Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This discussion and analysis reviews our consolidated financial statements and other relevant statistical data and is intended to enhance your understanding of our financial condition and results of operations. The information in this section has been derived from the Consolidated Financial Statements and footnotes thereto that appear in Item 8 of this Form 10-K. The information contained in this section should be read in conjunction with these Consolidated Financial Statements and footnotes and the business and financial information provided in this Form 10-K.
Overview
FS Bancorp, Inc. and its subsidiary bank, 1st Security Bank of Washington have been serving the Puget Sound area since 1936. Originally chartered as a credit union, known as Washington’s Credit Union, the credit union served various select employment groups. On April 1, 2004, the credit union converted to a Washington state-chartered mutual savings bank. On July 9, 2012, the Bank converted from mutual to stock ownership and became the wholly owned subsidiary of FS Bancorp, Inc.
The Company is relationship-driven, delivering banking and financial services to local families, local and regional businesses and industry niches within distinct Western Washington communities, predominately, the Puget Sound area, and one loan production office located in the Tri-Cities, Washington.
The Company also maintains its long-standing indirect consumer lending platform which operates throughout the West Coast. The Company emphasizes long-term relationships with families and businesses within the communities served, working with them to meet their financial needs. The Company is also actively involved in community activities and events within these market areas, which further strengthens our relationships within those markets.
The Company focuses on diversifying revenues, expanding lending channels, and growing the banking franchise. Management remains focused on building diversified revenue streams based upon credit, interest rate, and concentration risks. Our business plan remains as follows:
● Growing and diversifying our loan portfolio;
● Maintaining strong asset quality;
● Expanding the Company’s markets.
The Company is a diversified lender with a focus on the origination of one-to-four-family loans, commercial real estate mortgage loans, second mortgage or home equity loan products, consumer loans, including indirect home improvement (“fixture secured”) loans which also include solar-related home improvement loans, marine lending, and commercial business loans. As part of our expanding lending products, the Company experienced growth in residential mortgage and commercial construction warehouse lending consistent with our business plan to further diversify revenues. Historically, consumer loans, in particular, fixture secured loans had represented the largest portion of the Company’s loan portfolio and had traditionally been the mainstay of the Company’s lending strategy. At December 31, 2020, consumer loans represented 23.8% of the Company’s total gross loan portfolio, down slightly from 24.1% at December 31, 2019, due in part to growth in real estate and commercial business loans during the year ended December 31, 2020. In recent years, the Company has placed more of an emphasis on real estate lending products, such as one-to-four-family loans, commercial real estate loans, construction and development loans, including speculative residential construction loans, as well as commercial business loans, while growing the current size of the consumer loan portfolio. At December 31, 2020, real estate loans represented 58.8% of the Company’s total gross loan portfolio.
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Fixture secured loans to finance window, gutter, siding replacement, solar panels, pools, and other improvement renovations are a large and regionally expanding segment of the consumer loan portfolio. These fixture secured consumer loans are dependent on the Bank’s contractor/dealer network of 143 active dealers located throughout Washington, Oregon, California, Idaho, Colorado, Arizona, Nevada, and Minnesota with four contractor/dealers responsible for 39.2% of the funded loans dollar volume for the year ended December 31, 2020. The Company funded $185.7 million, or approximately 8,000 loans during the year ended December 31, 2020. The following table details fixture secured loan originations by state for the periods indicated:
For the Twelve Months Ended For the Twelve Months Ended
State Amount Percent Amount Percent
Nevada 1,222 0.6 — —
Minnesota 918 0.5 — —
The Company originates one-to-four-family residential mortgage loans through referrals from real estate agents, financial planners, builders, and from existing customers. Retail banking customers are also an important source of the Company’s loan originations. The Company originated $1.87 billion of one-to-four-family loans which includes loans held for sale, loans held for investment, and fixed seconds in addition to loans brokered to other institutions of $10.1 million through the home lending segment during the year ended December 31, 2020, of which $1.64 billion were sold to investors. Of the loans sold to investors, $1.48 billion were sold to the FNMA, FHLMC, FHLB, and/or GNMA with servicing rights retained for the purpose of further developing these customer relationships. At December 31, 2020, one-to-four-family residential mortgage loans held for investment, which excludes loans held for sale of $166.4 million, totaled $311.1 million, or 19.8%, of the total gross loan portfolio.
For the year ended December 31, 2020, there were higher volumes of refinances and sales of one-to-four-family homes, compared to the prior years’ surge in construction loans due to lower housing inventories. Residential construction and development lending, while not as common as other options like one-to-four-family loans, will continue to be an important element in our total loan portfolio, and we will continue to take a disciplined approach by concentrating our efforts on loans to builders and developers in our market areas known to us. These short-term loans typically mature in six to twelve months. In addition, the funding is usually not fully disbursed at origination, thereby reducing our net loans receivable in the short-term.
The Company is significantly affected by prevailing economic conditions, as well as government policies and regulations concerning, among other things, monetary and fiscal affairs. Deposit flows are influenced by a number of factors, including interest rates paid on time deposits, other investments, account maturities, and the overall level of personal income and savings. Lending activities are influenced by the demand for funds, the number and quality of lenders, and regional economic cycles. Sources of funds for lending activities include primarily deposits, including brokered deposits, borrowings, payments on loans, and income provided from operations.
The Company’s earnings are primarily dependent upon net interest income, the difference between interest income and interest expense. Interest income is a function of the balances of loans and investments outstanding during a given period and the yield earned on these loans and investments. Interest expense is a function of the amount of deposits and borrowings outstanding during the same period and interest rates paid on these deposits and borrowings. The significant 150 basis point reduction in the targeted federal funds rate during the quarter ended March 31, 2020, resulted in a larger impact to our interest-earning assets than to our interest-bearing liabilities, thereby decreasing our net interest margin to 4.02% for the year ended December 31, 2020, as compared to 4.53% for the year ended December 31, 2019. In addition, our net interest margin was adversely impacted by the low loan yields from the PPP loan portfolio. The continuing low
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interest rate environment is expected to continue to put downward pressure on loan yields and the yields on other floating rate interest earning assets as well. Further because the length of the COVID-19 pandemic and the efficacy of the extraordinary measures being put in place to address its economic consequences are unknown, including the 150 basis point reductions in the targeted federal funds rate in March 2020, until the pandemic subsides the Company expects its net interest income and net interest margin will be adversely affected in 2021 and possibly longer.
Another significant influence on the Company’s earnings is fee income from mortgage banking activities. The Company’s earnings are also affected by the provision for loan losses, service charges and fees, gains from sales of assets, operating expenses and income taxes. The Company recorded a provision of $13.0 million for the year ended December 31, 2020, compared to $2.9 million for the same period one year ago, due primarily to the incurred but not yet experienced probable loan losses reflecting credit deterioration due to the adverse impact of the COVID-19 pandemic, the increase in the loan portfolio due to organic growth, and net loan charge-offs.
Highlights in Response to the COVID-19 Pandemic
Due to the current global situation surrounding the COVID-19 pandemic, the Company is offering a variety of relief options designed to support our customers and the communities we serve.
Paycheck Protection Program ("PPP") Participation. In response to the COVID-19 pandemic, the Bank is committed to providing assistance to its customers. Under the CARES Act, as a qualified SBA lender, the Company was automatically authorized to originate PPP loans upon commencement of the program in April 2020. The PPP program initially concluded on August 8, 2020. At December 31, 2020, the Company had 423 PPP loans totaling $62.1 million for customers who are small- to mid-size businesses as well as independent contractors, sole proprietors and partnerships as allowed under the PPP guidance issued in April 2020. The CAA 2021 renewed and extended the PPP until March 31, 2021 by authorizing an additional $284.5 billion for the program. As a result, in January 2021, the Bank began accepting and processing loan applications under this second PPP program. The SBA has recently released a simplified forgiveness process for PPP loans of $150,000 or less. At December 31, 2020, the Bank held 352 of PPP loans of $150,000 or less with a combined balance of $16.6 million. We will also continue working with our customers to assist them with accessing other borrowing options, including SBA and other government sponsored lending programs, as appropriate.
We have utilized the Federal Reserve’s PPPLF, pursuant to which the Company has pledged its PPP loans as collateral at face value to obtain Federal Reserve Bank of San Francisco (“FRB”) non-recourse loans. For additional information regarding the PPPLF, see the discussion included in “Note 9 - Debt” to the Notes to Consolidated Financial Statements included in Part II. Item 8 of this report.
Allowance for Loan Losses and Loan Modifications
The Company recorded a provision of $1.6 million and $13.0 million for the quarter and year ended December 31, 2020, respectively, compared to $647,000 and $2.9 million for the quarter and year ended December 31, 2019, respectively, due primarily to probable loan losses reflecting the adverse impact of the COVID-19 pandemic on the economy. According to the CARES Act and related banking agency guidance, banks are not required to designate as TDRs the modification of loans as a result of the COVID-19 pandemic, made on a good faith basis to borrowers who were current, as defined under the CARES Act prior to any relief. This includes short-term (e.g. less than six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. Borrowers are considered current under the CARES Act and related banking agency guidance if they are not more than 30 days past due on their contractual payments as of December 31, 2019, or prior to any relief, respectively, and have experienced financial difficulty as a result of COVID-19. As of December 31, 2020, the amount of portfolio loans remaining under payment/relief agreements includes commercial real estate loans of $31.2 million, commercial business loans of $12.8 million, a portfolio one-to-four-family loan of $308,000, and consumer loans of $392,000. The primary method of relief is to allow the borrower up to 90-days of interest only payments and/or loan payment deferments, and, on a more limited basis, waived interest, late fees, or interest only loan payments and suspended foreclosure proceedings. These modifications were not classified as TDRs at December 31, 2020 in accordance with the guidance of the CARES Act and related banking agency guidance. All loans modified due to COVID-19 are separately monitored and any request for continuation of relief beyond the initial modification will be reassessed at that time to determine if a further modification
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should be granted and if a downgrade in risk rating is appropriate. Loan modifications in accordance with the CARES Act and related banking agency guidance are still subject to an evaluation in regard to determining whether or not a loan is deemed to be impaired.
