Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
ISABELLA BANK CORPORATION FINANCIAL REVIEW
(Dollars in thousands except per share amounts)
The following is management’s discussion and analysis of our financial condition and results of operations. This discussion and analysis is intended to provide a better understanding of the consolidated financial statements and statistical data included elsewhere in this Annual Report on Form 10-K.
Executive Summary
We reported net income of $18,167 and earnings per common share of $2.42 for the year ended December 31, 2023. Net income and earnings per common share for the same period of 2022 were $22,238 and $2.95, respectively. Net interest income decreased $2,537, or 4.19%, during 2023 compared to 2022. Rising interest rates and growth in core loans led to a $13,833, or 21.02%, increase in gross interest income during 2023 compared to 2022. Conversely, rising interest rates on deposits and an increase in borrowings led to a $16,370 increase in interest expense for the year ended December 31, 2023 when compared to the same period in 2022.
The provision for credit losses during the year ended December 31, 2023 was $629, compared to $483 for the same period in 2022. Credit quality remained strong at December 31, 2023, as evidenced by total past due and nonaccrual loans which were $4,964, or 0.37%, of gross loans. While maintaining strong credit quality, the ACL and provision for loan losses increased during 2023 as a result of core loan growth and economic related risk factors.
Noninterest income increased $161 during 2023 compared to the same period in 2022. This increase was driven by wealth management fees and ATM and debit card fee income, offset by a decrease in OMSR income and gain on sale of loans, as residential mortgages sold to the secondary market declined. Noninterest expenses increased $2,490 in 2023, when compared to the same period in 2022, and was primarily a result of increased compensation, equipment expense, other losses, and FDIC insurance premiums.
As of December 31, 2023, total assets and assets under management were $2,058,968 and $2,948,751, respectively. Assets under management include loans sold and serviced of $248,756 and investment and trust assets managed by Isabella Wealth of $641,027, in addition to assets on our consolidated balance sheet. Loans outstanding as of December 31, 2023 totaled $1,349,463. During 2023, gross loans grew $85,290 driven by growth in nearly all loan categories. Total deposits were $1,723,695 as of December 31, 2023, declining $20,580, or 1.2%, during the year as competition for deposits remained strong throughout 2023. All regulatory capital ratios for the Bank exceeded the minimum thresholds to be considered a "well capitalized" institution.
Our securities portfolio decreased $52,333 during 2023, predominantly due to maturities and principal paydowns. Unrealized losses on our AFS securities portfolio were $31,826 at December 31, 2023, improving $13,298 since December 31, 2022. Unrealized losses on our AFS securities portfolio resulted from increased short-term and intermediate-term benchmark interest rates throughout 2023. As a result, the higher level of unrealized losses has reduced our balance of shareholders' equity and negatively impacted our tangible book value. Management does not anticipate the need to sell securities and incur a loss as a result of the sale.
Our net yield on interest earning assets (FTE) was 3.05% for 2023, which decreased from 3.18% in 2022. To maintain a competitive edge in a rising interest rate environment, we increased most of our deposit rates beginning in the fourth quarter of 2022 and in recent periods, increased our level of borrowings to fund loan growth. As a result, this has negatively impacted our net yield on interest earning assets and further increases may slow improvement in our net yield on interest earning assets.
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Recent Events and Legislation
2023 Bank Failures and the Condition of the Banking Industry: In March 2023, disruptions in the industry resulted in FDIC seizures of three banking institutions. Each bank had its own unique balance sheet issues, none of which exist at Isabella Bank. Shortly after the FDIC takeovers, the Federal Reserve Bank and the Department of Treasury announced enhanced insurance coverage and a borrowing program to help banks in need of funding. Isabella Bank continues to monitor such events, as well as industry and regulatory responses, to assure we are prepared for any changes that might affect the bank, including the ability to timely address economic uncertainty.
Impact of the Adoption of ASC 326 (CECL): We adopted ASU No. 2016-13, as subsequently updated for certain clarifications, targeted relief and codification improvements, as of January 1, 2023. Based on portfolio characteristics and economic conditions and expectations as of January 1, 2023, we recorded a combined pre-tax increase of $3,059 to the ACL and reserve for unfunded commitments on January 1, 2023 upon the adoption of ASU 2016-13; this implementation resulted in a reduction to retained earnings of $2,417, net of tax, as of January 1, 2023. In connection with the adoption of ASC 326, we revised certain accounting policies and implemented certain accounting policy elections, which are included in “Note 1 – Significant Accounting Policies” of our interim condensed consolidated financial statements.
Reclassifications
Certain amounts reported in management's discussion and analysis of financial condition and results of operations for 2022 and 2021 have been reclassified to conform with the 2023 presentation.
Operating results for periods after January 1, 2023 are presented in accordance with ASC 326 while prior period amounts continue to be reported in accordance with previously applicable standards and the accounting policies described in our Annual Report on Form 10-K for the year ended December 31, 2022. In addition, the adoption of ASC 326 requires enhanced disclosures related to the significant estimates and judgments used in estimating credit losses.
Subsequent Events
We evaluated subsequent events after December 31, 2023 through the date our condensed consolidated financial statements were issued for potential recognition and disclosure. No subsequent events require financial statement recognition or disclosure between December 31, 2023 and the date our condensed consolidated financial statements were issued.
Other
We have not received, nor are aware of, any notices of regulatory actions as of March 6, 2024.
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Results of Operations
(Dollars in thousands except per share amounts)
The following table outlines the results of operations and provides certain key performance measures as of, and for the years ended, December 31:
INCOME STATEMENT DATA
PER SHARE
Quoted market value
PERFORMANCE RATIOS
Return on average total assets 0.89 % 1.08 % 0.96 %
Return on average shareholders' equity 9.52 % 11.41 % 8.83 %
Return on average tangible shareholders' equity 12.75 % 15.17 % 11.31 %
Net interest margin yield (FTE) 3.05 % 3.18 % 2.87 %
BALANCE SHEET DATA (1)
ASSETS UNDER MANAGEMENT (1)
ASSET QUALITY (1)
Nonperforming loans to gross loans 0.08 % 0.04 % 0.10 %
Nonperforming assets to total assets 0.07 % 0.05 % 0.08 %
CAPITAL RATIOS (1)
Shareholders' equity to assets 9.83 % 9.17 % 10.39 %
(1) At end of year
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The following table outlines our interim results of operations and key performance measures as of, and for the unaudited periods ended:
Quarter to Date
INCOME STATEMENT DATA
PER SHARE
Quarter to Date
INCOME STATEMENT DATA
PER SHARE
(1) At end of period
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CRITICAL ACCOUNTING POLICIES
Our significant accounting policies are set forth in “Note 1 – Significant Accounting Policies” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data. Of these significant accounting policies, we consider our policies regarding the ACL, acquisition intangibles and goodwill, and the determination of the fair value and assessment of credit related impairments of investment securities to be our most critical accounting policies.
The ACL requires our most subjective and complex judgment. Changes in economic conditions and other external factors can have a significant impact on the ACL and, therefore, the allowance for credit losses and results of operations. We have developed policies and procedures for assessing the appropriateness of the ACL, recognizing that this process requires a number of assumptions and estimates with respect to our loan portfolio. Our assessments may be impacted in future periods by changes in economic conditions, and the discovery of information with respect to borrowers which is not known to us at the time of the issuance of the consolidated financial statements. For additional discussion concerning our ACL and related matters, see “ACL - Loans” and “Note 4 – Loans and ACL” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data.
U.S. generally accepted accounting principles require that we determine the fair value of the assets and liabilities of an acquired entity, and record the fair value on the date of acquisition. We employ a variety of measures in the determination of the fair value, including the use of discounted cash flow analysis, market appraisals, and projected future revenue streams. For certain items that we believe we have the appropriate expertise to determine the fair value, we may choose to use our own calculations of the value. In other cases, where the value is not easily determined, we consult with independent experts to determine the fair value of the identified asset or liability. Once valuations have been determined, the net difference between the price paid for the acquired entity and the net value of assets acquired on our balance sheet, including identifiable intangibles, is recorded as goodwill. Acquisition intangibles and goodwill are qualitatively evaluated to determine if it is more likely than not that the carrying balance is impaired on at least an annual basis.
AFS securities are carried at fair value with changes in the fair value included as a component of other comprehensive income. Declines in the fair value of AFS securities below their cost that are other-than-temporary are reflected as realized losses in the consolidated statements of income. The market values for most AFS investment securities are typically obtained from outside sources and applied to individual securities within the portfolio. Municipal securities for which no readily determinable market values are available are priced using fair value curves which most closely match the securities' characteristics. AFS securities are reviewed quarterly for possible credit impairment. In determining whether a credit-related impairment exists for debt securities, we assess whether: (a) we do not have the intent to sell the security; and (b) it is more likely than not we will not have to sell the security before recovery of its cost basis. If either of these conditions are met, any previously recognized allowances are charged-off and the security's amortized cost is written down to fair value through income. If these conditions are not met, the security is evaluated to determine whether the decline in fair value has resulted from credit losses or other factors.
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Average Balances, Interest Rates, and Net Interest Income
The following schedules present the daily average amount outstanding for each major category of interest earning assets, non-earning assets, interest bearing liabilities, and noninterest bearing liabilities for the last three years. These schedules also present an analysis of interest income and interest expense for the periods indicated. All interest income is reported on a FTE basis using a federal income tax rate of 21%. Loans in nonaccrual status, for the purpose of the following computations, are included in the average loan balances. FRB and FHLB restricted equity holdings are included in other interest earning assets.
