Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General
Management's Discussion and Analysis of Financial Condition and Results of Operations is intended to assist in understanding the consolidated financial condition and results of operations of the Company. The information contained in this section should be read in conjunction with the Consolidated Financial Statements and accompanying notes thereto included in Item 8 of this Annual Report on Form 10-K.
Overview
Timberland Bancorp, Inc., a Washington corporation, is the holding company for Timberland Bank. The Bank opened for business in 1915 and serves consumers and businesses across Grays Harbor, Thurston, Pierce, King, Kitsap and Lewis counties, Washington with a full range of lending and deposit services through its 24 branches (including its main office in Hoquiam). At September 30, 2020, the Company had total assets of $1.57 billion, net loans receivable of $1.01 billion, total deposits of $1.36 billion and total shareholders’ equity of $187.63 million. The Company’s business activities generally are limited to passive investment activities and oversight of its investment in the Bank. Accordingly, the information set forth in this report relates primarily to the Bank’s operations.
On October 1, 2018, the Company completed the South Sound Acquisition. The operating results for the years ended September 30, 2019 and 2020 include the operating results produced by the net assets acquired in the South Sound Acquisition. For additional information on the South Sound Acquisition, see Note 2 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data."
The Bank is a community-oriented bank which has traditionally offered a variety of savings products to its retail and business customers while concentrating its lending activities on real estate secured loans. Lending activities have been focused primarily on the origination of loans secured by real estate, including residential construction loans, one- to four-family residential loans, multi-family loans and commercial real estate loans. The Bank originates adjustable-rate residential mortgage loans, some of which do not qualify for sale in the secondary market. The Bank also originates commercial business loans and other consumer loans.
The profitability of the Company’s operations depends primarily on its net interest income after provision for (recapture of) loan losses. Net interest income is the difference between interest income, which is the income that the Company earns on interest-earning assets, which are primarily loans and investments, and interest expense, the amount the Company pays on its interest-bearing liabilities, which are primarily deposits and borrowings (as needed). Net interest income is affected by changes in the volume and mix of interest-earning assets, the interest earned on those assets, the volume and mix of interest-bearing liabilities and the interest paid on those interest-bearing liabilities. Management attempts to maintain a net interest margin placing it within the top quartile of its Washington State peers. Because of the length of the COVID-19 pandemic and the efficacy of the extraordinary measures being put in place to address its economic consequences are unknown, including the 150 basis point reductions in the targeted federal funds rate (in March 2020), until the pandemic subsides, the Company expects its net interest income and net interest margin will be adversely affected.
The provision for (recapture of) loan losses is dependent on changes in the loan portfolio and management’s assessment of the collectability of the loan portfolio as well as prevailing economic and market conditions. The allowance for loan losses reflects the amount that the Company believes is adequate to cover probable credit losses inherent in its loan portfolio. The Company recorded provisions for loan losses of $3.70 million for the year ended September 30, 2020 compared to none for the year ended September 30, 2019 due primarily to forecasted probable loan losses reflecting the potential future impact of the COVID-19 pandemic on the economy.
On March 24, 2020, Washington State Governor Jay Inslee signed a statewide order due to the COVID-19 pandemic requiring residents to stay-at-home unless involved in an essential activity. All business, except those that are considered essential, were also ordered to close. Although the stay-at-home order has been lifted and certain businesses were allowed to re-open, many restrictions remain in place. As an essential business, the Company took various steps to ensure the safety of customers and personnel including branch lobby closures. To ensure the safety of the Company's customers and employees, services are offered through drive up facilities and/or by appointment at some locations and other branch offices are now open
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on a modified basis. Some of the Company's employees are working remotely or have flexible work schedules, and protective measures within the Company's offices have been established to help ensure the safety of those that employees who must work on-site.
The Company has worked with loan customers on loan deferral and forbearance plans. In response to requests from borrowers, the Company made payment deferral modifications (typically 90-day payment deferrals with interest continuing to accrue or scheduled to be paid monthly) on a number of loans. The majority of these borrowers had resumed making payments as of September 30, 2020 and only five loans totaling $5.87 million remained on deferral status as of that date. These modifications were not classified as TDRs at September 30, 2020 in accordance with guidance of the CARES Act and related regulatory guidance. The CARES Act also authorized the SBA to temporarily guarantee loans under a new loan program called the Paycheck Protection Program. As a qualified SBA lender, the Company was automatically authorized to originate PPP loans upon commencement of the program in April 2020 through its conclusion in August 2020. As of September 30, 2020, the Company had $126.82 million in PPP loans to new and existing customers who are small to midsize businesses as well as non-profit organizations, independent contractors, and partnerships as allowed under PPP guidance issued in April 2020.
Net income is also affected by non-interest income and non-interest expense. For the year ended September 30, 2020, non-interest income consisted primarily of service charges on deposit accounts, gain on sales of loans, ATM and debit card interchange transaction fees, an increase in the cash surrender value of BOLI, servicing income on loans sold, escrow fee and other operating income. Non-interest income is also increased by net recoveries on investment securities and reduced by net OTTI losses on investment securities, if any. Non-interest income is also decreased by by valuation allowances on servicing rights and increased by recoveries of valuation allowances on servicing rights, if any. Non-interest expense consisted primarily of salaries and employee benefits, premises and equipment, advertising, ATM and debit card interchange transaction fees, postage and courier expenses, amortization of CDI, state and local taxes, professional fees, FDIC insurance premiums, loan administration and foreclosure expenses, data processing and telecommunication expenses, deposit operation expenses and other non-interest expenses. Non-interest expense in certain periods are reduced by gains on the sale of premises and equipment and by gains on the sale of OREO. Non-interest income and non-interest expense are affected by the growth of the Company's operations and growth in the number and balances of loan and deposit accounts.
Results of operations may be affected significantly by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities.
Operating Strategy
The Company is a bank holding company which operates primarily through its subsidiary, the Bank. The Company's primary objective is to operate the Bank as a well capitalized, profitable, independent, community-oriented financial institution, serving customers in its primary market area of Grays Harbor, Pierce, Thurston, Kitsap, King and Lewis counties. The Company's strategy is to provide products and superior service to small businesses and individuals located in its primary market area.
The Company's goal is to deliver returns to shareholders by focusing on the origination of higher-yielding assets (in particular commercial real estate, construction, and commercial business loans), increasing core deposit balances, managing problem assets, efficiently managing expenses, and seeking expansion opportunities. The Company seeks to achieve these results by focusing on the following objectives:
Expand our presence within our existing market areas by capturing opportunities resulting from changes in the competitive environment. We currently conduct our business primarily in western Washington. We have a community bank strategy that emphasizes responsive and personalized service to our customers. As a result of the consolidation of banks in our market areas, we believe there is an opportunity for a community and customer focused bank to expand its customer base. By offering timely decision making, delivering appropriate banking products and services, and providing customer access to our senior managers we believe community banks, such as Timberland Bank, can distinguish themselves from larger banks operating in our market areas. We believe we have a significant opportunity to attract additional borrowers and depositors and expand our market presence and market share within our extensive branch footprint.
Portfolio diversification. In recent years, we have limited the origination of speculative construction loans and land development loans in favor of loans that possess credit profiles representing less risk to the Bank. We continue originating owner/builder and custom construction loans, multi-family loans, commercial business loans and commercial real estate loans which offer higher risk adjusted returns, shorter maturities and more sensitivity to interest rate fluctuations than fixed rate one-to four-family loans. We anticipate capturing more of each customer's banking relationship by cross selling our loan and deposit products and offering additional services to our customers.
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Increase core deposits and other retail deposit products. We focus on establishing a total banking relationship with our customers with the intent of internally funding our loan portfolio. We anticipate that the continued focus on customer relationships will increase our level of core deposits. In addition to our retail branches, we maintain technology based products such as business cash management and a business remote deposit product that enable us to compete effectively with banks of all sizes.
Managing exposure to fluctuating interest rates. For many years, the majority of the loans the Bank has retained in its portfolio have generally possessed periodic interest rate adjustment features or have been relatively short term in nature. Loans originated for portfolio retention have generally included ARM loans, short-term construction loans, and to a lesser extent commercial business loans with interest rates tied to a market index such as the Prime Rate. Longer term fixed-rate mortgage loans have generally been originated for sale into the secondary market, although from time to time the Bank may retain a portion of its fixed-rate mortgage loan originations and extend the initial fixed rate period of its hybrid ARM commercial real estate loans for asset/liability purposes.
Continue generating revenues through mortgage banking operations. The substantial majority of the fixed-rate residential mortgage loans we originate are sold into the secondary market with servicing retained. This strategy produces gains on the sale of such loans and reduces the interest rate and credit risk associated with fixed-rate residential lending. We continue to originate custom construction and owner/builder construction loans for sale into the secondary market upon the completion of construction.
Maintaining strong asset quality. We believe that strong asset quality is a key to our long-term financial success. The percentage of non-performing loans to loans receivable, net was 0.28% and 0.34% at September 30, 2020 and 2019, respectively. The Company's percentage of non-performing assets to total assets at September 30, 2020 was 0.27% compared to 0.40% at September 30, 2019. Non-performing assets have decreased to $4.16 million at September 30, 2020 from $14.98 million at September 30, 2015. We continue to seek to reduce the level of non-performing assets through collections, write-downs, modifications and sales of OREO. We also take proactive steps to resolve our non-performing loans, including negotiating payment plans, forbearances, loan modifications and loan extensions and accepting short payoffs on delinquent loans when such actions have been deemed appropriate. We have also accepted short payoffs on delinquent loans, particularly when such payoffs result in a smaller loss to us than foreclosure. Although the Company plans to continue to place emphasis on certain lending products, such as commercial real estate loans, construction loans, and commercial business loans, the Company expects to continue to manage its credit exposures through the use of experienced bankers and an overall conservative approach to lending.
Critical Accounting Policies and Estimates
The Company has established various accounting policies that govern the application of GAAP in the preparation of the Company's Consolidated Financial Statements. The Company has identified six policies that as a result of judgments, estimates and assumptions inherent in those policies, are critical to an understanding of the Company's Consolidated Financial Statements. These policies relate to the methodology for the determination of the allowance for loan losses, the determination of any OTTI in the fair value of investment securities, the valuation of servicing rights, the valuation of OREO, the valuation of assets acquired and liabilities assumed in acquisitions and the valuation of goodwill for potential impairment. These policies and the judgments, estimates and assumptions are described in greater detail in the notes to the Consolidated Financial Statements contained in Item 8 of this Form 10-K. In particular, Note 1 to the Consolidated Financial Statements, “Summary of Significant Accounting Policies,” generally describes the Company's accounting policies. Management believes that the judgments, estimates and assumptions used in the preparation of the Company's Consolidated Financial Statements are appropriate given the factual circumstances at the time. However, given the sensitivity of the Company's Consolidated Financial Statements to these critical policies, the use of other judgments, estimates and assumptions could result in material differences in the Company's results of operations or financial condition.
Market Risk and Asset and Liability Management
General. Market risk is the risk of loss from adverse changes in market prices and rates. The Bank's market risk arises primarily from interest rate risk inherent in its lending, investment, deposit and borrowing activities. The Bank, like other financial institutions, is subject to interest rate risk to the extent that its interest-earning assets reprice differently than its interest-bearing liabilities. Management actively monitors and manages its interest rate risk exposure. Although the Bank manages other risks, such as credit quality and liquidity risk, in the normal course of business management considers interest rate risk to be its most significant market risk that could potentially have the largest material effect on the Bank's financial condition and results of operations. The Bank does not maintain a trading account for any class of financial instruments nor does it engage in hedging activities. Furthermore, the Bank is not subject to foreign currency exchange rate risk or commodity price risk.
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Qualitative Aspects of Market Risk. The Bank's principal financial objective is to achieve long-term profitability while reducing its exposure to fluctuating market interest rates. The Bank has sought to reduce the exposure of its earnings to changes in market interest rates by attempting to manage the difference between asset and liability maturities and interest rates. The principal element in achieving this objective is to increase the interest rate sensitivity of the Bank's interest-earning assets by retaining in its portfolio, short-term loans and loans with interest rates subject to periodic adjustments. The Bank relies on retail deposits as its primary source of funds. As part of its interest rate risk management strategy, the Bank promotes transaction accounts and certificates of deposit with terms of up to five years.
The Bank has adopted a strategy that is designed to substantially match the interest rate sensitivity of assets relative to its liabilities. The primary elements of this strategy involve originating ARM loans for its portfolio, maintaining residential construction loans as a portion of total net loans receivable because of their generally shorter terms and higher yields than other one- to four-family residential mortgage loans, matching asset and liability maturities, investing in short-term securities, and originating fixed-rate loans for retention or sale in the secondary market while retaining the related servicing rights.