Branch Operations and Additional Client Support
We have taken various steps to ensure the safety of our customers and our personnel. The majority of our employees are working remotely or have flexible work schedules, and we have established protective measures within our offices to help ensure the safety of those employees who must work on-site. The Families First Coronavirus Response Act also provides additional flexibility to our employees to help navigate their individual challenges with paid sick leave or expanded family and medical leave for specified reasons related to COVID-19. All of our branches are currently open.
Overdraft and fee reversals are waived on a case-by-case basis. We are cautious when paying overdrafts beyond the client's total deposit relationship, overdraft protection options or their overdraft coverage limits.
Critical Accounting Policies and Estimates
Certain of the Company’s accounting policies are important to the portrayal of the Company’s financial condition and result of operations, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Facts and circumstances which could affect these judgments include, but are not limited to, changes in interest rates, changes in the performance of the economy, and changes in the financial condition of borrowers. Management believes that its critical accounting policies and estimates include the following:
Allowance for Loan and Lease Losses (“ALLL”). The ALLL is the amount estimated by management as necessary to cover probable losses inherent in the loan portfolio at the balance sheet date. The ALLL is established through the provision for loan losses, which is charged to income. A high degree of judgment is necessary when determining the amount of the ALLL. Among the material estimates required to establish the ALLL are: loss exposure at default; the amount and timing of future cash flows on impacted loans; value of collateral; and determination of loss factors to be applied to the various elements of the portfolio. All of these estimates are susceptible to significant change. Management reviews the level of the ALLL at least quarterly and establishes the provision for loan losses based upon an evaluation of the portfolio, past loss experience, current economic conditions, and other factors related to the collectability of the loan portfolio. Although the Company believes that the best information available currently is used to establish the ALLL, future adjustments to the ALLL may be necessary if economic or other conditions change. As the Company adds new products to the loan portfolio and expands the Company’s market area, management intends to enhance and adapt the methodology to keep pace with the size and complexity of the loan portfolio. Changes in any of the above factors could have a significant effect on the calculation of the ALLL in any given period. Management believes that its systematic methodology continues to be appropriate.
Servicing Rights. Servicing assets are recognized as separate assets when rights are acquired through the purchase or through the sale of financial assets. Generally, purchased servicing rights are capitalized at the cost to acquire the rights. For sales of mortgage loans, the value of servicing is capitalized during the month of sale. Fair value is based on market prices for comparable mortgage contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds, and default rates and losses.
Servicing assets are evaluated quarterly for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights into tranches based on predominant characteristics, such as interest rate, loan type, and investor type. Impairment is recognized through a valuation allowance for an individual tranche, to the extent that fair value is less than the capitalized amount for the tranches. If the Company later determines that all or a portion of the impairment no longer exists for a particular tranche, a reduction of the allowance may be recorded as a recovery and an increase to income. Capitalized servicing rights are stated separately on the Consolidated Balance Sheets
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and are amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets.
Derivative and Hedging Activity. Accounting Standards Codification (“ASC”) 815, “Derivatives and Hedging,” requires that derivatives of the Company be recorded in the consolidated financial statements at fair value. Management considers its accounting policy for derivatives to be a critical accounting policy because these instruments have certain interest rate risk characteristics that change in value based upon changes in the capital markets. Fair values for derivative assets and liabilities are measured on a recurring basis. The Company’s primary use of derivative instruments are related to the mortgage banking activities in the form of commitments to extend credit, commitments to sell loans, To-Be-Announced (“TBA”) mortgage-backed securities trades and option contracts to mitigate the risk of the commitments to extend credit. Estimates of the percentage of commitments to extend credit on loans to be held for sale that may not fund are based upon historical data and current market trends. The fair value adjustments of the derivatives are recorded in the Consolidated Statements of Income with offsets to other assets or other liabilities on the Consolidated Balance Sheets.
Derivative instruments not related to mortgage banking activities primarily relate to interest rate swap agreements accounted for as cash flow hedges. To qualify for hedge accounting, derivatives must be highly effective at reducing the risk associated with the exposure being hedged and must be designated as a hedge at the inception of the derivative contract. If derivative instruments are designated as cash flow hedges, fair value adjustments related to the effective portion are recorded in other comprehensive income and are reclassified to earnings when the hedged transaction is reflected in earnings. Ineffective portions of cash flow hedges are reflected in earnings as they occur. Actual cash receipts and/or payments and related accruals on derivatives related to hedges are recorded as adjustments to the interest income or interest expense associated with the hedged item. During the life of the hedge, the Company formally assesses whether derivatives designated as hedging instruments continue to be highly effective in offsetting changes in the fair value or cash flows of hedged items. If it is determined that a hedge has ceased to be highly effective, the Company will discontinue hedge accounting prospectively. At such time, previous adjustments to the carrying value of the hedged item are reversed into current earnings and the derivative instrument is reclassified to a trading position recorded at fair value. For derivatives not designated as hedges, changes in fair value are recognized in earnings, in noninterest income.
Fair Value.ASC 820, “Fair Value Measurements and Disclosures,” establishes a hierarchical disclosure framework associated with the level of pricing observability utilized in measuring financial instruments at fair value. The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of pricing observability and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no pricing observability and a higher degree of judgment utilized in measuring fair value. Pricing observability is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established and the characteristics specific to the transaction. The objective of a fair value measurement is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions (that is, an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability). For additional details, see “Note 15 - Fair Value Measurement” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K for additional information about the level of pricing transparency associated with financial instruments carried at fair value.
Income Taxes. Income taxes are reflected in the Company’s consolidated financial statements to show the tax effects of the operations and transactions reported in the consolidated financial statements and consist of taxes currently payable plus deferred taxes. ASC 740, “Accounting for Income Taxes,” requires the asset and liability approach for financial accounting and reporting for deferred income taxes. Deferred tax assets and liabilities result from temporary differences between the financial statement carrying amounts and the tax bases of assets and liabilities. They are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled and are determined using the assets and liability method of accounting. The deferred income provision represents the difference between net deferred tax asset/liability at the beginning and end of the reported period. In formulating the deferred tax asset, the Company is required to estimate income and taxes in the jurisdiction in which the Company operates. This process involves estimating the actual current tax exposure for the reported period together with assessing temporary
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differences resulting from differing treatment of items, such as depreciation and the provision for loan losses, for tax and financial reporting purposes.
Deferred tax assets and liabilities occur when taxable income is larger or smaller than reported income on the income statements due to accounting valuation methods that differ from tax, as well as tax rate estimates and payments made quarterly and adjusted to actual at the end of the year. Deferred tax assets and liabilities are temporary differences deductible or payable in future periods. The Company had net deferred tax liabilities of $58,000 and $2.0 million at December 31, 2020 and 2019, respectively.
The Company’s accounting policies are discussed in detail in “Note 1 - Basis of Presentation and Summary” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.
Our Business and Operating Strategy and Goals
The Company’s primary objective is to operate 1st Security Bank of Washington as a well capitalized, profitable, independent, community-oriented financial institution, serving customers in its primary market area defined generally as the greater Puget Sound market area. The Company’s strategy is to provide innovative products and superior customer service to small businesses, industry and geographic niches, and individuals located in its primary market area. Services are currently provided to communities through the main office and 21 full-service bank branches and are supported with 24/7 access to on-line banking and participation in a worldwide ATM network.
The Company focuses on diversifying revenues, expanding lending channels, and growing the banking franchise. Management remains focused on building diversified revenue streams based upon credit, interest rate, and concentration risks. The Board of Directors seeks to accomplish the Company’s objectives through the adoption of a strategy designed to improve profitability and maintain a strong capital position and high asset quality. This strategy primarily involves:
Growing and diversifying the loan portfolio and revenue streams. The Company is transitioning lending activities from a predominantly consumer-driven model to a more diversified consumer and business model by emphasizing three key lending initiatives: expansion of commercial business lending programs, increasing in-house originations of residential mortgage loans primarily for sale into the secondary market through the mortgage banking program; and commercial real estate lending. Additionally, the Company seeks to diversify the loan portfolio by increasing lending to small businesses in the market area, as well as residential construction lending.
Maintaining strong asset quality. The Company believes that strong asset quality is a key to long-term financial success. The percentage of nonperforming loans to total gross loans were 0.49% and 0.22% at December 31, 2020 and 2019, respectively. The percentage of nonperforming assets to total assets were 0.37% and 0.19% at December 31, 2020 and 2019, respectively. The Company has actively managed the delinquent loans and nonperforming assets by aggressively pursuing the collection of consumer debts and marketing saleable properties upon which were foreclosed or repossessed, work-outs of classified assets and loan charge-offs. In the past several years, the Company also began emphasizing consumer loan originations to borrowers with higher credit scores, generally credit scores over 720 (although the policy allows us to go lower). Although the Company plans to place more emphasis on certain lending products, such as commercial and multi-family real estate loans, construction and development loans, including speculative residential construction loans, and commercial business loans, while growing the current size of the one-to-four-family residential mortgage loans and the consumer loan portfolios, the Company continues to manage its credit exposures through the use of experienced bankers and an overall conservative approach to lending.
Emphasizing lower cost core deposits to reduce the costs of funding loan growth. The Company offers personal and business checking accounts, NOW accounts and savings and money market accounts, which generally are lower-cost sources of funds than certificates of deposit, and are less sensitive to withdrawal when interest rates fluctuate. In order to build a core deposit base, the Company is pursuing a number of strategies. First, a diligent attempt to recruit all commercial loan customers to maintain a deposit relationship with the Company, generally a business checking account relationship to the extent practicable, for the term of their loan. Second, interest rate
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promotions are provided on savings and checking accounts from time to time to encourage the growth of these types of deposits. Third, by hiring experienced personnel with relationships in the communities we serve.
Capturing customers’ full relationship. The Company offers a wide range of products and services that provide diversification of revenue sources and solidify the relationship with the Bank’s customers. The Company focuses on core retail and business deposits, including savings and checking accounts, that lead to long-term customer retention. As part of the commercial lending process, cross-selling the entire business banking relationship, including deposit relationships and business banking products, such as online cash management, treasury management, wires, direct deposit, payment processing and remote deposit capture. The Company’s mortgage banking program also provides opportunities to cross-sell products to new customers.
Expanding the Company’s markets. In addition to deepening relationships with existing customers, the Company intends to expand business to new customers by leveraging the Company’s well-established involvement in the community and by selectively emphasizing products and services designed to meet their banking needs. The Company also intends to pursue expansion in other market areas through selective growth of the home lending network.