Year Ended December 31
INTEREST EARNING ASSETS
NONEARNING ASSETS
INTEREST BEARING LIABILITIES
NONINTEREST BEARING LIABILITIES
Net yield on interest earning assets (FTE) 3.05 % 3.18 % 2.87 %
(1) Includes loans and mortgage loans AFS
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Net interest income is the amount by which interest income on earning assets exceeds the interest expense on interest bearing liabilities. Net interest income is influenced by changes in the balance and mix of assets and liabilities, as well as market interest rates. We exert some control over these factors; however, FRB monetary policy and competition have a significant impact. For analytical purposes, net interest income is adjusted to an FTE basis by including the income tax savings from interest on tax exempt loans and nontaxable investment securities, thus making year to year comparisons more meaningful. The FTE adjustment is based on a federal income tax rate of 21%.
Volume and Rate Variance Analysis
The following table sets forth the effect of volume and rate changes on interest income and expense for the periods indicated. For the purpose of this table, changes in interest due to volume and rate were determined as follows:
Volume—change in volume multiplied by the previous period's FTE rate.
Rate—change in the FTE rate multiplied by the previous period's volume.
All interest income presented in the table below is reported on a FTE basis using a federal income tax rate of 21%. The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.
Volume Rate Net Volume Rate Net
Changes in interest income
Fed Funds Sold — 1 1 — — —
Changes in interest expense
Federal funds purchased and repurchase agreements (12) 894 882 (8) 34 26
Subordinated debt, net of unamortized issuance costs 3 (3) — 445 5 450
Over the past several quarters, rising rates on deposit accounts and an increase in borrowed funds have reversed the improvement in our net interest margin. The higher interest rate environment is expected to continue to place pressure and slow improvement on our net yield on interest earning assets.
Average Yield / Rate for the Three-Month Periods Ended:
Net yield on interest earning assets (FTE) 2.85 % 3.02 % 3.11 % 3.22 % 3.43 %
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Quarter to Date Net Interest Income (FTE)
Past Due and Nonaccrual Loans
Fluctuations in past due and nonaccrual loans can have a significant impact on the ACL. To determine the potential impact, and corresponding estimated losses, we analyze our historical loss trends on loans past due greater than 30 days and nonaccrual loans for indications of additional deterioration.
Total Past Due and Nonaccrual Loans as of December 31
The increase in past due and nonaccrual loans within the commercial real estate and residential loan portfolios at the end of 2022 was the result of one past due relationship, which has since improved. The accrual of interest on commercial and agricultural loans, as well as residential real estate loans, is discontinued at the time a loan is 90 days or more past due unless the credit is well-secured and in the process of short-term collection. Upon transferring a loan to nonaccrual status, we perform an evaluation to determine the net realizable value of the underlying collateral. This evaluation is used to help determine if a charge-off is necessary. Consumer loans are typically charged-off no later than 180 days past due. Loans may be placed back on accrual status after six months of continued performance and achievement of current payment status.
The following table summarizes nonaccrual loans as of:
Commercial real estate — — — 57 14
A summary of loans past due by type and information related to nonaccrual status loans are included in “Note 4 – Loans and ACL” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data.
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Nonperforming Assets
The following table summarizes our nonperforming assets as of December 31:
Accruing loans past due 90 days or more 87 — 97 — —
Nonperforming loans as a % of total loans 0.08 % 0.04 % 0.10 % 0.43 % 0.55 %
Nonperforming assets as a % of total assets 0.07 % 0.05 % 0.08 % 0.31 % 0.40 %
ACL - Loans
The viability of any financial institution is ultimately determined by its management of risk. Loans represent our single largest concentration of risk. The ACL is our estimation of expected credit losses within the existing loan portfolio. We allocate the ACL throughout the loan portfolio based on our assessment of the underlying risks associated within each loan segment. Our assessments include allocations based on specific valuation allowances, historical charge-offs, internally assigned credit risk ratings, past due and nonaccrual balances, historical loss percentages, and other credit trends and risk characteristics, including current conditions and reasonable and supportable forecasts about the future.
Upon the adoption of ASC 326 on January 1, 2023, the total amount of the allowance for credit losses on loans estimated using the CECL methodology increased $2,744 compared to the total amount of the allowance for credit losses on loans estimated as of December 31, 2022 using the prior incurred loss methodology. The manner in which credit loss allowances are allocated to the individual portfolio segments was partly impacted by a change in the way the underlying loans within each segment are pooled for modeling purposes. The impact of varying economic conditions and portfolio risk factors are now a component of the credit loss models applied to each modeling pool. In that regard, the amounts allocated to the underlying pools of loans within each portfolio segment more directly reflect the economic variables and portfolio stress factors that correlate with credit losses within each portfolio. Under the prior methodology, allocations in excess of those derived from historical loss rates were recognized as unallocated. Nonetheless, despite fluctuations in the allocation of portions of the overall allowance to the various portfolio segments, the entire allowance is available to absorb any credit losses within the entire loan portfolio.
The following table summarizes our charge-offs, recoveries, provision for credit losses, and ACL balances as of, and for the unaudited three month periods ended:
Net loan charge-offs (recoveries) 381 (254) (3) (9) (230)
Provision for credit losses - loans $ 684 $ (320) $ 190 $ 37 $ (57)
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The following table summarizes charge-off and recovery activity by loan segment for the year ended December 31, 2023:
The following table summarizes charge-offs, recoveries, and provision for credit loss activity for the years ended December 31:
The following table illustrates the two main components of the ACL as of:
ACL
Individually evaluated $ 84 $ — $ — $ — $ 451
ACL to gross loans
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The following table illustrates the amounts of the ACL and ALLL allocated to each loan segment and the percentage of these loan segments to gross loans as of December 31:
While we utilize our best judgment and information available, the ultimate adequacy of the ACL is dependent upon a variety of factors beyond our control, including the performance of our borrowers, the economy, and changes in interest rates. We closely monitor overall credit quality indicators and our policies and procedures related to the analysis of the ACL to ensure that the ACL remains at an appropriate level.
For further discussion of the allocation of the ACL, see “Note 4 – Loans and ACL” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data.
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Noninterest Income and Noninterest Expenses
Significant noninterest income balances are highlighted in the following table for the years ended December 31:
Change Change
Service charges and fees
During 2022, we experienced an increase in service charges and fees on deposit accounts mainly due to an increase in the number of deposit accounts. Although deposit accounts continued to grow in 2023, we experienced a decline in fees due to the discontinuation of NSF fees. Although we expect a continuation in deposit account growth in 2024, fee levels may not exceed 2023 due to continued regulatory discussions around the practice of service charges and fees.
OMSR income results are driven, in part, by changes in offering rates on residential mortgage loans, anticipated prepayments in the servicing-retained portfolio, and the volume of loans within the servicing-retained portfolio. During 2022, prepayment speeds declined as a result of an increase in interest rates, resulting in income recognized during 2022. During 2023 the volume of loans serviced decreased, resulting in the recognition of losses. OMSR income during 2024 may continue to experience fluctuations and could vary from 2023 levels.
During 2023, we experienced an increase in wealth management fees driven by a combination of the growth in the stock market and increased new business activity. During 2022, there was strong growth in assets managed by Isabella Wealth, however the decline in the market offset the increase in fees related to growth in new business. We expect wealth management fees to exceed 2023 levels in 2024 as a result of new business activity.
The amount of loans sold is driven by customer demand and balance sheet management strategies. We experienced a significant increase in loan demand in early 2021 which led to an increase in the number and dollar amount of loans sold; as such, net gain on sale of mortgage loans increased significantly. In mid-2021, we decided to retain more loan originations on the balance sheet, due to our liquidity position, thereby decreasing the number of mortgage loans sold, which had an impact on the net gain on loans sold. As a result of this change in strategy, coupled with a decline in loan demand due to increased interest rates, net gain on sale of mortgage loans declined in the second half of 2021 and during 2022. During 2023, we experienced a decrease in gain on sale of mortgage loans as loan demand continued to decline. As demand is expected to remain at reduced levels in 2024, gain on sale of mortgage loans is not expected to exceed 2023 levels during 2024.
The fluctuations in all other income are spread throughout various categories, none of which is individually significant.
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Significant noninterest expense balances are highlighted in the following table for the years ended December 31:
Change Change
Other
The increase in compensation and benefits has been driven by merit increases and our employee incentive plans. We closely monitor compensation levels to ensure we attract and retain talent in a competitive labor market. While expenses related to our employee incentive plans fluctuate based on financial performance, compensation and benefits expense in 2024 is expected to continue to increase as a result of anticipated merit increases and insurance related benefits.
The decrease in ATM and debit card fees is primarily the result of a cost savings related to vendor reporting services. While the savings in the service fees will continue, ATM and debit card fees are expected to exceed 2023 levels in 2024 as a result of the continuation of increased card usage.
The increase in FDIC insurance premiums is due to the FDIC adopting a final rule, applicable to all insured depository institutions, to increase initial base deposit insurance assessment rate schedules uniformly by 2 basis points, beginning in the first quarterly assessment period of 2023. The increase in assessment rate schedules is intended to increase the likelihood that the reserve ratio of the Deposit Insurance fund reaches the statutory minimum of 1.35 percent by the statutory deadline of September 30, 2028. FDIC premiums are expected to maintain 2023 levels into 2024.
Donations and community relations increased during 2022 as a result of initiatives designed to deepen and strengthen our relationship with the communities in which we operate and serve, which includes an expanded footprint. During 2023 we maintained the same level of community support as in 2022. In 2024 we do not expect donations and community relations to exceed 2023 levels.
During the second quarter of 2023, we recognized a loss related to the settlement of a business matter. No further losses are anticipated related to this matter. As such, other losses are expected to decline during 2024 when compared to 2023 levels.
