Item 1A. Risk Factors
Risk Factors Summary
We assume and manage a certain degree of risk in order to conduct our business strategy. In addition to the risk factors described below, other risks and uncertainties not specifically mentioned, or that are currently known to, or deemed to be immaterial by management, also may materially and adversely affect our financial position, results of operations and/or cash flows. Before making an investment decision, you should carefully consider the risks described below together with all of the other information included in this Form 10-K and our other filings with the SEC. If any of the circumstances described in the following risk factors actually occur to a significant degree, the value of our common stock could decline, and you could lose all or part of your investment. This report is qualified in its entirety by these risk factors.
The most significant risks include the following:
Risks Related to the COVID-19 Pandemic and Associated Economic Slowdown
•The COVID-19 pandemic has adversely impacted our ability to conduct business and is expected to adversely impact our financial results and those of our customers. The ultimate impact will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic.Our business may be adversely affected by downturns in the national economy and in the economies in our market areas.
Risks Related to Economic Conditions
•Our business may be adversely affected by downturns in the national economy and in the economies in our market areas.
Risks Related to our Lending Activities
•Our real estate construction and land loans expose us to significant risks.
•Our emphasis on commercial real estate lending may expose us to increased lending risks.
•The level of our commercial real estate loan portfolio may subject us to additional regulatory scrutiny.
•Repayment of our commercial business loans is often dependent on the cash flows of the borrower, which may be unpredictable, and the collateral securing these loans may fluctuate in value.
•Our business may be adversely affected by credit risk associated with residential property.
•Our allowance for loan losses may prove to be insufficient to absorb losses in our loan portfolio.
•If our non-performing assets increase, our earnings will be adversely affected.
Risk Related to our Business Strategy
•We may be adversely affected by risks associated with completed and potential acquisitions.
Risk Related to Market Interest Rates
•Changes in interest rates may reduce our net interest income and may result in higher defaults in a rising rate environment.
•Our investment securities portfolio may be negatively impacted by fluctuations in market value and interest rates and result in losses.
•An increase in interest rates, change in the programs offered by Freddie Mac or our ability to qualify for their programs may reduce our mortgage revenues, which would negatively impact our non-interest income.
Risks Related to Laws and Regulations
•We operate in a highly regulated environment and may be adversely affected by changes in federal and state laws and regulations that could increase our costs of operations.
•Non-compliance with the USA PATRIOT Act, Bank Secrecy Act, or other laws and regulations could result in fines or sanctions and limit our ability to get regulatory approval of acquisitions.
Risks Related to Cybersecurity, Third Parties and Technology
•The financial services market is undergoing rapid technological changes, and if we are unable to stay current with those changes, we may not be able to effectively compete.
•We are subject to certain risks in connection with our use of technology.
•Our business may be adversely affected by an increasing prevalence of fraud and other financial crimes.
•Managing reputational risk is important to attracting and maintaining customers, investors and employees.
•We rely on other companies to provide key components of our business infrastructure.
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Risks Related to Accounting Matters
•We may experience future goodwill impairment, which could reduce our earnings.
•We may experience decreases in the fair value of our loan servicing rights, which could reduce our earnings.
•The required accounting treatment of loans we acquire through acquisitions including purchase credit impaired loans could result in higher net interest margins and interest income in current periods and lower net interest margins and interest income in future periods.
•If our investments in real estate are not properly valued or sufficiently reserved to cover actual losses, or if we are required to increase our valuation allowances, our earnings could be reduced.
Other Risks Related to Our Business
•Ineffective liquidity management could adversely affect our financial results and condition.
•Our growth or future losses may require us to raise additional capital in the future, but that capital may not be available when it is needed or the cost of that capital may be very high.
•Our framework for managing risks may not be effective in mitigating risk and loss to us.
•We are dependent on key personnel, and the loss of one or more of those key personnel may materially and adversely affect our prospects.
•We will be required to transition from the use of the LIBOR interest rate index in the future.
•Societal responses to climate change could adversely affect our business and performance, including indirectly through impacts on our customers.
Risks Related to the COVID-19 Pandemic and Associated Economic Slowdown
The COVID-19 pandemic has adversely impacted our ability to conduct business and is expected to adversely impact our financial results and those of our customers. The ultimate impact will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic.
The COVID-19 pandemic has adversely impacted our ability to conduct business, our financial results and those of our customers. The ultimate impact will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic.
During our fiscal year ended September 30, 2021, the COVID-19 pandemic significantly adversely affected our operations and the way we provided banking services to businesses and individuals during government issued modified stay-at-home orders. As an essential business, we continue to provide banking and financial services to our customers with drive-thru access available at the majority of our branch locations and in-person services available by appointment. We have re-opened branch lobbies with modified access. In addition, we continue to provide access to banking and financial services through online banking, ATMs and by telephone. As the government issued orders were lifted during the latter part of fiscal year 2021 and vaccinations were becoming available, businesses were able to reopen, but mask and social distancing measures slowed the pace of an economic rebound. We continue to monitor the impact of the new variants of COVID-19 which has prompted many health officials and municipalities to reinstate mask mandates and reconsider lifting pandemic restrictions. If the COVID-19 pandemic again worsens it could limit or disrupt our ability to provide banking and financial services to our customers.
A number of our employees currently are working remotely to enable us to continue to provide banking services to our customers. Heightened cybersecurity, information security and operational risks may result from these remote work-from-home arrangements. We also could be adversely affected if key personnel or a significant number of employees were to become unavailable due to the effects and restrictions of the continued pandemic impacted by the new variants. We rely upon our third-party vendors to help us conduct aspects of our business and to process, record and monitor transactions. If any of these vendors are unable to continue to provide us with their services, it could also negatively impact our ability to serve our customers. Although we have business continuity plans and other safeguards in place, there is no assurance that such plans and safeguards will be effective.
There is a pervasive uncertainty surrounding the future economic conditions that will emerge in the months and years following the start of the pandemic. As a result, management is confronted with a significant and unfamiliar degree of uncertainty in estimating the impact of the pandemic on credit quality, revenues and asset values. To date, the COVID-19 pandemic has resulted in changes in the demand for certain loan types, including government sponsored programs such as the Paycheck Protection Program ("PPP") through May 2021, deposit availability, market interest rates and negatively impacted many of our business and consumer borrower’s ability to make their loan payments. Because the length of the pandemic and the efficacy of the extraordinary measures being put in place to address its economic consequences are unknown, including a
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continued low targeted federal funds rate, until the pandemic subsides, we expect our net interest income and net interest margin will be adversely affected. Many of our borrowers have become unemployed or may face unemployment, and certain businesses are at risk of insolvency as their revenues decline precipitously, especially in businesses related to travel, hospitality, leisure and physical personal services. Businesses may ultimately not reopen as there is a significant level of uncertainty regarding the level of economic activity that will return to our markets over time, the impact of governmental assistance, the speed of economic recovery, the resurgence of COVID-19 in subsequent seasons and changes to demographic and social norms that will take place.
The impact of the pandemic may continue to adversely affect us during our 2022 fiscal year and possibly longer, as loan demand, market interest rates, and the ability of some customers to make timely loan payments has been significantly affected. Although the Company makes estimates of loan losses related to the pandemic as part of its evaluation of the allowance for loan losses, such estimates involve significant judgment and are made in the context of continued uncertainty as to the impact the pandemic will have on the credit quality of our loan portfolio. Consistent with guidance provided by banking regulators, we have modified loans by providing various loan payment deferral options to our borrowers affected by the COVID-19 pandemic. Notwithstanding these modifications, these borrowers may not be able to resume making full payments on their loans as the COVID-19 pandemic subsides. Any increases in the allowance for credit losses will result in a decrease in net income, and, most likely, capital, and may have a material negative effect on our financial condition and results of operations.
The SBA PPP loans made by the Bank are guaranteed by the SBA and, if used by the borrower for authorized purposes, may be fully forgiven. However, in the event of a loss resulting from a default on a SBA PPP loan and a determination by the SBA that there was a deficiency in the manner in which the PPP loan was originated, funded or serviced by the Bank, the SBA may deny its liability under the guaranty, reduce the amount of the guaranty, or, if it has already made payment under the guaranty, seek recovery of any loss related to the deficiency from the Bank. As of September 30, 2021, we hold and service SBA PPP loans with an aggregate balance of $40.92 million.
In accordance with GAAP, we record assets acquired and liabilities assumed at their fair value with the excess of the purchase consideration over the net assets acquired resulting in the recognition of goodwill. If adverse economic conditions or our stock price and market capitalization decreases as a result of the pandemic were to be deemed sustained rather than temporary, it may significantly affect the fair value of our goodwill and may trigger impairment charges. Any impairment charge could have a material adverse effect on our financial condition and results of operations.
We are an entity separate and distinct from our principal subsidiary, Timberland Bank, and derive substantially all of our revenue at the holding company level in the form of dividends from that subsidiary. If the COVID-19 pandemic were to materially adversely affect Timberland Bank’s regulatory capital levels or liquidity, it may result in Timberland Bank being unable to pay dividends to us, which may result in our not being able to pay dividends on our common stock at the same rate or at all.
Even after the COVID-19 pandemic subsides, the U.S. economy will likely require some time to recover from its effects, the length of which is unknown. and during which we may experience a recession. As a result, we anticipate that our business may be materially and adversely affected during this recovery. To the extent the effects of the COVID-19 pandemic adversely impact our business, financial condition, liquidity or results of operations, it may also have the effect of heightening many of the other risks described in this section.
Risks Related to Economic Conditions
Our business may be adversely affected by downturns in the national economy and in the economies in our market areas.
Substantially all of our loans are to businesses and individuals in the state of Washington. A decline in the economies of our local market areas of Grays Harbor, Pierce, Thurston, King, Kitsap and Lewis counties in which we operate, and which we consider to be our primary market areas, could have a material adverse effect on our business, financial condition, results of operations and prospects. Weakness in the global economy has adversely affected many businesses operating in our markets that are dependent upon international trade, and it is not known how the recent changes in tariffs being imposed on international trade may also affect these businesses.
Deterioration in economic conditions in the market areas we serve as a result of COVID-19 or other factors could result in the following consequences, any of which could have a materially adverse impact on our business, financial condition and results of operations:
•loan delinquencies, problem assets and foreclosures may increase;
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•we may increase our allowance for loan losses;
•the sale of foreclosed assets may slow;
•demand for our products and services may decline possibly resulting in a decrease in our total loans or assets;
•collateral for loans made may decline in value, exposing us to increased risk loans, reducing customers’ borrowing power, and reducing the value of assets and collateral associated with existing loans;
•the net worth and liquidity of loan guarantors may decline, impairing their ability to honor commitments to us; and
•the amount of our low-cost or non-interest bearing deposits may decrease and the composition of our deposits may be adversely affected.
A decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose real estate loans are geographically diverse. Many of the loans in our portfolio are secured by real estate. Deterioration in the real estate markets where collateral for a mortgage loan is located could negatively affect the borrower's ability to repay the loan and the value of the collateral securing the loan. Real estate values are affected by various other factors, including changes in general or regional economic conditions, government rules or policies and natural disasters such as fires and earthquakes. If we are required to liquidate a significant amount of collateral during a period of reduced real estate values, our financial condition and profitability could be adversely affected.
Risks Related to our Lending Activities
Our real estate construction and land loans expose us to significant risks.
We make real estate construction loans to individuals and builders, primarily for the construction of residential properties. We originate these loans whether or not the collateral property underlying the loan is under contract for sale. At September 30, 2021, construction loans totaled $233.21 million, or 21.5% of our total loan portfolio, of which $179.04 million were for residential real estate projects, $43.37 million for commercial real estate projects and $10.80 million for land development projects. This compares to total construction loans of $219.50 million, or 19.4% of our total loan portfolio at September 30, 2020, or an increase of 6.3% during the past year. Approximately $109.15 million of our residential construction loans at September 30, 2021 were made to finance the construction of owner-occupied homes and are structured to be converted to permanent loans at the end of the construction phase. In general, construction lending involves additional risks because funds are advanced upon estimates of costs in relation to values associated with the completed project. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the complete project and the effects of governmental regulations on real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the completed project loan-to-value ratio. Changes in demand for new housing and higher than anticipated building costs may cause actual results to vary significantly from those estimated. For these reasons, this type of lending also typically involves higher loan principal amounts and may be concentrated with a small number of builders. A downturn in housing, or the real estate market, could increase delinquencies, defaults and foreclosures, and significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. Some of the builders who are our customers have more than one loan outstanding with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss. In addition, during the term of some of our construction loans, no payment from the borrower is required since the accumulated interest is added to the principal of the loan through an interest reserve. As a result, these loans often involve the disbursement of funds with repayment substantially dependent on the success of the ultimate project and the ability of the borrower to sell or lease the property or obtain permanent take-out financing, rather than the ability of the borrower or guarantor to repay principal and interest. If our appraisal of the value of a completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project and may incur a loss. Because construction loans require active monitoring of the building process, including cost comparisons and on-site inspections, these loans are more difficult and costly to monitor. Increases in market rates of interest may have a more pronounced effect on construction loans by rapidly increasing the end-purchaser's borrowing costs, thereby possibly reducing the homeowner's ability to finance the home upon completion or the overall demand for the project. Properties under construction are often difficult to sell and typically must be completed in order to be successfully sold which also complicates the process of working our problem construction loans. This may require us to advance additional funds and/or contract with another builder to complete construction and assume the market risk of selling the project at a future market price, which may or may not enable us to fully recover unpaid loan funds and associated construction and liquidation costs. Furthermore, in the case of speculative construction loans, there is the added risk associated with identifying an end-purchaser for the finished project. At September 30, 2021, $17.81 million of our construction portfolio was comprised of speculative one- to four-family construction loans. We also make land loans for the acquisition of land upon which the purchaser can then build or make improvements necessary to build or to use for recreational purposes. At September 30, 2021, land loans totaled $19.94 million, or 1.8% of our total loan portfolio. Loans on land under development or held for future construction as well as land loans made to individuals for the future construction of a residence also pose additional risk because the length of time from financing to completion of a development project is significantly longer than for a traditional construction loan. This makes
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them more susceptible to declines in real estate values, declines in overall economic conditions which may delay the development of the land and changes in the political landscape that could affect the permitted and intended use of the land being financed, and the potential illiquid nature of the collateral. In addition, during this long period of time from financing to completion, the collateral often does not generate any cash flow to support the debt service. At September 30, 2021, all construction loans were performing in accordance to their terms and $683,000 of land loans were non-performing. A material increase in our non-performing construction or land loans could have a material adverse effect on our financial condition and results of operation.
Our emphasis on commercial real estate lending may expose us to increased lending risks.
Our current business strategy includes an emphasis on commercial real estate lending. This type of lending activity, while potentially more profitable than single-family residential lending, is generally more sensitive to regional and local economic conditions, making loss levels more difficult to predict. Collateral evaluation and financial statement analysis in these types of loans requires a more detailed analysis at the time of loan underwriting and on an ongoing basis. In our primary market of western Washington, a downturn in the real estate market could increase loan delinquencies, defaults and foreclosures, and significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. Many of our commercial borrowers have more than one loan outstanding with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss.
At September 30, 2021, we had $470.65 million of commercial real estate mortgage loans, representing 43.5% of our total loan portfolio. These loans typically involve higher principal amounts than other types of loans, and repayment is dependent upon income generated, or expected to be generated, by the property securing the loan in amounts sufficient to cover operating expenses and debt service, which may be adversely affected by changes in the economy or local market conditions. For example, if the cash flow from the borrower’s project is reduced as a result of leases not being obtained or renewed, the borrower’s ability to repay the loan may be impaired. Commercial real estate loans also expose a lender to greater credit risk than loans secured by residential real estate, because the collateral securing these loans typically cannot be sold as easily as residential real estate. In addition, many of our commercial real estate loans are not fully amortizing and contain large balloon payments upon maturity. Such balloon payments may require the borrower to either sell or refinance the underlying property in order to make the payment, which may increase the risk of default or non-payment.
A secondary market for most types of commercial real estate loans is not readily liquid, so we have less opportunity to mitigate credit risk by selling part or all of our interest in these loans. As a result of these characteristics, if we foreclose on a commercial real estate loan, our holding period for the collateral typically is longer than for one- to four-family residential mortgage loans because there are fewer potential purchasers of the collateral. Accordingly, charge-offs on commercial real estate loans may be larger as a percentage of the total principal outstanding than those incurred with our residential or consumer loan portfolios.
The level of our commercial real estate loan portfolio may subject us to additional regulatory scrutiny.
The FDIC, the Federal Reserve and the Office of the Comptroller of the Currency have promulgated joint guidance on sound risk management practices for financial institutions with concentrations in commercial real estate lending. Under this guidance, a financial institution that, like us, is actively involved in commercial real estate lending should perform a risk assessment to identify concentrations. A financial institution may have a concentration in commercial real estate lending if, among other factors (i) total reported loans for construction, land development and other land represent 100% or more of total capital, or (ii) total reported loans secured by multi-family and non-farm non-residential properties, loans for construction, land development and other land, and loans otherwise sensitive to the general commercial real estate market, including loans to commercial real estate related entities, represent 300% or more of total capital. The particular focus of the guidance is on exposure to commercial real estate loans that are dependent on the cash flow from the real estate held as collateral and that are likely to be at greater risk to conditions in the commercial real estate market (as opposed to real estate collateral held as a secondary source of repayment or as an abundance of caution). The purpose of the guidance is to guide banks in developing risk management practices and capital levels commensurate with the level and nature of real estate concentrations. The guidance states that management should employ heightened risk management practices including board and management oversight and strategic planning, development of underwriting standards, risk assessment and monitoring through market analysis and stress testing. We have concluded that we have a concentration in commercial real estate lending because our balance in commercial real estate loans (including owner-occupied loans) at September 30, 2021 represents more than 300% of total capital. While we believe we have implemented policies and procedures with respect to our commercial real estate loan portfolio consistent with this guidance, bank regulators could require us to implement additional policies and procedures consistent with their interpretation of the guidance that may result in additional costs to us.
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Repayment of our commercial business loans is often dependent on the cash flows of the borrower, which may be unpredictable, and the collateral securing these loans may fluctuate in value.
At September 30, 2021, we had $74.58 million, or 6.9%, of total loans in commercial business loans (excluding SBA PPP loans). Commercial business lending involves risks that are different from those associated with residential and commercial real estate lending. Real estate lending is generally considered to be collateral based lending with loan amounts based on predetermined loan to collateral values and liquidation of the underlying real estate collateral being viewed as the primary source of repayment in the event of borrower default. Our commercial business loans are primarily made based on the cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. The borrowers' cash flow may be unpredictable, and collateral securing these loans may fluctuate in value. Although commercial business loans are often collateralized by equipment, inventory, accounts receivable, or other business assets, the liquidation of collateral in the event of default is often an insufficient source of repayment because accounts receivable may be uncollectible and inventories may be obsolete or of limited use, among other things. Accordingly, the repayment of commercial business loans depends primarily on the cash flow and credit worthiness of the borrower and secondarily on the underlying collateral provided by the borrower.
Our business may be adversely affected by credit risk associated with residential property.
At September 30, 2021, $152.92 million, or 14.1%, of our total loan portfolio was secured by one- to four-family mortgage loans and home equity loans. This type of lending is generally sensitive to regional and local economic conditions that significantly impact the ability of borrowers to meet their loan payment obligations, making loss levels difficult to predict. Recessionary conditions or declines in the volume of single-family real estate and/or the sales prices as well as elevated unemployment rates may result in higher than expected loan delinquencies or problem assets, and a decline in demand for our products and services. These potential negative events may cause us to incur losses, adversely affect our capital and liquidity and damage our financial condition and business operations. Further, a decline in residential real estate values resulting from a downturn in the Washington housing market may reduce the value of the real estate collateral securing these types of loans and increase our risk of loss if borrowers default on their loans.
Many of our residential mortgage loans are secured by liens on mortgage properties in which the borrowers have little or no equity because either we originated the loan with a relatively high combined loan-to-value ratio or because of the decline in home values in our market areas subsequent to when the loans were originated. Residential loans with combined higher loan-to-value ratios will be more sensitive to declining property values than those with lower combined loan-to-value ratios and therefore may experience a higher incidence of default and severity of losses. In addition, if the borrowers sell their homes, such borrowers may be unable to repay their loans in full from the sale proceeds. Further, a significant amount of our home equity lines of credit consist of second mortgage loans. For those home equity lines secured by a second mortgage, it is unlikely that we will be successful in recovering all or a portion of our loan proceeds in the event of default unless we are prepared to repay the first mortgage loan and such repayment and the costs associated with a foreclosure are justified by the value of the property. For these reasons, we may experience higher rates of delinquencies, default and losses on our residential loans.
Our allowance for loan losses may prove to be insufficient to absorb losses in our loan portfolio.
Lending money is a substantial part of our business, and each loan carries a certain risk that it will not be repaid in accordance with its terms or that any underlying collateral will not be sufficient to assure repayment. This risk is affected by, among other things:
•the cash flow of the borrower and/or the project being financed;
•the changes and uncertainties as to the future value of the collateral, in the case of a collateralized loan;
•the duration of the loan;
•the credit history of a particular borrower; and
•changes in economic and industry conditions.