Comparison of Financial Condition at December 31, 2020 and December 31, 2019
Assets. Total assets increased $400.2 million, to $2.11 billion at December 31, 2020, from $1.71 billion at December 31, 2019, primarily due to increases in loans receivable, net of $208.6 million, loans held for sale of $96.7 million, securities available-for-sale of $52.0 million, total cash and cash equivalents of $45.8 million, securities held-to-maturity of $7.5 million, accrued interest receivable of $1.1 million, and servicing rights of $1.0 million, partially offset by decreases in certificates of deposit at other financial institutions of $8.6 million, other assets of $2.0 million and premises and equipment of $1.4 million. The increase in total assets were primarily funded by deposit growth, the use of PPPLF, and FHLB borrowings.
Loans receivable, net, increased $208.6 million, to $1.54 billion at December 31, 2020, from $1.34 billion at December 31, 2019. Total real estate loans increased $101.4 million, including increases in one-to-four-family portfolio loans of $49.6 million, which includes adjustable rate mortgage loans purchased in the first quarter of 2020 with a balance of $17.2 million at December 31, 2020, commercial real estate loans of $12.0 million, construction and development loans of $37.3 million, and home equity loans of $4.9 million, partially offset by a decrease in multi-family loans of $2.3 million. Undisbursed construction and development loan commitments increased $48.6 million, or 51.2%, to $143.7 at December 31, 2020, as compared to $95.0 million at December 31, 2019. Commercial business loans increased $71.9 million, due to increases in commercial and industrial loans of $83.9 million, reflecting primarily PPP loans of $62.1 million originated in the second and third quarters of 2020 and the purchase of a U.S. Department of Agriculture guaranteed loan in the first quarter of 2020 with a balance of $3.6 million at December 31, 2020, partially offset by the decrease in warehouse lending of $12.0 million. Consumer loans increased $49.0 million, primarily due to increases of $31.3 million in indirect home improvement loans and $18.6 million in marine loans.
Loans held for sale, consisting of one-to-four-family loans, increased by $96.7 million, or 138.8%, to $166.4 million at December 31, 2020, compared to $69.7 million for the prior year primarily due to increased loan production. The Company continues to expand its home lending operations by hiring additional lending staff and will continue selling one-to-four-family mortgage loans into the secondary market for asset/liability management purposes.
One-to-four-family loan originations included $1.73 billion of loans originated for sale, $132.3 million of portfolio loans including first and second liens, and $10.1 million of loans brokered to other institutions. Refinance activity increased significantly over the last year in response to decreases in market interest rates.
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Originations of one-to-four-family loans to purchase and to refinance a home for the periods indicated were as follows:
For the Year Ended For the Year Ended Year Year
December 31, 2020 December 31, 2019 over Year over Year
Amount Percent Amount Percent $ Change % Change
During the year ended December 31, 2020, the Company sold $1.64 billion of one-to-four-family loans, compared to sales of $785.4 million for the same period one year ago. In addition, the cash margin on loans sold, net of deferred fees and capitalized expenses, increased to 2.48% for the year ended December 31, 2020, compared to 1.74% for the year ended December 31, 2019. Margin reported is based on actual loans sold into the secondary market and the related value of capitalized servicing, partially offset by recognized deferred loans fees and capitalized expenses. The gross cash margins on loans sold, were 4.25% and 3.34% for the year ended December 31, 2020 and 2019, respectively. Gross cash margins on loans sold is defined as the margin on loans sold without the impact of deferred loan fees and costs.
The ALLL was $26.2 million, or 1.66% of gross loans receivable, excluding loans held for sale at December 31, 2020, compared to $13.2 million, or 0.98% of gross loans receivable, excluding loans held for sale, at December 31, 2019. Substandard loans increased to $17.6 million at December 31, 2020, compared to $6.7 million at December 31, 2019. This increase in substandard loans was primarily due to one relationship with mortgage loans totaling $4.5 million, one relationship with mortgage, commercial real estate, and commercial business loans totaling $3.3 million, and two commercial business loans totaling $4.4 million. Nonperforming loans, consisting solely of nonaccruing loans 90-days or more past due, increased to $7.8 million at December 31, 2020, from $3.0 million at December 31, 2019. At December 31, 2020, nonperforming loans consisted of $5.6 million in commercial business loans, $826,000 of indirect home improvement loans, $644,000 in one-to-four-family loans, and $636,000 of home equity loans. The ratio of nonperforming loans to total gross loans was 0.49% at December 31, 2020, compared to 0.22% at December 31, 2019. There was one OREO property in the amount of $90,000 at December 31, 2020, and two OREO properties totaling $168,000 at December 31, 2019. See “Item 1. Business - Lending Activities - Asset Quality” of this Form 10-K for additional information regarding the Company’s nonperforming loans.
In accordance with acquisition accounting, the ALLL does not include the recorded discount on loans acquired in the Anchor Acquisition of $1.5 million and $2.7 million on $132.6 million and $198.5 million of gross loans at December 31, 2020 and December 31, 2019, respectively.
Loans in their respective industries that were downgraded as a result of the COVID-19 pandemic and remain downgraded at the dates indicated are as follows:
(Dollars in thousands)
Additionally, management increased the economic qualitative factors of the ALLL associated with the loan portfolio based on current economic conditions and the potential effects from higher forecasted unemployment rates and lower gross
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domestic product, as well as the impact on other economic conditions on the U.S. and global economies from COVID-19. Management recognizes the potential impact on all of our customers and will continue to assess and evaluate our level of reserves against our homogenous residential and consumer portfolios during the COVID-19 pandemic.
Liabilities. Total liabilities increased $370.4 million to $1.88 billion at December 31, 2020, from $1.51 billion at December 31, 2019, primarily due to increases of $281.7 million in deposits and $80.9 million in borrowings.
Total deposits increased $281.7 million to $1.67 billion at December 31, 2020, from $1.39 billion at December 31, 2019. The increase in deposits was primarily driven by organic growth in customer relationships, proceeds from PPP loans and government stimulus checks deposited directly into customer accounts, and reduced withdrawals from deposit accounts due to a change in spending habits as a result of COVID-19. Relationship-based transactional accounts (noninterest-bearing checking, interest-bearing checking, and escrow accounts) increased $137.6 million to $589.1 million at December 31, 2020, from $451.6 million at December 31, 2019, primarily due to a $88.3 million increase in noninterest-bearing checking, and a $48.3 million increase in interest-bearing checking. Money market and savings accounts increased $193.1 million, or 49.6%, to $582.4 million at December 31, 2020, from $389.3 million at December 31, 2019. Time deposits decreased $49.0 million to $502.5 million at December 31, 2020, from $551.5 million at December 31, 2019, due to factors related to COVID-19 and a managed run-off of higher costing certificates of deposit (“CDs”). Nonretail CDs which includes brokered CDs, online CDs, and public funds increased $50.4 million to $196.6 million, at December 31, 2020, compared to $146.2 million at December 31, 2019, primarily due to a $45.0 million increase in brokered CDs. Management remains focused on increasing its lower cost relationship-based deposits to fund long-term asset growth.
Deposits are summarized as follows at the years indicated:
December 31, December 31,
Escrow accounts related to mortgages serviced 14,432 13,471
_______________________________
(5) Time deposits that meet or exceed the FDIC insurance limit.
As a result primarily of the COVID-19 pandemic and the resulting availability of PPP loan funds and stimulus funds made available during 2020, the tables above reflect year over year increases as well as changes in deposits, partially impacted by customers transferring funds from CDs to more liquid interest-bearing accounts, such as money market and interest-bearing checking.
Borrowings increased $80.9 million to $165.8 million at December 31, 2020, from $84.9 million at December 31, 2019, primarily related to $63.3 million of advances from the PPPLF and FHLB borrowings.
Management entered into three liability interest rate swap arrangements designated as cash flow hedges in 2020 to lock the expense costs associated with $90.0 million in brokered deposits and borrowings. The average cost of these $90 million in notional pay fixed interest rate swap agreements was 73 basis points as the Bank pays a fixed rate of 73 basis
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points to the interest rate swap counterparty quarterly instead of the variable amount tied to three month LIBOR. Management will continue to implement processes to match balance sheet funding duration and minimize interest rate risk and costs.
Stockholders’ Equity. Total stockholders’ equity increased $29.8 million, to $230.0 million at December 31, 2020, from $200.2 million at December 31, 2019. The increase in stockholders’ equity during the year ended December 31, 2020, was primarily due to net income of $39.3 million, partially offset by common stock repurchases of $9.8 million under our 2020 stock repurchase plans. The Company repurchased 260,363 shares of its common stock during the year ended December 31, 2020, at an average price of $39.33 per share. Book value per common share was $55.33 at December 31, 2020, compared to $45.85 at December 31, 2019.
We calculated book value based on common shares outstanding of 4,237,956 at December 31, 2020, less 55,092 unvested restricted stock shares, and 25,921 of unallocated ESOP shares for the reported common shares outstanding of 4,156,943. Common shares outstanding was calculated using 4,459,041 shares at December 31, 2019, less 40,215 unvested restricted stock shares, and 51,842 of unallocated ESOP shares for the reported common shares outstanding of 4,366,984.
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Average Balances, Interest and Average Yields/Cost
The following table sets forth for the periods indicated, information regarding average balances of assets and liabilities, as well as the total dollar amounts of interest income from average interest-earning assets and interest expense on average interest-bearing liabilities, resultant yields, interest rate spread, net interest margin (otherwise known as net yield on interest-earning assets), and the ratio of average interest-earning assets to average interest-bearing liabilities. Also presented is the weighted average yield on interest-earning assets, rates paid on interest-bearing liabilities and the resultant spread at December 31, 2020. Income and all average balances are monthly average balances. Nonaccruing loans have been included in the table as loans carrying a zero yield.
Year Ended December 31,
Average Interest Average Interest Average Interest
Interest-earning assets:
Interest-bearing liabilities:
Net interest rate spread 3.75 % 4.13 % 4.30 %
Net interest margin 4.02 % 4.53 % 4.61 %
____________________________
(1) The average loans receivable, net balances include nonaccruing loans.