The fluctuations in all other noninterest expenses are spread throughout various categories, none of which is individually significant.
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Analysis of Changes in Financial Condition
The following table shows the composition and changes in our balance sheet as of December 31:
Change
ASSETS
AFS securities
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities
A discussion of changes in balance sheet amounts by major categories follows:
Cash and cash equivalents
Included in cash and cash equivalents are funds held with the FRB which fluctuate from period to period. Cash levels declined slightly during 2023 driven by funding for loan growth.
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AFS securities
The primary objective of our investing activities is to manage our overall exposure to changes in interest rates. Secondary considerations include ensuring ample access to liquidity, generating returns, and providing current income. The following is a schedule of the carrying value of AFS securities as of December 31:
Excluding those holdings in government sponsored enterprises and municipalities within the State of Michigan, there were no investments in securities of any one issuer that exceeded 10% of shareholders’ equity during 2023, 2022, and 2021. We have a policy prohibiting investments in securities that we deem unsuitable due to their inherent credit or market risks. Prohibited investments include stripped mortgage-backed securities, zero coupon bonds, non-government agency asset-backed securities, and structured notes. Our holdings in mortgage-backed securities and collateralized mortgage obligations include only government agencies and government sponsored agencies as we hold no investments in private label mortgage-backed securities or collateralized mortgage obligations.
The following is a schedule of maturities of AFS securities and their weighted average yields as of December 31, 2023. Weighted average yields have been computed on an FTE basis using a tax rate of 21%. Our auction rate money market preferred investments are long-term floating rate instruments. The issuers of auction rate securities generally have the right to redeem or refinance the debt. Because of their lack of contractual maturities, auction rate money market preferred stocks are not reported by a specific maturity group. Mortgage-backed securities and collateralized mortgage obligations are not reported by a specific maturity group due to their variable monthly payments. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations.
Maturing
U.S. Treasury $ — — $ 214,801 0.98 $ — — $ — — $ — —
Mortgage-backed securities — — — — — — — — 32,815 2.36
Collateralized mortgage obligations — — — — — — — — 177,775 2.91
Auction rate money market preferred — — — — — — — — 2,931 7.78
Corporate — — — — 6,950 3.78 — — — —
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Loans
Loans are the largest component of earning assets. The proper management of credit and market risk inherent in the loan portfolio is critical to our financial stability. To control these risks, we have adopted strict underwriting standards, lending limits to a single borrower, loan to collateral value limits, and a defined market area. We also monitor and limit loan concentrations to specific industries. We have no foreign loans and there were no concentrations greater than 10% of total loans that are not disclosed as a separate category in the following table.
The following table presents the composition of the loan portfolio for the years ended December 31:
The following table presents the change in the loan portfolio categories for the years ended December 31:
$ Change % Change $ Change % Change $ Change % Change
We've experienced an increase in the commercial loan portfolio in recent periods as demand has increased. With the increased activity in mortgage lending in the second quarter of 2023, we elected to resume participation in a mortgage purchase program. Our participation in this program paused during most of 2022 and the first quarter of 2023 due to low mortgage volume. Residential mortgage lending activities continues to increase despite increased interest rates. As interest rates are expected to remain high throughout 2024, growth in residential loans is anticipated to continue, but at a slower pace. We've experienced growth in the consumer portfolio and expect this trend to continue in 2024.
Accrued interest receivable and other assets
Other assets consist primarily of prepaid expenses, OMSR, and net deferred tax assets. For more information related to estimates and deferred taxes, refer to “Note 1 – Significant Accounting Policies” and “Note 15 – Federal Income Taxes” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data.
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Deposits
Deposits are our primary source of funding. The following table presents the composition of the deposit portfolio as of December 31:
The following table presents the change in the deposit categories for the years ended December 31:
$ Change % Change $ Change % Change
Total deposits have decreased over the past 12 months driven by a decline in demand deposits. We have experienced significant growth in certificates of deposit accounts during 2023 as a result of increased interest rates. We expect interest rates on deposits to continue to rise into 2024 due to competitive pressures, and anticipate a continuation in the shift of customers moving to higher interest earning products.
The following table presents estimated balances of uninsured deposits as of December 31:
Uninsured deposits are the portion of deposit accounts in U.S. offices that exceed the FDIC insurance limits. The balance provided above are estimates and reflect the methodologies and assumptions used for regulatory reporting of uninsured deposits. The remaining maturity of estimated uninsured certificates of deposit, by account, as of December 31, 2023 is presented in the table below. Estimated uninsured certificates of deposit is based on individual accounts and does not reflect uninsured balances by account owner.
Maturity
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Borrowed Funds
Borrowed funds include FHLB advances, securities sold under agreements to repurchase, subordinated debt, and federal funds purchased. The balance of borrowed funds fluctuates from period to period based on our funding needs that arise from changes in loans, investments, and deposits. To provide balance sheet growth, we may utilize borrowings and brokered deposits to fund earning assets.
The following table presents borrowed funds balances as of December 31:
FHLB advances outstanding as of December 31, 2023 were short-term, with maturities within a week after December 31, 2023. In 2021, we completed a private placement of $30,000 in aggregate principal amount of 3.25% Fixed-to-Floating Rate Subordinated Notes due 2031 (the "Notes"). The Notes will initially bear a fixed interest rate of 3.25% until June 15, 2026, after which time until maturity on June 15, 2031, the interest rate will reset quarterly to an annual floating rate equal to the then-current 3-month SOFR plus 256 basis points. The Notes are redeemable by us at our option, in whole or in part, on or after June 15, 2026. The Notes are not subject to redemption at the option of the holders. For additional disclosure related to borrowed funds, see “Note 8 – Borrowed Funds” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data.
Accrued interest payable and other liabilities
Included in accrued interest payable and other liabilities are obligations related to our defined benefit pension plan and other employee benefits. For more information on the defined benefit pension plan and other employee benefits, see “Note 12 – Benefit Plans” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data.
Contractual Obligations and Loan Commitments
We have various financial obligations, including contractual obligations and commitments related to deposits and borrowings, which may require future cash payments. We also have loan related commitments that may impact liquidity. The commitments include unused lines of credit, commercial and standby letters of credit, and commitments to grant loans. These commitments to grant loans include residential mortgage loans with the majority committed to be sold to the secondary market. Many of these commitments historically have expired without being drawn upon and do not necessarily indicate our future cash requirements.
For additional disclosure related to Contractual Obligations and Loan Commitments, see “Note 9 – Off-Balance-Sheet Activities, Commitments and Other Matters” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data.
Capital
Capital consists solely of common stock, retained earnings, and accumulated other comprehensive income (loss). We are authorized to raise capital through dividend reinvestment, employee and director stock purchases, and shareholder stock purchases. Pursuant to these authorizations, we issued 75,488 shares or $1,617 of common stock during 2023, and 74,445 shares or $1,762 of common stock in 2022. We offer the Directors Plan in which participants purchase stock units through deferred fees, in lieu of cash payments. Pursuant to this plan, we increased shareholders’ equity by $529 and $463 during 2023 and 2022, respectively. We also grant restricted stock awards pursuant to the RSP, effective June 24, 2020. Pursuant to this plan, we increased shareholders’ equity by $253 and $147 during 2023 and 2022.
We have publicly announced a common stock repurchase plan. Pursuant to this plan, we repurchased 149,020 shares or $3,415 of common stock during 2023 and 47,665 shares or $1,124 during 2022. As of December 31, 2023, we were authorized to repurchase up to an additional 270,806 shares of common stock.
The FRB has established minimum risk-based capital guidelines. Pursuant to these guidelines, a framework has been established that assigns risk weights to each category of on and off-balance-sheet items to arrive at risk adjusted total assets. Regulatory capital is divided by the risk adjusted assets with the resulting ratio compared to the minimum standard to determine whether a corporation has adequate capital.
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The common equity tier 1 capital ratio has a minimum requirement of 4.50%. The minimum standard for primary, or Tier 1 capital is 6.00% and the minimum standard for total capital is 8.00%. The minimum requirements presented below include the minimum required capital levels based on the Basel III Capital Rules. Capital requirements to be considered well capitalized are based upon prompt corrective action regulations, as amended to reflect the changes under the Basel III Capital Rules. The following table sets forth these requirements and our ratios as of December 31:
Total capital includes Tier 1 capital and Tier 2 capital. Tier 2 capital includes a permissible portion of the allowances for credit losses and subordinated debt, net of unamortized issuance costs. There are no significant regulatory constraints placed on our capital. At December 31, 2023, the Bank exceeded minimum capital requirements. For further information regarding the Bank’s capital requirements, see “Note 10 – Minimum Regulatory Capital Requirements” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data.
Liquidity
Liquidity is monitored regularly by our ALCO, which consists of members of senior management. The committee reviews projected cash flows, key ratios, and liquidity available from both primary and secondary sources.
Our primary sources of liquidity are cash and cash equivalents and unencumbered AFS securities. These categories totaled $381,417 or 18.52% of assets as of December 31, 2023, compared to $488,981 or 24.08% as of December 31, 2022. The decline in the amount and percentage of primary liquidity is a direct result of an increase in loans and a decrease in unencumbered AFS securities collateralizing non-market funding. Liquidity is important for financial institutions because of their need to meet loan funding commitments, depositor withdrawal requests, and various other commitments including expansion of operations, investment opportunities, and payment of cash dividends. Based on these same factors, daily liquidity could vary significantly.
