
(in thousands)
Interest-bearing deposits:
The variety of deposit accounts we offer allows us to be competitive in obtaining funds and in responding to the threat of disintermediation (the flow of funds away from depository institutions such as banking institutions into direct investment vehicles such as government and corporate securities). Our ability to attract and maintain deposits, and the effect of such retention on our cost of funds, has been, and will continue to be, significantly affected by the general economy and market rates of interest.
The following table sets forth the maturities of certificates of deposit of $100 thousand and over as of December 31, 2020 (in thousands):
3 Months Months Months Months Total
We use borrowed funds to support our liquidity needs and to temporarily satisfy our funding needs from increased loan demand and for other shorter term purposes. We are a member of the FHLB and are authorized to obtain advances from the FHLB from time to time as needed. The FHLB has a credit program for members with different maturities and interest rates, which may be fixed or variable. We are required to collateralize our borrowings from the FHLB with our FHLB stock and other collateral acceptable to the FHLB. At December 31, 2020 and 2019, total FHLB borrowings were $100.0 million and $121.6 million, respectively. At December 31, 2020, we had $689.1 million of unused and available FHLB lines of credit.
Other borrowings can consist of FHLB convertible advances, FHLB overnight advances, other FHLB advances maturing within one year, federal funds purchased and securities sold under agreements to repurchase (“repo”) that
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mature within one year, which are secured transactions with customers. The balance in repo accounts at December 31, 2020 and 2019 was $16.1 million and $12.9 million, respectively.
Other borrowings consist of the following (in thousands):
December 31,
FHLB convertible advances maturing 3/1/2030 $ 100,000 $ — $ —
FHLB overnight advances — 81,000 5,500
Short-term FHLB advances maturing 3/10/2020 — 40,640 —
Short-term FHLB advances maturing 6/27/2019 — — 40,000
Short-term FHLB advances maturing 6/18/2019 — — 27,200
Short-term FHLB advances maturing 6/12/2019 — — 10,000
Short-term FHLB advances maturing 6/11/2019 — — 80,640
Weighted average interest rate at year end 3.55 % 1.75 % 2.68 %
Average interest rate during the year 0.89 % 2.30 % 1.91 %
Junior Subordinated Debt and Senior Subordinated Notes
The Company has $10.3 million of trust preferred securities that were issued on September 17, 2003 and placed through a Trust in a pooled underwriting totaling approximately $650 million. The trust issuer invested the total proceeds from the sale of the trust preferred securities in Floating Rate Junior Subordinated Deferrable Interest Debentures (“Junior Subordinated Debt”). At December 31, 2020 and 2019, we had $9.7 million and $9.6 million, respectively, of Junior Subordinated Debt outstanding. The trust preferred securities pay cumulative cash distributions quarterly at a variable rate per annum, reset quarterly, equal to the three-month LIBOR plus 2.95%. As of December 31, 2020 and 2019, the interest rate was 3.18% and 4.85%, respectively. The dividends paid to holders of the trust preferred securities, which are recorded as interest expense, are deductible for income tax purposes.
The trust preferred securities may be included in Tier 1 capital for regulatory capital adequacy determination purposes up to 25% of Tier 1 capital after its inclusion. At December 31, 2020, all of the trust preferred securities qualified as Tier 1 capital.
Subject to certain exceptions and limitations, Southern National is permitted to elect from time to time to defer regularly scheduled interest payments on its outstanding Junior Subordinated Debt relating to its trust preferred securities. If Southern National defers interest payments on the Junior Subordinated Debt for more than 20 consecutive quarters, Southern National would be in default under the governing agreements for such notes and the amount due under such agreements would be immediately due and payable.
On January 20, 2017, Southern National completed the sale of $27.0 million of its fixed-to-floating rate Subordinated Notes due 2027 (the “SNBV Senior Subordinated Notes”). The SNBV Senior Subordinated Notes will initially bear interest at 5.875% per annum until January 31, 2022; thereafter, the SNBV Senior Subordinated Notes will be payable at an annual floating rate equal to three-month LIBOR plus a spread of 3.95% until maturity or early redemption. At December 31, 2020, all of the SNBV Senior Subordinated Notes qualified as Tier 2 capital.