Sharp increases or decreases in interest rates may adversely affect the Bank's earnings. Management of the Bank monitors the Bank's interest rate sensitivity through the use of a model provided by NXTsoft Data Analytics, LLC (“NXTsoft”), a company that specializes in providing interest rate risk and balance sheet management services to the financial services industry. Based on a rate shock analysis prepared by NXTsoft based on data at September 30, 2020, an immediate increase in interest rates of 100 basis points would increase the Bank’s projected net interest income by approximately 7.7%, primarily because a larger portion of the Bank's interest rate sensitive assets than interest rate sensitive liabilities would reprice within a one year period. Conversely, an immediate decrease in interest rates of 100 basis points would decrease the Bank's projected net interest income by approximately 2.4%. See “Quantitative Aspects of Market Risk” below for additional information. Management has sought to sustain the match between asset and liability maturities and rates, while maintaining an acceptable interest rate spread. Pursuant to this strategy, the Bank actively originates adjustable-rate loans for retention in its loan portfolio. Fixed-rate mortgage loans with maturities greater than seven years generally are originated for the immediate or future resale in the secondary mortgage market. Although the Bank has sought to originate ARM loans, the ability to originate such loans depends to a great extent on market interest rates and borrowers' preferences. In lower interest rate environments, borrowers often prefer fixed-rate loans.
Consumer, commercial business and construction loans typically have shorter terms and higher yields than permanent residential mortgage loans, and accordingly reduce the Bank’s exposure to fluctuations in interest rates. At September 30, 2020, the consumer, commercial business and construction loan portfolios amounted to $35.65 million, $196.36 million and $219.50 million, or 3.1%, 17.3% and 19.4% of total loans receivable, respectively.
Quantitative Aspects of Market Risk. The model provided for the Bank by NXTsoft estimates the changes in net portfolio value ("NPV") and net interest income in response to a range of assumed changes in market interest rates. The model first estimates the level of the Bank's NPV (market value of assets, less market value of liabilities, plus or minus the market value of any off-balance sheet items) under the current rate environment. In general, market values are estimated by discounting the estimated cash flows of each instrument by appropriate discount rates. The model then recalculates the Bank's NPV under different interest rate scenarios. The change in NPV under the different interest rate scenarios provides a measure of the Bank's exposure to interest rate risk. The following table is provided by NXTsoft based on data at September 30, 2020:
Hypothetical Net Interest Income (1)(2) Current Market Value
Interest Rate Estimated $ Change % Change Estimated $ Change % Change
Scenario (3) Value from Base from Base Value from Base from Base
(Basis Points) (Dollars in thousands)
___________
(1)Does not include loan fees.
(2)Includes BOLI income, which is included in non-interest income in the Consolidated Financial Statements.
(3)No rates in the model are allowed to go below zero.
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Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan repayments and deposit decay, and should not be relied upon as indicative of actual results. Furthermore, the computations do not reflect any actions management may undertake in response to changes in interest rates.
In the event of a 100 basis point decrease in interest rates, the Bank would be expected to experience a 9.0% decrease in NPV and a 2.4% decrease in net interest income. In the event of a 100 basis point increase in interest rates, an 8.3% increase in NPV and a 7.7% increase in net interest income would be expected. Based upon the modeling described above, the Bank's asset and liability structure generally results in increases in net interest income and NPV in a rising interest rate scenario and decreases in net interest income and NPV in a declining interest rate scenario.
As with any method of measuring interest rate risk, certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets have features which restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, expected rates of prepayments on loans and early withdrawals from certificates of deposit could possibly deviate significantly from those assumed in calculating the table.
Comparison of Financial Condition at September 30, 2020 and September 30, 2019
The Company's total assets increased by $318.85 million, or 25.6%, to $1.57 billion at September 30, 2020 from $1.25 billion at September 30, 2019. The increase in assets was primarily due to increase in total cash and cash equivalents, net loans receivable, and investment securities. The increase in total assets was funded primarily by increases in total deposits and FHLB borrowings.
Net loans receivable increased by $127.21 million, or 14.3%, to $1.01 billion at September 30, 2020 from $886.66 million at September 30, 2019, primarily due to increases in commercial business (including $126.82 million of SBA PPP loans), commercial real estate, and multi-family loans. These increases were partially offset by decreases in one- to four-family mortgage and consumer loans.
Total deposits increased by $290.18 million, or 27.2%, to $1.36 billion at September 30, 2020 from $1.07 billion at September 30, 2019, primarily due to increases in non-interest bearing demand account balances, NOW checking account balances, savings account balances, and money market account balances.
Shareholders' equity increased by $16.56 million, or 9.7%, to $187.63 million at September 30, 2020 from $171.07 million at September 30, 2019. The increase was primarily due to net income for the year ended September 30, 2020 of $24.27 million which was partially offset by $7.08 million in dividends paid to shareholders and $1.24 million in common stock repurchases.
A more detailed explanation of the changes in significant balance sheet categories follows:
Cash and Cash Equivalents: Cash and cash equivalents increased by $171.44 million, or 119.9%, to $314.45 million at September 30, 2020 from $143.02 million at September 30, 2019. The increase was primarily a result of increases in total deposits, which exceeded the funds required for loan originations and purchases of investment securities.
CDs Held for Investment: CDs held for investment decreased by $12.80 million, or 16.3%, to $65.55 million at September 30, 2020 from $78.35 million at September 30, 2019. Funds received as CDs matured were invested into other interest-earning assets as interest rates on CDs decreased during the year.
Investment Securities and Investments in Equity Securities: Investment securities and investments in equity securities increased by $32.18 million, or 59.0%, to $86.77 million at September 30, 2020 from $54.59 million at September 30, 2019. The increase was primarily due to the purchase of additional agency mortgage-backed investment securities as the Company put a portion of its excess overnight liquidity into higher-earning investment securities during the year ended September 30, 2020. These increases were partially offset by maturities, prepayments and scheduled amortization of other investment securities. For additional details on investment securities, see "Item 1. Business - Investment Activities" and Note 4 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data."
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FHLB Stock: FHLB stock increased by $485,000, or 33.8%, to $1.92 million at September 30, 2020 from $1.44 million at September 30, 2019, due to purchases required by the FHLB as a result of the increase in total assets and FHLB borrowings.
Other Investments: Other investments consist solely of the Company's investment in the Solomon Hess SBA Loan Fund LLC, which was unchanged at both September 30, 2020 and 2019. This investment is utilized to help satisfy compliance with the Company's Community Reinvestment Act ("CRA") investment test requirements.
Loans Held for Sale: Loans held for sale decreased to $4.51 million, or 25.7%, at September 30, 2020 from $6.07 million at September 30, 2019, primarily due to the timing and volume of mortgage banking loan sales. The Company sells longer-term fixed-rate residential loans and the guaranteed portion of SBA commercial business loans for asset-liability management purposes and to generate non-interest income. The Company sold $167.24 million in loans during the year ended September 30, 2020 compared to $73.03 million for the year ended September 30, 2019. Sales of loans increased primarily due to increased refinance activity for one- to four-family loans due to the decrease in mortgage interest rates.
Loans Receivable, Net of Allowance for Loan Losses: Net loans receivable increased by $127.21 million, or 14.3%, to $1.01 billion at September 30, 2020 from $886.66 million at September 30, 2019. The increase consisted of a $131.60 million increase in commercial business loans (including a $126.82 million increase in SBA PPP loans), a $34.46 million increase in commercial real estate loans, a $9.02 million increase in multi-family loans and smaller increases in several other categories. These increases were partially offset by a $14.08 million decrease in one- to four-family loans, an $8.85 million decrease in consumer loans and smaller decreases in several other categories.
Loan originations increased by $241.15 million, or 67.7%, to $597.19 million for the year ended September 30, 2020 from $356.04 million for the year ended September 30, 2019. The increase in loan originations was primarily due to the funding of SBA PPP loans, increased loan demand for one- to four-family mortgage loan refinances, and the funding of several larger commercial business and commercial real estate loans. For additional information on loans, see "Item 1. Business - Lending Activities" and Note 5 to the Consolidated Financial Statements contained in "Item 8, Financial Statements and Supplementary Data."
Premises and Equipment, Net: Premises and equipment increased by $205,000, or 0.9%, to $23.04 million at September 30, 2020 from $22.83 million at September 30, 2019. The increase was primarily due to capitalized remodeling costs associated with the Company's new data center facility. This increase was partially offset by normal depreciation and the sale of land acquired in the South Sound Acquisition that had been held for future expansion. For additional information on premises and equipment, see "Item 2. Properties" and Note 6 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data."
OREO and Other Repossessed Assets: OREO and other repossessed assets decreased by $633,000, or 37.6%, to $1.05 million at September 30, 2020 from $1.68 million at September 30, 2019. The decrease was primarily due to the sales of $460,000 in OREO properties and OREO valuation write-downs of $173,000. At September 30, 2020, total OREO and other repossessed assets consisted of six land parcels totaling $1.05 million. The largest OREO property at September 30, 2020 was an undeveloped land parcel located in Lewis County with a balance of $702,000. For additional information on OREO and other repossessed assets, see "Item 1. Business - Lending Activities - Other Real Estate Owned and Other Repossessed Assets" and Note 7 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data."
Bank Owned Life Insurance ("BOLI"): BOLI increased by $591,000, or 2.8%, to $21.60 million at September 30, 2020 from $21.01 million at September 30, 2019. The increase was due to net BOLI earnings, representing the increase in cash surrender value of the BOLI policies.
Goodwill: The recorded amount of goodwill remained unchanged at $15.13 million at September 30, 2020 from September 30, 2019. The Company performed its annual review of goodwill during the quarter ended June 30, 2020 and determined that there was no impairment. As of September 30, 2020, management believes that there had been no subsequent events or changes in circumstances that would indicate a potential impairment of goodwill. For additional information on goodwill, see Note 8 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data."
CDI: CDI decreased by $406,000, or 20.0% to $1.63 million at September 30, 2020 from $2.03 million at September 30, 2019 due to scheduled amortization. For additional information on CDI, see Note 8 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data."
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Servicing Rights, Net: Servicing rights increased by $687,000, or 28.5%, to $3.10 million at September 30, 2020 from $2.41 million at September 30, 2019, primarily due to additional capitalized Freddie Mac servicing rights for loans being sold with servicing retained, which was partially offset by amortization and valuation allowances. The principal amount of loans serviced for Freddie Mac and the SBA increased by $27.46 million, or 6.9%, to $426.58 million at September 30, 2020 from $399.12 million at September 30, 2019. For additional information on servicing rights, see Note 9 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data."
Operating Lease Right-of-Use Assets: Operating lease right-of-use-assets increased to $2.59 million at September 30, 2020 as the Company adopted ASC 842 on October 1, 2019 and began recording operating lease right-of-use assets and operating lease liabilities on the balance sheet. The operating lease right-of-use assets at September 30, 2020 represented the present value of three operating leases on branch facilities. The Company adopted the provisions of ASC 842 utilizing the optional transition method and therefore prior periods have not been restated. For additional information on leases, see Note 10 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data."
Other Assets: Other assets decreased by $2.02 million, or 38.0%, to $3.30 million at September 30, 2020 from $5.32 million at September 30, 2019. The decrease was primarily due to decreases in miscellaneous receivables (including income tax receivables) and prepaid expenses.
Deposits: Deposits increased by $290.18 million, or 27.2%, to $1.36 billion at September 30, 2020 from $1.07 billion at September 30, 2019. The increase consisted of a $145.42 million increase in non-interest bearing demand account balances, a $79.84 million increase in NOW checking account balances, a $55.36 million increase in savings account balances, and a $16.69 million increase in money market account balances. These increases were partially offset by a $7.13 million decrease in certificates of deposit account balances. The increase in deposits was primarily driven by proceeds from SBA PPP loans and government stimulus checks deposited directly into customer accounts, organic growth in customer relationships and reduced withdrawals from deposit accounts due to a change in spending habits as a result of COVID-19. For additional information on deposits, see "Item 1. Business - Deposit Activities and Other Sources of Funds" and Note 11 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data."
FHLB Borrowings: The Company has short- and long-term borrowing lines with the FHLB with total credit available on the lines equal to 45% of the Bank's total assets, limited by available collateral. FHLB borrowings increased to $10.00 million at September 30, 2020, as the Company borrowed funds consistent with its asset-liability objectives in March 2020 as long-term rates dropped to historic lows in response to the COVID-19 pandemic. At September 30, 2020, FHLB borrowings consisted of two $5.00 million borrowings, with scheduled maturities at March 2025 and March 2027, which bear interest at 1.19% and 1.11%, respectively. The Company did not have any FHLB borrowings at September 30, 2019. For additional information on FHLB borrowings, see Note 12 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data".
Operating Lease Liabilities: Operating lease liabilities increased to $2.63 million at September 30, 2020 as the Company adopted ASC 842 on October 1, 2019 and began recording operating lease liabilities and operating lease right-of-use assets on the balance sheet. The operating lease liability at September 30, 2020 represented the present value of three operating leases on branch facilities. The Company adopted the provisions of ASC 842 utilizing the optional transition method and therefore prior periods have not been restated. For additional information on leases, see Note 10 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data."