Deposit accounts are our primary source of funds. Our secondary sources include the ability to borrow from the FHLB, from the FRB, and through various correspondent banks in the form of federal funds purchased and a line of credit. These funding methods typically carry a higher interest rate than traditional market deposit accounts. Some borrowed funds, including FHLB advances, FRB Discount Window advances, and repurchase agreements, require us to pledge assets, typically in the form of AFS securities or loans, as collateral. As of December 31, 2023, we had available lines of credit of $338,080.
The frequency and complexity of our liquidity stress testing has increased due to economic uncertainly and changes within the interest rate and economic environment. Our liquidity position remained strong at the end of 2023, which is illustrated in the following table:
Total cash and cash equivalents $ 33,672
Available lines of credit
Fed funds lines with correspondent banks 93,000
FRB Discount Window 28,220
Other lines of credit 5,000
Total available lines of credit 338,080
Unencumbered lendable value of FRB collateral, estimated1 320,000
Total cash and liquidity $ 691,752
(1)Includes estimated unencumbered lendable value of FHLB collateral of $230,000
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The following table summarizes our sources and uses of cash for the years ended December 31:
Net cash provided by (used in) operating activities $ 23,715 $ 26,937 $ (3,222)
Net cash provided by (used in) financing activities (3,188) 12,912 (16,100)
Increase (decrease) in cash and cash equivalents (5,252) (66,406) 61,154
Fair Value
We utilize fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. AFS securities, cash flow hedge derivative instruments and certain liabilities are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record at fair value other assets on a nonrecurring basis, such as mortgage loans AFS, impaired loans, goodwill, foreclosed assets, OMSR, and certain other assets and liabilities. These nonrecurring fair value adjustments typically involve the application of lower of cost or market accounting or write downs of individual assets.
For further information regarding fair value measurements, see “Note 1 – Significant Accounting Policies” and “Note 17 – Fair Value” of “Notes to Consolidated Financial Statements” in Item 8. Financial Statements and Supplementary Data.
Market Risk
Our primary market risks are interest rate risk and liquidity risk. IRR is the exposure of our net interest income to changes in interest rates. IRR results from the difference in the maturity or repricing frequency of a financial institution's interest earning assets and its interest bearing liabilities. Managing IRR is the fundamental method by which financial institutions earn income and create shareholder value. Excessive exposure to IRR could pose a significant risk to our earnings and capital.
The FRB has adopted a policy requiring banks to effectively manage the various risks that can have a material impact on safety and soundness. The risks include credit, interest rate, liquidity, operational, and reputational. We have policies, procedures, and internal controls for measuring and managing these risks. Specifically, our ALCO policy and procedures include defining acceptable types and terms of investments and funding sources, liquidity requirements, limits on investments in long-term assets, limiting the mismatch in repricing opportunities of assets and liabilities, and the frequency of measuring and reporting to our Board of Directors.
The primary technique to measure IRR is simulation analysis. Simulation analysis forecasts the effects on the balance sheet structure and net interest income under a variety of scenarios that incorporate changes in interest rates, the shape of the yield curve, interest rate relationships, loan prepayments, and funding sources. These forecasts are compared against net interest income projected in a stable interest rate environment. While many assets and liabilities reprice either at maturity or in accordance with their contractual terms, several balance sheet components demonstrate characteristics that require an evaluation to more accurately reflect their repricing behavior. Key assumptions in the simulation analysis include prepayments on loans, probable calls of investment securities, changes in market conditions, loan volumes and loan pricing, deposit sensitivity, and customer preferences. These assumptions are inherently uncertain as they are subject to fluctuation and revision in a dynamic rate environment. As a result, the simulation analysis cannot precisely forecast the impact of rising and falling interest rates on net interest income. Actual results will differ from simulated results due to many other factors, including changes in balance sheet components, interest rate changes, changes in market conditions, and management strategies. We regularly monitor our projected net interest income sensitivity to ensure that it remains within established limits.
Gap analysis, the secondary method to measure IRR, measures the cash flows and/or the earliest repricing of our interest bearing assets and liabilities. This analysis is useful for measuring trends in the repricing characteristics of the balance sheet. Significant assumptions are required in this process because of the embedded repricing options contained in assets and liabilities. Residential real estate and consumer loans allow the borrower to repay the balance prior to maturity without penalty, while commercial and agricultural loans may have prepayment penalties. The amount of prepayments is dependent upon many factors, including the interest rate of a given loan in comparison to the current offering rates, the level of home sales, and the overall availability of credit in the market place. Generally, a decrease in interest rates will result in an increase in cash flows from these assets. A significant portion of our securities are callable or have prepayment options. The call and prepayment options are more likely to be exercised in a period of decreasing interest rates. Savings and demand accounts may generally be withdrawn on request without prior notice. The timing of cash flows from these deposits is estimated based on historical experience. Certificates of deposit have penalties that discourage early withdrawals.
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We do not believe there has been a material change in the nature or categories of our primary market risk exposure, or the particular markets that present the primary risk of loss. We do not know of or expect there to be any material change in the general nature of our primary market risk exposure in the near term, and we do not expect to make material changes to our market risk methods in the near term. We may change those methods in the future to adapt to changes in circumstances or to implement new techniques.
Gap analysis is also utilized as a method to measure interest rate sensitivity. Interest rate sensitivity is determined by the amount of earning assets and interest bearing liabilities repricing within a specific time period, and their relative sensitivity to a change in interest rates. We strive to achieve reasonable stability in the net interest margin through periods of changing interest rates. One specific focus of interest rate sensitivity is the loan portfolio, primarily with commercial and agricultural loans.
The following table shows the maturity of loans outstanding at December 31, 2023 based on contractual terms. Also provided are the amounts classified according to the sensitivity to changes in interest rates.
1 Yearor Less 1 to 5Years 5 to 15Years Over 15Years Total
Fixed interest rates
Variable interest rates
Advances to mortgage brokers — — — — —
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
The information presented in the section captioned “Market Risk” in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations is incorporated herein by reference.
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Item 8. Financial Statements and Supplementary Data.
The following consolidated financial statements accompanied by the report of our independent registered public accounting firm are set forth beginning on the following page of this report:
Consolidated Balance Sheets
Consolidated Statements of Changes in Shareholders’ Equity
Consolidated Statements of Income
Consolidated Statements of Comprehensive Income (Loss)
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Supplementary data regarding quarterly results of operations is included in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
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Report of Independent Registered Public Accounting Firm
Shareholders and Board of Directors
Isabella Bank Corporation (the "Corporation")
Mount Pleasant, Michigan
Opinion on the Financial Statements and Internal Control over Financial Reporting
We have audited the accompanying consolidated balance sheets of Isabella Bank Corporation as of December 31, 2023 and 2022, and the related consolidated statements of changes in shareholders’ equity, income, comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2023, and the related notes (collectively referred to as the financial statements). We also have audited Isabella Bank Corporation’s internal control over financial reporting as of December 31, 2023, based on criteria established in the Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria).
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Isabella Bank Corporation as of December 31, 2023 and 2022, and the consolidated results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2023, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion Isabella Bank Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2023, based on the COSO criteria.
Adoption of New Accounting Standard
As discussed in Notes 1 and 4 to the consolidated financial statements, Isabella Bank Corporation changed its method for accounting for credit losses on loans in 2023. As explained below, auditing the Corporation's allowance for credit losses on loans, including adoption of the new accounting guidance related to the estimate of allowance for credit losses on loans, was a critical audit matter.
Basis for Opinions
Isabella Bank Corporation’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on Isabella Bank Corporation’s consolidated financial statements and on Isabella Bank Corporation’s internal control over financial reporting based on our integrated audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to Isabella Bank Corporation in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.
Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material misstatement exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. We believe that our audits provide a reasonable basis for our opinions.
Definition and Limitations of Internal Control over Financial Reporting
A corporation’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of consolidated financial statements for external purposes in accordance with generally accepted accounting principles. A corporation’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the corporation; (2) provide reasonable assurance that transactions are recorded as
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necessary to permit preparation of consolidated financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the corporation are being made only in accordance with authorizations of management and directors of the corporation; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the corporation’s assets that could have a material effect on the consolidated financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
One Critical Audit Matter
The critical audit matter communicated below arising from the current period audit of the financial statements was communicated or is required to be communicated to the Corporation's audit committee and (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective or complex judgments. The communication of the critical audit matter does not alter in any way our opinion on the consolidated financial statements, taken as a whole, nor our opinion on internal control over financial reporting, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.
Allowance for Credit Losses
Description of the Matter
The Corporation’s loan portfolio totaled $1.3 billion as of December 31, 2023 and the associated allowance for credit losses on loans was $13.1 million at that date. The Corporation’s unfunded loan commitments totaled $321.7 million, with an associated allowance for credit loss of $315 thousand. Together these amounts represent the allowances for credit losses (“ACL”). As described in Notes 1 and 4 to the consolidated financial statements, in the cases of loans, the allowance for credit losses is a contra-asset valuation account, calculated in accordance with ASC 326 that is deducted from the amortized cost basis of loans to present the net amount expected to be collected. As described in Notes 1 and 9 to the consolidated financial statements, in the case of unfunded loan commitments, the allowance for credit losses is a liability account, calculated in accordance with ASC 326, reported as a component of accrued interest payable and other liabilities. The Corporation adopted ASC 326 effective January 1, 2023. The amount of each allowance account represented management’s best estimate of current expected credit losses on these financial instruments considering all available information, from internal and external sources, relevant to assessing exposure to credit loss over the contractual term of the instrument. In calculating the allowance for credit losses, most loans were segmented into pools based upon similar characteristics and risk profiles. For each loan pool, management measured expected credit losses over the life of each loan utilizing a model which measured probability of default (“PD”), probability of attrition (“PA”), loss given default (“LGD”), and exposure at default (“EAD”). Expected credit losses were calculated as the product of PD (adjusted for attrition), LGD, and EAD. PD and PA were estimated by analyzing internally sourced data related to historical performance of each loan pool over an economic cycle. PD and PA were adjusted to reflect the current impact of certain macroeconomic variables as well as their expected changes over a reasonable and supportable forecast period. After the reasonable and supportable forecast period, the forecasted macroeconomic variables were reverted to their historical mean utilizing a rational, systematic basis. The LGD was based on historical recovery averages for each loan pool, adjusted to reflect the current impact of certain macroeconomic variables as well as their expected changes over the reasonable and supportable forecast period. EAD was estimated using a linear regression model that estimates the average percentage of the loan balance that remains at the time of default. In some cases, management determined that an individual loan exhibited unique risk characteristics which differentiated the loan from other loans with the identified loan pools. In such cases the loans were evaluated for expected credit losses on an individual basis and excluded from the collective evaluation. Management qualitatively adjusted model results for risk factors that were not considered within the modeling processes but were nonetheless relevant in assessing the expected credit losses within the loan pools. These qualitative factor adjustments modified management’s estimate of expected credit losses by a calculated percentage or amount based upon the estimated level of risk.
