First National Corp 10-Q for FY2020 Q3
First National Corp (FXNC)
About this 10-Q
First National Corp filed this 10-Q on November 9, 2020, covering the quarter ended September 30, 2020 (FY2020 Q3).
Headline figures
Quarter ended September 30, 2020, as reported in this filing, compared with the same period a year earlier where the filing states it.
- Revenue
- $2.01M
- up 0.7% from $2M a year earlier
- Net income
- $1.75M
- down 29.6% from net income of $2.49M a year earlier
- Diluted EPS
- $0.36
- down 28.0% from $0.50 a year earlier
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM
| | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended
or
| | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission File Number:
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Securities registered pursuant to Section 12(b) of the Act:
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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
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If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. As of November 9, 2020,
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Consolidated Balance Sheets as of September 30, 2020 (unaudited) and December 31, 2019 |
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Management’s Discussion and Analysis of Financial Condition and Results of Operations |
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PART I – FINANCIAL INFORMATION
Item 1. Financial Statements
FIRST NATIONAL CORPORATION
Consolidated Balance Sheets
(in thousands, except share and per share data)
| (unaudited) | ||||||||
| September 30, | December 31, | |||||||
| 2020 | 2019* | |||||||
| Assets | ||||||||
| Cash and due from banks | $ | $ | ||||||
| Interest-bearing deposits in banks | ||||||||
| Securities available for sale, at fair value | ||||||||
| Securities held to maturity, at amortized cost (fair value, 2020, $; 2019, $) | ||||||||
| Restricted securities, at cost | ||||||||
| Loans held for sale | ||||||||
| Loans, net of allowance for loan losses, 2020, $; 2019, $ | ||||||||
| Premises and equipment, net | ||||||||
| Accrued interest receivable | ||||||||
| Bank owned life insurance | ||||||||
| Core deposit intangibles, net | ||||||||
| Other assets | ||||||||
| Total assets | $ | $ | ||||||
| Liabilities and Shareholders’ Equity | ||||||||
| Liabilities | ||||||||
| Deposits: | ||||||||
| Noninterest-bearing demand deposits | $ | $ | ||||||
| Savings and interest-bearing demand deposits | ||||||||
| Time deposits | ||||||||
| Total deposits | $ | $ | ||||||
| Subordinated debt | ||||||||
| Junior subordinated debt | ||||||||
| Accrued interest payable and other liabilities | ||||||||
| Total liabilities | $ | $ | ||||||
| Commitments and contingencies | ||||||||
| Shareholders’ Equity | ||||||||
| Preferred stock, par value $ per share; authorized shares; issued and outstanding | $ | $ | ||||||
| Common stock, par value $ per share; authorized shares; issued and outstanding, 2020, shares; 2019, shares | ||||||||
| Surplus | ||||||||
| Retained earnings | ||||||||
| Accumulated other comprehensive income, net | ||||||||
| Total shareholders’ equity | $ | $ | ||||||
| Total liabilities and shareholders’ equity | $ | $ | ||||||
*Derived from audited consolidated financial statements.
See Notes to Consolidated Financial Statements
Consolidated Statements of Income (Unaudited)
(in thousands, except per share data)
| Three Months Ended | Nine Months Ended | |||||||||||||||
| September 30, | September 30, | September 30, | September 30, | |||||||||||||
| 2020 | 2019 | 2020 | 2019 | |||||||||||||
| Interest and Dividend Income | ||||||||||||||||
| Interest and fees on loans | $ | $ | $ | $ | ||||||||||||
| Interest on deposits in banks | ||||||||||||||||
| Interest and dividends on securities: | ||||||||||||||||
| Taxable interest | ||||||||||||||||
| Tax-exempt interest | ||||||||||||||||
| Dividends | ||||||||||||||||
| Total interest and dividend income | $ | $ | $ | $ | ||||||||||||
| Interest Expense | ||||||||||||||||
| Interest on deposits | $ | $ | $ | $ | ||||||||||||
| Interest on federal funds purchased | ||||||||||||||||
| Interest on subordinated debt | ||||||||||||||||
| Interest on junior subordinated debt | ||||||||||||||||
| Interest on other borrowings | ||||||||||||||||
| Total interest expense | $ | $ | $ | $ | ||||||||||||
| Net interest income | $ | $ | $ | $ | ||||||||||||
| Provision for loan losses | ||||||||||||||||
| Net interest income after provision for loan losses | $ | $ | $ | $ | ||||||||||||
| Noninterest Income | ||||||||||||||||
| Service charges on deposit accounts | $ | $ | $ | $ | ||||||||||||
| ATM and check card fees | ||||||||||||||||
| Wealth management fees | ||||||||||||||||
| Fees for other customer services | ||||||||||||||||
| Income from bank owned life insurance | ||||||||||||||||
| Net gains on securities available for sale | ||||||||||||||||
| Net gains on sale of loans | ||||||||||||||||
| Other operating income | ||||||||||||||||
| Total noninterest income | $ | $ | $ | $ | ||||||||||||
| Noninterest Expense | ||||||||||||||||
| Salaries and employee benefits | $ | $ | $ | $ | ||||||||||||
| Occupancy | ||||||||||||||||
| Equipment | ||||||||||||||||
| Marketing | ||||||||||||||||
| Supplies | ||||||||||||||||
| Legal and professional fees | ||||||||||||||||
| ATM and check card expense | ||||||||||||||||
| FDIC assessment | ( | ) | ||||||||||||||
| Bank franchise tax | ||||||||||||||||
| Data processing expense | ||||||||||||||||
| Amortization expense | ||||||||||||||||
| Net gains on disposal of premises and equipment | ( | ) | ||||||||||||||
| Other operating expense | ||||||||||||||||
| Total noninterest expense | $ | $ | $ | $ | ||||||||||||
See Notes to Consolidated Financial Statements
FIRST NATIONAL CORPORATION
Consolidated Statements of Income (Unaudited)
(Continued)
(in thousands, except per share data)
| Three Months Ended | Nine Months Ended | |||||||||||||||
| September 30, | September 30, | September 30, | September 30, | |||||||||||||
| 2020 | 2019 | 2020 | 2019 | |||||||||||||
| Income before income taxes | $ | $ | $ | $ | ||||||||||||
| Income tax expense | ||||||||||||||||
| Net income | $ | $ | $ | $ | ||||||||||||
| Earnings per common share | ||||||||||||||||
| Basic | $ | $ | $ | $ | ||||||||||||
| Diluted | $ | $ | $ | $ | ||||||||||||
See Notes to Consolidated Financial Statements
Consolidated Statements of Comprehensive Income (Unaudited)
(in thousands)
| Three Months Ended | Nine Months Ended | |||||||||||||||
| September 30, | September 30, | September 30, | September 30, | |||||||||||||
| 2020 | 2019 | 2020 | 2019 | |||||||||||||
| Net income | $ | $ | $ | $ | ||||||||||||
| Other comprehensive income, net of tax, | ||||||||||||||||
| Unrealized holding gains on available for sale securities, net of tax $ and $ for the three months and $ and $ for the nine months ended September 30, 2020 and 2019, respectively | ||||||||||||||||
| Unrealized holding losses on securities transferred from held to maturity to available for sale, net of tax $ and $ for the three months and $ and ($) for the nine months ended September 30, 2020 and 2019, respectively | ( | ) | ||||||||||||||
| Reclassification adjustment for gains included in net income, net of tax ($) and $ for the three months and ($) and $ for the nine months ended September 30, 2020 and 2019, respectively | ( | ) | ( | ) | ||||||||||||
| Change in fair value of cash flow hedges, net of tax $ and $ for the three months and $ and $ for the nine months ended September 30, 2020 and 2019, respectively | ||||||||||||||||
| Total other comprehensive income | ||||||||||||||||
| Total comprehensive income | $ | $ | $ | $ | ||||||||||||
See Notes to Consolidated Financial Statements
Consolidated Statements of Cash Flows (Unaudited)
(in thousands)
| Nine Months Ended | ||||||||
| September 30, | September 30, | |||||||
| 2020 | 2019 | |||||||
| Cash Flows from Operating Activities | ||||||||
| Net income | $ | $ | ||||||
| Adjustments to reconcile net income to net cash provided by operating activities: | ||||||||
| Depreciation and amortization of premises and equipment | ||||||||
| Amortization of core deposit intangibles | ||||||||
| Amortization of debt issuance costs | ||||||||
| Origination of loans held for sale | ( | ) | ( | ) | ||||
| Proceeds from sale of loans held for sale | ||||||||
| Net gains on sales of loans held for sale | ( | ) | ( | ) | ||||
| Provision for loan losses | ||||||||
| Net gains on securities available for sale | ( | ) | ||||||
| Increase in cash value of bank owned life insurance | ( | ) | ( | ) | ||||
| Accretion of discounts and amortization of premiums on securities, net | ||||||||
| Accretion of premium on time deposits | ( | ) | ( | ) | ||||
| Stock-based compensation | ||||||||
| Excess tax benefits on stock-based compensation | ( | ) | ( | ) | ||||
| Gains on disposal of premises and equipment | ( | ) | ||||||
| Deferred income tax benefit | ( | ) | ( | ) | ||||
| Changes in assets and liabilities: | ||||||||
| (Increase) decrease in interest receivable | ( | ) | ||||||
| Decrease (increase) in other assets | ( | ) | ||||||
| (Decrease) increase in accrued expenses and other liabilities | ( | ) | ||||||
| Net cash provided by operating activities | $ | $ | ||||||
| Cash Flows from Investing Activities | ||||||||
| Proceeds from maturities, calls, principal payments, and sales of securities available for sale | $ | $ | ||||||
| Proceeds from maturities, calls, and principal payments of securities held to maturity | ||||||||
| Purchases of securities available for sale | ( | ) | ( | ) | ||||
| Net purchase of restricted securities | ( | ) | ( | ) | ||||
| Purchase of premises and equipment | ( | ) | ( | ) | ||||
| Proceeds from sale of premises and equipment | ||||||||
| Purchase of bank owned life insurance | ( | ) | ||||||
| Net increase in loans | ( | ) | ( | ) | ||||
| Net cash used in investing activities | $ | ( | ) | $ | ( | ) | ||
See Notes to Consolidated Financial Statements
FIRST NATIONAL CORPORATION
Consolidated Statements of Cash Flows (Unaudited)
(Continued)
(in thousands)
| Nine Months Ended | ||||||||
| September 30, | September 30, | |||||||
| 2020 | 2019 | |||||||
| Cash Flows from Financing Activities | ||||||||
| Net increase in demand deposits and savings accounts | $ | $ | ||||||
| Net (decrease) increase in time deposits | ( | ) | ||||||
| Proceeds from subordinated debt, net of issuance costs | ||||||||
| Cash dividends paid on common stock, net of reinvestment | ( | ) | ( | ) | ||||
| Repurchase of common stock, stock incentive plan | ( | ) | ( | ) | ||||
| Repurchase of common stock, employee stock ownership plan | ( | ) | ||||||
| Repurchase of common stock, stock repurchase plan | ( | ) | ||||||
| Net cash provided by financing activities | $ | $ | ||||||
| Increase in cash and cash equivalents | $ | $ | ||||||
| Cash and Cash Equivalents | ||||||||
| Beginning | $ | $ | ||||||
| Ending | $ | $ | ||||||
| Supplemental Disclosures of Cash Flow Information | ||||||||
| Cash payments for: | ||||||||
| Interest | $ | $ | ||||||
| Income taxes | $ | $ | ||||||
| Supplemental Disclosures of Noncash Investing and Financing Activities | ||||||||
| Unrealized gains on securities available for sale | $ | $ | ||||||
| Unrealized losses on securities transferred from held to maturity to available for sale | $ | $ | ( | ) | ||||
| Fair value of securities transferred from held to maturity to available for sale | $ | $ | ||||||
| Change in fair value of cash flow hedges | $ | $ | ||||||
| Issuance of common stock, dividend reinvestment plan | $ | $ | ||||||
See Notes to Consolidated Financial Statements
Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)
(in thousands, except share and per share data)
| Common Stock | Surplus | Retained Earnings | Accumulated Other Comprehensive Income | Total | ||||||||||||||||
| Balance, June 30, 2019 | $ | $ | $ | $ | $ | |||||||||||||||
| Net income | ||||||||||||||||||||
| Other comprehensive income | ||||||||||||||||||||
| Cash dividends on common stock ($ per share) | ( | ) | ( | ) | ||||||||||||||||