In 2017, the Company assumed the Senior Subordinated Note Purchase Agreement dated April 22, 2015 with certain institutional accredited investors, pursuant to which $20.0 million in aggregate principal amount of its 6.50% Fixed-to-
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Floating Rate Subordinated Notes due 2025 was sold to the investors. At December 31, 2020, 80% of the Senior Subordinated Notes qualified as Tier 2 capital. On February 1, 2021, 100% of the notes were redeemed.
On August 25, 2020, Southern National completed the sale of $60.0 million of its fixed-to-floating rate Subordinated Notes due 2030 (the “SNBV Subordinated Notes”). The SNBV Subordinated Notes will bear interest at an initial rate of 5.40% per annum, payable semi-annually in arrears on March 1 and September 1 of each year, commencing on March 1, 2021. From and including September 1, 2025 to, but excluding the maturity date or the date of earlier redemption (the “floating rate period”), the interest rate will reset quarterly to an annual interest rate equal to the Benchmark Rate, which is expected to be three-month Term SOFR, plus 531 basis points for each quarterly interest period during the floating rate period, payable quarterly in arrears on March 1, June 1, September 1, and December 1 of each year, commencing on December 1, 2025. Notwithstanding the foregoing, in the event that the Benchmark Rate is less than zero, the Benchmark Rate shall be deemed to be zero. At December 31, 2020, all of the SNBV Subordinated Notes qualified as Tier 2 capital.
Interest Rate Sensitivity and Market Risk
We are engaged primarily in the business of investing funds obtained from deposits and borrowings into interest-earning loans and investments. Consequently, our earnings depend to a significant extent on our net interest income, which is the difference between the interest income on loans and other investments and the interest expense on deposits and borrowings. To the extent that our interest-bearing liabilities do not reprice or mature at the same time as our interest-earning assets, we are subject to interest rate risk and corresponding fluctuations in net interest income. Our Asset-Liability Committee (“ALCO”) meets regularly and is responsible for reviewing our interest rate sensitivity position and establishing policies to monitor and limit exposure to interest rate risk. The policies established by the ALCO are reviewed and approved by our Board of Directors. We have employed asset/liability management policies that seek to manage our net interest income, without having to incur unacceptable levels of credit or investment risk.
We use simulation modeling to manage our interest rate risk, and review quarterly interest sensitivity. This approach uses a model which generates estimates of the change in our economic value of equity (“EVE”) over a range of interest rate scenarios. EVE is the present value of expected cash flows from assets, liabilities and off-balance sheet contracts using assumptions about estimated loan prepayment rates, reinvestment rates and deposit decay rates.
The following tables are based on an analysis of our interest rate risk as measured by the estimated change in EVE resulting from instantaneous and sustained parallel shifts in the yield curve (plus 400 basis points or minus 100 basis points, measured in 100 basis point increments) as of December 31, 2020 and 2019. All changes are within our Asset/Liability Risk Management Policy guidelines except for the change resulting from the 100 basis point decrease in interest rates at December 31, 2020 and 2019.
Sensitivity of Economic Value of Equity
Economic Value of
Economic Value of Equity Equity as a % of
Change in Interest Rates $ Change % Change Total Equity
in Basis Points (Rate Shock) Amount From Base From Base Assets Book Value
(dollar amounts in thousands)
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Sensitivity of Economic Value of Equity
Economic Value of
Economic Value of Equity Equity as a % of
Change in Interest Rates $ Change % Change Total Equity
in Basis Points (Rate Shock) Amount From Base From Base Assets Book Value
(dollar amounts in thousands)
Our interest rate sensitivity is also monitored by management through the use of a model that generates estimates of the change in the net interest income (“NII”) over a range of interest rate scenarios. NII depends upon the relative amounts of interest-earning assets and interest-bearing liabilities and the interest rates earned or paid on them. In this regard, the model assumes that the composition of our interest sensitive assets and liabilities existing at December 31, 2020 and 2019 remains constant over the period being measured and also assumes that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration to maturity or repricing of specific assets and liabilities. All changes are within our ALM Policy guidelines at December 31, 2020 and 2019.