Auditing management’s estimate of the ACL involved a high degree of subjectivity due to the nature of the qualitative factor adjustments included in the allowances for credit losses and complexity due to the implementation of the PD, PA, LGD, and EAD models (the “Models”). Management’s identification and measurement of the qualitative factor adjustments is highly judgmental and could have a significant effect on the ACL.
How We Addressed the Matter in Our Integrated Audit
We obtained an understanding of the Corporation’s process for establishing the ACL, including the implementation of Models and the qualitative factor adjustments of the ACL. We evaluated the design and tested the operating effectiveness of related controls over the reliability and accuracy of data used to calculate and estimate the various components of the ACL, the
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accuracy of the calculation of the ACL, management’s review and approval of methodologies used to establish the ACL, validation procedures over the Models, analysis of changes in various components of the ACL relative to changes in the Corporation’s loan portfolio and economy and evaluation of the overall reasonableness and appropriateness of the ACL. In doing so, we tested the operating effectiveness of review and approval controls in the Corporation’s governance process designed to identify and assess the qualitative factor adjustments which is meant to measure expected credit losses associated with factors not captured fully in the other components of the ACL.
To test the reasonableness of the qualitative factor adjustments, we performed audit procedures that included, among others testing the appropriateness of the methodologies used by the Corporation to estimate the ACL, testing the completeness and accuracy of data and information used by the Corporation in estimating the components of the ACL, assessing the reasonableness of the Models, evaluating the appropriateness of assumptions used in estimating the qualitative factor adjustments, analyzing the changes in assumptions and various components of the ACL relative to changes in the Corporation’s loan portfolio and the economy and evaluating the appropriateness and level of the qualitative factor adjustments. For example, we evaluated the appropriateness of the design and operation of the model, analyzed the changes, assumptions and modifications made to the qualitative factor adjustments, and evaluated the appropriateness and completeness of risk factors used in determining the amount of the qualitative factor adjustments. We also evaluated the data and information utilized by management to estimate the qualitative factor adjustments by independently obtaining internal and external data and information to assess the appropriateness of the data and information used by management and to consider the existence of new and potentially contradictory information used. In addition, we evaluated the overall ACL amounts, inclusive of the adjustments for the qualitative factor adjustments, and whether the amount appropriately reflects losses expected in the loan portfolio as of the consolidated balance sheet date by comparing the overall ACL to those established by similar banking institutions with similar loan portfolios. We also reviewed subsequent events and transactions and considered whether such information serves to corroborate or contradict the Corporation’s conclusion.
/s/Rehmann Robson LLC
We have served as Isabella Bank Corporation's independent auditor since 1996.
Saginaw, Michigan
March 7, 2024
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CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
December 31
ASSETS
Cash and cash equivalents
Cash and demand deposits due from banks $ 25,628 $ 27,420
Fed Funds sold and interest bearing balances due from banks 8,044 11,504
Mortgage loans AFS — 379
Corporate owned life insurance policies 33,892 32,988
Equity securities without readily determinable fair values 15,848 15,746
Accrued interest receivable and other assets 35,130 33,586
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits
Borrowed funds
Federal funds purchased and repurchase agreements 46,801 57,771
Subordinated debt, net of unamortized issuance costs 29,335 29,245
Accrued interest payable and other liabilities 16,735 12,766
Shareholders’ equity
Shares to be issued for deferred compensation obligations 3,693 5,005
Accumulated other comprehensive income (loss) (25,896) (37,194)
The accompanying notes are an integral part of these consolidated financial statements.
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CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(Dollars in thousands except per share amounts)
Common Stock
Share-based payment awards under the Directors Plan — — 433 — — 433
Cash dividends paid ($1.08 per common share) — — — (8,367) — (8,367)
Share-based payment awards under the Directors Plan — — 463 — — 463
Cash dividends paid ($1.09 per common share) — — — (8,082) — (8,082)
Share-based payment awards under the Directors Plan — — 529 — — 529
Cash dividends paid ($1.12 per common share) — — — (8,216) — (8,216)
The accompanying notes are an integral part of these consolidated financial statements.
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CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands except per share amounts)
Year Ended December 31
Interest income
AFS securities
Interest expense
Borrowings
Federal funds purchased and repurchase agreements 961 79 53
Subordinated debt, net of unamortized issuance costs 1,065 1,065 615
Noninterest income
Earnings on corporate owned life insurance policies 920 884 800
Noninterest expenses
Earnings per common share
Cash dividends per common share $ 1.12 $ 1.09 $ 1.08
The accompanying notes are an integral part of these consolidated financial statements.
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CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Dollars in thousands)
Year Ended December 31
Unrealized gains (losses) on AFS securities
Unrealized gains (losses) arising during the period 13,365 (50,015) (8,371)
Unrealized gains (losses) on AFS securities, net of tax 10,629 (39,701) (6,612)
Unrealized gains (losses) on derivative instruments
Tax effect (1) — — (11)
Unrealized gains (losses) on derivative instruments, net of tax — — 42
Change in unrecognized pension cost on defined benefit pension plan
Change in unrecognized pension cost arising during the period 752 762 955
Net change in unrecognized pension cost 847 821 924
Change in unrealized pension cost, net of tax 669 648 731
(1)See “Note 16 – Accumulated Other Comprehensive Income (Loss)” in the accompanying notes to consolidated financial statements for tax effect reconciliation.
The accompanying notes are an integral part of these consolidated financial statements.
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CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
Year Ended December 31
OPERATING ACTIVITIES
Reconciliation of net income to net cash provided by operating activities:
Amortization of acquisition intangibles 3 15 29
Amortization of subordinated debt issuance costs 90 87 52
Net gains on sale of AFS securities (67) — —
Net gain on sale of mortgage loans (317) (631) (1,694)
Change in OMSR valuation allowance — (532) —
Net (gains) losses on foreclosed assets (158) (13) (39)
Gains from redemption of corporate owned life insurance policies — (57) (271)
Share-based payment awards under the Directors Plan 529 463 433
Share-based payment awards under the RSP 253 147 86
Deferred income tax expense (benefit) 1,008 13 (523)
Net changes in operating assets and liabilities which provided (used) cash:
Accrued interest receivable and other assets (809) (2,813) 1,208
Accrued interest payable and other liabilities 1,006 2,182 146
INVESTING ACTIVITIES
Activity in AFS securities
Purchase of equity investments (102) (250) —
Proceeds from sales of foreclosed assets 569 241 716
Purchases of corporate owned life insurance policies — — (4,272)
Proceeds from redemption of corporate owned life insurance policies — 359 1,114
Proceeds from sale of FHLB Stock — 2,288 —
Purchases of FRB Stock — (401) —
Funding of low income housing tax credit investments (623) (46) (413)
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CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
(Dollars in thousands)
Year Ended December 31
FINANCING ACTIVITIES
Issuance of subordinated debt, net of unamortized issuance costs — — 29,106
Net cash provided by (used in) financing activities (3,188) 12,912 62,824
SUPPLEMENTAL CASH FLOWS INFORMATION:
SUPPLEMENTAL NONCASH INFORMATION:
Investment in low income housing tax credits $ 5,000 $ — $ —
Transfers of loans to foreclosed assets 378 456 361
The accompanying notes are an integral part of these consolidated financial statements.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands except per share amounts)
Note 1 – Significant Accounting Policies
BASIS OF PRESENTATION AND CONSOLIDATION: The consolidated financial statements include the accounts of Isabella Bank Corporation, a financial services holding company, and its wholly owned subsidiary, Isabella Bank. All intercompany balances and accounts have been eliminated in consolidation. References to “the Corporation”, “Isabella”, “we”, “our”, “us”, and similar terms refer to the consolidated entity consisting of Isabella Bank Corporation and its subsidiary. References to Isabella Bank or “the Bank” refers to Isabella Bank Corporation’s subsidiary, Isabella Bank.
For additional information, see “Note 18 – Related Party Transactions.”
NATURE OF OPERATIONS: Isabella Bank Corporation is a financial services holding company offering a wide array of financial products and services in several mid-Michigan counties. Our banking subsidiary, Isabella Bank, offers banking services throughout 31 locations, 24 hour banking services locally and nationally through shared ATMs, online banking, mobile banking, and direct deposits to businesses, institutions, individuals and their families. Lending services offered include commercial loans, agricultural loans, residential real estate loans, and consumer loans. Deposit services include interest and noninterest bearing checking accounts, savings accounts, money market accounts, certificates of deposit, direct deposits, cash management services, mobile and internet banking, and ATMs. Other related financial products include trust and investment services, safe deposit box rentals, and various insurance related products. Active competition, principally from other commercial banks, savings and loan associations, mortgage brokers, finance companies, credit unions, retail brokerage firms, and insurance companies, exists in all of our principal markets. Our results of operations can be significantly affected by changes in interest rates, changes in the local economic environment and changes in regulations.
