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 and its subsidiary bank, 1st Security Bank 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.
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, one loan production office located in the Tri-Cities, and our newest loan production office located in Vancouver, Washington. On February 24, 2023, the Company completed its previously announced Columbia Branch Purchase of seven retail bank branches from Columbia State Bank and acquired approximately $425.5 million in deposits and $65.8 million in loans based on February 24, 2023 financial information (subject to a post-closing confirmation and adjustment review). The seven acquired branches are located in the communities of White Salmon and Goldendale, Washington, and Newport, Waldport, Ontario, Manzanita, and Tillamook, Oregon. The Columbia Branch Purchase serves to expand our Puget Sound-focused retail footprint into southeast Washington and the state of Oregon as well as providing an opportunity to extend our unique brand of community banking into those communities.
The Company also maintains its long-standing indirect consumer lending platform which operates primarily throughout the West Coast, expanding our partnership with companies present in other states as well. 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
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and had traditionally been the mainstay of the Company’s lending strategy. At December 31, 2022, consumer loans represented 25.6% of the Company’s total gross loan portfolio, up from 24.1% at December 31, 2021. 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, including speculative residential construction loans, as well as commercial business loans, while growing the current size of the consumer loan portfolio.
Fixture secured loans to finance window, gutter, siding replacement, solar panels, spas, 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 119 active dealers located throughout Washington, Oregon, California, Idaho, Colorado, Nevada, Arizona, Minnesota, and recently Texas, Utah, Massachusetts, and Montana with five contractor/dealers responsible for 53.0% of the funded loans dollar volume for the year ended December 31, 2022. The Company funded $315.0 million, or approximately 13,000 loans during the year ended December 31, 2022.
The following table details fixture secured loan originations by state for the periods indicated:
(Dollars in thousands) For the Year Ended For the Year Ended
State Amount Percent Amount Percent
Texas 572 0.2 — —
Utah 2,674 0.9 — —
Massachusetts 137 — — —
Montana 577 0.2 — —
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 $828.8 million 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 $13.5 million through the home lending segment during the year ended December 31, 2022, of which $715.6 million were sold to investors. Of the loans sold to investors, $477.5 million 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, 2022, one-to-four-family residential mortgage loans held for investment, which excludes loans held for sale of $20.1 million, totaled $469.5 million, or 21.2%, of the total gross loan portfolio.
For the year ended December 31, 2022, one-to-four-family loan originations and refinancing activity decreased as a result of increased market interest rates, compared to the same period in the prior year when home refinancing surged due to the lowering of market interest rates in response to COVID-19. Residential construction and development lending, while not as common as other loan origination 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 18 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
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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 the interest rates paid on these deposits and borrowings.
The Company’s earnings are also significantly affected by fee income from mortgage banking activities, the provision for credit losses on loans, service charges and fees, gains from sales of assets, operating expenses and income taxes. The Company recorded a provision for credit losses on loans of $6.6 million for the year ended December 31, 2022, compared to $500,000 for the same period one year ago, primarily due to loan growth.
Critical Accounting Estimates
We prepare our consolidated financial statements in accordance with GAAP. In doing so, we have to make estimates and assumptions. Our critical accounting estimates are those estimates that involve a significant level of uncertainty at the time the estimate was made, and changes in the estimate that are reasonably likely to occur from period to period, or use of different estimates that we reasonably could have used in the current period, would have a material impact on our financial condition or results of operations. Accordingly, actual results could differ materially from our estimates. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We have reviewed our critical accounting estimates with the audit committee of our Board of Directors.
See Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for a summary of significant accounting policies and the effect on our financial statements.
Allowance for Credit Losses on Loans (“ACLL”). The ACLL is the amount estimated by management as necessary to cover expected losses in the loan portfolio at the balance sheet date. The ACLL is established through the provision for credit losses on loans, which is charged to income. A high degree of judgment is necessary when determining the amount of the ACLL. Among the material estimates required to establish the ACLL are: probability of default; 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 ACLL at least quarterly and establishes the provision for credit losses on loans based upon an evaluation of the portfolio, past loss experience, current economic conditions, reasonable and supportable forecasts, and other factors related to the collectability of the loan portfolio. Although the Company believes that use of the best information available currently establishes the ACLL, future adjustments to the ACLL may be necessary if economic conditions differ substantially from the assumptions used in making the evaluation. 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 ACLL in any given period.
Because current economic conditions and forecasts can change and future events make it inherently difficult to predict the anticipated amount of estimated credit losses on loans, management's determination of the appropriateness of the ACL, could change significantly. It is difficult to estimate how potential changes in any one economic factor or input might affect the overall allowance because a wide variety of factors and inputs are considered in estimating the allowance and changes in those factors and inputs considered may not occur at the same rate and may not be consistent across all product types. Additionally, changes in factors and inputs may move independently of one another, such that improvement in one or certain factors may offset deterioration in others. Management believes that its systematic methodology continues to be appropriate.
In June 2016, the Financial Accounting Standards Board issued ASU No. 2016-13, Measurement of Credit Losses on Financial Instruments, referred to as the CECL model, which was early adopted by the Company and effective January 1, 2022. For additional information on CECL see “Note 1 - Basis of Presentation and Summary of Significant Accounting
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Policies – Application of New Accounting Guidance Adopted in 2022” of the Notes to the Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.
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. The valuation of servicing rights is based on various assumptions which are set forth in ‘Note 4 - Servicing Rights” of the Notes to the Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K. It also provides sensitivity analysis based on the assumptions used. The sensitivity analyses are hypothetical and have been provided to indicate the potential impact that changes in assumptions may have on the estimate of the fair value of the servicing rights.
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 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 is 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 on 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 and fair value 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 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. 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.
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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.
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 tax 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 differences resulting from differing treatment of items, such as depreciation and the provision for credit 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 assets of $6.7 million and net deferred tax liabilities of $1.2 million at December 31, 2022 and 2021, respectively.
Goodwill and Other Intangibles. The Company records all assets and liabilities acquired in purchase acquisitions, including goodwill and other intangibles, at fair value. Goodwill and indefinite-lived assets are not amortized but are subject, at a minimum, to annual tests for impairment. In certain situations, interim impairment tests may be required if events occur or circumstances change that would more likely than not reduce the fair value of a reporting segment below its carrying amount. Other intangible assets are amortized over their estimated useful lives using straight-line and accelerated methods and are subject to impairment if events or circumstances indicate a possible inability to realize the carrying amount.