Other Liabilities and Accrued Expenses: Other liabilities and accrued expenses decreased by $526,000, or 6.7%, to $7.31 million at September 30, 2020 from $7.84 million at September 30, 2019. The decrease was primarily due to timing differences in the normal course of business and a reduction in deferred compensation payable.
Shareholders' Equity: Total shareholders' equity increased by $16.56 million, or 9.7%, to $187.63 million at September 30, 2020 from $171.07 million at September 30, 2019. The increase was primarily due to net income of $24.27 million for the year ended September 30, 2020, which was partially offset by the payment of $7.08 million in dividends to common shareholders and the repurchase of 56,601 shares of the Company's common stock for $1.24 million during the year ended September 30, 2020. For additional information on shareholders' equity, see the Consolidated Statements of Shareholders' Equity contained in "Item 8. Financial Statements and Supplementary Data."
Comparison of Operating Results for the Years Ended September 30, 2020 and 2019
Net income for the year ended September 30, 2020 increased by $249,000, or 1.0%, to $24.27 million from $24.02 million for the year ended September 30, 2019. Net income per diluted common share increased by $0.04, or 1.4%, to $2.88
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for the year ended September 30, 2020 from $2.84 for the year ended September 30, 2019. The increase in net income was primarily due to an increase in non-interest income and a decrease in non-interest expense. These increases to net income were partially offset by an increase in the provision for loan losses and a decrease in net interest income. The increase in non- interest income was primarily due to an increase in gain on sales of loans. The decrease in non-interest expense was primarily due to a decrease in data processing and telecommunication expenses. The increase in the provision for loan losses was primarily due to economic uncertainties associated with the COVID-19 pandemic.
A more detailed explanation of the income statement categories is presented below.
Net Interest Income: Net interest income decreased by $278,000, or 0.5%, to $50.88 million for the year ended September 30, 2020 from $51.16 million for the year ended September 30, 2019. The decrease in net interest income was primarily due to a decrease in the average yield on interest-earning assets, which was partially offset by an increase in the average balance of interest-earning assets.
Total interest and dividend income decreased by $142,000, or 0.3%, to $55.58 million for the year ended September 30, 2020 from $55.73 million for the year ended September 30, 2019, primarily due to a decrease in the average yield on interest-earning assets, which was partially offset by an increase in the average balance of interest-earning assets. The average yield on interest-earnings assets decreased to 4.26% for the year ended September 30, 2020 from 4.90% for the year ended September 30, 2019 as market rates decreased. Beginning in August 2019, the Federal Reserve reduced the targeted federal funds rate by 25 basis points three times in 2019 and during the quarter ended March 31, 2020 by 150 basis points in response to the COVID-19 pandemic, to a range of 0.00% to 0.25% at September 30, 2020. Partially offsetting the decrease in the average yield on interest-earning assets was an increase in the average balance of interest-earning assets. Average total interest-earning assets increased by $166.51 million, or 14.6%, to $1.30 billion for the year ended September 30, 2020 from $1.14 billion for the year ended September 30, 2019. Interest income on loans receivable and loans held for sale increased by $2.21 million, or 4.5%, to $51.34 million for the year ended September 30, 2020 from $49.13 million for the year ended September 30, 2019, primarily due to a $91.42 million increase in the average balance of loans receivable during the current year. This increase was partially offset by a decrease in the average yield on loans receivable to 5.29% for the year ended September 30, 2020 from 5.59% for the year ended September 30, 2019.
During the year ended September 30, 2020, the accretion of the purchase accounting fair value discount on loans acquired in the South Sound Acquisition increased interest income on loans by $597,000 compared to $645,000 for the year ended September 30, 2019. The accretion of the net fair value discount on acquired loans increased the average yield on loans by six basis points for the year ended September 30, 2020 and seven basis points for the year ended September 30, 2019. The incremental accretion and the impact on loan yield will change during any period based on the volume of prepayments, but it is expected to decrease over time as the balance of the net discount declines. The remaining net discount on these acquired loans was $790,000 at September 30, 2020. During the year ended September 30, 2020 a total of $911,000 in non-accrual interest, pre-payment penalties and late fees was collected compared to $372,000 for the year ended September 30, 2019.
Also impacting the average yield and average interest-earning asset balances during the year ended September 30, 2020 were SBA PPP loans originated. These PPP loans have a prescribed interest rate of 1.00% and are also subject to loan origination fees which are accreted into interest income over the life of each loan. For the year ended September 30, 2020, average PPP loans were $55.40 million and the Company recorded $556,000 in interest income and accreted $1.04 million in PPP loan origination fees into income. Interest income on investment securities increased by $315,000, or 24.9%, to $1.58 million for the year ended September 30, 2020 from $1.26 million for the year ended September 30, 2019 primarily due to an increase in the average balance of investment securities, which was partially offset by a decrease in the average yield on investment securities. Interest income on interest-bearing deposits in banks and CDs decreased by $2.64 million, or 51.0%, to $2.54 million for the year ended September 30, 2020 from $5.17 million for the year ended September 30, 2019, primarily due to an decrease in the average yield to 1.00% from 2.41% as market rates decreased. The decrease in the average yield was partially offset by an increase in the average balance of interest-bearing deposits in banks and CDs.
Total interest expense increased by $136,000, or 3.0%, to $4.70 million for the year ended September 30, 2020 from $4.57 million for the year ended September 30, 2019. The increase in interest expense was primarily due to a increases in the average balances of interest-bearing deposits and FHLB borrowings, which were partially offset by a decrease in the average cost of interest-bearing liabilities. Average interest-bearing deposits increased by $62.52 million, or 8.1%, to $829.91 million for the year ended September 30, 2020 from $767.39 million for the year ended September 30, 2019 and average FHLB borrowings increased to $5.69 million for the year ended September 30, 2020 from $0 for the year ended September 30, 2019. The average cost of interest-bearing liabilities decreased to 0.56% for the year ended September 30, 2020 from 0.59% for the year ended September 30, 2019 as market interest rates for deposits decreased.
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As a result of these changes, the net interest margin decreased 60 basis points to 3.90% for the year ended September 30, 2020 from 4.50% for the year ended September 30, 2019.
Provision for Loan Losses: Provisions for loan losses totaled $3.70 million for the year ended September 30, 2020 compared to no provision for loan losses for the year ended September 30, 2019. The provision for loan for the current fiscal year was primarily due to the deteriorating economic conditions and probable loan losses driven by the impact of the COVID-19 pandemic on the U.S. and global economies. The Company had net recoveries of $24,000 for the year ended September 30, 2020 and net recoveries of $160,000 for the year ended September 30, 2019. The net charge-offs (recoveries) to average outstanding loans ratio was 0.00% for the year ended September 30, 2020 and (0.02)% for the year ended September 30, 2019. The level of delinquent loans (loans 30 or more days past due) decreased by $177,000, or 4.5%, to $3.75 million at September 30, 2020 from $3.93 million at September 30, 2019 and the level of loans graded substandard decreased by $1.67 million, or 31.4%, to $3.65 million at September 30, 2020 from $5.32 million at September 30, 2019. Special mention loans increased by $3.32 million or 130.2%, to $5.86 million at September 30, 2020 from $2.55 million at September 30, 2019. Non-accrual loans decreased by $128,000, or 4.2%, to $2.91 million at September 30, 2020 from $3.03 million at September 30, 2019.
The Company has worked with loan customers impacted by the COVID-19 pandemic on loan deferral and forbearance plans. In response to requests from borrowers, the Company made payment deferral modifications (typically 90-day payment deferrals with interest continuing to accrue or scheduled to be paid monthly) on a number of loans during the year ended September 30, 2020. Most of these borrowers had resumed making payments during the year and only five loans totaling $5.87 million remained on deferral status as of September 30, 2020. These modifications were not classified as TDRs at September 30, 2020 in accordance with guidance of the CARES Act and related regulatory guidance.
The $126.82 million balance of SBA PPP loans was omitted from the Company's normal allowance for loan losses calculation at September 30, 2020 as these loans are fully guaranteed by the SBA and management expects that most PPP borrowers will seek full or partial forgiveness of their loan obligations from the SBA within a short time frame, which will in turn reimburse the Bank for the amount forgiven.
The Company has established a comprehensive methodology for determining the allowance for loan losses. On a quarterly basis the Company performs an analysis that considers pertinent factors underlying the quality of the loan portfolio. These factors include changes in the amount and composition of the loan portfolio, historic loss experience for various loan segments, changes in economic conditions, delinquency rates, a detailed analysis of impaired loans, and other factors to determine an appropriate level of allowance for loan losses. Impaired loans are subject to an impairment analysis to determine an appropriate reserve amount to be allocated to each loan. The aggregate principal impairment amount determined at September 30, 2020 was $41,000 compared to $172,000 at September 30, 2019.
In accordance with GAAP, loans acquired in the South Sound Acquisition were recorded at their estimated fair value, which resulted in a net discount to the loans' contractual amounts, of which a portion reflects a discount for possible credit losses. Credit discounts are included in the determination of fair value and as a result no allowance for loan losses is recorded for acquired loans at the acquisition date. The discount recorded on the acquired loans is not reflected in the allowance for loan losses or related allowance coverage ratios. The remaining fair value discount on loans acquired in the South Sound Acquisition was $790,000 at September 30, 2020. The Company believes this should be considered by investors when comparing the Company's allowance for loan losses to total loans in periods prior to the South Sound Acquisition.
Based on the comprehensive methodology, management believes the allowance for loan losses of $13.41 million at September 30, 2020 (1.31% of loans receivable and 461.8% of non-performing loans) was adequate to provide for probable losses based on an evaluation of known and inherent risks in the loan portfolio at that date. While the Company believes it has established its existing allowance for loan losses in accordance with GAAP, there can be no assurance that bank regulators, in reviewing the Company's loan portfolio, will not request the Company to increase significantly its allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that substantial increases will not be necessary should the quality of any loans deteriorate. Any material increase in the allowance for loan losses would adversely affect the Company's financial condition and results of operations. For additional information, see "Item 1. Business - Lending Activities -- Allowance for Loan Losses."
Non-interest Income: Total non-interest income increased by $2.85 million, or 19.9%, to $17.19 million for the year ended September 30, 2020 from $14.34 million for the year ended September 30, 2019. The increase was primarily due to a $4.23 million increase in gain on sales of loans, recoveries of $483,000 of previously charged off receivables acquired in the South Sound Acquisition (which are recorded in the "Other, net" non-interest category), and smaller increases in several other categories. These increases were partially offset by a $1.05 million decrease in BOLI net earnings, a $757,000 decrease in
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service charges on deposits and smaller decreases in several other categories. The increase in gain on sales of loans was primarily due to an increase in the dollar amount of fixed rate one- to four-family loans originated and sold during the current year and an increase in the average pricing margin. The increase in mortgage banking volumes were largely due to increased refinance activity for single family homes due to lower mortgage interest rates. Net BOLI earnings were higher for the comparable period one year ago primarily due to a BOLI death benefit claim. The decrease in service charges on deposits was primarily due to a decrease in overdraft fee income.
Non-interest Expense: Total non-interest expense decreased by $1.52 million, or 4.3%, to $34.06 million for the year ended September 30, 2020 from $35.58 million for the year ended September 30, 2019. The decrease was primarily due to a $1.42 million decrease in data processing and telecommunications expense and smaller decreases in several other categories. Data processing related expenses were elevated for the year ended September 30, 2019 due to the Company's core operating system and ancillary technology systems conversions. The efficiency ratio for the year ended September 30, 2020 improved to 50.04% from 54.32% for the year ended September 30, 2019.
Provision for Income Taxes: The provision for income taxes increased by $137,000, or 2.3% to $6.04 million for the year ended September 30, 2020 from $5.90 million for the year ended September 30, 2019. The increase in the provision for income taxes was primarily due to higher income before income taxes. The Company's effective income tax rate was 19.9% for the year ended September 30, 2020 compared to 19.7% for the year ended September 30, 2019. Contributing to the lower effective income tax rate for the year ended September 30, 2019 was a higher percentage of tax-exempt income, primarily due to a BOLI death benefit claim. For additional information on income taxes, see Note 14 of the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data."
Average Balances, Interest and Average Yields/Cost
The earnings of the Company depend largely on the spread between the yield on interest-earning assets and the cost of interest-bearing liabilities, as well as the relative amount of the Company's interest-earning assets and interest- bearing liability portfolios.
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The following table sets forth, for the periods indicated, information regarding average balances of assets and liabilities as well as the total dollar amounts of interest income from average interest-earning assets and interest expense on average interest-bearing liabilities and average yields and costs. Such yields and costs for the periods indicated are derived by dividing income or expense by the average daily balance of assets or liabilities, respectively, for the periods presented.