| Stock-based compensation | ||||||||||||||||||||
| Issuance of shares common stock, dividend reinvestment plan | ||||||||||||||||||||
| Issuance of shares common stock, stock incentive plan | ( | ) | ||||||||||||||||||
| Repurchase of shares common stock, employee stock ownership plan | ( | ) | ( | ) | ( | ) | ||||||||||||||
| Balance, September 30, 2019 | $ | $ | $ | $ | $ | |||||||||||||||
| Common Stock | Surplus | Retained Earnings | Accumulated Other Comprehensive Income | Total | ||||||||||||||||
| Balance, June 30, 2020 | $ | $ | $ | $ | $ | |||||||||||||||
| Net income | ||||||||||||||||||||
| Other comprehensive income | ||||||||||||||||||||
| Cash dividends on common stock ($ per share) | ( | ) | ( | ) | ||||||||||||||||
| Stock-based compensation | ||||||||||||||||||||
| Issuance of shares common stock, dividend reinvestment plan | ||||||||||||||||||||
| Issuance of shares common stock, stock incentive plan | ( | ) | ||||||||||||||||||
| Balance, September 30, 2020 | $ | $ | $ | $ | $ | |||||||||||||||
| Common Stock | Surplus | Retained Earnings | Accumulated Other Comprehensive Income (Loss) | Total | ||||||||||||||||
| Balance, December 31, 2018 | $ | $ | $ | $ | ( | ) | $ | |||||||||||||
| Net income | ||||||||||||||||||||
| Other comprehensive income | ||||||||||||||||||||
| Cash dividends on common stock ($ per share) | ( | ) | ( | ) | ||||||||||||||||
| Stock-based compensation | ||||||||||||||||||||
| Issuance of shares common stock, dividend reinvestment plan | ||||||||||||||||||||
| Issuance of shares common stock, stock incentive plan | ( | ) | ||||||||||||||||||
| Repurchase of shares common stock, stock incentive plan | ( | ) | ( | ) | ( | ) | ||||||||||||||
| Repurchase of shares common stock, employee stock ownership plan | ( | ) | ( | ) | ( | ) | ||||||||||||||
| Balance, September 30, 2019 | $ | $ | $ | $ | $ | |||||||||||||||
| Common Stock | Surplus | Retained Earnings | Accumulated Other Comprehensive Income | Total | ||||||||||||||||
| Balance, December 31, 2019 | $ | $ | $ | $ | $ | |||||||||||||||
| Net income | ||||||||||||||||||||
| Other comprehensive income | ||||||||||||||||||||
| Cash dividends on common stock ($ per share) | ( | ) | ( | ) | ||||||||||||||||
| Stock-based compensation | ||||||||||||||||||||
| Issuance of shares common stock, dividend reinvestment plan | ||||||||||||||||||||
| Issuance of shares common stock, stock incentive plan | ( | ) | ||||||||||||||||||
| Repurchase of shares common stock, stock incentive plan | ( | ) | ( | ) | ( | ) | ||||||||||||||
| Repurchase of shares common stock, stock repurchase plan | ( | ) | ( | ) | ( | ) | ||||||||||||||
| Balance, September 30, 2020 | $ | $ | $ | $ | $ | |||||||||||||||
See Notes to Consolidated Financial Statements
Notes to Consolidated Financial Statements (Unaudited)
Note 1. General
The accompanying unaudited consolidated financial statements of First National Corporation (the Company) and its subsidiary, First Bank (the Bank), have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information. Accordingly, they do not include all of the information and footnotes required by GAAP. All significant intercompany balances and transactions have been eliminated. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments and reclassifications of a normal and recurring nature considered necessary to present fairly the financial positions at September 30, 2020 and December 31, 2019, the statements of income and comprehensive income for the three and nine months ended September 30, 2020 and 2019, the cash flows for the nine months ended September 30, 2020 and 2019, and the changes in shareholders’ equity for the three and nine months ended September 30, 2020 and 2019. The statements should be read in conjunction with the consolidated financial statements and related notes included in the Annual Report on Form 10-K for the year ended December 31, 2019. Operating results for the three and nine months ended September 30, 2020 are not necessarily indicative of the results that may be expected for the year ending December 31, 2020.
Risks and Uncertainties
The outbreak of COVID-19 has adversely impacted a broad range of industries in which the Company’s customers operate and could impair their ability to fulfill their financial obligations to the Company. The World Health Organization has declared COVID-19 to be a global pandemic indicating that almost all public commerce and related business activities must be, to varying degrees, curtailed with the goal of decreasing the rate of new infections. The spread of the outbreak has caused disruptions in the U.S. economy and has disrupted banking and other financial activity in the areas in which the Company operates. While there has been no material impact to the Company’s employees to date, COVID-19 could also potentially create widespread business continuity issues for the Company.
Congress, the President, and the Federal Reserve have taken several actions designed to cushion the economic fallout. Most notably, the Coronavirus Aid, Relief and Economic Security (CARES) Act was signed into law in March 2020 as a $2 trillion legislative package. The goal of the CARES Act is to prevent a severe economic downturn through various measures, including direct financial aid to American families and economic stimulus to significantly impacted industry sectors. The package also includes extensive emergency funding for hospitals and providers. In addition to the general impact of COVID-19, certain provisions of the CARES Act as well as other recent legislative and regulatory relief efforts may have a material impact on the Company’s operations.
The Company’s business is dependent upon the willingness and ability of its employees and customers to conduct banking and other financial transactions. If the global response to contain COVID-19 escalates further or is unsuccessful, the Company could experience a material adverse effect on its business, financial condition, results of operations and cash flows. While it is not possible to know the full universe or extent that the impact of COVID-19, and resulting measures to curtail its spread, will have on the Company’s operations, the Company is disclosing potentially material items of which it is aware.
Results of Operations
The Company’s net interest income could decrease due to COVID-19. In keeping with guidance from regulators, the Company worked with certain COVID-19 affected borrowers in the second and third quarters of 2020 to defer their payments, interest, and fees. While interest still accrues to income, through normal GAAP accounting, should eventual credit losses on these deferred payments emerge, interest income accrued would need to be reversed. In such a scenario, interest income in future periods could be negatively impacted. At this time, the Company is unable to project the materiality of such an impact but recognizes the breadth of the economic impact may affect its borrowers' ability to repay in future periods.
The Company's noninterest income could decrease due to COVID-19. The Bank suspended certain overdraft fees at the beginning of the second quarter in an effort to provide relief to its customers who may experience financial difficulties related to the pandemic, and as a result, service charges on deposits decreased during those periods as a result of the suspension. Although the overdraft fees that were temporarily suspended have resumed on October 1, 2020, the impact on overdraft income in future periods is uncertain. ATM and check card income could decrease in future periods from changes in customer spending. Wealth management revenue may decrease in future periods if the market values of investments decline and mortgage fee income may decrease from less home buying activity in the Company's market area. At this time, the Company is unable to project the materiality of such an impact but recognizes it may unfavorably affect its noninterest income in future periods.
The Company’s noninterest expense could increase due to COVID-19. If the Bank's asset quality worsens, it may incur additional loan expenses in future periods from obtaining updated appraisals on loan collateral, additional legal and professional expenses related to the resolution of problem loans, an increase in other real estate owned expense, and potential losses on the sale of other real estate owned.
At this time, the Company is unable to project the full extent or materiality of the foregoing impacts but recognizes the breadth of the economic impacts of COVID-19 may have an unfavorable impact on net interest income, noninterest income, noninterest expense, and loan customers' ability to repay loans, in future periods.
Notes to Consolidated Financial Statements (Unaudited)
Capital and Liquidity
While the Company believes it has sufficient capital to withstand an extended economic recession brought about by COVID-19, its reported and regulatory capital ratios could be adversely impacted by provision for loan losses in future periods. Larger amounts of provision for loan losses may result from factors including higher specific reserves on newly identified and existing impaired loans, higher levels of net charge-offs, and additional adjustments to qualitative factors in the general reserve component of the Bank’s allowance for loan losses. In March 2020, the Company suspended future stock repurchases under its stock repurchase program due to the economic uncertainty caused by the pandemic, and the program remained suspended in the second and third quarters of 2020. In June 2020, the Company issued $
The Company maintains access to multiple sources of liquidity. While wholesale funding markets have remained open, interest rates for short term funding could become volatile. If funding costs would become elevated for an extended period of time, it may have an adverse effect on the Company’s net interest margin. If an extended recession causes large numbers of the Company’s deposit customers to withdraw their funds, the Company could become more reliant on volatile or more expensive sources of funding.
Processes, Controls and Business Continuity Plan
The Company continues to operate under its Pandemic Continuity of Operations Plan that includes a remote working strategy. The Company has not incurred additional material costs related to employees working remotely. No material operational or internal control challenges or risks have been identified to date. The Company does not anticipate significant challenges to its ability to maintain its systems and controls in light of the measures the Company has taken to prevent the spread of COVID-19. The Company does not currently face any material resource constraint through the implementation of its business continuity plan.
Lending Operations and Accommodations to Borrowers
In keeping with regulatory guidance to work with borrowers during this unprecedented situation, the Company offered a payment deferral program for its individual and business customers adversely affected by the pandemic that deferred loan payments for up to 90 days. As of September 30, 2020, loans participating in the program totaled $
With the passage of the Paycheck Protection Program (PPP), administered by the Small Business Administration (SBA), the Company actively participated in assisting its customers with applications for resources through the program. During the second and third quarters of 2020, the Bank originated $
Asset Quality
The economic impact of the pandemic had an unfavorable impact on the financial condition of certain Bank customers. Although many borrowers participated in the loan payment deferral program to date, the Bank plans to consider additional loan modifications in the fourth quarter of 2020 to provide relief to certain customers if they are continuing to experience temporary business interruptions from the pandemic, if the Bank believes the modifications would minimize potential loan charge-offs. We expect significant pressure on several sectors of the loan portfolio to continue, including retail shopping, lodging and leisure, among others.