The initial recognition of goodwill and other intangible assets and subsequent impairment analysis require management to make subjective judgments concerning estimates of how the acquired assets will perform in the future using valuation methods including discounted cash flow analysis. Additionally, estimated cash flows may extend beyond 10 years and, by their nature, are difficult to determine over an extended timeframe. Events and factors that may significantly affect the estimates include, among others, competitive forces, customer behaviors and attrition, changes in revenue growth trends, cost structures, technology, changes in discount rates and specific industry and market conditions. In determining the reasonableness of cash flow estimates, the Company reviews historical performance of the underlying assets or similar assets in an effort to assess and validate assumptions utilized in its estimates.
The Company’s annual assessment of potential goodwill impairment was completed during the fourth quarter of 2022. Based on the results of this assessment, no goodwill impairment was recognized. Because of current economic conditions the Company continues to monitor goodwill and other intangible assets for impairment indicators throughout the year.
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On an on-going basis, the Company evaluates its estimates. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The Company’s policies related to these estimates can be found in “Note 1 - Basis of Presentation and Summary of Significant Accounting Policies” of the Notes to the Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K. 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 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, 20 full-service bank branches and seven stand-alone loan production offices, 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 0.39% and 0.33% at December 31, 2022 and 2021, respectively. The percentage of nonperforming assets to total assets were 0.35% and 0.25% at December 31, 2022 and 2021, 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 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.
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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, 2022 and December 31, 2021
Assets. Total assets increased $346.5 million, to $2.63 billion at December 31, 2022, from $2.29 billion at December 31, 2021, primarily due to increases in loans receivable, net of $462.3 million, total cash and cash equivalents of $14.9 million, deferred tax assets, net of $6.7 million, Federal Home Loan Bank (“FHLB”) stock of $5.8 million, other assets of $5.0 million, accrued interest receivable of $3.6 million, operating lease right-of-use of $1.7 million, and servicing rights of $1.0 million, partially offset by decreases in loans held for sale of $105.7 million, securities available-for-sale of $42.1 million, certificates of deposit at other financial institutions of $5.8 million, and premises and equipment, net of $1.5 million. The increase in total assets was primarily funded by deposit growth and borrowings during the year ended December 31, 2022.
Loans receivable, net, increased $462.3 million, to $2.19 billion at December 31, 2022, from $1.73 billion at December 31, 2021. Total real estate loans increased $331.0 million, including increases in one-to-four-family portfolio loans of $103.3 million, construction and development loans of $102.0 million, commercial real estate loans of $69.6 million, multi-family loans of $41.6 million, and home equity loans of $14.4 million. Undisbursed construction and development loan commitments increased $19.4 million, or 10.6%, to $201.7 million at December 31, 2022, as compared to $182.3 million at December 31, 2021. Consumer loans increased $147.5 million, primarily due to increases of $159.7 million in indirect home improvement loans, partially offset by a decrease of $12.2 million in marine loans. Commercial business loans decreased $13.8 million due to a decrease in commercial and industrial loans of $11.8 million as a result of the repayment of $23.8 million in PPP loans, and a decrease in warehouse lending of $2.0 million reflecting the recent increase in residential mortgage interest rates and reduced refinance activity. The decrease in commercial and industrial loans resulting from the repayment of PPP loans was partially offset by the focused increase in commercial and industrial loans tied to the Bank’s investment in our business lending platform, including employees to service business lending customers and cash management teams to support business deposits.
Loans held for sale, consisting of one-to-four-family loans, decreased by $105.7 million, or 84.0%, to $20.1 million at December 31, 2022, compared to $125.8 million at December 31, 2021. Higher market rates in 2022 reduced purchase and refinance activity. The Company continues to invest in its home lending operations and strategically adds production staff in the markets we serve.
One-to-four-family loan originations for the year ended December 31, 2022, included $580.3 million of loans originated for sale, $235.0 million of portfolio loans including first and second liens, and $13.5 million of loans brokered to other institutions.
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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:
(Dollars in thousands) For the Year Ended December 31,
Amount Percent Amount Percent $ Change % Change
During the year ended December 31, 2022, the Company sold $715.6 million of one-to-four-family loans, compared to sales of $1.42 billion one year ago. The decrease in loan purchase and refinance activity, as well as sales activity, compared to the prior year reflects the impact of rising interest rates. The cash margin on loans sold, net of deferred fees and capitalized expenses, decreased to 1.39% for the year ended December 31, 2022, compared to 2.69% for the year ended December 31, 2021. 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 2.78% and 3.97% for the year ended December 31, 2022 and 2021, respectively. Gross cash margins on loans sold is defined as the margin on loans sold without the impact of deferred loan costs.
The ACLL was $28.0 million, or 1.26% of gross loans receivable, excluding loans held for sale at December 31, 2022, compared to $25.6 million, or 1.46% of gross loans receivable, excluding loans held for sale, at December 31, 2021. The increase was primarily due to an increase in the provision for credit losses on loans of $6.1 million during the period due to loan growth, partially offset with the one-time cumulative-effect adjustment of $2.9 million as of the CECL adoption date. The allowance for credit losses - unfunded loan commitments increased $2.0 million to $2.5 million at December 31, 2022, from $499,000 at December 31, 2021, primarily due to the one-time cumulative-effect adjustment of $2.4 million as of the CECL adoption date and increases in unfunded commitments.
Loans classified as substandard increased to $20.2 million at December 31, 2022, compared to $18.1 million at December 31, 2021. This increase in substandard loans was primarily due to increases of $4.5 million in commercial real estate loans, $522,000 in indirect home improvement loans, and $450,000 in one-to-four-family loans, partially offset by a decrease of $3.3 million in commercial and industrial loans. Nonperforming loans, consisting solely of nonaccrual loans, increased $2.9 million to $8.7 million at December 31, 2022, from $5.8 million at December 31, 2021. At December 31, 2022, nonperforming loans consisted of $6.3 million in commercial business loans, $1.1 million of indirect home improvement loans, $920,000 in one-to-four-family loans, $267,000 in marine loans, $46,000 of home equity loans and $9,000 of other consumer loans. The ratio of nonperforming loans to total gross loans was 0.39% at December 31, 2022, compared to 0.33% at December 31, 2021. There was one OREO property totaling $570,000 at December 31, 2022, compared to none at December 31, 2021. At December 31, 2022, the Company had two commercial business loans that were classified as TDRs totaling $3.7 million on nonaccrual status. See “Item 1. Business - Lending Activities - Asset Quality” of this Form 10-K for additional information regarding the Company’s nonperforming loans.