Sensitivity of Net Interest Income
Adjusted Net Interest Income Net Interest Margin
Change in Interest Rates $ Change % Change
in Basis Points (Rate Shock) Amount From Base Percent From Base
(dollar amounts in thousands)
Sensitivity of Net Interest Income
Adjusted Net Interest Income Net Interest Margin
Change in Interest Rates $ Change % Change
in Basis Points (Rate Shock) Amount From Base Percent From Base
(dollar amounts in thousands)
Certain shortcomings are inherent in the methodology used in the above interest rate risk measurements. Modeling changes in EVE requires the making of certain assumptions that may or may not reflect the manner in which actual yields and costs respond to changes in market interest rates. Accordingly, although the EVE tables and NII tables provide an indication of our interest rate risk exposure at a particular point in time, such measurements are not intended to, and do not, provide a precise forecast of the effect of changes in market interest rates on our net worth and NII. Sensitivity of EVE and NII are modeled using different assumptions and approaches.
Liquidity and Funds Management
The objective of our liquidity management is to ensure the ability to meet our financial obligations. These obligations include the payment of deposits on demand or at maturity, the repayment of borrowings at maturity and the ability to
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fund commitments and other new business opportunities. We obtain funding from a variety of sources, including customer deposit accounts, customer certificates of deposit and payments on our loans and investments. Historically, our level of core deposits has been insufficient to fully fund our lending activities. As a result, we have sought funding from additional sources, including institutional certificates of deposit and the sale of available for sale investment securities. In addition, we maintain lines of credit with the FHLB of Atlanta, federal funds lines of credit with three correspondent banks and utilize securities sold under agreements to repurchase and reverse repurchase agreement borrowings from approved securities dealers. For additional information about borrowings and anticipated principal repayments refer to the discussion about Contractual Obligations below and “Item 8. Financial Statements and Supplementary Data, Note 9 – Securities Sold Under Agreements To Repurchase And Other Short-Term Borrowings and Note 10 – Junior Subordinated Debt and Senior Subordinated Notes.”
We prepare a cash flow forecast on a 30, 60 and 90 day basis along with a one and a two year basis. The projections incorporate expected cash flows on loans, investment securities, and deposits based on data used to prepare our interest rate risk analyses. To estimate loan growth, the projection incorporates the scheduled loan closings in the Loan Pipeline Report along with other management estimates.
During the year ended December 31, 2020, we funded our financial obligations with deposits and borrowings from the FHLB of Atlanta. At December 31, 2020, we had $355.3 million of unfunded lines of credit and undisbursed construction loan funds. The amount of certificate of deposit accounts maturing in less than one year was $369.7 million as of December 31, 2020. Management anticipates that funding requirements for these commitments can be met from the normal sources of funds.
On August 25, 2020, Southern National completed the sale of $60.0 million of its fixed-to-floating rate Subordinated Notes due 2030 (the “SNBV Subordinated Notes”). The SNBV Subordinated Notes will bear interest at an initial rate of 5.40% per annum, payable semi-annually in arrears on March 1 and September 1 of each year, commencing on March 1, 2021. From and including September 1, 2025 to, but excluding the maturity date or the date of earlier redemption (the “floating rate period”), the interest rate will reset quarterly to an annual interest rate equal to the Benchmark rate, which is expected to be three-month Term SOFR plus 531 basis points, for each quarterly interest period during the floating rate period, payable quarterly in arrears on March 1, June 1, September 1, and December 1 of each year, commencing on December 1, 2025. Notwithstanding the foregoing, in the event that the Benchmark rate is less than zero, the Benchmark rate shall be deemed to be zero.