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Rate/Volume Analysis
The following table presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It distinguishes between the changes related to outstanding balances and that due to the changes in interest rates. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (i.e., changes in volume multiplied by old rate) and (ii) changes in rate (i.e., changes in rate multiplied by old volume). For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the change due to volume and the change due to rate.
(In thousands) Volume Rate (Decrease) Volume Rate (Decrease)
Interest-earning assets:
HTM Investment securities 123 — 123 — — —
Interest-bearing liabilities:
Subordinated note 2 95 97 1 (1) —
Net change in net interest income $ 3,812 $ 18,210
__________________________
(1) The average loans receivable, net balances include nonaccruing loans.
Comparison of Results of Operations for the Years Ended December 31, 2020 and 2019
General. Net income for the year ended December 31, 2020, increased $16.5 million, or 72.8%, to $39.3 million, from $22.7 million for the year ended December 31, 2019. The increase in net income was primarily a result of a $32.3 million, or 140.3% increase in noninterest income and a $3.8 million increase in net interest income, partially offset by a $10.2 million increase in provision for loan losses, a $5.2 million increase in provision for income tax expense, and a $4.3 million increase in noninterest expense.
Net Interest Income. Net interest income increased $3.8 million, to $74.1 million for the year ended December 31, 2020, from $70.3 million for the year ended December 31, 2019. This increase was due to decreases in interest expense of $4.6 million and interest income of $788,000.
The net interest margin (“NIM”) decreased 51 basis points to 4.02% for the year ended December 31, 2020, from 4.53% for the same period last year. The decrease in NIM was primarily impacted by lower interest rates on recent fixed-rate real
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estate loan originations and adjustable-rate commercial loans, as well as the PPP loans and repricing loans since the 150 basis point reduction in the targeted federal funds rate in March 2020 due to COVID-19. The average cost of funds for total interest-bearing liabilities decreased 57 basis points to 1.07% for the year ended December 31, 2020, from 1.64% for the year ended December 31, 2019. This decrease was predominantly due to the lowering of our deposit rates commensurate with the low rate environment during the year. Management remains focused on matching deposit and liability duration with the duration of loans and assets where appropriate.
Interest Income. Interest income for the year ended December 31, 2020, decreased $788,000, to $88.8 million, from $89.6 million for the year ended December 31, 2019. The decrease during the year was primarily attributable to a 95 basis point decrease in the average yield on interest-earning assets to 4.82% for the year ended December 31, 2020, compared to 5.77% for the year ended December 31, 2019. The decrease in average yield on interest-earning assets compared to the same period a year earlier primarily reflects the reduction of higher interest rate and fee income loans, particularly construction and development loans, the impact of refinances of one-to-four-family loans and the origination of low yielding PPP loans. The impact of PPP loans on loan yields will change during any period based on the volume of prepayments or amounts forgiven by the SBA as certain criteria are met but is expected to cease completely after the maturity of the loans. For the year ended December 31, 2020, the Company recognized $646,000 in net deferred fees on PPP loans in interest income.
The following table compares average earning asset balances, associated yields, and resulting changes in interest income for the years ended December 31, 2020 and 2019:
Year Ended December 31,
Average Average Increase
Balance Yield/ Balance Yield/ in Interest
(Dollars in thousands) Outstanding Rate Outstanding Rate Income
Investment securities held-to-maturity 2,441 5.04 — — 123
___________________________
(1) The average loans receivable, net balances include nonaccruing loans.
Interest Expense. Interest expense decreased $4.6 million, to $14.7 million for the year ended December 31, 2020, from $19.3 million for the prior year, primarily due to decreased interest expense on deposits of $4.2 million, and interest expense on borrowings of $515,000. The average cost of funds for total interest-bearing liabilities decreased 57 basis points to 1.07% for the year ended December 31, 2020, compared to 1.64% for the year ended December 31, 2019. The decrease was predominantly due to lowered borrowing interest expense, primarily due to the reduction of interest rates for the use of FHLB borrowings and the repricing of CD deposits. The average cost of interest-bearing deposits decreased 53 basis points to 0.98% for the year ended December 31, 2020, compared to 1.51% for the year ended December 31, 2019, reflecting lower market interest rates, primarily in interest-bearing checking deposits, as well as brokered and retail CDs.
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The following table details average balances for cost of funds on interest-bearing liabilities and the change in interest expense for the years ended December 31, 2020 and 2019:
Year Ended December 31,
Average Average Increase
Balance Yield/ Balance Yield/ in Interest
(Dollars in thousands) Outstanding Rate Outstanding Rate Expense
Provision for Loan Losses. For the year ended December 30, 2020, the provision for loan losses was $13.0 million, compared to $2.9 million for the year ended December 31, 2019, due primarily to the incurred but not yet reported probable loan losses reflecting credit deterioration due to the adverse impact of the COVID-19 pandemic and the increase in the loan portfolio due to organic growth. The $62.1 million balance of PPP loans was omitted from the calculation for the ALLL at December 31, 2020 as these loans are fully guaranteed by the SBA and management expects that the great majority of PPP borrowers will seek full or partial forgiveness of their loan obligations from the SBA within a short time frame, which in turn will reduce the Bank’s loan balance for the amount forgiven. In addition, the provision for credit losses also reflects risk rating downgrades on loans that are considered at risk due to the COVID-19 pandemic. During the year ended December 31, 2020, net charge-offs totaled $93,000 compared to $2.0 million during the year ended December 31, 2019. A further decline in national and local economic conditions, as a result of the COVID-19 pandemic or other factors, could result in a material increase in the ALLL and may adversely affect the Company’s financial condition and results of operations.
The following table details activity and information related to the allowance for loan losses for the years ended December 31, 2020 and 2019:
At or For the Year Ended December 31,
Provision for loan losses $ 13,036 $ 2,880
Net charge-offs (recoveries) $ 93 $ 2,000
Nonaccrual and 90 days or more past due loans $ 7,761 $ 3,033
Management considers the ALLL at December 31, 2020, to be adequate to cover estimated losses inherent in the loan portfolio based on the assessment of the above-mentioned factors affecting the loan portfolio. While management believes the estimates and assumptions used in its determination of the adequacy of the allowance are reasonable, there can be no assurance that such estimates and assumptions will not be proven incorrect in the future, or that the actual amount of future provisions will not exceed the amount of past provisions or that any increased provisions that may be required will not adversely impact the Company’s financial condition and results of operations. In addition, the determination of the amount of allowance for loan losses is subject to review by bank regulators, as part of the routine examination process, which may
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result in the establishment of additional reserves based upon their judgment of information available to them at the time of their examination.
Noninterest Income. Noninterest income increased $32.3 million, to $55.4 million for the year ended December 31, 2020, from $23.0 million for the year ended December 31, 2019. The following table provides a detailed analysis of the changes in the components of noninterest income:
Year Ended December 31, Increase/(Decrease)
(Dollars in thousands) 2020 2019 Amount Percent
Loss on disposed fixed assets — (26) 26 (100.0)
Gain on sale of investment securities 300 32 268 837.5
Earnings on cash surrender value of BOLI 870 872 (2) (0.2)
The year over year increases included a $34.6 million, or 242.8% increase in gain on sale of loans, primarily due to higher sales volume, and an increase in other noninterest income mostly due to the net gain from a one-time sale of Class B Visa stock shares of $1.5 million, partially offset by a $4.2 million, or 63.8% decrease in net service charges and fee income, primarily due to an increase in mortgage servicing rights amortization of $4.0 million, reflecting higher volumes of loan payoffs in the underlying servicing portfolio from declining interest rates and increased refinancing activity. During the year ended December 31, 2020, the Company originated $1.87 billion of one-to-four-family mortgages during 2020 and sold $1.64 billion to secondary mortgage market investors, compared to sales of $785.4 million during the year ended December 31, 2019. The increase was primarily attributable to increased refinance activity compared to the prior year in response to decreases in market interest rates, and increased purchase activity as a result of the Company’s focus on purchase originations and a favorable interest rate environment for home purchases.
Noninterest Expense. Noninterest expense increased $4.3 million, to $66.6 million for the year ended December 31, 2020, compared to $62.3 million for the year ended December 31, 2019. The following table provides an analysis of the changes in the components of noninterest expense:
Year Ended December 31, Increase/(Decrease)
(Dollars in thousands) 2020 2019 Amount Percent
Loss (gain) on sale of OREO 2 (138) 140 (101.4)
OREO expenses 4 13 (9) (69.2)
Amortization of core deposit intangible 706 760 (54) (7.1)
The increase in noninterest expense was primarily due a $4.3 million increase in salaries and benefits, primarily attributable to increases in incentives and commissions of $16.0 million, driven by increased production of HFS loans, and compensation of $2.9 million, partially offset by an increase in recognized deferred costs on direct loan origination activities of $16.1 million, as well as no acquisition costs for the year ended December 31, 2020, compared to $1.8 million for the year ended December 31, 2019. Other increases between the periods included $1.9 million in the impairment of
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servicing rights, and $749,000 in operations expense, partially offset by decreases of $1.2 million in loan costs and $584,000 in data processing.
The efficiency ratio, which is noninterest expense as a percentage of net interest income and noninterest income, improved to, 51.43% for the year ended December 31, 2020, compared to 66.8% for the year ended December 31, 2019.
Provision for Income Tax. For the year ended December 31, 2019, the Company recorded a provision for income tax expense of $10.6 million on pre-tax income of $49.9 million, as compared to a provision of income tax expense of $5.4 million on pre-tax income of $28.1 million for the year ended December 31, 2019. There was a net deferred tax liability of $58,000 and $2.0 million at December 31, 2020 and 2019, respectively. The effective corporate income tax rates for the years ended December 31, 2020 and 2019 were 21.2% and 19.2%, respectively. For additional information regarding income taxes, see “Note 11 - Income Taxes” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.
Asset and Liability Management and Market Risk
Risk When Interest Rates Change. The rates of interest the Company earns on assets and pays on liabilities generally is established contractually for a period of time. Market rates change over time. Like other financial institutions, the Company’s results of operations are impacted by changes in interest rates and the interest rate sensitivity of the Company’s assets and liabilities. The risk associated with changes in interest rates and the Company’s ability to adapt to these changes is known as interest rate risk and is the most significant market risk.