Liabilities. Total liabilities increased $362.3 million to $2.40 billion at December 31, 2021, from $2.04 billion at December 31, 2021, primarily due to increases of $212.0 million in deposits, $144.0 million in borrowings, and $5.8 million in other liabilities.
Total deposits increased $212.0 million to $2.13 billion at December 31, 2022, from $1.92 billion at December 31, 2021. Certificates of deposits increased $369.1 million to $729.8 million at December 31, 2022, from $360.7 million at December 31, 2021. Transactional accounts (noninterest-bearing checking, interest-bearing checking, and escrow accounts) decreased $119.5 million to $689.3 million at December 31, 2022, from $808.8 million at December 31, 2021, primarily due to a $92.9 million decrease in interest-bearing checking and a $26.4 million decrease in noninterest-bearing checking. Money market and savings accounts decreased $37.6 million, to $708.6 million at December 31, 2022, from $746.3 million at December 31, 2021. A portion of our wholesale funding activity has been tied to liability interest rate swap arrangements of $90.0 million that are funded with 90-day liabilities, as discussed below.
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Deposits are summarized as follows at the years indicated:
(Dollars in thousands) December 31,
Escrow accounts related to mortgages serviced (6) 16,236 16,389
_______________________________
(5) Time deposits that meet or exceed the FDIC insurance limit
(6) Noninterest-bearing checking.
Borrowings comprised of FHLB advances, increased $144.0 million to $186.5 million at December 31, 2022, from $42.5 million at December 31, 2021, which were used to fund loan growth.
Management entered into two liability interest rate swap arrangements designated as cash flow hedges during 2020 and one liability interest rate swap arrangement in 2020 to lock the expense costs associated with $90.0 million in brokered deposits and borrowings. The average cost of these $90.0 million in notional pay fixed interest rate swap agreements was 73 basis points for which the Bank pays a fixed rate of 73 basis points to the interest rate swap counterparty, compared to the quarterly reset of three-month LIBOR that will adjust quarterly. Management entered into two asset interest rate swap arrangements designated as fair value hedges in 2022 to offset changes in the fair value of $60.0 million in available for sale securities due to rising interest rates. The average cost of these $60.0 million in notional pay fixed interest rate swap agreements was 256 basis points for which the Bank will pay a fixed rate of 256 basis points to the interest rate swap counterparty, compared to receiving the monthly reset of SOFR. Management will continue to implement processes to match balance sheet funding duration and minimize interest rate risk and costs.
Stockholders’ Equity. Total stockholders’ equity decreased $15.8 million, to $231.7 million at December 31, 2022, from $247.5 million at December 31, 2021. The decrease in stockholders’ equity during the year ended December 31, 2022, was primarily due to net unrealized losses in securities available-for-sale of $32.9 million, common stock repurchases of $16.4 million and cash dividends paid of $7.1 million, partially offset by net income of $29.6 million. In addition, the adoption of CECL on January 1, 2022, resulted in a $297,000 increase to retained earnings reflecting the combined impact of the $2.9 million decrease to our ACLL and a $2.4 million increase to the allowance for credit losses - unfunded commitments as of the adoption date. The Company repurchased 550,680 shares of its common stock during the year ended December 31, 2022, at an average price of $29.85 per share. Book value per common share was $30.42 at December 31, 2022, compared to $30.75 at December 31, 2021.
We calculated book value based on common shares outstanding of 7,736,185 at December 31, 2022, less 118,530 unvested restricted stock shares for the reported common shares outstanding of 7,617,655. Common shares outstanding was calculated using 8,169,887 shares at December 31, 2021, less 121,672 unvested restricted stock shares for the reported common shares outstanding of 8,048,215.
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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, 2022. Income and all average balances are monthly average balances. Nonaccrual loans have been included in the table as loans carrying a zero yield. The yields on tax-exempt municipal bonds have not been computed on a tax equivalent basis.
Year Ended December 31,
Average Interest Average Interest Average Interest
Interest-earning assets:
Interest-bearing liabilities:
Net interest rate spread 4.15 % 3.91 % 3.75 %
Net interest margin 4.46 % 4.13 % 4.02 %
____________________________
(1) The average loans receivable, net balances include nonaccrual 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 for the periods indicated. 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.
(Dollars in thousands) Volume Rate (Decrease) Volume Rate (Decrease)
Interest-earning assets:
Taxable HTM Investment securities 30 (1) 29 255 2 257
Interest-bearing liabilities:
Net change in net interest income $ 17,631 $ 12,529
__________________________
(1) The average loans receivable, net balances include nonaccrual loans.
Comparison of Results of Operations for the Years Ended December 31, 2022 and 2021
General. Net income was $29.6 million for the year ended December 31, 2022, and $37.4 million for the year ended December 31, 2021. The decrease in net income was primarily the result of a $19.4 million, or 51.7% reduction in noninterest income, primarily due to a decrease in gain on sale of loans, a $5.7 million, or 1,143.4% increase in the provision for credit losses on loans, and a $2.9 million, or 3.9% increase in noninterest expense, partially offset by a $17.6 million, or 20.3% increase in net interest income and a $2.7 million, or 26.7% decrease in the provision for income tax expense.
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Net Interest Income. Net interest income increased $17.6 million, to $104.3 million for the year ended December 31, 2022, from $86.6 million for the year ended December 31, 2021. This increase was primarily the result of increased balances in higher yielding loans and an improved mix of loans versus other interest-earning assets. Interest income increased $22.3 million, primarily due to an increase of $20.9 million in interest income on loans receivable, including fees, impacted primarily by organic loan growth. Interest expense increased $4.7 million, primarily as a result of repricing deposit rates and an increase in higher cost borrowings and brokered deposits.
The net interest margin (“NIM”) increased 33 basis points to 4.46% for the year ended December 31, 2022, from 4.13% for the same period in the prior year. The increase in NIM reflects new loan originations at higher market interest rates, variable rate interest-earning assets repricing higher following recent increases in market interest rates, and an improved asset mix of higher yielding assets as lower yielding excess cash funded higher yielding loans. The benefit from higher yields and increased interest-earning assets was partially offset by rising deposit and borrowing costs. Increases in average balances of higher costing CDs and borrowings placed additional pressure on the NIM. Management remains focused on matching deposit/liability duration with the duration of loans/assets where appropriate.
Interest Income. Interest income for the year ended December 31, 2022, increased $22.3 million, to $118.7 million, from $96.4 million for the year ended December 31, 2021. The increase during the year was attributable to an increase in the average balance of total interest-earning assets and to a lesser extent, a 48 basis point increase in the average yield earned on interest-earning assets, primarily loans receivable, net and loans held for sale as indicated in the table below.