We maintain an allowance for loan losses, which is a reserve established through a provision for loan losses charged against operating income, which we believe is appropriate to provide for probable losses in our loan portfolio. The amount of this allowance is determined by our management through periodic comprehensive reviews and consideration of several factors, including, but not limited to:
•an ongoing review of the quality, size and diversity of the loan portfolio;
•evaluation of non-performing loans;
•historical default and loss experience;
•existing economic conditions and management's expectations of future events;
•risk characteristics of the various classifications of loans;
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•the amount and quality of collateral, including guarantees, securing the loans; and
•regulatory requirements and expectations.
The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. In determining the amount of the allowance for loan losses, we review our loans and the loss experience and evaluate economic conditions and make significant estimates of current credit risks and future trends, all of which may undergo material changes. If our estimates are incorrect, the allowance for loan losses may not be sufficient to cover losses inherent in our loan portfolio, resulting in the need for increases in our allowance for loan losses through the provision for losses on loans which is charged against income. Management also recognizes that significant new growth in loan portfolios, new loan products and the refinancing of existing loans can result in portfolios comprised of unseasoned loans that may not perform in a historical or projected manner and will increase the risk that our allowance may be insufficient to absorb losses without significant additional provisions. Further, the FASB has adopted a new accounting standard that will be effective for our fiscal year beginning October 1, 2023. This standard, referred to as Current Expected Credit Loss ("CECL") will require financial institutions to determine periodic estimates of lifetime expected credit losses on loans, and recognize the expected credit losses as allowances for credit losses. This will change the current method of providing allowances for credit losses that are probable. We anticipate that our allowance for loan losses will increase as a result of the implementation of CECL; however, until our evaluation is complete, the magnitude of the increase will be unknown.
Deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may also require an increase in the allowance for loan losses. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on judgments different from those of management. If charge-offs in future periods exceed the allowance for loan losses, we will need additional provisions to replenish the allowance for loan losses. Any additional provisions will result in a decrease in net income and possibly capital, and may have a material adverse effect on our financial condition and results of operations.
If our non-performing assets increase, our earnings will be adversely affected.
At September 30, 2021, our non-performing assets (which consist of non-accruing loans, accruing loans 90 days or more past due, non-accrual investment securities, and OREO and other repossessed assets) were $3.17 million, or 0.18% of total assets. Our non-performing assets adversely affect our net income in various ways:
•We do not record interest income on non-accrual loans or non-performing investment securities, except on a cash basis when the collectibility of the principal is not in doubt.
•We must provide for probable loan losses through a current period charge to the provision for loan losses.
•Non-interest expense increases when we must write down the value of properties in our OREO portfolio to reflect changing market values.
•Non-interest income decreases when we must recognize other-than-temporary impairment on non-performing investment securities.
•There are legal fees associated with the resolution of problem assets, as well as carrying costs, such as taxes, insurance, and maintenance costs related to our OREO.
•The resolution of non-performing assets requires the active involvement of management, which can distract them from more profitable activities.
If additional borrowers become delinquent and do not pay their loans and we are unable to successfully manage our non-performing assets, our losses and troubled assets could increase significantly, which could have a material adverse effect on our financial condition and results of operations. In addition to the non-performing loans, there were $2.37 million in loans classified as performing troubled debt restructurings at September 30, 2021.
Risk Related to our Business Strategy
We may be adversely affected by risks associated with completed and potential acquisitions.
As part of our general growth strategy, on October 1, 2018, we completed the acquisition of South Sound Bank, a Washington-state chartered bank, headquartered in Olympia, Washington. Although our business strategy emphasizes organic expansion, we continue, from time to time in the ordinary course of business, to engage in preliminary discussions with potential acquisition targets. There can be no assurance that, in the future, we will successfully identify suitable acquisition candidates, complete acquisitions and successfully integrate acquired operations into our existing operations or expand into new markets.
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The consummation of any future acquisitions may dilute shareholder value or may have an adverse effect upon our operating results while the operations of the acquired business are being integrated into our operations. In addition, once integrated, acquired operations may not achieve levels of profitability comparable to those achieved by our existing operations, or otherwise perform as expected. Further, transaction-related expenses may adversely affect our earnings. These adverse effects on our earnings and results of operations may have a negative impact on the value of our common stock. Acquiring banks, bank branches or businesses involves risks commonly associated with acquisitions, including:
•We may be exposed to potential asset quality issues or unknown or contingent liabilities of the banks, businesses, assets, and liabilities we acquire. If these issues or liabilities exceed our estimates, our results of operations and financial condition may be materially negatively affected;
•We could experience higher than expected deposit attrition;
•The acquisition of other entities generally requires integration of systems, procedures and personnel of the acquired entity into our company to make the transaction economically successful. This integration process is complicated and time consuming and can also be disruptive to the customers of the acquired business. If the integration process is not conducted successfully and with minimal adverse effect on the acquired business and its customers, we may not be able to realize the anticipated economic benefits of particular acquisitions within the expected time frame, and we may lose customers or employees of the acquired business. We may also experience greater than anticipated customer losses even if the integration process is successful;
•To the extent that our costs of an acquisition exceed the fair value of the net assets acquired, the acquisition will generate goodwill. As discussed below, we are required to assess our goodwill for impairment at least annually, and any goodwill impairment charge could have a material adverse effect on our results of operation and financial condition;
•We expect that our net income will increase following an acquisition; however, we also expect our general and administrative expenses to increase, which could result to an increase in our efficiency ratio. Ultimately, we would expect our efficiency ratio to improve; however, if we are not successful in our integration process, this may not occur, and our acquisition or branching activities may not be accretive to earnings in the short or long-term.
Risk Related to Market Interest Rates
Changes in interest rates may reduce our net interest income and may result in higher defaults in a rising rate environment.
Our earnings and cash flows are largely dependent upon our net interest income. Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Reserve Board. In response to the COVID-19 pandemic, the Federal Reserve decreased the target federal funds rate by 150 basis points to a range of 0.00% to 0.25%. If the Federal Reserve Board increases the Fed Funds rate, overall interest rates will likely rise, which may negatively impact both the housing markets by reducing refinancing activity and new home purchases and the U.S. economy. In addition, inflationary pressures will increase our operational costs and could have a significant negative effect on our borrowers, especially our business borrowers.
We principally manage interest rate risk by managing our volume and mix of our earning assets and funding liabilities. Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and investments and the amount of interest we pay on deposits and borrowings, but these changes could also affect: (1) our ability to originate and/or sell loans and obtain deposits; (2) the fair value of our financial assets and liabilities, which could negatively impact shareholders’ equity, and our ability to realize gains from the sale of such assets; (3) our ability to obtain and retain deposits in competition with other available investment alternatives; (4) the ability of our borrowers to repay adjustable or variable rate loans; and (5) the average duration of our investment securities portfolio and other interest-earning assets. If the interest rates paid on deposits and borrowings increase at a faster rate than the interest received on loans and other investments, our net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments decline more rapidly than the interest rates paid on deposits and other borrowings. In a changing interest rate environment, we may not be able to manage this risk effectively. If we are unable to manage interest rate risk effectively, our business, financial condition and results of operations could be materially affected.
Changes in interest rates could also have a negative impact on our results of operations by reducing the ability of borrowers to repay their current loan obligations or by reducing our margins and profitability. Our net interest margin is the difference between the yield we earn on our assets and the interest rate we pay for deposits and our other sources of funding. Changes in interest rates (up or down) could adversely affect our net interest margin and, as a result, our net interest income. Although the yield we earn on our assets and our funding costs tends to move in the same direction in response to changes in interest rates, one can rise or fall faster than the other, causing our net interest margin to expand or contract. Changes in the slope of the "yield curve," or the spread between short-term and long-term interest rates, could also reduce our net interest margin. Normally the yield curve is upward sloping, meaning short-term rates are lower than long-term rates. Because our
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liabilities tend to be shorter in duration than our assets, when the yield curve flattens or even inverts, we could experience pressure on our net interest margin as our cost of funds increases relative to the yield we can earn on our assets. Also, interest rate decreases can lead to increased prepayments of loans and mortgage-backed securities as borrowers refinance their loans to reduce borrowing costs. Under these circumstances we are subject to reinvestment risk as we may have to redeploy such repayment proceeds into lower yielding investments, which would likely negatively impact our income.
A sustained increase or decrease in market interest rates could adversely affect our earnings. As is the case with many financial institutions, our emphasis on increasing the development of core deposits, those deposits bearing no or a relatively low rate of interest with no stated maturity, has resulted in our having a significant amount of these deposits bearing a relatively low rate of interest and having a shorter duration than our assets. At September 30, 2021, we had $81.42 million in certificates of deposit that mature within one year and $1.44 billion in non-interest bearing, NOW checking, savings and money market accounts. We would incur a higher cost of funds to retain these deposits in a rising interest rate environment. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, our net interest income, and therefore earnings, could be adversely affected. In addition, a substantial amount of our residential mortgage loans and home equity lines of credit have adjustable interest rates. As a result, these loans may experience a higher rate of default in a rising interest rate environment.
Changes in interest rates also affect the value of our interest-earning assets and in particular our investment securities portfolio. Generally, the fair value of fixed-rate securities fluctuates inversely with changes in interest rates. Unrealized gains and losses on investment securities available for sale are reported as a separate component of equity, net of tax. Decreases in the fair value of investment securities available for sale resulting from increases in interest rates could have an adverse effect on stockholders' equity.
Any substantial, unexpected or prolonged change in market interest rates could have a material adverse effect on our financial condition, liquidity and results of operations. Also, our interest rate risk modeling techniques and assumptions likely may not fully predict or capture the impact of actual interest rate changes on our balance sheet or projected operating results. For further discussion of how changes in interest rates could impact us, see "Part II, Item 7A. Quantitative and Qualitative Disclosures About Market Risk" for additional information about our interest rate risk management.
Our investment securities portfolio may be negatively impacted by fluctuations in market value and interest rates and result in losses.
Our investment securities portfolio may be impacted by fluctuations in market value, potentially reducing accumulated other comprehensive income (loss) and/or earnings. Fluctuations in market value may be caused by changes in market interest rates, lower market prices for investment securities and limited investor demand. Our held to maturity and available for sale investment securities are evaluated for other-than-temporary-impairment ("OTTI"). If this evaluation shows impairment to the actual or projected cash flows associated with one or more investment securities, a potential loss to earnings may occur. Changes in interest rates can also have an adverse effect on our financial condition, as our available-for-sale investment securities are reported at their estimated fair value, and therefore are impacted by fluctuations in interest rates. Shareholders' equity is increased or decreased by the amount of change in the estimated fair value of the available-for-sale investment securities, net of income taxes. There can be no assurance that the declines in market value, including as a result of the COVID-19 pandemic, will not result in OTTI of these assets, which would lead to accounting charges that could have a material adverse effect on our net income and capital levels.