Year Ended September 30,
(Dollars in thousands)
Interest-earning assets:
Interest-bearing liabilities:
_______________________________________________
(1)Does not include interest on loans on non-accrual status. Includes loans held for sale and interest earned on loans held for sale. Amortized net deferred loan fees, late fees, extension fees and prepayment penalties (year ended September 30, 2020 - $3,196; year ended September 30, 2019 - $1,743 and year ended September 30, 2018 - $1,426) are included with interest and dividends. Accretion of the fair value discount on loans acquired in the South Sound Acquisition for the years ended September 30, 2020 and 2019 of $597 and $645, respectively, is included with interest and dividends.
(2)Average balances include loans and investment securities on non-accrual status.
(3)Includes FHLB borrowings with original maturities of one year or greater.
(4)Net interest income divided by total average interest-earning assets.
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Rate/Volume Analysis
The following table sets forth the effects of changing rates and volumes on net interest income on the Company. Information is provided with respect to the (i) effects on interest income attributable to changes in volume (changes in volume multiplied by prior rate), (ii) effects on interest income attributable to changes in rate (changes in rate multiplied by prior volume), and (iii) the net change (sum of the prior columns). Changes in both rate and volume have been allocated to rate and volume variances based on the absolute values of each.
Rate Volume NetChange Rate Volume NetChange
(Dollars in thousands)
Interest-earning assets:
Interest-bearing liabilities:
______________
(1)Excludes interest on loans on non-accrual status. Includes loans held for sale and interest earned on loans held for sale.
Liquidity and Capital Resources
The Company's primary sources of funds are customer deposits, proceeds from principal and interest payments on loans, the sale of loans, maturing investment securities, maturing CDs held for investment and FHLB borrowings (if needed). While the maturities and the scheduled amortization of loans are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition.
The Bank must maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund loan originations and deposit withdrawals, to satisfy other financial commitments and to take advantage of investment opportunities. The Bank generally maintains sufficient cash and short-term investments to meet short-term liquidity needs. At September 30, 2020, the Bank's regulatory liquidity ratio (net cash, and short-term and marketable assets, as a percentage of net deposits and short-term liabilities) was 29.1%. At September 30, 2020, the Bank maintained an uncommitted credit facility with the FHLB that provided for immediately available borrowings up to an aggregate amount equal to 45% of total assets, limited by available collateral, under which $10.0 million was outstanding. The Bank had $364.09 million available for additional borrowings with the FHLB at September 30, 2020. The Bank maintains a short-term borrowing line with the FRB with total credit based on eligible collateral. At September 30, 2020, the Bank had no outstanding balance on this borrowing line, under which $71.90 million was available for future borrowings. The Bank also maintains a $50.00 million overnight borrowing line with PCBB. At September 30, 2020, the Bank did not have an outstanding balance on this borrowing line.
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Liquidity management is both a short and long-term responsibility of the Bank's management. The Bank adjusts its investments in liquid assets based upon management's assessment of (i) expected loan demand, (ii) projected loan sales, (iii) expected deposit flows, and (iv) yields available on interest-bearing deposits. Excess liquidity is invested generally in interest-bearing overnight deposits, CDs held for investment and short-term government and agency obligations. If the Bank requires funds beyond its ability to generate them internally, it has additional borrowing capacity with the FHLB, the FRB and PCBB.
The Bank's primary investing activity is the origination of loans. During the years ended September 30, 2020, 2019 and 2018, the Bank originated $597.19 million, $356.04 million and $329.59 million of loans, respectively. At September 30, 2020, the Bank had loan commitments totaling $141.61 million and undisbursed construction loans in process totaling $100.56 million. The Bank anticipates that it will have sufficient funds available to meet current loan commitments. CDs that are scheduled to mature in less than one year from September 30, 2020 totaled $102.86 million. Historically, the Bank has been able to retain a significant amount of its deposits as they mature.
The Bank’s liquidity is also affected by the volume of loans sold and loan principal payments. During the years ended September 30, 2020, 2019 and 2018, the Bank sold $167.24 million, $73.03 million and $66.40 million in loans and loan participation interests, respectively. During the years ended September 30, 2020, 2019 and 2018, the Bank received $287.04 million, $241.66 million and $235.61 million in principal repayments, respectively.
The Bank’s liquidity has been impacted by increases in deposit levels. During the years ended September 30, 2020, 2019 and 2018, deposits increased by $290.18 million, $178.72 million and $51.61 million, respectively.
Cash and cash equivalents, CDs held for investment and investment securities increased to $465.79 million at September 30, 2020 from $275.00 million at September 30, 2019.
Timberland Bancorp is a separate legal entity from the Bank and must provide for its own liquidity and pay its own operating expenses. Sources of capital and liquidity for Timberland Bancorp include distributions from the Bank and the issuance of debt or equity securities. At September 30, 2020, Timberland Bancorp (on an unconsolidated basis) had liquid assets of $2.63 million.
Bank holding companies and federally-insured state-chartered banks are required to maintain minimum levels of regulatory capital. At September 30, 2020, Timberland Bancorp and the Bank were in compliance with all applicable capital requirements. For additional details see Note 18 to the Consolidated Financial Statements contained in “Item 8. Financial Statements and Supplementary Data” and “Item 1. Business - Regulation of the Bank - Capital Requirements.”
Contractual obligations. The following table presents, as of September 30, 2020, the Company’s significant fixed and determinable contractual operating lease obligations by payment date. There were no other fixed determinable contractual obligations outstanding at September 30, 2020.
Payments due by period
Contractual obligations
(Dollars in thousands)
Off-Balance Sheet Activities. The Company is a party to financial instruments with off-balance sheet risk in the normal course of business in order to meet the financial needs of its customers. For information regarding our commitments and off-balance sheet arrangements, see Note 17 of the Notes to Consolidated Financial Statements included in Item 8. "Financial Statements and Supplementary Data" of this Form 10-K.
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A summary of the Company's commitments at September 30, 2020 and 2019 is as follows (in thousands):
Undisbursed portion of construction loans in process $ 100,558 $ 92,226
Effect of Inflation and Changing Prices
The consolidated financial statements and related financial data presented herein have been prepared in accordance with GAAP which require the measurement of financial position and operating results in terms of historical dollars, without considering the change in the relative purchasing power of money over time due to inflation. The primary impact of inflation on the operation of the Company is reflected in increased operating costs. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant impact on a financial institution's performance than do general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.
New Accounting Pronouncements
For a discussion of new accounting pronouncements and their impact on the Company, see Note 1 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data".
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The information contained under “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Market Risk and Asset and Liability Management” of this Form 10-K is incorporated herein by reference.
Item 8. Financial Statements and Supplementary Data
TIMBERLAND BANCORP, INC. AND SUBSIDIARY
Index to Consolidated Financial Statements
Page
Report of Independent Registered Public Accounting Firm 70
Consolidated Balance Sheets as of September 30, 2020 and 2019 71
Consolidated Statements of Income for the Years Ended
Consolidated Statements of Comprehensive Income for the
Consolidated Statements of Shareholders' Equity for the
Consolidated Statements of Cash Flows for the Years Ended
Notes to Consolidated Financial Statements 80
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Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of
Timberland Bancorp, Inc.
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of Timberland Bancorp, Inc. and Subsidiary (collectively, "the Company") as of September 30, 2020 and 2019, and the related consolidated statements of income, comprehensive income, shareholders' equity, and cash flows for each of the years in the three-year period ended September 30, 2020, and the related notes (collectively referred to as "the financial statements"). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of September 30, 2020 and 2019, and the results of its operations and its cash flows for each of the years in the three-year period ended September 30, 2020, in conformity with accounting principles generally accepted in the United States of America (U.S.).
Basis for Opinion
These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits, we are required to obtain an understanding of internal control over financial reporting, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the 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 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 financial statements. We believe that our audits provide a reasonable basis for our opinion.
/s/ Delap LLP
We have served as the Company's auditor since 2010.
Lake Oswego, Oregon
December 9, 2020
70
Consolidated Balance Sheets
(Dollars in Thousands, Except Per Share Amounts)
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
Assets
Cash and cash equivalents:
Cash and due from financial institutions $ 21,877 $ 25,179
Investment securities available for sale, at fair value 57,907 22,532
Investments in equity securities, at fair value 977 958
Federal Home Loan Bank of Des Moines (“FHLB”) stock 1,922 1,437
Other real estate owned (“OREO”) and other repossessed assets, net 1,050 1,683
Core deposit intangible (“CDI”), net 1,625 2,031
Operating lease right-of-use ("ROU") assets 2,587 —
Liabilities and shareholders’ equity
Liabilities
Deposits:
Operating lease liabilities 2,630 —
Other liabilities and accrued expenses 7,312 7,838
Commitments and contingencies (See Note 17)
See notes to consolidated financial statements
71
Consolidated Balance Sheets (continued)
(Dollars in Thousands, Except Per Share Amounts)
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
Accumulated other comprehensive income 61 50
See notes to consolidated financial statements
72
Consolidated Statements of Income
(Dollars in Thousands, Except Per Share Amounts)
Timberland Bancorp, Inc. and Subsidiary
Years Ended September 30, 2020, 2019 and 2018
Interest and dividend income
Dividends from mutual funds, FHLB stock and other investments 128 162 120
Interest expense
FHLB borrowings 66 — —
Provision for loan losses 3,700 — —
Non-interest income
Recoveries on investment securities 120 71 73
Net recoveries on investment securities 120 59 68
Gain on sales of investment securities, net — 47 —
ATM and debit card interchange transaction fees 4,378 4,036 3,570
Valuation allowance on servicing rights, net (221) (4) —
Fee income from non-deposit investment sales 22 46 109
See notes to consolidated financial statements
73
Consolidated Statements of Income (continued)
(Dollars in Thousands, Except Per Share Amounts)
Timberland Bancorp, Inc. and Subsidiary
Years Ended September 30, 2020, 2019 and 2018
Non-interest expense
Loss (gain) on sales/dispositions of premises and equipment, net (98) 7 (102)
OREO and other repossessed assets, net 276 221 140
ATM and debit card interchange transaction fees 1,628 1,583 1,296
Federal Deposit Insurance Corporation ("FDIC") insurance 204 187 294
Loan administration and foreclosure 448 382 336
Net income per common share
See notes to consolidated financial statements
74
Consolidated Statements of Comprehensive Income
(Dollars in Thousands)
Timberland Bancorp, Inc. and Subsidiary
Years Ended September 30, 2020, 2019 and 2018
Comprehensive income
Other comprehensive income (loss)
Change in OTTI on investment securities held to maturity, net of income taxes:
Total other comprehensive income (loss), net of income taxes 11 116 (5)
See notes to consolidated financial statements
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Consolidated Statements of Shareholders’ Equity
(Dollars in Thousands, Except Per Share Amounts)
Timberland Bancorp, Inc. and Subsidiary
Years Ended September 30, 2020, 2019 and 2018
Number of Shares Amount RetainedEarnings Total
Other comprehensive loss — — — — (5) (5)
Common stock dividends ($0.60 per common share) — — — (4,431) — (4,431)
Earned ESOP shares, net of income taxes — 618 264 — — 882
Stock option compensation expense — 172 — — — 172
Other comprehensive income — — — — 116 116
Common stock dividends ($0.78 per common share) — — — (6,495) — (6,495)
Earned ESOP shares, net of income taxes — 308 133 — — 441
Stock option compensation expense — 159 — — — 159
Adoption of Accounting Standards Update ("ASU") 2016-01 — — — (63) 63 —
See notes to consolidated financial statements
76
Consolidated Statements of Shareholders’ Equity (continued)
(Dollars in Thousands, Except Per Share Amounts)
Timberland Bancorp, Inc. and Subsidiary
Years Ended September 30, 2020, 2019 and 2018
Common Stock AccumulatedOtherComprehensiveIncome (Loss)
Number of Shares Amount RetainedEarnings Total
Other comprehensive income — — — 11 11
Common stock dividends ($0.85 per common share) — — (7,083) — (7,083)
Earned ESOP shares, net of income taxes — 31 — — 31
Stock option compensation expense — 182 — — 182
See notes to consolidated financial statements
77
Consolidated Statements of Cash Flows
(Dollars in Thousands)
Timberland Bancorp, Inc. and Subsidiary
Years Ended September 30, 2020, 2019 and 2018
Cash flows from operating activities
Accretion of discount on purchased loans (597) (645) —
Gain on sales of investment securities — (47) —
Net recoveries on investment securities (120) (59) (68)
Change in fair value of investments in equity securities (19) (41) —
Gain on sales of OREO and other repossessed assets, net (35) (89) (229)
(Accretion) amortization of discounts and premiums on securities (183) 167 (17)
(Gain) loss on sales/dispositions of premises and equipment, net (98) 7 (102)
Provision for loan losses 3,700 — —
Valuation adjustment on servicing rights, net 221 8 —
BOLI death benefit in excess of cash surrender value — (1,028) —
Increase in deferred loan origination fees 3,637 161 171
Cash flows from investing activities
Purchase of investment securities held to maturity (10,255) (13,166) (6,073)
Purchase of investment securities available for sale (41,212) (20,909) —
Proceeds from sale of investment securities held to maturity — 2,937 —
Proceeds from sales of investment securities available for sale — 2,332 —
Purchase of FHLB stock (485) (42) (83)
Proceeds from sales of OREO and other repossessed assets 495 613 1,693
Proceeds from sales/dispositions of premises and equipment 307 — 463
Proceeds from death benefit on BOLI — 3,078 —
Cash acquired, net of cash consideration paid in business combination — 14,284 —
Escrow deposit for business combination — 6,900 (6,900)
See notes to consolidated financial statements
78
Consolidated Statements of Cash Flows (continued)
(Dollars in Thousands)
Timberland Bancorp, Inc. and Subsidiary
Years Ended September 30, 2020, 2019 and 2018
Cash flows from financing activities
Proceeds from FHLB borrowings 10,000 — —
Proceeds from exercise of stock options 391 401 318
Repurchase of common stock (1,238) (499) —
Net increase (decrease) in cash and cash equivalents 171,437 (5,849) 676
Cash and cash equivalents
Supplemental disclosure of cash flow information
Supplemental disclosure of non-cash investing activities
Loans transferred to OREO and other repossessed assets $ — $ 293 $ 324
Other comprehensive income (loss) related to investment securities 11 116 (5)
Operating lease liabilities arising from recording of ROU assets 2,889 — —
See notes to consolidated financial statements
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Notes to Consolidated Financial Statements
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
Note 1 - Summary of Significant Accounting Policies
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of Timberland Bancorp, Inc. (“Timberland Bancorp”); its wholly owned subsidiary, Timberland Bank (the “Bank”); and the Bank’s wholly owned subsidiary, Timberland Service Corp. (collectively, the "Company”). All significant intercompany transactions and balances have been eliminated in consolidation.