The following table compares average earning asset balances, associated yields, and resulting changes in interest income for the years ended December 31, 2022 and 2021:
(Dollars in thousands) Year Ended December 31,
Average Average $ Change
Balance Yield/ Balance Yield/ in Interest
Outstanding Rate Outstanding Rate Income
___________________________
(1) The average loans receivable, net balances include nonaccrual loans.
Interest Expense. Interest expense increased $4.7 million, to $14.4 million for the year ended December 31, 2022, from $9.7 million for the prior year, primarily due to an increase in interest expense on deposits of $2.5 million and an increase in higher cost borrowings of $2.0 million. The average cost of funds for total interest-bearing liabilities increased 24 basis points to 0.92% for the year ended December 31, 2022, compared to 0.68% for the year ended December 31, 2021. This increase was predominantly due to the increase in the average rates paid on deposits and borrowings reflecting the increase in market rates during 2022. The average cost of interest-bearing deposits increased 14 basis points to 0.66% for the year ended December 31, 2022, compared to 0.52% for the year ended December 31, 2021, reflecting higher market interest rates. Total funding costs factoring in average outstanding noninterest-bearing deposits of $580.0 million during 2022 was 0.67%, compared to total funding costs factoring in average outstanding noninterest-bearing deposits of $486.3 million during 2021 of 0.51%.
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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, 2022 and 2021:
(Dollars in thousands) Year Ended December 31,
Average Average $ Change
Balance Yield/ Balance Yield/ in Interest
Outstanding Rate Outstanding Rate Expense
Provision for Credit Losses. For the year ended December 31, 2022, the provision for credit losses on loans was $6.6 million as calculated under CECL, compared to $500,000 for the year ended December 31, 2021 as calculated under the prior incurred loss methodology. The provision for credit losses on loans reflects the increase in total loans receivable, partially offset with the one-time cumulative-effect adjustment of $2.9 million as of the CECL adoption date. For the year ended December 31, 2022, the Company recorded a negative provision for credit losses on unfunded commitments of $365,000, compared to a provision of $92,000 for the year ended December 31, 2021. The decrease was attributable to a change in methodology as a result of the adoption of CECL, as well as decreases in total unfunded commitments during the year.
During the year ended December 31, 2022, net charge-offs totaled $1.4 million, compared to $1.0 million during the year ended December 31, 2021. The increase in net charge-offs was primarily due to increases in the following loan categories: $326,000 in other consumer loans (which includes deposit overdraft net charge-offs of $301,000), and $94,000 in marine loans, partially offset by decreases of $38,000 in commercial business loans and $12,000 in indirect home improvement loans. A further decline in national and local economic conditions, as a result of current economic factors, could result in a material increase in the allowance for credit losses and may adversely affect the Company’s financial condition and result of operations.
The following table details activity and information related to the allowance for credit losses on loans for the years ended December 31, 2022 and 2021:
At or For the Year Ended December 31,
Provision for credit losses on loans $ 6,623 $ 500
Allowance for credit losses on loans $ 27,992 $ 25,635
Nonperforming loans $ 8,652 $ 5,829
Management considers the ACLL at December 31, 2022, to be adequate to cover forecasted losses 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
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adversely impact the Company’s financial condition and results of operations. In addition, the determination of the amount of allowance for credit losses on loans is subject to review by bank regulators, as part of the routine examination process, which may 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 decreased $19.4 million, to $18.1 million for the year ended December 31, 2022, from $37.5 million for the year ended December 31, 2021. 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) 2022 2021 Amount Percent
Earnings on cash surrender value of BOLI 876 866 10 1.2
The year over year decreases include a $23.2 million, or 74.5% decrease in gain on sale of loans, primarily due to a reduction in origination and sales volume of loans held for sale and a reduction in gross margins of sold loans, partially offset by a $4.2 million increase in service charges and fee income as a result of less MSR amortization reflecting increased market interest rates and increased servicing fees from non-portfolio service loans. Gross margins on home loan sales decreased to 2.78% for the year ended December 31, 2022, from 3.97% for the year ended December 31, 2021.
Noninterest Expense. Noninterest expense increased $2.9 million, to $79.2 million for the year ended December 31, 2022, from $76.2 million for the year ended December 31, 2021. The following table provides an analysis of the changes in the components of noninterest expense:
Year Ended December 31, (Decrease)/Increase
(Dollars in thousands) 2022 2021 Amount Percent
Loss on sale of OREO — 9 (9) (100.0)
Amortization of core deposit intangible 691 691 — —
The increase in noninterest expense was primarily due to a reduction in the recovery of servicing rights to $1,000 from $2.1 million, along with increases of $1.1 million in data processing, $898,000 in acquisition costs related to the pending Columbia Branch Acquisition, $588,000 in FDIC insurance, $273,000 in occupancy, and $263,000 in marketing and advertising expenses, partially offset by a decrease of $2.1 million in salaries and benefits, primarily due to a reduction in incentive compensation and commissions.
The efficiency ratio, which is noninterest expense as a percentage of net interest income and noninterest income, rose to, 64.70% for the year ended December 31, 2022, compared to 61.41% for the year ended December 31, 2021, primarily as a result of a decrease in noninterest income and an increase in noninterest expense as noted above.
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Provision for Income Tax. For the year ended December 31, 2022, the Company recorded a provision for income tax expense of $7.3 million on pre-tax income of $37.0 million, as compared to a provision of income tax expense of $10.0 million on pre-tax income of $47.4 million for the year ended December 31, 2021. There was a net deferred tax asset of $6.7 million and a net deferred tax liability of $1.2 million at December 31, 2022 and 2021, respectively. The effective corporate income tax rates for the years ended December 31, 2022 and 2021 were 19.8% and 21.1%, 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.
Comparison of Results of Operations for the Years Ended December 31, 2021 and 2020
See Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2021 filed with the SEC.
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, subordinated notes, 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 the Company. Therefore, the Company will control the level of economic risk by limiting the amount of long-term, fixed-rate assets it will have and by setting a limit on concentrations and maturities of securities.
Interest Rate Risk. If the Federal Reserve 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, 2022, is an analysis prepared for the Company 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. 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, 2022.
Change in 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 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,
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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’s level of interest rate risk is acceptable under this approach.
In evaluating the Company’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. The Company considers all of these factors in monitoring its exposure to interest rate risk.
Liquidity and Capital Resources
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. While the maturities and the scheduled amortization of loans are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition.