During the years ended September 30, 2021, 2020 and 2019, we recognized a $20,000, $120,000 and $59,000 recovery of OTTI charges on private label mortgage-backed securities we hold for investment, respectively. At September 30, 2021, our remaining private label mortgage-backed securities portfolio totaled $13.93 million of which $159,000 was on non-accrual status.
The valuation of our investment securities also is influenced by additional external market and other factors, including implementation of SEC and FASB guidance on fair value accounting, default rates on residential mortgage securities and rating agency actions. Accordingly, there can be no assurance that future declines in the market value of our private label mortgage-backed securities or other investment securities will not result in additional OTTI of these assets and lead to accounting charges that could have an adverse effect on our results of operations.
An increase in interest rates, change in the programs offered by Freddie Mac or our ability to qualify for their programs may reduce our mortgage revenues, which would negatively impact our non-interest income.
The sale of residential mortgage loans to Freddie Mac provides a significant portion of our non-interest income. Any future changes in their program, our eligibility to participate in such program, the criteria for loans to be accepted or laws that
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significantly affect the activity of Freddie Mac could, in turn, materially adversely affect our results of operations if we could not find other purchasers. Mortgage banking is generally considered a volatile source of income because it depends largely on the level of loan volume which, in turn, depends largely on prevailing market interest rates. In a rising or higher interest rate environment, the demand for mortgage loans, particularly refinancing of existing mortgage loans, tends to fall and our originations of mortgage loans may decrease, resulting in fewer loans that are available to be sold. This would result in a decrease in mortgage revenues and a corresponding decrease in non-interest income. In addition, our results of operations are affected by the amount of non-interest expense associated with our loan sale activities, such as salaries and employee benefits, occupancy, equipment and data processing expense and other operating costs. During periods of reduced loan demand, our results of operations may be adversely affected to the extent that we are unable to reduce expenses commensurate with the decline in loan originations. In addition, although we sell loans to Freddie Mac or into the secondary market without recourse, we are required to give customary representations and warranties about the loans we sell. If we breach those representations and warranties, we may be required to repurchase the loans and we may incur a loss on the repurchase.
Risks Related to Laws and Regulations
We operate in a highly regulated environment and may be adversely affected by changes in federal and state laws and regulations that could increase our costs of operations.
The banking industry is extensively regulated. Federal banking regulations are designed primarily to protect the deposit insurance funds and consumers, not to benefit a company's shareholders. These regulations may sometimes impose significant limitations on our operations. Certain significant federal and state banking regulations that affect us are described in this report under the heading "Item 1. Business-How We Are Regulated". These regulations, along with the currently existing tax, accounting, securities, insurance, and monetary laws, regulations, rules, standards, policies, and interpretations control the methods by which financial institutions conduct business, implement strategic initiatives and tax compliance, and govern financial reporting and disclosures. These laws, regulations, rules, standards, policies, and interpretations are constantly evolving and may change significantly over time. Any new regulations or legislation, change in existing regulations or oversight, whether a change in regulatory policy or a change in a regulator's interpretation of a law or regulation, could have a material impact on our operations, increase our costs of regulatory compliance and of doing business and adversely affect our profitability. In this regard, the U.S. Department of the Treasury's Financial Crimes Enforcement Network ("FinCEN"), published guidelines in 2014 for financial institutions servicing marijuana businesses that are legal under state law. These guidelines allow us to work with marijuana-related businesses that are operating in accordance with state laws and regulations, as long as we comply with required regulatory oversight of their accounts with us. In addition, legislation is currently pending in Congress that would allow banks and financial institutions to serve marijuana businesses in states where it is legal without any risk of federal prosecution. At September 30, 2021, approximately 2.1% of our total deposits and a portion of our service charges from deposits are from legal marijuana-related businesses. Any adverse change in this FinCEN guidance, any new regulations or legislation, any change in existing regulations or oversight, whether a change in regulatory policy or a change in a regulator's interpretation of a law or regulation, could have a negative impact on our non-interest income, as well as the cost of our operations, increasing our cost of regulatory compliance and of doing business and/or otherwise affect us, which may materially affect our profitability.
Non-compliance with the USA PATRIOT Act, Bank Secrecy Act, or other laws and regulations could result in fines or sanctions and limit our ability to get regulatory approval of acquisitions.
The USA PATRIOT and Bank Secrecy Acts require financial institutions to develop programs to prevent financial institutions from being used for money laundering and terrorist activities. Failure to comply with these regulations could result in fines or sanctions and limit our ability to get regulatory approval of acquisitions. Recently, several banking institutions have received large fines for non-compliance with these laws and regulations. While we have developed policies and procedures designed to assist in compliance with these laws and regulations, no assurance can be given that these policies and procedures will be effective in preventing violations of these laws and regulations. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us. Any of these results could have a material adverse effect on our business, financial condition, results of operations and growth prospects.
Risks Related to Cybersecurity, Third-Parties and Technology
The financial services market is undergoing rapid technological changes, and if we are unable to stay current with those changes, we may not be able to effectively compete.
The financial services market, including banking services, is undergoing rapid changes with frequent introductions of new technology-driven products and services. Our future success will depend, in part, on our ability to keep pace with the technological changes and to use technology to satisfy and grow customer demand for our products and services and to create
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additional efficiencies in our operations. We expect that we will need to make substantial investments in our technology and information systems to compete effectively and to stay current with technological changes. Some of our competitors have substantially greater resources to invest in technological improvements and will be able to invest more heavily in developing and adopting new technologies, which may put us at a competitive disadvantage. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. As a result, our ability to effectively compete to retain or acquire new business may be impaired, and our business, financial condition or results of operations may be adversely affected.
We are subject to certain risks in connection with our use of technology.
Our security measures may not be sufficient to mitigate the risk of a cyber-attack. Communications and information systems are essential to the conduct of our business, as we use such systems to manage our customer relationships, our general ledger and virtually all other aspects of our business. Our operations rely on the secure processing, storage, and transmission of confidential and other information in our computer systems and networks. Although we take protective measures and endeavor to modify them as circumstances warrant, the security of our computer systems, software, and networks may be vulnerable to breaches, fraudulent or unauthorized access, denial or degradation of service attacks, misuse, computer viruses, malware or other malicious code and cyber-attacks that could have a security impact. If one or more of these events occur, this could jeopardize our or our customers' confidential and other information processed and stored in, and transmitted through, our computer systems and networks, or otherwise cause interruptions or malfunctions in our operations or the operations of our customers or counterparties. We may be required to expend significant additional resources to modify our protective measures or to investigate and remediate vulnerabilities or other exposures, and we may be subject to litigation and financial losses that are either not insured or not fully covered through any insurance maintained by us. We could also suffer significant reputational damage.
Security breaches in our internet banking activities could further expose us to possible liability and damage our reputation. Increases in criminal activity levels and sophistication, advances in computer capabilities, new discoveries, vulnerabilities in third-party technologies (including browsers and operating systems) or other developments could result in a compromise or breach of the technology, processes and controls that we use to prevent fraudulent transactions and to protect data about us, our clients and underlying transactions. Any compromise of our security could deter customers from using our internet banking services that involve the transmission of confidential information. We rely on standard internet security systems to provide the security and authentication necessary to effect secure transmission of data. Although we have developed and continue to invest in systems and processes that are designed to detect and prevent security breaches and cyber attacks and periodically test our security, these precautions may not protect our systems from compromises or breaches of our security measures, and could result in losses to us or our customers, our loss of business and/or customers, damage to our reputation, the incurrence of additional expenses, disruption to our business, our inability to grow our online services or other businesses, additional regulatory scrutiny or penalties, or our exposure to civil litigation and possible financial liability, any of which could have a material adverse effect on our business, financial condition and results of operation.
Our security measures may not protect us from system failures or interruptions. While we have established policies and procedures to prevent or limit the impact of systems failures and interruptions, there can be no assurance that such events will not occur or that they will be adequately addressed if they do. In addition, we outsource certain aspects of our data processing and other operational functions to certain third-party providers. While the Company selects third-party vendors carefully, it does not control their actions. If our third-party providers encounter difficulties, including those resulting from breakdowns, or other disruptions in communication services provided by a vendor, failure of a vendor to handle current or higher transaction volumes, cyber-attacks and security breaches or if we otherwise have difficulty in communicating with them, our ability to adequately process and account for transactions could be affected, and our ability to deliver products and services to our customers and otherwise conduct business operations could be adversely impacted. Replacing these third-party vendors could also entail significant delay and expense. Threats to information security also exist in the processing of customer information through various other vendors and their personnel.
We cannot assure that such breaches, failures or interruptions will not occur or, if they do occur, that they will be adequately addressed by us or the third-parties on which we rely. We may not be insured against all types of losses as a result of third-party failures and insurance coverage may be inadequate to cover all losses, resulting from breaches, systems failures or other disruptions. If any of our third-party service providers experience financial, operational or technological difficulties, or if there is any other disruption in our relationships with them, we may be required to identify alternative sources of such services, and we cannot assure that we could negotiate terms that are as favorable to us or could obtain services with similar functionality as found in our existing systems without the need to expend substantial resources, if at all. Further, the occurrence of any systems failure or interruption could damage our reputation and result in a loss of customers and business, could subject us to additional regulatory scrutiny, or could expose us to legal liability. Any of these occurrences could have a material adverse effect on our financial condition and results of operations.
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The Board of Directors oversees the risk management process, including the risk of cybersecurity, and engages with management on cybersecurity issues.
Our business may be adversely affected by an increasing prevalence of fraud and other financial crimes.
As a bank, we are susceptible to fraudulent activity that may be committed against us or our customers which may result in financial losses or increased costs to us or our customers, disclosure or misuse of our information or our customers' information, misappropriation of assets, privacy breaches against our customers, litigation or damage to our reputation. Such fraudulent activity may take many forms, including check fraud, electronic fraud, wire fraud, phishing, social engineering and other dishonest acts. Nationally, reported incidents of fraud and other financial crimes have increased. We have also experienced losses due to apparent fraud and other financial crimes. While we have policies and procedures designed to prevent such losses, there can be no assurance that such losses will not occur.
Managing reputational risk is important to attracting and maintaining customers, investors and employees.
Threats to our reputation can come from many sources, including adverse sentiment about financial institutions generally, unethical practices, employee misconduct, failure to deliver minimum standards of service or quality, compliance deficiencies and questionable or fraudulent activities of our customers. We have policies and procedures in place to protect our reputation and promote ethical conduct, but these policies and procedures may not be fully effective. Negative publicity regarding our business, employees, or customers, with or without merit, may result in the loss of customers, investors and employees, costly litigation, a decline in revenues and increased governmental regulation.
We rely on other companies to provide key components of our business infrastructure.