On October 1, 2018, the Company completed the acquisition of South Sound Bank, a Washington-state chartered bank, headquartered in Olympia, Washington ("South Sound Acquisition"). The Company acquired 100% of the outstanding common stock of South Sound Bank, and South Sound Bank was merged into the Bank. The results of operations of the acquired assets and assumed liabilities have been included in the Company's consolidated financial statements as of and for the period since the acquisition date. See Note 2 for additional information on the South Sound Acquisition.
Nature of Operations
Timberland Bancorp is a bank holding company which operates primarily through its subsidiary, the Bank. The Bank was established in 1915 and, through its 24 branches located in Grays Harbor, Pierce, Thurston, Kitsap, King and Lewis counties in Washington State, attracts deposits from the general public, and uses those funds, along with other borrowings, primarily to provide residential real estate, construction, commercial real estate, commercial business and consumer loans to borrowers primarily in western Washington.
Consolidated Financial Statement Presentation
The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S.") (“GAAP”) and prevailing practices within the banking industry.The preparation of consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities, as of the date of the consolidated balance sheets, and the reported amounts of income and expenses during the reporting period. 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 allowance for loan losses, the determination of any OTTI in the fair value of investment securities, the valuation of servicing rights, the valuation of OREO, the valuation of assets acquired and liabilities assumed in acquisitions and the valuation of goodwill for potential impairment.
Certain prior year amounts have been reclassified to conform to the 2020 fiscal year presentation with no change to previously reported net income or shareholders’ equity.
Segment Reporting
The Company has one reportable operating segment which is defined as community banking in western Washington under the operating name “Timberland Bank.”
Cash and Cash Equivalents and Cash Flows
The Company considers amounts included in the consolidated balance sheets’ captions “Cash and due from financial institutions” and “Interest-bearing deposits in banks,” all of which mature within ninety days, to be cash equivalents for purposes of reporting cash flows.
Interest-bearing deposits in banks as of September 30, 2020 and 2019 included deposits with the Federal Reserve Bank of San Francisco ("FRB") of $266,171,000 and $102,189,000, respectively. The Company also maintains balances in correspondent bank accounts which, at times, may exceed the FDIC insurance limit of $250,000 per correspondent bank. Management believes that its risk of loss associated with such balances is minimal due to the financial strength of the FRB and the correspondent banks.
80
Notes to Consolidated Financial Statements
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
CDs Held for Investment
CDs held for investment include amounts invested with other FDIC-insured financial institutions for a stated interest rate and with a fixed maturity date. Such CDs generally have maturities of 12 to 60 months from the date of purchase by the Company. Early withdrawal penalties may apply; however, the Company intends to hold these CDs to maturity. The Company generally limits its purchases of CDs to a maximum of $250,000 (the FDIC insurance coverage limit) with any single financial institution.
Investment Securities
Investments in debt securities are classified upon acquisition as held to maturity or available for sale. Investments in debt securities that the Company has the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost. Investments in debt securities classified as available for sale are reported at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income (loss), net of income tax effects. Premiums and discounts are amortized to interest income using the interest method over the contractual lives of the securities. Gains and losses on sales of investment securities are recognized on the trade date and determined using the specific identification method.
In estimating whether there are any OTTI losses, management considers (1) the length of time and the extent to which the fair value has been less than amortized cost, (2) the financial condition and near term prospects of the issuer, (3) the impact of changes in market interest rates and (4) the intent and ability of the Company to retain its investment for a period of time sufficient to allow for any anticipated recovery in fair value.
Declines in the fair value of individual debt securities available for sale that are deemed to be other than temporary are recognized in earnings when identified. The fair value of the debt security then becomes the new cost basis. For individual debt securities that are held to maturity which the Company does not intend to sell, and it is not more likely than not that the Company will be required to sell before recovery of its amortized cost basis, the other than temporary decline in the fair value of the debt security related to: (1) credit loss is recognized in earnings and (2) market or other factors is recognized in other comprehensive income (loss). Credit loss is recorded if the present value of expected future cash flows is less than the amortized cost. For individual debt securities which the Company intends to sell or more likely than not will not recover all of its amortized cost, the OTTI is recognized in earnings equal to the entire difference between the debt security’s cost basis and its fair value at the consolidated balance sheet date. For individual debt securities for which credit loss has been recognized in earnings, interest accruals and amortization and accretion of premiums and discounts are suspended when the credit loss is recognized. Interest received after accruals have been suspended is recognized on a cash basis.
Investments in Equity Securities
Investments in equity securities are stated at fair value. Prior to October 1, 2018, changes in the fair value of investments in equity securities were excluded from earnings and reported in other comprehensive income (loss), net of income tax effects. On October 1, 2018, the Company adopted ASU 2016-01 and reclassified its mutual funds as investments in equity securities. Beginning October 1, 2018, changes in the fair value of investments in equity securities are recorded in other non-interest income.
FHLB Stock
The Bank, as a member of the FHLB, is required to maintain an investment in capital stock of the FHLB in an amount equal to 0.12% of the Bank's total assets plus 4.00% of any borrowings from the FHLB. No ready market exists for this stock, and it has no quoted market value. However, redemption of FHLB stock has historically been at par value. The Company's investment in FHLB stock is carried at cost, which approximates fair value.
The Company evaluates its FHLB stock for impairment as needed. The Company's determination of whether this investment is impaired is based on its assessment of the ultimate recoverability of cost rather than by recognizing temporary declines in value. The determination of whether a decline affects the ultimate recoverability of cost is influenced by criteria such as (1) the significance of any decline in net assets of the FHLB as compared with the capital stock amount and the length of time any decline has persisted; (2) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLB; (3) the impact of legislative and regulatory changes on
institutions and, accordingly, the customer base of the FHLB; and (4) the liquidity position of the FHLB. Based on its evaluation, the Company determined that there was no impairment of FHLB stock at September 30, 2020 and 2019.
81
Notes to Consolidated Financial Statements
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
Other Investments
The Bank invests in the Solomon Hess SBA Loan Fund LLC - a private investment fund - to help satisfy compliance with the Bank's Community Reinvestment Act ("CRA") investment test requirements. Shares in this fund are not publicly traded and therefore have no readily determinable fair value. The Bank's investment in the fund is recorded at cost. An investor can have its investment in the fund redeemed for the balance of its capital account at any quarter end with a 60 day notice to the fund.
Loans Held for Sale
Mortgage loans and commercial business loans originated and intended for sale in the secondary market are stated in the aggregate at the lower of cost or estimated fair value. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income. Gains or losses on sales of loans are recognized at the time of sale. The gain or loss is the difference between the net sales proceeds and the recorded value of the loans, including any remaining unamortized deferred loan origination fees.
Loans Receivable
Loans are stated at the amount of unpaid principal, reduced by the undisbursed portion of construction loans in process, net deferred loan origination fees and the allowance for loan losses.
Interest on loans is accrued daily based on the principal amount outstanding. Generally, the accrual of interest on loans is discontinued when, in management’s opinion, the borrower may be unable to make payments as they become due or when they are past due 90 days as to either principal or interest (based on contractual terms), unless the loan is well secured and in the process of collection. In determining whether a borrower may be able to make payments as they become due, management considers circumstances such as the financial strength of the borrower, the estimated collateral value, reasons for the delays in payments, payment record, the amounts past due and the number of days past due. All interest accrued but not collected for loans that are placed on non-accrual status or charged off is reversed against interest income. Subsequent collections on a cash basis are applied proportionately to past due principal and interest, unless collectability of principal is in doubt, in which case all payments are applied to principal. Loans are returned to accrual status when the loan is deemed current, and the collectability of principal and interest is no longer doubtful, or, in the case of one- to four-family loans, when the loan is less than 90 days delinquent. The categories of non-accrual loans and impaired loans overlap, although they are not identical.
The Company charges fees for originating loans. These fees, net of certain loan origination costs, are deferred and amortized to income on the level-yield basis over the loan term. If the loan is repaid prior to maturity, the remaining unamortized deferred loan origination fee is recognized in income at the time of repayment.
Acquired Loans
Purchased loans, including loans acquired in business combinations, are recorded at their estimated fair value at the acquisition date. Credit discounts are included in the determination of fair value; therefore, an allowance for loan losses is not recorded at the acquisition date. Acquired loans are evaluated upon acquisition and classified as either purchased credit-impaired ("PCI") or purchased non-credit-impaired. PCI loans reflect credit deterioration since origination such that it is probable at acquisition that the Company will be unable to collect all contractually required payments. The excess of the cash flows expected to be collected over a PCI loan's carrying value is considered to be the accretable yield and is recognized as interest income over the estimated life of the PCI loan using the effective yield method. The excess of the undiscounted contractual balances due over the cash flows expected to be collected is considered to be the nonaccretable difference. The nonaccretable difference represents the Company's estimate of the credit losses expected to occur and would be considered in determining the estimated
fair value of the loans as of the acquisition date. Subsequent to the acquisition date, any increases in expected cash flows over those expected at the purchase date in excess of fair value are adjusted through a change to the accretable yield on a prospective basis. Any subsequent decreases in expected cash flows attributable to credit deterioration are recognized by recording an allowance for loan losses. PCI loans were insignificant as of September 30, 2020 and 2019.
For purchased non-credit-impaired loans, the difference between the fair value and unpaid principal balance of the loan at the acquisition date is amortized or accreted to interest income over the life of the loans. Any subsequent deterioration in credit quality is recognized by recording an allowance for loan losses.
82
Notes to Consolidated Financial Statements
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
Troubled Debt Restructured Loans
A troubled debt restructured loan ("TDR") is a loan for which the Company, for reasons related to a borrower’s financial difficulties, grants a concession to the borrower that the Company would not otherwise consider. Examples of such concessions include, but are not limited to: a reduction in the stated interest rate; an extension of the maturity at an interest rate below current market rates; a reduction in the face amount of the debt; a reduction in the accrued interest; or re-amortizations, extensions, deferrals and renewals. TDRs are considered impaired and are individually evaluated for impairment. TDRs are classified as non-accrual (and considered to be non-performing) unless they have been performing in accordance with modified terms for a period of at least six months. In March 2020, the Company announced loan modification programs to support and provide relief for its borrowers during the novel coronavirus of 2019 ("COVID-19") pandemic. The Company has followed the loan modification criteria within the Coronavirus Aid, Relief, and Economic Security Act of 2020 ("CARES Act"), which was signed into law on March 27, 2020 and interagency guidance from the federal banking agencies when determining if a borrower's modification is subject to a TDR classification. If it is determined that the modification does not meet the criteria under the CARES Act or interagency guidance to be excluded from TDR classification, the Company evaluates the loan modifications under its existing TDR framework. Loans subject to forbearance under the COVID-19 loan modification program are not reported as past due or placed on non-accrual status during the forbearance time period, and interest income continues to be recognized over the contractual life of the loans.