The magnitude of the potential decline in the Bank’s loan quality will likely depend on the length and extent that the Bank’s customers experience business interruptions from the pandemic. In addition, the Bank’s loan deferral program could make it difficult to identify the extent that asset quality may be worsening until the payment deferral periods have ended and scheduled loan payments become due.
Notes to Consolidated Financial Statements (Unaudited)
Derivative Financial Instruments
On April 21, 2020, the Company entered into two interest rate swap agreements related to its outstanding junior subordinated debt. The Company recognizes derivative financial instruments at fair value as either an other asset or other liability in its Consolidated Balance Sheets. The Company’s derivative financial instruments are comprised of interest rate swaps that qualify and are designated as cash flow hedges on the Company’s junior subordinated debt. Gains or losses on the Company’s cash flow hedges are reported as a component of other comprehensive income, net of deferred income taxes, and reclassified into earnings in the same period(s) during which the hedged transactions affect earnings. The Company’s derivative financial instruments are described more fully in Note 16.
Adoption of New Accounting Pronouncements
In January 2017, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2017-04, “Intangibles - Goodwill and Other (Topic 350) - Simplifying the Test for Goodwill Impairment” (ASU 2017-04). ASU 2017-04 simplifies the accounting for goodwill impairment for all entities by requiring impairment charges to be based on the first step in the previous two-step impairment test. Under the new guidance, if a reporting unit’s carrying amount exceeds its fair value, an entity will record an impairment charge based on that difference. The impairment charge will be limited to the amount of goodwill allocated to that reporting unit. The standard eliminates the prior requirement to calculate a goodwill impairment charge using Step 2, which requires an entity to calculate any impairment charge by comparing the implied fair value of goodwill with its carrying amount. ASU 2017-04 was effective for the Company on January 1, 2020. The adoption of this standard did not have a material effect on the Company's consolidated financial statements.
In August 2018, the FASB issued ASU No. 2018-13, “Fair Value Measurement (Topic 820) - Changes to the Disclosure Requirements for Fair Value Measurement” (ASU 2018-13). ASU 2018-13 modifies the disclosure requirements on fair value measurements by requiring that Level 3 fair value disclosures include the range and weighted average of significant unobservable inputs used to develop those fair value measurements. For certain unobservable inputs, an entity may disclose other quantitative information in lieu of the weighted average if the entity determines that other quantitative information would be a more reasonable and rational method to reflect the distribution of unobservable inputs used to develop Level 3 fair value measurements. Certain disclosure requirements in Topic 820 were also removed or modified. ASU 2018-13 was effective for the Company on January 1, 2020. The adoption of this standard did not have a material effect on the Company's consolidated financial statements.
In March 2020 (revised in April 2020), various regulatory agencies, including the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation, (the agencies) issued an interagency statement on loan modifications and reporting for financial institutions working with customers affected by the Coronavirus. The interagency statement was effective immediately and impacted accounting for loan modifications. Under Accounting Standards Codification 310-40, “Receivables – Troubled Debt Restructurings by Creditors,” (ASC 310-40), a restructuring of debt constitutes a troubled debt restructuring (TDR) if the creditor, for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider. The agencies confirmed with the staff of the FASB that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief, are not to be considered TDRs. This includes short-term (e.g., six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. Borrowers considered current are those that are less than 30 days past due on their contractual payments at the time a modification program is implemented. This interagency guidance is expected to have a material impact on the Company's financial statements; however, this impact cannot be quantified at this time. For further information about the Company's short-term modifications in response to COVID-19 to borrowers who were current prior to any relief, see Note 4.
Recent Accounting Pronouncements
In June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” (ASU 2016-13). The amendments in this ASU, among other things, require the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. In addition, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. The FASB has issued multiple updates to ASU 2016-13 as codified in Topic 326, including ASU’s 2019-04, 2019-05, 2019-10, 2019-11, 2020-02, and 2020-03. These ASU’s have provided for various minor technical corrections and improvements to the codification as well as other transition matters. Smaller reporting companies who file with the U.S. Securities and Exchange Commission (SEC) and all other entities who do not file with the SEC are required to apply the guidance for fiscal years, and interim periods within those years, beginning after December 15, 2022. The Company is currently assessing the impact that ASU 2016-13 will have on its consolidated financial statements. The Company has formed a committee to address the compliance requirements of this ASU, which has analyzed gathered data, defined loan pools and segments, and selected methods for applying the concepts included in this ASU. The Company is in the process of testing selected models, building policy and processing documentation, modeling the impact of the ASU on the capital and strategic plans, performing model validation, and finalizing policies and procedures. This guidance may result in material changes in the Company's accounting for credit losses of financial instruments.
Notes to Consolidated Financial Statements (Unaudited)
In January 2020, the FASB issued ASU No. 2020-01, “Investments – Equity Securities (Topic 321), Investments – Equity Method and Joint Ventures (Topic 323), and Derivatives and Hedging (Topic 815) – Clarifying the Interactions between Topic 321, Topic 323, and Topic 815” (ASU 2020-01). The ASU is based on a consensus of the Emerging Issues Task Force and is expected to increase comparability in accounting for these transactions. ASU 2016-01 made targeted improvements to accounting for financial instruments, including providing an entity the ability to measure certain equity securities without a readily determinable fair value at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. Among other topics, the amendments clarify that an entity should consider observable transactions that require it to either apply or discontinue the equity method of accounting. For public business entities, the amendments in the ASU are effective for fiscal years beginning after December 15, 2020, and interim periods within those fiscal years. Early adoption is permitted. The Company does not expect the adoption of ASU 2020-01 to have a material impact on its consolidated financial statements.
In March 2020, the FASB issued ASU No. 2020-04, “Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting” (ASU 2020-04). These amendments provide temporary optional guidance to ease the potential burden in accounting for reference rate reform. The ASU provides optional expedients and exceptions for applying generally accepted accounting principles to contract modifications and hedging relationships, subject to meeting certain criteria, that reference LIBOR or another reference rate expected to be discontinued. It is intended to help stakeholders during the global market-wide reference rate transition period. The guidance is effective for all entities as of March 12, 2020 through December 31, 2022. The Company is currently in the process of identifying loans and other financial instruments that are directly or indirectly influenced by LIBOR. The Company is assessing ASU 2020-04 and its impact on the Company's transition away from LIBOR for its loan and other financial instruments.
On March 12, 2020, the SEC finalized amendments to the definitions of its “accelerated filer” and “large accelerated filer” definitions. The amendments increase the threshold criteria for meeting these filer classifications and are effective on April 27, 2020. Any changes in filer status are to be applied beginning with the filer’s first annual report filed with the SEC subsequent to the effective date. Prior to these changes, the Company was required to comply with section 404(b) of the Sarbanes Oxley Act concerning auditor attestation over internal control over financial reporting as an “accelerated filer” as it had more than $75 million in public float but less than $700 million at the end of the Company’s most recent second quarter. The rule change revises the definition of “accelerated filers” to exclude entities with public float of less than $700 million and less than $100 million in annual revenues. The Company does not expect to meet this revised category of accelerated filer and will no longer be considered as such. If the Company’s annual revenues exceed $100 million, its category will change back to “accelerated filer”. The classifications of “accelerated filer” and “large accelerated filer” require a public company to obtain an auditor attestation concerning the effectiveness of internal control over financial reporting (ICFR) and include the opinion on ICFR in its annual report on Form 10-K. Non-accelerated filers, such as the Company, also have additional time to file quarterly and annual financial statements. All public companies are required to obtain and file annual financial statement audits, as well as provide management’s assertion on effectiveness of internal control over financial reporting, but the external auditor attestation of internal control over financial reporting is not required for non-accelerated filers. These amendments will change the Company's reporting and audit requirements as it will have the additional time provided to file quarterly and annual financial statements and will no longer be required to obtain an auditor attestation concerning the internal controls over financial reporting.
In August 2020, the FASB issued ASU No. 2020-06, "Debt – Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging – Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity" (ASU 2020-06). The ASU simplifies accounting for convertible instruments by removing major separation models required under current U.S. GAAP. Consequently, more convertible debt instruments will be reported as a single liability instrument and more convertible preferred stock as a single equity instrument with no separate accounting for embedded conversion features. The ASU removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception, which will permit more equity contracts to qualify for it. The ASU also simplifies the diluted earnings per share (EPS) calculation in certain areas. In addition, the amendment updates the disclosure requirements for convertible instruments to increase the information transparency. For public business entities, excluding smaller reporting companies, the amendments in the ASU are effective for fiscal years beginning after December 15, 2021, and interim periods within those fiscal years. For all other entities, the standard will be effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. Early adoption is permitted. The Company does not expect the adoption of ASU 2020-06 to have a material impact on its consolidated financial statements.
In October 2020, the FASB issued ASU No. 2020-08, "Codification Improvements to Subtopic 310-20, Receivables – Nonrefundable fees and Other Costs" (ASU 2020-08). This ASU clarifies that an entity should reevaluate whether a callable debt security is within the scope of ASC paragraph 310-20-35-33 for each reporting period. For public business entities, the ASU is effective for fiscal years beginning after December 15, 2021, and interim periods within those fiscal years. Early adoption is not permitted. All entities should apply ASU 2020-08 on a prospective basis as of the beginning of the period of adoption for existing or newly purchased callable debt securities. The Company does not expect the adoption of ASU 2020-08 to have a material impact on its consolidated financial statements.