The Bank must maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund its operations. The Bank generally maintains sufficient cash and short-term investments to meet short-term liquidity needs. At December 31, 2022, the Bank’s total borrowing capacity was $601.7 million with the FHLB of Des Moines, with unused borrowing capacity of $414.8 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, 2022, the Bank held approximately $840.2 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 $205.8 million, and a combined credit limit of $101.0 million in written federal funds lines of credit through correspondent banking relationships at December 31, 2022. The FRB borrowing limit is based on certain categories of loans, primarily consumer loans, that qualify as collateral for FRB line of credit. At December 31, 2022, the Bank held approximately $579.8 million in loans that qualify as collateral for the FRB line of credit. Subject to market conditions, we expect to utilize these borrowing facilities from time to time in the future to fund loan originations and deposit withdrawals, to satisfy other financial commitments, repay maturing debt and to take advantage of investment opportunities to the extent feasible.
The Bank’s Asset and Liability Management Policy permits management to utilize brokered deposits up to 20% of deposits or $427.0 million at December 31, 2022. Total brokered deposits at December 31, 2022 were $393.9 million. Management utilizes brokered deposits to mitigate interest rate risk and to enhance liquidity 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, 2022, the outstanding loan commitments totaled $549.3 million, which included $201.7 million of undisbursed construction and development loan commitments. 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. Securities purchased during the years ended December 31, 2022 and 2021 totaled
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$24.0 million and $130.1 million, respectively, and securities repayments, maturities and sales in those periods were $21.2 million and $29.9 million, respectively.
The Bank’s liquidity is also affected by the volume of loans sold and loan principal payments. During the years ended December 31, 2022 and 2021, the Bank sold $740.4 million and $1.40 billion in loans, respectively. During the years ended December 31, 2022 and 2021, the Bank received $737.3 million and $899.3 million in principal repayments on loans, respectively.
The Bank’s liquidity has been positively impacted by increases in deposit levels. During the years ended December 31, 2022 and 2021, deposits increased by $212.0 million and $241.5 million, respectively. Our liquid assets in the form of cash and cash equivalents, CDs at other financial institutions and investment securities decreased to $283.9 million at December 31, 2022 from $315.9 million at December 31, 2021. CDs scheduled to mature in one year or less at December 31, 2022, totaled $472.2 million. It is management’s policy to offer deposit rates that are competitive with other local financial institutions. Based on this management strategy, the Bank believes that a majority of maturing relationship deposits will remain with the Bank.
We incur capital expenditures on an ongoing basis to expand and improve our product offerings, enhance and modernize our technology infrastructure, and to introduce new technology-based products to compete effectively in our markets. We evaluate capital expenditure projects based on a variety of factors, including expected strategic impacts (such as forecasted impact on revenue growth, productivity, expenses, service levels and customer retention) and our expected return on investment. The amount of capital investment is influenced by, among other things, current and projected demand for our services and products, cash flow generated by operating activities, cash required for other purposes and regulatory considerations. Based on current capital allocation objectives, there are no projects scheduled for capital investments in premises and equipment during the year ending December 31, 2023 that would materially impact liquidity. We also have purchase obligations, generally with remaining terms of less than three years and contracts with various vendors to provide services, including information processing, for periods generally ranging from one to five years, for which our financial obligations are dependent upon acceptable performance by the vendor.
For the year ending December 31, 2023, we project that fixed commitments will include $1.5 million of operating lease payments and $182.6 million of scheduled payments and maturities of FHLB advances during the year ending December 31, 2023. For information regarding our operating leases and FHLB advances, see “Note 6 - Leases” and “Note 9 - Debt”, respectively, of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.
The Bank's management believes that the liquid assets combined with the available lines of credit provide adequate liquidity to meet current financial obligations for at least the next 12 months.
As a separate legal entity from the Bank, FS Bancorp must provide for its own liquidity. Sources of capital and liquidity for FS Bancorp 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, 2022, FS Bancorp, Inc. had $7.2 million in unrestricted cash to meet liquidity needs.
The Company currently expects to continue the current practice of paying quarterly cash dividends on common stock subject to the Board of Directors' discretion to modify or terminate this practice at any time and for any reason without prior notice. Our current quarterly common stock dividend rate is $0.25 per share, which we believe is a dividend rate per share which enables us to balance our multiple objectives of managing and investing in the Bank, and returning a substantial portion of our cash to our shareholders. Assuming continued cash dividend payment during 2023 at this rate of $0.25 per share, our average total dividend paid each quarter would be approximately $1.9 million based on the number of our current outstanding shares as of December 31, 2022.
The Bank is subject to minimum capital requirements imposed by the FDIC. Based on its capital levels at December 31, 2022, 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, 2022, the Bank was considered to be well capitalized. At December 31, 2022,
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the Bank exceeded all regulatory capital requirements with Tier 1 leverage-based capital, Tier 1 risk-based capital, total risk-based capital, and common equity Tier 1 capital ratios of 11.3%, 12.5%, 13.7%, and 12.5%, respectively.
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 were subject to regulatory capital guidelines for bank holding companies with $3.0 billion or more in assets at December 31, 2022, FS Bancorp would have exceeded all regulatory capital requirements. For informational purposes, the regulatory capital ratios calculated for FS Bancorp at December 31, 2022 were 9.7% for Tier 1 leverage-based capital, 10.7% for Tier 1 risk-based capital, 14.0% for total risk-based capital, and 10.7% for CET 1 capital ratio. For additional information regarding 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.
Recent Accounting Pronouncements
For a discussion of recent accounting standards, please see “Note 1- Basis of Presentation and Summary of Significant Accounting Policies” 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
Consolidated Balance Sheets at December 31, 2022 and 2021 79
Notes to Consolidated Financial Statements 86
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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, 2022 and 2021, the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2022, 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, 2022, 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, 2022 and 2021, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2022, 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, 2022, based on criteria established in Internal Control - Integrated Framework (2013) issued by COSO.
Change in Accounting Principle
As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for credit losses effective January 1, 2022, due to the adoption of Accounting Standards Codification Topic 326, Financial Instruments - Credit Losses (Topic 326). The Company adopted the new credit loss standard using the modified retrospective approach such that prior period amounts are not adjusted and continue to be reported in accordance with previously applicable generally accepted accounting principles. The new credit loss standard is also communicated as a critical audit matter below.
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
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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 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 Credit Losses on Loans
As described in Note 1 and 3 to the consolidated financial statements, the Company’s allowance for credit losses on loans totaled $28.0 million as of December 31, 2022. The allowance for credit losses on loans is a valuation account that is deducted from the loans’ amortized cost basis to present the net amount expected to be collected on the loans. The measurement of the net amount expected to be collected on loans is based on relevant available information, from internal and external sources, relating to past events, current conditions, historical loss experience, and reasonable and supportable forecasts.