Allowance for Loan Losses
The allowance for loan losses is maintained at a level sufficient to provide for probable losses inherent in the loan portfolio. The allowance is provided based upon management's comprehensive analysis of the pertinent factors underlying the quality of the loan portfolio. These factors include changes in the amount and composition of the loan portfolio, delinquency levels, actual loan loss experience, current economic conditions, and a detailed analysis of individual loans for which full collectability may not be assured. The detailed analysis includes methods to estimate the fair value of loan collateral and the existence of potential alternative sources of repayment. The allowance consists of specific and general components. The specific component relates to loans that are deemed impaired. For loans that are classified as impaired, an allowance is established when the discounted cash flows, collateral value less selling costs (if applicable), or observable market price of the impaired loan is lower than the recorded value of that loan. The general component covers non-impaired loans and is based on historical loss experience adjusted for qualitative factors. The Company's historical loss experience is determined by evaluating the average net charge-offs over the most recent economic cycle, but not to exceed six years. Qualitative factors are determined by loan type and allow management to adjust reserve levels to reflect the current general economic environment and portfolio performance trends including recent charge-off trends. Allowances are provided based on management’s continuing evaluation of the pertinent factors underlying the quality of the loan portfolio, including changes in the size and composition of the loan portfolio, actual loan loss experience, current economic conditions, collateral values, geographic concentrations, seasoning of the loan portfolio, specific industry conditions, the duration of the current business cycle, and regulatory requirements and expectations. When determining the appropriate historical loss and qualitative factors, management took into consideration the impact of the COVID-19 pandemic on such factors as the national and state unemployment rates and related trends, the amount of and timing of financial assistance provided by the government, consumer spending levels and trends, industries significantly impacted by the COVID-19 pandemic, and the Company's COVID-19 loan modification program. The appropriateness of the allowance for loan losses is estimated based upon these factors and trends identified by management at the time the consolidated financial statements are prepared.
A loan is considered impaired when it is probable that the Company will be unable to collect all amounts (principal and interest) when due according to the contractual terms of the loan agreement. Smaller balance homogeneous loans, such as residential mortgage loans and consumer loans, may be collectively evaluated for impairment. When a loan has been identified as being impaired, the amount of the impairment is measured by using discounted cash flows, except when, as an alternative, the current estimated fair value of the collateral (reduced by estimated costs to sell, if applicable) or observable market price is used. The valuation of real estate collateral is subjective in nature and may be adjusted in future periods because of changes in economic conditions. Management considers third-party appraisals, as well as independent fair market value assessments from realtors or persons involved in selling real estate, in determining the estimated fair value of particular properties. In addition, as certain of
these third-party appraisals and independent fair market value assessments are only updated periodically, changes in the values of specific properties may have occurred subsequent to the most recent appraisals. Accordingly, the amounts of any such potential changes and any related adjustments are generally recorded at the time such information is received. When the estimated net realizable value of the impaired loan is less than the recorded investment in the loan (including accrued interest
83
Notes to Consolidated Financial Statements
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
and net deferred loan origination fees or costs), impairment is recognized by creating or adjusting an allocation of the allowance for loan losses and uncollected accrued interest is reversed against interest income. If ultimate collection of principal is in doubt, all cash receipts on impaired loans are applied to reduce the principal balance.
A provision for (recapture of) loan losses is charged (credited) to operations and is added to (deducted from) the allowance for loan losses based on a quarterly comprehensive analysis of the loan portfolio. The allowance for loan losses is allocated to
certain loan categories based on the relative risk characteristics, asset classifications and actual loss experience of the loan portfolio. While management has allocated the allowance for loan losses to various loan portfolio segments, the allowance is general in nature and is available for the loan portfolio in its entirety.
The ultimate recovery of all loans is susceptible to future market factors beyond the Company’s control. These factors may result in losses or recoveries differing significantly from those provided in the consolidated financial statements. If real estate values decline and as updated appraisals are received on collateral for impaired loans, the Company may need to increase the allowance for loan losses appropriately. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses, and may require the Company to make additions to the allowance based on their judgment about information available to them at the time of their examinations.
Premises and Equipment
Premises and equipment are recorded at cost. Depreciation is computed using the straight-line method over the following estimated useful lives: buildings and improvements - five to 40 years and furniture and equipment - three to seven years. The cost of maintenance and repairs is charged to expense as incurred. Gains and losses on dispositions are reflected in earnings.
Impairment of Long-Lived Assets
Long-lived assets, consisting of premises and equipment, are reviewed for impairment whenever events or changes in circumstances indicate that the recorded amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the recorded amount of an asset to undiscounted future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the recorded amount of the assets exceeds the discounted recovery amount or estimated fair value of the assets. No events or changes in circumstances have occurred during the years ended September 30, 2020 or 2019 that would cause management to evaluate the recoverability of the Company’s long-lived assets.
OREO and Other Repossessed Assets
OREO and other repossessed assets consist of properties or assets acquired through or in lieu of foreclosure, and are recorded initially at the estimated fair value of the properties less estimated costs of disposal, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. When the property is acquired, any excess of the loan balance over the estimated net realizable value is charged to the allowance for loan losses. The valuation of real estate is subjective in nature and may be adjusted in future periods because of changes in economic conditions. Management considers third-party appraisals, as well as independent fair market value assessments from realtors or persons involved in selling real estate, in determining the estimated fair values of particular properties. In addition, as certain of these third-party appraisals and independent fair market value assessments are only updated periodically, changes in the values of specific properties may have occurred subsequent to the most recent appraisals. Accordingly, the amounts of any such potential changes and any related adjustments are generally recorded at the time such information is received. Costs relating to development and improvement of the properties or assets are capitalized, while costs relating to holding the properties or assets are expensed.
BOLI
BOLI policies are recorded at their cash surrender value less applicable cash surrender charges. Income from BOLI is recognized when earned.
84
Notes to Consolidated Financial Statements
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
Goodwill
Goodwill is initially recorded when the purchase price paid in a business combination exceeds the estimated fair value of the net identified tangible and intangible assets acquired and liabilities assumed. Goodwill is presumed to have an indefinite useful life and is analyzed annually for impairment. The Company performs an annual review during the third quarter of each fiscal year, or more frequently if indicators of potential impairment exist, to determine if the recorded goodwill is impaired. For purposes of goodwill impairment testing, the services offered through the Bank and its subsidiary are managed as one strategic unit and represent the Company's only reporting unit.
The annual goodwill impairment test begins with a qualitative assessment of whether it is "more likely than not" that the reporting unit's fair value is less than its carrying amount. If an entity concludes that it is not "more likely than not" that the fair value of a reporting unit is less than its carrying amount, it need not perform a two-step impairment test. If the Company's qualitative assessment concluded that it is "more likely than not" that the fair value of its reporting unit is less than its carrying amount, it must perform the two-step impairment test to identify potential goodwill impairment and measure the amount of goodwill impairment loss to be recognized, if any. The first step of the goodwill impairment test compares the estimated fair value of the reporting unit with its carrying amount, or the book value, including goodwill. If the estimated fair value of the reporting unit equals or exceeds its book value, goodwill is considered not impaired, and the second step of the impairment test is unnecessary.
The second step, if necessary, measures the amount of goodwill impairment loss to be recognized. The reporting unit must determine fair value for all assets and liabilities, excluding goodwill. The net of the assigned fair value of assets and liabilities is then compared to the book value of the reporting unit, and any excess book value becomes the implied fair value of goodwill. If the carrying amount of the goodwill exceeds the newly calculated implied fair value of goodwill, an impairment loss is recognized in the amount required to write-down the goodwill to the implied fair value.
Management's qualitative assessment takes into consideration macroeconomic conditions, industry and market considerations, cost or margin factors, financial performance and the share price of the Company's common stock. The Company performed its fiscal year 2020 goodwill impairment test during the quarter ended June 30, 2020 with the assistance of an independent third-party firm specializing in goodwill impairment valuations for financial institutions. The third-party analysis was conducted as of May 31, 2020 and the step one test concluded that the reporting unit's fair value was more than its recorded value and, therefore, step two of the analysis was not necessary. Accordingly, the recorded value of goodwill as of May 31, 2020 was not impaired.
A significant amount of judgment is involved in determining if an indicator of goodwill impairment has occurred. Such indicators may include, among others: a significant decline in expected future cash flows; a sustained, significant decline in the Company's stock price and market capitalization; a significant adverse change in legal factors or in the business climate; adverse assessment or action by a regulator; and unanticipated competition. Any change in these indicators could have a significant negative impact on the Company's financial condition, impact the goodwill impairment analysis or cause the Company to perform a goodwill impairment analysis more frequently than once per year.
As of September 30, 2020, management believes that there were no events or changes in the circumstances since May 31, 2020 that would indicate a potential impairment of goodwill. No assurances can be given, however, that the Company will not record an impairment loss on goodwill in the future. If adverse economic conditions or the recent decrease in the Company's stock price and market capitalization as a result of the COVID-19 pandemic were deemed to be other than temporary, it may significantly affect the fair value of the Company's goodwill and may trigger impairment charges. Any impairment charge could have a material adverse effect on the Company's results of operation and financial condition.
CDI
CDI represents the future economic benefit of the potential cost savings from acquiring core deposits as part of a business combination compared to the cost of alternative funding sources. CDI is amortized to non-interest expense using an accelerated method based on an estimated runoff of related deposits over a period of ten years. CDI is evaluated for impairment whenever events or changes in circumstances indicate that its carrying amount may not be recoverable, with any changes in estimated useful life accounted for prospectively over the revised remaining life.
85
Notes to Consolidated Financial Statements
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
Servicing Rights
The Company holds rights to service (1) loans that it has originated and sold to the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and (2) the guaranteed portion of U.S. Small Business Administration ("SBA") loans sold in the secondary market. Servicing rights are capitalized at estimated fair value when acquired through the origination of loans that are subsequently sold with the servicing rights retained. Servicing rights are amortized to servicing income on loans sold approximately in proportion to and over the period of estimated net servicing income. The value of servicing rights at the date of the sale of loans is estimated based on the discounted present value of expected future cash flows using key assumptions for servicing income and costs and expected prepayment rates on the underlying loans. The estimated fair value is periodically evaluated for impairment by comparing actual cash flows and estimated future cash flows from the servicing assets to those estimated at the time the servicing assets were originated. Fair values are estimated using expected future discounted cash flows based on current market rates of interest. For purposes of measuring impairment, the servicing rights must be stratified by one or more predominant risk characteristics of the underlying loans. The Company stratifies its capitalized servicing rights based on product type and term of the underlying loans. The amount of impairment recognized is the amount, if any, by which the amortized cost of the servicing rights exceeds their fair value. Impairment, if deemed temporary, is recognized through a valuation allowance to the extent that fair value is less than the recorded amount.
Transfers of Financial Assets
Transfers of financial assets are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Income Taxes
The Company files a consolidated federal and various state income tax returns. The Bank provides for income taxes separately and remits to (receives from) Timberland Bancorp amounts currently due (receivable).
Deferred income taxes result from temporary differences between the tax basis of assets and liabilities, and their reported amounts in the consolidated financial statements. These temporary differences will result in differences between income for tax purposes and income for financial reporting purposes in future years. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Valuation allowances are established to reduce the net recorded amount of deferred tax assets if it is determined to be more likely than not that all or some portion of the potential deferred tax asset will not be realized.
With respect to accounting for uncertainty in incomes taxes, a tax provision is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely to be realized upon examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. The Company recognizes interest and/or penalties related to income tax matters as income tax expense. The Company is no longer subject to U.S. federal income tax examination by tax authorities for years ended on or before September 30, 2016.
ESOP
The Bank sponsors a leveraged ESOP; however, all ESOP debt was fully repaid during the year ended September 30, 2019. The debt of the ESOP was payable to Timberland Bancorp, was recorded as other borrowed funds of the Bank, and was eliminated in the consolidated financial statements. The shares of the Company's common stock pledged as collateral for the ESOP's debt were reported as unearned shares issued to the ESOP in the consolidated financial statements. As shares were released from collateral, compensation expense was recorded equal to the average market price of the shares for the period, and the shares became available for net income per common share calculations. Dividends paid on unallocated shares reduced the Company’s cash contributions to the ESOP.
86
Notes to Consolidated Financial Statements
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
Advertising
Costs for advertising and marketing are expensed as incurred.
Stock-Based Compensation
The Company measures compensation cost for all stock-based awards based on the grant-date fair value of the stock-based awards and recognizes compensation cost over the service period of stock-based awards. The fair value of stock options is determined using the Black-Scholes valuation model. Stock option forfeitures are accounted for as they occur.
Net Income Per Common Share
Basic net income per common share is computed by dividing net income to common shareholders by the weighted average number of common shares outstanding during the period, without considering any dilutive items. Diluted net income per common share is computed by dividing net income to common shareholders by the weighted average number of common shares and common stock equivalents for items that are dilutive, net of shares assumed to be repurchased using the treasury stock method at the average share price for the Company's common stock during the period. Common stock equivalents arise from the assumed conversion of outstanding stock options. Shares owned by the Bank’s ESOP that have not been allocated are not considered to be outstanding for the purpose of computing basic and diluted net income per common share.