Notes to Consolidated Financial Statements (Unaudited)
Note 2. Securities
The Company invests in U.S. agency and mortgage-backed securities, obligations of state and political subdivisions, and corporate debt securities. Amortized costs and fair values of securities at September 30, 2020 and December 31, 2019 were as follows (in thousands):
| September 30, 2020 | ||||||||||||||||
| Amortized Cost | Gross Unrealized Gains | Gross Unrealized (Losses) | Fair Value | |||||||||||||
| Securities available for sale: | ||||||||||||||||
| U.S. agency and mortgage-backed securities | $ | $ | $ | ( | ) | $ | ||||||||||
| Obligations of states and political subdivisions | ||||||||||||||||
| Total securities available for sale | $ | $ | $ | ( | ) | $ | ||||||||||
| Securities held to maturity: | ||||||||||||||||
| U.S. agency and mortgage-backed securities | $ | $ | $ | $ | ||||||||||||
| Obligations of states and political subdivisions | ||||||||||||||||
| Corporate debt securities | ||||||||||||||||
| Total securities held to maturity | $ | $ | $ | $ | ||||||||||||
| Total securities | $ | $ | $ | ( | ) | $ | ||||||||||
| December 31, 2019 | ||||||||||||||||
| Amortized Cost | Gross Unrealized Gains | Gross Unrealized (Losses) | Fair Value | |||||||||||||
| Securities available for sale: | ||||||||||||||||
| U.S. agency and mortgage-backed securities | $ | $ | $ | ( | ) | $ | ||||||||||
| Obligations of states and political subdivisions | ( | ) | ||||||||||||||
| Total securities available for sale | $ | $ | $ | ( | ) | $ | ||||||||||
| Securities held to maturity: | ||||||||||||||||
| U.S. agency and mortgage-backed securities | $ | $ | $ | ( | ) | $ | ||||||||||
| Obligations of states and political subdivisions | ||||||||||||||||
| Corporate debt securities | ||||||||||||||||
| Total securities held to maturity | $ | $ | $ | ( | ) | $ | ||||||||||
| Total securities | $ | $ | $ | ( | ) | $ | ||||||||||
Notes to Consolidated Financial Statements (Unaudited)
At September 30, 2020 and December 31, 2019, investments in an unrealized loss position that were temporarily impaired were as follows (in thousands):
| September 30, 2020 | ||||||||||||||||||||||||
| Less than 12 months | 12 months or more | Total | ||||||||||||||||||||||
| Fair Value | Unrealized (Loss) | Fair Value | Unrealized (Loss) | Fair Value | Unrealized (Loss) | |||||||||||||||||||
| Securities available for sale: | ||||||||||||||||||||||||
| U.S. agency and mortgage-backed securities | $ | $ | ( | ) | $ | $ | $ | $ | ( | ) | ||||||||||||||
| Total securities available for sale | $ | $ | ( | ) | $ | $ | $ | $ | ( | ) | ||||||||||||||
| December 31, 2019 | ||||||||||||||||||||||||
| Less than 12 months | 12 months or more | Total | ||||||||||||||||||||||
| Fair Value | Unrealized (Loss) | Fair Value | Unrealized (Loss) | Fair Value | Unrealized (Loss) | |||||||||||||||||||
| Securities available for sale: | ||||||||||||||||||||||||
| U.S. agency and mortgage-backed securities | $ | $ | ( | ) | $ | $ | ( | ) | $ | $ | ( | ) | ||||||||||||
| Obligations of states and political subdivisions | ( | ) | ( | ) | ||||||||||||||||||||
| Total securities available for sale | $ | $ | ( | ) | $ | $ | ( | ) | $ | $ | ( | ) | ||||||||||||
| Securities held to maturity: | ||||||||||||||||||||||||
| U.S. agency and mortgage-backed securities | $ | $ | ( | ) | $ | $ | ( | ) | $ | $ | ( | ) | ||||||||||||
| Total securities held to maturity | $ | $ | ( | ) | $ | $ | ( | ) | $ | $ | ( | ) | ||||||||||||
| Total securities | $ | $ | ( | ) | $ | $ | ( | ) | $ | $ | ( | ) | ||||||||||||
The tables above provide information about securities that have been in an unrealized loss position for less than twelve consecutive months and securities that have been in an unrealized loss position for twelve consecutive months or more. Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Impairment is considered to be other-than-temporary if the Company (1) intends to sell the security, (2) more likely than not will be required to sell the security before recovering its cost, or (3) does not expect to recover the security’s entire amortized cost basis. Presently, the Company does not intend to sell any of these securities, does not expect to be required to sell these securities, and expects to recover the entire amortized cost of all the securities.
Notes to Consolidated Financial Statements (Unaudited)
At September 30, 2020, there was out of
The amortized cost and fair value of securities at September 30, 2020 by contractual maturity are shown below (in thousands). Expected maturities of mortgage-backed securities will differ from contractual maturities because borrowers may have the right to prepay obligations with or without call or prepayment penalties.
| Available for Sale | Held to Maturity | |||||||||||||||
| Amortized Cost | Fair Value | Amortized Cost | Fair Value | |||||||||||||
| Due within one year | $ | $ | $ | $ | ||||||||||||
| Due after one year through five years | ||||||||||||||||
| Due after five years through ten years | ||||||||||||||||
| Due after ten years | ||||||||||||||||
| $ | $ | $ | $ | |||||||||||||
On January 1, 2019 the Company adopted ASU No. 2017-12 and reclassified eligible securities with a fair value of $
Federal Home Loan Bank, Federal Reserve Bank, and Community Bankers’ Bank stock are generally viewed as long-term investments and as restricted securities, which are carried at cost, because there is a minimal market for the stock. Therefore, when evaluating restricted securities for impairment, their value is based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value. The Company does not consider these investments to be other-than-temporarily impaired at September 30, 2020, and
The composition of restricted securities at September 30, 2020 and December 31, 2019 was as follows (in thousands):
| September 30, 2020 | December 31, 2019 | |||||||
| Federal Home Loan Bank stock | $ | $ | ||||||
| Federal Reserve Bank stock | ||||||||
| Community Bankers’ Bank stock | ||||||||
| $ | $ | |||||||
The Company also holds limited partnership investments in Small Business Investment Companies (SBICs), which are included in other assets in the Consolidated Balance Sheets. The limited partnership investments are measured as equity investments without readily determinable fair values at their cost, less any impairment. The amounts included in other assets for the limited partnership investments were $
Notes to Consolidated Financial Statements (Unaudited)
Note 3. Loans
Loans at September 30, 2020 and December 31, 2019 are summarized as follows (in thousands):
| September 30, 2020 | December 31, 2019 | |||||||
| Real estate loans: | ||||||||
| Construction and land development | $ | $ | ||||||
| Secured by 1-4 family residential | ||||||||
| Other real estate loans | ||||||||
| Commercial and industrial loans | ||||||||
| Consumer and other loans | ||||||||
| Total loans | $ | $ | ||||||
| Allowance for loan losses | ( | ) | ( | ) | ||||
| Loans, net | $ | $ | ||||||
Net deferred loan fees included in the above loan categories were $
Risk characteristics of each loan portfolio class that are considered by the Company include:
| • | 1-4 family residential mortgage loans carry risks associated with the continued creditworthiness of the borrower and changes in the value of the collateral. |
| • | Real estate construction and land development loans carry risks that the project may not be finished according to schedule, the project may not be finished according to budget, and the value of the collateral may, at any point in time, be less than the principal amount of the loan. Construction loans also bear the risk that the general contractor, who may or may not be a loan customer, may be unable to finish the construction project as planned because of financial pressure or other factors unrelated to the project. |
| • | Other real estate loans carry risks associated with the successful operation of a business or a real estate project, in addition to other risks associated with the ownership of real estate, because repayment of these loans may be dependent upon the profitability and cash flows of the business or project. |
| • | Commercial and industrial loans carry risks associated with the successful operation of a business because repayment of these loans may be dependent upon the profitability and cash flows of the business. In addition, there is risk associated with the value of collateral other than real estate which may depreciate over time and cannot be appraised with as much reliability. |
| • | Consumer and other loans carry risk associated with the continued creditworthiness of the borrower and the value of the collateral, if any. These loans are typically either unsecured or secured by rapidly depreciating assets such as automobiles. They are also likely to be immediately and adversely affected by job loss, divorce, illness, personal bankruptcy, or other changes in circumstances. Consumer and other loans also include purchased consumer loans which could have been originated outside of the Company's market area. |
Notes to Consolidated Financial Statements (Unaudited)
The following tables provide a summary of loan classes and an aging of past due loans as of September 30, 2020 and December 31, 2019 (in thousands):
| September 30, 2020 | ||||||||||||||||||||||||||||||||
| 30-59 Days Past Due | 60-89 Days Past Due | > 90 Days Past Due | Total Past Due | Current | Total Loans | Non-accrual Loans | 90 Days or More Past Due and Accruing | |||||||||||||||||||||||||
| Real estate loans: | ||||||||||||||||||||||||||||||||
| Construction and land development | $ | $ | $ | $ | $ | $ | $ | $ | ||||||||||||||||||||||||
| Secured by 1-4 family residential | ||||||||||||||||||||||||||||||||
| Other real estate loans | ||||||||||||||||||||||||||||||||
| Commercial and industrial | ||||||||||||||||||||||||||||||||
| Consumer and other loans | ||||||||||||||||||||||||||||||||
| Total | $ | $ | $ | $ | $ | $ | $ | $ | ||||||||||||||||||||||||
| December 31, 2019 | ||||||||||||||||||||||||||||||||
| 30-59 Days Past Due | 60-89 Days Past Due | > 90 Days Past Due | Total Past Due | Current | Total Loans | Non-accrual Loans | 90 Days or More Past Due and Accruing | |||||||||||||||||||||||||
| Real estate loans: | ||||||||||||||||||||||||||||||||
| Construction and land development | $ | $ | $ | $ | $ | $ | $ | $ | ||||||||||||||||||||||||
| Secured by 1-4 family residential | ||||||||||||||||||||||||||||||||
| Other real estate loans | ||||||||||||||||||||||||||||||||
| Commercial and industrial | ||||||||||||||||||||||||||||||||
| Consumer and other loans | ||||||||||||||||||||||||||||||||
| Total | $ | $ | $ | $ | $ | $ | $ | $ | ||||||||||||||||||||||||
Credit Quality Indicators
As part of the ongoing monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to the risk grading of specified classes of loans. The Company utilizes a risk grading matrix to assign a rating to each of its loans. The loan ratings are summarized into the following categories: pass, special mention, substandard, doubtful, and loss. Pass rated loans include all risk rated credits other than those included in special mention, substandard, or doubtful. Loans classified as loss are charged-off. Loan officers assign risk grades to loans at origination and as renewals arise. The Bank’s Credit Administration department reviews risk grades for accuracy on a quarterly basis and as credit issues arise. In addition, a certain amount of loans are reviewed each year through the Company’s internal and external loan review process. A description of the general characteristics of the loan grading categories is as follows:
Pass – Loans classified as pass exhibit acceptable operating trends, balance sheet trends, and liquidity. Sufficient cash flow exists to service the loan. All obligations have been paid by the borrower as agreed.
Special Mention – Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or the Bank’s credit position at some future date.
Notes to Consolidated Financial Statements (Unaudited)
Substandard – Loans classified as substandard are inadequately protected by the current net worth and payment capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.
Doubtful – Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. The Company considers all doubtful loans to be impaired and places the loan on non-accrual status.
Loss – Loans classified as loss are considered uncollectable and of such little value that their continuance as bankable assets is not warranted.