While the Company believes that wholesale funding markets have remained open to us in the economic environment caused by COVID-19, the rates for short term funding have recently been volatile. If funding costs are elevated for an extended period of time, it could have an adverse effect on the Company’s net interest margin. If an extended recession causes a large number of the Company’s deposit customers to withdraw their funds, the Company might become more reliant on volatile or more expensive sources of funding. As of December 31, 2020, Southern National was not aware of any other known trends, events or uncertainties that have or are reasonably likely to have a material impact on our liquidity. As of December 31, 2020, Southern National has no material commitments or long-term debt for capital expenditures.
Capital Resources
Capital management consists of providing equity to support both current and future operations. We and the Bank are subject to risk-based capital adequacy requirements imposed by the Federal Reserve.
See “Item 1. Business, Supervision and Regulation—Capital Requirements.”
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The following table provides a comparison of the leverage and risk-weighted capital ratios of Sonabank at the periods indicated to the minimum and well-capitalized required regulatory standards:
Minimum
Required for
Capital Actual Ratio at
Adequacy To Be Categorized December 31, December 31,
Sonabank
Impact of Inflation and Changing Prices
The financial statements and related financial data presented in this Annual Report on Form 10-K concerning Southern National have been prepared in accordance with U.S. GAAP, which require the measurement of financial position and operating results in terms of historical dollars, without considering changes 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. Unlike most industrial companies, substantially all of the assets and liabilities of a financial institution are monetary in nature. As a result, changes in interest rates have a more significant impact on our performance than do the effects of changes in the general rate of inflation and changes in prices. Interest rates do not necessarily move in the same direction or in the same magnitude as the prices of goods and services. Many factors impact interest rates, including the FRB, inflation, recession, changes in unemployment, the money supply, and international disorder and instability in domestic and foreign financial markets. Like most financial institutions, changes in interest rates can impact our net interest income which is the difference between interest earned from interest-earning assets, such as loans and investment securities, and interest paid on interest-bearing liabilities, such as deposits and borrowings, as well as the valuation of our assets and liabilities.
Our interest rate risk management is the responsibility of the Bank’s Asset/Liability Management Committee (the “Asset/Liability Committee”). The Asset/Liability Committee has established policies and limits for management to monitor, measure and coordinate our sources, uses and pricing of funds. The Asset/Liability Committee makes reports to the board of directors on a quarterly basis.
Seasonality and Cycles
We do not consider our commercial banking business to be seasonal.
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Contractual Obligations
The following table reflects the contractual maturities of our term liabilities as of December 31, 2020. The amounts shown do not reflect contractual interest, early withdrawal or prepayment assumptions.
Contractual Obligations
Less Than One to Three to More Than
One Year Three Years Five Years Five Years Total
(in thousands)
Repurchase agreements 16,065 — — — 16,065
Junior subordinated debt — — — 10,310 10,310
Off-Balance Sheet Arrangements
Southern National is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit and guarantees of credit card accounts. These instruments involve elements of credit and funding risk in excess of the amount recognized in the consolidated balance sheet. Letters of credit are written conditional commitments issued by Southern National to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. We had letters of credit outstanding totaling $15.9 million and $17.7 million as of December 31, 2020 and 2019, respectively.
Our exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and letters of credit is based on the contractual amount of these instruments. We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments. Unless noted otherwise, we do not require collateral or other security to support financial instruments with credit risk.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments are made predominately for adjustable rate loans, and generally have fixed expiration dates of up to three months or other termination clauses and usually require payment of a fee. Since many of the commitments may expire without being completely drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis.
At December 31, 2020 and 2019, we had unfunded lines of credit and undisbursed construction loan funds totaling $355.3 million and $324.8 million, respectively. Virtually all of our unfunded lines of credit and undisbursed construction loan funds are variable rate.