USE OF ESTIMATES: In preparing consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, we make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the consolidated balance sheet and reported amounts of revenues and expenses during the reporting year. Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the ACL, the fair value of AFS investment securities, and the valuation of goodwill and other intangible assets.
ACCOUNTING CHANGES AND RECLASSIFICATIONS: Certain amounts reported in the 2022 and 2021 consolidated financial statements have been reclassified to conform with the 2023 presentation.
On January 1, 2023, we adopted ASU 2016-13, “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments,” as subsequently updated for certain clarifications, targeted relief and codification improvements. ASC 326 updated the measurement for credit losses for AFS debt securities and assets measured at amortized cost, which includes loans, trade receivables, and any other financial assets with the contractual right to receive cash and requires enhanced disclosures related to the significant estimates and judgments used in estimating credit losses.
Prior to ASU No. 2016-13, GAAP required an “incurred loss” methodology for recognizing credit losses that delayed recognition until it was probable a loss has been incurred. Under the incurred loss approach, entities were limited to a probable initial recognition threshold when credit losses were measured; an entity generally considered only past events and current conditions when measuring the incurred loss.
We adopted ASC 326 using the modified retrospective method for all financial assets measured at amortized cost and off balance sheet credit exposures. Results for reporting periods beginning January 1, 2023 are presented under ASC 326, while prior period amounts continue to be reported in accordance with previously applicable GAAP and the accounting policies described in our Annual Report on Form 10-K for the year ended December 31, 2022. We recorded a net decrease to retained earnings of $2,417 as of January 1, 2023 for the cumulative effect of adopting ASC 326.
We adopted ASC 326 using the prospective transition approach for AFS debt securities for which other-than-temporary impairment had been recognized prior to January 1, 2023. As a result, the amortized cost basis remains the same before and after the effective date of ASC 326. The effective interest rate on these debt securities was not changed. Amounts previously recognized in accumulated other comprehensive income as of January 1, 2023 relating to improvements in cash flows expected to be collected will be accreted into income over the remaining life of the asset. Recoveries of amounts previously written off relating to improvements in cash flows beginning January 1, 2023 will be recorded in earnings when received.
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The following table details the impact of the adoption of ASC 326:
Loans:
Off-balance-sheet credit exposures $ — $ 315 $ 315 $ (249)
In connection with the adoption of ASC 326, we revised certain accounting policies and implemented certain accounting policy elections, which are provided below. All other accounting policies are materially the same as those discussed in Note 1 to the Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2022.
FAIR VALUE MEASUREMENTS: Fair value refers to the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants in the market in which the reporting entity transacts such sales or transfers based on the assumptions market participants would use when pricing an asset or liability. Assumptions are developed based on prioritizing information within a fair value hierarchy that gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data, such as the reporting entity’s own data. We may choose to measure eligible items at fair value at specified election dates.
For assets and liabilities recorded at fair value, it is our policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements for those financial instruments for which there is an active market. In cases where the market for a financial asset or liability is not active, we include appropriate risk adjustments that market participants would make for nonperformance and liquidity risks when developing fair value measurements. Fair value measurements for assets and liabilities for which limited or no observable market data exists are accordingly based primarily upon estimates, are often calculated based on the economic and competitive environment, the characteristics of the asset or liability and other factors. Therefore, the results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values.
We utilize fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Investment securities AFS and derivative instruments are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record other assets and liabilities at fair value on a nonrecurring basis, such as mortgage loans AFS, collateral dependent loans, foreclosed assets, OMSR, goodwill, and certain other assets and liabilities. These nonrecurring fair value adjustments typically involve the application of lower of cost or market accounting or write downs of individual assets.
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Fair Value Hierarchy
Under fair value measurement and disclosure authoritative guidance, we group assets and liabilities measured at fair value into three levels, based on the markets in which the assets and liabilities are traded, and the reliability of the assumptions used to determine fair value, based on the prioritization of inputs in the valuation techniques. These levels are:
The asset’s or liability’s fair value measurement level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. Valuation techniques maximize the use of observable inputs and minimize the use of unobservable inputs. Transfers between measurement levels are recognized at the end of reporting periods.
For further discussion of fair value considerations, refer to “Note 17 – Fair Value.”
SIGNIFICANT GROUP CONCENTRATIONS OF CREDIT RISK: Most of our activities are conducted with customers located within the central Michigan area. A significant amount of our outstanding loans are secured by commercial and residential real estate. Other than these types of loans, there is no significant concentration to any other industry or any one customer.
CASH AND CASH EQUIVALENTS: For purposes of the consolidated statements of cash flows, cash and cash equivalents include cash and balances due from banks, federal funds sold, and other deposit accounts. Generally, federal funds sold are for a one day period. We maintain deposit accounts in various financial institutions which generally exceed federally insured limits or are not insured. We do not believe we are exposed to any significant interest, credit or other financial risk as a result of these deposits.
AFS SECURITIES: Purchases of investment securities are generally classified as AFS. However, we may elect to classify securities as either held to maturity or trading. Securities classified as AFS debt securities are recorded at fair value, with unrealized gains and losses, net of the effect of deferred income taxes, excluded from earnings and reported in other comprehensive income (loss). Included in AFS securities are auction rate money market preferred securities. These investments, for federal income tax purposes, have no federal income tax impact given the nature of the investments. Auction rate money market preferred securities are recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income (loss). Purchase premiums and discounts are recognized in interest income using the interest method over the term of the securities. Realized gains and losses on the sale of AFS securities are determined using the specific identification method.
ACL - AFS SECURITIES: AFS securities are reviewed quarterly for possible credit impairment. In determining whether a credit-related impairment exists for debt securities, we assess whether: (a) we do not have the intent to sell the security; and (b) it is more likely than not we will not have to sell the security before recovery of its cost basis. If either of these conditions are met, any previously recognized allowances are charged-off and the security's amortized cost is written down to fair value through income. If these conditions are not met, the security is evaluated to determine whether the decline in fair value has resulted from credit losses or other factors.
In order to determine the amount of the credit loss for a debt security, we calculate the recovery value by performing a discounted cash flow analysis based on the current cash flows and future cash flows we expect to recover. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an allowance for credit losses is recorded for the credit loss, limited by the amount that the fair value is less than the amortized cost basis. The amount of the impairment related to other risk factors is recognized as a component of other comprehensive income. Adjustments to the allowance are reported in the income statement as a provision for credit losses.
We made an accounting policy election to exclude accrued interest receivable on AFS securities from the estimate of credit losses. Accrued interest receivable on AFS securities was $2,247 at December 31, 2023. AFS securities are charged-off against the allowance or, in the absence of any allowance, written down through income when deemed uncollectible by management, or when criteria regarding intent or requirement to sell is met.
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LOANS: Loans that we have the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at their outstanding principal balance adjusted for any charge-offs, the ACL, and any deferred fees or costs. Interest income on loans is accrued over the term of the loan based on the principal amount outstanding. Loan origination fees and certain direct loan origination costs are capitalized and recognized as a component of interest income over the term of the loan using the appropriate yield methods.
The accrual of interest on agricultural, commercial and mortgage loans is discontinued at the time the loan is 90 days or more past due unless the credit is well secured and in the process of collection. Consumer loans are typically charged-off no later than 180 days past due. Past due status is based on contractual terms of the loan. In all cases, loans are placed in nonaccrual status or charged-off at an earlier date if collection of principal or interest is considered doubtful. For loans that are placed on nonaccrual status or charged-off, all interest accrued in the current calendar year, but not collected, is reversed against interest income while interest accrued in prior calendar years, but not collected is charged against the ACL. Interest income on loans in nonaccrual status is not recognized until qualifying for return to accrual status. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured. For loans not classified as nonaccrual, interest income continues to be accrued over the term of the loan based on the principal amount outstanding.
ACL - LOANS: The ACL on loans is calculated in accordance with ASC 326 and is deducted from the amortized cost basis of loans to present our best estimate of the net amount expected to be collected. The ACL is established through a provision for credit losses charged to earnings. Loan losses are charged against the allowance when we believe the uncollectability of the loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. We made an accounting policy election to exclude accrued interest receivable on loans from the estimate of credit losses. Accrued interest receivable on loans was $5,920 at December 31, 2023.
We evaluate the ACL on a regular basis. Our periodic review of the collectability of loans considers historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions, and reasonable and supportable forecasts. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
The ACL consists of a general component and loans individually analyzed. The general component covers loans not specifically analyzed and is based on historical loss experience, current conditions, and reasonable and supportable forecasts. The general component also includes uncertainties that we believe could affect our estimate of probable losses based on qualitative factors.
Loans in nonaccrual status are individually analyzed on a loan-by-loan basis. Loans evaluated individually are not included in the general, or pooled, component of the ACL. For collateralized loans, the loan's specific allowance is measured by the fair value of the collateral approach. The specific reserve is based on the fair value of the collateral, less costs to sell if foreclosure is probable, and an allowance is established when the collateral value is lower than the carrying value of the loan. When the discounted cash flow method is used to measure the loan's specific allowance, the effective interest rate is used to discount expected cash flows to incorporate expected prepayments. An allowance is established when the discounted cash flows are lower than the carrying value of the loan. For large groups of smaller-balance, homogeneous loans, we may collectively evaluate these loans for measurement of an allowance.
