Item 1A. Risk Factors
The performance of our Company is subject to various risks. We consider the risks described below to be the most significant risks we face, but such risks are not the only risk factors that could affect us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially and adversely affect our business, financial condition or results of operations. For a discussion of the impact of risks on our financial condition and results of operations in recent years and on forward looking statements contained in this report, reference is made to Item 7 below.
Risks Related to the Company's Business
We may be adversely affected by economic conditions in the local economies in which we conduct our operations, and in the United States in general.
Our primary market includes the Iowa counties of Johnson, Linn and Washington. Our market has been one of the strongest economic areas in Iowa exhibiting economic growth over the past ten years. The unemployment rate for our prime market area is favorable and the rate historically has been lower than the unemployment rates for both the United States and the State of Iowa. However, unfavorable or uncertain economic and market conditions may adversely affect our business and profitability. Our business faces various material risks, including credit risk, liquidity risk and the risk that the demand for our products and services will decrease. Consumer confidence, real estate values, interest rates and investment returns could make the types of loans we originate less profitable and could increase our credit risk and litigation expense. And, while the presence of the University of Iowa and its affiliated institutions has a significant favorable impact upon the regional economy, it is unclear what impact the State budget and funding models will have on the University of Iowa and the University of Iowa Hospitals and Clinics.
The ongoing COVID-19 pandemic and measures intended to prevent its spread could have a material adverse effect on our business, results of operations and financial condition, and such effects will depend on future developments, which are highly uncertain and are difficult to predict.
In December 2019, a novel coronavirus (COVID-19) was reported in China, and, in March 2020, the World Health Organization declared it a pandemic. On March 12, 2020, the President of the United States declared the COVID-19 outbreak in the United States a national emergency. The COVID-19 pandemic has caused significant economic dislocation in the United States as many state and local governments ordered non-essential businesses to close and residents to shelter in place at home. This has resulted in an unprecedented slow-down in economic activity and a related increase in unemployment. Since the COVID-19 outbreak, more than 65 million people have filed claims for unemployment, and stock markets have experienced significant volatility and, in particular, bank stocks have significantly declined in value. In response to the COVID-19 outbreak, the Federal Reserve Board has reduced the benchmark fed funds rate to a target range of 0% to 0.25%, and the yields on 10 and 30-year treasury notes have declined to historic lows. The federal banking agencies have encouraged financial institutions to prudently work with affected borrowers and have passed multiple rounds of legislation to provide relief from reporting loan classifications due to modifications related to the COVID-19 outbreak.
Finally, the spread of the coronavirus caused the Company to modify its business practices, including employee travel, employee work locations, and cancellation of physical participation in meetings, events and conferences. The Company may take further actions as may be required by government authorities or that it determines are in the best interests of employees, customers and business partners. There is no certainty that such measures will be sufficient to mitigate the risks posed by the virus or will otherwise be satisfactory to government authorities. In addition, the success of the Company’s operations substantially depends on the management skills of its executive officers and directors, many of whom have held officer and director positions with the Company for many years. The Company’s Treasurer and Chief Financial Officer resigned in September 2020. The Company has commenced a search for a chief financial officer and will make a subsequent announcement regarding such appointment upon completion. Pending the completion of its search, the Company retained an outside consultant to assist the Chief Executive Officer in managing the responsibilities of the Chief Financial Officer position. The unanticipated loss or unavailability of key employees due to the outbreak could harm our ability to operate our business or execute our business strategy.
Given the ongoing and dynamic nature of the circumstances, it remains difficult to predict the full impact of the COVID-19 outbreak on our business. The United States government has taken steps to attempt to mitigate some of the more severe anticipated economic effects of the virus, including the passage of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). Further legislation was passed in December 2020, the Coronavirus Response and Relief Supplemental Appropriations Act 2021, which extended many provisions in the CARES Act, but there can be no assurance that such steps
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will be effective or achieve their desired results in a timely fashion. The extent of such impact from the COVID-19 outbreak and related mitigation efforts will depend on future developments, which are highly uncertain, including but not limited to, the duration and spread of the outbreak, its severity, the actions to contain the virus or treat its impact, the broad distribution of vaccines, and how quickly and to what extent normal economic and operating conditions can resume. As a result, the Company could be subject to any of the following risks, any of which could have a material, adverse effect on our business, financial condition, liquidity, and results of operations:
•demand for our products and services may decline, making it difficult to grow assets and income;
•if the economy is unable to substantially reopen, and high levels of unemployment continue for an extended period of time, loan delinquencies, problem assets, and foreclosures may increase, resulting in increased charges and reduced income;
•collateral for loans, especially real estate, may decline in value, which could cause loan losses to increase;
•our allowance for loan losses may be insufficient given the significant economic uncertainties created by the pandemic and, as a result, may have to be increased if borrowers experience financial difficulties beyond forbearance periods, which will adversely affect our net income;
•the net worth and liquidity of loan guarantors may decline, impairing their ability to honor commitments to us;
•as the result of the decline in the Federal Reserve Board’s target federal funds rate, the yield on our assets may decline to a greater extent than the decline in our cost of interest-bearing liabilities, reducing our net interest margin and spread and reducing net income;
•a material decrease in net income or a net loss over several quarters could result in a decrease in the rate of our quarterly cash dividend;
•we rely on third party vendors for certain services and the unavailability of a critical service due to the COVID-19 outbreak could have an adverse effect on us; and
•Federal Deposit Insurance Corporation premiums may increase if the agency experiences additional resolution costs.
Any one or a combination of the factors identified above could negatively impact our business, financial condition and results of operations and prospects. Even after the COVID-19 outbreak has subsided, the Company may continue to experience materially adverse impacts to our business as a result of the virus’s global economic impact, including the availability of credit, adverse impacts on our liquidity and any recession that has occurred or may occur in the future.
As a participating lender in the Paycheck Protection Program (PPP), the Company and the Bank are subject to additional risks of litigation from the Bank’s customers or other parties regarding the Bank’s processing of loans for the PPP and risks that the Small Business Administration (SBA) may not fund some or all PPP loan guarantees.
The CARES Act included a loan program administered through the SBA referred to as the PPP. Under the PPP, small businesses and other entities and individuals can apply for loans from existing SBA lenders and other approved regulated lenders that enroll in the program, subject to numerous limitations and eligibility criteria. The initial PPP opened on April 3, 2020 through August 2020, with another round of PPP funding approved in December 2020 with the Coronavirus Response and Relief Supplemental Appropriations Act 2021; however, there has been some ambiguity in the laws, rules and guidance regarding the operation of the PPP, which exposes the Company to risks relating to noncompliance with the PPP.
Since the opening of the PPP, several other larger banks have been subject to litigation regarding the process and procedures that such banks used in processing applications for the PPP and claims related to agent fees. The Company and the Bank may be exposed to the risk of similar litigation from both customers and non-customers that approached the Bank regarding PPP loans. If any such litigation is filed against the Company or the Bank and is not resolved in a manner favorable to the Company or the Bank, it may result in significant financial liability or adversely affect the Company’s reputation. In addition, litigation can be costly, regardless of outcome. Any financial liability, litigation costs or reputational damage caused by PPP related litigation could have a material adverse impact on our business, financial condition and results of operations.
The Bank also has credit risk on PPP loans if a determination is made by the SBA that there is a deficiency in the manner in which the loan was originated, funded, or serviced by the Bank, such as an issue with the eligibility of a borrower to receive a PPP loan, which may or may not be related to the ambiguity in the laws, rules and guidance regarding the operation of the PPP. In the event of a loss resulting from a default on a PPP loan and a determination by the SBA that there was a deficiency in the manner in which the PPP loan was originated, funded, or serviced by the Company, the SBA may deny its liability under the guaranty, reduce the amount of the guaranty, or, if it has already paid under the guaranty, seek recovery of any loss related to the deficiency from the Company.
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Our profitability and liquidity may be adversely affected by deterioration in the credit quality of, or defaults by, third parties who owe us money or other assets.
We are exposed to the risk that third parties that owe us money or other assets will not fulfill their obligations. These parties may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure or other reasons. Our rights against third parties may not be enforceable in all circumstances. In addition, deterioration in the credit quality of third parties whose securities or obligations we hold could result in losses and/or adversely affect our ability to use those securities or obligations for liquidity purposes.
Our financial condition has not been materially impacted by the deterioration in the credit quality of third parties except as related to borrower credit quality. Management believes that the allowance for loan losses is adequate to absorb probable losses on any existing loans that may become uncollectible but cannot predict loan losses with certainty and cannot assure that our allowance for loan losses will prove sufficient to cover actual losses in the future.
Our allowance for loan losses may not be adequate to cover actual losses.
Like all financial institutions, we maintain an allowance for loan losses to provide for loan defaults and non-performance. Our allowance for loan losses is based on our historical loss experience as well as an evaluation of the risks associated with our loan portfolio, including the size and composition of the loan portfolio, current economic conditions and concentrations within the portfolio. The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Economic conditions affecting borrowers, including, but not limited to, the ongoing economic impact of the COVID-19 pandemic and the related uncertainties created thereby, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in the allowance for loan losses. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed expectations, we will need additional provisions to increase the allowance for loan losses. Any increases in the allowance for loan losses may result in a decrease in net income and capital, and may have a material adverse effect on our financial condition and results of operations.
In June 2016, the Financial Accounting Standards Board (FASB) issued ASU 2016-13, "Financial Instruments - Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments," which replaces the current "incurred loss" model for recognizing credit losses with an "expected loss" model referred to as the Current Expected Credit Loss model, or CECL. Under the CECL model, we will be required to present certain financial assets carried at amortized cost, such as loans held for investment and held-to-maturity debt securities, at the net amount expected to be collected. The measurement of expected credit losses is to be based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This measurement will take place at the time the financial asset is first added to the balance sheet and periodically thereafter. This differs significantly from the "incurred loss" model required under current GAAP, which delays recognition until it is probable a loss has been incurred. Accordingly, we expect that the adoption of the CECL model will materially affect how we determine our allowance for loan losses and could require us to significantly increase our allowance. Moreover, the CECL model may create more volatility in the level of our allowance for loan losses.
The Company is currently finalizing the CECL model and upon adoption of ASU 2016-13 (CECL) in the first quarter of 2021 anticipates an increase to the allowance for credit losses for loans of approximately $2 to $4 million and an unfunded commitment liability of approximately $3 to $4 million. See Note 1 for further discussion.
Our loan portfolio has a large concentration of real estate loans, which involve risks specific to real estate value.
Real estate loans, which constitute a large portion of our loan portfolio, include home equity, commercial, construction and residential loans, and such loans are concentrated in the Bank’s trade area. As of December 31, 2020, 82.69% of our loans had real estate as a primary component of collateral. The market value of real estate may fluctuate significantly in a short period of time as a result of market conditions in the geographic area in which the real estate is located. Adverse developments affecting real estate values in our market could increase the credit risk associated with our loan portfolio. Also, real estate lending typically involves higher loan principal amounts and the repayment of the loans generally is dependent, in large part, on sufficient income from the properties securing the loans to cover operating expenses and debt service. Economic events or governmental regulations outside of the control of the borrower could adversely impact the future cash flow and market values of the affected properties.
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If the loans that are collateralized by real estate become troubled during a time when market conditions are declining or have declined, then we may not be able to realize the amount of security that we anticipated at the time of originating the loan, which could cause us to increase our provision for loan losses and adversely affect our operating results and financial condition.
Our real estate loans also include construction loans, including land acquisition and development. Construction, land acquisition and development lending involves additional risks because funds are advanced based upon estimates of costs and the estimated value of the completed project. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation on real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the related loan-to-value ratio. As a result, commercial construction loans often involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property, rather than the ability of the borrower or guarantor to repay principal and interest. If our appraisal of the value of the completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project.
Commercial loans make up a significant portion of our loan portfolio.
Our commercial loans are primarily made based on the identified cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. Repayment of our commercial loans is often dependent on the cash flows of the borrower, which may be unpredictable. Most often, this collateral is accounts receivable, inventory, machinery and equipment. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. The other types of collateral securing these loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business.
There may be issues with environmental law compliance if we take possession of real property that secures a loan.
A significant portion of our loan portfolio is secured by real property. We may foreclose on and take title to certain real property. There is a risk that hazardous substances could be found on the property and we may be liable for remediation costs, personal injury and/or property damage. We may incur substantial expenses to comply with environmental laws which may materially reduce the property's value or limit our ability to dispose of the property. The remediation costs and any other financial liabilities associated with the property could have a material adverse effect on our financial condition and results of operations.
Our agricultural loans may involve a greater degree of risk than other loans, and the ability of the borrower to repay may be affected by many factors outside of the borrower’s control.
Payments on agricultural real estate loans are dependent on the profitable operation or management of the farm property securing the loan. The success of the farm may be affected by many factors outside the control of the borrower, including adverse weather conditions that prevent the planting of a crop or limit crop yields (such as hail, drought and floods), loss of livestock due to disease or other factors, changes in market prices for agricultural products (both domestically and internationally) and the impact of government regulation (including changes in price supports, subsidies and environmental regulation). In addition, many farms are dependent on a limited number of key individuals whose injury or death may significantly affect the successful operation of the farm. If the cash flow from a farming operation is diminished, the borrower’s ability to repay the loan may be impaired. The primary crops in our market areas are corn and soybeans. Accordingly, adverse circumstances affecting these crops could have an adverse effect on our agricultural real estate loan portfolio.