We rely on numerous external vendors to provide us with products and services necessary to maintain our day-to-day operations. Accordingly, our operations are exposed to risk that these vendors will not perform in accordance with the contracted arrangements under service level agreements. The failure of an external vendor to perform in accordance with the contracted arrangements under service level agreements because of changes in the vendor's organizational structure, financial condition, support for existing products and services or strategic focus or for any other reason, could be disruptive to our operations, which in turn could have a material negative impact on our financial condition and results of operations. We also could be adversely affected to the extent that such an agreement is not renewed by a third-party vendor or is renewed on terms less favorable to us. Additionally, the bank regulatory agencies expect financial institutions to be responsible for all aspects of our vendors' performance, including aspects which they delegate to third-parties. Disruptions or failures in the physical infrastructure or operating systems that support our business and customers, or cyber-attacks or security breaches of the networks, systems or devices that our customers use to access our products and services could result in client attrition, regulatory fines, penalties or intervention, reputational damage, reimbursement or other compensation costs, and/or additional compliance costs, any of which could materially adversely affect our results of operations or financial condition.
Risks Related to Accounting Matters
We may experience future goodwill impairment, which could reduce our earnings.
We performed our test for goodwill impairment for fiscal year 2021, and the test concluded that recorded goodwill was not impaired. Our test of goodwill for potential impairment is based on a qualitative assessment by management that takes into consideration macroeconomic conditions, industry and market conditions, cost or margin factors, financial performance and share price. Our evaluation of the fair value of goodwill involves a substantial amount of judgment. If our judgment was incorrect, or if events or circumstances change, and an impairment of goodwill was deemed to exist, we would be required to write down our goodwill resulting in a charge against operations, which would adversely affect our results of operations, perhaps materially; however, it would have no impact on our liquidity, operations or regulatory capital. The acquisition of South Sound Bank on October 1, 2018 substantially increased our goodwill.
We may experience decreases in the fair value of our loan servicing rights, which could reduce our earnings.
Loan servicing rights are capitalized at estimated fair value when acquired through the origination of loans that are subsequently sold with servicing rights retained. At September 30, 2021, our loan servicing rights totaled $3.48 million (including a valuation allowance of $119,000). Loan servicing rights are amortized to servicing income on loans sold over the period of estimated net servicing income. The estimated fair value of loan servicing rights at the date of the sale of loans is determined based on the discounted present value of expected future cash flows using key assumptions for servicing income and costs and prepayment rates on the underlying loans. On a quarterly basis, we evaluate the fair value of loan servicing rights
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for impairment by comparing actual cash flows and estimated cash flows from the loan servicing assets to those estimated at the time loan servicing assets were originated. Our methodology for estimating the fair value of loan servicing rights is highly sensitive to changes in assumptions, such as prepayment speeds. The effect of changes in market interest rates on estimated rates of loan prepayments represents the predominant risk characteristic underlying the loan servicing rights portfolio. For example, a decrease in interest rates typically increases the prepayment speeds of loan servicing rights and therefore decreases the fair value of the loan servicing rights. Future decreases in interest rates could decrease the fair value of our loan servicing rights below their recorded amount, which would decrease our earnings.
The required accounting treatment of loans we acquire through acquisitions including purchase credit impaired loans could result in higher net interest margins and interest income in current periods and lower net interest margins and interest income in future periods.
Under GAAP, we are required to record loans acquired through acquisitions, including purchase credit impaired loans, at fair value. Estimating the fair value of such loans requires management to make estimates based on available information and facts and circumstances on the acquisition date. Actual performance could differ from management’s initial estimates. If these loans outperform our original fair value estimates, the difference between our original estimate and the actual performance of the loan (the “discount”) is accreted into net interest income. Thus, our net interest margins may initially increase due to the discount accretion. We expect the yields on our loans to decline as our acquired loan portfolio pays down or matures and the discount decreases, and we expect downward pressure on our interest income to the extent that the runoff on our acquired loan portfolio is not replaced with comparable high-yielding loans. This could result in higher net interest margins and interest income in current periods and lower net interest margins and lower interest income in future periods.
If our investments in real estate are not properly valued or sufficiently reserved to cover actual losses, or if we are required to increase our valuation allowances, our earnings could be reduced.
We obtain updated valuations in the form of appraisals and broker price opinions when a loan has been foreclosed and the property is taken in as OREO, and at certain other times during the asset's holding period. Our net book value (“NBV”) in the loan at the time of foreclosure and thereafter is compared to the updated estimated market value of the foreclosed property less estimated selling costs (fair value). A charge-off is recorded for any excess in the asset’s NBV over its fair value. If our valuation process is incorrect or if the property declines in value after foreclosure, the fair value of our OREO may not be sufficient to recover our NBV in such assets, resulting in the need for a valuation allowance.
In addition, bank regulators periodically review our OREO and may require us to recognize further valuation allowances. Significant charge-offs to our OREO may have an adverse effect on our financial condition and results of operations.
Other Risks Related to Our Business
Ineffective liquidity management could adversely affect our financial results and condition.
Effective liquidity management is essential for the operation of our business. We require sufficient liquidity to meet customer loan requests, customer deposit maturities and withdrawals, payments on our debt obligations as they come due and other cash commitments under both normal operating conditions and other unpredictable circumstances causing industry or general financial market stress. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a substantial negative effect on our liquidity. We rely on customer deposits and at times, borrowings from the FHLB, borrowings from the FRB and other borrowings to fund our operations. At September 30, 2021, we had $5.00 million in outstanding FHLB borrowings and an additional $465.02 million of available borrowing capacity through the FHLB and the FRB. Deposit flows and the prepayment of loans and mortgage-related securities are strongly influenced by such external factors as the direction of interest rates, whether actual or perceived, and the competition for deposits and loans in the markets we serve. Further, changes to the FHLB's underwriting guidelines for wholesale borrowings or lending policies may limit or restrict our ability to borrow, and could therefore have a significant adverse impact on our liquidity. Although we have historically been able to replace maturing deposits and borrowings if desired, we may not be able to replace such funds in the future if, among other things, our financial condition, the financial condition of the FHLB or FRB, or market conditions change. Our access to funding sources in amounts adequate to finance our activities or on terms which are acceptable to us could be impaired by factors that affect us specifically or the financial services industry or economy in general, such as a disruption in the financial markets or negative views and expectations about the prospects for the financial services industry. Additional factors that could detrimentally impact our access to liquidity sources include a decrease in the level of our business activity as a result of a downturn in the Washington markets where our loans and deposits are concentrated or adverse regulatory action against us. Our access to deposits may also be affected by the liquidity needs of our depositors. In particular, a majority of our liabilities are checking accounts and other liquid deposits, which are payable on demand or upon several days’ notice, while by
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comparison, a substantial majority of our assets are loans, which cannot be called or sold in the same time frame. Although we have historically been able to replace maturing deposits and borrowings as necessary, we might not be able to replace such funds in the future, especially if a large number of our depositors seek to withdraw their accounts, regardless of the reason. A failure to maintain adequate liquidity could materially and adversely affect our business, results of operations, or financial condition.
Our financial flexibility will be severely constrained if we are unable to maintain our access to funding or if adequate financing is not available to accommodate future growth at acceptable interest rates. Although we consider our sources of funds adequate for our liquidity needs, we may seek additional debt in the future to achieve our long-term business objectives. Additional borrowings, if sought, may not be available to us or, if available, may not be available on reasonable terms. If additional financing sources are unavailable, or are not available on reasonable terms, our financial condition, results of operations, growth and future prospects could be materially adversely affected. Finally, if we are required to rely more heavily on more expensive funding sources to support future growth, our income may not increase proportionately to cover our costs.
Our growth or future losses may require us to raise additional capital in the future, but that capital may not be available when it is needed or the cost of that capital may be very high.
We are required by federal regulatory authorities to maintain adequate levels of capital to support our operations. Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside our control, and on our financial condition and performance. If we are able to raise capital, it may not be on terms that are acceptable to us. Accordingly, we cannot make assurances that we will be able to raise additional capital if needed on terms that are acceptable to us, or at all. If we cannot raise additional capital when needed, our ability to further expand our operations could be materially impaired and our financial condition and liquidity could be materially and adversely affected. In addition, any additional capital we obtain may result in the dilution of the interests of existing holders of our common stock. Further, if we are unable to raise additional capital when required by our bank regulators, we may be subject to adverse regulatory action.
Our framework for managing risks may not be effective in mitigating risk and loss to us.
We have established processes and procedures intended to identify, measure, monitor, report, analyze and control the types of risk to which we are subject. These risks include liquidity risk, credit risk, market risk, interest rate risk, operational risk, legal and compliance risk, and reputational risk, among others. We also maintain a compliance program to identify, measure, assess, and report on our adherence to applicable laws, policies and procedures. While we assess and improve these programs on an ongoing basis, there can be no assurance that our risk management or compliance programs, along with other related controls, will effectively mitigate all risk and limit losses in our business. As with any risk management framework, there are inherent limitations to our risk management strategies as there may exist, or develop in the future, risks that we have not appropriately anticipated or identified. If our risk management framework proves ineffective, we could suffer unexpected losses which could have a material adverse effect on our financial condition and results of operations.
We are dependent on key personnel, and the loss of one or more of those key personnel may materially and adversely affect our prospects.
Competition for qualified employees and personnel in the banking industry is intense, and there are a limited number of qualified persons with knowledge of, and experience in, the community banking industry where the Bank conducts its business. The process of recruiting personnel with the combination of skills and attributes required to carry out our strategies is often lengthy. Our success depends to a significant degree upon our ability to attract and retain qualified management, loan origination, finance, administrative, marketing and technical personnel and upon the continued contributions of our management and personnel. In particular, our success has been and continues to be highly dependent upon the abilities of key executives, including our President, and certain other employees. In addition, our success has been and continues to be highly dependent upon the services of our directors, and we may not be able to identify and attract suitable candidates to replace such directors.
We will be required to transition from the use of the LIBOR interest rate index in the future.
Some of our loans are indexed to LIBOR to calculate the loan interest rate. LIBOR will be discontinued on December 31, 2021. Although we expect that the capital and debt markets will cease to use LIBOR as a benchmark in the near future and the administrator of LIBOR has announced its intention to extend the publication of most tenors of LIBOR for U.S. dollars through June 30, 2023, we cannot predict whether or when LIBOR will actually cease to be available, whether the Secured Overnight Funding Rate, or SOFR, will become the market benchmark in its place or what impact such a transition may have on our business, financial condition and results of operations.
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At this time, no consensus exists as to what rate or rates may become acceptable alternatives to LIBOR. Regulators, industry groups and certain committees (e.g. the Alternative Reference Rates Committee) have published recommended fallback language for LIBOR-linked financial instruments, identified recommended alternatives for the LIBOR, such as SOFR, and proposed implementations of the recommended alternatives in floating-rate financial instruments. At this time, it is not possible to predict whether these specific recommendations and proposals will be broadly accepted. The implementation of a substitute index or indices for the calculation of interest rates under our loan agreements with our borrowers may result in our incurring significant expenses in implementing the transition, may result in reduced loan balances if borrowers do not accept the substitute index or indices, and may result in disputes or litigation with customers over the appropriateness or comparability to LIBOR of the substitute index or indices, which could have an adverse effect on our results of operations.