The following tables provide an analysis of the credit risk profile of each loan class as of September 30, 2020 and December 31, 2019 (in thousands):
| September 30, 2020 | ||||||||||||||||||||
| Pass | Special Mention | Substandard | Doubtful | Total | ||||||||||||||||
| Real estate loans: | ||||||||||||||||||||
| Construction and land development | $ | $ | $ | $ | $ | |||||||||||||||
| Secured by 1-4 family residential | ||||||||||||||||||||
| Other real estate loans | ||||||||||||||||||||
| Commercial and industrial | ||||||||||||||||||||
| Consumer and other loans | ||||||||||||||||||||
| Total | $ | $ | $ | $ | $ | |||||||||||||||
| December 31, 2019 | ||||||||||||||||||||
| Pass | Special Mention | Substandard | Doubtful | Total | ||||||||||||||||
| Real estate loans: | ||||||||||||||||||||
| Construction and land development | $ | $ | $ | $ | $ | |||||||||||||||
| Secured by 1-4 family residential | ||||||||||||||||||||
| Other real estate loans | ||||||||||||||||||||
| Commercial and industrial | ||||||||||||||||||||
| Consumer and other loans | ||||||||||||||||||||
| Total | $ | $ | $ | $ | $ | |||||||||||||||
Notes to Consolidated Financial Statements (Unaudited)
Note 4. Allowance for Loan Losses
The following tables present, as of September 30, 2020, December 31, 2019 and September 30, 2019, the total allowance for loan losses, the allowance by impairment methodology, and loans by impairment methodology (in thousands):
| September 30, 2020 | ||||||||||||||||||||||||
| Construction and Land Development | Secured by 1-4 Family Residential | Other Real Estate | Commercial and Industrial | Consumer and Other Loans | Total | |||||||||||||||||||
| Allowance for loan losses: | ||||||||||||||||||||||||
| Beginning Balance, December 31, 2019 | $ | $ | $ | $ | $ | $ | ||||||||||||||||||
| Charge-offs | ( | ) | ( | ) | ( | ) | ||||||||||||||||||
| Recoveries | ||||||||||||||||||||||||
| Provision for (recovery of) loan losses | ( | ) | ( | ) | ||||||||||||||||||||
| Ending Balance, September 30, 2020 | $ | $ | $ | $ | $ | $ | ||||||||||||||||||
| Ending Balance: | ||||||||||||||||||||||||
| Individually evaluated for impairment | ||||||||||||||||||||||||
| Collectively evaluated for impairment | ||||||||||||||||||||||||
| Loans: | ||||||||||||||||||||||||
| Ending Balance | $ | $ | $ | $ | $ | $ | ||||||||||||||||||
| Individually evaluated for impairment | ||||||||||||||||||||||||
| Collectively evaluated for impairment | ||||||||||||||||||||||||
| December 31, 2019 | ||||||||||||||||||||||||
| Construction and Land Development | Secured by 1-4 Family Residential | Other Real Estate | Commercial and Industrial | Consumer and Other Loans | Total | |||||||||||||||||||
| Allowance for loan losses: | ||||||||||||||||||||||||
| Beginning Balance, December 31, 2018 | $ | $ | $ | $ | $ | $ | ||||||||||||||||||
| Charge-offs | ( | ) | ( | ) | ( | ) | ( | ) | ( | ) | ( | ) | ||||||||||||
| Recoveries | ||||||||||||||||||||||||
| Provision for (recovery of) loan losses | ( | ) | ( | ) | ||||||||||||||||||||
| Ending Balance, December 31, 2019 | $ | $ | $ | $ | $ | $ | ||||||||||||||||||
| Ending Balance: | ||||||||||||||||||||||||
| Individually evaluated for impairment | ||||||||||||||||||||||||
| Collectively evaluated for impairment | ||||||||||||||||||||||||
| Loans: | ||||||||||||||||||||||||
| Ending Balance | $ | 43,164 | $ | 229,438 | $ | 236,555 | $ | 50,153 | $ | 15,036 | $ | 574,346 | ||||||||||||
| Individually evaluated for impairment | ||||||||||||||||||||||||
| Collectively evaluated for impairment | ||||||||||||||||||||||||
Notes to Consolidated Financial Statements (Unaudited)
| September 30, 2019 | ||||||||||||||||||||||||
| Construction and Land Development | Secured by 1-4 Family Residential | Other Real Estate | Commercial and Industrial | Consumer and Other Loans | Total | |||||||||||||||||||
| Allowance for loan losses: | ||||||||||||||||||||||||
| Beginning Balance, December 31, 2018 | $ | $ | $ | $ | $ | $ | ||||||||||||||||||
| Charge-offs | ( | ) | ( | ) | ( | ) | ( | ) | ||||||||||||||||
| Recoveries | ||||||||||||||||||||||||
| Provision for (recovery of) loan losses | ( | ) | ( | ) | ||||||||||||||||||||
| Ending Balance, September 30, 2019 | $ | $ | $ | $ | $ | $ | ||||||||||||||||||
| Ending Balance: | ||||||||||||||||||||||||
| Individually evaluated for impairment | ||||||||||||||||||||||||
| Collectively evaluated for impairment | ||||||||||||||||||||||||
| Loans: | ||||||||||||||||||||||||
| Ending Balance | $ | 45,193 | $ | 226,828 | $ | 233,067 | $ | 50,557 | $ | 15,608 | $ | 571,253 | ||||||||||||
| Individually evaluated for impairment | ||||||||||||||||||||||||
| Collectively evaluated for impairment | ||||||||||||||||||||||||
Notes to Consolidated Financial Statements (Unaudited)
Impaired loans and the related allowance at September 30, 2020, December 31, 2019 and September 30, 2019, were as follows (in thousands):
| September 30, 2020 | ||||||||||||||||||||||||||||
| Unpaid Principal Balance | Recorded Investment with No Allowance | Recorded Investment with Allowance | Total Recorded Investment | Related Allowance | Average Recorded Investment | Interest Income Recognized | ||||||||||||||||||||||
| Real estate loans: | ||||||||||||||||||||||||||||
| Construction and land development | $ | $ | $ | $ | $ | $ | $ | |||||||||||||||||||||
| Secured by 1-4 family | ||||||||||||||||||||||||||||
| Other real estate loans | ||||||||||||||||||||||||||||
| Commercial and industrial | ||||||||||||||||||||||||||||
| Total | $ | $ | $ | $ | $ | $ | $ | |||||||||||||||||||||
| December 31, 2019 | ||||||||||||||||||||||||||||
| Unpaid Principal Balance | Recorded Investment with No Allowance | Recorded Investment with Allowance | Total Recorded Investment | Related Allowance | Average Recorded Investment | Interest Income Recognized | ||||||||||||||||||||||
| Real estate loans: | ||||||||||||||||||||||||||||
| Construction and land development | $ | $ | $ | $ | $ | $ | $ | |||||||||||||||||||||
| Secured by 1-4 family | ||||||||||||||||||||||||||||
| Other real estate loans | ||||||||||||||||||||||||||||
| Commercial and industrial | ||||||||||||||||||||||||||||
| Total | $ | $ | $ | $ | $ | $ | $ | |||||||||||||||||||||
| September 30, 2019 | ||||||||||||||||||||||||||||
| Unpaid Principal Balance | Recorded Investment with No Allowance | Recorded Investment with Allowance | Total Recorded Investment | Related Allowance | Average Recorded Investment | Interest Income Recognized | ||||||||||||||||||||||
| Real estate loans: | ||||||||||||||||||||||||||||
| Construction and land development | $ | $ | $ | $ | $ | $ | $ | |||||||||||||||||||||
| Secured by 1-4 family | ||||||||||||||||||||||||||||
| Other real estate loans | ||||||||||||||||||||||||||||
| Commercial and industrial | ||||||||||||||||||||||||||||
| Total | $ | $ | $ | $ | $ | $ | $ | |||||||||||||||||||||
The “Recorded Investment” amounts in the table above represent the outstanding principal balance on each loan represented in the table. The “Unpaid Principal Balance” represents the outstanding principal balance on each loan represented in the table plus any amounts that have been charged off on each loan and/or payments that have been applied towards principal on non-accrual loans. Only loan classes with balances are included in the tables above.
As of September 30, 2020, loans classified as troubled debt restructurings (TDRs) and included in impaired loans in the disclosure above totaled $
Notes to Consolidated Financial Statements (Unaudited)
In response to the COVID-19 pandemic, the Company offered a payment deferral program for its individual and business customers adversely affected by the pandemic. As of September 30, 2020, loans participating in the program totaled $
For the three and nine months ended September 30, 2020 and 2019, there were TDRs that subsequently defaulted within twelve months of the loan modification. Management defines default as over ninety days past due or the foreclosure and repossession of the collateral or charge-off of the loan during the twelve month period subsequent to the modification.
Note 5. Other Real Estate Owned (OREO)
The Bank did have any OREO activity during the nine months ended September 30, 2020 or the year ended December 31, 2019. Accordingly, there were residential real estate properties included in the ending OREO balances at September 30, 2020 and December 31, 2019. The Bank did have any consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings were in process as of September 30, 2020.
The Bank did have any expenses applicable to OREO for the nine months ended September 30, 2020 and 2019. Net expenses applicable to OREO, other than the provision for losses, were $
Note 6. Other Borrowings
The Company had an unsecured line of credit totaling $
The Bank had unused lines of credit totaling $
Notes to Consolidated Financial Statements (Unaudited)
Note 7. Capital Requirements
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk-weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
The final rules implementing the Basel Committee on Banking Supervision’s capital guidelines for U.S. banks (Basel III rules) became effective January 1, 2015, with full compliance of all the requirements phased in over a multi-year schedule, and became fully phased in January 1, 2019. As part of the new requirements, the common equity Tier 1 capital ratio is calculated and utilized in the assessment of capital for all institutions. The final rules also established a “capital conservation buffer” above the new regulatory minimum capital requirements. The capital conservation buffer has been phased-in over four years, which began on January 1, 2016 and was fully implemented on January 1, 2019.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of total (as defined in the regulations), Tier 1 (as defined), and common equity Tier 1 capital (as defined) to risk-weighted assets (as defined), and of Tier 1 capital to average assets. Management believes, as of September 30, 2020 and December 31, 2019, that the Bank met all capital adequacy requirements to which it is subject.
As of September 30, 2020, the most recent notification from the Federal Reserve Bank categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum risk-based capital and leverage ratios as set forth in the following table. There are no conditions or events since that notification that management believes have changed the Bank’s category.
A comparison of the capital of the Bank at September 30, 2020 and December 31, 2019 with the minimum regulatory guidelines were as follows (dollars in thousands):
| Actual | Minimum Capital Requirement | Minimum To Be Well Capitalized Under Prompt Corrective Action Provisions | ||||||||||||||||||||||
| Amount | Ratio | Amount | Ratio | Amount | Ratio | |||||||||||||||||||
| September 30, 2020 | ||||||||||||||||||||||||
| Total Capital (to Risk-Weighted Assets) | $ | % | $ | % | $ | % | ||||||||||||||||||
| Tier 1 Capital (to Risk-Weighted Assets) | $ | % | $ | % | $ | % | ||||||||||||||||||
| Common Equity Tier 1 Capital (to Risk-Weighted Assets) | $ | % | $ | % | $ | % | ||||||||||||||||||
| Tier 1 Capital (to Average Assets) | $ | % | $ | % | $ | % | ||||||||||||||||||
| December 31, 2019 | ||||||||||||||||||||||||
| Total Capital (to Risk-Weighted Assets) | $ | % | $ | % | $ | % | ||||||||||||||||||
| Tier 1 Capital (to Risk-Weighted Assets) | $ | % | $ | % | $ | % | ||||||||||||||||||
| Common Equity Tier 1 Capital (to Risk-Weighted Assets) | $ | % | $ | % | $ | % | ||||||||||||||||||
| Tier 1 Capital (to Average Assets) | $ | % | $ | % | $ | % | ||||||||||||||||||
In addition to the regulatory minimum risk-based capital amounts presented above, the Bank must maintain a capital conservation buffer as required by the Basel III final rules. Accordingly, the Bank was required to maintain a capital conservation buffer of
Notes to Consolidated Financial Statements (Unaudited)
Note 8. Subordinated Debt
On October 30, 2015, the Company entered into a Subordinated Loan Agreement (the Agreement) pursuant to which the Company issued an interest only subordinated term note due 2025 in the aggregate principal amount of $
On June 29, 2020, the Company issued an interest only subordinated term note due 2030 in the aggregate principal amount of $
Both of the notes are unsecured, subordinated obligations of the Company and they rank junior in right of payment to the Company’s existing and future senior indebtedness and to the Company’s obligations to its general creditors. The notes rank equally with all other unsecured subordinated debt, except any which by its terms is expressly stated to be subordinated to the notes. The notes rank senior to all current and future junior subordinated debt obligations, preferred stock, and common stock of the Company. The notes are not convertible into common stock or preferred stock, and are not callable by the holders.