We identified management’s risk-grade grouping of loans, the application of reasonable and supportable forecasts of future economic conditions, and qualitative and environmental adjustments, each of which are used in the calculation of the allowance for credit losses on loans, as a critical audit matter. The Company groups loans by call report code and then by risk-grade grouping. Risk-grade groupings are internally developed based on relevant credit quality indicators for each loan group, and estimated losses for each loan group are based upon risk-grade groupings. The determination of risk-grade groupings involves significant management judgment. Management utilizes reasonable and supportable forecasts of future economic conditions when estimating the allowance for credit losses on loans. The allowance for credit loss on loans includes a 12-month probability of default forecast based a regression model comparing peer nonperforming loan ratios to the national unemployment rate. The qualitative and environmental adjustments are used to estimate factors that are not captured in the modeled historical losses. In turn, auditing management’s complex judgments regarding the determination of risk grades, forecasted economic conditions, and qualitative and environmental adjustments applied to the allowance for credit losses on loans involved a high degree of auditor judgment due to the nature and extent of the audit evidence and effort required to audit these matters.
The primary procedures we performed to address this critical audit matter included:
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/s/ Moss Adams LLP
Everett, Washington
March 16, 2023
We have served as the Company’s auditor since 2006.
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FS BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2022 AND 2021
(Dollars in thousands, except share data)
December 31, December 31,
Interest-bearing deposits at other financial institutions 30,912 14,448
Certificates of deposit at other financial institutions 4,712 10,542
Securities available-for-sale, at fair value 229,252 271,359
Operating lease right-of-use (“ROU”) assets 6,226 4,557
Federal Home Loan Bank (“FHLB”) stock, at cost 10,611 4,778
Other real estate owned (“OREO”) 570 —
Deferred tax asset, net 6,670 —
Bank owned life insurance (“BOLI”), net 36,799 37,092
Servicing rights, held at the lower of cost or fair value 18,017 16,970
Core deposit intangible, net 3,369 4,060
LIABILITIES
Deposits:
Subordinated notes:
Unamortized debt issuance costs (539) (606)
Total subordinated notes less unamortized debt issuance costs 49,461 49,394
Operating lease liabilities 6,474 4,792
Deferred tax liability, net — 1,183
COMMITMENTS AND CONTINGENCIES (NOTE 12)
STOCKHOLDERS’ EQUITY
Accumulated other comprehensive (loss) income, net of tax (25,632) 252
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, 2022, 2021, and 2020
(Dollars in thousands, except earnings per share data)
_________________________________________________________________________________________________________________________
Year Ended
December 31,
INTEREST INCOME
INTEREST EXPENSE
NONINTEREST INCOME
Gain on sale of investment securities — — 300
Earnings on cash surrender value of BOLI 876 866 870
NONINTEREST EXPENSE
Loss on sale of OREO — 9 2
OREO expenses — — 4
Federal Deposit Insurance Corporation (“FDIC”) insurance 1,224 636 829
Acquisition cost 898 — —
Amortization of core deposit intangible 691 691 706
(Recovery) impairment of servicing rights (1) (2,059) 1,969
Basic earnings per share $ 3.75 $ 4.48 $ 4.58
Diluted earnings per share $ 3.70 $ 4.37 $ 4.49
Share and per share data has been adjusted for all periods to reflect a two-for-one stock split effective July 14, 2021.
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, 2022, 2021, and 2020
(Dollars in thousands)
Year Ended
December 31,
Other comprehensive (loss) income:
Securities available-for-sale:
Derivative financial instruments:
Unrealized derivative gain (loss) during period 9,844 1,706 (1,429)
Other comprehensive (loss) income, net of tax (25,884) (2,281) 1,745
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, 2022, 2021, and 2020
(Dollars in thousands, except share amounts)
Accumulated
Other
Additional Comprehensive Unearned Total
Common Stock Paid-in Retained Income (Loss), ESOP Stockholders’
Shares Amount Capital Earnings Net of Tax Shares Equity
Net income — $ — — 39,264 — — $ 39,264
Share-based compensation — $ — 1,020 — — — $ 1,020
Restricted stock awards 49,760 $ 1 — — — — $ 1
ESOP shares allocated — $ — 1,025 — — 282 $ 1,307
Dividends paid ($0.56 per share) — $ — — (4,602) — — $ (4,602)
Share-based compensation — $ — 1,446 — — — $ 1,446
Restricted stock awards 41,350 $ — — — — — $ —
Stock options exercised, net 176,978 $ 1 (2,077) — — — $ (2,076)
Other comprehensive loss, net of tax — $ — — — (2,281) — $ (2,281)
ESOP shares allocated — $ — 1,482 — — 291 $ 1,773
Share and per share data has been adjusted for all periods to reflect a two-for-one stock split effective July 14, 2021.
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FS BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2022, 2021, and 2020 (Continued)
(Dollars in thousands, except share amounts)
Accumulated
Other
Additional Comprehensive Total
Common Stock Paid-in Retained Income (Loss), Stockholders’
Shares Amount Capital Earnings Net of Tax Equity
Dividends paid ($0.90 per share) — $ — — (7,096) — $ (7,096)
Share-based compensation — $ — 1,971 — — $ 1,971
Restricted stock awards 35,050 $ — — — — $ —
Stock options exercised, net 64,994 $ — 568 — — $ 568
Other comprehensive loss, net of tax — $ — — — (25,884) $ (25,884)
Share and per share data has been adjusted for all periods to reflect a two-for-one stock split effective July 14, 2021.