Allowance For Credit Losses - Off-Balance-Sheet Credit Exposures
The allowance for credit losses on off-balance-sheet credit exposures is a liability account, calculated in accordance with ASC 326, representing expected credit losses over the contractual period for which we are exposed to credit risk resulting from a contractual obligation to extend credit. No allowance is recognized if we have the unconditional right to cancel the obligation. Off-balance-sheet credit exposures primarily consist of amounts available under outstanding lines of credit and letters of credit detailed above. For the period of exposure, the estimate of expected credit losses considers both the likelihood that funding will occur and the amount expected to be funded over the estimated remaining life of the commitment or other off-balance-sheet exposure. The likelihood and expected amount of funding are based on historical utilization rates. The amount of the allowance represents management's best estimate of expected credit losses on
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commitments expected to be funded over the contractual life of the commitment. Estimating credit losses on amounts expected to be funded uses the same methodology as described for loans in Note 3 - Loans and Allowance, as if such commitments were funded.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
This information is incorporated herein by reference from “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Annual Report on Form 10-K.
Item 8. Financial Statements and Supplementary Data
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Shareholders and the Board of Directors
Southern National Bancorp of Virginia, Inc.
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated balance sheets of Southern National Bancorp of Virginia, Inc. (the "Company") as of December 31, 2020 and 2019, the related consolidated statements of income and comprehensive income, changes in stockholders’ equity, and cash flows, for each of the three years in the period ended December 31, 2020, and the related notes (collectively referred to as the "financial statements"). In our opinion, based on our audits and the report of the other auditors, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020, in conformity with U.S. generally accepted accounting principles.
We did not audit the financial statements of Southern Trust Mortgage, LLC (“STM”) as of and for the year ended December 31, 2020. STM, an affiliate of the Company, is accounted for as an equity method investment. The Company’s financial statements for the year ended December 31, 2020 reported an equity gain from mortgage affiliate totaling $10.8 million, or approximately 36% of the Company’s income before income taxes. STM’s financial statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for STM, is based solely on the report of the other auditors.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) ("PCAOB"), the Company's internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 16, 2021 expressed an unqualified opinion thereon.
Adoption of New Accounting Standard
As discussed in Note 1 to the financial statements, the Company changed its method of accounting for credit losses effective January 1, 2020 due to the adoption of Accounting Standards Codification (ASC) Topic 326, Financial Instruments – Credit Losses.
Basis for Opinion
These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the 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 financial statements are free of material misstatement, whether due to error or fraud.
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Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits and the report of the other auditors provide a reasonable basis for our opinion.
Critical Audit Matters
The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter(s) below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate.
Allowance for Credit Losses
As described in Notes 1 and 3 to the financial statements, the Company’s allowance for credit losses was $36.3 million at December 31, 2020. As further described in Notes 1 and 3, the Company adopted ASC Topic 326 Financial Instruments – Credit Losses as of January 1, 2020.
The Company’s allowance for credit losses (“ACL”) is measured on a pooling basis when similar risk characteristics exist, and by individually evaluating loans that do not share similar risk characteristics. The Company measures the ACL using a combination of probability of default (PD), probability of attrition (PA), loss given default (LGD), and exposure at default (EAD), calculated based on the application of historical loss experience, and adjusted for a reasonable and supportable forecast. Estimates are qualitatively adjusted for risk factors that are not considered within the quantitative modeling process. Estimating an appropriate allowance requires management to make numerous assumptions about losses that will occur over the remaining contractual life of loans recorded as of the balance sheet date. The most significant judgments in the ACL as of December 31, 2020 include the determination of a reasonable and supportable forecast and the impact of qualitative factors.
We identified the ACL as a critical audit matter. The principal considerations for our determination of the ACL as a critical audit matter included the high degree of judgment and subjectivity relating to management’s determination of reasonable and supportable forecasts and the identification and measurement of the qualitative factors. In turn, auditing management’s judgments regarding credit loss estimates and assumptions, specifically the determination of reasonable and supportable forecasts and qualitative factors involved a high degree of subjectivity and an increased extent of audit effort.
The primary procedures we performed to address this critical audit matter included:
o Completeness and accuracy of input into the model used to determine the ACL.
o The determination of a reasonable and supportable forecast.
o The determination of qualitative factors.