Note 9. Junior Subordinated Debt
On June 8, 2004, First National (VA) Statutory Trust II (Trust II), a wholly-owned subsidiary of the Company, was formed for the purpose of issuing redeemable capital securities, commonly known as trust preferred securities. On June 17, 2004, $
On July 24, 2006, First National (VA) Statutory Trust III (Trust III), a wholly-owned subsidiary of the Company, was formed for the purpose of issuing redeemable capital securities. On July 31, 2006, $
Note 10. Benefit Plans
The Company maintains a 401(k) plan (the Plan) for all eligible employees. Participating employees may elect to contribute up to the maximum percentage allowed by the Internal Revenue Service, as defined in the Plan. The Company makes matching contributions, on a dollar-for dollar basis, for the first percent of an employee’s compensation contributed to the Plan and cents for each dollar of the employee’s contribution between percent and percent. The Company also makes an additional contribution based on years of service to participants who have completed at least hours of service during the year and who are employed on the last day of the Plan Year. All employees who are age or older are eligible. Employee contributions vest immediately. Employer matching contributions vest after Plan service years with the Company. The Company has the discretion to make a profit sharing contribution to the Plan each year based on overall performance, profitability, and other economic factors. For the nine months ended September 30, 2020 and 2019, expense attributable to the Plan amounted to $
Notes to Consolidated Financial Statements (Unaudited)
On March 15, 2019, the Company entered into supplemental executive retirement plans and participation agreements with of its employees. The retirement benefits are fixed and provide for retirement benefits payable in
See Note 13 of the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019 for additional information about the Company’s benefit plans.
Note 11. Earnings per Common Share
Basic earnings per common share represents income available to common shareholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per common share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance.
The following table presents the computation of basic and diluted earnings per share for the three and nine months ended September 30, 2020 and 2019 (dollars in thousands, except per share data):
| Three Months Ended | Nine Months Ended | |||||||||||||||
| September 30, 2020 | September 30, 2019 | September 30, 2020 | September 30, 2019 | |||||||||||||
| (Numerator): | ||||||||||||||||
| Net income | $ | $ | $ | $ | ||||||||||||
| (Denominator): | ||||||||||||||||
| Weighted average shares outstanding – basic | ||||||||||||||||
| Potentially dilutive common shares – restricted stock units | ||||||||||||||||
| Weighted average shares outstanding – diluted | ||||||||||||||||
| Income per common share | ||||||||||||||||
| Basic | $ | $ | $ | $ | ||||||||||||
| Diluted | $ | $ | $ | $ | ||||||||||||
Restricted stock units for
Note 12. Fair Value Measurements
The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. In accordance with the “Fair Value Measurement and Disclosures” topic of FASB ASC, the fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.
The fair value guidance provides a consistent definition of fair value, which focuses on exit price in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.
Notes to Consolidated Financial Statements (Unaudited)
Fair Value Hierarchy
In accordance with this guidance, the Company groups its assets and liabilities generally measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.
| Level 1 - | Valuation is based on quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 1 assets and liabilities generally include debt and equity securities that are traded in an active exchange market. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities. |
| Level 2 - | Valuation is based on inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. The valuation may be based on quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability. |
| Level 3 - | Valuation is based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which determination of fair value requires a significant management judgment or estimation. |
An instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.
The following describes the valuation techniques used by the Company to measure certain assets recorded at fair value on a recurring basis in the financial statements:
Securities available for sale
Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2).
Derivative asset/liability - cash flow hedges
Cash flow hedges are recorded at fair value on a recurring basis. The fair value of the Company's cash flow hedges is determined by a third party vendor using the discounted cash flow method (Level 2).
Notes to Consolidated Financial Statements (Unaudited)
The following tables present the balances of assets and liabilities measured at fair value on a recurring basis as of September 30, 2020 and December 31, 2019 (in thousands).
| Fair Value Measurements at September 30, 2020 | ||||||||||||||||
| Description | Balance as of September 30, 2020 | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | ||||||||||||
| Assets: | ||||||||||||||||
| Securities available for sale | ||||||||||||||||
| U.S. agency and mortgage-backed securities | $ | $ | $ | $ | ||||||||||||
| Obligations of states and political subdivisions | ||||||||||||||||
| Total securities available for sale | $ | $ | $ | $ | ||||||||||||
| Derivatives - cash flow hedges | ||||||||||||||||
| Total assets | $ | $ | $ | $ | ||||||||||||
| Fair Value Measurements at December 31, 2019 | ||||||||||||||||
| Description | Balance as of December 31, 2019 | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | ||||||||||||
| Assets: | ||||||||||||||||
| Securities available for sale | ||||||||||||||||
| U.S. agency and mortgage-backed securities | $ | $ | $ | $ | ||||||||||||
| Obligations of states and political subdivisions | ||||||||||||||||
| Total assets | $ | $ | $ | $ | ||||||||||||
Certain assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.
The following describes the valuation techniques used by the Company to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements:
Loans held for sale
Loans held for sale are carried at the lower of cost or market value. These loans currently consist of one-to-four family residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale (Level 2). As such, the Company records any fair value adjustments on a nonrecurring basis. nonrecurring fair value adjustments were recorded on loans held for sale during the nine months ended September 30, 2020 and the year ended December 31, 2019.
Impaired Loans
Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreements will not be collected. The measurement of loss associated with impaired loans can be based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the observable market price of the loan, or the fair value of the collateral less estimated costs to sell. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the Company’s collateral is real estate. The value of real estate collateral is determined utilizing a market valuation approach based on an appraisal conducted by an independent, licensed appraiser using observable market data (Level 2) within the last twelve months. However, if the collateral is a house or building in the process of construction or if an appraisal of the property is more than one year old and not solely based on observable market comparables or management determines the fair value of the collateral is further impaired below the appraised value, then a Level 3 valuation is considered to measure the fair value. The value of business equipment is based upon an outside appraisal, of one year or less, if deemed significant, or the net book value on the applicable business’s financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the allowance for loan losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.
Notes to Consolidated Financial Statements (Unaudited)
The following tables summarize the Company’s assets that were measured at fair value on a nonrecurring basis during the periods (dollars in thousands):
| Fair Value Measurements at September 30, 2020 | ||||||||||||||||
| Description | Balance as of September 30, 2020 | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | ||||||||||||
| Impaired loans, net | $ | $ | $ | $ | ||||||||||||
| Fair Value Measurements at December 31, 2019 | ||||||||||||||||
| Description | Balance as of December 31, 2019 | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | ||||||||||||
| Impaired loans, net | $ | $ | $ | $ | ||||||||||||
| Quantitative information about Level 3 Fair Value Measurements for September 30, 2020 | ||||||||||||||
| Fair Value | Valuation Technique | Unobservable Input | Range (Weighted Average) (1) | |||||||||||
| Impaired loans, net | $ | Property appraisals | Selling cost | % | ||||||||||
| Impaired loans, net | Present value of cash flows | Discount rate | % | |||||||||||
| Quantitative information about Level 3 Fair Value Measurements for December 31, 2019 | ||||||||||||||
| Fair Value | Valuation Technique | Unobservable Input | Range (Weighted Average) (1) | |||||||||||
| Impaired loans, net | $ | Property appraisals | Selling cost | % | ||||||||||
| (1) | Unobservable inputs were weighted by the relative fair value of the instruments. |
Notes to Consolidated Financial Statements (Unaudited)
Accounting guidance requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis. The carrying values and estimated fair values of the Company’s financial instruments at September 30, 2020 and December 31, 2019 are as follows (in thousands):
| Fair Value Measurements at September 30, 2020 Using | ||||||||||||||||||||
| Carrying Amount | Quoted Prices in Active Markets for Identical Assets Level 1 | Significant Other Observable Inputs Level 2 | Significant Unobservable Inputs Level 3 | Fair Value | ||||||||||||||||
| Financial Assets | ||||||||||||||||||||
| Cash and short-term investments | $ | $ | $ | $ | $ | |||||||||||||||
| Securities available for sale | ||||||||||||||||||||
| Securities held to maturity | ||||||||||||||||||||
| Restricted securities | ||||||||||||||||||||
| Loans, net | ||||||||||||||||||||
| Bank owned life insurance | ||||||||||||||||||||
| Accrued interest receivable | ||||||||||||||||||||
| Derivatives - cash flow hedges | ||||||||||||||||||||
| Financial Liabilities | ||||||||||||||||||||
| Deposits | $ | $ | $ | $ | $ | |||||||||||||||
| Subordinated debt | ||||||||||||||||||||
| Junior subordinated debt | ||||||||||||||||||||
| Accrued interest payable | ||||||||||||||||||||
| Fair Value Measurements at December 31, 2019 Using | ||||||||||||||||||||
| Carrying Amount | Quoted Prices in Active Markets for Identical Assets Level 1 | Significant Other Observable Inputs Level 2 | Significant Unobservable Inputs Level 3 | Fair Value | ||||||||||||||||
| Financial Assets | ||||||||||||||||||||
| Cash and short-term investments | $ | $ | $ | $ | $ | |||||||||||||||
| Securities available for sale | ||||||||||||||||||||
| Securities held to maturity | ||||||||||||||||||||
| Restricted securities | ||||||||||||||||||||
| Loans held for sale | ||||||||||||||||||||
| Loans, net | ||||||||||||||||||||
| Bank owned life insurance | ||||||||||||||||||||
| Accrued interest receivable | ||||||||||||||||||||
| Financial Liabilities | ||||||||||||||||||||
| Deposits | $ | $ | $ | $ | $ | |||||||||||||||
| Subordinated debt | ||||||||||||||||||||
| Junior subordinated debt | ||||||||||||||||||||
| Accrued interest payable | ||||||||||||||||||||
Notes to Consolidated Financial Statements (Unaudited)
The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the Company’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company’s overall interest rate risk.
Note 13. Stock Compensation Plans
On May 13, 2014, the Company’s shareholders approved the First National Corporation 2014 Stock Incentive Plan, which makes available up to
Stock Awards
Whenever the Company deems it appropriate to grant a stock award, the recipient receives a specified number of unrestricted shares of employer stock. Stock awards may be made by the Company at its discretion without cash consideration and may be granted as settlement of a performance-based compensation award.
During the third quarter of 2020, the Company granted and issued
Restricted Stock Units
Restricted stock units are an award of units that correspond in number and value to a specified number of shares of employer stock which the recipient receives according to a vesting plan and distribution schedule after achieving required performance milestones or upon remaining with the employer for a particular length of time. Each restricted stock unit that vests entitles the recipient to receive share of common stock on a specified issuance date.