Societal responses to climate change could adversely affect our business and performance, including indirectly through impacts on our customers.
Concerns over the long-term impacts of climate change have led and will continue to lead to governmental efforts around the world to mitigate those impacts. Consumers and businesses also may change their behavior on their own as a result of these concerns. We and our customers will need to respond to new laws and regulations as well as consumer and business preferences resulting from climate change concerns. We and our customers may face cost increases, asset value reductions and operating process changes. The impact on our customers will likely vary depending on their specific attributes, including reliance on or role in carbon intensive activities. Among the impacts to us could be a drop in demand for our products and services, particularly in certain industry sectors. In addition, we could face reductions in creditworthiness on the part of some customers or in the value of assets securing loans. Our efforts to take these risks into account in making lending and other decisions, including by increasing our business with climate-friendly companies, may not be effective in protecting us from the negative impact of new laws and regulations or changes in consumer or business behavior.
Item 1B. Unresolved Staff Comments
Not applicable.
Item 2. Properties
At September 30, 2021, the Bank operated 24 full service facilities. The following table sets forth certain information regarding the Bank’s offices, all of which are owned, except for the Tacoma office, the Lacey office at 1751 Circle Lane SE and the Lacey office at 4530 Lacey Blvd SE, which are leased.
Location Year Opened ApproximateSquare Footage Deposits atSeptember 30, 2021
(In thousands)
Main Office:
Branch Offices:
.
(table continued on the following page)
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Location Year Opened ApproximateSquare Footage Deposits atSeptember 30, 2021
(In thousands)
Loan Center/Data Center:
Administrative Offices:
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Management believes that all facilities are appropriately insured and are adequately equipped for carrying on the business of the Bank.
At September 30, 2021, the Bank operated 25 proprietary automated teller machines ("ATMs") that are part of a nationwide cash exchange network.
Leases
The Company adopted Accounting Standards Codification ("ASC") 842 ("ASC 842") on October 1, 2019 and began recording operating lease liabilities and operating lease right-of-use ("ROU") assets in the consolidated balance sheets. The Company has operating leases for three retail bank branch offices. The ROU assets totaled $2.89 million at October 1, 2019. The Company's leases have remaining lease terms of ten months to ten years, some of which include options to extend the leases for up to five years. For additional information regarding operating lease liabilities and operating lease ROU assets, see Note 10 of the Notes to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.
Item 3. Legal Proceedings
Periodically, there have been various claims and lawsuits involving the Company, such as claims to enforce liens, condemnation proceedings on properties in which the Company holds security interests, claims involving the making and servicing of real property loans and other issues incident to the Company's business. The Company is not a party to any pending legal proceedings that it believes would have a material adverse effect on the financial condition or operations of the Company.
Item 4. Mine Safety Disclosures
Not applicable.
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The Company's common stock is traded on the Nasdaq Global Market under the symbol “TSBK.” As of December 2, 2021, there were 8,354,717 shares of common stock issued and approximately 436 shareholders of record. Our cash dividend payout policy is reviewed regularly by management and the Board of Directors. Our Board of directors has declared quarterly cash dividends on our common stock for 36 consecutive quarters. Any dividends declared and paid in the future would depend upon a number of factors, including capital requirements, our financial condition and results of operations, tax considerations, statutory and regulatory limitations, and general economic conditions. No assurances can be given that any dividends will be paid or that, if paid, will not be reduced or eliminated in future periods. Our future payment of dividends may depend, in part, upon receipt of dividends from the Bank, which are restricted by banking regulations.
Stock Repurchases
The Company is subject to certain restrictions on its ability to repurchase its common stock. The Company is required to give the Federal Reserve prior written notice of any purchase or redemption of its outstanding equity securities if the consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of its consolidated net worth. The Federal Reserve may disapprove a purchase or redemption if it determines that the proposal would constitute an unsafe or unsound practice or would violate any law, regulation, Federal Reserve order, or any condition imposed by, or written agreement with, the Federal Reserve.
The Company has had various stock repurchase programs since January 1998. On February 24, 2021, the Company announced a plan to repurchase 415,970 shares of the Company's common stock. This marked the Company's 18th stock repurchase plan. As of September 30, 2021, the Company had repurchased 16,688 shares under this plan at an average price of $28.08 per share. Cumulatively, since January 1998, the Company has repurchased 8,011,351 shares at an average price of $9.19 per share.
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The following table sets forth the Company's repurchases of its outstanding Common Stock during the fourth quarter of the year ended September 30, 2021:
Five-Year Stock Performance Graph
The following graph compares the cumulative total shareholder return on our common stock with the cumulative total return on the Nasdaq Composite Index and with the S&P 600 Thrifts & Mortgage Finance Index, peer group indices. The S&P 600 Thrifts & Mortgage Finance Index replaces the SNL Thrift $500M-$1B Index used in prior years as this index was retired in August 2021. Total return assumes the reinvestment of all dividends and that the value of the Company’s Common Stock and each index was $100 on September 30, 2016.
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Year Ended
* Source: S&P Global Market Intelligence
For additional information, see Part III, Item 12 of this Form 10-K for information regarding the Company's Equity Compensation Plans, which is incorporated into this Item 5 by reference.
Item 6. Reserved
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, 2021, the Company had total assets of $1.79 billion, net loans receivable of $968.45 million, total deposits of $1.57 billion and total shareholders’ equity of $206.90 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, 2020 and 2021 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 until the pandemic subsides, the Company expects its net interest income and net interest margin will be adversely affected.
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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 did not record a provision for loan losses for the year ended September 30, 2021, primarily reflecting the improving economy and the resulting decline in forecasted probable loan losses from COVID-19 during this fiscal year. The Company recorded a provision for loan losses of $3.70 million for the year ended September 30, 2020, which was due primarily to forecasted probable loan losses reflecting the potential future impact of the COVID-19 pandemic on the economy based on the economic outlook at that time..
The Company maintains its commitment to supporting its community and customers during these unprecedented times as a result of the COVID-19 pandemic. The Company remains focused on keeping its employees safe and the Bank running effectively to serve its customers. The Bank is managing branch access and occupancy levels in relation to cases and close contact scenarios, following governmental restrictions and public health authority guidelines. 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 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, 2021 with one loan totaling $233,000 on deferral status compared to five loans totaling $5.87 million on deferral status as of September 30, 2020. These modifications were not classified as TDRs at September 30, 2021 and 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 the program's initial conclusion in August 2020. The CAA 2021, which was signed into law on December 27, 2020, renewed and extended the PPP until May 31, 2021. As a result, the Company began originating PPP loans again in January 2021. As of September 30, 2021, the Company had $40.92 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.
Net income is also affected by non-interest income and non-interest expense. For the year ended September 30, 2021, 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 valuation allowances on loan servicing rights and increased by recoveries of valuation allowances on loan 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:
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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 that 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, that we believe that community banks, such as Timberland Bank, can distinguish themselves from larger banks operating in our market areas. We believe that 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.
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 0.29% and 0.28% at September 30, 2021 and 2020, respectively. The Company's percentage of non-performing assets to total assets at September 30, 2021 was 0.18% compared to 0.27% at September 30, 2020. Non-performing assets have decreased to $3.17 million at September 30, 2021 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. 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.
Selected Financial Data
The following table sets forth certain information concerning the consolidated financial position and results of operations of the Company and its subsidiary at and for the dates indicated. The consolidated data is derived in part from, and should be read in conjunction with, the Consolidated Financial Statements of the Company and its subsidiary presented herein.
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At September 30,
(In thousands)
SELECTED FINANCIAL CONDITION DATA:
Year Ended September 30,
(In thousands, except per share data)
SELECTED OPERATING DATA:
Provision for loan losses — 3,700 — — (1,250)
Provision for state income taxes — — — — —
Net income (loss) per common share:
______________
(1)Cash dividends to common shareholders divided by net income to common shareholders.
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At September 30,
OTHER DATA:
At or For the Year Ended September 30,
KEY FINANCIAL RATIOS:
Performance Ratios:
Asset Quality Ratios:
Net charge-offs (recoveries) to average outstanding loans — — (0.02) — (0.14)
Capital Ratios:
__________________
(1)Net income divided by average total assets.
(2)Net income divided by average total equity.
(3)Difference between weighted average yield on interest-earning assets and weighted average cost of interest-bearing liabilities.
(4)Net interest income before provision for (recapture of) loan losses as a percentage of average interest-earning assets.
(5)Non-interest expenses divided by the sum of net interest income and non-interest income.
(6)Non-performing assets include non-accrual loans, loans past due 90 days or more and still accruing, non-accrual investment securities, OREO and other repossessed assets.
(7)Loans receivable is before the allowance for loan losses.
(8)Non-performing loans include non-accrual loans and loans past due 90 days or more and still accruing. TDRs that are on accrual status are not included.
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,
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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 loan servicing rights, the valuation of OREO, the valuation of assets acquired and liabilities assumed in acquisitions and the valuation of goodwill for potential impairment. 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.
Further, subsequent changes in economic or market conditions could have a material impact on these estimates and our financial condition and operating results in future periods. There have been no significant changes in our application of accounting policies since September 30, 2021. For additional information concerning critical accounting policies, see Note 1 of the Notes to Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data." and the following:
Provision and Allowance for Loan Losses
The methodology for determining the allowance for loan losses is considered a critical accounting policy by management because of the high degree of judgment involved, the subjectivity of the assumptions used, and the potential for changes in the economic environment that could result in changes to the amount of the recorded allowance for loan losses. The provision for loan losses reflects the amount required to maintain the allowance for loan losses at an appropriate level based upon management’s evaluation of the adequacy of general and specific loss reserves. Determining the amount of the allowance for loan losses involves a high degree of judgment. Among the material estimates required to establish the allowance for loan losses are: overall economic conditions; value of collateral; strength of guarantors; loss exposure at default; the amount and timing of future cash flows on impaired loans; and determination of loss factors to be applied to the various elements of the portfolio. All of these estimates are susceptible to significant change. We have established systematic methodologies for the determination of the adequacy of our allowance for loan losses. The methodologies are set forth in a formal policy and take into consideration the need for an overall general valuation allowance as well as specific allowances that are tied to individual problem loans. We increase our allowance for loan losses by charging provisions for probable loan losses against our income.
