ITEM 1A. RISK FACTORS
The significant risks and uncertainties related to us, our business and our securities of which we are aware are discussed below. Investors and shareholders should carefully consider these risks and uncertainties before making investment decisions with respect to the Corporation’s securities. Any of these factors could materially and adversely affect our business, financial condition, operating results and prospects and could negatively impact the market price of the Corporation’s securities. If any of these risks materialize, the holders of the Corporation’s securities could lose all or part of their investments in the Corporation. Additional risks and uncertainties that we do not yet know of, or that we currently think are immaterial, may also impair our business operations. Investors and shareholders should also consider the other information contained in this annual report, including our financial statements and the related notes, before making investment decisions with respect to the Corporation’s securities.
Risks Relating to First United Corporation and its Affiliates
First United Corporation’s future success depends on the successful growth of its subsidiaries.
The Corporation’s primary business activity for the foreseeable future will be to act as the holding company of the Bank and its other direct and indirect subsidiaries. Therefore, the Corporation’s future profitability will depend on the success and growth of these subsidiaries.
The Bank’s funding sources may prove insufficient to replace deposits and support our future growth.
The Bank relies on customer deposits, advances from the FHLB, lines of credit at other financial institutions and brokered funds to fund our operations. Although the Bank has historically been able to replace maturing deposits and advances if desired, no assurance can be given that the Bank would be able to replace such funds in the future if our financial condition or the financial condition of the FHLB or market conditions were to change. Our financial flexibility
16
Tae of Contents
will be severely constrained and/or our cost of funds will increase if we are unable to maintain our access to funding or if financing necessary to accommodate future growth is not available at favorable interest rates. Finally, if we are required to rely more heavily on more expensive funding sources to support future growth, our revenues may not increase proportionately to cover our costs. In that case, our profitability would be adversely affected.
Interest rates and other economic conditions will impact our results of operations.
Our net income depends primarily upon our net interest income. Net interest income is the difference between interest income earned on loans, investments and other interest-earning assets and the interest expense incurred on deposits and borrowed funds. The level of net interest income is primarily a function of the average balance of our interest-earning assets, the average balance of our interest-bearing liabilities, and the spread between the yield on such assets and the cost of such liabilities. These factors are influenced by both the pricing and mix of our interest-earning assets and our interest-bearing liabilities which, in turn, are impacted by such external factors as the local economy, competition for loans and deposits, the monetary policy of the Federal Open Market Committee of the Federal Reserve Board of Governors, and market interest rates.
Different types of assets and liabilities may react differently, and at different times, to changes in market interest rates. We expect that we will periodically experience gaps in the interest rate sensitivities of our assets and liabilities. That means either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest-earning assets, or vice versa. When interest-bearing liabilities mature or re-price more quickly than interest-earning assets, an increase in market rates of interest could reduce our net interest income. Likewise, when interest-earning assets mature or re-price more quickly than interest-bearing liabilities, falling interest rates could reduce our net interest income. We are unable to predict changes in market interest rates, which are affected by many factors beyond our control, including inflation, deflation, recession, unemployment, money supply, domestic and international events and changes in the United States and other financial markets.
We also attempt to manage risk from changes in market interest rates, in part, by controlling the mix of interest rate sensitive assets and interest rate sensitive liabilities. However, interest rate risk management techniques are not exact. A rapid increase or decrease in interest rates could adversely affect our results of operations and financial performance.
Changes to LIBOR may adversely impact the value of, and the return on, our loans, investment securities and derivatives which are indexed to LIBOR.
We have certain loans, investment securities, interest rate swaps and long-term debt indexed to LIBOR to calculate the loan interest rate. On July 27, 2017, the United Kingdom Financial Conduct Authority, which regulates LIBOR, announced that it will no longer persuade or compel banks to submit rates for the calculation of LIBOR to the LIBOR administrator after 2021. The announcement also indicates that the continuation of LIBOR on the current basis cannot and will not be guaranteed after 2021. The Adjustable Interest Rate Act (“the LIBOR ACT”), enacted in March 2022, provides a statutory framework to replace U.S. dollar LIBOR with a benchmark rate based on the Secured Overnight Financing Rate (“SOFR”) for contracts governed by U.S. law that have no or ineffective fallbacks, and in December 2022, the Federal Reserve Board adopted related implementing rules. Although governmental authorities have endeavored to facilitate an orderly discontinuation of LIBOR, no assurance can be provided that this aim will be achieved or that the use, level, and volatility of LIBOR or other interest rates or the value of LIBOR-based securities will not be adversely affected. As a result, and despite the enactment of the LIBOR Act, for the most commonly used LIBOR settings, the use or selection of a successor rate could expose us to risks associated with disputes and litigation with our customers and counterparties and other market participants in connection with implementing LIBOR fallback provision.
The majority of our business is concentrated in Maryland and West Virginia, much of which involves real estate lending, so a decline in the real estate and credit markets could materially and adversely impact our financial condition and results of operations.
Most of the Bank’s loans are made to borrowers located in Western Maryland and Northeastern West Virginia, and many of these loans, including construction and land development loans, are secured by real estate. Accordingly, a decline in local economic conditions would likely have an adverse impact on our financial condition and results of
17
Tae of Contents
operations, and the impact on us would likely be greater than the impact felt by larger financial institutions whose loan portfolios are geographically diverse. We cannot guarantee that any risk management practices we implement to address our geographic and loan concentrations will be effective to prevent losses relating to our loan portfolio.
The Bank’s concentrations of commercial real estate loans could subject it to increased regulatory scrutiny and directives, which could force us to preserve or raise capital and/or limit future commercial lending activities.
The federal banking regulators believe that institutions that have particularly high concentrations of CRE loans within their lending portfolios face a heightened risk of financial difficulties in the event of adverse changes in the economy and CRE markets. Accordingly, through published guidance, these regulators have directed institutions whose concentrations exceed certain percentages of capital to implement heightened risk management practices appropriate to their concentration risk. The guidance provides that banking regulators may require such institutions to reduce their concentrations and/or maintain higher capital ratios than institutions with lower concentrations in CRE. At December 31, 2022, our CRE concentrations were below the heightened risk management thresholds set forth in this guidance.
The Bank may experience loan losses in excess of its allowance for loan losses, which would reduce our earnings.
The risk of credit losses on loans varies with, among other things, general economic conditions, the type of loans being made, the creditworthiness of the borrowers over the term of the loans and, in the case of collateralized loans, the value and marketability of the collateral for the loans. Management of the Bank maintains an ALL based upon, among other things, historical experience, an evaluation of economic conditions and regular reviews of delinquencies and loan portfolio quality. Based upon such factors, management makes various assumptions and judgments about the ultimate collectability of the loan portfolio and provides the ALL based upon a percentage of the outstanding balances and for specific loans when their ultimate collectability is considered questionable. If management’s assumptions and judgments prove to be incorrect and the ALL is inadequate to absorb future losses, or if the bank regulatory authorities require us to increase the ALL as a part of its examination process, our earnings and capital could be significantly and adversely affected. Although management continually monitors our loan portfolio and makes determinations with respect to the ALL, future adjustments may be necessary if economic conditions differ substantially from the assumptions used or adverse developments arise with respect to our non-performing or performing loans. Material additions to the ALL could result in a material decrease in our net income and capital; and could have a material adverse effect on our financial condition.
We depend on the accuracy and completeness of information about customers and counterparties, and inaccurate, incomplete or misleading information provided to us by these persons could cause us to suffer losses.
In deciding whether to extend credit or enter into other transactions, we rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports and other financial information. We also rely on representations of those customers, counterparties or other third parties, such as independent auditors, as to the accuracy and completeness of that information. Reliance on inaccurate or misleading financial statements, credit reports or other financial information could have a material adverse impact on our business, financial condition and results of operations.
Our accounting estimates and risk management processes rely on analytical and forecasting models, the inadequacy of which could have a material adverse effect on our financial condition and/or results of operations.
The processes we use to estimate our allowance for loan losses and to measure the fair value of financial instruments, as well as the processes used to estimate the effects of changing interest rates and other market measures on our financial condition and results of operations, depends upon the use of analytical and forecasting models. These models reflect assumptions that may not be accurate, particularly in times of market stress or other unforeseen circumstances. Even if these assumptions are adequate, the models may prove to be inadequate or inaccurate because of other flaws in their design or their implementation, including flaws caused by failures in controls, data management, human error or from the reliance on technology. If the models we use for interest rate risk and asset-liability management are inadequate, we may incur increased or unexpected losses upon changes in market interest rates or other market measures. If the models we use for estimating our expected credit losses are inadequate, the allowance for credit losses may not be sufficient to
18
Tae of Contents
support future charge-offs. If the models we use to measure the fair value of financial instruments are inadequate, the fair value of such financial instruments may fluctuate unexpectedly or may not accurately reflect what we could realize upon sale or settlement of such financial instruments. Any such failure in our analytical or forecasting models could have a material adverse effect on our business, financial condition and results of operations.
A new accounting standard will likely require us to increase our allowance for loan losses and may have a material adverse effect on our financial condition and results of operations.
The FASB has adopted a new accounting standard that was originally effective for the Corporation and the Bank beginning with our first full fiscal year after December 15, 2019. In November 2019, the FASB approved a delay of the required implementation date of ASU No. 2016-13 for smaller reporting companies, as defined by the SEC, and other non-SEC reporting entities, including the Corporation, resulting in a required implementation date for the Corporation of January 1, 2023. This standard, referred to as Current Expected Credit Loss, or CECL, will require financial institutions to determine periodic estimates of lifetime expected credit losses on loans, and recognize the expected credit losses as allowances for loan losses. This standard will change the current method of providing allowances for loan losses that are probable, which would likely require us to increase our ALL, and to greatly increase the types of data we would need to collect and review to determine the appropriate level of the ALL. Any increase in our ALL or expenses incurred to determine the appropriate level of the ALL may have a material adverse effect on our financial condition and results of operations.