We also originate agricultural operating loans. As with agricultural real estate loans, the repayment of operating loans is dependent on the successful operation or management of the farm property. Likewise, agricultural operating loans involve a greater degree of risk than lending on residential properties, particularly in the case of loans that are unsecured or secured by rapidly depreciating assets such as farm equipment or assets such as livestock or crops. The primary livestock in our market areas is hogs and turkeys. In these cases, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation.
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The ongoing impact of the derecho storm could have a material adverse effect on our business, results of operations and financial condition, and such effects will depend on future developments, which are highly uncertain and are difficult to predict.
On August 10, 2020, a derecho impacted Eastern Iowa, primarily Cedar Rapids, Iowa and the surrounding areas. The derecho caused widespread high winds up to 140 mph, the equivalent of a Category 4 hurricane, torrential rain, large hail and low-class tornadoes. The damage from the derecho was significant across the east central Iowa area, including wide-scale utility disruptions, residential and commercial property damage and severe damage to corn and soybeans crops. The Bank has assisted customers impacted by the derecho by providing short-term loan modifications to defer principal payments on loans totaling $21.36 million, $14.87 million of which were still active as of December 31, 2020, primarily for 1 to 4 family non-owner occupied, multifamily and commercial real estate loans. Further deterioration to the local economy caused by the derecho could have a materially negative impact on the Bank’s financial condition and results of operation in future periods.
We may be required to repurchase mortgage loans or reimburse investors and others as a result of breaches in contractual representations and warranties.
We sell residential mortgage loans to various parties that purchase mortgage loans for investment. The agreements under which we sell mortgage loans contain various representations and warranties regarding the origination and characteristics of the mortgage loans, including ownership of the loan, compliance with loan criteria set forth in the applicable agreement, validity of the lien securing the loan, absence of delinquent taxes or liens against the property securing the loan, and compliance with applicable origination laws. We may be required to repurchase mortgage loans, indemnify the investor, or reimburse the investor for credit losses incurred on loans in the event of a breach of contractual representations or warranties. The agreements under which we sell mortgage loans require us to deliver various documents to the investor, and we may be obligated to repurchase any mortgage loan as to which the required documents are not delivered or are defective.
We depend on the accuracy and completeness of information about customers and counterparties.
In deciding whether to extend credit or enter into other transactions with customers and counterparties, we may rely on information furnished by or on behalf of customers and counterparties, including financial statements and other financial information. We also may rely on representations of clients and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors and accountants if made available. If this information is inaccurate, we may be subject to regulatory action, reputational harm or other adverse effects with respect to the operation of our business, our financial condition and our results of operation.
If we are unable to continuously attract deposits and other short-term funding, our financial condition and our business prospects could be adversely affected.
In managing our liquidity, our primary source of short-term funding is customer deposits. Our ability to continue to attract these deposits, and other short-term funding sources, is subject to variability based upon a number of factors, including the relative interest rates we are prepared to pay for these liabilities and the perception of safety of those deposits or short-term obligations relative to alternative short-term investments. The availability and cost of credit in short-term markets depends upon market perceptions of our liquidity and creditworthiness. Our efforts to monitor and manage liquidity risk may not be successful or sufficient to deal with dramatic or unanticipated changes in event-driven reductions in liquidity. In such events, our cost of funds may increase, thereby reducing our net interest revenue, or we may need to dispose of a portion of our investment portfolio, which, depending on market conditions, could result in our realizing a loss or experiencing other adverse consequences.
Conditions in the financial markets may limit our access to funding to meet our liquidity needs.
Liquidity is essential to our business, as we must maintain sufficient funds to respond to the needs of depositors and borrowers. An inability to raise funds through deposits, borrowings, the sale or pledging as collateral of loans and other assets could have a substantial adverse effect on our liquidity. Our access to funding sources in the amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general. Factors that could adversely affect our access to liquidity sources include a decrease in the level of our business activity due to a market downturn or adverse regulatory action against us. Our ability to borrow could also be impaired by factors that are not specific to us, such as severe disruption of the financial markets or adverse news and expectations about the prospects for the financial services industry as a whole.
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As a part of our liquidity management, we use a number of funding sources in addition to core deposit growth and repayments and maturities of loans and investments. These sources include brokered money markets and certificates of deposit, federal funds purchased, lines of credit and Federal Home Loan Bank advances. Negative operating results or changes in industry conditions could lead to an inability to replace these additional funding sources at maturity. Our financial flexibility could be constrained if we are unable to maintain our access to funding or if adequate financing is not available to accommodate future growth at acceptable 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 this case, our results of operations and financial condition would be adversely affected.
Reduction in the value, or impairment of our investment securities, may impact our earnings and stockholders' equity.
We maintained a balance of $416.54 million, or 11.02% of our assets, in investment securities at December 31, 2020. Changes in market interest rates may affect the value of these investment securities, with increasing interest rates generally resulting in a reduction of value. Although the reduction in value from temporary increases in market rates does not affect our income until the security is sold, it does result in an unrealized loss recorded in other comprehensive income that may reduce our stockholders' equity. Further, we periodically test our investment securities for other-than-temporary impairment in value. In assessing whether the impairment of investment securities is other-than-temporary, we consider 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.
Our growth strategy relies heavily on our management team, and the unexpected loss of key managers and/or officers may adversely affect our operations.
Our success is dependent on experienced senior management with a strong local community network. Our ability to retain the current management team is key to the successful implementation of our growth strategy. It is equally important that we are able to continue to attract and retain quality and community-focused managers and officers. The unexpected loss of one of our key managers and/or officers or the inability to attract qualified personnel could have an adverse effect on our operations, financial condition and reputation. The Company’s Treasurer and Chief Financial Officer resigned in September 2020. The Company has commenced a search for a chief financial officer and will make a subsequent announcement regarding such appointment upon completion. Pending the completion of its search, the Company retained an outside consultant to assist the Chief Executive Officer in managing the responsibilities of the Chief Financial Officer position.
The potential for business interruption exists throughout our organization.
Integral to our performance is the continued efficacy of our technical systems, operational infrastructure, relationships with third parties and the array of personnel involved with bank operations. Failure by any or all of these resources subjects us to risks that may vary in size, scale and scope. This includes, but is not limited to, operational or technical failures, ineffectiveness or exposure due to interruption in third-party support, as well as the loss of key individuals or failure on the part of key individuals to perform properly. These risks are heightened during data system changes or conversions. Although management has established policies and procedures to address such failures, the occurrence of any such event could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.
Our risk management framework may not be effective in mitigating risk and loss.
We maintain an enterprise risk management program that is designed to identify, quantify, monitor, report and control the risks that we face. These include credit, liquidity, market, operational, reputational, compliance, strategic, information technology and security, and trust risks. While we assess this program on an ongoing basis, there can be no assurance that its approach and framework for risk management and related controls will effectively mitigate risk and limit losses in our business. If conditions or circumstances arise that expose flaws or gaps in the risk management program or if its controls break down, the performance and value of our business could be adversely affected.
Our internal controls may be ineffective.
We regularly review and update our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well-designed and operated, is based in part on certain assumptions and may provide only reasonable, not absolute, assurances that the objectives of the controls are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, financial condition and results of operation.
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We are subject to a variety of litigation or other proceedings, which could adversely affect our business.
We are involved from time to time in a variety of litigation or other proceedings arising out of business or operations. We establish reserves for claims when appropriate under accounting principles generally accepted in the United States of America, but costs often may be incurred in connection with a matter before any reserve has been created. In addition, the actual costs associated with resolving a claim may be substantially higher than amounts that we have reserved. Substantial legal claims could have a detrimental impact on our business, results of operations, and financial condition and may cause reputational harm.
Risks Related to the Banking Industry in General and Community Banking in Particular
Changes in U.S. trade policies, such as the implementation of tariffs, and other factors beyond the Company’s control may adversely impact our business, financial condition and results of operations.
The U.S. government has implemented tariffs on certain products from countries or entities such as Mexico, Canada, China and the European Union. These countries have issued or continue to threaten retaliatory tariffs against products from the United States, including agricultural products. The United States and these countries may impose additional tariffs and retaliatory tariffs in the future. Tariffs, retaliatory tariffs or other trade restrictions on products and materials that our customers import or export, including agricultural products such as soybeans, could cause the prices of our customers’ products to increase which could reduce demand for such products, or reduce our customer margins, and adversely impact their revenues, financial results and ability to service debt. This could adversely affect our financial condition and results of operations. In addition, to the extent changes in the political environment have a negative impact on us or on the markets in which we operate, our business, results of operations and financial condition could be materially and adversely impacted in the future. In January 2020, passage of the United States-Mexico-Canada (USMCA) trade agreement helped to alleviate some of these risks. The USMCA updates trading rules to better reflect 21st century technology, regulates labor and environmental standards in Mexico, tightens the rules the auto industry must follow to trade vehicles duty free across the three countries and provides tariff-free trade in North America.
We may be adversely impacted by recent legislation and potential additional legislation and rulemaking.
The 2008-2009 recession produced a number of new laws that impact financial institutions including the Dodd-Frank Act. The Dodd-Frank Act established the Consumer Financial Protection Bureau (the “CFPB”) and granted it the broad authority to administer and enforce a new federal regulatory framework of consumer financial regulation. Any changes to state and federal banking laws and regulations may adversely impact our ability to expand services and to increase the value of our business. We are subject to extensive state and federal regulation, supervision, and legislation that govern almost all aspects of our operations. These laws may change from time to time and are primarily intended for the protection of consumers, depositors and the deposit insurance funds. In addition, our earnings are affected by the monetary policies of the Board of Governors of the Federal Reserve. These policies, which include regulating the national supply of bank reserves and bank credit, may have a major effect upon the source and cost of funds and the rates of return earned on loans and investments. The Federal Reserve influences the size and distribution of bank reserves through its open market operations and changes in cash reserve requirements against member bank deposits. We cannot predict what effect such act and any presently contemplated or future changes in the laws or regulations or their interpretations would have on us, including changes with the new government administration, but such changes could be materially adverse to our financial performance.
Changing interest rates may adversely affect our profits.
Our income and cash flows depend to a great extent on the difference between the interest rates earned by us on interest-earning assets such as loans and investment securities and the interest rates paid by us on interest-bearing liabilities such as deposits and borrowings. Our net interest margin will be affected by general economic conditions, fiscal and monetary policies of the federal government, and our ability to respond to changes in such rates. Our assets and liabilities are affected differently by a change in interest rates. An increase or decrease in rates, the length of loan terms or the mix of adjustable and fixed rate loans in our portfolio could have a positive or negative effect on our net income, capital and liquidity. We measure interest rate risk under various rate scenarios and using specific criteria and assumptions. A summary of this process is presented under the heading "Quantitative and Qualitative Disclosures about Market Risk" included under Item 7A of Part II of this Form 10-K. Although we believe our current level of interest rate sensitivity is reasonable and effectively managed, significant fluctuations in interest rates may have an adverse effect on our business, financial condition and results of operations. Also, our interest rate risk modeling techniques and assumptions may not fully predict or capture the impact of actual interest rate changes on our financial condition and results of operations.
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The replacement of LIBOR could adversely affect the Company’s revenue or expenses and the value of those assets or obligations.
LIBOR and certain other “benchmarks” are the subject of recent national, international and other regulatory guidance and proposals for reform. These reforms may cause such benchmarks to perform differently than in the past or have other consequences which cannot be predicted. LIBOR is set based on interest information reported by certain banks, which may stop reporting such information after 2021. It is uncertain at this time whether LIBOR will change or cease to exist or the extent to which those entering into financial contracts will transition to any particular benchmark.
While there is no consensus on what rate or rates may become accepted alternatives to LIBOR, a group of large banks, the Alternative Reference Rate Committee or ARRC, selected by the Federal Reserve Bank of New York, started in May 2018 to publish the Secured Overnight Finance Rate or SOFR as an alternative to LIBOR. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities, given the depth and robustness of the U.S. Treasury repurchase market. At this time, it is impossible to predict whether SOFR will become an accepted alternative to LIBOR.
The market transition away from LIBOR to an alternative reference rate, including SOFR, is complex and could have a range of adverse effects on the Bank’s business, financial condition and results of operations. In particular, any such transition could:
•adversely affect the interest rates paid or received on, and the revenue and expenses associated with, the Bank’s floating rate obligations, loans, deposits, derivatives and other financial instruments tied to LIBOR rates, or other securities or financial arrangements given LIBOR’s role in determining market interest rates globally;
•adversely affect the value of the Bank’s floating rate obligations, loans, deposits, derivatives and other financial instruments tied to LIBOR rates, or other securities or financial arrangements given LIBOR’s role in determining market interest rates globally;
•prompt inquiries or other actions from regulators in respect of the Bank’s preparation and readiness for the replacement of LIBOR with an alternative reference rate;
•result in disputes, litigation or other actions with counterparties regarding the interpretation and enforceability of certain fallback language in LIBOR-based securities; and
•require the transition to or development of appropriate systems and analytics to effectively transition the Bank’s risk management processes from LIBOR-based products to those based on the applicable alternative pricing benchmark, such as SOFR.