The allowance for loan losses is maintained at a level sufficient to provide for probable losses based on evaluating known and inherent risks in the loan portfolio and upon our continuing analysis of the factors underlying the quality of the loan portfolio. These factors include, among others, changes in the size and composition of the loan portfolio, delinquency rates, actual loan loss experience, current and economic conditions, detailed analysis of individual loans for which full collectability may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans. Realized losses related to specific assets are applied as a reduction of the carrying value of the assets and charged immediately against the allowance for loan loss reserve. Recoveries on previously charged off loans are credited to the allowance for loan losses. The reserve is based upon factors and trends identified by us at the time financial statements are prepared. Although we use the best information available, future adjustments to the allowance for loan losses may be necessary due to economic, operating, regulatory and other conditions beyond our control. The adequacy of general and specific reserves is based on our continuing evaluation of the pertinent factors underlying the quality of the loan portfolio as well as individual review of certain large balance loans. Loans are considered impaired when, based on current information and events, we determine that it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Factors involved in determining impairment include, but are not limited to, the financial condition of the borrower, the value of the underlying collateral less selling costs and the current status of the economy. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, at the loan’s observable market price or the fair value of collateral if the loan is collateral dependent. We continue to assess the collateral of these loans and update our appraisals on large balance impaired loans on an annual basis. To the extent the property values decline, there could be additional losses on these impaired loans, which may be material. Subsequent changes in the value of impaired loans are included within the provision for loan losses in the same manner in which impairment initially was recognized or as a reduction in the provision that would otherwise be reported. Large groups of smaller-balance homogeneous loans are collectively evaluated for impairment. Loans that are collectively evaluated for impairment include residential real estate and consumer loans and, as appropriate, smaller balance non-homogeneous loans. Larger balance non-homogeneous residential construction and land, commercial real estate, commercial business loans and unsecured loans are individually evaluated for impairment.
Our methodology for assessing the appropriateness of the allowance for loan losses consists of several key elements, which include specific allowances, an allocated formula allowance and an unallocated allowance. Losses on specific loans are provided for when the losses are probable and estimable. General loan loss reserves are established to provide for inherent loan portfolio risks not specifically provided for. The level of general reserves is based on analysis of potential exposures existing in
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our loan portfolio including evaluation of historical trends, current market conditions and other relevant factors identified by us at the time the financial statements are prepared. The formula allowance is calculated by applying loss factors to outstanding loans, excluding those loans that are subject to individual analysis for specific allowances. Loss factors are based on our historical loss experience adjusted for significant environmental considerations, including the experience of other banking organizations, which in our judgment affect the collectability of the loan portfolio as of the evaluation date. The unallocated allowance is based upon our evaluation of various factors that are not directly measured in the determination of the formula and specific allowances. This methodology may result in actual losses or recoveries differing significantly from the allowance for loan losses in the Consolidated Financial Statements.
While we believe the estimates and assumptions used in our determination of the adequacy of the allowance for loan losses are reasonable, there can be no assurance that such estimates and assumptions will not be proven incorrect in the future, or that the actual amount of future provisions will not exceed the amount of past provisions or that any increased provisions that may be required will not adversely impact our financial condition and results of operations. In addition, the determination of the amount of the Banks’ allowance for loan losses is subject to review by bank regulators as part of the routine examination process, which may result in the adjustment of reserves based upon their judgment of information available to them at the time of their examination.
Fair Value Accounting and Measurement
We use fair value measurements to record fair value adjustments to certain financial assets and liabilities and to determine fair value disclosures. We include in the Notes to the Consolidated Financial Statements information about the extent to which fair value is used to measure financial assets and liabilities, the valuation methodologies used and the impact on our results of operations and financial condition. Additionally, for financial instruments not recorded at fair value we disclose, where required, our estimate of their fair value. For more information regarding fair value accounting, please refer to Note 18 in the Notes to the Consolidated Financial Statements.
Loan Servicing Rights
Loan servicing rights are recognized as separate assets when rights are acquired through purchase or through sale of loans. Generally, purchased loan servicing rights are capitalized at the cost to acquire the rights. For sales of mortgage loans, the value of the loan servicing right is estimated and capitalized. Fair value is based on market prices for comparable loan servicing contracts. The fair value of the loan servicing rights includes an estimate of the life of the underlying loans which is affected by estimated prepayment speeds. The estimate of prepayment speeds is based on current market conditions. Actual market conditions could vary significantly from current conditions which could result in the estimated life of the underlying loans being different which would change the fair value of the loan servicing right. Capitalized loan servicing rights are reported in other assets and are amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets.
Valuation of OREO
Real estate properties acquired through foreclosure or by deed-in-lieu of foreclosure are recorded at the lower of cost or fair value less estimated costs to sell. Fair value is generally determined by management based on a number of factors, including third-party appraisals of fair value in an orderly sale. Accordingly, the valuation of OREO is subject to significant external and internal judgment. If the carrying value of the loan at the date a property is transferred into OREO exceeds the fair value less estimated costs to sell, the excess is charged to the allowance for loan losses. Management periodically reviews OREO values to determine whether the property continues to be carried at the lower of its recorded book value or fair value, net of estimated costs to sell. Any further decreases in the value of OREO are considered valuation adjustments and are charged to non-interest expense in the Consolidated Income Statements. Expenses and income from the maintenance and operations and any gains or losses from the sales of OREO are included in non-interest expense.
Business Combinations
The Company applies the acquisition method of accounting for business combinations. Under the acquisition method, the acquiring entity in a business combination recognizes all of the identifiable assets acquired and liabilities assumed at their acquisition date fair values. Management utilizes prevailing valuation techniques appropriate for the asset or liability being measured in determining these fair values. Any excess of the purchase price over amounts allocated to assets acquired, including identifiable intangible assets, and liabilities assumed is recorded as goodwill. Where amounts allocated to assets acquired and liabilities assumed is greater than the purchase price, a bargain purchase gain is recognized. Acquisition-related costs are expensed as incurred unless they are directly attributable to the issuance of the Company's common stock in a business combination and the Company chooses to record these acquisition-related costs through stockholders' equity. There were no
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business combinations during the years ended September 30, 2021 and September 30, 2020. For additional information see Note (2) Business Combination of the Notes to Consolidated Financial Statements included in Item 8. Financial Statements..
Goodwill
Goodwill represents the excess of the purchase consideration paid over the fair value of the assets acquired, net of the fair values of liabilities assumed in a business combination and is not amortized but is reviewed annually, or more frequently as current circumstances and conditions warrant, for impairment. An assessment of qualitative factors is completed to determine if it is more likely than not that the fair value of a reporting unit is less than its carrying amount. The qualitative assessment involves judgment by management on determining whether there have been any triggering events that have occurred which would indicate potential impairment. If the qualitative analysis concludes that further analysis is required, then a quantitative impairment test would be completed. The quantitative goodwill impairment test is used to identify the existence of impairment and the amount of impairment loss and compares the reporting unit's estimated fair values, including goodwill, to its carrying amount. If the fair value exceeds the carry amount then goodwill is not considered impaired. If the carrying amount exceeds its fair value, an impairment loss would be recognized equal to the amount of excess, limited to the amount of total goodwill allocated to the reporting unit. The impairment loss would be recognized as a charge to earnings.
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.
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 loan 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 using data at September 30, 2021, an immediate increase in interest rates of 100 basis points would increase the Bank’s projected net interest income by approximately 11.6%, 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 4.7%. 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.
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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, 2021, the consumer, commercial business and construction loan portfolios amounted to $35.50 million, $115.50 million and $233.21 million, respectively or 3.3%, 10.7% and 21.5%, respectively of total loans receivable.
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, 2021:
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.
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 10.6% decrease in NPV and a 4.7% decrease in net interest income. In the event of a 100 basis point increase in interest rates, a 6.9% increase in NPV and a 11.6% 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, 2021 and September 30, 2020
The Company's total assets increased by $226.20 million, or 14.4%, to $1.79 billion at September 30, 2021 from $1.57 billion at September 30, 2020. The increase in assets was primarily due to an increase in total cash and cash equivalents, and to a much lesser extent, an increase in investment securities, partially offset by decreases in CDs held for investment and loans receivable. The increase in total assets was funded primarily by an increase in total deposits.
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Net loans receivable decreased by $45.42 million, or (4.5)%, to $968.45 million at September 30, 2021 from $1.01 billion at September 30, 2020, primarily due to decreases in SBA PPP loans, and smaller decreases in several other loan categories. These decreases to net loans receivable were partially offset by increases in commercial real estate and construction loans, and smaller increases in several other loan categories.
Total deposits increased by $212.15 million, or 15.6%, to $1.57 billion at September 30, 2021 from $1.36 billion at September 30, 2020, primarily due to increases in non-interest-bearing demand account balances, NOW checking account balances, money market account balances, and savings account balances. These increases were partially offset by a decrease in certificates of deposit account balances.
Shareholders' equity increased by $19.27 million, or 10.3%, to $206.90 million at September 30, 2021 from $187.63 million at September 30, 2020. The increase was primarily due to net income for the year ended September 30, 2021 of $27.58 million which was partially offset by $8.59 million in dividends paid to shareholders.
A more detailed explanation of the changes in significant balance sheet categories follows:
Cash and Cash Equivalents: Cash and cash equivalents increased by $265.74 million, or 84.5%, to $580.20 million at September 30, 2021 from $314.45 million at September 30, 2020. The increase was primarily a result of an increase 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 $37.06 million, or 56.5%, to $28.48 million at September 30, 2021 from $65.55 million at September 30, 2020. Funds received as CDs matured were invested into other higher yielding interest-earning assets as interest rates on CDs held for investment decreased during the year.
Investment Securities and Investments in Equity Securities: Investment securities and investments in equity securities increased by $46.46 million, or 53.6%, to $133.23 million at September 30, 2021 from $86.77 million at September 30, 2020. The increase was primarily due to the purchase of U.S. Treasury and U.S. government agency securities and additional agency and private label residential 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, 2021. 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."
FHLB Stock: FHLB stock increased by $181,000 or 9.4%, to $2.10 million at September 30, 2021 from $1.92 million at September 30, 2020, due to purchases required by the FHLB as a result of the increase in total assets.
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, 2021 and 2020. 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 by $1.29 million, or 28.7%, to $3.22 million at September 30, 2021 from $4.51 million at September 30, 2020, 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 $150.20 million in loans during the year ended September 30, 2021 compared to $167.24 million for the year ended September 30, 2020. Sales of loans over the past two years have increased, from historical levels, 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 decreased by $45.42 million, or (4.5)%, to $968.45 million at September 30, 2021 from $1.01 billion at September 30, 2020. The decrease was primarily due to an $85.90 million decrease in SBA PPP loans, a $5.64 million decrease in land loans, and smaller decreases in several other loan categories. These decreases were partially offset by a $17.08 million increase in commercial real estate loans, a $13.71 million increase in construction loans, and smaller increases in several other loan categories. The SBA PPP loan balances decreased primarily due to borrowers applying for forgiveness from the SBA and the loans being subsequently paid off by the SBA and was partially offset by new SBA PPP loans funded after the renewal of the program in December 2020.