The Bank’s lending activities subject the Bank to the risk of environmental liabilities.
A significant portion of the Bank’s loan portfolio is secured by real property. During the ordinary course of business, the Bank may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, the Bank may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require the Bank to incur substantial expenses and may materially reduce the affected property’s value or limit the Bank’s ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase the Bank’s exposure to environmental liability. Although the Bank has policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations.
The market value of our investments could decline.
At December 31, 2022, investment securities in our investment portfolio having a cost basis of $149.8 million and a market value of $125.9 million were classified as available-for-sale pursuant to FASB Accounting Standards Codification (“ASC”) Topic 320, Investments – Debt and Equity Securities,relating to accounting for investments. Topic 320 requires that unrealized gains and losses in the estimated value of the available-for-sale portfolio be “marked to market” and reflected as a separate item in shareholders’ equity (net of tax) as accumulated other comprehensive loss. There can be no assurance that future market performance of our investment portfolio will enable us to realize income from sales of securities. Shareholders’ equity will continue to reflect the unrealized gains and losses (net of tax) of these investments. Moreover, there can be no assurance that the market value of our investment portfolio will not decline, causing a corresponding decline in shareholders’ equity.
Several factors could affect the market value of our investment portfolio. These include, but are not limited to, changes in interest rates or expectations of changes, the degree of volatility in the securities markets, inflation rates or expectations of inflation and the slope of the interest rate yield curve (the yield curve refers to the differences between shorter-term and longer-term interest rates; a positively sloped yield curve means shorter-term rates are lower than longer-term rates). Also, the passage of time will affect the market values of our investment securities, in that the closer they are to maturing, the closer the market price should be to par value. These and other factors may impact specific categories of the portfolio differently, and management cannot predict the effect these factors may have on any specific category.
19
Tae of Contents
Impairment of investment securities, goodwill and other intangible assets, or deferred tax assets could require charges to earnings, which could result in a negative impact on our results of operations.
In assessing whether the impairment of investment securities is other-than-temporary, management considers the length of time and extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability to retain our investment in the security for a period of time sufficient to allow for any anticipated recovery in fair value in the near term.
Under current accounting standards, goodwill and other intangible assets are subject to impairment tests on at least an annual basis or more frequently if an event occurs or circumstances change that reduce the fair value of a reporting unit below its carrying amount. A decline in the price of the shares of Common Stock or occurrence of a triggering event following any of our quarterly earnings releases and prior to the filing of the periodic report for that period could, under certain circumstances, cause us to perform a goodwill impairment test and result in an impairment charge being recorded for that period which was not reflected in such earnings release. In the event that we conclude that all or a portion of our goodwill and other intangible assets may be impaired, a non-cash charge for the amount of such impairment would be recorded to earnings. Such a charge would have no impact on tangible capital. At December 31, 2022, we had recorded goodwill and other intangible assets of $12.4 million, representing approximately 8.2% of shareholders’ equity. See the discussion under the heading “Estimates and Critical Accounting Policies – Goodwill” in Item 7 of Part II of this annual report for further information.
At December 31, 2022, our net deferred tax assets were valued at $10.6 million. Included in that total is $2.9 million of state net operating loss carryforwards (“NOLs”) associated with separate company tax filings of the Corporation, which we do not expect to use and, thus, we have established a $2.9 million valuation allowance. A deferred tax asset is reduced by a valuation allowance if, based on the weight of the evidence available, both negative and positive, including the recent trend of quarterly earnings, the Company determines that it is more likely than not that some portion or all of the total deferred tax asset will not be realized. Moreover, our ability to utilize our net operating loss carryforwards to offset future taxable income may be significantly limited if we experience an “ownership change,” as determined under Section 382 of the Code. If an ownership change were to occur, the limitations imposed by Section 382 of the Code could result in a portion of our net operating loss carryforwards expiring unused, thereby impairing their value. Section 382’s provisions are complex, and we cannot predict any circumstances surrounding the future ownership of the Common Stock. Accordingly, we cannot provide any assurance that we will not experience an ownership change in the future.
The impact of each of these impairment matters could have a material adverse effect on our business, results of operations, and financial condition.
Adverse developments affecting the financial services industry, such as actual events or concerns involving liquidity, defaults, or non-performance by financial institutions or transactional counterparties, could adversely affect our financial condition and results of operations.
Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships, and we routinely execute transactions with counterparties in the financial industry. Actual events involving limited liquidity, defaults, non-performance or other adverse developments that affect financial institutions, transactional counterparties or other companies in the financial services industry or the financial services industry generally, or concerns or rumors about any events of these kinds or other similar risks, have in the past and may in the future lead to market-wide liquidity problems.
Increases in bond interest rates have led to a significant decline in the fair value of investment securities. Although the Treasury, the FDIC and the FRB have announced a program to provide up to $25 billion of loans to financial institutions secured by certain of such government-backed agency securities held by financial institutions to mititgate the risk of potential losses on the sale of such instruments, widespread demands for customer withdrawals or other liquidity needs of financial institutions for immediate liquidity might exceed the capacity of such program.
20
Tae of Contents
In addition to the risk that occurrence of such events could adversely impact our ability to engage in routine funding transactions, they could also lead to losses or defaults by us or by other institutions, either of which could have a material adverse effect on our business, results of operations and financial condition.
Increases in FDIC insurance premiums may have a material adverse effect on our results of operations.
In general, we are unable to control the amount of preimums that are required to be paid for FDIC insurance. In October 2022, the FDIC finalized a rule to increase the assessment rate by two basis points beginning in the first quarter of 2023. The increase in the assessment rate for banks is intended to increase the Deposit Insurance Fund reserve ratio to 1.35%. In early March 2023, the FDIC was appointed receiver for two banks, in each case due primarily to liquidity concerns at those institutions. Promptly following these events, the federal banking regulators announced that the FDIC will use funds from the Deposit Insurance Fund to ensure that all depositors of the two failed institutions are made whole, at no cost to taxpayers. We anticipate that the FDIC will impose special assessments on all banks to replenish the Deposit Insurance Fund. As a result of these and/or other financial institution failures, we may be required to pay significantly higher premiums than the levels currently imposed, as well as additional special assessments or taxes, which could adversely affect earnings. Any future increases or required repayments in FDIC insurance premiums may materially adversely affect our results of operations.
We operate in a competitive environment, and our inability to effectively compete could adversely and materially impact our financial condition and results of operations.
We operate in a competitive environment, competing for loans, deposits, and customers with commercial banks, savings associations and other financial entities. Competition for deposits comes primarily from other commercial banks, savings associations, credit unions, money market and mutual funds and other investment alternatives. Competition for loans comes primarily from other commercial banks, savings associations, mortgage banking firms, credit unions and other financial intermediaries. Competition for other products, such as securities products, comes from other banks, securities and brokerage companies, and other non-bank financial service providers in our market area. Many of these competitors are much larger in terms of total assets and capitalization, have greater access to capital markets, and/or offer a broader range of financial services than those that we offer. In addition, banks with a larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the needs of larger customers.
In addition, changes to the banking laws over the last several years have facilitated interstate branching, merger and expanded activities by banks and holding companies. For example, the federal Gramm-Leach-Bliley Act (the “GLB Act”) revised the BHC Act and repealed the affiliation provisions of the Glass-Steagall Act of 1933, which, taken together, limited the securities and other non-banking activities of any company that controls an FDIC insured financial institution. As a result, the ability of financial institutions to branch across state lines and the ability of these institutions to engage in previously-prohibited activities are now accepted elements of competition in the banking industry. These changes may bring us into competition with more and a wider array of institutions, which may reduce our ability to attract or retain customers. Management cannot predict the extent to which we will face such additional competition or the degree to which such competition will impact our financial conditions or results of operations.
The banking industry is heavily regulated; significant regulatory changes could adversely affect our operations.
Our operations will be impacted by current and future legislation and by the policies established from time to time by various federal and state regulatory authorities. The Corporation is subject to supervision by the Federal Reserve. The Bank is subject to supervision and periodic examination by the Maryland Commissioner of Financial Regulation, the West Virginia Division of Banking, and the FDIC. Banking regulations, designed primarily for the safety of depositors, may limit a financial institution’s growth and the return to its investors by restricting such activities as the payment of dividends, mergers with or acquisitions by other institutions, investments, loans and interest rates, interest rates paid on deposits, expansion of branch offices, and the offering of securities or trust services. The Corporation and the Bank are also subject to capitalization guidelines established by federal law and could be subject to enforcement actions to the extent that either is found by regulatory examiners to be undercapitalized. It is not possible to predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on our future
21
Tae of Contents
business and earnings prospects. Management also cannot predict the nature or the extent of the effect on our business and earnings of future fiscal or monetary policies, economic controls, or new federal or state legislation. Further, the cost of compliance with regulatory requirements may adversely affect our ability to operate profitably.
The Consumer Financial Protection Bureau may continue to reshape the consumer financial laws through rulemaking and enforcement of the prohibitions against unfair, deceptive and abusive business practices. Compliance with any such change may impact our business operations.
The CFPB has broad rulemaking authority to administer and carry out the provisions of the Dodd-Frank Act with respect to financial institutions that offer covered financial products and services to consumers. The CFPB has also been directed to adopt rules identifying practices or acts that are unfair, deceptive or abusive in connection with any transaction with a consumer for a consumer financial product or service, or the offering of a consumer financial product or service. The concept of what may be considered to be an “abusive” practice is fluid and can change based on politically-appointed leadership at the CFPB. We have been required to dedicate significant personnel resources to address the compliance burdens imposed by the CFBP’s adoption of various rules, and the adoption of additional rules in the future would likely require us to dedicate even more resources.