Related Party Transactions
The Chairman of the Board of the Bank and Timberland Bancorp is a member of the law firm that provides general counsel to the Company. Legal and other fees paid to this law firm for the years ended September 30, 2020, 2019 and 2018 totaled $78,000, $69,000 and $94,000, respectively.
Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board ("FASB") issued ASU 2014-09, Revenue from Contracts with Customers, which created FASB Accounting Standards Codification ("ASC") Topic 606 ("ASC 606"). The core principle of ASC 606 is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve that core principle, an entity should apply the following steps: (1) identify the contract(s) with a customer, (2) identify the performance obligations in the contract, (3) determine the transaction price, (4) allocate the transaction price to the performance obligations in the contract and (5) recognize revenue when (or as) the entity satisfies a performance obligation. ASC 606 was effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company adopted ASC 606 on October 1, 2018 using the modified retrospective approach. Therefore, the comparative information has not been adjusted and continues to be reported under the superseded ASC 605. There was no cumulative effect adjustment as of October 1, 2018, and there were no material changes to the timing or amount of revenue recognized for the year ended September 30, 2019; however, additional disclosures were incorporated in the footnotes upon adoption. The majority of the Company's revenue is comprised of interest income from financial assets, which is explicitly excluded from the scope of ASC 606. The Company elected to apply the practical expedient pursuant to ASC 606 and therefore does not disclose information about remaining performance obligations that have an original expected term of one year or less and allows the Company to expense costs related to obtaining a contract as incurred when the amortization period would have been one year or less. See Note 24 for additional information.
In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2016-01 generally requires equity investments - except those accounted for under the equity method of accounting or those that result in consolidation of the investee - to be measured at fair value with changes in fair value recognized in net income. However, an entity may choose to measure equity investments that do not have readily determinable fair values at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. ASU 2016-01 is intended to simplify the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment. ASU 2016-01 also eliminates certain disclosures related to the fair value of financial instruments and requires entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes. ASU 2016-01 was effective for fiscal years beginning after December 15, 2017, including interim periods
87
Notes to Consolidated Financial Statements
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
within those fiscal years. The Company adopted ASU 2016-01 on October 1, 2018. As required by ASU 2016-01, on October 1, 2018 the Company recorded a one-time cumulative effect adjustment of $63,000 representing net unrealized losses on equity securities (mutual funds) between accumulated other comprehensive loss and retained earnings on the accompanying consolidated balance sheet. Additionally, the fair values of financial instruments for disclosure purposes were computed using an exit price notion and deposits with no stated maturity are no longer included in the fair value disclosures in Note 22.
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which created FASB ASC Topic 842 ("ASC 842") and is intended to increase transparency and comparability among organizations by requiring the recognition of lease assets and lease liabilities on the balance sheet and disclosure of key information about leasing arrangements. The principal change required by ASC 842 relates to lessee accounting, and is that for operating leases, a lessee is required to (1) recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments, in the statement of financial position, (2) recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term generally on a straight-line basis, and (3) classify all cash payments within operating activities in the statement of cash flows. For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and lease liabilities. If a lessee makes this election, it should recognize lease expense for such leases generally on a straight-line basis over the lease term. ASC 842 also changes disclosure requirements related to leasing activities and requires certain qualitative disclosures along with specific quantitative disclosures. ASC 842 also provides an optional transition method for adoption, under which an entity initially applies ASC 842 at the adoption date and recognizes a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. Consequently, an entity's reporting for the comparative periods presented in the financial statements in which it adopts ASC 842 will continue to be in accordance with current GAAP. ASC 842 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018. Early application of ASC 842 is permitted. The Company adopted the provisions of ASC 842 effective October 1, 2019 utilizing the optional transition method and will not restate comparative periods. The Company also elected the package of practical expedients permitted under ASC 842's transition guidance, which allows the Company to carryforward its historical lease classifications and its assessment as to whether a contract is or contains a lease. The Company also elected to not recognize lease assets and lease liabilities for leases with an initial term of 12 months or less. As a result of adopting ASC 842, ROU assets and operating lease liabilities increased by $2.89 million on October 1, 2019.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses, as amended by ASU 2018-19, ASU 2019-04 and ASU 2019-05. This ASU replaces the existing incurred losses methodology with a current expected losses methodology with respect to most financial assets measured at amortized cost and certain other instruments, including trade and other receivables, loans, held to maturity investment securities and off-balance sheet commitments. In addition, this ASU requires credit losses relating to available for sale debt securities to be recorded through an allowance for credit losses rather than as a reduction of the carrying amount. ASU 2016-13 also changes the accounting for purchased credit-impaired debt securities and loans. ASU 2016-13 retains many of the current disclosure requirements in GAAP and expands certain disclosure requirements. ASU 2016-13 is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Upon adoption, the Company expects a change in the processes and procedures to calculate the allowance for loan losses, including changes in the assumptions and estimates to consider expected credit losses over the life of the loan versus the current accounting practice that utilizes the incurred loss model. In addition, the current policy for other-than-temporary impairment on investment securities available for sale will be replaced with an allowance approach. The Company is reviewing the requirements of ASU 2016-13 and has begun developing and implementing processes and procedures to ensure it is fully compliant with the amendments at the adoption date. At this time, the Company anticipates the allowance for loan losses will increase as a result of the implementation of this ASU; however, until its evaluation is complete, the magnitude of the increase will be unknown.
In January 2017, the FASB issued ASU 2017-04, Intangibles - Goodwill and Other: Simplifying the Test for Goodwill Impairment. This ASU simplifies the subsequent measurement of goodwill and eliminates Step 2 from the goodwill impairment test. In computing the implied fair value of goodwill under Step 2, an entity had to perform procedures to determine the fair value of its assets and liabilities (including unrecognized assets and liabilities) at the impairment testing date following the procedure that would be required in determining the fair value of assets acquired and liabilities assumed in a business combination. Under ASU 2017-04, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by
which the carrying amount exceeds the reporting unit's fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. Additionally, an entity should consider income tax effects from any tax
deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable. ASU 2017-04 is effective for annual or interim goodwill impairment tests in fiscal years beginning after December 15, 2022.
88
Notes to Consolidated Financial Statements
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
The adoption ASU 2017-04 is not expected to a have a material impact on the Company's future consolidated financial statements.
In March 2017, the FASB issued ASU 2017-08, Receivables - Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. This ASU shortens the amortization period for certain callable debt securities held at a premium to the earliest call date. This ASU was effective for fiscal years, including interim periods within those fiscal years, beginning after December 15, 2018. The Company adopted ASU 2017-08 effective October 1, 2019 and it did not have a material impact on the Company's consolidated financial statements.
In May 2017, the FASB issued ASU 2017-09, Compensation-Stock Compensation (Topic 718): Scope of Modification Accounting. This ASU was issued to provide clarity as to when to apply modification accounting when there is a change in the terms or conditions of a share-based payment award. According to the ASU, an entity should account for the effects of a modification unless the fair value, vesting conditions, and balance sheet classification of the award are the same after the modification as compared to the original award prior to modification. ASU 2017-09 was effective for fiscal years, including interim periods within those fiscal years, beginning after December 15, 2017, with early adoption permitted. The Company adopted ASU 2017-09 effective October 1, 2018 and it did not have a material impact on the Company's consolidated financial statements.
In June 2018, the FASB issued ASU 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting. This ASU was issued to expand the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from nonemployees. Previously, these awards were recorded at the fair value of consideration received or the fair value of the equity instruments issued and were measured at the earlier of the commitment date or the date performance was completed. The amendments in this ASU require nonemployee share-based payment awards to be measured at the grant-date fair value of the equity instrument. ASU 2018-07 was effective for fiscal years, including interim periods within those fiscal years, beginning after December 15, 2018. The Company adopted ASU 2018-07 effective October 1, 2019 and it did not have a material impact on the Company's consolidated financial statements.
In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement. This ASU modifies the disclosure requirements for fair value measurements. The following disclosure requirements were removed from ASC Topic 820, Fair Value Measurement: (1) the amount of and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy; (2) the policy for timing of transfers between levels; and (3) the valuation process for Level 3 fair value measurements. This ASU clarifies that the measurement uncertainty disclosure is to communicate information about the uncertainty in measurement as of the reporting date. This ASU adds the following disclosure requirements for Level 3 measurements: (1) changes in unrealized gains and losses for the period included in other comprehensive income for the recurring Level 3 fair value measurements held at the end of the reporting period, and (2) the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements. ASU 2018-13 was effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The Company adopted ASU 2018-13 effective October 1, 2020 and it is not expected to have a material impact on the Company's future consolidated financial statements.
In August 2018, the FASB issued ASU 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40), Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract. The amendments in this ASU broaden the scope of ASC Subtopic 350-40 to include costs incurred to implement a hosting arrangement that is a service contract. The amendments align the requirements for capitalizing implementation costs incurred
in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software license). The costs are capitalized or expensed depending on the nature of the costs and the project stage during which they are incurred, consistent with the accounting for internal-use software costs. The amendments in this ASU result in consistent capitalization of implementation costs of a hosting arrangement that is a service contract and implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software license). The accounting for the service element of a hosting arrangement that is a service contract is not affected by the amendments in this ASU. ASU 2018-15 was effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The Company adopted ASU 2018-15 effective October 1, 2020 and it is not expected to have a material impact on the Company's future consolidated financial statements.
89
Notes to Consolidated Financial Statements
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
In December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740), Simplifying the accounting for Income Taxes. The amendments in this ASU simplify the accounting for income taxes by removing certain exceptions to the general principles in Topic 740. The amendments also improve consistent application of and simplify GAAP for other areas of Topic 740 by clarifying and amending existing guidelines. ASU 2019-12 is effective for fiscal years beginning after December 15, 2021,
including interim periods within fiscal years. The adoption of ASU 2019-12 is not expected to have a material impact on the Company's future consolidated financial statements.
In March 2020, the FASB issued ASU No. 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting. This ASU applies to contracts, hedging relationships and other transactions that reference the London Interbank Offered Rate ("LIBOR") or other rate references expected to be discontinued because of reference rate reform. The ASU permits an entity to make necessary modifications to eligible contracts or transactions without requiring contract remeasurement or reassessment of a previous accounting determination. This ASU is effective for all entities as of March 12, 2020 through December 31, 2022. The Company has not adopted ASU 2020-04 as of September 30, 2020. The adoption of ASU 2020-04 is not expected to have a material impact on the Company's future consolidated financial statements.
On March 22, 2020, federal banking regulators issued an interagency statement that included guidance on their approach for the accounting of loan modifications in light of the economic impact of the COVID-19 pandemic. The guidance interprets current accounting standards and indicates that a lender can conclude that a borrower is not experiencing financial difficulty if short-term modifications are made in response to COVID-19, such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant related to the loans in which the borrower is less than 30 days past due on its contractual payments at the time a modification is implemented. The agencies confirmed in working with the staff of the FASB that short-term modification made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not troubled debt restructurings.
Note 2 - Business Combination
On October 1, 2018, the Company completed the South Sound Acquisition. The primary reason for the acquisition was to expand the Company's presence along Washington State's economically important I-5 corridor.
Pursuant to the terms of the merger agreement, South Sound Bank shareholders received 0.746 of a share of the Company's common stock and $5.68825 in cash per share of South Sound Bank common stock. The Company issued 904,826 shares of its common stock (valued at $28,267,000 based on the Company's closing stock price on September 30, 2018 of $31.24 per share) and paid $6,903,000 in cash in the transaction for total consideration paid of $35,170,000.
The South Sound Acquisition constitutes a business combination as defined by GAAP, which establishes principles and requirements for how the acquirer in a business combination recognizes and measures in its financial statements the identifiable assets acquired and liabilities assumed. The Company was considered the acquirer in this transaction. Accordingly, the estimated fair values of the acquired assets, including the identifiable intangible assets, and the assumed liabilities in the South Sound Acquisition were measured and recorded as of October 1, 2018. The excess of the total consideration paid over the fair value of the net assets acquired was allocated to goodwill. The South Sound Acquisition resulted in $9,481,000 of goodwill. The goodwill arising from this transaction consists largely of the synergies and expected economies of scale from combining the operations of the Company and South Sound Bank. This goodwill is not deductible for tax purposes.
In most instances, determining the estimated fair values of the acquired assets and assumed liabilities requires the Company to estimate cash flows expected to result from those assets and liabilities and to discount those cash flows at the appropriate rate of interest. Differences may arise between contractually required payments and the expected cash flows at the acquisition date due to items such as estimated credit losses, prepayments or early withdrawal, and other factors. One of the most significant of those determinations relates to the valuation of acquired loans. For such loans, the excess of cash flows expected at acquisition over the estimated fair value is recognized as interest income over the remaining lives of the loans. In accordance with GAAP, there was no carry-over of South Sound Bank's previously established allowance for loan losses.