In the first quarter of 2020,
A summary of the activity for the Company’s restricted stock units for the period indicated is presented in the following table:
| Nine Months Ended | ||||||||
| September 30, 2020 | ||||||||
| Shares | Weighted Average Grant Date Fair Value | |||||||
| Unvested, beginning of year | $ | |||||||
| Granted | ||||||||
| Vested | ( | ) | ||||||
| Forfeited | ||||||||
| Unvested, end of period | $ | |||||||
At September 30, 2020, based on restricted stock unit awards outstanding at that time, the total unrecognized pre-tax compensation expense related to unvested restricted stock unit awards was $
Notes to Consolidated Financial Statements (Unaudited)
Note 14. Accumulated Other Comprehensive Income (Loss)
Changes in each component of accumulated other comprehensive income (loss) were as follows (in thousands):
| Net Unrealized Gains on Securities | Change in Fair Value of Cash Flow Hedges | Accumulated Other Comprehensive Income | ||||||||||
| Balance at June 30, 2019 | $ | $ | $ | |||||||||
| Unrealized holding gains (net of tax, $) | ||||||||||||
| Change during period | ||||||||||||
| Balance at September 30, 2019 | $ | $ | $ | |||||||||
| Balance at June 30, 2020 | $ | $ | ( | ) | $ | |||||||
| Unrealized holding gains (net of tax, $) | ||||||||||||
| Reclassification adjustment (net of tax, ($)) | ( | ) | ( | ) | ||||||||
| Change in fair value (net of tax, $) | ||||||||||||
| Change during period | ( | ) | ||||||||||
| Balance at September 30, 2020 | $ | $ | $ | |||||||||
| Net Unrealized Gains (Losses) on Securities | Change in Fair Value of Cash Flow Hedges | Accumulated Other Comprehensive Income (Loss) | ||||||||||
| Balance at December 31, 2018 | $ | ( | ) | $ | $ | ( | ) | |||||
| Unrealized holding gains (net of tax, $) | ||||||||||||
| Unrealized holding losses transferred from held to maturity to available for sale (net of tax, ($)) | ( | ) | ( | ) | ||||||||
| Change during period | ||||||||||||
| Balance at September 30, 2019 | $ | $ | $ | |||||||||
| Balance at December 31, 2019 | $ | $ | $ | |||||||||
| Unrealized holding gains (net of tax, $) | ||||||||||||
| Reclassification adjustment (net of tax, ($)) | ( | ) | ( | ) | ||||||||
| Change in fair value (net of tax, $) | ||||||||||||
| Change during period | ||||||||||||
| Balance at September 30, 2020 | $ | $ | $ | |||||||||
The following tables present information related to reclassifications from accumulated other comprehensive income (loss) for the three and nine months ended September 30, 2020 and 2019 (in thousands).
| Details About Accumulated Other Comprehensive Income | Amount Reclassified from Accumulated Other Comprehensive Income | Affected Line Item in the Consolidated Statements of Income | |||||||
| Three Months Ended | |||||||||
| September 30, 2020 | September 30, 2019 | ||||||||
| Securities available for sale: | |||||||||
| Net securities gains reclassified into earnings | $ | ( | ) | $ | Net gains on securities available for sale | ||||
| Related income tax expense | Income tax expense | ||||||||
| Total reclassifications | $ | ( | ) | $ | Net of tax | ||||
| Details About Accumulated Other Comprehensive Income (Loss) | Amount Reclassified from Accumulated Other Comprehensive Income (Loss) | Affected Line Item in the Consolidated Statements of Income | |||||||
| Nine Months Ended | |||||||||
| September 30, 2020 | September 30, 2019 | ||||||||
| Securities available for sale: | |||||||||
| Net securities gains reclassified into earnings | $ | ( | ) | $ | Net gains on securities available for sale | ||||
| Related income tax expense | Income tax expense | ||||||||
| Total reclassifications | $ | ( | ) | $ | Net of tax | ||||
Notes to Consolidated Financial Statements (Unaudited)
Note 15. Revenue Recognition
On January 1, 2018, the Company adopted ASU No. 2014-09, "Revenue from Contracts with Customers: Topic 606" and all subsequent ASUs that modified Topic 606. Most revenue associated with financial instruments, including interest income, loan origination fees, and credit card fees, is outside the scope of the guidance. Gains and losses on investment securities, derivatives, financial guarantees, and sales of financial instruments are similarly excluded from the scope. The guidance is applicable to noninterest revenue streams such as service charges on deposit accounts, ATM and check card fees, wealth management fees, and fees for other customer services. Noninterest revenue streams within the scope of Topic 606 are discussed below.
Service charges on deposit accounts
Service charges on deposit accounts consist of monthly service fees, overdraft and nonsufficient funds fees, and other deposit account related fees. The Company's performance obligation for monthly service fees is generally satisfied, and the related revenue recognized, over the period in which the service is provided. Payment for service charges on deposit accounts is primarily received immediately or in the following month through a direct charge to customers' accounts. Overdraft and nonsufficient funds fees and other deposit account related fees are transactional based, and therefore, the Company's performance obligation is satisfied, and related revenue recognized, at a point in time.
ATM and check card fees
ATM fees are primarily generated when a Company cardholder uses a non-Company ATM or a non-Company cardholder uses a Company ATM. ATM fees are transactional based, and therefore, the Company's performance obligation is satisfied, and related revenue recognized, at a point in time. Check card fees are primarily comprised of interchange fee income. Interchange fees are earned whenever the Company's debit cards are processed through card payment networks, such as Visa. The Company's performance obligation for interchange fee income is largely satisfied, and related revenue recognized, when the services are rendered or upon completion. Payment is typically received immediately or in the following month. In compliance with Topic 606, debit card fee income is presented net of associated expense.
Wealth management fees
Wealth management fees are primarily comprised of fees earned from the management and administration of trusts and other customer assets. The Company's performance obligation is generally satisfied over time and the resulting fees are primarily recognized monthly, based upon the month-end market value of the assets under management and the applicable fee rate. Payment is generally received a few days after month-end through a direct charge to customers' accounts. Estate management fees are based upon the size of the estate. Revenue for estate management fees are recorded periodically, according to a fee schedule, and are based on the services that have been provided.
Fees for other customer services
Fees for other customer services include check ordering charges, merchant services income, safe deposit box rental fees, and other service charges. Check ordering charges are transactional based, and therefore, the Company's performance obligation is satisfied, and related revenue recognized, at a point in time. Merchant services income mainly represent fees charged to merchants to process their debit and credit card transactions. The Company's performance obligation for merchant services income is largely satisfied, and related revenue recognized, when the services are rendered or upon completion. Payment is typically received immediately or in the following month. Safe deposit box rental fees are charged to the customer on an annual basis and recognized upon receipt of payment. The Company determined that since rentals and renewals occur fairly consistently over time, revenue is recognized on a basis consistent with the duration of the performance obligation.
The following table presents noninterest income, segregated by revenue streams in-scope and out-of-scope of Topic 606, for the three and nine months ended September 30, 2020 and 2019 (in thousands):
| Three Months Ended | Nine Months Ended | |||||||||||||||
| September 30, 2020 | September 30, 2019 | September 30, 2020 | September 30, 2019 | |||||||||||||
| Noninterest Income | ||||||||||||||||
| Service charges on deposit accounts | $ | $ | $ | $ | ||||||||||||
| ATM and check card fees | ||||||||||||||||
| Wealth management fees | ||||||||||||||||
| Fees for other customer services | ||||||||||||||||
| Noninterest income (in-scope of Topic 606) | $ | $ | $ | $ | ||||||||||||
| Noninterest income (out-of-scope of Topic 606) | ||||||||||||||||
| Total noninterest income | $ | $ | $ | $ | ||||||||||||
Notes to Consolidated Financial Statements (Unaudited)
Note 16. Derivative Financial Instruments
On April 21, 2020, the Company entered into interest rate swap agreements related to its outstanding junior subordinated debt. One swap agreement was related to the Company’s junior subordinated debt with a redemption date of June 17, 2034, which became effective on March 17, 2020. The notional amount of the interest rate swap was $
The Company entered into interest rate swaps to reduce interest rate risk and to manage interest expense. By entering into these agreements, the Company converted variable rate debt into fixed rate debt. Alternatively, the Company may enter into interest rate swap agreements to convert fixed rate debt into variable rate debt. Interest differentials paid or received under interest rate swap agreements are reflected as adjustments to interest expense. The Company designated the interest rate swaps as hedging instruments in qualifying cash flow hedges, as discussed in Note 1 to the Consolidated Financial Statements. Changes in fair value of these designated hedging instruments is reported as a component of other comprehensive income. Interest rate swaps designated as cash flow hedges are expected to be highly effective in offsetting the effect of changes in interest rates on the amount of variable rate interest payments, and the Company assesses the effectiveness of each hedging relationship quarterly. If the Company determines that a cash flow hedge is no longer highly effective, future changes in the fair value of the hedging instrument would be reported as earnings. As of September 30, 2020, the Company has designated cash flow hedges to manage its exposure to variability in cash flows on certain variable rate borrowings for periods that end between June 2034 and October 2036.The notional amounts of the interest rate swaps were not exchanged and do not represent exposure to credit loss. In the event of default by a counterparty, the risk in these transactions is the cost of replacing the agreements at current market rates.
All interest rate swaps were entered into with counterparties that met the Company's credit standards and the agreements contain collateral provisions protecting the at-risk party. The Company believes that the credit risk inherent in these derivative contracts is not significant.
Unrealized gains or losses recorded in other comprehensive income related to cash flow hedges are reclassified into earnings in the same period(s) during which the hedged interest payments affect earnings. When a designated hedging instrument is terminated and the hedged interest payments remain probable of occurring, any remaining unrecognized gain or loss in other comprehensive income is reclassified into earnings in the period(s) during which the forecasted interest payments affect earnings. Amounts reclassified into earnings and interest receivable or payable under designated interest rate swaps are reported in interest expense. The Company does not expect any unrealized losses related to cash flow hedges to be reclassified into earnings in the next twelve months.
The following table summarizes key elements of the Company's derivative instruments at September 30, 2020 (in thousands):
| September 30, 2020 | ||||||||||||||||
| Notional Amount | Assets | Liabilities | Collateral Pledged(1) | |||||||||||||
| Cash Flow Hedges | ||||||||||||||||
| Interest rate swap contracts | $ | $ | $ | $ | ||||||||||||
| (1) | Collateral pledged may be comprised of cash or securities. |
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Cautionary Statement Regarding Forward-Looking Statements
First National Corporation makes forward-looking statements in this Form 10-Q that are subject to risks and uncertainties. These forward-looking statements include statements regarding profitability, liquidity, adequacy of capital, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals. The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or other similar words or terms are intended to identify forward-looking statements. These forward-looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:
| • | the effects of the COVID-19 pandemic, including its potential adverse effect on economic conditions and the Company's employees, customers, credit quality, and financial performance; | |
| • |
general business conditions, as well as conditions within the financial markets; |
| • |
general economic conditions, including unemployment levels and slowdowns in economic growth; |
| • |
the Company’s branch and market expansions, technology initiatives and other strategic initiatives; |
| • |
the impact of competition from banks and non-banks, including financial technology companies (Fintech); |
| • |
the composition of the loan and deposit portfolio, including the types of accounts and customers, may change, which could impact the amount of net interest income and noninterest income in future periods, including revenue from service charges on deposits; |
| • |
limited availability of financing or inability to raise capital; |
| • |
reliance on third parties for key services; |
| • |
the Company’s credit standards and its on-going credit assessment processes might not protect it from significant credit losses; |
| • |
the quality of the loan portfolio and the value of the collateral securing those loans; |
|
| • | demand for loan products; | |
| • | deposit flows; |
| • |
the level of net charge-offs on loans and the adequacy of the allowance for loan losses; |
| • |
the concentration in loans secured by real estate may adversely affect earnings due to changes in the real estate markets; |
| • |
the value of securities held in the Company's investment portfolio; |
| • |
legislative or regulatory changes or actions, including the effects of changes in tax laws; |
| • |
accounting principles, policies and guidelines and elections made by the Company thereunder; |
| • |
cyber threats, attacks or events; |
| • |
the ability to maintain adequate liquidity by retaining deposit customers and secondary funding sources, especially if the Company’s reputation would become damaged; |
| • |
monetary and fiscal policies of the U.S. Government, including policies of the U.S. Department of the Treasury and the Federal Reserve Board, and the effect of those policies on interest rates and business in the Company's markets; |
| • |
changes in interest rates could have a negative impact on the Company’s net interest income and an unfavorable impact on the Company’s customers’ ability to repay loans; and |
| • |
other factors identified in Item 1A. Risk Factors of the Company’s Form 10-K for the year ending December 31, 2019 and in this Quarterly Report on Form 10-Q. |
Because of these and other uncertainties, actual future results may be materially different from the results indicated by these forward-looking statements. In addition, past results of operations do not necessarily indicate future results. The following discussion and analysis of the financial condition at September 30, 2020 and statements of income of the Company for the three and nine months ended September 30, 2020 and 2019 should be read in conjunction with the consolidated financial statements and related notes included in Part I, Item 1, of this Form 10-Q and in Part II, Item 8, of the Form 10-K for the period ending December 31, 2019. The statements of income for the three and nine months ended September 30, 2020 may not be indicative of the results to be achieved for the year.