Bank regulators and other regulations, including the Basel III Capital Rules, may require higher capital levels, impacting our ability to pay dividends or repurchase our stock.
The capital standards to which we are subject, including the standards created by the Basel III Capital Rules, may materially limit our ability to use our capital resources and/or could require us to raise additional capital by issuing additional shares of Common Stock or other equity securities. In addition, we could experience increases in deposits and assets as a result of other depository institutions’ difficulties or failures, which would increase the capital that we are required to maintain to support such growth. The issuance of additional equity securities to fund our capital needs could dilute existing stockholders.
A material weakness or significant deficiency in our disclosure or internal controls could have an adverse effect on us.
The Corporation is required by the Sarbanes-Oxley Act of 2002 to establish and maintain disclosure controls and procedures and internal control over financial reporting. These control systems are intended to provide reasonable assurance that material information relating to the Corporation is made known to our management and reported as required by the Exchange Act, to provide reasonable assurance regarding the reliability and preparation of our financial statements, and to provide reasonable assurance that fraud and other unauthorized uses of our assets are detected and prevented. We may not be able to maintain controls and procedures that are effective at the reasonable assurance level. If that were to happen, our ability to provide timely and accurate information about the Corporation, including financial information, to investors could be compromised and our results of operations could be harmed. Moreover, if the Corporation or its independent registered public accounting firm were to identify a material weakness or significant deficiency in any of those control systems, our reputation could be harmed and investors could lose confidence in us, which could cause the market price of the Corporation’s stock to decline and/or limit the trading market for the shares of the Common Stock.
We may not be able to keep pace with developments in technology.
We use various technologies in conducting our businesses, including telecommunication, data processing, computers, automation, internet-based banking, and debit cards. The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. Our future success depends, in part, on our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology driven products and services or be successful in marketing these products and services to our customers. In addition, our implementation of certain new technologies, such as those related to artificial intelligence, automation and algorithms, in our business processes may have unintended consequences due to their limitations or our failure to use them effectively. In addition, cloud technologies are also critical to the operation of our systems, and our reliance on cloud
22
Tae of Contents
technologies is growing. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse effect on our business, financial condition and results of operations.
Our operational or communications systems or infrastructure may fail or may be the subject of a breach or cyber-attack that, if successful, could adversely affect our business or disrupt business continuity.
Our business depends heavily on the use of computer systems, the Internet and other means of electronic communication and recordkeeping to process, record, and monitor client transactions and to communicate with clients and other institutions on a continuous basis. As client, industry, public, and regulatory expectations regarding operational and information security have increased, our operational systems and infrastructure continue to be safeguarded and monitored for potential failures, disruptions, and breakdowns, whether as a result of events beyond our control or otherwise.
Our business, financial, accounting, data processing, or other operating systems and facilities may stop operating properly or become disabled or damaged as a result of a number of factors, including events that are wholly or partially beyond our control. For example, there could be sudden increases in client transaction volume; electrical or telecommunications outages; natural disasters such as earthquakes, tornadoes, floods, and hurricanes; disease pandemics; events arising from local or larger scale political or social matters, including terrorist acts; occurrences of employee error, fraud, theft, or malfeasance; disruptions caused by technology implementation, including hardware deployment and software updates; and, as described below, cyber-attacks.
Although we have business continuity plans and other safeguards in place, our operations and communications may be adversely affected by significant and widespread disruption to our systems and infrastructure that support our businesses, clients, and teammates. While we continue to evolve and modify our business continuity plans, there can be no assurance in an escalating threat environment that they will be effective in avoiding disruption and business impacts. Our insurance may not be adequate to compensate us for all resulting losses, and the cost to obtain adequate coverage may increase for us or the industry.
Security risks for financial institutions such as ours have dramatically increased in recent years in part because of the proliferation of new technologies, the use of the internet and telecommunications technologies to conduct financial transactions, and the increased sophistication, resources, and activities of hackers, terrorists, activists, industrial spies, insider bad actors, organized crime, and other external parties, including nation state actors. In addition, to access our products and services, clients may use devices and/or software that are beyond our control environment, which may provide additional avenues for attackers to gain access to confidential information. Although we have information security procedures and controls in place, our technologies, systems, networks, and clients' devices and software may become the target of cyber-attacks, information security breaches, business email compromise, or information theft that could result in the unauthorized release, gathering, monitoring, misuse, loss, change, or destruction of our or our clients' or teammates' confidential, proprietary, or other information (including personal identifying information of individuals), or otherwise disrupt our or our clients' or our third parties' business operations. U.S. financial institutions and financial service companies have reported breaches in the security of their websites or other systems, including attempts to shut down access to their networks and/or systems in an attempt to extract compensation from them to regain control. Financial institutions, including the Bank, have experienced distributed denial-of-service attacks, a sophisticated and targeted attack intended to disable or degrade internet service or to sabotage systems.
We and others in our industry are regularly the subject of attempts by attackers to gain unauthorized access to our networks, systems, and data, or to obtain, change, or destroy confidential data (including personal identifying information of individuals) through a variety of means, including computer viruses, malware, business email compromise, and phishing. These attacks may result in unauthorized individuals obtaining access to our confidential information or that of our clients or teammates, or otherwise accessing, compromising, damaging, or disrupting our systems or infrastructure.
We are continuously developing and enhancing our controls, processes, and practices designed to protect our systems, computers, software, data, and networks from attack, damage, or unauthorized access. This continued development and enhancement will require us to expend additional resources, including resources to investigate and remediate any information security vulnerabilities that may be detected. Despite our ongoing investments in security resources, talent, and business practices, we are unable to assure that any security measures will be effective.
23
Tae of Contents
If our systems and infrastructure were to be breached, compromised, damaged, or disrupted, or if we were to experience a loss of our confidential information or that of our clients or teammates, we could be subject to serious negative consequences, including disruption of our operations, damage to our reputation, a loss of trust in us on the part of our clients, vendors or other counterparties, client or teammate attrition, reimbursement or other costs, increased compliance costs, significant litigation exposure and legal liability, or regulatory fines, penalties or intervention. Any of these could materially and adversely affect our results of operations, our financial condition, and/or our share price.
A disruption, breach, or failure in the operational systems or infrastructure of our third party vendors or other service providers, including as a result of cyber-attacks, could adversely affect our business.
Third parties perform significant operational services on our behalf. These third parties with whom we do business or that facilitate our business activities, including exchanges, clearing houses, central clearing counterparties, financial intermediaries, or vendors that provide services or security solutions for our operations, could also be sources of operational and information security risk to us, including from breakdowns or failures of their own systems or capacity constraints. In particular, operating our business requires us to provide access to client, teammate, and other sensitive Company information to our contractors, consultants, and other third parties and authorized entities. Controls and oversight mechanisms are in place that are designed to limit access to this information and protect it from unauthorized disclosure, theft, and disruption. However, control systems and policies pertaining to system access are subject to errors in design, oversight failure, software failure, human error, intentional subversion, or other compromise resulting in theft, error, loss, or inappropriate use of information or systems to commit fraud, cause embarrassment to us or our executives or to gain competitive advantage. In addition, regulators expect financial institutions to be responsible for all aspects of their performance, including aspects which they delegate to third parties. If a disruption, breach, or failure in the system or infrastructure of any third party with whom we do business occurred, then our business may be materially and adversely affected in a manner similar to if our own systems or infrastructure had been compromised. As has been the case in other major system events in the U.S., our systems and infrastructure may also be attacked, compromised, or damaged as a result of, or as the intended target of, any disruption, breach, or failure in the systems or infrastructure of any third party with whom we do business.
We may be subject to claims and the costs of defensive actions, and such claims and costs could materially and adversely impact our financial condition and results of operations.
Our customers may sue us for losses due to alleged breaches of fiduciary duties, errors and omissions of employees, officers and agents, incomplete documentation, our failure to comply with applicable laws and regulations, or many other reasons. Also, our employees may knowingly or unknowingly violate laws and regulations. Management may not be aware of any violations until after their occurrence. This lack of knowledge may not insulate us from liability. Claims and legal actions will result in legal expenses and could subject us to liabilities that may reduce our profitability and hurt our financial condition
The loss of key personnel could disrupt our operations and result in reduced earnings.
Our growth and profitability will depend upon our ability to attract and retain skilled managerial, marketing and technical personnel. Competition for qualified personnel in the financial services industry is intense, and there can be no assurance that we will be successful in attracting and retaining such personnel. Our current executive officers provide valuable services based on their many years of experience and in-depth knowledge of the banking industry and the market areas we serve. Due to the intense competition for financial professionals, these key personnel would be difficult to replace and an unexpected loss of their services could result in a disruption to the continuity of operations and a possible reduction in earnings.
We are a community banking organization and our ability to maintain our reputation is critical to the success of our business.
We are a community banking organization, and our reputation is one of the most valuable components of our business. A key component of our business strategy is to rely on our reputation for customer service and knowledge of
24
Tae of Contents
local markets to expand our presence by capturing new business opportunities from existing and prospective customers in our current market and contiguous areas. As such, we strive to conduct our business in a manner that enhances our reputation. This is done, in part, by recruiting, hiring and retaining employees who share our core values of being an integral part of the communities we serve, delivering superior service to our customers and caring about our customers and associates. If our reputation is negatively affected by the actions of our employees, by our inability to conduct our operations in a manner that is appealing to current or prospective customers, or otherwise, our business and, therefore, our operating results may be materially adversely affected.
We could be adversely affected by risks associated with future acquisitions and expansions.