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Goodwill Impairment Assessment
As described in Notes 1 and 7 to the financial statements, the Company’s goodwill balance was $101.9 million at December 31, 2020, which is allocated to the Company’s reporting units. Goodwill is tested for impairment at least annually at the reporting unit level. The determination of the fair value of the reporting units requires management to make significant estimates and assumptions in determining the appropriate valuation methodology and key inputs to the selected methodology.
We identified the Company’s goodwill impairment assessment as a critical audit matter. Management makes estimates and assumptions for each reporting unit. As a result, auditing the reasonableness of management’s significant estimates and assumptions involves a higher degree of judgment and subjectivity.
The primary procedures we performed to address this critical audit matter included:
● We tested key financial data used within the valuation to supporting evidence.
/s/ Dixon Hughes Goodman LLP
We have served as the Company's auditor since 2013.
Greenville, NC
March 16, 2021
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Shareholders and the Board of Directors
Southern National Bancorp of Virginia, Inc.
Opinion on Internal Control Over Financial Reporting
We have audited Southern National Bancorp of Virginia, Inc.’s (the “Company”)’s internal control overfinancial reporting as of December 31, 2020, based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. In our opinion, Southern National Bancorp of Virginia, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated financial statements of Southern National Bancorp of Virginia, Inc. as of December 31, 2020 and 2019, and for each of the three years in the period ended December 31, 2020, and our report dated March 16, 2021, expressed an unqualified opinion on those consolidated financial statements.
Basis for Opinion
The Company's management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
Definition and Limitations of Internal Control Over Financial Reporting
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
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Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ Dixon Hughes Goodman LLP
Greenville, NC
March 16, 2021
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REPORTOFINDEPENDENTREGISTEREDPUBLICACCOUNTINGFIRM
To the Board of Directors
Southern Trust Mortgage, LLC
VirginiaBeach,Virginia
OpinionontheFinancialStatements
We have audited the accompanying balance sheets of Southern Trust Mortgage, LLC (the Company) as of December 31, 2020 and 2019, and the related statements of operations, changes in membersʹ equity, and cash flows for each of the three years in the period ended December 31, 2020, and the related notes (collectively, referred to as the financial statements). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020, in conformity with accounting principles generally accepted in the United States of America.
BasisforOpinion
These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our 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 audits to obtain reasonable assurance about whether the 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. 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. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
CriticalAuditMatters
Critical audit matters are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgements. We determined that there are no critical audit matters.
/s/ Richey,May&Co.,LLP.
WehaveservedasSouthernTrustMortgage,LLC’sauditorsince2014.
Englewood, Colorado
March12,2021
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SOUTHERN NATIONAL BANCORP OF VIRGINIA, INC.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except per share amounts)
December 31, December 31,
ASSETS
Cash and cash equivalents:
Cash and due from financial institutions $ 8,585 $ 7,909
Interest-bearing deposits in other financial institutions 187,600 24,019
Securities available for sale, at fair value 153,233 164,820
Less allowance for credit losses (36,345) (10,261)
Equity method investment in mortgage affiliate 12,652 5,020
Preferred investment in mortgage affiliate 3,305 3,305
Operating lease right-of-use assets 7,511 8,013
Core deposit intangibles, net 5,826 7,191
Accrued interest receivable 19,998 8,210
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest-bearing deposits:
Securities sold under agreements to repurchase - short term 16,065 12,883
Junior subordinated debt - long term 9,682 9,632
Senior subordinated notes - long term 105,647 47,051
Operating lease liabilities 8,238 8,469
Commitments and contingencies (See Note 14)
Stockholders' equity:
Accumulated other comprehensive income 3,485 783
See accompanying notes to consolidated financial statements.
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SOUTHERN NATIONAL BANCORP OF VIRGINIA, INC.
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
(dollars in thousands, except per share amounts)
For the Years Ended December 31,
Interest and dividend income:
Interest and dividends on taxable securities 4,244 5,639 5,752
Interest and dividends on tax exempt securities 486 585 634
Interest and dividends on other earning assets 1,402 2,119 2,308
Interest expense:
Interest on FRB borrowings 424 — —