The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. Consequently, the fair value of the Company’s consolidated financial instruments will change when interest rate levels change, and that change may either be favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed interest rate obligations are less likely to prepay in a rising interest rate environment and more likely to prepay in a falling interest rate environment. Conversely, depositors who are receiving fixed interest rates are more likely to withdraw funds before maturity in a rising interest rate environment and less likely to do so in a falling interest rate environment. Management monitors interest rates and maturities of assets and liabilities, and attempts to minimize interest rate risk by adjusting terms of new loans, and deposits, and by investing in securities with terms that mitigate the Company’s overall interest rate risk.
How The Company Measures Risk of Interest Rate Changes. As part of an attempt to manage exposure to changes in interest rates and comply with applicable regulations, the Company monitors interest rate risk. In doing so, the Company analyzes and manages assets and liabilities based on their interest rates and payment streams, timing of maturities, repricing opportunities, and sensitivity to actual or potential changes in market interest rates.
The Company is subject to interest rate risk to the extent that its interest-bearing liabilities, primarily deposits and FHLB advances, reprice more rapidly or at different rates than the interest-earning assets. In order to minimize the potential for adverse effects of material prolonged increases or decreases in interest rates on the Company’s results of operations, the Company has adopted an Asset and Liability Management Policy. The Board of Directors sets the Asset and Liability Management Policy for the Bank, which is implemented by the Asset/Liability Committee (“ALCO”), an internal management committee. The board-level oversight for ALCO is performed by the Audit Committee of the Board of Directors.
The purpose of the ALCO is to communicate, coordinate, and control asset/liability management consistent with the business plan and board-approved policies. The committee establishes and monitors the volume and mix of assets and funding sources, taking into account relative costs and spreads, interest rate sensitivity and liquidity needs. The objectives are to manage assets and funding sources to produce results that are consistent with liquidity, capital adequacy, growth, risk, and profitability goals.
The committee generally meets monthly to, among other things, protect capital through earnings stability over the interest rate cycle; maintain the Bank’s well capitalized status; and provide a reasonable return on investment. The committee recommends appropriate strategy changes based on this review. The committee is responsible for reviewing and reporting
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the effects of the policy implementations and strategies to the Board of Directors at least quarterly. The Chief Financial Officer oversees the process on a daily basis.
A key element of the Bank’s asset/liability management plan is to protect net earnings by managing the maturity or repricing mismatch between interest-earning assets and rate-sensitive liabilities. The Company seeks to accomplish this by extending funding maturities through wholesale funding sources, including the use of FHLB advances and brokered certificates of deposit, and through asset management, including the use of adjustable-rate loans and selling certain fixed-rate loans in the secondary market. Management is also focused on matching deposit duration with the duration of earning assets as appropriate.
As part of the efforts to monitor and manage interest rate risk, a number of indicators are used to monitor overall risk. Among the measurements are:
Market Risk. Market risk is the potential change in the value of investment securities if interest rates change. This change in value impacts the value of the Company and the liquidity of the securities. Market risk is controlled by setting a maximum average maturity/average life of the securities portfolio to 10 years.
Economic Risk. Economic risk is the risk that the underlying value of a bank will change when rates change. This can be caused by a change in value of the existing assets and liabilities (this is called Economic Value of Equity or EVE), or a change in the earnings stream (this is caused by interest rate risk). The Company takes economic risk primarily when fixed rate loans are made, or purchase fixed-rate investments, or issue long term certificates of deposit or take fixed-rate FHLB advances. It is the risk that interest rates will change and these fixed-rate assets and liabilities will change in value. This change in value usually is not recognized in the earnings, or equity (other than marking to market securities available-for-sale or fair value adjustments on loans held for sale). The change is recognized only when the assets and liabilities are liquidated. Although the change in market value is usually not recognized in earnings or in capital, the impact is real to the long-term value of 1st Security Bank of Washington. Therefore, the Company will control the level of economic risk by limiting the amount of long-term, fixed-rate assets the Company will have and by setting a limit on concentrations and maturities of securities.
Interest Rate Risk. If the Federal Reserve Board changes the Fed Funds rate 100, 200 or 300 basis points, the Bank policy dictates that a change in net interest income should not change more that 7.5%, 15% and 30%, respectively.
The table presented below, as of December 31, 2020, is an analysis prepared for 1st Security Bank of Washington by a third-party consultant utilizing various market and actual experience-based assumptions. The table represents a static shock to the net interest income using instantaneous and sustained shifts in the yield curve, in 100 basis point increments, up and down 100 basis points. No rates in the model are allowed to go below zero. Given that the current targeted Fed Funds rate is a range of 1.00% to 1.25%, a 200 or 300 basis point reduction in rates is not reported. The results reflect a projected income statement with minimal exposure to instantaneous changes in interest rates. These results are primarily based upon historical prepayment speeds within the consumer lending portfolio in combination with the above average yields associated with the consumer portfolio if those prepayments do not occur. The table illustrates the estimated change in our net interest income over the next 12 months from December 31, 2020.
Interest Net Interest Income
Rates in Basis Points Amount Change Change
(Dollars in thousands)
In managing the assets/liability mix the Company typically places an equal emphasis on maximizing net interest margin and matching the interest rate sensitivity of the assets and liabilities. From time to time, however, depending on the relationship between long- and short-term interest rates, market conditions and consumer preference, the Company may place somewhat greater emphasis on maximizing net interest margin than on strict dollar for dollar categories matching
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the interest rate sensitivity of the assets and liabilities. Management also believes that the increased net income which may result from a prepayment assumption mismatch in the actual maturity or repricing of the asset and liability portfolios can, during periods of changing interest rates, provide sufficient returns to justify the increased exposure to sudden and unexpected increases in interest rates which may result from such a mismatch. Management believes that 1st Security Bank of Washington’s level of interest rate risk is acceptable under this approach.
In evaluating 1st Security Bank of Washington’s exposure to interest rate movements, certain shortcomings inherent in the method of analysis presented in the foregoing table must be considered. For example, although certain assets and liabilities may have similar maturities or repricing periods, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in interest rates. Additionally, certain assets, such as adjustable rate mortgages, have features which restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a significant change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed above. Finally, the ability of many borrowers to service their debt may decrease in the event of an interest rate increase. 1st Security Bank of Washington considers all of these factors in monitoring its exposure to interest rate risk.
Liquidity
Management maintains a liquidity position that it believes will adequately provide funding for loan demand and deposit runoff that may occur in the normal course of business. The Company relies on a number of different sources in order to meet potential liquidity demands. The primary sources are increases in deposit accounts, FHLB advances, purchases of federal funds, sale of securities available-for-sale, cash flows from loan payments, sales of one-to-four-family loans held for sale, and maturing securities.
At December 31, 2020, the Bank’s total borrowing capacity was $568.2 million with the FHLB of Des Moines, with unused borrowing capacity of $459.9 million. The FHLB borrowing limit is based on certain categories of loans, primarily real estate loans that qualify as collateral for FHLB advances. At December 31, 2020, the Bank held approximately $774.8 million in loans that qualify as collateral for FHLB advances.
In addition to the availability of liquidity from the FHLB of Des Moines, the Bank maintained a short-term borrowing line of credit with the FRB, with a current limit of $179.6 million, and a combined credit limit of $101.0 million in written federal funds lines of credit through correspondent banking relationships as of December 31, 2020. The FRB borrowing limit is based on certain categories of loans, primarily consumer loans that qualify as collateral for the FRB’s line of credit. At December 31, 2020, the Bank held approximately $369.2 million in loans that qualify as collateral for the FRB line of credit. As of December 31, 2020, the Bank had pledged $62.1 million in PPP loans as collateral under the PPPLF, with no additional borrowing capacity under the PPPLF. The Bank may obtain additional available liquidity from the PPPLF as additional PPP loans are originated in 2021.
At December 31, 2020, the outstanding balances of FHLB advances and PPPLF borrowings were $102.5 million and $63.3 million, respectively. The Bank’s Asset and Liability Management Policy permits management to utilize brokered deposits up to 20% of deposits or $337.7 million at December 31, 2020. Total brokered deposits at December 31, 2020 were $201.4 million. Management utilizes brokered deposits to mitigate interest rate risk and liquidity risk exposure when appropriate.
Liquidity management is both a daily and long-term function of the Company’s management. Excess liquidity is generally invested in short-term investments, such as overnight deposits and federal funds. On a longer-term basis, a strategy is maintained of investing in various lending products and investment securities, including U.S. Government obligations and U.S. agency securities. The Company uses sources of funds primarily to meet ongoing commitments, pay maturing deposits and fund withdrawals, and to fund loan commitments. At December 31, 2020, the approved outstanding loan commitments, including unused lines of credit, amounted to $528.2 million. Certificates of deposit scheduled to mature in one year or less at December 31, 2020, totaled $340.9 million. It is management’s policy to offer deposit rates that are competitive with other local financial institutions. Based on this management strategy, the Company believes that a majority of maturing relationship deposits will remain with the Bank.
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As a separate legal entity from the Bank, FS Bancorp, Inc. must provide for its own liquidity. Sources of capital and liquidity for FS Bancorp, Inc. include distributions from the Bank and the issuance of debt or equity securities. Dividends and other capital distributions from the Bank are subject to regulatory notice. At December 31, 2020, FS Bancorp, Inc. had $14.5 million in unrestricted cash to meet liquidity needs. Subsequent to December 31, 2020, on February 10, 2021, FS Bancorp, Inc. completed the private placement of $50.0 million of its 3.75% fixed-to-floating rate subordinated notes due 2031 (the “Notes”) at an offering price equal to 100% of the aggregate principal amount of the Notes, resulting in net proceeds, after placement agent fees and offering expenses, of approximately 49.3 million. For regulatory capital purposes, the subordinated notes have been structured to qualify initially as Tier 2 capital for the Company.
Commitments and Off-Balance Sheet Arrangements
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business in order to meet the financing needs of its customers. For information regarding our commitments and off-balance sheet arrangements, see “Note 12 - Commitments and Contingencies” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.
A summary of off-balance sheet commitments to extend credit at December 31, 2020 was as follows:
(In thousands)
Off-balance sheet loan commitments:
Commercial business loans 159,080
Home equity loans and lines of credit 52,457
Total commitments to extend credit $ 528,231
__________________________
(1) Includes held for sale interest rate lock commitments.