Although our core growth strategy is focused around organic growth, we may from time to time consider acquisition and expansion opportunities involving a bank or other entity operating in the financial services industry. We cannot predict if or when we will engage in such a strategic transaction, or the nature or terms of any such transaction. To the extent that we grow through an acquisition, we cannot assure investors that we will be able to adequately and profitably manage that growth or that an acquired business will be integrated into our existing businesses as efficiently or as timely as we may anticipate. Acquiring another business would generally involve risks commonly associated with acquisitions, including:
● increased capital needs;
● increased and new regulatory and compliance requirements;
● transition of the acquired business’s users and customers onto our systems;
● retention of employees from the acquired business;
● integration of employees from the acquired business into our organization;
● potential goodwill impairment.
Our failure to execute our acquisition strategy could adversely affect our business, results of operations, financial condition and future prospects risks of unknown or contingent liabilities.
New lines of business, products or services may subject us to additional risks.
From time to time, we implement new lines of business or offer new products and services within existing lines of business. For instance, we recently formed First United Legacy Advisors for the purpose of engaging in the business of providing investment advisory and related services. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. In developing and marketing new lines of business and/or new products and services we invest significant time and resources. Initial timetables for the introduction and development of new lines of business and/or new products or services may not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives, and shifting market preferences, may also impact the successful implementation of a new line of business or a new product or service. Furthermore, any new line of business, new product or service and/or new technology could have a significant impact on the effectiveness of our system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business, new products or services and/or new technologies could have a material adverse effect on our business, financial condition and results of operations.
25
Tae of Contents
Increasing scrutiny and evolving expectations from customers, regulators, investors, and other stakeholders with respect to our environmental, social and governance practices may impose additional costs on us or expose us to new or additional risks.
Many companies are facing increasing scrutiny from customers, regulators, investors, and other stakeholders related to their environmental, social and governance (“ESG”) practices and disclosure. Investor advocacy groups, investment funds and influential investors are also increasingly focused on these practices, especially as they relate to the environment, health and safety, diversity, labor conditions and human rights. Increased ESG-related compliance costs could result in increases to our overall operational costs. Failure to adapt to or comply with regulatory requirements or investor or stakeholder expectations and standards could negatively impact our reputation, ability to do business with certain partners, and our stock price. New government regulations could also result in new or more stringent forms of ESG oversight and expanding mandatory and voluntary reporting, diligence, and disclosure.
Climate change could have a material adverse impact on us and our customers.
Our business, as well as the operations and activities of our customers, could be negatively impacted by climate change. Climate change presents both immediate and long-term risks to us and our customers and these risks are expected to increase over time. Climate changes presents multi-faceted risks, including (i) operational risk from the physical effects of climate events on our facilities and other assets as well as those of our customers; (ii) credit risk from borrowers with significant exposure to climate risk; and (iii) reputational risk from stakeholder concerns about our practices related to climate change, our carbon footprint and our business relationships with customers who operate in carbon-intensive industries. Our business, reputation and ability to attract and retain employees may also be harmed if our response to climate change is perceived to be ineffective or insufficient.
Climate change exposes us to physical risk as its effects may lead to more frequent and more extreme weather events, such as prolonged droughts or flooding, tornados, hurricanes, wildfires and extreme seasonal weather; and longer-term shifts, such as increasing average temperatures, ozone depletion and rising sea levels. Such events and long-term shifts may damage, destroy or otherwise impact the value or productivity of our properties and other assets; reduce the availability of insurance; and/or disrupt our operations and other activities through prolonged outages. Such events and long-term shifts may also have a significant impact on our customers, which could amplify credit risk by diminishing borrowers' repayment capacity or collateral values, and other businesses and counterparties with whom we transact, which could have a broader impact on the economy, supply chains and distribution networks.
Climate change also exposes us to transition risks associated with the transition to a less carbon-dependent economy. Transition risks may result from changes in policies; laws and regulations; technologies; and/or market preferences to address climate change. Such changes could materially, negatively impact our business, results of operations, financial condition and/or our reputation, in addition to having a similar impact on our customers. We have customers who operate in carbon-intensive industries like oil and gas that are exposed to climate risks, such as those risks related to the transition to a less carbon-dependent economy, as well as customers who operate in low-carbon industries that may be subject to risks associated with new technologies. Federal and state banking regulators and supervisory authorities, investors and other stakeholders have increasingly viewed financial institutions as important in helping to address the risks related to climate change both directly and with respect to their customers, which may result in financial institutions coming under increased pressure regarding the disclosure and management of their climate risks and related lending and investment activities. Given that climate change could impose systemic risks upon the financial sector, either via disruptions in economic activity resulting from the physical impacts of climate change or changes in policies as the economy transitions to a less carbon-intensive environment, we face regulatory risk of increasing focus on our resilience to climate-related risks, including in the context of stress testing for various climate stress scenarios. Ongoing legislative or regulatory uncertainties and changes regarding climate risk management and practices may result in higher regulatory, compliance, credit and reputational risks and costs.
26
Tae of Contents
Risks Relating to First United Corporation’s Securities
The shares of Common Stock are not insured.
The shares of the Common Stock are not deposits and are not insured against loss by the FDIC or any other governmental or private agency.
The shares of Common Stock are not heavily traded.
Shares of the Common Stock are listed on the NASDAQ Global Select Market but are not heavily traded. Securities that are not heavily traded can be more volatile than stock trading in an active public market. Factors such as our financial results, the introduction of new products and services by us or our competitors, changes in the financial estimates by securities analysts, market conditions within the banking industry, the general state of the securities market, general economic condition, and investor speculation as to our future plans and strategies could have a significant impact on the market price and trading volume of the shares of Common Stock. Likewise, events that are unrelated to the Corporation but that affect the equity markets generally, such as national or international health crises, wars, political instability, the loss of investor or depositor confidence due to the failure of one or more financial institutions, and similar factors, could also have a significant impact on the market price and trading volume of the shares of Common Stock. Management cannot predict the extent to which an active public market for shares of Common Stock will develop or be sustained in the future. Accordingly, shareholders may not be able to sell their shares at the volumes, prices, or times that they desire.
Significant sales of shares of Common Stock, or the perception that significant sales may occur in the future, could adversely affect the market price of shares of Common Stock.
The sale of a substantial number of shares of the Common Stock could adversely affect the market price of such shares. The availability of shares for future sale could adversely affect the prevailing market price of shares of Common Stock and could cause the market price of such shares to remain low for a substantial amount of time. In addition, the Corporation may grant equity awards under its equity compensation plans from time to time in effect, including fully-vested shares of Common Stock. It is possible that if a significant percentage of such available shares were attempted to be sold within a short period of time, the market for the shares would be adversely affected. Management cannot predict whether the market for shares of Common Stock could absorb a large number of attempted sales in a short period of time, regardless of the price at which they might be offered. Even if a substantial number of sales do not occur within a short period of time, the mere existence of this “market overhang” could have a negative impact on the market for the common stock and our ability to raise capital in the future.
The Corporation’s ability to pay dividends on the common stock is subject to the terms of the outstanding TPS Debentures, which prohibit the Corporation from paying dividends during an interest deferral period.
In March 2004, the Corporation issued approximately $30.9 million, in the aggregate, of junior subordinated debentures (“TPS Debentures”) to the Trusts in connection with the Trusts’ sales to third party investors of $30.0 million, in the aggregate, in mandatorily redeemable preferred capital securities. The terms of the TPS Debentures require the Corporation to make quarterly payments of interest to the Trusts, as the holders of the TPS Debentures, although the Corporation has the right to defer payments of interest for up to 20 consecutive quarterly periods, and the Corporation has exercised this deferral right in the past. An election to defer interest payments does not constitute an event of default under the terms of the TPS Debentures. The terms of the TPS Debentures prohibit the Corporation from declaring or paying any dividends or making other distributions on, or from repurchasing, redeeming or otherwise acquiring, any shares of its capital securities, including the common stock, if the Corporation elects to defer quarterly interest payments under the TPS Debentures. In addition, a deferral election will require the Trusts to likewise defer the payment of quarterly dividends on their related trust preferred securities.
27
Tae of Contents
Applicable banking and Maryland laws impose additional restrictions on the ability of the Corporation and the Bank to pay dividends and make other distributions on their capital securities, and, in any event, the payment of dividends is at the discretion of the boards of directors of the Corporation and the Bank.
In the past, the Corporation has funded dividends on its capital securities using cash received from the Bank, and this will likely be the case for the foreseeable future. No assurance can be given that the Bank will be able to pay dividends to the Corporation for these purposes at times and/or in amounts requested by the Corporation. Both federal and state laws impose restrictions on the ability of the Bank to pay dividends. Under Maryland law, a state-chartered commercial bank may pay dividends only out of undivided profits or, with the prior approval of the Maryland Commissioner, from surplus in excess of 100% of required capital stock. If, however, the surplus of a Maryland bank is less than 100% of its required capital stock, cash dividends may not be paid in excess of 90% of net earnings. In addition to these specific restrictions, bank regulatory agencies have the ability to prohibit proposed dividends by a financial institution which would otherwise be permitted under applicable regulations if the regulatory body determines that such distribution would constitute an unsafe or unsound practice. Banks that are considered “troubled institution” are prohibited by federal law from paying dividends altogether. Notwithstanding the foregoing, shareholders must understand that the declaration and payment of dividends and the amounts thereof are at the discretion of the Corporation’s Board of Directors. Thus, even at times when the Corporation is not prohibited from paying cash dividends on its capital securities, neither the payment of such dividends nor the amounts thereof can be guaranteed.
The Corporation’s Articles of Incorporation and Bylaws and Maryland law may discourage a corporate takeover.