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, 2022, 2021, and 2020
(Dollars in thousands)
Year Ended December 31,
CASH FLOWS FROM (USED BY) OPERATING ACTIVITIES 2022 2021 2020
Adjustments to reconcile net income to net cash from operating activities
ESOP compensation expense for allocated shares — 1,773 1,307
Provision (benefit) for deferred income taxes (844) 1,750 (2,390)
Change in cash surrender value of BOLI (876) (866) (870)
Gain on sale of portfolio loans (596) (106) —
Gain on sale of investment securities — — (300)
(Recovery) impairment of servicing rights (1) (2,059) 1,969
Loss on sale of OREO — 9 2
Changes in operating assets and liabilities
CASH FLOWS USED BY INVESTING ACTIVITIES
Activity in securities available-for-sale:
Proceeds from sale of investment securities — — 12,214
Activity in securities held-to-maturity:
Proceeds from sale of portfolio loans 39,034 2,699 —
Proceeds from sale of OREO, net 145 81 76
Purchase of premises and equipment (1,551) (1,984) (1,379)
Proceeds from bank owned life insurance death benefits 1,169 — —
CASH FLOWS FROM FINANCING ACTIVITIES
Net proceeds from issuance of subordinated notes — 49,333 —
Repayment of subordinated notes — (10,000) —
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FS BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2022, 2021, and 2020 (Continued)
Issuance of common stock - employee stock purchase plan 503 — —
SUPPLEMENTARY DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the year for:
OREO received in settlement of loans 145 — —
Transfer of closed retail branch to OREO 570 — —
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 20 full-service bank branches, a headquarters that also originates loans and accepts deposits, and loan production offices in suburban communities in the greater Puget Sound area, the Tri-Cities and, our newest one in Vancouver, Washington as of December 31, 2022. 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 credit losses on loans, 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 and its wholly owned subsidiary, 1st Security Bank. 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, 2022, for potential recognition or disclosure.
On November 5, 2022, 1st Security Bank entered into a purchase and assumption agreement to acquire seven branches from Columbia State Bank. On February 24, 2023, the Bank completed the purchase of the branches. The seven branches are located in the communities of Manzanita, Newport, Ontario, Tillamook, and Waldport, Oregon and Goldendale and White Salmon, Washington. In connection with the purchase, the Bank acquired approximately $425.5 million in deposits and $65.8 million in associated loans based on February 24, 2023 financial information and subject to post-closing confirmation and adjustment review. For additional information see “Note 24 - Recent Developments.”
Error Corrections - The Company has evaluated error corrections in earnings per share and deposits as follows:
Earnings Per Share
Prior presentations of earnings per share were revised due to the improper inclusion of certain unvested shares of the Company’s commons stock in the denominator of basic and diluted earnings per share. As a result of the inclusion, earnings per share was understated for the years ended December 31, 2021 and 2020. Basic earnings per share for December 31, 2021 was updated to $4.48, from $4.42 as previously reported, and diluted earnings per share was updated to $4.37, from $4.32 as previously reported. Basic earnings per share for December 31, 2020 was updated to $4.58, from $4.57, as previously reported and diluted earnings per share was unchanged at $4.49.
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Management evaluated the materiality of this error from qualitative and quantitative perspectives and concluded that the error was immaterial to the prior period financial statements taken as a whole. Consequently, the financial statements for the prior periods include the impact of the correction of the error, and prior period financial statements have not been restated. The error correction did not affect total assets, net income, or cash flows for the periods.
Deposits
Prior presentation of interest-bearing and noninterest-bearing checking balances was revised due to the misclassification of certain checking products in previous periods. As a result of the misclassification, an interest-bearing checking balance of $121.2 million at December 31, 2021, was reclassified to noninterest-bearing checking for comparative purposes.
Management evaluated the materiality of this error from qualitative and quantitative perspectives and concluded that the error was immaterial to the prior period financial statements taken as a whole. Consequently, the financial statements for the prior periods include the impact of the correction of the error, and prior period financial statements have not been restated. The error correction did not affect total assets, net income, or cash flows for the periods.
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, 2022 and 2021, the Company had $281,000 and $327,000, 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 credit 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 non-contingently callable debt securities which are amortized to the earliest call date, rather than the contractual maturity date. Dividends and interest income are recognized when earned.
Management no longer evaluates securities for other-than-temporary impairment, as ASC Subtopic 326-30, Financial Instruments - Credit Losses - Available for Sale Debt Securities, changes the accounting for recognizing impairment on available for sale and held to maturity debt securities. Each quarter management evaluates impairment where there has been a decline in fair value below the amortized cost basis of a security to determine whether there is a credit loss associated with the decline in fair value. Management considers the nature of the collateral, potential future changes in collateral values, default rates, delinquency rates, third-party guarantees, credit ratings, interest rate changes since purchase, volatility of the security’s fair value and historical loss information for financial assets secured with similar collateral among other factors. Credit losses are calculated individually, rather than collectively, using a discounted cash flow method, whereby management compares the present value of expected cash flows with the amortized cost basis of the security. The credit loss component recognized through the Provision for Credit Losses on the Consolidated Statements of Income. (See Note 2 - Investments).
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 $2.5 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, 2022 and 2021, the Bank’s minimum level of investment requirement in FHLB stock was $10.6 million and $4.8 million,
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respectively. The Bank was in compliance with the FHLB minimum investment requirement at December 31, 2022 and 2021.
Management evaluates FHLB stock for impairment annually. 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, 2022 and 2021, 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”) is recorded initially at the lower of cost or fair value less selling costs, with any initial charge made to the allowance for credit losses on loans. 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.
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 credit losses on loans and net deferred fees or costs and premiums or discounts. Interest on loans is calculated using the simple
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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.
Income Recognition on Nonaccrual Loans and Securities - 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. While less common, similar interest reversal and nonaccrual treatment is applied to investment securities if their ultimate collectability becomes questionable.
Allowance for Credit Losses on Held-to-Maturity Securities -Management measures expected credit losses on held-to-maturity securities by individual security. Accrued interest receivable on held-to-maturity debt securities is excluded from the estimate of credit losses. The estimate of expected credit losses considers credit ratings and historical credit loss information that is adjusted for current conditions and reasonable and supportable forecasts.
The held-to-maturity portfolio consists entirely of corporate securities. Securities are generally rated BBB- or higher. Securities are analyzed individually to establish a reserve.
Allowance for Credit Losses on Available-for-Sale Securities -For available-for-sale securities in an unrealized loss position, management first assesses whether it intends to sell, or is more likely than not to be required to sell, the security before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the security’s amortized cost basis is written down to fair value through income. For debt securities available-for-sale that do not meet the aforementioned criteria, the Company evaluates whether the decline in fair value has resulted from credit losses or other factors. In making this assessment, management considers the extent to which fair value is less than amortized cost, any changes to the rating of the security by a rating agency, and adverse conditions specifically related to the security, among other factors. If this assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security are compared to the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an allowance for credit losses (“ACL”) is recorded for the credit loss, limited by the amount that the fair value is less than the amortized cost basis.
Changes in the ACL are recorded as a provision for (or reversal of) credit loss expense. Losses are charged against the allowance when management believes the uncollectibility of an available-for-sale security is confirmed or when either of the criteria regarding intent or requirement to sell is met. Accrued interest receivable on available-for-sale debt securities is not included in the estimate of credit losses.