The manner and impact of this transition, as well as the effect of these developments on the Bank’s funding costs, loan and investment and trading securities portfolios, asset-liability management, and business, is uncertain.
We experience intense competition for loans and deposits.
Competition in banking and financial services business in our market is highly competitive and is currently undergoing significant change. Our competitors include local commercial banks, local credit unions, online banks, mortgage companies, finance companies and other non-bank financial services providers. Increasingly, competitors are able to provide integrated financial services over a broad geographic area. Increased competition may result in a decrease in the amounts of loans and deposits, reduced spreads between loan rates and deposit rates or loan terms that are less favorable to us. Competition may also accelerate investments in technology or infrastructure. Any of these results could have a material adverse effect on our ability to grow and remain profitable.
Growth levels in local and national real estate markets may impact our operations and/or financial condition.
Change in growth in the national housing market as evidenced by reports of levels of new and existing home sales, inventories of houses on the market, property values, building permits, and the time houses remain on the market may indicate increased levels of credit risk. In past history of real estate growth, some lenders made many adjustable-rate mortgage loans, and lowered their credit standards with respect to mortgage loans and home equity loans. A subsequent slowdown in the national housing market created uncertainty and liquidity issues relating to the value of such mortgage loans, which caused disruption in credit markets. Management will continue to monitor that the Bank has maintained appropriate lending standards in times of real estate growth and decline. No assurance can be given that these conditions will not directly or indirectly affect our operations.
We are subject to risks associated with technological changes and the resources needed to implement the changes.
Our industry is susceptible to significant technological changes as there continue to be a high level of new technology driven products and services introduced. Technological advancement aids us in providing customer service and increases efficiency. Our national competitors may have more resources to invest in technological changes. As a result they may be able to offer
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products and services that are more technologically advanced and that may put us at a competitive disadvantage. Our future may depend on our ability to analyze technological changes to determine the best course of action for our business, customers and shareholders.
We rely heavily on our network security and any system failure or data breach could subject us to increased costs as well as reputational risk.
Our operations are dependent on our ability to process financial transactions in a secure manner. Failure in or breach of our operational or security systems or infrastructure, or those of our third-party vendors and other service providers, could disrupt our business or the businesses of our customers, result in the disclosure or misuse of confidential or proprietary information, damage our reputation, increase our costs and cause losses. We must ensure that information is properly protected from a variety of threats such as cyber attacks, error, fraud, sabotage, terrorism, industrial espionage, privacy violation, service interruption, and natural disaster. These threats arise from numerous sources including human error, fraud on the part of employees or third parties, technological failure, telecommunication outages, and severe weather conditions. Information security risks for financial institutions like us have increased recently in part because of new technologies, the increased use of the internet and telecommunications technologies (including mobile devices and cloud computing) to conduct financial and other business transactions, political activism, and the increased sophistication and activities of organized crime. Although we employ detection and response mechanisms designed to contain and mitigate security incidents, early detection may be thwarted by persistent sophisticated attacks and malware designed to avoid detection.
While we have not been materially impacted by cyber incidents, we have been subject to other intentional cyber incidents from third parties over the last several years, including denial of service attacks which attempt to interrupt service to customers and malicious software attacks on computer systems which attempt to allow unauthorized entrance. We also face risks related to cyber attacks and other security breaches in connection with card transactions that typically involve the transmission of sensitive information regarding our customers through various third parties. Some of these parties have in the past been the target of security breaches and cyber attacks, and because the transactions involve third parties and environments that we do not control or secure, future security breaches or cyber attacks affecting any of these third parties could impact us through no fault of our own, and in some cases we may have exposure and suffer losses for breaches or attacks relating to them. We also rely on numerous other third party service providers to conduct other aspects of our business operations and face similar risks relating to them. While we conduct security assessments on our higher risk third party service providers, we cannot be sure that their information security protocols are sufficient to withstand a cyber attack or other security breach. There can be no assurance that cyber incidents will not occur and they could occur more frequently and on a more significant scale.
We devote significant resources to implement, maintain, monitor and regularly upgrade our systems and networks with measures such as intrusion detection and prevention and firewalls to safeguard critical business applications. The additional cost to the Company of our cyber security monitoring and protection systems and controls includes the cost of hardware and software, third party technology providers, consulting, and legal fees, in addition to the incremental cost of our personnel who focus a substantial portion of their responsibilities on cyber security. In addition, because cyber attacks can change frequently we may be unable to implement effective preventive or proactive measures in time. With the assistance of third-party service providers, we intend to continue to implement security technology and establish procedures to maintain network security, but there is no assurance that these measures will be successful. As cyber threats continue to evolve, we may be required to expend significant additional resources to continue to modify or enhance our protective measures or to investigate and remediate any information security vulnerabilities.
Any activity that jeopardizes our network and the security of the information stored thereon may result in significant cost and have a significant adverse effect on our reputation. We maintain insurance coverage that may, subject to policy terms and conditions, cover certain aspects of cyber risks. Such insurance coverage may be insufficient to cover all losses.
Any successful cyber attack or other security breach involving the misappropriation or other unauthorized disclosure of confidential customer information or that compromises our ability to function could severely damage our reputation, erode confidence in the security of our systems, products and services, expose us to the risk of litigation and liability, disrupt our operations and have a material adverse effect on our business. Any successful cyber attack may also subject the Company to regulatory investigations, litigation or enforcement, or require the payment of regulatory fines or penalties or undertaking costly remediation efforts with respect to third parties affected by a cyber security incident, all or any of which could adversely affect the Company’s business, financial condition or results of operations and damage its reputation.
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Loss of key third-party vendor relationships or failure of a vendor to protect information of our customers or employees could adversely affect our business or result in losses.
We rely on third-party vendors to provide key components of our business operations such as data processing, recording and monitoring transactions, online and mobile banking interfaces and services, internet connections and network access. While we have performed due diligence procedures in selecting vendors, we do not control their actions. In the event that one or more of our vendors suffers a bankruptcy or otherwise becomes unable to continue to provide products or services, or fails to protect non-public personal information of our customers or employees, we may suffer operational impairments, reputational damage and financial losses. Replacing these third-party vendors could create significant delay and expense. Accordingly, use of such third parties creates an inherent risk to our business operations.
New products and services are essential to remain competitive but may subject us to additional risks.
We consistently attempt to offer new products and services to our customers to remain competitive. There can be risks and uncertainties associated with these new products and services especially if they are newer to market products and services. We may spend significant time and resources in development of new products and services to market to customers. Through our development and implementation process we may incur risks associated with delivery timetables, pricing and profitability, compliance with regulations, effect on internal controls and shifting customer preferences. Failure to successfully manage these risks could have a material effect on our financial condition, result of operations, and business.
Our customers may decide to use non-bank competitors for financial transactions, which could result in loss of business.
Advancement in technology and other changes are increasing the ability for customers to complete financial transactions that have traditionally involved banks through non-bank competitors. Elimination of banks as intermediaries of financial transactions could result in the loss of customer deposits as well as fee income to us.
We are subject to risks associated with negative publicity.
Reputational risk arises from the potential that negative publicity regarding our business practices, whether true or not, could cause a decline in our customer base, costly litigation, or revenue reductions. In addition, our success in maintaining our reputation depends on the ability to adapt to a rapidly changing environment including increasing reliance on social media.
We may be adversely affected by changes in U.S. tax laws and regulations.
The Tax Cuts and Jobs Act was signed into law in December 2017, reforming the U.S. tax code. The legislation includes lowering the federal corporate income tax rate to 21 percent beginning in 2018 from a maximum rate of 35 percent, modifying the U.S. taxation of income earned outside the U.S. and limiting or eliminating various deductions, tax credits and/or other tax preferences. The legislation could negatively impact our customers because it lowers the existing caps on mortgage interest deductions and limits the state and local tax deductions. These changes could make it more difficult for borrowers to make their loan payments and could also negatively impact the housing market, which could adversely affect our business and loan growth. Also, the changes in the government administration could result in changes to U.S. tax laws and regulations.
Risks Related to the Company's Common Stock
Our stock is thinly traded.
The average daily trading volume of our common stock is relatively small compared to many public companies. The desired market characteristics of depth, liquidity, and orderliness require the substantial presence of willing buyers and sellers in the marketplace at any given time. In our case, this presence depends on the individual decisions of a relatively small number of investors and general economic and market conditions over which we have no control. Due to the relatively small trading volume of our common stock, significant sales of our common stock, or the expectation of these sales, could cause the stock price to fall more than would be justified by the inherent worth of the Company. Conversely, attempts to purchase a significant amount of our stock could cause the market price to rise above the reasonable inherent worth of the Company.
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The stock market can be volatile, and fluctuations in our operating results and other factors could cause our stock price to decline.
The stock market has experienced, and may continue to experience, fluctuations that significantly impact the market prices of securities issued by many companies. Market fluctuations could adversely affect our stock price. These fluctuations have often been unrelated or disproportionate to the operating performance of particular companies. These broad market fluctuations, as well as general economic, systemic, political and market conditions, such as recessions, loss of investor confidence, or interest rate changes, may negatively affect the market price of our common stock. Moreover, our operating results may fluctuate and vary from period to period due to the risk factors set forth herein. As a result, period-to-period comparisons should not be relied upon as an indication of future performance. Our stock price could fluctuate significantly in response to the impact these risk factors have on our operating results or financial position.
There can be no assurances concerning continuing dividend payments.
Our common stockholders are only entitled to receive the dividends declared by our Board of Directors. Although we have historically paid annual dividends on our common stock, there can be no assurances that we will be able to continue to pay regular annual dividends or that any dividends we do declare will be in any particular amount. The primary source of money to pay our dividends comes from dividends paid to the Company by the Bank. The Bank’s ability to pay dividends to the Company is subject to, among other things, its earnings, financial condition and applicable regulations, which in some instances limit the amount that may be paid as dividends.
If we do not continue to meet or exceed regulatory capital requirements and maintain our “well-capitalized” status, there could be an adverse effect on the manner in which we do business and on the confidence of our customers in us.
Under regulatory capital adequacy guidelines, we must meet guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items. Failure to meet minimum capital requirements could have a material effect on our financial condition and could subject us to a variety of enforcement actions, as well as certain restrictions on our business. Failure to maintain the status of “well-capitalized” under the regulatory framework could adversely affect the confidence that our customers have in us, which may lead to a decline in the demand for or a reduction in the prices that we are able to charge for our products and services. Failure to meet the guidelines could also limit our access to liquidity sources.
Our growth may require us to raise additional capital in the future, but that capital may not be available.
We may at some point need to raise additional capital to maintain our “well-capitalized” status. Any capital we obtain may result in the dilution of the interests of existing holders of our stock. Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside our control, and on our financial condition and performance. Accordingly, we cannot make assurances of our ability to raise additional capital if needed, or if the terms will be acceptable to us.
Item 1B. Unresolved Staff Comments
None.
Item 2. Properties
The Company's office and the main office of the Bank are located at 131 E. Main Street, Hills, Iowa. This is a brick building containing approximately 45,000 square feet. A portion of the building was built in 1977, a two-story addition was completed in 1984, and a two-story brick addition was completed in February 2001. With the completion of the 2001 addition, the entire Bank’s operations and administrative functions were consolidated in Hills, Iowa. The Bank operates its business from its main office and its 18 full service branches in the Iowa counties of Johnson, Linn and Washington. The Bank owns its main office complex and 14 of its branch offices. Four of the Bank’s branches are leased.
All of the properties owned by the Bank are free and clear of any mortgages or other encumbrances of any type. See Note 15 to the Consolidated Financial Statements for minimum future rental commitments for leased properties.
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Item 3. Legal Proceedings
None.
Item 4. Mine Safety Disclosures
Not applicable.
PART II
As of January 31, 2021, the Company had 2,701 stockholders. There is no established trading market for the Company's common stock, and the Company's stock is not actively traded. Our common stock is not listed on the NASDAQ stock market or any other stock exchange. While there is no established public trading market for our common stock, our shares are currently quoted in the inter-dealer quotation, or “over-the-counter,” marketplace under the trading symbol “HBIA.” The principal over-the-counter market is operated by OTC Markets Group, Inc., which provides quotes for the Company on its OTC Pink tier.
The high and low bid information for the Company’s stock for each quarter of the two most recent fiscal years, as reported by OTC Market Groups, Inc., is provided below. The prices indicated reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.
High Low High Low
In addition, based on the Company’s stock transfer records and information informally provided to the Company, stock trading transactions have been as follows:
(1)2020 transactions included repurchases by the Company of 133,622 shares of stock under the 2005 Stock Repurchase Program. 2020 transactions made under the 2005 Stock Repurchase Program were made at prices that ranged from $60.00 to $66.00 per share.
(2)2019 transactions included repurchases by the Company of 89,124 shares of stock under the 2005 Stock Repurchase Program. 2019 transactions made under the 2005 Stock Repurchase Program were made at prices that ranged from $61.00 to $65.00 per share.
(3)2018 transactions included repurchases by the Company of 116,962 shares of stock under the 2005 Stock Repurchase Program. 2018 transactions made under the 2005 Stock Repurchase Program were made at prices that ranged from $54.00 to $61.00 per share.