LOANS HELD FOR SALE: Mortgage loans held for sale on the secondary market are carried at the lower of cost or fair value as determined by aggregating outstanding commitments from investors or current investor yield requirements. Net unrealized losses, if any, would be recognized as a component of other noninterest expenses.
Mortgage loans held for sale are sold with the mortgage servicing rights retained by us. Gains or losses on sales of mortgage loans are recognized based on the difference between the selling price and the carrying value of the related mortgage loans sold.
TRANSFERS OF FINANCIAL ASSETS: Transfers of financial assets, including mortgage loans and participation loans, are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is determined to be surrendered when 1) the assets have been legally isolated from us, 2) the transferee obtains the right (free of conditions that constrain it from taking advantage of the right) to pledge or exchange the transferred assets, and 3) we do not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. Other than servicing, we have no substantive continuing involvement related to these loans.
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SERVICING: Servicing assets are recognized as separate assets when rights are acquired through purchase or through sale of financial assets. We have no purchased servicing rights. For sales of mortgage loans, a portion of the cost of originating the loan is allocated to the servicing right based on relative fair value. Fair value is based on market prices for comparable mortgage servicing contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses.
Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights into tranches based on predominant risk characteristics, such as interest rate, loan type, and investor type. Impairment is recognized through a valuation allowance for an individual tranche, to the extent that fair value is less than the capitalized amount for the tranche. If we later determine that all or a portion of the impairment no longer exists for a particular tranche, a reduction of the valuation allowance may be recorded as an increase to income. Capitalized servicing rights are reported in other assets and are amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. The unpaid principal balance of mortgages serviced for others was $248,756 and $264,206 with capitalized servicing rights of $2,422 and $2,559 at December 31, 2023 and 2022, respectively, which are included in other assets.
Servicing fee income is recorded for fees earned for servicing loans for others. The fees are based on a contractual percentage of the outstanding principal or a fixed amount per loan and are recorded as income when earned. We recorded servicing fee revenue of $630, $669, and $747 related to residential mortgage loans serviced for others during 2023, 2022, and 2021, respectively, which is included in other noninterest income.
FORECLOSED ASSETS: Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at the lower of our carrying amount or fair value less estimated selling costs at the date of transfer, establishing a new cost basis. Any write downs based on the asset’s fair value at the date of acquisition are charged to the ACL. After foreclosure, property held for sale is carried at the lower of the new cost basis or fair value less costs to sell. Impairment losses on property to be held and used are measured at the amount by which the carrying amount of property exceeds its fair value. Costs relating to holding these assets are expensed as incurred. We periodically perform valuations and any subsequent write downs are recorded as a charge to operations, if necessary, to reduce the carrying value of a property to the lower of our carrying amount or fair value less costs to sell. Foreclosed assets of $406 and $439 as of December 31, 2023 and 2022, respectively, are included in other assets.
PREMISES AND EQUIPMENT: Land is carried at cost. Buildings and equipment are carried at cost, less accumulated depreciation which is computed principally by the straight-line method based upon the estimated useful lives of the related assets, which range from 3 to 40 years. Major improvements are capitalized and appropriately amortized based upon the useful lives of the related assets or the expected terms of the leases, if shorter, using the straight-line method. Maintenance, repairs and minor alterations are charged to current operations as expenditures occur. We annually review these assets to determine whether carrying values have been impaired.
EQUITY SECURITIES WITHOUT READILY DETERMINABLE FAIR VALUES: Included in equity securities without readily determinable fair values are our holdings in FHLB stock and FRB stock. Equity securities without readily determinable fair values consist of the following holdings as of December 31:
EQUITY COMPENSATION PLANS: At December 31, 2023, the Directors Plan had 154,119 shares eligible to be issued to participants, for which the Rabbi Trust held 150,581 shares. We had 207,840 shares to be issued at December 31, 2022, with 154,879 shares held in the Rabbi Trust.
Under the RSP, compensation expense for nonvested stock awards is based on the fair value of the award on the measurement date. The fair value of nonvested stock awards is based on the date of the grant and is recognized over the requisite service period. The impact of forfeitures of share-based payment awards on compensation expense is recognized as forfeitures occur.
Compensation costs relating to share-based payment transactions are recognized as the services are rendered, with the cost measured based on the fair value of the equity or liability instruments issued (see “Note 12 – Benefit Plans”).
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CORPORATE OWNED LIFE INSURANCE: We have purchased life insurance policies on key members of management, partially for the purpose of funding certain post-retirement benefits. In the event of death of one of these individuals, we would receive a specified cash payment equal to the face value of the policy. Such policies are recorded at their cash surrender value, or the amount that can be realized on the balance sheet date. Increases in cash surrender value in excess of single premiums paid are reported as other noninterest income.
Of the purchased life insurance policies, we hold post retirement benefits with a present value estimated to be $2,515 and $2,905 as of December 31, 2023 and 2022, respectively, which is included in accrued interest payable and other liabilities. The expenses associated with these policies totaled $173, $61, and $33 for 2023, 2022, and 2021, respectively.
ACQUISITION INTANGIBLES AND GOODWILL: We previously acquired branch facilities and related deposits in business combinations accounted for as a purchase. The acquisitions included amounts related to the valuation of customer deposit relationships (core deposit intangibles). Core deposit intangibles arising from acquisitions are included in goodwill and other intangible assets are being amortized over their estimated lives and evaluated for potential impairment on at least an annual basis. Goodwill, which represents the excess of the purchase price over identifiable assets, is not amortized but is evaluated for impairment on at least an annual basis. Acquisition intangibles and goodwill are typically qualitatively evaluated to determine if it is more likely than not that the carrying balance is impaired. If it is determined that the carrying balance is more likely than not to be impaired, we perform a cash flow valuation to determine the extent of the potential impairment. This valuation method requires a significant degree of our judgment. In the event the projected undiscounted net operating cash flows for these intangible assets are less than the carrying value, the asset is recorded at fair value as determined by the valuation model.
OFF BALANCE SHEET CREDIT RELATED FINANCIAL INSTRUMENTS: In the ordinary course of business, we have entered into commitments to extend credit, including commitments under credit card arrangements, commercial lines of credit, home equity lines of credit, commercial letters of credit, and standby letters of credit. Such financial instruments are recorded only when funded. In connection with these commitments, we established an allowance for credit losses related to off-balance-sheet credit exposures. The allowance, recorded in a liability account, is calculated in accordance with ASC 326 and represents expected credit losses over the contractual period for which we are exposed to credit risk resulting from a contractual obligation to extend credit. The estimate of expected credit losses considers both the likelihood that funding will occur and the amount expected to be funded over the estimated remaining life of the commitment. The likelihood and expected amount of funding are based on historical utilization rates. No allowance is recognized if we have the unconditional right to cancel the obligation. The allowance is reported as a component of accrued interest payable and other liabilities in our consolidated balance sheets. Adjustments to the allowance are reported in our income statement as a component of provision for credit losses.
REVENUE RECOGNITION: Our revenue is comprised primarily of interest income, service charges and fees, gains on the sale of loans and AFS securities, earnings on corporate owned life insurance policies, and other noninterest income. Other noninterest income is typically service and performance driven in nature and comprised primarily of investment and trust advisory fees. We recognize revenue, excluding interest income and other income specifically scoped out, in accordance with ASC 606, Revenue From Contracts with Customers. Revenue is recognized when our performance obligation has been satisfied according to our contractual obligation.
FEDERAL INCOME TAXES: Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax assets or liabilities are determined based on the tax effects of the temporary differences between the book and tax basis on the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws. Valuation allowances are established, where necessary, to reduce deferred tax assets to the amount expected to be realized. Income tax expense is the tax payable or refundable for the year plus or minus the change during the year in deferred tax assets and liabilities.
We analyze our filing positions in the jurisdictions where we are required to file income tax returns, as well as all open tax years in these jurisdictions. We also treat interest and penalties attributable to income taxes, to the extent they arise, as a component of our noninterest expenses.
DEFINED BENEFIT PENSION PLAN: We maintain a noncontributory defined benefit pension plan, which was curtailed effective March 1, 2007. The service cost component of the defined benefit pension plan is included in “compensation and benefits” on the consolidated statements of income and is funded consistent with the requirements of federal laws and regulations. All other costs related to the defined benefit pension plan are included in “other” noninterest expenses on the consolidated statements of income. The current benefit obligation is included in "accrued interest payable and other liabilities" on the consolidated balance sheets. Inherent in the determination of defined benefit pension costs are assumptions concerning future events that will affect the amount and timing of required benefit payments under the plan. These assumptions include demographic assumptions such as mortality, a discount rate used to determine the current benefit obligation and a long-term
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expected rate of return on plan assets. Net periodic benefit cost includes the interest cost based on the assumed discount rate, an expected return on plan assets based on an actuarially derived market-related value of assets, and amortization of unrecognized net actuarial gains or losses. Actuarial gains and losses result from experience different from that assumed and from changes in assumptions (excluding asset gains and losses not yet reflected in market-related value). Amortization of actuarial gains and losses is included as a component of net periodic defined benefit pension cost.
For additional information, see “Note 12 – Benefit Plans.”
MARKETING COSTS: Marketing costs are expensed as incurred (see “Note 14 – Other Noninterest Expenses”).
Note 2 – Accounting Standards Updates
Pending Accounting Standards Updates
ASU No. 2023-09: “Income Tax (Topic 740): Improvement to Income tax Disclosures
In December 2023, ASU No. 2023-09 was issued to enhance the transparency and decision usefulness of income tax disclosures. The existing disclosure is being enhanced to provide information to help investors, lenders, creditors and all other allocators of capital asses how an entity's operations and related tax risks and tax planning and operational opportunities affect its tax rate and prospects for future cash flows. The new authoritative guidance is effective for interim and annual periods beginning after December 15, 2024 and is not expected to have a significant impact on our operations or financial statement disclosures.