The Corporation’s Amended and Restated Articles of Incorporation (the “Charter”) and its Amended and Restated Bylaws (the “Bylaws”) contain certain provisions designed to enhance the ability of the Corporation’s Board of Directors to deal with attempts to acquire control of the Corporation. First, the Board of Directors is classified into three classes. Directors of each class serve for staggered three-year periods, and no director may be removed except for cause, and then only by the affirmative vote of either a majority of the entire Board of Directors or a majority of the outstanding voting stock. Although the Corporation’s board has amended the Bylaws to eliminate this classified Board structure, the declassification will not be fully phased in until after the 2024 annual meeting of shareholders. Second, the Board has the authority to classify and reclassify unissued shares of stock of any class or series of stock by setting, fixing, eliminating, or altering in any one or more respects the preferences, rights, voting powers, restrictions and qualifications of, dividends on, and redemption, conversion, exchange, and other rights of, such securities. The Board could use this authority, along with its authority to authorize the issuance of securities of any class or series, to issue shares having terms favorable to management or to a person or persons affiliated with or otherwise friendly to management. In addition, the Bylaws require any shareholder who desires to nominate a director to abide by strict notice requirements.
Maryland laws include provisions that could discourage a sale or takeover of the Corporation. The Maryland Business Combination Act generally prohibits, subject to certain limited exceptions, corporations from being involved in any “business combination” (defined as a variety of transactions, including a merger, consolidation, share exchange, asset transfer or issuance or reclassification of equity securities) with any “interested shareholder” for a period of five years following the most recent date on which the interested shareholder became an interested shareholder. An interested shareholder is defined generally as a person who is the beneficial owner of 10% or more of the voting power of the outstanding voting stock of the corporation after the date on which the corporation had 100 or more beneficial owners of its stock or who is an affiliate or associate of the corporation and was the beneficial owner, directly or indirectly, of 10% percent or more of the voting power of the then outstanding stock of the corporation at any time within the two-year period immediately prior to the date in question and after the date on which the corporation had 100 or more beneficial owners of its stock. The Maryland Control Share Acquisition Act applies to acquisitions of “control shares”, which, subject to certain exceptions, are shares the acquisition of which entitle the holder, directly or indirectly, to exercise or direct the exercise of the voting power of shares of stock of the corporation in the election of directors within any of the following ranges of voting power: one-tenth or more, but less than one-third of all voting power; one-third or more, but less than a majority of all voting power or a majority or more of all voting power. Control shares have limited voting rights. Maryland banking laws provide that the Maryland Commissioner must approve certain acquisitions of the common stock of the Corporation and/or the Bank, and these laws impose penalties on persons who effect such acquisitions without approval, including a five year voting prohibition.
28
Tae of Contents
Although these provisions do not preclude a sale or takeover, they may have the effect of discouraging, delaying or deferring a sale, tender offer, or takeover attempt that a shareholder might consider in his or her best interest, including those attempts that might result in a premium over the market price for the common stock. Such provisions will also render the removal of the Board of Directors and of management more difficult and, therefore, may serve to perpetuate current management. These provisions could potentially adversely affect the market prices of the Corporation’s securities.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2. PROPERTIES
The headquarters of the Corporation and the Bank occupies approximately 29,000 square feet at 19 South Second Street, Oakland, Maryland, and a 30,000 square feet operations center located at 12892 Garrett Highway, Oakland Maryland. These premises are owned by the Corporation. The Bank owns 19 of its banking offices and leases seven. Total rent expense on the leased offices and properties was $0.4 million in 2022.
ITEM 3. LEGAL PROCEEDINGS
None
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
29
Tae of Contents
PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Shares of the Corporation’s common stock are listed on the NASDAQ Global Select Market under the symbol “FUNC”. As of February 28, 2023, the issued and outstanding shares of Common Stock were held by 1,327 shareholders of record.
The ability of the Corporation to declare dividends is limited by federal banking laws and Maryland corporation laws. Subject to these and the terms of its other securities, including the TPS Debentures, the payment of dividends on the shares of common stock and the amounts thereof are at the discretion of the Corporation’s board of directors. Cash dividends are typically declared on a quarterly basis. When paid, dividends to shareholders are dependent on the ability of the Corporation’s subsidiaries, especially the Bank, to declare dividends to the Corporation. Like the Corporation, the Bank’s ability to declare and pay dividends is subject to limitations imposed by federal and Maryland banking and Maryland corporation laws. A complete discussion of these and other dividend restrictions is contained in Item 1A of Part I of this annual report under the heading “Risks Relating to First United Corporation’s Securities” and in Note 4 to the Consolidated Financial Statements, both of which are incorporated herein by reference. Accordingly, there can be no assurance that dividends will be declared on the shares of common stock in any future fiscal quarter.
The Corporation’s Board of Directors periodically evaluates the Corporation’s dividend policy, both internally and in consultation with the Federal Reserve.
Issuer Repurchases
Neither First United Corporation nor any of its affiliated purchasers (as defined in Rule 10b-18 promulgated under the Exchange Act) purchased any shares of Common Stock during the three-month period ended December 31, 2022.
Equity Compensation Plan Information
Pursuant to the SEC’s Regulation S-K Compliance and Disclosure Interpretation 106.01, the information required by this Item pursuant to Item 201(d) of Regulation S-K relating to securities authorized for issuance under the Corporation’s equity compensation plans is located in Item 12 of Part III of this annual report and is incorporated herein by reference.
ITEM 6. [Reserved]
30
Tae of Contents
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and notes thereto for the years ended December 31, 2022 and 2021, which are included in Item 8 of Part II of this annual report.
Overview
First United Corporation is a bank holding company that, through the Bank and its non-bank subsidiaries, provides an array of financial products and services primarily to customers in four Western Maryland counties and four Northeastern West Virginia counties. Its principal operating subsidiary is the Bank, which consists of a community banking network of 26 branch offices located throughout its market areas. Our primary sources of revenue are interest income earned from our loan and investment securities portfolios and fees earned from financial services provided to customers.
Consolidated net income for the year ended December 31, 2022 was $25.0 million compared to $19.8 million in 2021. The year-over-year increase was primarily due to a $5.1 million increase in net interest income resulting from a $4.2 million increase in interest income and a decrease in interest expense of $0.9 million. Net gains were down $1.1 million in 2022 when compared to 2021 as management made the strategic decision to book the higher rate mortgage loans in 2022 as opposed to selling them to the secondary market. Other income declined in 2022 due to a decrease of $0.4 million in trust and brokerage income and a decrease of $1.4 million due to an insurance reimbursement received in 2021. These declines were slightly offset by an increase of $0.2 million in service charges and debit card income. Provision expense was up $0.2 million as compared to 2021. Salaries and benefits increased by $2.1 million when compared to 2021 due to a lower reduction of loan origination costs of $1.0 million and a $1.1 million increase due to performance related pay and the competitive employment environment. Other changes year-over-year included increased other real estate owned (“OREO”) expenses of $1.5 million in 2022 due to gains on sale of OREO booked during 2021, other net increases in expenses of $0.8 million and increased income taxes of $1.6 million. Non-interest expense decreased significantly due to our payment of $3.3 million in litigation settlement expenses during the first quarter of 2021 and a $2.4 million prepayment penalty for the early repayment of $70.0 million of FHLB advances recognized in the third quarter of 2021, a reduction of $2.4 million in professional and investor relations expenses primarily related to reimbursement of $0.7 in litigation expenses, a reduction of $0.4 million in investor relations costs and a $1.3 million reduction in legal fees. Charitable contributions also declined by $0.9 million primarily due to the decision to make a $1.0 million contribution in 2021 to fund the newly created First United Community Dreams Foundation (the “Foundation”).
The provision for loan losses was a credit of $0.6 million for the year ended December 31, 2022 and a credit of $0.8 million for the year December 31, 2021. Net charge-offs of $0.7 million were recorded for the year ended December 31, 2022, compared to net recoveries of $0.3 million for 2021. The ratio of the ALL to loans outstanding, including Paycheck Protection Program (“PPP”) loan balances, was 1.14% at December 31, 2022 compared to 1.38% at December 31, 2021. The ratio of ALL to loans outstanding, excluding PPP loan balances of $0.4 million and $7.7 million, was 1.14% and 1.39% at December 31, 2022 and 2021, respectively, non-GAAP.
Other operating income, including net gains on sales of mortgage loans and sales of investment securities, decreased by approximately $2.7 million when compared to 2021. This decrease was partially due to a $1.4 million insurance reimbursement that was received in 2021 and a decrease in net gains from the sale of residential mortgage loans of $1.1 million as refinance activity slowed considerably and due to management’s strategic decision to book new mortgage loans at higher rates to our in-house portfolio. These decreases were partially offset by a net increase in service charge, debit card and other income of $0.2 million.
Other operating expenses decreased $4.6 million compared to the year ended December 31, 2021. Salaries and benefits increased by $2.1 million compared to 2021 due to a lower reduction of loan origination costs of $1.0 million and a $1.1 million increase due to performance related pay and the competitive employment environment. Other changes year-over-year included increased OREO expenses of $1.5 million in 2022 due to gains on sale of OREO booked during 2021 and other net increases in expenses of $0.8 million. Non-interest expense decreased significantly due to our payment of $3.3 million in litigation settlement expenses during the first quarter of 2021 and a $2.4 million prepayment penalty for the early repayment of $70.0 million of FHLB advances recognized in the third quarter of 2021, a reduction of $2.4 million
31
Tae of Contents
in professional and investor relations expenses primarily related to reimbursement of $0.7 in litigation expenses, a reduction of $0.4 million in investor relations costs and a $1.3 million reduction in legal fees. Charitable contributions also declined by $0.9 million primarily due to the funding of the Foundation at the end of 2021.