All transactions under the 2005 Stock Repurchase Program were at a price equal to the most recent quarterly independent appraisal of the shares of the Company's common stock. The most recent independent current quarterly appraisal value of the stock is $63.50 a share. The closing bid for the Company's stock on February 12, 2021 was $62.25 a share as reported by the OTC Markets Group, Inc.
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The Company currently pays an annual dividend on its common stock to stockholders, and it expects to continue to maintain its annual dividend for the foreseeable future periods.
The following performance graph provides information regarding cumulative, five-year shareholder returns on an indexed basis of the Company's Common Stock compared to the NASDAQ Market Index and the Regional-Southwest Banks Index prepared by MORNINGSTAR of Chicago, IL. The latter index reflects the performance of twenty-five bank holding companies operating principally in the Midwest as selected by MORNINGSTAR. The indexes assume the investment of $100 on December 31, 2015 in Company Common Stock, the NASDAQ Index and the Regional-Southwest Banks Index, with all dividends reinvested.
Note regarding the performance graph: Cumulative five-year Shareholder returns on an indexed basis. The indexes assume the investment of $100 in year with all dividends reinvested.
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The following table sets forth the Company’s equity compensation plan information as of December 31, 2020, all of which relates to stock options issued under stock option plans approved by stockholders of the Company:
Equity compensation plans approved by security holders 13,025 $ 45.92 231,425
Equity compensation plans not approved by security holders — — —
On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to a total of 1,500,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”). The Company’s Board of Directors has authorized the 2005 Stock Repurchase Program through December 31, 2021. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis. All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis. The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors.
The following table sets forth information about the Company’s stock purchases pursuant to the 2005 Stock Repurchase Program for the quarter ended December 31, 2020:
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Item 6. Selected Financial Data
CONSOLIDATED FIVE-YEAR STATISTICAL SUMMARY
The following table sets forth certain of our financial and statistical information for each of the years in the five-year period ended December 31, 2020. This data should be read in conjunction with the consolidated financial statements and the accompanying notes thereto included or incorporated by reference elsewhere in this document.
YEAR-END TOTALS (Amounts in Thousands)
EARNINGS (Amounts in Thousands)
Net income before Tax Act (1) NA NA NA 32,770 NA
PER SHARE
Net income:
Basic before Tax Act (1) NA NA NA 3.51 NA
Diluted before Tax Act (1) NA NA NA 3.51 NA
Increase (decrease) in book value due to:
SELECTED RATIOS
Return on average assets before Tax Act (1) NA NA NA 1.19 NA
Return on average equity before Tax Act (1) NA NA NA 10.79 NA
(1)Non-GAAP financial measurement. For further information, refer to the Non-GAAP Financial Measures section of this report in Item 7.
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The following discussion by management is presented regarding the financial results for the Company for the dates and periods indicated. The discussion should be read in conjunction with the “Selected Consolidated Five-Year Statistical Summary” and the consolidated financial statements and the accompanying notes thereto included or incorporated by reference elsewhere in this document.
An overview of the year 2020 is presented following the section discussing a special note regarding forward looking statements.
Special Note Regarding Forward Looking Statements
This report contains, and future oral and written statements of the Company and its management may contain, forward-looking statements within the meaning of such term in the Private Securities Litigation Reform Act of 1995 with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company. Actual results may differ materially from those included in the forward-looking statements. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company’s management and on information currently available to management, are generally identifiable by the use of words such as “believe,” “expect,” “anticipate,” “plan,” “intend,” “estimate,” “may,” “will,” “would,” “could,” “should” or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events.
The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations and future prospects of the Company include, but are not limited to, the following:
•The strength of the United States economy in general and the strength of the local economies in which the Company conducts its operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of the Company’s assets.
•The effects of financial market disruptions and/or an economic recession, and monetary and other governmental actions designed to address such disruptions and recession.
•The financial strength of the counterparties with which the Company or the Company’s customers do business and as to which the Company has investment or financial exposure.
•The credit quality and credit agency ratings of the securities in the Company’s investment securities portfolio, a deterioration or downgrade of which could lead to other-than-temporary impairment of the affected securities and the recognition of an impairment loss.
•The effects of, and changes in, laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters as well as any laws otherwise affecting the Company.
•The effects of changes in interest rates (including the effects of changes in the rate of prepayments of the Company’s assets) and the policies of the Board of Governors of the Federal Reserve System.
•The ability of the Company to compete with other financial institutions as effectively as the Company currently intends due to increases in competitive pressures in the financial services sector.
•The ability of the Company to obtain new customers and to retain existing customers.
•The timely development and acceptance of products and services, including products and services offered through alternative electronic delivery channels.
•Technological changes implemented by the Company and by other parties, including third-party vendors, which may be more difficult or more expensive than anticipated or which may have unforeseen consequences to the Company and its customers.
•The ability of the Company to develop and maintain secure and reliable technology systems.
•The ability of the Company to retain key executives and employees and the difficulty that the Company may experience in replacing key executives and employees in an effective manner.
•Consumer spending and saving habits which may change in a manner that affects the Company’s business adversely.
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•The economic impact of natural disasters, diseases and/or pandemics, such as the COVID-19 pandemic, terrorist attacks and military actions.
•Business combinations and the integration of acquired businesses and assets which may be more difficult or expensive than expected.
•The costs, effects and outcomes of existing or future litigation.
•Changes in accounting policies and practices that may be adopted by state and federal regulatory agencies and the Financial Accounting Standards Board.
•The ability of the Company to manage the risks associated with the foregoing as well as anticipated.
These risks and uncertainties should be considered in evaluating forward-looking statements, and undue reliance should not be placed on such statements. Additional information concerning the Company and its business, including other factors that could materially affect the Company’s financial results, is included in the Company’s filings with the Securities and Exchange Commission.
COVID-19: What the Company knows and what steps we have taken.
The outbreak of Coronavirus Disease 2019 (“COVID-19”) has and will continue to adversely impact a broad range of industries in which the Company’s customers operate and impair their ability to fulfill their financial obligations to the Company. The World Health Organization has declared COVID-19 to be a global pandemic indicating that almost all public commerce and related business activities must be, to varying degrees, curtailed with the goal of decreasing the rate of new infections.
The spread of the outbreak has caused significant disruptions in the U.S. economy and is highly likely to disrupt banking and other financial activity in the areas in which the Company operates and could also potentially create widespread business continuity issues for the Company. The Company’s business is dependent upon the willingness and ability of its employees and customers to conduct banking and other financial transactions. If the global response to contain COVID-19 escalates or is unsuccessful, the Company could experience a material adverse effect on its business, financial condition, results of operations and cash flows.
Communities
Offices
With the health of our employees and customers being our top concern, as of March 17, 2020, the Bank temporarily suspended branch lobby hours to the public for walk-in transactions while allowing limited scheduled appointments. The Bank reopened branch lobbies in the third quarter of 2020, but in November 2020 again temporarily suspended branch lobby hours to the public for walk-in transactions. In late January 2021, the Bank has since started the process of reopening branch lobbies. The Bank implemented the following changes in response to the pandemic:
•Plexiglass windows on our teller stations and reception areas
•A limit on the number of people who can be in the lobbies at one time
•Transaction areas and reusable items will be frequently cleaned
•Hand sanitizing stations located at each entrance
•Floor stickers to guide social distancing while waiting in line
•Require both customers and employees to wear protective face coverings, among other social distancing requirements for both customers and employees.
Drive-thru services remain available as well as all ATM’s to complete needed transactions. Customers are also able to directly contact our bankers through calling the customer contact center, engaging with a digital banker via the HERE by Hills Bank app, or through Hills Bank Online which is available 24/7.
The Bank continues to promote social distancing by encouraging employees who can work remotely to do so and in other cases, departments have been dispersed to keep the team separated. We do not anticipate significant challenges to our ability to maintain our systems and controls in light of the measures we have taken to prevent the spread of COVID-19. No material operational or internal control challenges or risks have been identified to date.
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Customers
Loans
With the Federal Reserve rate drops of 150 basis points in March (100 basis points of which was directly related to the effects of the virus on the economy), a surge in home loan activity has occurred, a significant portion of which is refinance related. The Bank sells most of its home loans into the secondary market and has seen a significant increase in the net gain on the sale of these loans.
The Bank is working with customers who request forbearance agreements and has also provided short-term modifications for customers primarily through deferrals of principal only payments for three to six months. Throughout 2020, COVID-19 related payment deferrals provided for customers totaled approximately 14.82% of total loans. As of December 31, 2020, COVID-19 related payment deferrals were approximately 1.20% of total loans.
The Bank continues to assist customers through this difficult time in the best manner possible by providing $127.10 million of Paycheck Protection Program (PPP) loans through December 31, 2020. The PPP loans have a two or five year term and earn interest at 1%. Loans funded through the PPP program are fully guaranteed by the U.S. government if certain criteria are met. The Bank believes that the majority of these loans will ultimately be forgiven by the SBA in accordance with the terms of the program. As of December 31, 2020, the Bank has outstanding PPP loan balances of $86.5 million and has received forgiveness payments totaling $40.4 million from the SBA. With the passage of the Coronavirus Response and Relief Supplemental Appropriations Act 2021 in late December 2020, the Bank is planning to provide additional PPP loans beginning in late January 2021 to further assist our customers.
Financial - Exposures
As discussed above, throughout 2020 the Company provided a significant number of PPP loans to customers as well as short-term loan modifications deferring principal and interest or principal only for three to six months. During late summer and fall, a significant number of the COVID-19 related short-term loan modifications expired with the majority of customers able to return to scheduled payments. A small percentage of customers have requested additional pandemic-related modifications described above.
Section 4013 of the CARES Act, “Temporary Relief From Troubled Debt Restructurings,” allows financial institutions the option to temporarily suspend certain requirements under GAAP related to TDRs for a limited period of time during the COVID-19 pandemic. In March 2020, various regulatory agencies, including the FRB and the FDIC, issued an interagency statement, effective immediately, on loan modifications and reporting for financial institutions working with customers affected by COVID-19. The agencies confirmed with the staff of the FASB that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not to be considered TDRs. This includes short-term (e.g., six months) modifications, such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. As of December 31, 2020, the total amount of the eligible loans in deferral (deferral of principal and/or interest) that met the requirements set forth under the interagency statement and therefore were not considered TDRs was 13 loans, totaling $9.4 million. The Bank anticipates that the current and future economic conditions will continue to have an impact on the initial modifications that were made that qualified under such criteria.
The COVID-19 pandemic represents an unprecedented challenge to the global economy in general and the financial services sector in particular. However, there is still significant uncertainty regarding the overall length of the pandemic and the aggregate impact that it will have on global and regional economies, including uncertainties regarding the potential positive effects of governmental actions taken in response to the pandemic during 2020. With so much uncertainty, it is impossible for the Bank to accurately predict the impact that the pandemic will have on the Bank’s primary markets and the overall extent to which it will affect the Bank’s financial condition and results of operations into 2021. Nonetheless, management believes that the Bank’s current regulatory capital position is adequate to face the coming challenges.
To account for potential exposures resulting from the pandemic, the Bank has increased its allowance for loan losses for the year ended December 31, 2020 by approximately $3.3 million since December 31, 2019. The Bank is fully prepared to make additional provisions as warranted by the COVID-19 situation. The Bank anticipates that a significant portion of the Bank’s borrowers in the hospitality industry, which represents approximately 0.2% of our loan portfolio, will endure significant economic distress which will adversely affect their ability to repay existing indebtedness. These developments, together with economic conditions generally, are also expected to impact the value of certain collateral securing our loans.
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Our credit administration is closely monitoring and analyzing the higher risk segments within the loan portfolio, tracking loan payment deferrals, customer liquidity and providing timely reports to senior management and the board of directors. Based on the Company’s capital levels, prudent underwriting policies, loan concentration diversification and our geographic footprint, we currently expect to be able to manage the economic risks and uncertainties associated with the pandemic and remain adequately capitalized.
The Company continued to maintain the payment of its annual dividend consistent with its past practices.
Government Response
Congress, the FRB and the other U.S. state and federal financial regulatory agencies have taken actions to mitigate disruptions to economic activity and financial stability resulting from the COVID-19 pandemic. The federal banking agencies have encouraged financial institutions to prudently work with affected borrowers and passed measures to provide relief from reporting loan classifications due to modifications related to the COVID-19 outbreak. The descriptions below summarize additional significant government actions taken in response to the COVID-19 pandemic. The descriptions are qualified in their entirety by reference to the particular statutory or regulatory provisions or government programs summarized.
The CARES Act
The Coronavirus Aid, Relief and Economic Security (CARES) Act was signed into law on March 27, 2020. Among other provisions, the CARES Act includes funding for the SBA to expand lending, relief from certain U.S. GAAP requirements to allow COVID-19-related loan modifications to not be categorized as troubled debt restructurings and a range of incentives to encourage deferment, forbearance or modification of consumer credit and mortgage contracts. One of the key CARES Act programs is the Paycheck Protection Program, which temporarily expanded the SBA’s business loan guarantee program to include forgivable loans used for permissible purposes, which were issued under the program through August 8, 2020. Paycheck Protection Program loans are available to a broader range of entities than ordinary SBA loans, and the loan may be forgiven in an amount equal to payroll costs and certain other expenses during either an eight-week or twenty-four week “covered period.” The Bank is participating in this program as described above.