Capital Resources
The Bank is subject to minimum capital requirements imposed by the FDIC. Based on its capital levels at December 31, 2020, the Bank exceeded these requirements as of that date. Consistent with our goals to operate a sound and profitable organization, our policy is for the Bank to maintain a well capitalized status under the capital categories of the FDIC. Based on capital levels at December 31, 2020, the Bank was considered to be well capitalized. Effective January 1, 2020, a bank that elects to use the Community Bank Leverage Ratio (“CBLR”) will generally be considered well capitalized and to have met the risk-based and leverage capital requirements of the capital regulations if it has a leverage ratio greater than 9.0%. At December 31, 2020, the Bank qualified and elected to use the CBLR to measure capital adequacy. The Tier 1 leverage-based capital ratio calculated for the Bank at December 31, 2020 was 10.9%, compared to 11.6% at December 31, 2019. As required by the CARES Act, the FDIC has temporarily lowered the CBLR to 8% beginning in the second quarter of 2020 through the end of the year. Beginning in 2021, the CBLR increased to 8.5% for that calendar year. The CBLR will return to 9% on January 1, 2022.
As a bank holding company registered with the Federal Reserve, the Company is subject to the capital adequacy requirements of the Federal Reserve. Bank holding companies with less than $3.0 billion in assets are generally not subject to compliance with the Federal Reserve’s capital regulations, which are generally the same as the capital regulations applicable to the Bank. The Federal Reserve has a policy that a bank holding company is required to serve as a source of financial and managerial strength to the holding company’s subsidiary bank and the Federal Reserve expects the holding company’s subsidiary bank to be well capitalized under the prompt corrective action regulations. If FS Bancorp, Inc. were subject to regulatory capital guidelines for bank holding companies with $3.0 billion or more in assets at December 31, 2020, FS Bancorp would have exceeded all regulatory capital requirements. The Tier 1 leverage-based capital ratio calculated for FS Bancorp, Inc. at December 31, 2020 was 11.1%. For additional information regarding the Bank’s regulatory capital compliance, see the discussion included in “Note 14 - Regulatory Capital” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.
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Recent Accounting Pronouncements
For a discussion of recent accounting standards, please see “Note 1- Basis of Presentation and Summary” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Market risk is the risk of loss from adverse changes in market prices and rates. The Company’s market risk arises principally from interest rate risk inherent in lending, investing, deposit and borrowings activities. Management actively monitors and manages its interest rate risk exposure. In addition to other risks that are managed in the normal course of business, such as credit quality and liquidity, management considers interest rate risk to be a significant market risk that could potentially have a material effect on the Company’s financial condition and result of operations. The information contained in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management” of this Form 10-K is incorporated herein by reference.
Item 8. Financial Statements and Supplementary Data
FS BANCORP, INC. AND SUBSIDIARY
INDEX TO FINANCIAL STATEMENTS
Index to Consolidated Financial Statements
Page
Report of Independent Registered Public Accounting Firm 88
Consolidated Balance Sheets at December 31, 2020 and 2019 91
Notes to Consolidated Financial Statements 97
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Report of Independent Registered Public Accounting Firm
To the Shareholders and the Board of Directors of
FS Bancorp, Inc.
Opinions on the Financial Statements and Internal Control over Financial Reporting
We have audited the accompanying consolidated balance sheets of FS Bancorp, Inc. and subsidiary (the “Company”) as of December 31, 2020 and 2019, the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for the years then ended, and the related notes (collectively referred to as the “consolidated financial statements”). We also have audited 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 (“COSO”).
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2020 and 2019, and the consolidated results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the Company 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 COSO.
Basis for Opinions
The Company’s management is responsible for these consolidated financial statements, 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 Report on Internal Control over Financial Reporting included in Item 9A. Our responsibility is to express an opinion on the Company’s consolidated financial statements and an opinion on the Company’s internal control over financial reporting 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 consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.
Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures to respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
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
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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.
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.
Critical Audit Matter
The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that (1) relates to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.
Allowance for Loan Losses
As described in Notes 1 and 3 to the consolidated financial statements, the Company’s consolidated allowance for loan losses balance was $26.2 million at December 31, 2020. The allowance for loan losses is maintained to provide for probable losses on existing loans based on evaluating risks in the loan portfolio and is based upon the Company’s analysis of the factors underlying the quality of the loan portfolio. These factors include, among others, changes in the size and composition of the loan portfolio, the estimated value of any underlying collateral, actual loan loss experience, current economic conditions, and detailed analysis of individual loans for which full collectability may not be assured. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information is available.
We identified management’s risk ratings of loans and the estimation of qualitative factors, both of which are used in the allowance for loan losses calculation, as a critical audit matter. The Company uses internally determined risk ratings to classify loans into pools and to estimate loss rates for each of the loan pools, which are used in the calculation of the allowance for loan losses. Determination of the risk grades involves significant management judgement. The qualitative factors are used to estimate probable losses incurred related to factors that are not captured in the past loss experience, are based on management’s evaluation of available internal and external data, and involve significant management judgement. Auditing management’s judgments regarding the determination of risk grades and qualitative factors applied to the allowance for loan losses involved a high degree of subjectivity.
The primary procedures we performed to address this critical audit matter included:
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/s/ Moss Adams LLP
Everett, Washington
March 16, 2021
We have served as the Company’s auditor since 2006.
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FS BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2020 AND 2019
(In thousands, except share data)
December 31, December 31,
Interest-bearing deposits at other financial institutions 80,022 32,603
Certificates of deposit at other financial institutions 12,278 20,902
Securities available-for-sale, at fair value 178,018 126,057
Securities held-to-maturity (fair value of $7,556) 7,500 —
Accrued interest receivable 7,030 5,908
Operating lease right-of-use (“ROU”) assets 4,949 5,016
Federal Home Loan Bank (“FHLB”) stock, at cost 7,439 8,045
Other real estate owned (“OREO”) 90 168
Bank owned life insurance (“BOLI”), net 36,226 35,356
Servicing rights, held at the lower of cost or fair value 12,595 11,560
Core deposit intangible, net 4,751 5,457
LIABILITIES
Deposits:
Subordinated note:
Unamortized debt issuance costs — (115)
Total subordinated note less unamortized debt issuance costs 10,000 9,885
Operating lease liabilities 5,176 5,214
Deferred tax liability, net 58 1,971
COMMITMENTS AND CONTINGENCIES (NOTE 12)
STOCKHOLDERS’ EQUITY
Accumulated other comprehensive income, net of tax 2,533 788
Unearned shares – Employee Stock Ownership Plan (“ESOP”) (291) (573)
See accompanying notes to these consolidated financial statements.
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FS BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31, 2020 and 2019
(In thousands, except earnings per share data)
_________________________________________________________________________________________________________________________
Year Ended
December 31,
INTEREST INCOME
Loans receivable, including fees $ 84,128 $ 84,706
Total interest and dividend income 88,837 89,625
INTEREST EXPENSE
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 61,084 67,428
NONINTEREST INCOME
Service charges and fee income 2,373 6,554
Loss on disposed fixed assets — (26)
Gain on sale of investment securities 300 32
Earnings on cash surrender value of BOLI 870 872
NONINTEREST EXPENSE
Loss (gain) on sale of OREO 2 (138)
OREO expenses 4 13
Professional and board fees 2,797 2,426
Federal Deposit Insurance Corporation (“FDIC”) insurance 829 358
Marketing and advertising 530 678
Acquisition costs — 1,756
Amortization of core deposit intangible 706 760
Impairment of servicing rights 1,969 92
INCOME BEFORE PROVISION FOR INCOME TAXES 49,850 28,130
Basic earnings per share $ 9.14 $ 5.13
Diluted earnings per share $ 8.97 $ 5.01
See accompanying notes to these consolidated financial statements.
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FS BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
FOR THE YEARS ENDED DECEMBER 31, 2020 and 2019
(In thousands)
Year Ended
December 31,
Other comprehensive income:
Securities available-for-sale:
Unrealized holding gain during period 3,754 2,920
Income tax provision related to unrealized holding gain (807) (628)
Cash flow hedges:
Unrealized derivative losses during period (1,429) —
Income tax benefit related to unrealized derivative losses 307 —
Income tax provision related to reclassification for expense, net (43) —
Other comprehensive income, net of tax 1,745 2,267
See accompanying notes to these consolidated financial statements.
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FS BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2020 and 2019
(In thousands, except share data)
Accumulated
Other
Additional Comprehensive Unearned Total
Common Stock Paid-in Retained (Loss) Income, ESOP Stockholders’
Shares Amount Capital Earnings Net of Tax Shares Equity
Dividends paid ($0.65 per share) — $ — — (2,856) — — $ (2,856)
Share-based compensation — $ — 869 — — — $ 869
Restricted stock awards 20,215 $ — — — — — $ —
Stock options exercised 52,769 $ — 705 — — — $ 705
Other comprehensive income, net of tax — $ — — — 2,267 — $ 2,267
ESOP shares allocated — $ — 1,231 — — 275 $ 1,506
Dividends paid ($0.84 per share) — $ — — (3,574) — — $ (3,574)
Share-based compensation — $ — 1,020 — — — $ 1,020
Restricted stock awards 24,880 $ 1 — — — — $ 1
Stock options exercised 14,398 $ — (161) — — — $ (161)
Other comprehensive income, net of tax — $ — — — 1,745 — $ 1,745
ESOP shares allocated — $ — 1,025 — — 282 $ 1,307
See accompanying notes to these consolidated financial statements.