Outstanding loans of $1.3 billion at December 31, 2022 reflected a growth of $125.8 million during 2022. Since December 31, 2021, commercial real estate loans increased by $84.5 million and acquisition and development loans decreased by $57.5 million due primarily to the payoff of one large credit early in the third quarter. Commercial and industrial loans increased by $64.4 million for the year, primarily in new floor plan business, new commercial clients and continued expansion of existing client relationships. Residential mortgage loans increased $39.7 million related to management’s strategic decision to book new mortgage loans at higher rates to our in-house portfolio. The consumer loan portfolio decreased by $5.4 million due to amortization and payoffs of the existing portfolio slightly offset by new production.
Net interest income, on a non-GAAP, fully-taxable equivalent (“FTE”) basis, increased by $5.1 million. Interest income increased by $4.2 million and interest expense decreased by $0.9 million. The yield on earning assets increased 22 basis points to 3.85% in 2022 compared to 3.63% in 2021 in correlation with an increase in average earning assets as well as the rising interest rate environment and new loans booked at higher rates. Interest expense on deposits decreased by $0.2 million while the average balance of deposits increased by $26.1 million and interest on long-term borrowings decreased by $0.7 million related to the prepayment of $70.0 million of FHLB advances in the third quarter of 2021. The decreased interest expense resulted in an overall decrease of 7 basis points on the cost of interest-bearing liabilities. We anticipate increased margin pressure in 2023 due to increasing deposit pricing demands in our market areas. The net interest margin for the year ended December 31, 2022 was 3.56% compared to 3.28% for the year ended December 31, 2021.
Comparing the year ended December 31, 2022 with the year ended December 31, 2021, interest income increased by $4.2 million. Interest and fees on loans increased by $1.5 million and investment income increased by $2.4 million. Excess cash balances during 2022 were invested at the Fed Funds rate, which also positively affected interest income for the year ended December 31, 2022 when compared to 2021. Increases in loan interest income stemmed from the growth of core loans in 2022. The rate earned on the loan portfolio remained stable when comparing the year ended December 31, 2022 to the year ended December 31, 2021.
Total deposits at December 31, 2022 increased by $101.4 million when compared to deposits at December 31, 2021. Non-interest-bearing deposits increased by $5.0 million. Interest bearing demand deposits increased by $99.5 million and traditional savings accounts increased by $14.1 million. The increase in interest bearing demand deposits was attributable to an increase in municipality funding into a higher yielding indexed product. Money market balances increased by $25.4 million. Time deposits decreased by $42.7 million related to maturing balances moving to more liquid accounts, or brokerage investment accounts, due to the rising deposit rates as well as municipal funds moving to higher yielding State funding alternatives.
The decrease in interest expense for 2022 was driven by a decrease in interest rates of 7 basis points, which offset the increase in average balances of $26.1 million on interest bearing deposits, and a $46.4 million decline in average balances on long term borrowings related to the prepayment of $70.0 million in FHLB advances in the third quarter of 2021. This decrease in average long-term borrowings help offset the increase in yields of 190 basis points on interest paid on borrowings during 2022. Proactive efforts to reduce the cost of funds by further reductions to rates on deposit accounts throughout 2021, the runoff of balances in the time deposits, including brokered deposits, and the expiration of empowered rates on money market accounts continued throughout early 2022.
Estimates and Critical Accounting Policies
This discussion and analysis of our financial condition and results of operations is based upon our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. (See Note 1 to the Consolidated Financial Statements.) On an on-going basis, management evaluates estimates and bases
32
Tae of Contents
those 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 identifies the following critical accounting policies may affect our more significant judgments and estimates used in the preparation of the Consolidated Financial Statements.
Allowance for Loan Losses
One of our most important accounting policies is that related to the monitoring of the loan portfolio. A variety of estimates impact the carrying value of the loan portfolio and resulting interest income, including the calculation of the ALL, the valuation of underlying collateral, and the timing of loan charge-offs. The ALL is established and maintained at a level that is adequate to cover losses resulting from the inability of borrowers to make required payments on loans. Estimates for loan losses are arrived at by analyzing risks associated with specific loans and the loan portfolio, current and historical trends in delinquencies and charge-offs, and changes in the size and composition of the loan portfolio. The analysis also requires consideration of the economic climate and direction, changes in lending rates, political conditions, legislation impacting the banking industry and economic conditions specific to Western Maryland and Northeastern West Virginia. Because the calculation of the ALL relies on management’s estimates and judgments relating to inherently uncertain events, actual results may differ from management’s estimates.
The ALL is also discussed below in Item 7 under the heading “Allowance for Loan Losses” and in Note 6 to the Consolidated Financial Statements.
Liquidity Sources
As of December 31, 2022, the Corporation had approximately $140.0 million in unsecured lines of credit with its correspondent banks, $9.6 million available through a secured line of credit with the Federal Reserve Discount Window, and approximately $195.3 million of secured borrowings with the FHLB. Additionally, the Corporation has access to the brokered certificates of deposit market.
Capital
The Corporation’s and the Bank’s capital ratios are strong, and both institutions are considered to be well-capitalized by applicable regulatory measures
Adoption of New Accounting Standards and Effects of New Accounting Pronouncements
Note 1 to the Consolidated Financial Statements discusses new accounting pronouncements that, when adopted, could affect our future consolidated financial statements.
CONSOLIDATED STATEMENT OF INCOME REVIEW
Net Interest Income
Net interest income is our largest source of operating revenue. Net interest income is the difference between the interest that we earn on our interest-earning assets and the interest expense we incur on our interest-bearing liabilities. For analytical and discussion purposes, net interest income is adjusted to an FTE basis to facilitate performance comparisons between taxable and tax-exempt assets by increasing tax-exempt income by an amount equal to the federal income taxes that would have been paid if this income were taxable at the statutorily applicable rate. This is a non-GAAP disclosure and it is not materially different than the corresponding GAAP disclosure.
33
Tae of Contents
The table below summarizes net interest income for 2022 and 2021.
GAAP Non-GAAP - FTE
Net interest margin % 3.50% 3.22% 3.56% 3.28%
Net interest income, on a non-GAAP, FTE basis, increased by $5.1 million (9.5%) during the year ended December 31, 2022 when compared to the year ended December 31, 2021, driven by a $4.2 million (7.0%) increase in interest income and a decrease in interest expense of $0.9 million (16.2%). The decrease in interest expense resulted from proactive efforts to reduce the cost of funds by further reductions in rates on deposit accounts throughout 2021, the runoff of balances in the time deposits, including brokered deposits, and the expiration of empowered rates on money market accounts. The net interest margin, on an FTE basis, increased to 3.56% for the year ended December 31, 2022 from 3.28% for the year ended December 31, 2021.
Comparing the year ended December 31, 2022 with the year ended December 31, 2021, interest income increased by $4.2 million . Interest and fees on loans increased by $1.5 million investment income increased by of $2.4 million. The increase in interest on loans was primarily due to an increase of $49.4 million in average loan balance in 2022 compared to 2021. The rate earned on the loan portfolio remained stable when comparing the year ended December 31, 2022 to the year ended December 31, 2021. The increase in investment income was due to the increase in average balances of $77.7 million for the year ended December 31, 2022 compared to the year ended December 31, 2021 as well as an increase in interest yield of 23 basis points.
The decrease in interest expense for 2022 was driven by a decrease of $46.4 million in average balances on long term borrowings related to the prepayment of $70.0 million in FHLB advances in the third quarter of 2021. The decrease of $0.7 million in interest expense on long-term borrowing was partially offset by the 190 basis point increase in rate paid on borrowings for the year ended December 31, 2022 compared to 2021. Average rates paid on deposit accounts decreased slightly in 2022 compared to 2021, which was offset by the growth of $26.1 million in interest-bearing deposits during the year.
As shown below, the composition of total interest income between 2022 and 2021 remained relatively stable.
% of Total Interest Income
Interest and fees on loans 87% 91%
Interest on investment securities 12% 8%
Other 1% 1%
34
Tae of Contents
The following table sets forth the average balances, net interest income and expense, and average yields and rates for our interest-earning assets and interest-bearing liabilities for 2022 and 2021:
Distribution of Assets, Liabilities and Shareholders’ Equity
Interest Rates and Interest Differential – Tax Equivalent Basis
For the Years Ended December 31
Assets
Investment Securities:
Allowance for loan losses (15,568) (16,825)
Non-earning assets 170,128 152,674
Liabilities and Shareholders’ Equity
Non-interest-bearing deposits 533,096 491,967
Other liabilities 33,169 28,013
Shareholders’ Equity 137,685 132,550
Net interest margin 3.56 % 3.28 %
Notes:
(4) The average yields on investments are based on amortized cost.
The following table sets forth an analysis of volume and rate changes in interest income and interest expense of our average interest-earning assets and average interest-bearing liabilities for 2022 and 2021. This table distinguishes between the changes related to average outstanding balances (changes in volume created by holding the interest rate constant) and the changes related to average interest rates (changes in interest income or expense attributed to average rates created by holding the outstanding balance constant).
35
Tae of Contents
Interest Variance Analysis (1)
(In thousands and tax equivalent basis) Volume Rate Net
Interest Income:
Non-taxable Investments 113 (60) 53
Federal funds sold (128) 505 377
Interest-bearing deposits — 22 22
Other interest earning assets (88) (10) (98)
Interest Expense:
Interest-bearing demand deposits 225 77 302
Interest-bearing money markets (37) 857 820
Savings deposits 11 62 73
Short-term borrowings 8 18 26
Long-term borrowings (1,295) 591 (704)
Total interest expense (1,807) 882 (925)
Note:
Provision for Loan Losses
The provision for loan losses was a credit of $0.6 million for the year ended December 31, 2022 and a credit of $0.8 million for the year ended December 31, 2021. Net charge-offs of $0.7 million were recorded for the year ended December 31, 2022, compared to net recoveries of $0.3 million for 2021. The ratio of the ALL to loans outstanding was 1.14% at December 31, 2022 compared to 1.38% at December 31, 2021. The ALL reflects a level commensurate with the risk inherent in our loan portfolio.