The CARES Act contains additional protections for homeowners and renters of properties with federally-backed mortgages, including a 60-day moratorium on the initiation of foreclosure proceedings beginning on March 18, 2020 and a 120-day moratorium on initiating eviction proceedings effective March 27, 2020. These foreclosure and eviction moratoriums have been extended through year-end by the Federal Housing Administration. Borrowers of federally-backed mortgages have the right under the CARES Act to request up to 360 days of forbearance on their mortgage payments if they experience financial hardship directly or indirectly due to the coronavirus-related public health emergency.
Also pursuant to the CARES Act, the U.S. Treasury has the authority to provide loans, guarantees and other investments in support of eligible businesses, states and municipalities affected by the economic effects of COVID-19. Some of these funds have been used to support several FRB programs and facilities described below or additional programs or facilities that are established by its authority under Section 13(3) of the Federal Reserve Act and meeting certain criteria.
Coronavirus Response and Relief Supplemental Appropriations Act 2021
On December 21, 2020, the House and Senate passed legislation to supply the latest round of COVID-19 relief, authorizing more than $900 billion in economic aid to small businesses and consumers—the second largest stimulus in history, behind only the CARES (Coronavirus Aid Relief and Economic Security) Act that Congress enacted in March. The bill also includes appropriations provisions to keep the government funded through September 30, 2021, as well as a host of miscellaneous items.
The summary below focuses on key banking provisions while omitting significant provisions on many other important topics, including an extension of enhanced unemployment insurance and funding for vaccine distribution, school reopening, and the airline industry.
In particular, the banking aspects of the package include the following:
a.An additional $284.6 billion in Paycheck Protection Program (PPP) funding for loans to small businesses, including for borrowers who have previously received a PPP loan.
b.A one-page simplified forgiveness process for PPP loans under $150,000.
c.Clarification to various CARES Act provisions, the tax treatment of PPP expenses, lender responsibilities for agent fees, and lender “hold harmless” protections under the PPP and other laws.
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d.A further delay in Troubled Debt Restructuring (TDR) accounting until 60 days after the termination of the national emergency, or January 1, 2022.
e.A further optional delay in Current Expected Credit Loss (CECL) accounting until January 1, 2022.
f.A new round of Economic Impact Payments (EIPs) for consumers, with aggressive distribution timelines and new exemptions from garnishments.
g.Significant added support for Community Development Financial Institutions (CDFIs) and Minority Depository Institutions (MDIs).
h.Funding for agricultural support programs and for renter assistance programs.
i.Termination of existing Federal Reserve emergency lending authority under the CARES Act, while preserving the Fed’s general 13(3) emergency authority existing prior to that Act.
FRB Actions
The FRB has taken a range of actions to support the flow of credit to households and businesses. For example, on March 15, 2020, the FRB reduced the target range for the federal funds rate to 0 to 0.25% and announced that it would increase its holdings of U.S. Treasury securities and agency mortgage-backed securities and begin purchasing agency commercial mortgage-backed securities. The FRB has also encouraged depository institutions to borrow from the discount window and has lowered the primary credit rate for such borrowing by 150 basis points while extending the term of such loans up to 90 days. Reserve requirements have been reduced to zero as of March 26, 2020.
In addition, the FRB has established, or has taken steps to establish, a range of facilities and programs to support the U.S. economy and U.S. marketplace participants in response to economic disruptions associated with COVID-19. Through these facilities and programs, the FRB, relying on its authority under Section 13(3) of the Federal Reserve Act, has taken steps to directly or indirectly purchase assets from, or make loans to, U.S. companies, financial institutions, municipalities and other market participants.
Non-GAAP Financial Measures
This report contains references to financial measures that are not defined in GAAP. Such non-GAAP financial measures include the Company's presentation of net income without the effect of the Tax Cut and Jobs Act enacted on December 22, 2017 (the "Tax Act"), and the presentation of earnings per share, return on assets and return on equity with the adjusted net income figure. Management believes these Non-GAAP financial measures provide useful information to both management and investors to analyze and evaluate the Company's financial performance. Limitations associated with non-GAAP financial measures include the risks that persons might disagree as to the appropriateness of items included in these measures. These non-GAAP disclosures should not be considered an alternative to the Company's GAAP results. The following table reconciles the non-GAAP financial measures to GAAP.
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Reconciliation of net income before effect of Tax Act to net income (GAAP):
Net Income (GAAP) $ 28,061
Tax Act related tax expense 4,709
Net Income before Tax Act related expense $ 32,770
Non-GAAP net income reconciled above $ 32,770
Weighted average shares outstanding (basic) 9,330,003
Earnings Per Share (basic) before effect of Tax Act $ 3.51
Weighted average shares outstanding (diluted) 9,334,635
Earnings Per Share (diluted) before effect of Tax Act $ 3.51
Non-GAAP net income reconciled above $ 32,770
Return on average assets before effect of Tax Act 1.19 %
Non-GAAP net income reconciled above $ 32,770
Return on average equity before effect of Tax Act 10.79 %
Overview
The Company is a bank holding company engaged, through its wholly-owned subsidiary bank, in the business of commercial banking. The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa. The Bank was formed in Hills, Iowa in 1904. The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids, Marion and Washington, Iowa.
The Company’s net income for 2020 was $38.65 million compared to $45.32 million in 2019 and $36.77 million in 2018. Diluted earnings per share were $4.12, $4.85, and $3.92 for the years ended December 31, 2020, 2019 and 2018, respectively.
The Bank’s net interest income is the largest component of the Bank’s revenue, and is a function of the average earning assets and the net interest margin percentage. Net interest margin is the ratio of net interest income to average earning assets. For the years ended December 31, 2020 and 2019, the Bank achieved a net interest margin of 3.00% and 3.18%, respectively. For the year ended December 31, 2020, net interest income on a tax equivalent basis increased by $4.14 million. In 2020, net interest income increased $10.57 million due to growth of $309.59 million in the Bank's average earning assets and decreased $6.43 million due to interest rate changes.
Highlights with respect to items on the Company’s balance sheet as of December 31, 2020 included the following:
•Total assets were $3.781 billion, an increase of $479.72 million since December 31, 2019.
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•Cash and cash equivalents were $574.31 million, an increase of $332.35 million since December 31, 2019. A substantial portion of the increase can be attributed to increased savings with the current negative economic environment due to the pandemic and equity investors fleeing volatile capital markets in an effort to preserve principal.
•Loans, net of allowance for loan losses and unamortized fees and costs, totaling $2.718 billion.
•Net loan growth in 2020 of $67.74 million. The increase was primarily due to PPP loans provided to customers totaling $127.10 million. Loans held for sale increased $35.55 million since December 31, 2019 due to the significant reduction in interest rates during 2020, resulting in a significant amount of mortgage loan refinance activity.
•Deposit growth of $531.20 million in 2020. Deposits increased to $3.193 billion and included $74.08 million of brokered deposits. A substantial portion of the increase can be attributed to the current negative economic environment.
•FHLB borrowings decreased $80.00 million. The decrease was largely due to prepaying $55 million of FHLB borrowings.
•Stockholders’ equity increased $40.87 million to $416.08 million in 2020, with dividends having been paid in 2020 of $8.33 million.
Reference is made to Note 13 of the Company’s consolidated financial statements for a discussion of fair value measurements which relate to methods used by the Company in recording certain assets and liabilities on its consolidated financial statements.
The return on average equity was 8.72% in 2020 compared to 11.23% in 2019. The returns for the three previous years, 2018, 2017 and 2016, were 9.92%, 9.24% and 11.26%, respectively. Before the effect of the Tax Act, the Company's 2017 return on average equity would have been 10.79%. (1) The Company remains well-capitalized as of December 31, 2020 with total risk-based capital at 18.50% and Tier 1 risk-based capital at 17.25%. The minimum regulatory guidelines are 8% and 6% respectively. The Company paid a dividend per share of $0.890 in 2020, $0.820 in 2019 and $0.750 in the year ended December 31, 2018.
A detailed discussion of the financial position and results of operations follows this overview.
(1) Non-GAAP financial measurement. For further information, refer to the Non-GAAP Financial Measurement section of this report.
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Critical Accounting Policies
The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within these financial statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Based on its consideration of accounting policies that involve the most complex and subjective decisions and assessments, management has identified its most critical accounting policies to be those which are related to the allowance for loan losses.
Allowance for Loan Losses
The Company separates its portfolio loans and leases into segments for determining the allowance for loan losses. The Company's portfolio segments includes agricultural, commercial and financial, real estate, loans to individuals and obligations of state and political subdivisions. The Company further separates its portfolio into classes for purposes of monitoring and assessing credit quality based on certain risk characteristics. Classes within the real estate portfolio segment includes 1 to 4 family residential construction, land development and commercial construction, farmland, 1 to 4 family first liens, 1 to 4 family junior liens, multi-family and commercial. For an analysis of the Company's allowance for loan losses by portfolio segment and credit risk rating information by class, see Note 3 to the Company's Consolidated Financial Statements.
Loans that exhibit probable or observed credit weaknesses, as well as loans that have been modified in a troubled debt restructuring ("TDR loans"), are subject to individual review for impairment. When individual loans are reviewed for impairment, the Company determines allowances based on management's estimate of the borrower's ability to repay the loan given the availability of the collateral, other sources of cash flow, as well as evaluation of legal options available. Allowances for impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or the fair value of the underlying collateral.
Historical loss rates are applied to loans that are not individually reviewed for impairment. A 20 quarter migration analysis performed by management uses loan level attributes to track the movement of loans through the various credit risk rating categories in order to estimate the percentage of historical loss to apply to each specific credit risk rating in each loan category. The credit risk rating system currently utilized for allowance analysis purposes encompasses six categories.
The Company's allowance for loan loss methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan losses that management believes is appropriate at each reporting date. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, changes in impaired loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers' sensitivity to interest rate movements. Qualitative factors include changes in lending policies and procedures; changes in national and local economic and business conditions; changes in the nature and volume of the loan portfolio; changes in the experience, ability and depth of lending management and staff; changes in the quality of the Bank's loan review system; the existence and effect of concentrations of credit; and the effect of any other identified external factors.
Determinations relating to the possible level of future loan losses are based in part on subjective judgments by management. Future loan losses in excess of current estimates, could materially adversely affect our results of operations or financial position. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion of the Company’s critical accounting policies should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes presented elsewhere herein, as well as other relevant portions of Management’s Discussion and Analysis of Financial Condition and Results of Operations. Although management believes the levels of the allowance for loan losses as of December 31, 2020 and 2019 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.
The Company is currently finalizing the CECL model and upon adoption of ASU 2016-13 (CECL) in the first quarter of 2021 anticipates an increase to the allowance for credit losses for loans of approximately $2 to $4 million and an unfunded commitment liability of approximately $2 to $4 million. See Note 1 to the Company's Consolidated Financial Statements for further discussion.
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Financial Position
(Amounts In Thousands)
Total assets at December 31, 2020 increased $479.72 million, or 14.53%, from the prior year-end. Asset growth from 2018 to 2019 was $258.42 million and represented a 8.49% increase. The largest growth in assets in 2020 occurred in Cash and Cash Equivalents, which increased $332.35 million as of December 31, 2020 compared to December 31, 2019 and increased $198.66 million as of December 31, 2019 compared to December 31, 2018. Net Loans increased $67.74 million and $15.19 million for the years ended December 31, 2020 and 2019, respectively. Loans held for sale to the secondary market increased $35.55 million and increased $6.42 for the years ended December 31, 2020 and 2019, respectively. Loans held for investment represent the largest component of the Bank’s earning assets. Loans held for investment were $2.711 billion and $2.640 billion at December 31, 2020 and 2019, respectively.
The local economy that generated consistent demand for loans was a significant factor in the trend of increasing net loans in past years. The trend of increasing Net Loans did slow in 2020 and may not continue, and as a result, may not be indicative of future performance. The primary reason for the increase in 2020 was PPP loans provided to customers in response to the COVID-19 pandemic as discussed previously.
Commercial and financial loans represent the largest increase in loan growth. These loans increased $64.92 million in 2020 and decreased $8.18 million in 2019. Commercial and financial loans increased due to PPP loans provided to customers, which had an outstanding balance of $86.5 million as of December 31, 2020.
On a net basis, the Company originated $72.14 million and $13.02 million in loans to customers for the years ended December 31, 2020 and 2019, respectively. Net loan originations increased 453.89% in 2020 compared to 2019. The increase in net loan originations in 2020 as compared to 2019 is reflective of loan demand primarily for PPP loans provided in response to the COVID-19 pandemic. The Company does not engage in significant participation activity and does not purchase participations from outside its established trade area. The Company’s policy allows for the purchase or sale of participations related to existing customers or to participate in community development activity. The Company held participations purchased of $19.83, $15.17 and $14.03 million as of December 31, 2020, 2019 and 2018, respectively. The participations purchased were less than one percent of loans held for investment for each of the three years.