90
Notes to Consolidated Financial Statements
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
The following table summarizes the fair value of consideration paid, the estimated fair values of assets acquired and liabilities assumed as of the acquisition date, and the resulting goodwill relating to the transaction:
Book Value Fair Value Adjustment Estimated Fair Value
(Dollars in thousands)
Total acquisition consideration $ 35,170
Recognized amounts of identifiable assets acquired and liabilities assumed
Identifiable assets acquired:
Investment securities available for sale 5,022 — 5,022
Accrued interest receivable 554 — 554
Liabilities assumed:
Other liabilities and accrued expenses 3,291 — 3,291
Goodwill recognized $ 9,481
The acquired loan portfolio was valued using Level 3 inputs (see Note 22) and included the use of present value techniques, including cash flow estimates and incorporated assumptions that the Company believes marketplace participants would use in estimating fair values.
The operating results of the Company for the years ended September 30, 2020 and 2019 include the operating results produced by the net assets acquired in the South Sound Acquisition since the October 1, 2018 acquisition date. The Company determined
that the disclosure requirements related to the amounts of revenues and earnings from the net assets acquired in the South Sound Acquisition since the October 1, 2018 acquisition date is impracticable. The financial activity and operating results of the net assets acquired in the South Sound Acquisition were commingled with the Company's financial activity and operating results as of the acquisition date.
During the year ended September 30, 2020, the Company incurred acquisition-related expenses of $2,000 related to the South Sound Acquisition. During the year ended September 30, 2019, the Company incurred acquisition-related expenses of $462,000 related to the South Sound Acquisition, of which $317,000 is included in data processing and $145,000 is included in
91
Notes to Consolidated Financial Statements
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
professional fees in the accompanying consolidated statement of income. During the year ended September 30, 2018, the Company incurred acquisition-related expenses of $616,000 related to the South Sound Acquisition, which are all included in professional fees in the accompanying consolidated statement of income. South Sound Bank incurred acquisition-related expenses of $1,598,000 for the fiscal year ended September 30, 2018 related to the South Sound Acquisition.
Note 3 - Restricted Assets
Federal Reserve regulations require that the Bank maintain certain minimum reserve balances on hand or on deposit with the FRB, based on a percentage of transaction account deposits. In response to the COVID-19 pandemic the Federal Reserve reduced the reserve requirement ratio to zero percent, effective March 26, 2020. The amounts of the reserve requirement balances as of September 30, 2020 and 2019 were $0 and $1,898,000, respectively.
Note 4 - Investment Securities
Held to maturity and available for sale investment securities were as follows as of September 30, 2020 and 2019 (dollars in thousands):
AmortizedCost GrossUnrealizedGains GrossUnrealizedLosses EstimatedFair Value
Held to Maturity
Mortgage-backed securities ("MBS"):
Bank issued trust preferred securities 500 — (1) 499
Available for Sale
Held to Maturity
MBS:
U.S. Treasury and U.S. government agency securities 2,999 — (8) 2,991
Available for Sale
92
Notes to Consolidated Financial Statements
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
Held to maturity and available for sale investment securities with unrealized losses were as follows as of September 30, 2020 (dollars in thousands):
Less Than 12 Months 12 Months or Longer Total
Held to Maturity
MBS:
Private label residential 7 — 1 11 (1) 2 18 (1)
Bank issued trust preferred securities 499 (1) 1 — — — 499 (1)
Available for Sale
MBS:
Held to maturity investment securities with unrealized losses were as follows as of September 30, 2019 (dollars in thousands):
Less Than 12 Months 12 Months or Longer Total
Held to Maturity
MBS:
Private label residential — — — 23 (1) 5 23 (1)
U.S. Treasury and U.S. government agency securities — — — 2,991 (8) 1 2,991 (8)
The Company has evaluated the investment securities in the above tables and has determined that the decline in their fair value is temporary. The unrealized losses are primarily due to changes in market interest rates and spreads in the market for mortgage-related products. The fair value of these securities is expected to recover as the securities approach their maturity dates and/or as the pricing spreads narrow on mortgage-related securities. The Company has the ability and the intent to hold the investments until the fair value of these securities recovers. Additional deterioration in market and economic conditions related to the COVID-19 pandemic may, however, have an adverse impact on credit quality in the future and result in OTTI charges.
The Company bifurcates OTTI into (1) amounts related to credit losses which are recognized through earnings and (2) amounts related to all other factors which are recognized as a component of other comprehensive income (loss).
To determine the component of the gross OTTI related to credit losses, the Company compared the amortized cost basis of the OTTI security to the present value of its revised expected cash flows, discounted using its pre-impairment yield. The revised expected cash flow estimates for individual securities are based primarily on an analysis of default rates, prepayment speeds and
93
Notes to Consolidated Financial Statements
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
third-party analytic reports. Significant judgment by management is required in this analysis that includes, but is not limited to, assumptions regarding the collectability of principal and interest, net of related expenses, on the underlying loans.
The following table presents a summary of the significant inputs utilized to measure management’s estimates of the credit loss component on OTTI securities as of September 30, 2020, 2019 and 2018:
Range Weighted
Minimum Maximum Average
Loss severity rate — % 11.27 % 2.87 %
Loss severity rate — % 10.59 % 4.07 %
Collateral default rate — % 10.42 % 5.03 %
The following table presents the OTTI recoveries for the years ended September 30, 2020, 2019 and 2018 (dollars in thousands):
Held ToMaturity Held ToMaturity Held To Maturity
Net recoveries recognized in earnings (2) $ 120 $ 59 $ 68
________________________
(1)Represents OTTI related to all other factors.
(2)Represents OTTI related to credit losses.
94
Notes to Consolidated Financial Statements
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
The following table presents a roll forward of the credit loss component of held to maturity and available for sale debt securities that have been written down for OTTI with the credit loss component recognized in earnings for the years ended September 30, 2020, 2019 and 2018 (dollars in thousands):
Additions:
Subtractions:
Realized losses previously recorded as credit losses (66) (23) (80)
Recovery of prior credit loss (123) (72) (82)
During the year ended September 30, 2020, the Company recorded a $66,000 net realized loss (as a result of investment securities being deemed worthless) on nineteen held to maturity investment securities, all of which had been recognized previously as a credit loss. During the year ended September 30, 2019, the Company recorded a $23,000 net realized loss (as a result of investment securities being deemed worthless) on seventeen held to maturity investment securities, all of which had been recognized previously as a credit loss. During the year ended September 30, 2018, the Company recorded an $80,000 net realized loss (as a result of investment securities being deemed worthless) on sixteen held to maturity investment securities, all of which had been recognized previously as a credit loss.
The recorded amount of investment securities pledged as collateral for public fund deposits, federal treasury tax and loan deposits and FHLB collateral totaled $81,028,000 and $18,587,000 at September 30, 2020 and 2019, respectively.
The contractual maturities of debt securities at September 30, 2020 are as follows (dollars in thousands). Expected maturities may differ from scheduled maturities due to the prepayment of principal or call provisions.
Held to Maturity Available for Sale
AmortizedCost EstimatedFairValue AmortizedCost EstimatedFairValue
Due within one year $ — $ — $ 831 $ 830
95
Notes to Consolidated Financial Statements
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
Note 5 - Loans Receivable and Allowance for Loan Losses
Loans receivable by portfolio segment consisted of the following at September 30, 2020 and 2019 (dollars in thousands):
Mortgage loans:
Construction – speculative one- to four-family 14,592 16,445
Construction – land development 7,712 2,404
Consumer loans:
Commercial loans:
Total commercial business and SBA PPP loans 196,360 64,764
Less:
Undisbursed portion of construction loans in process 100,558 92,226
Deferred loan origination fees, net 6,436 2,798
Loans receivable at September 30, 2020 and 2019 are reported net of unamortized discounts totaling $790,000 and $1,386,000, respectively.
Significant Concentrations of Credit Risk
Most of the Company’s lending activity is with customers located in the state of Washington and involves real estate. At September 30, 2020, the Company had $934,351,000 (including $100,558,000 of undisbursed construction loans in process) in loans secured by real estate, which represented 82.4% of total loans receivable. The real estate loan portfolio is primarily secured by one- to four-family properties, multi-family properties, land, and a variety of commercial real estate property types. At September 30, 2020, there were no concentrations of real estate loans to a specific industry or secured by a specific collateral type that equaled or exceeded 20% of the Company’s total loan portfolio, other than loans secured by one-to four-
family properties. The ultimate collectability of a substantial portion of the loan portfolio is susceptible to changes in economic and market conditions in the region and the impact of those changes on the real estate market. The Company typically originates real estate loans with loan-to-value ratios of no greater than 90%. Collateral and/or guarantees are required for all loans.
96
Notes to Consolidated Financial Statements
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
Related Party Loans
Certain related parties of the Company, principally Bank directors and officers, are loan customers of the Bank in the ordinary course of business. Such related party loans were performing according to their repayment terms at September 30, 2020 and 2019. Activity in related party loans during the years ended September 30, 2020, 2019 and 2018 was as follows (dollars in thousands):
Balance, beginning of year $ 94 $ 119 $ 741
Repayments and reclassifications (24) (26) (990)
Loan Segment Risk Characteristics
The Company believes that its loan classes are the same as its loan segments.
One- To Four-Family Residential Lending: The Company originates both fixed-rate and adjustable-rate loans secured by one- to four-family residences. A portion of the fixed-rate one- to four-family loans are sold in the secondary market for asset/liability management purposes and to generate non-interest income. The Company’s lending policies generally limit the maximum loan-to-value on one- to four-family loans to 90% of the lesser of the appraised value or the purchase price. However, the Company usually obtains private mortgage insurance on the portion of the principal amount that exceeds 80% of the appraised value of the property.
Multi-Family Lending: The Company originates loans secured by multi-family dwelling units (more than four units). Multi-family lending generally affords the Company an opportunity to receive interest at rates higher than those generally available from one- to four-family residential lending. However, loans secured by multi-family properties usually are greater in amount, more difficult to evaluate and monitor and, therefore, involve a greater degree of risk than one- to four-family residential mortgage loans. Because payments on loans secured by multi-family properties are often dependent on the successful operation and management of the properties, repayment of such loans may be affected by adverse conditions in the real estate market or economy. The Company attempts to minimize these risks by scrutinizing the financial condition of the borrower, the quality of the collateral and the management of the property securing the loan.
Commercial Mortgage Lending: The Company originates commercial real estate loans secured by properties such as office buildings, retail/wholesale facilities, motels, restaurants, mini-storage facilities and other commercial properties. Commercial real estate lending generally affords the Company an opportunity to receive interest at higher rates than those available from one- to four-family residential lending. However, loans secured by such properties usually are greater in amount, more difficult to evaluate and monitor and, therefore, involve a greater degree of risk than one- to four-family residential mortgage loans. Because payments on loans secured by commercial properties are often dependent on the successful operation and management of the properties, repayment of these loans may be affected by adverse conditions in the real estate market or economy. The Company attempts to mitigate these risks by generally limiting the maximum loan-to-value ratio to 80% and scrutinizing the financial condition of the borrower, the quality of the collateral and the management of the property securing the loan.
Construction Lending: The Company currently originates the following types of construction loans: custom construction loans, owner/builder construction loans, speculative construction loans, commercial real estate construction loans, multi-family construction loans and land development loans.
Construction lending affords the Company the opportunity to achieve higher interest rates and fees with shorter terms to maturity than does its single-family permanent mortgage lending. Construction lending, however, is generally considered to involve a higher degree of risk than one- to four family residential lending because of the inherent difficulty in estimating both a property’s value at completion of the project and the estimated cost of the project. The nature of these loans is such that they are generally more difficult to evaluate and monitor. If the estimated cost of construction proves to be inaccurate, the Company may be required to advance funds beyond the amount originally committed to complete the project. If the estimate of value upon completion proves to be inaccurate, the Company may be confronted with a project whose value is insufficient to assure full repayment, and the Company may incur a loss. Projects may also be jeopardized by disagreements between borrowers and builders and by the failure of builders to pay subcontractors. Loans to construct homes for which no purchaser has been
97
Notes to Consolidated Financial Statements
Timberland Bancorp, Inc. and Subsidiary
September 30, 2020 and 2019
identified carry more risk because the payoff for the loan depends on the builder’s ability to sell the property prior to the time that the construction loan is due. The Company attempts to mitigate these risks by adhering to its underwriting policies, disbursement procedures and monitoring practices.
Construction Lending – Custom and Owner/Builder: Custom construction and owner/builder construction loans are originated to home owners and are typically refinanced into permanent loans at the completion of construction.
Construction Lending – Speculative One- To Four-Family: Speculative one-to four-family construction loans are made to home builders and are termed “speculative” because the home builder does not have, at the time of the loan origination, a signed contract with a home buyer who has a commitment for permanent financing with the Company or another lender for the finished home. The home buyer may be identified either during or after the construction period.
Construction Lending – Commercial: Commercial construction loans are originated to construct properties such as office buildings, hotels, retail rental space and mini-storage facilities.