36
Tae of Contents
Other Operating Income
The following table shows the major components of other operating income for the past two years, exclusive of net gains, and the percentage changes during these years:
(Dollars in thousands) 2022 2021 % Change
Service charges on deposit accounts $ 1,981 $ 1,771 11.86%
Insurance reimbursement — 1,375 (100.00)%
Other operating income, exclusive of gains, decreased $1.6 million during the year ended December 31, 2022 when compared to the same period of 2021. The decrease was primarily a result of a decrease of $1.4 million in insurance reimbursements and a $0.4 million decrease in trust income in 2022 when compared to 2021. These decreases were partially offset by increased debit card income of $0.3 million for the year ended December 31, 2022 when compared to 2021 due to growth in deposit relationships and increased customer usage of our electronic services and increased service charge income of $0.2 million in 2022 when compared to 2021. Other income decreased $0.4 million.
Net gains of $0.2 million and $1.2 million were reported through other income for the years ended December 31, 2022 and 2021, respectively. The $1.1 million decrease in gains for 2022 was primarily attributable to the decrease in gains on the sale of mortgage loans to the secondary market of $1.1 million due to refinancing activity occurring at a slower pace than the pace experienced in 2021 and due to management’s strategic decision to book new mortgage loans at higher rates to our in-house portfolio.
Other Operating Expense
The following table compares the major components of other operating expense for 2022 and 2021:
(Dollars in thousands) 2022 2021 % Change
Total OREO expenses/(income), net 590 (945) (162.43)%
Settlement expense — 3,300 (100.00)%
FHLB prepayment expense — 2,368 (100.00)%
Other operating expenses decreased $4.6 million for the year ended December 31, 2022 when compared to 2021. Salaries and benefits increased by $2.1 million when compared to 2021 due to a lower reduction of loan origination costs of $1.0 million and a $1.1 million increase due to performance related pay and the competitive employment environment.
37
Tae of Contents
Other changes year-over-year included increased OREO expenses of $1.5 million in 2022 due to gains on sale of OREO booked during 2021 and other net increases in expenses of $0.8 million. Non-interest expense decreased significantly due to our payment of $3.3 million in litigation settlement expenses during the first quarter of 2021 and a $2.4 million prepayment penalty for the early repayment of $70.0 million of FHLB advances recognized in the third quarter of 2021, a reduction of $2.4 million in professional and investor relations expenses primarily related to reimbursement of $0.7 in litigation expenses, a reduction of $0.4 million in investor relations costs and a $1.3 million reduction in legal fees. Charitable contributions also declined by $0.9 million primarily due to the funding of the Foundation at the end of 2021.
Applicable Income Taxes
We recognized a tax expense of $8.1 million in 2022, compared to a tax expense of $6.5 million in 2021. See the discussion under “Income Taxes” in Note 14 to the Consolidated Financial Statements presented elsewhere in this annual report for a detailed analysis of our deferred tax assets and liabilities. Our effective tax rate was 24.5% in 2022 and 24.9% in 2021. The decrease in the tax rate for 2022 was primarily due to the increase in tax credits related to a new 2021 investment in a low-income housing tax credit that began to provide tax benefits in 2022 and will continue to provide benefits in the coming years.
At December 31, 2022, the Corporation had Maryland Net Operating Losses (“NOLs”) of $41.0 million for which a deferred tax asset of $2.7 million has been recorded. There was also a Maryland state interest expense carryforward of $3.1 million, for which a deferred tax asset of $0.2 million has been recorded. There has been and continues to be a full valuation allowance on these NOLs and interest expense deferred tax assets, based on management’s belief that it is more likely than not that these NOLs will not be realized prior to the expiration of their carry-forward periods because the Corporation will not generate sufficient taxable income in the future to fully utilize the NOLs. The valuation allowance was $2.9 million and $3.0 million at December 31, 2022 and 2021, respectively.
We have concluded that no valuation allowance is deemed necessary for our remaining federal and state deferred tax assets at December 31, 2022, as it is more likely than not that they will be realized based on the expected reversal of deferred tax liabilities, the generation of future income sufficient to realize the deferred tax assets as they reverse, and the ability to implement tax planning strategies to prevent the expiration of any carry-forward periods.
38
Tae of Contents
GAAP and Non-GAAP measures
The following tables sets forth certain selected financial data for the years ended December 31, 2022 and 2021 and is qualified in its entirety by the detailed information and unaudited financial statements, including the notes thereto, included elsewhere in this annual report.
For the year ended
December 31,
Per Share Data
Basic net income per common share (1) - as reported $ 3.77 $ 2.95
Basic net income per common share (1) - non-GAAP 3.77 3.54
Diluted net income per common share (1) - as reported $ 3.76 $ 2.95
Diluted net income per common share (1) - non-GAAP 3.76 3.54
Significant Ratios:
Return on Average Assets (a) (1) - as reported 1.39 % 1.12 %
Adjusted Return on Average Assets (a) (1) (non-GAAP) 1.39 % 1.35 %
Return on Average Equity (a) (1) - as reported 18.19 % 14.92 %
Adjusted Return on Average Equity (a) (1) (non-GAAP) 18.19 % 17.82 %
Year Ended
(in thousands, except for per share amount)
Adjustments:
Settlement expense — 3,300
FHLB penalty — 2,368
Charitable contribution — 1,000
Insurance reimbursement — (1,375)
Income tax effect of adjustment — (1,227)
Adjusted net income (non-GAAP) $ 25,048 $ 23,836
Basic earnings per share - as reported $ 3.77 $ 2.95
Adjustments:
Settlement expense — 0.47
FHLB penalty — 0.35
Charitable contribution — 0.15
Insurance reimbursement — (0.20)
Income tax effect of adjustment — (0.18)
Adjusted basic earnings per share (non-GAAP) $ 3.77 $ 3.54
Diluted earnings per share - as reported $ 3.76 $ 2.95
39
Tae of Contents
CONSOLIDATED BALANCE SHEET REVIEW
Overview
Total assets at December 31, 2022 increased by $118.3 million since December 31, 2021. During 2022, cash and interest-bearing deposits in other banks decreased by $41.4 million, the investment portfolio increased by $18.5 million and gross loans increased by $125.8 million. Management made strategic decisions to deploy excess cash balances in 2022. Cash was utilized to purchase a $73.3 million in securities in 2022. OREO balances increased by $0.3 million due to foreclosure activity in 2022. Other assets, including deferred taxes, premises and equipment, and accrued interest receivable, increased by $3.4 million. Total liabilities increased by $101.4 million since December 31, 2021. Non-interest bearing deposits increased by $5.0 million. Interest bearing demand deposits increased by $99.5 million and traditional savings accounts increased by $14.1 million. The increase in interest bearing demand deposits was attributable to an increase in municipality funding into a higher yielding indexed product. Money market balances increased by $25.4 million. Time deposits decreased by $42.7 million related to maturing balances moving to more liquid accounts, or broker investment accounts, due to the rising deposit rates as well as municipal funds moving to higher yielding State funding alternatives. Total shareholders’ equity increased by $9.9 million during the year ended December 31, 2022, as net income of $25.0 million and the issuance of $0.7 million of new shares of common stock was offset by other comprehensive losses of $11.7 million and the payment of $4.2 million in dividends.
As indicated below, the total interest-earning asset mix remained relatively constant at December 31, 2022 as compared to December 31, 2021. The mix for each year is illustrated below.
Year End Percentageof Total Assets
Cash and cash equivalents 4% 7%
Net loans 68% 66%
Investments 20% 20%
The year-end total liability mix has remained consistent during the two-year period as illustrated below.
Year End Percentageof Total Liabilities
Total deposits 93% 93%
Total borrowings 6% 6%
Loan Portfolio
The Bank is actively engaged in originating loans to customers primarily in Allegany County, Frederick County, Garrett County, and Washington County in Maryland, and in Berkeley County, Mineral County, Monongalia County, and Harrison County in West Virginia; and the surrounding regions of West Virginia and Pennsylvania. We have policies and procedures designed to mitigate credit risk and to maintain the quality of our loan portfolio. These policies include underwriting standards for new credits as well as continuous monitoring and reporting policies for asset quality and the adequacy of the ALL. These policies, coupled with ongoing training efforts, have provided effective checks and balances for the risk associated with the lending process. Lending authority is based on the type of the loan, and the experience of the lending officer.
Commercial loans are collateralized primarily by real estate and, to a lesser extent, equipment and vehicles. Unsecured commercial loans represent an insignificant portion of total commercial loans. Residential mortgage loans are collateralized by the related property. Generally, a residential mortgage loan exceeding a specified internal loan-to-value ratio requires private mortgage insurance. Installment loans are typically collateralized, with loan-to-value ratios which are established based on the financial condition of the borrower. We also have made unsecured consumer loans to qualified
40
Tae of Contents
borrowers meeting our underwriting standards. Additional information about our loans and underwriting policies can be found in Item 1 of Part I of this annual report under the heading “Banking Products and Services”.
The following table sets forth the composition of our loan portfolio. Historically, our policy has been to make the majority of our loan commitments in our market areas. We had no foreign loans in our portfolio as of December 31 for any of the years presented.