Loan originations increased by $5.16 million, or 0.9%, to $602.34 million for the year ended September 30, 2021 from $597.19 million for the year ended September 30, 2020. The increase in loan originations was primarily due to increased demand for commercial real estate and construction loans, which was partially offset by a decrease in SBA PPP loans funded.
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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 decreased by $668,000, or 2.9%, to $22.37 million at September 30, 2021 from $23.04 million at September 30, 2020. The decrease was primarily due to normal depreciation. 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 $893,000, or 85.0%, to $157,000 at September 30, 2021 from $1.05 million at September 30, 2020. The decrease was primarily due to the sales of $893,000 in OREO properties. At September 30, 2021, total OREO and other repossessed assets consisted of three land parcels totaling $157,000. 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 $597,000, or 2.8%, to $22.19 million at September 30, 2021 from $21.60 million at September 30, 2020. 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 both September 30, 2021 and September 30, 2020. The Company performed its annual review of goodwill during the quarter ended June 30, 2021 and determined that there was no impairment. As of September 30, 2021, 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 $361,000, or 22.2% to $1.26 million at September 30, 2021 from $1.63 million at September 30, 2020 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."
Loan Servicing Rights, Net: Loan servicing rights increased by $387,000, or 12.5%, to $3.48 million at September 30, 2021 from $3.10 million at September 30, 2020, primarily due to additional capitalized Freddie Mac servicing rights for loans being sold with servicing retained, and a $110,000 valuation recovery, which was partially offset by amortization. The principal amount of loans serviced for Freddie Mac and the SBA decreased by $144,000 to $426.44 million at September 30, 2021 from $426.58 million at September 30, 2020. For additional information on loan 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 ROU assets decreased by $304,000, or 11.8%, to $2.28 million at September 30, 2021 from $2.59 million at September 30, 2020, primarily due to the amortization of the ROU assets. The operating lease ROU assets at September 30, 2021 represented the present value of three operating leases on branch facilities. 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 $425,000, or 12.9%, to $2.87 million at September 30, 2021 from $3.30 million at September 30, 2020. The decrease was primarily due to decreases in miscellaneous receivables (including income tax receivables) and prepaid expenses.
Deposits: Deposits increased by $212.15 million, or 15.6%, to $1.57 billion at September 30, 2021 from $1.36 billion at September 30, 2020. The increase consisted of a $93.32 million increase in non-interest bearing demand account balances, a $53.20 million increase in NOW checking account balances, a $49.20 million increase in money market account balances, and a $40.82 increase in savings account balances. These increases were partially offset by a $24.40 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 decreased to $5.00 million at September 30, 2021 from $10.00 million at September 30, 2020. At September 30, 2021, FHLB borrowings
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consisted of a single $5.00 million borrowing, with a scheduled maturity in March 2025. 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 decreased by $271,000, or 10.3%, to $2.36 million at September 30, 2021 from $2.63 million at September 30, 2020, primarily due to required annual lease payments. The operating lease liability at September 30, 2021 represented the present value of three operating leases on branch facilities. 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 increased by $55,000, or 0.8%, to $7.37 million at September 30, 2021 from $7.31 million at September 30, 2020. The increase was primarily due to timing differences in the normal course of business.
Shareholders' Equity: Total shareholders' equity increased by $19.27 million, or 10.3%, to $206.90 million at September 30, 2021 from $187.63 million at September 30, 2020. The increase was primarily due to net income of $27.58 million for the year ended September 30, 2021, which was partially offset by the payment of $8.59 million in dividends to common shareholders and the repurchase of 19,588 shares of the Company's common stock for $527,000 during the year ended September 30, 2021. 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, 2021 and 2020
Net income for the year ended September 30, 2021 increased by $3.31 million, or 13.7%, to $27.58 million from $24.27 million for the year ended September 30, 2020. Net income per diluted common share increased by $0.39, or 13.5%, to $3.27 for the year ended September 30, 2021 from $2.88 for the year ended September 30, 2020. The increase in net income was primarily due to a $3.70 million decrease in the provision for loan losses and a $976,000 increase in net-interest income. These increases in net interest income were partially offset by a $528,000 increase in non-interest expense and an $807,000 increase in the provision for income taxes.
A more detailed explanation of the income statement categories is presented below.
Net Interest Income: Net interest income increased by $976,000, or 1.9%, to $51.86 million for the year ended September 30, 2021 from $50.88 million for the year ended September 30, 2020. The increase in net interest income was primarily due to an increase in the average balance of interest-earning assets and a decrease in the average cost of deposits, which was partially offset by a decrease in the average yield on interest-earning assets.
Total interest and dividend income decreased by $621,000, or 1.1%,to$54.96 million for the year ended September 30, 2021 from $55.58 million for the year ended September 30, 2020, 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 3.45% for the year ended September 30, 2021 from 4.26% for the year ended September 30, 2020, as market rates decreased following the 150 basis point decrease in the targeted federal funds rate in March 2020 in response to the COVID-19 pandemic, to a range of 0.00% to 0.25% at September 30, 2021 putting downward pressure on adjustable rate instruments combined with the impact of the low loan yields on the SBA PPP loan portfolio and lower loan yields on new loan originations. The substantial increase in the average balance of interest-bearing deposits in banks and CDs balances as a result of the increase in deposit balances, is also negatively impacting the average yield on interest-earning assets.. 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 $291.83 million, or 22.4%, to $1.60 billion for the year ended September 30, 2021 from $1.30 billion for the year ended September 30, 2020. Interest income on loans receivable and loans held for sale increased by $1.19 million, or 2.3%, to $52.54 million for the year ended September 30, 2021 from $51.34 million for the year ended September 30, 2020, primarily due to a $56.34 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 5.12% for the year ended September 30, 2021 from 5.29% for the year ended September 30, 2020.
During the year ended September 30, 2021, the accretion of the purchase accounting fair value discount on loans acquired in the South Sound Acquisition increased interest income on loans by $340,000 compared to $597,000 for the year ended September 30, 2020. The accretion of the net fair value discount on acquired loans increased the average yield on loans by three basis points for the year ended September 30, 2021 and six basis points for the year ended September 30, 2020. The incremental accretion and the impact on loan yield will change during any period based on the volume of prepayments, but it is
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expected to decrease over time as the balance of the net discount declines. The remaining net discount on these acquired loans was $449,000 at September 30, 2021. During the year ended September 30, 2021, a total of $942,000 in non-accrual interest, pre-payment penalties and late fees was collected compared to $911,000 for the year ended September 30, 2020.
Also impacting the average yield and average interest-earning asset balances during the years ended September 30, 2021 and 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, 2021, average PPP loans were $107.00 million and the Company recorded $1.06 million in interest income and accreted $5.07 million in PPP loan origination fees into income compared to average PPP loans of $55.40 million, $556,000 in interest income and $1.04 million in PPP loan origination fees for the year ended September 30, 2020. The Company anticipates that interest income related to PPP loans will decrease significantly during the year ending September 30, 2022 as the remaining PPP loan balances and deferred loan originations fees have been reduced. At September 30, 2021, the Company had $1.83 million in PPP deferred loan origination fees, which will be accreted into interest income over the remaining life of the PPP loans.
Interest income on investment securities decreased by $384,000, or 24.3%, to $1.20 million for the year ended September 30, 2021 from $1.58 million for the year ended September 30, 2020 primarily due to a decrease in the average yield on investment securities, which was partially offset by an increase in the average balance of investment securities. Interest income on interest-bearing deposits in banks and CDs decreased by $1.42 million, or 56.0%, to $1.12 million for the year ended September 30, 2021 from $2.54 million for the year ended September 30, 2020, primarily due to an decrease in the average yield to 0.24% from 1.00% 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 decreased by $1.60 million, or 34.0%, to $3.10 million for the year ended September 30, 2021 from $4.70 million for the year ended September 30, 2020. The decrease in interest expense was primarily due to a decrease in the average cost of interest-bearing liabilities, primarily deposits, which was partially offset by an increase in the average balance of interest-bearing liabilities. The average cost of interest-bearing liabilities decreased to 0.32% for the year ended September 30, 2021 from 0.56% for the year ended September 30, 2020 as market interest rates for deposits decreased. Average interest-bearing deposits increased by $146.61 million, or 17.7%, to $976.52 million for the year ended September 30, 2021 from $829.91 million for the year ended September 30, 2020. The average balance of interest-bearing deposits increased, however, interest expense on deposits decreased by $1.62 million as a result of the decrease in the average cost of interest-bearing deposits primarily as a result of the Company decreasing the interest rates paid on deposit products because of the decreasing rate environment. The increase in the average balance of interest-bearing deposits is due primarily to proceeds from SBA PPP loans deposited directly into customer accounts, government stimulus checks and an increase in savings trends and reduced withdrawals from deposit accounts due to a change in spending habits as a result of COVID-19.
The net interest margin decreased 65 basis points to 3.25% for the year ended September 30, 2021 from 3.90% for the year ended September 30, 2020.
Provision for Loan Losses: There was no provision for loans losses for the year ended September 30, 2021 compared to a provision for loan losses of $3.70 million for the year ended September 30, 2020, due primarily to improvement in forecasted probable credit losses from the COVID-19 pandemic on the economy as of September 30, 2021. The provision for loan losses for the prior 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 $55,000 for the year ended September 30, 2021 and net recoveries of $24,000 for the year ended September 30, 2020. The net charge-offs (recoveries) to average outstanding loans ratio was (0.01)% for the year ended September 30, 2021 and 0.00% for the year ended September 30, 2020. The level of delinquent loans (loans 30 or more days past due) decreased by $709,000, or 18.9%, to $3.04 million at September 30, 2021 from $3.75 million at September 30, 2020 and the level of loans graded substandard decreased by $45,000, or 1.2%, to $3.60 million at September 30, 2021 from $3.65 million at September 30, 2020. Special mention loans decreased by $852,000 or 14.5%, to $5.01 million at September 30, 2021 from $5.86 million at September 30, 2020. Non-accrual loans decreased by $51,000, or 1.8%, to $2.85 million at September 30, 2021 from $2.91 million at September 30, 2020.
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 since the COVID-19 pandemic began. Most of these borrowers have resumed making payments, and only one loan totaling $233,000 was on deferred status as of September 30, 2021 compared to five loans totaling $5.87 million of deferral status as of September 30, 2020. These modifications were not classified as TDRs in accordance with guidance of the CARES Act and related regulatory guidance.
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The $40.92 million balance of SBA PPP loans was omitted from the Company's normal allowance for loan losses calculation at September 30, 2021, 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, 2021 was $247,000 compared to $41,000 at September 30, 2020.
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 $449,000 at September 30, 2021. 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.