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FS BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2020 and 2019
(In thousands)
Year Ended December 31,
CASH FLOWS (USED BY) FROM OPERATING ACTIVITIES 2020 2019
Adjustments to reconcile net income to net cash from operating activities
Depreciation, amortization and accretion 13,618 12,003
ESOP compensation expense for allocated shares 1,307 1,506
(Benefit) provision for deferred income taxes (2,390) 988
Increase in cash surrender value of BOLI (870) (872)
Gain on sale of loans held for sale (48,842) (14,126)
Gain on sale of portfolio loans — (122)
Gain on sale of investment securities (300) (32)
Loss on disposed fixed assets — 26
Impairment of servicing rights 1,969 92
Loss (gain) on sale of OREO 2 (138)
Changes in operating assets and liabilities
Accrued interest receivable (1,122) (147)
Net cash (used by) from operating activities (32,317) 9,177
CASH FLOWS USED BY INVESTING ACTIVITIES
Activity in securities available-for-sale:
Proceeds from sale of investment securities 12,214 10,554
Maturities, prepayments, and calls 37,964 24,293
Activity in securities held-to-maturity:
Purchases (7,500) —
Loan originations and principal collections, net (189,162) (36,904)
Purchase of portfolio loans (32,743) (1,799)
Proceeds from sale of portfolio loans — 8,487
Proceeds from sale of OREO, net 76 901
Purchase of premises and equipment, net (1,379) (2,463)
Change in FHLB stock, net 606 1,842
Net cash used by investing activities (270,690) (55,201)
CASH FLOWS FROM FINANCING ACTIVITIES
Dividends paid on common stock (3,574) (2,856)
(Disbursements) proceeds from stock options exercised, net (161) 705
Restricted stock awards (34) (204)
Common stock repurchased (9,802) (4,800)
NET INCREASE IN CASH AND CASH EQUIVALENTS 45,798 12,999
CASH AND CASH EQUIVALENTS, beginning of year 45,778 32,779
CASH AND CASH EQUIVALENTS, end of year $ 91,576 $ 45,778
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FS BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2020 and 2019 (Continued)
SUPPLEMENTARY DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for:
Interest on deposits and borrowings $ 14,584 $ 18,709
Change in unrealized gain on investment securities, net $ 3,454 $ 2,888
Change in unrealized loss on cash flow hedges, net (1,231) —
Property taken in settlement of loans — 312
Right-of-use assets in exchange for lease liabilities 1,202 6,232
See accompanying notes to these consolidated financial statements.
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NOTE 1 - BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations -FS Bancorp, Inc. (the “Company”) was incorporated in September 2011 as the holding company for 1st Security Bank of Washington (the “Bank” or “1st Security Bank”) in connection with the Bank’s conversion from the mutual to stock form of ownership which was completed on July 9, 2012. The Bank is a community-based savings bank with 21 full-service bank branches, a headquarters that produces loans and accepts deposits, and nine home loan production offices in suburban communities in the greater Puget Sound area which includes Snohomish, King, Pierce, Jefferson, Kitsap, Clallam, Grays Harbor, Thurston, and Lewis counties, and one loan production office in the market area of the Tri-Cities, Washington. The Bank provides loan and deposit services to customers who are predominantly small- and middle-market businesses and individuals. The Company and its subsidiary are subject to regulation by certain federal and state agencies and undergo periodic examination by these regulatory agencies.
Financial Statement Presentation -The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) and with prevailing practices within the banking and securities industries. In preparing such financial statements, management is required to make certain estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the balance sheet and the reported amounts of revenues and expenses for the reporting period. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan and lease losses, fair value of financial instruments, the valuation of servicing rights, deferred income taxes, and if needed, a deferred tax asset valuation allowance.
Amounts presented in the consolidated financial statements and footnote tables are rounded and presented to the nearest thousands of dollars except per share amounts. If the amounts are above $1.0 million, they are rounded one decimal point, and if they are above $1.0 billion, they are rounded two decimal points.
Principles of Consolidation -The consolidated financial statements include the accounts of FS Bancorp, Inc. and its wholly owned subsidiary, 1st Security Bank of Washington. All material intercompany accounts have been eliminated in consolidation.
Segment Reporting - The Company operates in two business segments through the Bank: commercial and consumer banking and home lending. The Company’s business segments are determined based on the products and services provided, as well as the nature of the related business activities, and they reflect the manner in which financial information is regularly reviewed for the purpose of allocating resources and evaluating performance of the Company’s businesses. The results for these business segments are based on management’s accounting process, which assigns income statement items and assets to each responsible operating segment. This process is dynamic and is based on management’s view of the Company’s operations. See “Note 20 - Business Segments.”
Subsequent Events - The Company has evaluated events and transactions subsequent to December 31, 2020 for potential recognition or disclosure.
Cash and Cash Equivalents - Cash and cash equivalents include cash and due from banks, and interest-bearing balances due from other banks and the Federal Reserve Bank of San Francisco (“FRB”) and have an original maturity of 90 days or less at the time of purchase. At times, cash balances may exceed Federal Deposit Insurance Corporation (“FDIC”) insured limits. At December 31, 2020 and 2019, the Company had $17.0 million and $8.6 million, respectively, of cash and due from banks and interest-bearing deposits at other financial institutions in excess of FDIC insured limits.
Securities - Securities are classified as held-to-maturity when the Company has the ability and positive intent to hold them to maturity. Securities classified as held-to-maturity are carried at cost, adjusted for amortization of premiums to the earliest callable date and accretion of discounts to the maturity date and, if appropriate, any other-than-temporary impairment losses.. Securities available-for-sale consist of debt securities that the Company has the intent and ability to hold for an indefinite period, but not necessarily to maturity. Such securities may be sold to implement the Company’s asset/liability management strategies and in response to changes in interest rates and similar factors. Securities available-for-sale are reported at fair value. Realized gains and losses on securities available-for-sale, determined using the specific identification method, are included in results of operations. Amortization of premiums and accretion of discounts are recognized as adjustments to yield over the contractual lives of the related securities with the exception of premiums for
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non-contingently callable debt securities which are amortized to the earliest call date, rather than the contractual maturity date.
Unrealized holding gains and losses, net of the related deferred tax effect, are reported as a net amount in a separate component of equity entitled accumulated other comprehensive income (loss). Any declines in the values of these securities that are considered to be other-than-temporary-impairment (“OTTI”) and credit-related are recognized in earnings. Noncredit-related OTTI on securities not expected to be sold is recognized in other comprehensive income (loss). The review for OTTI is conducted on an ongoing basis and takes into account the severity and duration of the impairment, recent events specific to the issuer or industry, fair value in relationship to cost, extent and nature of change in fair value, creditworthiness of the issuer including external credit ratings and recent downgrades, trends and volatility of earnings, current analysts’ evaluations, and other key measures. In addition, the Company does not intend to sell the securities and it is more likely than not that we will not be required to sell the securities before recovery of their amortized cost basis. In doing this, we take into account our balance sheet management strategy and consideration of current and future market conditions. Dividends and interest income are recognized when earned.
Federal Home Loan Bank Stock - The Bank’s investment in FHLB stock is carried at cost, which approximates fair value. As a member of the FHLB system, the Bank is required to maintain an investment in capital stock of the FHLB in an amount of $2.1 million and 4.0% of advances from the FHLB. The Bank’s required minimum level of investment in FHLB stock is based on specific percentages of its outstanding mortgages, total assets, or FHLB advances. At December 31, 2020 and 2019, the Bank’s minimum level of investment requirement in FHLB stock was $7.4 million and $8.0 million, respectively. The Bank was in compliance with the FHLB minimum investment requirement at December 31, 2020 and 2019.
Management evaluates FHLB stock for impairment as needed. Management’s determination of whether these investments are impaired is based on its assessment of the ultimate recoverability of cost rather than by recognizing temporary declines in value. The determination of whether a decline affects the ultimate recoverability of cost is influenced by criteria such as (1) the significance of any decline in net assets of the FHLB as compared with the capital stock amount for the FHLB and the length of time this situation has persisted; (2) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLB; (3) the impact of legislative and regulatory changes on institutions and, accordingly, the customer base of the FHLB; and (4) the liquidity position of the FHLB. Based on its evaluation, management determined that there was no impairment of FHLB stock at December 31, 2020 and 2019, respectively.
Loans Held for Sale - The Bank records all mortgage loans held for sale at fair value. Fair value is determined by outstanding commitments from investors or current investor yield requirements calculated on the aggregate loan basis. Gains and losses on fair value changes of loans held for sale are recorded in the gain on sale of loans component of noninterest income. Origination fees and costs are recognized in earnings at the time of origination. Mortgage loans held for sale are sold with the mortgage service rights either released or retained by the Bank. Gains or losses on sales of mortgage loans are recognized based on the difference between the selling price and the carrying value of the related mortgage loans sold. All sales are made with limited recourse against the Company.
Other Real Estate Owned - Other real estate owned(“OREO”) consists of properties or assets acquired through or in lieu of foreclosure, and are recorded initially at fair value less selling costs, with the initial charge made to the allowance for loan losses. Costs relating to development and improvement of the properties or assets are capitalized while costs relating to holding the properties or assets are expensed. Valuations are periodically performed by management, and a charge to earnings is recorded if the recorded value of a property exceeds its estimated net realizable value.
Derivatives - Commitments to fund mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of these mortgage loans are accounted for as free-standing derivatives. The fair value of the interest rate lock is recorded at the time the commitment to fund the mortgage loan is executed and is adjusted for the expected exercise of the commitments to fund the loans, the Company enters into forward commitments for the future delivery of mortgage loans when interest rate locks are entered. Fair values of these mortgage derivatives are estimated based on changes in mortgage interest rates from the date the interest on the loan is locked. Changes in the fair values of these derivatives are reported in “Gain on sale of loans” on the Consolidated Statements of Income.
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The accounting for changes in the fair value of derivatives depends on the intended use of the derivative and resulting designation. The Company’s hedging policies permit the use of various derivative financial instruments to manage interest rate risk or to hedge specified assets and liabilities. To qualify for hedge accounting, derivatives must be highly effective at reducing the risk associated with the exposure being hedged and must be designated as a hedge at the inception of the derivative contract. If derivative instruments are designated as fair value hedges, and such hedges are highly effective, both the change in the fair value of the hedge and the hedged item are included in current earnings. If derivative instruments are designated as cash flow hedges, fair value adjustments related to the effective portion are recorded in other comprehensive income and are reclassified to earnings when the hedged transaction is reflected in earnings. Ineffective portions of cash flow hedges are reflected in earnings as they occur. Actual cash receipts and/or payments and related accruals on derivatives related to hedges are recorded as adjustments to the interest income or interest expense associated with the hedged item. During the life of the hedge, the Company formally assesses whether derivatives designated as hedging instruments continue to be highly effective in offsetting changes in the fair value or cash flows of hedged items. If it is determined that a hedge has ceased to be highly effective, the Company will discontinue hedge accounting prospectively. At such time, previous adjustments to the carrying value of the hedged item are reversed into current earnings and the derivative instrument is reclassified to a trading position recorded at fair value. For derivatives not designated as hedges, changes in fair value are recognized in earnings, in noninterest income.