The Company did not experience a material change in the composition of its loans held for investment in 2020 or 2019. Residential real estate loans, including first and junior liens, were $1,019.92 million, $1,059.97 million and $1,064.68 million as of December 31, 2020, 2019 and 2018, respectively. The dollar total of residential real estate loans decreased 3.78% in 2020 and decreased 0.44% in 2019. Residential real estate loans were 37.63% of the loan portfolio at December 31, 2020, 40.16% at December 31, 2019 and 40.51% at December 31, 2018. Commercial real estate loans totaled $417.14 million at December 31, 2020, a 3.72% increase over the December 31, 2019 total of $402.18 million. Commercial real estate loans increased 4.92% in 2019. Commercial real estate loans totaled $383.31 million at December 31, 2018. Commercial real estate loans represented 15.39%, 15.24% and 14.59% of the Company’s loan portfolio as of December 31, 2020, 2019 and 2018, respectively. The Company monitors its commercial real estate level so that it does not have a concentration in that category that exceeds 300% of its capital. Commercial real estate loan concentration was 165.93% of capital as of December 31, 2020.
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The following table shows the composition of loans (before deducting the allowance for loan losses) as of December 31 for each of the last five years. The table does not include loans held for sale to the secondary market.
Real estate:
There were no foreign loans outstanding for any of the years presented.
The following table shows the principal payments due on loans as of December 31, 2020:
(Amounts In Thousands)
(1)A significant portion of the commercial loans are due in one year or less. A significant percentage of the loans will be re-evaluated prior to their maturity and are likely to be extended.
(2)Commercial, multi-family, construction 1 to 4 family residential, construction land development and commercial, and agricultural real estate loans are reflected in the Commercial and Agricultural total.
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The overall economy in the Company’s trade area, Johnson, Linn and Washington Counties, remains in stable condition with levels of unemployment below national and state levels. The following table shows unemployment as of December 31, 2020, 2019 and 2018 and median income information as of December 31, 2019, 2018 and 2017, as December 31, 2020 information is not available as of the date of this report:
Unemployment Rate % Median Income
Competition for quality loans and deposits may continue to be a challenge. The increased competition for both loans and deposits could result in a lower interest rate margin that could result in lower net interest income if the volume of loans and deposits does not increase to offset any such reduction in the interest margin.
Total deposits increased by $531.20 million in 2020. Deposits increased by $240.24 million in 2019. As of June 30, 2020 (latest data available from the FDIC), Johnson County total deposits were $9.490 billion and the Company’s deposits were $2.060 billion, which represent a 21.71% market share. The Company had nine office locations in Johnson County as of June 30, 2020. The total banking locations in Johnson County was 49 as of June 30, 2020. At June 30, 2019, the Company’s deposits were $1.925 billion or a 23.6% market share. As of June 30, 2020, Linn County total deposits were $7.791 billion and there were 102 total banking locations in the county. The seven Linn County offices of the Company had deposits of $612 million or a 7.9% share of the market. The Company’s Linn County deposits at June 30, 2019 were $488.05 million and represented a 7.1% market share. As of June 30, 2020, the Company’s three Washington County offices had deposits of $254 million which was 33.0% of the County’s total deposits of $769 million. Washington County had a total of 15 banking locations as of June 30, 2020. In 2019, the Company’s Washington County deposits were $207.78 million or a 32.3% market share.
The following tables show the amounts of the Company's average deposits and average rates paid on such deposits for the years ended December 31, 2020, 2019 and 2018 and the composition of the certificates of deposit issued in denominations in excess of $100,000 as of December 31, 2020, 2019 and 2018:
December 31,
(Amounts In Thousands)
Time certificates issued in amounts of $100,000 or more with maturity in:
(Amounts In Thousands)
Investment securities increased $50.18 million in 2020. In 2019, investment securities increased by $35.27 million. The investment portfolio consists of $408.37 million of securities that are stated at fair value, with any unrealized gain or loss, net of
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income taxes, reported as a separate component of stockholders’ equity. The securities portfolio is used for liquidity and pledging purposes and to provide a rate of return that is acceptable to management.
The following tables show the carrying value of the investment securities held by the Bank, including stock of the Federal Home Loan Bank, as of December 31, 2020, 2019 and 2018 and the maturities and weighted average yields of the investment securities, computed on a tax-equivalent basis using a federal tax rate of 21%, as of December 31, 2020:
December 31,
(Amounts In Thousands)
Carrying value:
CarryingValue WeightedAverageYield
(Amounts In Thousands)
U.S. Treasury
Other securities (FHLB, FHLMC and FNMA), maturities:
From 5 to 10 years — —
Stock of the Federal Home Loan Bank $ 8,172 2.82 %
Obligations of state and political subdivisions, maturities:
As of December 31, 2020, the Company held no investment securities exceeding 10% of stockholders’ equity, other than securities of the U.S. Government agencies and corporations. The Company does not hold any investments in FNMA preferred stock, any pooled trust preferred stocks or other preferred stock type investments. See Note 2 to the Company’s Consolidated Financial Statements.
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During 2020, the major funding source for the growth in loans and other assets was the $531.20 million increase in deposits. In 2019, the major source of funding for the growth in loans was deposit growth of $240.24 million. Brokered deposits totaled $74.08 million and $109.29 million as of December 31, 2020 and 2019, respectively. Total advances from the FHLB were $105.00 million at December 31, 2020 and $185.00 million in 2019. It is expected that the FHLB funding source and brokered deposits funding will be considered in the future if loan growth continues to exceed core deposit increases and the interest rates on funds borrowed from the FHLB and interest rates on brokered deposits are favorable compared to other funding alternatives.
Stockholders’ equity was $416.08 million at December 31, 2020 compared to $375.21 million at December 31, 2019. The Company’s capital resources are discussed in detail in the Liquidity and Capital Resources section. Over the last five years, the Company has realized cumulative earnings of $180.35 million and paid shareholders dividends of $35.53 million, or 19.70% of earnings, while maintaining capital ratios in excess of regulatory requirements.
The following table presents the return on average assets, return on average stockholders' equity, the dividend payout ratio and average stockholders’ equity to average assets ratio for the years ended December 31, 2020, 2019 and 2018:
Return on average stockholders' equity 8.72 11.23 9.92
Average stockholders' equity to average assets ratio 12.47 12.45 12.35
Net Income Overview
Net income and diluted earnings per share for the last five years are as presented below:
Year Net Income % (Decrease) Increase Earnings PerShare - Diluted
(In Thousands)
(1)Non-GAAP financial measurement. For further information, refer to the Non-GAAP Financial Measurement section of this report.
Net income for 2020 decreased by $(6.67) million or (14.72)% and diluted earnings per share decreased by (15.05)%. In 2020, net interest income increased $10.57 million due to growth of $309.59 million in the Bank's average earning assets and decreased $6.43 million due to interest rate changes. Noninterest income increased by $3.54 million, the provision for loan losses increased by $7.24 million and total noninterest expenses increased by $8.37 million.
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Annual fluctuations in the Company's net income are driven primarily by four important factors. The first important factor is net interest margin. Net interest income of $101.58 million in 2020 was derived from the Company's $3.442 billion of average earning assets and its net interest margin of 3.00%, compared to $3.133 billion of average earning assets and a 3.18% net interest margin in 2019. The importance of net interest margin is illustrated by the fact that a decrease or an increase in the net interest margin of 10 basis points would result in a $3.44 million decrease or increase in income before taxes. Net interest margin in 2018 was 3.25%. Net interest income for the Company increased primarily as a result of growth in the volume of earning assets (offsetting reductions in interest income caused by declines in interest rates) and the continued low interest rates on interest bearing deposits resulting in decreased interest expense. The Company expects net interest compression to impact earnings for the foreseeable future due to competition for loans and deposits combined with the interest rate decreases by the Federal Reserve Board. The Company believes growth in net interest income will be contingent on the growth of the Company’s earnings assets and maintaining yield on loans. Net interest income was also impacted by the decrease in interest expense of $7.92 million compared to 2019, primarily driven by interest rate decreases which accounted for $8.54 million of the change. A significant portion of the increase in the loan portfolio is attributable to PPP loans. The Company anticipates most PPP loans will be forgiven in accordance with the SBA's requirements.
The second significant factor affecting the Company's net income is the provision for loan losses. The majority of the Company's interest-earning assets are in loans outstanding, which amounted to $2.755 billion at the end of 2020. The Company’s allowance for loan losses was $37.07 million at December 31, 2020. The allowance in 2020 increased in comparison to 2019 due to a increased provision for loan losses of $7.24 million resulting from a combination of the composition of loan growth, historical loss rates, changes in the composition of loans among the credit risk ratings in 2020 and management's evaluation of qualitative factors given the current and expected national and local economic conditions primarily given the impact of the COVID-19 pandemic. The loan loss provision, which is the amount necessary to adjust the allowance to the level considered appropriate by management, totaled an expense of $4.36 million for 2020, a reduction of expense of $2.88 million for 2019 and an expense of $8.50 million for 2018. Provision expense is expected to be dependent on the Company’s loan growth, local economic conditions, including, but not limited to, conditions associated with the COVID-19 pandemic and the attendant risks and uncertainties related thereto, asset quality and the adoption of ASU 2016-13, or CECL, through the end of 2021. See Note 3 to the Company's Consolidated Financial Statements. A detailed discussion is included in the Provision for Loan Losses section below.
The third significant factor affecting the Company’s net income is net gain on the sale of loans. The net gain on the sale of loans was $6.68 million and $3.54 million for the years ended December 31, 2020 and 2019, respectively, an increase of 88.70% for the year ended December 31, 2020 compared to the same period in 2019. Loans originated for sale in 2020 totaled $475.19 million compared to $299.22 million in the same period in 2019, an increase of 58.81%. The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates and has been significantly impacted by the Federal Reserve Board's reduction of the federal funds rate to 0.25%, resulting in a significant amount of mortgage loan refinance activity.
The fourth significant factor affecting the Company's net income is noninterest expenses. Noninterest expenses were $75.63 million and 67.26 million for the years ended December 31, 2020 and 2019, respectively. Salaries and employee benefits increased $3.91 million in 2020. The increase is primarily the result of annual salary adjustments, hiring of additional employees to staff growth, increased variable compensation due to the increase in loans originated for sale described above and increased overtime due to the increase in loans originated for sale and processing of PPP loans. Other noninterest expenses increased $3.07 million in 2020 primarily due to $2.53 million in fees incurred from the prepayment of FHLB borrowings and $2.68 million paid for the early termination of the interest rate swap.
Net income for 2019 was $45.32 million, or diluted earnings per share of $4.85. For 2019, diluted earnings per share increased by $0.93 per share compared to 2018. Net interest income increased $5.55 million for the year ended December 31, 2019 compared to 2018. This increase in net interest income was due to an increase in average earning assets of $229.77 million in 2019. Noninterest income increased 4.09% in 2019 to $24.79 million. Noninterest expense increased from $62.12 million in 2018 to $67.26 million in 2019, or 8.28%.
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Net Interest Income
Net interest income is the excess of the interest and fees received on interest-earning assets over the interest paid on the interest-bearing liabilities. The factors that have the greatest impact on net interest income are the volume of average earning assets and the net interest margin. The volume of average earning assets has continued to grow each year, primarily due to net loan growth. The net interest margin was 3.00% in 2020, 3.18% in 2019, 3.25% in 2018, 3.43% in 2017, and 3.43% in 2016. The measure is shown on a tax-equivalent basis using a rate of 21% for 2020, 2019 and 2018 to make the interest earned on taxable and nontaxable assets more comparable. Interest income and expense for 2020, 2019 and 2018 are indicated on the following table:
Years Ended December 31,
(Amounts In Thousands)
Income:
Interest-bearing cash and cash equivalents 945 3,980 1,939
Expense:
(1) Presented on a tax equivalent basis using a rate of 21% for 2020, 2019 and 2018.
Net interest income on a tax-equivalent basis changed in 2020 as follows:
Change In Change In Increase (Decrease)
AverageBalance AverageRate VolumeChanges RateChanges NetChange
(Amounts In Thousands)
Interest income:
Interest expense:
Other borrowings 1 (1.71) — — —
Interest-bearing other liabilities — — — — —
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Rate/volume variances are allocated on a consistent basis using the absolute values of changes in volume compared to the absolute values of the changes in rates. Loan fees included in interest income are not material. Interest on nontaxable securities and loans is shown at tax equivalent amounts.
Net interest income on a tax equivalent basis changed in 2019 as follows:
Change In Average Balance Change In Average Rate Increase (Decrease)
VolumeChanges RateChanges NetChange
(Amounts In Thousands)
Interest income:
Federal funds sold 33 1.13 — — —
Interest expense:
Other borrowings (1) (0.07) — — —
Interest-bearing other liabilities — — — — —
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A summary of the average yields, average rates paid, net interest spread and margin is as follows:
Years Ended December 31,
Average yields:
Nontaxable securities (tax equivalent basis) 2.65 2.72 2.61
Interest-bearing cash and cash equivalents 0.26 2.09 1.84
Average rates paid:
Interest-bearing demand deposits 0.48 0.87 0.63
Yield on average interest-earning assets 3.78 4.29 4.15
Rate on average interest-bearing liabilities 1.02 1.42 1.17
(1)Non-accruing loans have been included in the average loan balances for purposes of this computation.
(2)Net interest spread is the difference between the yield on average interest-earning assets and the yield on average interest-paying liabilities stated on a tax equivalent basis using a federal rate of 21% for 2020, 2019 and 2018. The net interest spread decreased 10 basis points in 2020 compared to 2019 and the net interest spread decreased 13 basis points compared to 2018.