Note 3 – AFS Securities
The amortized cost and fair value of AFS securities, with gross unrealized gains and losses, are as follows as of December 31:
AmortizedCost GrossUnrealizedGains GrossUnrealizedLosses FairValue
AmortizedCost GrossUnrealizedGains GrossUnrealizedLosses FairValue
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The amortized cost and fair value of AFS securities by contractual maturity at December 31, 2023 are as follows:
Maturing Securities with Variable Monthly Payments or Noncontractual Maturities
Auction rate money market preferred — — — — 3,200 3,200
Expected maturities for government sponsored enterprises and states and political subdivisions may differ from contractual maturities because issuers may have the right to call or prepay obligations.
As the auction rate money market preferred investments have continual call dates, they are not reported by a specific maturity group. Because of their variable monthly payments, mortgage-backed securities and collateralized mortgage obligations are not reported by a specific maturity group. Approximately $143,000 of the amortized cost of the collateralized mortgage portfolio consist of agency commercial mortgage-backed securities with defined maturity dates of less than ten years.
A summary of the sales activity of AFS securities during the years ended December 31 is displayed in the following table.
Proceeds from sales of AFS securities $ 18,089 $ — $ —
Realized gains (losses) $ 67 $ — $ —
Applicable income tax expense (benefit) $ 14 $ — $ —
The information on the following tables pertains to AFS securities with gross unrealized losses at December 31, 2023 and 2022 aggregated by investment category and length of time that individual securities have been in a continuous loss position.
Less Than Twelve Months Twelve Months or More
Auction rate money market preferred — — 269 2,931 269
Number of securities in an unrealized loss position: 22 186 208
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Less Than Twelve Months Twelve Months or More
Auction rate money market preferred — — 858 2,342 858
Number of securities in an unrealized loss position: 178 266 444
The unrealized loss on our AFS securities portfolio resulted from the increase in short-term and intermediate-term interest rates.
As of December 31, 2023, no allowance for credit losses has been recognized on AFS securities in an unrealized loss position, as management does not believe any of the securities are impaired due to reasons of credit quality. This is based on our analysis of the underlying risk characteristics, including credit ratings, and other qualitative factors related to our AFS securities and consideration of our historical credit loss experience and internal forecasts. The issuers of these securities continue to make timely principal and interest payments under the contractual terms of the securities. Furthermore, management does not have the intent to sell any of the securities classified as AFS in the table above, and believes it is more likely than not that we will not have to sell any such securities before a recovery of cost. The unrealized losses are due to increases in market interest rates over the yields available at the time the underlying securities were purchased. The fair value is expected to recover as the securities approach their respective maturity date or repricing date, or if the market yields for such investments decline.
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Note 4 – Loans and ACL
Loan Composition
The following table provides a detailed listing of our loan portfolio at December 31:
Balance Percent of Total Balance Percent of Total
Commercial and industrial
Commercial real estate
Advances to mortgage brokers 18,541 1.37 % — — %
Agricultural
Residential real estate
Consumer
We grant commercial, agricultural, residential real estate, and consumer loans to customers situated primarily in Bay, Clare, Gratiot, Isabella, Mecosta, Midland, Montcalm, and Saginaw counties in Michigan. The ability of the borrowers to honor their repayment obligations is often dependent upon the real estate, agricultural, manufacturing, retail, gaming, tourism, health care, higher education, and general economic conditions of this region. Substantially all of our consumer and residential real estate loans are secured by various items of property, while commercial loans are secured primarily by real estate, business assets, and personal guarantees. A portion of loans is unsecured.
Loans that we have the intent and ability to hold in our portfolio are reported at their outstanding principal balance adjusted for any charge-offs, the ACL, and deferred fees or costs. Unless a loan has a nonaccrual status, interest income is accrued over the term of the loan based on the principal amount outstanding. Loan origination fees and certain direct loan origination costs are capitalized and recognized as a component of interest income over the term of the loan using the appropriate amortization method.
Commercial and agricultural loans include loans for commercial real estate, commercial operating loans, advances to mortgage brokers, farmland and agricultural production, and loans to states and political subdivisions. Repayment of these loans is dependent upon the successful operation and management of a business. We minimize our risk by limiting the amount of direct credit exposure to any one borrower to $18,000. Borrowers with direct credit needs of more than $18,000 may be serviced through the use of loan participations with other commercial banks. Commercial and agricultural real estate loans commonly require loan-to-value limits of 80% or less. Depending upon the type of loan, past credit history, and current operating results, we may require the borrower to pledge accounts receivable, inventory, property, or equipment. Government agency guarantee may be required. Personal guarantees and/or life insurance beneficiary assignments are generally required from the owners of
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closely held corporations, partnerships, and sole proprietorships. In addition, we may require annual financial statements, prepare cash flow analyses, and review credit reports.
We offer adjustable rate mortgages, construction loans, and fixed rate residential real estate loans which have amortization periods up to a maximum of 30 years. We consider the anticipated direction of interest rates, balance sheet duration, the sensitivity of our balance sheet to changes in interest rates, our liquidity needs, and overall loan demand to determine whether or not to sell fixed rate loans to Freddie Mac.
Our lending policies generally limit the maximum loan-to-value ratio on residential real estate loans to 100% of the lower of the appraised value of the property or the purchase price. Private mortgage insurance is typically required on loans with loan-to-value ratios in excess of 80% unless the loan qualifies for government guarantees.
Underwriting criteria for residential real estate loans generally include:
•Evaluation of the borrower’s ability to make monthly payments.
•Evaluation of the value of the property securing the loan.
•Ensuring the payment of principal, interest, taxes, and hazard insurance does not exceed 28% of a borrower’s gross income.
•Ensuring all debt servicing does not exceed 40% of income.
•Verification of acceptable credit reports.
•Verification of employment, income, and financial information.
Appraisals are performed by independent appraisers and are reviewed for appropriateness. Generally, mortgage loan requests are reviewed by our mortgage loan committee or through a secondary market underwriting system; loans in excess of $1,000 require the approval of one or more of the following committees: Internal Loan Committee, the Executive Loan Committee, or the Board of Directors.
Consumer loans include secured and unsecured personal loans. Loans are amortized for a period of up to 15 years based on the age and value of the underlying collateral. The underwriting emphasis is on a borrower’s perceived intent and ability to pay rather than collateral value. No consumer loans are sold to the secondary market.
Nonaccrual and Past Due Loans
The accrual of interest on commercial and agricultural loans, as well as residential real estate loans, is discontinued at the time a loan is 90 days or more past due unless the credit is well-secured and in the process of short-term collection. Upon transferring a loan to nonaccrual status, we perform an evaluation to determine the net realizable value of the underlying collateral. This evaluation is used to help determine if a charge-off is necessary. Consumer loans are typically charged-off no later than 180 days past due. Past due status is based on the contractual term of the loan. In all cases, a loan is placed in nonaccrual status at an earlier date if collection of principal or interest is considered doubtful.
When a loan is placed in nonaccrual status, all interest accrued in the current calendar year, but not collected, is reversed against interest income while interest accrued in prior calendar years, but not collected, is charged against the ACL. Loans may be returned to accrual status after six months of continuous performance and achievement of current payment status.
The following table summarizes nonaccrual loan data by class of loans as of December 31:
Commercial and industrial:
Commercial real estate:
Commercial mortgage 1-4 family investor — — 14 14
Agricultural:
Residential real estate:
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The following tables summarize the past due and current loans for the entire loan portfolio as of December 31:
Past Due:
Commercial and industrial
Commercial real estate
Commercial mortgage non-owner occupied — — — 216,292 216,292 —
Commercial mortgage 1-4 family investor — — — 89,208 89,208 —
Commercial mortgage multifamily — — — 78,108 78,108 —
Agricultural
Residential real estate
Consumer
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Past Due:
Commercial and industrial
Commercial real estate
Commercial mortgage multifamily — — — 84,526 84,526 —
Advances to mortgage brokers — — — — — —
Agricultural
Residential real estate
Consumer
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Credit Quality Indicators
The following table displays commercial and agricultural loans by credit risk ratings and year of origination as of December 31:
Commercial and industrial: Secured
Risk rating 8 — — — — — — — — —
Risk rating 9 — — — — — — — — —
Current year-to-date gross charge-offs $ 200 $ — $ — $ — $ — $ — $ — $ — $ 200
Commercial and industrial: Unsecured
Risk rating 6 — — — — — — — — —
Risk rating 7 — — — — — — — — —
Risk rating 8 — — — — — — — — —
Risk rating 9 — — — — — — — — —
Current year-to-date gross charge-offs $ 8 $ — $ — $ — $ — $ — $ 68 $ — $ 76
Commercial real estate: Owner occupied
Risk rating 7 — — — — — — — — —
Risk rating 8 — — — — — — — — —
Risk rating 9 — — — — — — — — —
Current year-to-date gross charge-offs $ — $ — $ — $ — $ — $ — $ — $ — $ —
Commercial real estate: Non-owner occupied
Risk rating 7 — — — — — — — — —
Risk rating 8 — — — — — — — — —
Risk rating 9 — — — — — — — — —
Current year-to-date gross charge-offs $ — $ — $ — $ — $ — $ — $ — $ — $ —
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Commercial real estate: 1-4 family investor
Risk rating 7 — — — — — — — — —
Risk rating 8 — — — — — — — — —