Summary of Loan Portfolio
The following table presents the composition of our loan portfolio as of December 31 for the past two years:
Commercial real estate $ 458.8 $ 374.3
Acquisition and development 70.6 128.1
Commercial and industrial * 245.4 181.0
Residential mortgage 444.4 404.7
*Includes PPP loans of $0.4 million and $7.7 million at December 31, 2022 and December 31, 2021, respectively.
Outstanding loans of $1.3 billion at December 31, 2022 reflected an increase of $125.8 million during 2022. Since December 31, 2021, commercial real estate loans increased by $84.5 million and acquisition and development loans decreased by $57.5 million due primarily to the payoff of one large credit early in the third quarter. Commercial and industrial loans increased by $64.4 million for the year, primarily in new floor plan business, new commercial clients and continued expansion of existing client relationships. Residential mortgage loans increased $39.7 million related to management’s strategic decision to book new mortgage loans at higher rates to our in-house portfolio. The consumer loan portfolio decreased by $5.3 million due to amortization and payoffs of the existing portfolio slightly offset by new production.
Commercial loan production for the year ended December 31, 2022 was approximately$374.2 million, with $53.3 million originated during the fourth quarter. At December 31, 2022, unfunded, committed commercial construction loans totaled approximately $27.8 million. Commercial amortization and payoffs were approximately $282.7 million through December 31, 2022.
Consumer mortgage loan production was approximately $91.8 million through December 31, 2022. The pipeline of in-house, portfolio loans as of December 31, 2022, consisted of $7.5 million. The residential mortgage production level slowed in the fourth quarter of 2022 due to the increasing interest rates that occurred in 2022.
41
Tae of Contents
The following table sets forth the maturities, based upon contractual dates, for selected loan categories as of December 31, 2022:
Maturities of Loan Portfolio at December 31, 2022
Fixed Rate Loans
Variable Rate Loans
Management monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a required payment is past due. A loan is considered to be past due when a scheduled payment has not been received for 30 days past its contractual due date. For all loan segments, the accrual of interest is discontinued when principal or interest is delinquent for 90 days or more unless the loan is well-secured and in the process of collection. All non-accrual loans are considered to be impaired. Interest payments received on non-accrual loans are applied as a reduction of the loan principal balance. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured. Our policy for recognizing interest income on impaired loans does not differ from our overall policy for interest recognition.
42
Tae of Contents
The following sets forth the amounts of non-accrual, past-due and restructured loans for the past two years:
Risk Elements of Loan Portfolio
At December 31,
Non-accrual loans:
Commercial real estate $ 145 $ 81
Acquisition and development 146 390
Commercial and industrial — 90
Total non-accrual loans $ 3,495 $ 2,462
Accruing Loans Past Due 90 days or more:
Residential mortgage 282 148
Total accruing loans past due 90 days or more $ 307 $ 300
Total non-accrual and past due 90 days or more $ 3,802 $ 2,762
Restructured Loans (TDRs):
Non-accrual (included above) 277 300
Other Real Estate Owned $ 4,733 $ 4,477
Total Non-performing assets $ 8,535 $ 7,239
Impaired loans without a valuation allowance $ 6,153 $ 5,248
Impaired loans with a valuation allowance 345 480
Valuation allowance related to impaired loans $ 26 $ 64
Non-accrual loans to total loans (as %) 0.27% 0.21%
Non-performing loans to total loans (as %) 0.30% 0.24%
Non-performing assets to total assets (as %) 0.46% 0.42%
Allowance for loan losses to non-accrual loans (as %) 418.77% 648.05%
43
Tae of Contents
The following table sets forth the percent applicable by portfolio for non-accrual loans for the past two years:
Non-Accrual Loans as a % of Applicable Portfolio
Commercial real estate 0.0% 0.0%
Acquisition and development 0.2% 0.3%
Commercial and industrial 0.0% 0.0%
Residential mortgage 0.7% 0.5%
Consumer 0.0% 0.0%
We would have recognized $0.2 million in interest income for the year ended December 31, 2022 had our non-accrual loans been current and performing in accordance with their terms. During 2022, we recognized, on a cash basis, $0.2 million of interest income on non-accrual loans that paid off.
Performing loans considered to be impaired (including performing troubled debt restructurings, or TDRs), as defined and identified by management, amounted to $3.0 million at December 31, 2022 and $3.3 million at December 31, 2021. Loans are identified as impaired when, based on current information and events, management determines that we will be unable to collect all amounts due according to contractual terms. These loans consist primarily of acquisition and development loans and CRE loans. The fair values are generally determined based upon independent third-party appraisals of the collateral or discounted cash flows based upon the expected proceeds. Specific allocations have been made where there is insufficient collateral to repay the loan balance if liquidated and there is no secondary source of repayment available.
The level of performing impaired loans (other than performing TDRs) decreased by $0.3 million during the year ended December 31, 2022. The decrease in allowance for loan losses as a percentage of non-accrual loans was related to the increase in non-accrual loans in 2022 compared to 2021.
A troubled debt restructuring is the restructuring of a loan in which one or more concessions are granted to a borrower who is experiencing financial difficulties. A loan will be classified as a TDR if the Bank restructures the loan’s terms (i.e., interest rate, payment amount, amortization period and/or maturity date) after determining that the borrower is experiencing financial difficulties. A modified loan is considered to be a TDR when the Bank has determined that the borrower is experiencing financial difficulties. The Bank evaluates the probability that the borrower will be in payment default on any of its debt in the foreseeable future without modification. To make this determination, the Bank performs a global financial review of the borrower and loan guarantors to assess their current ability to meet their financial obligations.
44
Tae of Contents
The following table presents the details of TDRs by loan class at December 31, 2022 and December 31, 2021:
Performing
Commercial real estate
Non owner-occupied 1 $ 100 1 $ 106
Acquisition and development
1-4 family residential construction 1 210 1 239
All other A&D — — — —
Commercial and industrial — — — —
Residential mortgage
Residential mortgage – term 6 423 6 474
Residential mortgage – home equity — — — —
Consumer — — — —
Non-accrual
Commercial real estate
Non owner-occupied — $ — — $ —
All other CRE — — — —
Acquisition and development
1-4 family residential construction — — — —
All other A&D — — — —
Commercial and industrial — — — —
Residential mortgage
Residential mortgage – term 2 277 2 300
Residential mortgage – home equity — — — —
Consumer — — — —
Total non-accrual 2 277 2 300
The level of TDRs decreased by $0.3 million during the year ended December 31, 2022. There were no new loans added to TDRs and one loan already in performing TDRs was re-modified. Net principal payments totaling $0.3 million were received during the same time period.
At December 31, 2022, there were no additional funds committed to be advanced in connection with TDRs. In 2022, interest income not recognized due to rate modifications of TDRs was $55 thousand and interest income recognized on all TDRs was $0.2 million.
Allowance for Loan Losses
The ALL is maintained to absorb probable incurred credit losses from the loan portfolio. The ALL is based on management’s continuing evaluation of the quality of the loan portfolio, assessment of current economic conditions, diversification and size of the portfolio, adequacy of collateral, past and anticipated loss experience, and the amount of non-performing loans.
The ALL is also based on estimates, and actual losses will vary from current estimates. These estimates are reviewed quarterly, and as adjustments, either positive or negative, become necessary, a corresponding increase or decrease is made in the ALL. The methodology used to determine the adequacy of the ALL is consistent with prior years. An estimate for probable losses related to unfunded lending commitments, such as letters of credit and binding but unfunded loan commitments is also prepared. This estimate is computed in a manner similar to the methodology described above, adjusted for the probability of actually funding the commitment. At December 31, 2022 and 2021, the balance for reserve
45
Tae of Contents
for probable losses on unfunded commitments, included in other liabilities in the consolidated statements of financial condition was $0.1 million.
The ALL was $14.6 million at December 31, 2022 compared to $16.0 million at December 31, 2021, a decrease of 8.3% that resulted primarily from improvements in unemployment rates and a decline in total delinquencies. Net charge-offs of $0.7 million were recorded for 2022, compared to net recoveries of $0.3 million for 2021. The ratio of the ALL to loans outstanding was 1.14% at December 31, 2022 compared to 1.38% at December 31, 2021.
The ratio of net charge-offs to average loans for the year ended December 31, 2022 was an annualized 0.06%, compared to net recoveries to average loans of 0.02% for the year ended December 31, 2021. The increase in net charge-offs was primarily related to increased charge-offs in our consumer loan portfolio. Our special assets team continues to effectively collect on charged-off loans, resulting in ongoing overall low charge-off ratios.
Accruing loans past due 30 days or more decreased to 0.16%, compared to 0.31% at December 31, 2021. Non-accrual loans totaled $3.5 million at December 31, 2022 compared to $2.5 million at December 31, 2021. The increase in non-accrual balances at December 31, 2022 was primarily related to one residential real estate loan of $1.5 million added to non-accrual in 2022. This was partially offset by reductions in principal balance of existing non-accrual loans.
The ALL at December 31, 2022 is adequate to provide for probable losses inherent in our loan portfolio. Amounts that will be recorded for the provision for loan losses in future periods will depend upon trends in the loan balances, including the composition of the loan portfolio, changes in loan quality and loss experience trends, potential recoveries on previously charged-off loans and changes in other qualitative factors. Management also applies interest rate risk, collateral value and debt service sensitivity analyses to the CRE loan portfolio and obtains new appraisals on specific loans under defined parameters to assist in the determination of the periodic provision for loan losses.
46
Tae of Contents
The following table presents the activity in the ALL by major loan category for the past two years.
Analysis of Activity in the Allowance for Loan Losses
For the Years Ended December 31,
Charge-offs:
Commercial real estate — (14)
Acquisition and development (20) (85)
Commercial and industrial (134) (2)
Residential mortgage (46) (141)
Total charge-offs (1,121) (638)
Recoveries:
Commercial real estate 1 —