(3)Net interest margin is net interest income, on a tax equivalent basis, divided by average interest-earning assets. The net interest margin decreased 18 basis points in 2020. The net interest margin decreased 7 basis points in 2019 compared to 2018.
In March 2020, the Federal Open Market Committee decreased the target rate to 0.25%. Interest rates on loans are generally affected by the target rate since interest rates for the U.S. Treasury market normally correlate to the Federal Reserve Board federal funds rate. In pricing of loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates. As of December 31, 2020, the average rate indexes for the one, three and five year indexes were 0.10%, 0.17% and 0.36%, respectively. The one year index decreased 93.71% from December 31, 2019, the three year index decreased 89.51% and the five year index decreased 78.70%.
Provision for Loan Losses
Management has determined that the allowance for loan losses was appropriate at December 31, 2020, and that the loan portfolio is diversified and secured, without undue concentration in any specific risk area. This process involves a high degree of management judgment; however, the allowance for loan losses is based on a comprehensive and well-documented applied analysis of the Company’s loan portfolio. This analysis takes into consideration all available information existing as of the financial statement date, including environmental factors such as economic, industry, geographical and political factors. The relative level of allowance for loan losses is reviewed and compared to industry peers. This review encompasses levels of total impaired loans, portfolio mix, portfolio concentrations, current geographic risks and overall levels of net charge-offs.
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The allowance for loan losses totaled $37.07 million at December 31, 2020 compared to $33.76 million at December 31, 2019. The increase in 2020 is the result of an increase of $3.39 million due to changes in average balances, composition of loans outstanding and significant uncertainties with respect to qualitative factors considered by management due to the COVID-19 pandemic's economic impact. There was a decrease of $0.08 million in the amount allocated to the allowance due to improvements in credit quality. The percentage of the allowance to outstanding loans was 1.37% and 1.28% at December 31, 2020 and 2019, respectively. The provision for loan losses totaled an expense of $4.36 million in 2020, a reduction of expense of $2.88 million in 2019 and an expense of $8.50 million for 2018. Loan charge-offs net of recoveries were $1.05 million in 2019. Loan charge-offs net of recoveries were $1.17 million in 2019 and loan recoveries net of charge-offs were $0.09 million in 2018.
The provision for loan losses is the amount necessary to adjust the allowance for loan losses to the level considered appropriate by management. The adequacy of the allowance for loans and any related provision is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of significant factors, including the size and growth of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact of the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more and the trends in problem and watch loans. In addition, management considers the credit quality of the loans based on management’s review of special mention and substandard loans, including loans with historical higher credit risks. Quantitative factors include the Company’s historical loss experience, which is then adjusted for levels and trends in past due loans, levels and trends in charged-off and recovered loans, trends in volume growth, trends in problem and watch loans, trends in TDR loans, local economic trends and conditions, industry and other conditions, and effects of changing interest rates.
In accordance with Staff Accounting Bulletin No. 102, Selected Loan Loss Allowance Methodology and Documentation Issues, the Company determines and assigns ratings to loans using factors that include the following: an assessment of the financial condition of the borrower; a realistic determination of the value and adequacy of underlying collateral; the condition of the local economy and the condition of the specific industry of the borrower; an analysis of the levels and trends of loan categories; and a review of delinquent and classified loans.
Through the credit risk rating process, loans are reviewed to determine if they are performing in accordance with the original contractual terms. If the borrower has failed to comply with the original contractual terms, further action may be required by the Company, including a downgrade in the credit risk rating, movement to nonaccrual status, a charge-off or the establishment of a specific impairment reserve. In the event a collateral shortfall is identified during the credit review process, the Company will work with the borrower for a principal reduction payment and/or a pledge of additional collateral and/or additional guarantees. In the event that these options are not available, the loan may be subject to a downgrade of the credit risk rating. If we determine that a loan amount, or portion thereof, is uncollectible, the loan’s credit risk rating is immediately downgraded and the uncollectible amount is charged-off. The Bank’s credit and legal departments undertake a thorough and ongoing analysis to determine if additional impairment and/or charge-offs are appropriate and to begin a workout plan for the loan to minimize realized loss.
In certain circumstances, the Bank may modify the terms of a loan to maximize the collection of amounts due. In most cases, the modification is either a reduction in interest rate, conversion to interest only payments, deferral of payments or extension of the maturity date. Generally, the borrower is experiencing financial difficulties or is expected to experience difficulties in the near-term, so concessionary modification is granted to the borrower that otherwise would not be considered. TDR loans accrue interest as long as the borrower complies with the revised terms and conditions and has demonstrated repayment performance at a level commensurate with the modified terms over several payment cycles. The Bank’s TDR loans occur on a case-by-case basis in connection with ongoing loan collection processes.
For loans that are collateral dependent, losses are evaluated based on the portion of a loan that exceeds the fair market value of the collateral that can be identified as uncollectible. In general, this is the amount that the carrying value of the loan exceeds the related appraised value less estimated selling costs. Generally, it is the Company’s policy not to rely on appraisals that are older than one year prior to the date the impairment is being measured. The most recent appraisal values may be adjusted if, in the Company’s judgment, experience and other market data indicate that the property’s value, use, condition, exit market or other variable affecting its value may have changed since the appraisal was performed, consistent with the December 2006 joint interagency guidance on the allowance for loan losses. The charge-off or loss adjustment supported by an appraisal is considered the minimum charge-off. Any adjustments made to the appraised value are to provide additional charge-off or loss allocations based on the applicable facts and circumstances. In instances where there is an estimated decline in value, a loss allocation may be provided or a charge-off taken pending confirmation of the amount of the loss from an updated appraisal. Upon receipt of the new appraisals, an additional loss allocation may be provided or charge-off taken based on the appraised value of the collateral. On average, appraisals are obtained within one month of order.
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The Company has not experienced any significant time lapses in recognizing the required provisions for collateral dependent loans, nor has the Company delayed appropriate charge-offs. When an updated appraisal value has been obtained, the Company has used the appraisal amount in determining the appropriate charge-off or required reserve. The Company also evaluates any changes in the financial condition of the borrower and guarantors (if applicable), economic conditions, and the Company’s loss experience with the type of property in question. Any information utilized in addition to the appraisal is intended to identify additional charge-offs or provisions, not to override the appraised value.
The Bank regularly reviews loans in the portfolio and assesses whether the loans are impaired in accordance with ASC 310-10-35, Accounting by Creditors for Impairment of a Loan. If the loans are impaired, the Bank determines if a specific allowance is appropriate. In addition, the Bank's management also reviews and, where determined necessary, provides allowances for particular loans based upon (1) reviews of specific borrowers and (2) management’s assessment of areas that management considers are of higher credit risk, including loans that have been restructured. Loans that are determined not to be impaired and for which there are no specific allowances are classified into one or more risk categories. Based upon the risk category assigned, the Bank allocates a percentage, as determined by management, for a required allowance needed. The determination concerning the appropriate percentage begins with historical loss experience factors, which are then adjusted for levels and trends in past due loans, levels and trends in charged-off and recovered loans, trends in volume growth, trends in problem and watch loans, trends in TDR loans, local economic trends and conditions, industry and other conditions, and effects of changing interest rates.
Specific allowances for losses on impaired loans are established if the loan balances exceed the net present value of the relevant future cash flows or the fair value of the collateral based on updated appraisals and/or updated collateral analysis for the properties if the loan is collateral dependent. The Company may recognize a charge-off related to an impaired loan when loan balances exceed net present value of cash flows or collateral. Impaired loans decreased by $0.20 million from December 31, 2019 to December 31, 2020. Impaired loans include any loan that has been placed on nonaccrual status, accruing loans past due 90 days or more and TDR loans. Impaired loans also include loans that, based on management’s evaluation of current information and events, the Bank expects to be unable to collect in full according to the contractual terms of the original loan agreement. The decrease in impaired loans is primarily due to a decrease in nonaccrual loans of $1.92 million and offset by an increase of accruing loans past due 90 days or more of $0.45 million, an increase of $0.43 million in specific reserve loans and an increase in TDR loans of $0.94 million from December 31, 2019 to December 31, 2020.
Special mention loan balances were $78.05 million at December 31, 2020 and $66.81 million at December 31, 2019. These asset quality changes increased the provision by $0.13 million based upon the relative mix of special mention loans by category. The $11.24 million increase in special mention loans is related to management’s evaluation of its loan portfolio. The total increase of $11.24 million is comprised of approximately $2.03 million in agricultural operating loans, $3.10 million in commercial loans, $3.04 million in real estate farmland, $1.72 million in 1 to 4 family residential mortgages and $14.94 million for commercial real estate mortgages. The increase is offset by a decrease in the special mention classification of $0.63 million in construction 1 to 4 family residential, $0.29 million in construction land development and commercial, $0.16 million in 1 to 4 family junior mortgages, $12.18 million for multi-family real estate mortgages, $0.09 million in individual loans and $0.24 million for obligations of state and political subdivisions.
Substandard loan balances were $51.03 million at December 31, 2020 and $43.34 million at December 31, 2019. These asset quality changes increased the provision by $0.21 million at December 31, 2020 due to the mix of the reserve required for certain substandard loans. The increase of $7.69 million in substandard loans at December 31, 2020 includes an increase of $2.01 million in commercial loans, $0.32 million in construction 1 to 4 family residential, $1.11 million in construction land development, $0.02 million in 1 to 4 family junior mortgages, $12.31 million in multi-family real estate mortgages, $1.02 million in commercial real estate mortgages and $0.03 million in loans to individuals. The increase is offset by a decrease in the substandard classification of $1.90 million in agricultural operating loans, $5.09 million in real estate farmland and $2.14 million of 1 to 4 family residential mortgages. A description of the Bank's credit quality indicators are discussed in Note 3 to the Company's Consolidated Financial Statements.
The Company evaluates the following loans to determine impairment: 1) all nonaccrual and TDR loans, 2) all non-consumer and non 1 to 4 family residential loans with prior charge-offs, 3) all non-consumer and non 1 to 4 family loan relationships classified as substandard and 4) loans with indications of or suspected deteriorating credit quality.
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The following table summarizes the Company's impaired loans and non-performing assets as of December 31 for each of the years presented:
(Amounts In Thousands)
Other real estate — — — — 237
(1)The gross interest income that would have been recorded if the loans had been current in accordance with their original terms and had been outstanding throughout the period or since origination if held for part of the period was $0.66 million in 2020 and $0.58 million in 2019. The amount of interest income on the loans that was included in income was $0.57 million in 2020 and $0.53 million in 2019.
(2)The accruing loans past due 90 days or more are still believed to be adequately collateralized. Loans are placed on nonaccrual status when management believes the collection of future principal and interest is not reasonably assured.
(3)Total TDR loans were $13.22, $13.71, $13.38, $12.09 and $9.64 million as of December 31, 2020, 2019, 2018, 2017 and 2016, respectively. Included in the total nonaccrual loans were $2.97, $4.34, $4.84, $3.62 and $4.23 million of TDR loans as of December 31, 2020, 2019, 2018, 2017 and 2016, respectively.
The ratio of allowance for loan losses to impaired loans increased to 178.83% as of December 31, 2020 compared to 161.34% as of December 31, 2019. The increase in 2020 is the result of an increase in the allowance for loan losses primarily due to management's evaluation of qualitative factors in response to the COVID-19 pandemic and related uncertainties. The ratio of impaired loans to total gross loans was 0.76% and 0.79% at December 31, 2020 and 2019, respectively. The decrease in the 2020 ratio is primarily due to the decrease in nonaccrual loans.
Other factors that are considered in determining the credit quality of the Company’s loan portfolio are the vacancy rates for both residential and commercial space, current equity the borrower has in the property and overall financial strength of the customer including cash flow to continue to fund loan payments. The Company also considers the state of the total economy including unemployment levels. In most instances, the borrowers have used in their rental projections of income at least a 10% vacancy rate. As of December 31, 2020, the unemployment levels in Johnson County and Linn County were 2.8% and 3.8%, respectively, compared to 2.2% and 3.1% in December of 2019. These levels compare favorably to the State of Iowa at 3.1% and the national unemployment level at 6.7% in December 2020 compared to 2.7% and 3.5%, respectively in December 2019.
The residential rental vacancy rates in 2019 and 2020 in Johnson and Linn County were estimated between 6.0% and 8.0%. The State of Iowa vacancy rate is 8.5% and the national rate is 6.5% with the Midwest rate at 7.8%. These vacancy rates one year ago were 6.7%, 6.4% and 6.8%, respectively. The Company continues to consider those vacancy rates among other factors in its current evaluation of the real estate portion of its loan portfolio. Favorable vacancy rates may not continue in 2021, and vacancy rates may rise and affect the overall quality of the loan portfolio.
See Note 3 to the Company's Consolidated Financial Statements for additional disclosures on loans.
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SUMMARY OF LOAN LOSS EXPERIENCE
The allowance for loan losses balance is also affected by the charge-offs and recoveries for the periods presented. For the years ended December 31, 2020, 2019 and 2018, recoveries were $1.87 million, $1.80 million and $2.24 million, respectively; charge-offs were $2.92 million, $2.97 million and $2.32 million in 2020, 2019 and 2018, respectively.