Loans Receivable - Loans receivable, are stated at the amount of unpaid principal reduced by an allowance for loan losses and net deferred fees or costs. Interest on loans is calculated using the simple interest method based on the daily balance of the principal amount outstanding and is credited to income as earned. Loan fees, net of direct origination costs, are deferred and amortized over the life of the loan using the effective yield method. If the loan is repaid prior to maturity, the remaining unamortized net deferred loan origination fee is recognized in income at the time of repayment.
Interest on loans is accrued daily based on the principal amount outstanding. Generally, the accrual of interest on loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due or when they are past due 90 days as to either principal or interest (based on contractual terms), unless they are well secured and in the process of collection. All interest accrued but not collected for loans that are placed on nonaccrual status or charged off are reversed against interest income. Subsequent collections on a cash basis are applied proportionately to past due principal and interest, unless collectability of principal is in doubt, in which case all payments are applied to principal. Loans are returned to accrual status when the loan is performing according to its contractual terms for at least six months and the collectability of principal and interest is no longer doubtful. The Company did not designate loans with payment deferrals granted due to the novel coronavirus of 2019 (“COVID-19’) pandemic as delinquent in accordance with provisions of The Coronavirus Aid, Relief, and Economic Security Act of 2020 (the “CARES Act”) and the Consolidated Appropriations Act, 2021 (the “CAA 2021”) and related regulatory guidance.
Impaired Loans - A loan is considered impaired when it is probable the Company will be unable to collect all contractual principal and interest payments due in accordance with the original or modified terms of the loan agreement. Impaired loans are measured on a loan by loan basis based on the estimated fair value of the collateral less estimated cost to sell if the loan is considered collateral dependent. Impaired loans not considered to be collateral dependent are measured based on the present value of expected future cash flows. Regular credit reviews of the portfolio also identify loans that are considered potentially impaired except for the smaller groups of homogeneous consumer loans.
The categories of nonaccrual loans and impaired loans overlap, although they are not coextensive. The Company considers all circumstances regarding the loan and borrower on an individual basis when determining whether an impaired loan should be placed on nonaccrual status, such as the financial strength of the borrower, the collateral value, reasons for delay, payment record, the amount of past due and the number of days past due. Loans that experience insignificant payment delays and payment shortfalls are generally not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of shortfall in relation to the principal and interest owed.
Troubled Debt Restructured Loans - Troubled debt restructured (“TDR”) loans are loans for which the Company, for economic or legal reasons related to the borrower’s financial condition, has granted a significant concession to the borrower that it would otherwise not consider. The loan terms which have been modified or restructured due to a borrower’s financial difficulty may include, but are not limited to: a reduction in the stated interest rate; an extension of
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the maturity at an interest rate below current market; a reduction in the face amount of the debt; a reduction in the accrued interest; or re-aging, extensions, deferrals and renewals. TDR loans are considered impaired loans and are individually evaluated for impairment and can be classified as either accrual or nonaccrual. TDR loans are classified as nonperforming loans unless they have been performing in accordance with their modified terms for a period of at least six months in which case they are placed on accrual status. See “ Recent Accounting Pronouncements, Recent Events” below for payment deferrals considered to be short-term that are not considered TDRs.
Allowance for Loan and Lease Losses (“ALLL”) - The ALLL is maintained at a level considered adequate to provide for probable losses on existing loans based on evaluating known and inherent risks in the loan portfolio. The allowance is reduced by loans charged off and increased by provisions charged to earnings and recoveries on loans previously charged-off. The allowance is based on management’s periodic, and systematic evaluation of factors underlying the quality of the loan portfolio including changes in the size and composition of the loan portfolio, the estimated value of any underlying collateral, actual loan loss experience, current economic conditions, and detailed analysis of individual loans for which full collectability may not be assured. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. While management uses the best information available to make its estimates, future adjustments to the allowance may be necessary if there is a significant change in economic and other conditions. Additional analysis was completed on the ALLL during 2020 based on the significance of loan modifications in accordance with the CARES Act and regulatory guidance and loan risk rating downgrades as well as additional risk factors related to COVID-19. The appropriateness of the ALLL is estimated based on these factors and trends identified by management at the time the financial statements are prepared.
When available information confirms that specific loans or portions thereof are uncollectible, these amounts are charged-off against the ALLL. The existence of some or all of the following criteria will generally confirm that a loss has been incurred: the loan is significantly delinquent and the borrower has not evidenced the ability or intent to bring the loan current; the Company has no recourse to the borrower, or if it does, the borrower has insufficient assets to pay the debt; the estimated fair value of the loan collateral is significantly below the current loan balance, and there is little or no near-term prospect for improvement.
A provision for loan losses is charged against income and added to the ALLL based on regular assessment of the loan portfolio. The ALLL is allocated to certain loan categories based on the relative risk characteristics, asset classifications, and actual loss experience within the loan portfolio. Although management has allocated the ALLL to various loan portfolio segments, the allowance is general in nature and is available for the loan portfolio in its entirety.
The ultimate recovery of all loans is susceptible to future market factors beyond the Company’s control. These factors may result in losses or recoveries differing significantly from those provided for in the financial statements. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s ALLL, and may require the Company to make additions to the allowance based on their judgment about information available to them at the time of their examinations.
Reserve for Unfunded Loan Commitments - The reserve for unfunded loan commitments is maintained at a level believed by management to be sufficient to absorb estimated probable losses related to these unfunded credit facilities. The determination of the adequacy of the reserve is based on periodic evaluations of the unfunded credit facilities including an assessment of the probability of commitment usage, credit risk factors for loans outstanding to these same customers, and the terms and expiration dates of the unfunded credit facilities. The reserve for unfunded loan commitments is included in other liabilities on the consolidated balance sheet, with changes to the balance charged against noninterest expense.
Premises and Equipment, Net - Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. The estimated useful lives used to compute depreciation include building and building improvements from 25 to 40 years and furniture, fixtures, and equipment from three to 10 years. Leasehold and tenant improvements are amortized using the straight-line method over the lesser of useful life or the life of the related lease. Gains or losses on dispositions are reflected in Consolidated Statements of Income.
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Management reviews buildings, improvements and equipment for impairment on an annual basis or whenever events or changes in the circumstances indicate that the undiscounted cash flows for the property are less than its carrying value. If identified, an impairment loss is recognized through a charge to earnings based on the fair value of the property.
Right of Use Lease Asset & Lease Liability -The Company leases retail space, office space, storage space, and equipment under operating leases. Most leases require the Company to pay real estate taxes, maintenance, insurance and other similar costs in addition to the base rent. Certain leases also contain lease incentives, such as tenant improvement allowances and rent abatement. Variable lease payments are recognized as lease expense as they are incurred. The Company records an operating lease right of use (ROU) asset and an operating lease liability (lease liability) for operating leases with a lease term greater than 12 months. The ROU asset and lease liability are recorded in other assets and other liabilities, respectively, in the consolidated statement of financial condition.
ROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. ROU assets and lease liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of the Company’s leases do not provide an implicit rate, the Company generally uses its incremental borrowing rate based on the estimated rate of interest for collateralized borrowing over a similar term of the lease payments at commencement date. Many of the Company’s leases contain various provisions for increases in rental rates, based either on changes in the published Consumer Price Index or a predetermined escalation schedule, which are factored into our determination of lease payments when appropriate. Substantially all of the leases provide the Company with the option to extend the lease term one or more times following expiration of the initial term. The ROU asset and lease liability terms may include options to extend or terminate the lease when it is reasonably certain that the Company will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term.
Transfers of Financial Assets - Transfers of an entire financial asset, a group of entire financial assets, or participating interest in an entire financial asset are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Servicing Rights - Servicing assets are recognized as separate assets when rights are acquired through purchase or through sale of financial assets. Generally, purchased servicing rights are capitalized at the cost to acquire the rights. For sales of mortgage, commercial and consumer loans, a portion of the cost of originating the loan is allocated to the servicing right based on relative fair value. Fair value is based on market prices for comparable mortgage, commercial, or consumer servicing contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds, and default rates and losses.
Servicing assets are evaluated quarterly for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights into tranches based on predominant characteristics, such as interest rate, loan type, and investor type. Impairment is recognized through a valuation allowance for an individual tranche, to the extent that fair value is less than the capitalized amount for the tranche. If the Company later determines that all or a portion of the impairment no longer exists for a particular tranche, a reduction of the allowance may be recorded as an increase to income. Capitalized servicing rights are stated separately on the Consolidated Balance Sheets and are amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets.
Income Taxes - The Company files a consolidated federal income tax return. Deferred federal income taxes result from temporary differences between the tax basis of assets and liabilities, and their reported amounts in the financial statements. These will result in differences between income for tax purposes and income for financial reporting purposes in future years. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Valuation allowances are established to reduce the net recorded amount of deferred tax assets if it is determined to be more likely than not, that all or some portion of the potential deferred tax asset will not be realized.
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The Company follows the authoritative guidance issued related to accounting for uncertainty in income taxes. The guidance prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. It is the Company’s policy to record any penalties or interest arising from federal or state taxes as a component of income tax expense.
Employee Stock Ownership Plan - Compensation expense recognized for the Company’s ESOP equals the fair value of shares that have been allocated or committed to be released for allocation to participants. Any difference between the fair value of the shares at the time and the ESOP’s original acquisition cost is charged or credited to stockholders’ equity (additional paid-in capital). The cost of ESOP shares that have not yet been allocated or committed to be released is deducted from stockholders’ equity.
Earnings Per Share (“EPS”) - Basic EPS are computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. For purposes of computing basic and dilutive EPS, ESOP shares that have been committed to be released are outstanding and ESOP shares that have not been committed to be released shall not be considered outstanding.
Comprehensive Income (Loss) - Comprehensive income (loss) is comprised of net income and other comprehensive income (loss). Other comprehensive income (loss) includes unrealized holding gains and losses on securities available-for-sale, net of tax and unrealized holding losses on derivatives designated as cash flow hedges, net of tax recorded directly to equity.
Financial Instruments - In the ordinary course of business, the Company has entered into agreements for off-balance-sheet financial instruments consisting of commitments to extend credit and stand-by letters of credit. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received.