Allowance for Credit Losses on Loans -The allowance for credit losses on loans (“ACLL”) is a valuation account that is deducted from the loans’ amortized cost basis to present the net amount expected to be collected on the loans. Loans are charged off against the allowance when management believes the uncollectibility of a loan balance is confirmed and recoveries are credited to the allowance when received. In the case of recoveries, amounts may not exceed the aggregate of amounts previously charged off.
Management utilizes relevant available information, from internal and external sources, relating to past events, current conditions, historical loss experience, and reasonable and supportable forecasts. The lookback period in the analysis includes historical data from 2009 to present. Adjustments to historical loss information are made when management determines historical data is not likely reflective of the current portfolio such as limited data sets or lack of default or loss history. Management may selectively apply external market data to subjectively adjust the Company’s own loss history including index or peer data. Accrued interest receivable is excluded from the estimate of credit losses for loans.
Collective Assessment -The ACLL is measured on a collective cohort basis when similar risk characteristics exist. Generally, collectively assessed loans are grouped by call report code and then risk-grade grouping. Risk grade is grouped
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within each call report code by pass, watch, special mention, substandard, and doubtful. Other loan types are separated into their own cohorts due to specific risk characteristics for that pool of loans.
The Company has elected a non-discounted cash flow methodology with probability of default (“PD”) and loss given default (“LGD”) for all call report code cohorts (“cohorts”), with the exception of the indirect and marine portfolios which are evaluated under a vintage methodology. The vintage methodology measures the expected loss calculation for future periods based on historical performance by the origination period of loans with similar life cycles and risk characteristics. Guaranteed portions of loans are measured with zero risk due to cash collateral and full guaranty.
The PD calculation looks at the historical loan portfolio at particular points in time (each month during the lookback period) to determine the probability that loans in a certain cohort will default over the next 12-month period. A default is defined as a loan that has moved to past due 90 days and greater, nonaccrual status, or experienced a charge-off during the period. In cohorts where the Company’s historical data is insufficient due to a minimal amount of default activity or zero defaults, management uses index PDs comprised of rates derived from the PD experience of other community banks in place of the Company’s historical PDs. Additionally, management reviews all other cohorts to determine if index PDs should be used outside of these criteria.
The LGD calculation looks at actual losses (net charge-offs) experienced over the entire lookback period for each cohort of loans. The aggregate loss amount is divided by the exposure at default to determine an LGD rate. All defaults (non-accrual, charge-off, or greater than 90 days past due) occurring during the lookback period are included in the denominator, whether a loss occurred or not and exposure at default is determined by the loan balance immediately preceding the default event (i.e., nonaccrual or charge-off). Due to very limited charge-off history, management uses index LGDs comprised of rates derived from the LGD experience of other community banks in place of the Company’s historical LGDs.
The Company utilizes reasonable and supportable forecasts of future economic conditions when estimating the ACLL. The calculation includes a 12-month PD forecast based on the Company’s regression model comparing peer nonperforming loan ratios to the national unemployment rate. After the forecast period, PD rates revert on a straight-line basis back to long-term historical average rates over a 12-month period. Due to very limited default history, management uses index PDs comprised of rates derived from the PD experience of other community banks in place of the Company’s historical PDs.
The Company recognizes that all significant factors that affect the collectability of the loan portfolio must be considered to determine the estimated credit losses as of the evaluation date. Furthermore, the methodology, in and of itself and even when selectively adjusted by comparison to market and peer data, does not provide a sufficient basis to determine the estimated credit losses. The Company adjusts the modeled historical losses by qualitative and environmental adjustments to incorporate all significant risks to form a sufficient basis to estimate the credit losses.
Individual Assessment -Loans classified as nonaccrual, trouble debt restructuring (“TDR”), or reasonably expected TDR will be reviewed quarterly for potential individual assessment. Any loan classified as a nonaccrual or TDR that is not determined to need individual assessment will be evaluated collectively within its respective cohort. All reasonably expected TDR loans will be evaluated individually to account for expected modifications in loan terms.
Where the primary and/or expected source of repayment of a specific loan is believed to be the future liquidation of available collateral, impairment will generally be measured based upon expected future collateral proceeds, net of disposition expenses including sales commissions as well as other costs potentially necessary to sell the asset(s) (i.e., past due taxes, liens, etc.). Estimates of future collateral proceeds will be based upon available appraisals, reference to recent valuations of comparable properties, use of consultants or other professionals with relevant market and/or property-specific knowledge, and any other sources of information believed appropriate by management under the specific circumstances. When appraisals are ordered to support the impairment analysis of an impaired loan, the appraisal is reviewed by the Company’s internal appraisal reviewer.
Where the primary and/or expected source of repayment of a specific loan is believed to be the receipt of principal and interest payments from the borrower and/or the refinancing of the loan by another creditor, impairment will generally be measured based upon the present value of expected proceeds discounted at the contractual interest rate. Expected refinancing proceeds may be estimated from review of term sheets actually received by the borrower from other creditors and/or from the Company’s knowledge of terms generally available from other banks.
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Determining the Contractual Term -Expected credit losses are estimated over the contractual term of the loans, adjusted for expected prepayments when appropriate. The contractual term excludes expected extensions, renewals and modifications unless either of the following applies: management has a reasonable expectation at the reporting date that a TDR will be executed with an individual borrower or the extension or renewal options are included in the original or modified contract at the reporting date and are not unconditionally cancellable by the Company. Prepayment assumptions will be determined by analysis of historical behavior by loan cohort.
Troubled Debt Restructurings -A loan for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, is considered to be a TDR. Any loan that is being considered for modification and expected to result in a TDR is identified as a reasonably expected TDR. Reasonably expected TDRs are assessed in the Current Expected Credit Loss (“CECL”) calculation utilizing their expected modified terms. The ACL on a TDR is measured using the same method as all other loans held for investment, except that the original interest rate is used to discount the expected cash flows when a rate modification has occurred.
Allowance for Credit Losses on Unfunded Commitments -The Company estimates expected credit losses over the contractual period in which the Company is exposed to credit risk via a contractual obligation to extend credit unless that obligation is unconditionally cancellable by the Company. The ACL on unfunded commitments is adjusted through a provision for credit loss expense. The estimate includes consideration of the likelihood that funding will occur and an estimate of expected credit losses on commitments expected to be funded over its estimated life. The estimate utilizes the same factors and assumptions as the allowance for credit losses on loans and is applied at the same collective cohort level.
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 up to 25 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 on the Consolidated Statements of Income.
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 ROU asset and an operating 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, on the Consolidated Balance Sheets.
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.