Overall credit quality may deteriorate in 2021. Such deterioration could cause increases in impaired loans, allowance for loan losses provision expense and net charge-offs. Management will monitor changing market conditions as a part of its allowance for loan loss methodology. The following table summarizes the Bank's loan loss experience for the years ended December 31 for each of the years presented:
(Amounts In Thousands)
Allowance for loan losses:
(Amounts In Thousands)
Allowance for loan losses:
(Amounts In Thousands)
Allowance for loan losses:
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(Amounts In Thousands)
Allowance for loan losses:
(Amounts In Thousands)
Allowance for loan losses:
The ratio of net charge-offs to average net loans outstanding during the years ended December 31, 2020, 2019, 2018, 2017 and 2016 was 0.04%, 0.04%, 0.00%, (0.05)% and (0.05)%, respectively.
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ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
The following table presents the allowance for loan losses by type of loans, the percentage of the allocation for each category to the total allowance and the percentage of all loans in each category to total loans as of December 31, 2020, 2019, 2018, 2017 and 2016:
(In Thousands) (In Thousands)
Real estate:
Real estate:
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Amount % of Total Allowance % of Loansto Total Loans
(In Thousands)
Real estate:
Construction, land development and commercial 1,867 7.04 5.34
Obligations of state and political subdivisions 381 1.44 2.39
The Company believes that the allowance for loan losses is at a level commensurate with the overall risk exposure of the loan portfolio. However, if economic conditions deteriorate, certain borrowers may experience difficulty and the level of impaired loans, charge-offs and delinquencies could rise and require increases in the provision for loan losses. The Company will continue to monitor the adequacy of the allowance on a quarterly basis and will consider the impact of economic conditions on the borrowers’ ability to repay, loan collateral values, past collection experience, the risk characteristics of the loan portfolio and such other factors that deserve current recognition.
Noninterest Income
The following table sets forth the various categories of noninterest income for the years ended December 31, 2020, 2019 and 2018.
Year Ended December 31, $ Change % Change
(Amounts in thousands)
Gain (loss) on sale of investment securities $ 10 $ (28) $ — 38 (28) (135.71) —
The noninterest income of the Company was $28.34 million in 2020 compared to $24.79 million in 2019. The increase of $3.54 million in 2020 was the result of a combination of factors discussed below. In 2019, the total noninterest income increased $0.97 million from 2018.
Loans originated for sale in 2020, which consist primarily of fixed rate residential mortgage loans, totaled $475.19 million compared to $299.22 million in 2019, an increase of 58.81%. In the year ended December 31, 2020 and 2019, the net gain on sale of loans was $6.68 million and $3.54 million, respectively. The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level
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of interest rates and has been significantly impacted by the Federal Reserve Board's reduction of the federal funds rate to 0.25% in 2020, resulting in a significant amount of mortgage loan refinance activity. The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income.
Trust fees increased $0.70 million to $10.28 million in 2020. Trust fees decreased $(0.43) million in 2019. As of December 31, 2020, the Bank’s Trust Department had $2.176 billion in assets under management compared to $1.919 billion and $1.618 billion at December 31, 2019 and 2018, respectively. In 2020, the Dow Jones Industrial Average increased 7.25%. The market value of the Dow Jones Industrial Average increased 22.34% in 2019 and decreased 5.63% in 2018.
Other noninterest income decreased $1.25 million in 2019 primarily due to the sale of the insurance department in August 2018 for a gain of $885,000.
Noninterest Expenses
The following table sets forth the various categories of noninterest expenses for the year ended December 31, 2020, 2019 and 2018.
Year Ended December 31, $ Change % Change
(Amounts in thousands)
Total noninterest expenses were $75.63 and $67.26 million for the years ended December 31, 2020 and 2019, respectively. The increase is $8.37 million or 12.44% in 2020 and an increase of $5.14 million or 8.28% in 2019.
Salaries and employee benefits increased $3.91 million in 2020. The increase is primarily the result of annual salary adjustments, hiring of additional employees to staff growth, increased variable compensation due to the increase in loans originated for sale described above and increased overtime due to the increase in loans originated for sale and processing of PPP loans.
Furniture and equipment increased $0.56 million in 2020 primarily due to planned increases in software maintenance contract costs.
Advertising and business development decreased $0.51 million in 2020 due to lower spending in response to the pandemic.
FDIC insurance assessment increased $0.66 million in 2020 primarily due to the use of the credit carryover in 2019.
Other noninterest expenses increased $3.07 million in 2020 primarily due to $2.53 million in fees incurred from the prepayment of FHLB borrowings and $2.68 million paid for the early termination of the interest rate swap.
Total noninterest expenses were $62.12 million for the year ended December 31, 2018. The increase in expenses in 2019 was $5.14 million. This included an increase of $1.73 million in salaries and benefits, which was the direct result of salary adjustments and hiring additional employees. Furniture and equipment increased $1.05 million in 2019 primarily due to
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increases in software maintenance contract costs. Other noninterest expenses increased $2.63 million in 2019 primarily due to $2.09 million in fees incurred from the prepayment of FHLB borrowings.
Income Taxes
Income tax expense was $11.28, $12.55 and $8.91 million for the years ended December 31, 2020, 2019 and 2018, respectively. Income taxes as a percentage of income before income taxes were 22.59% in 2020, 21.69% in 2019 and 19.50% in 2018. The amount of tax credits were $0.05, $0.53 and $1.29 million for 2020, 2019, and 2018, respectively.
Effects of Inflation
The consolidated financial statements and the accompanying notes have been prepared in accordance with accounting principles generally accepted in the United States of America. These principles require the measurement of financial position and operating results in terms of historical dollar amounts without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Company’s operations. Nearly all of the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a more significant impact in the Company’s performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the price of goods and services. Liquidity and interest rate adjustments are features of the Company’s asset/liability management, which are important to the maintenance of acceptable performance levels. Item 7A of this Form 10-K contains a more thorough discussion of interest rate risk. The Company attempts to maintain a balance between monetary assets and monetary liabilities to offset the potential effects of changing interest rates.
Liquidity and Capital Resources
The objective of liquidity management is to ensure the availability of sufficient cash flows to fund operations, to meet depositor withdrawals, to provide for our customers' credit needs and to meet maturing obligations and existing commitments. The Company's principal source of funds is deposits. Other sources include loan principal repayments, proceeds from the maturity and sale of investment securities, federal funds purchased, advances from the FHLB, advances on bank lines of credit, brokered deposit relationships and funds provided by operations. Liquidity management is conducted on both a daily and a long-term basis. Investments in liquid assets are adjusted based on expected loan demand, projected loan and investment securities maturities and payments, expected deposit flows and the objectives set by the Company's asset-liability management, liquidity and contingency funding policies.
As of December 31, 2020, the Company had additional borrowing capacity available from the FHLB of $776.67 million. In addition, the Company had $523.07 million in borrowing capacity available through secured and unsecured lines of credit with correspondent banks. The Company had no amounts outstanding under those federal funds lines as of December 31, 2020.
On an unconsolidated basis, the Company had cash balances of $1.10 million as of December 31, 2020. In 2020, the Company received dividends of $14.82 million from its subsidiary Bank and used those funds to pay dividends to its stockholders of $8.33 million and to fund purchases of treasury stock under the 2005 Stock Repurchase Program. The total purchase of treasury stock under the 2005 Stock Repurchase Program totaled $8.55 and $5.53 million for the years ended December 31, 2020 and 2019, respectively.
As of December 31, 2020 and 2019, stockholders' equity, before deducting for the maximum cash obligation related to the ESOP, was $463.41 million and $427.04 million, respectively. This measure of stockholders’ equity as a percent of total assets was 12.26% at December 31, 2020 and 12.94% at December 31, 2019. As of December 31, 2020, total equity, after deducting the maximum cash value related to the ESOP, was 11.01% of assets compared to 11.37% of assets at the prior year end.
The Company and the Bank are subject to the Federal Deposit Insurance Corporation Improvement Act of 1991, and the Bank is subject to Prompt Corrective Action Rules as determined and enforced by the Federal Reserve. These regulations establish minimum capital requirements that member banks must maintain.
The Bank is classified as "well-capitalized" by FDIC capital guidelines. For more information regarding regulatory capital requirements, see the section under Part I, Item 1 to this 10-K captioned “Supervision and Regulation.”
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On a consolidated basis, 2020 cash flows from operations provided $8.15 million and net increases in deposits provided $531.20 million. These cash flows were invested in Net Loans of $72.14 million and $129.36 million in purchases of investment securities. In addition, $1.86 million was used to purchase property and equipment and leasehold improvements.
The Bank has a contingency funding plan to address liquidity issues in times of crisis. The primary source of funding will be the Bank’s customer deposit base. The Bank has established alternative sources of funding available to increase liquidity. The availability of the funding sources is tested on an annual basis. The Bank performs quarterly stress testing to determine if the Bank has an appropriate amount of funding sources to address potential liquidity needs. At December 31, 2020, the Bank had total outstanding loan commitments and unused portions of lines of credit totaling $491.66 million (see Note 15 to the Company's Consolidated Financial Statements). Management believes that its liquidity levels are sufficient at this time, but the Bank may increase its liquidity by limiting the growth of its assets, by selling more loans in the secondary market or selling portions of loans to other banks through participation agreements. Another liquidity source includes obtaining additional funds from the Federal Home Loan Bank (FHLB). As of December 31, 2020, the Bank can obtain an additional $776.67 million from the FHLB based on the current real estate mortgage loans held. In addition, the Bank has arranged $513.07 million of credit lines at three banks. The borrowings under these credit lines would be secured by the Bank’s investment securities. Other liquidity sources include a $10.00 million line of credit with the Federal Reserve Bank of Chicago and various sources of brokered deposits.
The following table shows outstanding balances, weighted average interest rates at year end, maximum month-end balances, average month-end balances and weighted average interest rates of federal funds purchased and securities sold under agreements to repurchase during 2020, 2019 and 2018:
(Amounts In Thousands)
Outstanding balance as of December 31 $ — $ — $ —
Weighted average interest rate at year end — % — % — %
Maximum month-end balance — — —
Average month-end balance — — —
Weighted average interest rate for the year 0.93 % 2.64 % 2.71 %
The following table shows outstanding balances, weighted average interest rates at year end, maximum month-end balances, average month-end balances and weighted average interest rates of Federal Home Loan Bank borrowings during 2020, 2019 and 2018:
(Amounts In Thousands)
Weighted average interest rate at year end 2.93 % 2.93 % 2.94 %
Weighted average interest rate for the year 2.93 % 2.93 % 2.94 %
The Bank has off-balance sheet commitments to fund additional borrowings of customers as well as derivative financial instruments, consisting of interest rate swaps as disclosed in Note 17 to the Company's Consolidated Financial Statements. Contractual commitments to fund loans are met from the proceeds of federal funds sold or investment securities and additional borrowings. Many of the contractual commitments to extend credit will not be funded because they represent the credit limits on credit cards and home equity lines of credits.
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As disclosed in Note 15 to the Company's Consolidated Financial Statements, the Company has certain obligations and commitments to make future payments under contracts. The following table summarizes significant contractual obligations and other commitments as of December 31, 2020:
Payments Due By Period
(Amounts In Thousands)
Total Less ThanOne Year One -Three Years Three -Five Years More ThanFive Years
Contractual obligations:
Other commitments:
Standby letters of credit 8,056 8,056 — — —
The Company and the Bank have no additional material commitments or plans that will materially affect liquidity or capital resources. Property and equipment may be acquired in cash purchases, or they may be financed if favorable terms are available.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The Company's primary market risk exposure is to changes in interest rates. Interest rate risk is the risk to current or anticipated earnings or capital arising from movements in interest rates. Interest rate risk arises from repricing risk, basis risk, yield curve risk and options risk. Repricing risk is the difference between the timing of rate changes and the timing of cash flows. Basis risk is the difference from changing rate relationships among different yield curve affecting Bank activities. Yield curve risk is the difference from changing rate relationships across the spectrum of maturities. Option risk is the difference resulting from interest-related options imbedded in Bank products. The Bank’s primary source of interest rate risk exposure arises from repricing risk. To measure this risk the Bank uses a static gap measurement system that identifies the repricing gaps across the full maturity spectrum of the Bank’s assets and liabilities and an earnings simulation approach. The gap schedule is known as the interest rate sensitivity report. The report reflects the repricing characteristics of the Bank’s assets and liabilities. The report details the calculation of the gap ratio. This ratio indicated the amount of interest-earning assets repricing within a given period in comparison to the amount of interest-bearing liabilities repricing within the same period of time. A gap ratio of 1.0 indicates a matched position, in which case the effect on net interest income due to interest rate movements will be minimal. A gap ratio of less than 1.0 indicates that more liabilities than assets reprice within the time period, and a ratio greater than 1.0 indicates that more assets reprice than liabilities.
The Company's asset/liability management, or its management of interest rate risk, is focused primarily on evaluating and managing net interest income given various risk criteria. Factors beyond the Company's control, such as market interest rates and competition, may also have an impact on the Company's interest income and interest expense. In the absence of other factors, the Company's overall yield on interest-earning assets will increase as will its cost of funds on its interest-bearing liabilities when market interest rates increase over an extended period of time. Inversely, the Company's yields and cost of funds will decrease when market rates decline. The Company is able to manage these swings to some extent by attempting to control the maturity or rate adjustments of its interest-earning assets and interest-bearing liabilities over given periods of time.