Executive Overview
The Company
First National Corporation (the Company) is the bank holding company of:
| • |
First Bank (the Bank). The Bank owns: |
| • |
First Bank Financial Services, Inc. |
| • |
Shen-Valley Land Holdings, LLC |
| • |
First National (VA) Statutory Trust II (Trust II) |
| • |
First National (VA) Statutory Trust III (Trust III and, together with Trust II, the Trusts) |
First Bank Financial Services, Inc. invests in entities that provide title insurance and investment services. Shen-Valley Land Holdings, LLC was formed to hold other real estate owned and future office sites. The Trusts were formed for the purpose of issuing redeemable capital securities, commonly known as trust preferred securities and are not included in the Company’s consolidated financial statements in accordance with authoritative accounting guidance because management has determined that the Trusts qualify as variable interest entities.
Products, Services, Customers and Locations
The Bank offers loan, deposit, and wealth management products and services. Loan products and services include consumer loans, residential mortgages, home equity loans, and commercial loans. Deposit products and services include checking accounts, treasury management solutions, savings accounts, money market accounts, certificates of deposit, and individual retirement accounts. Wealth management services include estate planning, investment management of assets, trustee under an agreement, trustee under a will, individual retirement accounts, and estate settlement. Customers include small and medium-sized businesses, individuals, estates, local governmental entities, and non-profit organizations. The Bank’s office locations are well-positioned in attractive markets along the Interstate 81, Interstate 66, and Interstate 64 corridors in the Shenandoah Valley, central regions of Virginia, and the city of Richmond. Within this market area, there are diverse types of industry including medical and professional services, manufacturing, retail, warehousing, Federal government, hospitality, and higher education.
The Bank’s products and services are delivered through 14 bank branch offices located throughout the Shenandoah Valley and central regions of Virginia, a loan production office, and a customer service center in a retirement village. The branch offices are comprised of 13 full service retail banking offices and one drive-through express banking office. The location and general character of these properties is further described in Part I, Item 2 of Form 10-K for the year ended December 31, 2019. Many of the Bank’s services are also delivered through the Bank’s mobile banking platform, its website, www.fbvirginia.com, and a network of ATMs located throughout its market area.
Revenue Sources and Expense Factors
The primary source of revenue is from net interest income earned by the Bank. Net interest income is the difference between interest income and interest expense and typically represents between 70% and 80% of the Company’s total revenue. Interest income is determined by the amount of interest-earning assets outstanding during the period and the interest rates earned on those assets. The Bank’s interest expense is a function of the amount of interest-bearing liabilities outstanding during the period and the interest rates paid. In addition to net interest income, noninterest income is the other source of revenue for the Company. Noninterest income is derived primarily from service charges on deposits, fee income from wealth management services, and ATM and check card fees.
Primary expense categories are salaries and employee benefits, which comprised 57% of noninterest expenses for the nine months ended September 30, 2020, followed by occupancy and equipment expense, which comprised 14% of noninterest expenses. The provision for loan losses is also a primary expense of the Bank. The provision is determined by factors that include net charge-offs, asset quality, economic conditions, and loan growth. Changing economic conditions caused by inflation, recession, unemployment, or other factors beyond the Company’s control have a direct correlation with asset quality, net charge-offs, and ultimately the required provision for loan losses.
COVID-19 Pandemic Update
Operations
During the third quarter, the Bank continued to follow its Pandemic Plan that strives to protect the health of its employees and customers, while continuing to deliver essential banking services. The Bank entered phase two of its Pandemic Plan on July 1, 2020 and re-opened branch lobbies with limited hours for in-person transactions without appointments while it continued to deliver banking services through branch drive throughs, ATMs, and mobile and internet banking platforms.
Paycheck Protection Program
The Bank participated as a lender in the U.S. Small Business Administration’s (SBA) Paycheck Protection Program (PPP) to support local small businesses and non-profit organizations. During the second and third quarters of 2020, the Bank originated $76.6 million of PPP loans, received $2.5 million of loan fees, and incurred $535 thousand of loan origination costs. The loan fees are being accreted into earnings evenly over the life of the loans, net of the loan costs, through interest and fees on loans. At September 30, 2020, PPP loan balances totaled $73.7 million with 99% of the loan balances maturing in the second quarter of 2022 and 1% of loan balances maturing in the third quarter of 2025. Customers with PPP loan balances totaling $11.3 million had requested debt forgiveness but have not yet been forgiven by the SBA at September 30, 2020.
Loan Payment Deferral Program
In response to the unknown impact of the pandemic on the economy and customers, the Bank created and implemented a loan payment deferral program for individual and business customers beginning in the first quarter of 2020 that provided the opportunity to defer monthly payments for 90 days. At September 30, 2020, loans participating in the program totaled $22.6 million, or 3% of the Bank’s total loan balances, which included $21.6 million of loans that were provided a second 90 day loan payment deferral period. Loans participating in the program at September 30, 2020 decreased significantly compared to $182.6 million, or 28% of the Bank's loan balances at June 30, 2020. A majority of the loans that transitioned out of the payment deferral program during the quarter have returned to current payment status. Interest income continued to accrue to the Bank on the loans in the program during the deferral periods.
Asset Quality Impact
The pandemic has had an unfavorable impact on the financial condition of the Bank’s loan customers, and as a result, the Bank has continued the process of identifying credit risk with the goal of mitigating the risk and minimizing future loan charge-offs. Certain sectors of the commercial real estate loan portfolio, including retail shopping, lodging and leisure have experienced elevated financial pressure. Those sectors comprised approximately 5%, 5% and 2% of the loan portfolio at September 30, 2020, respectively, excluding PPP loans. The magnitude of the potential decline in the Bank’s loan quality will likely depend on the severity and duration of the pandemic and the extent that the Bank’s customers experience business interruptions. The Bank considered the impact of the pandemic on the loan portfolio while determining an appropriate allowance for loan losses.
Capital
The stock repurchase plan remained suspended during the third quarter. The Company updates its enterprise risk assessment and capital plans quarterly, and as a result, issued $5.0 million of subordinated debt in June 2020. The purpose of the issuance was primarily to further strengthen holding company liquidity and to remain a source of strength for the Bank in the event of a severe economic downturn. The Company may also use the proceeds of the issuance for general corporate purposes, including the potential repayment of the Company’s existing subordinated debt, which becomes callable in January 2021. The Company declared and paid an $0.11 per share dividend during the third quarter that was unchanged from the dividends declared and paid during the first and second quarters of 2020.
Quarterly Financial Performance
Net income decreased by $739 thousand to $1.8 million, or $0.36 per basic and diluted share, for the three months ended September 30, 2020, compared to $2.5 million, or $0.50 per basic and diluted share, for the same period in 2019. Return on average assets was 0.74% and return on average equity was 8.52% for the third quarter of 2020, compared to 1.27% and 13.31%, respectively, for the same period in 2019.
The $739 thousand decrease in net income for the three months ended September 30, 2020 resulted primarily from a $1.5 million increase in provision for loan losses, compared to the same period of 2019. This unfavorable variance was partially offset by a $503 thousand, or 7%, increase in net interest income, a $10 thousand increase in noninterest income, and a $51 thousand, or 1%, decrease in noninterest expenses, compared to the same period of 2019.
Net interest income increased primarily from a decrease in interest expense on deposits, which was attributable to reductions in interest rates paid. Average earning asset balances increased 22%, while the net interest margin decreased 46 basis points to 3.41% for the third quarter of 2020, compared to the same period in 2019. Noninterest income increased primarily from higher amounts of ATM and check card fees, wealth management fees, and fees for other customer services, which were mostly offset by lower service charges on deposit accounts. Noninterest expense decreased primarily from lower salaries and employee benefits expense, marketing expense, and other operating expense.
Based on management's analysis and the supporting allowance for loan loss calculation, a provision for loan losses of $1.5 million was recorded during the third quarter of 2020. A provision for loan losses was not required during the third quarter of 2019. The increase in provision for loan losses was primarily attributable to an increase in the specific reserve component of the allowance for loan losses.
For a more detailed discussion of the Company's quarterly performance, see "Net Interest Income,” “Provision for Loan Losses,” "Noninterest Income," "Noninterest Expense" and "Income Taxes" below.
Year-to-Date Financial Performance
Net income decreased by $1.1 million to $5.7 million, or $1.17 per basic and diluted share, for the nine months ended September 30, 2020, compared to $6.8 million, or $1.38 per basic and diluted share, for the same period in 2019. Return on average assets was 0.86% and return on average equity was 9.49% for the nine months ended September 30, 2020, compared to 1.19% and 12.85%, respectively, for the same period in 2019.
The $1.1 million decrease in net income for the nine months ended September 30, 2020 resulted primarily from a $3.0 million increase in provision for loan losses and a $138 thousand, or 2%, decrease in noninterest income, compared to the same period of 2019. These unfavorable variances were partially offset by a $1.1 million, or 5%, increase in net interest income and a $622 thousand, or 3%, decrease in noninterest expenses.
Net interest income increased primarily from a decrease in interest expense on deposits, which was attributable to reductions in interest rates paid. Average earning asset balances increased 15%, while the net interest margin decreased 33 basis points to 3.58% for the nine months ended September 30, 2020, compared to the same period in 2019. Noninterest income decreased primarily from lower service charges on deposit accounts, which was partially offset by higher amounts of ATM and check card fees, wealth management fees, and fees for other customer services. Noninterest expense decreased primarily from lower salaries and employee benefits expense, marketing expense, and other operating expense.
Based on management's analysis and the supporting allowance for loan loss calculation, a provision for loan losses of $3.2 million was recorded during the nine months ended September 30, 2020, compared to a provision for loan losses of $200 thousand during the nine months ended September 30, 2019. The increase in provision for loan losses was attributable to increases in both the general and specific reserve components of the allowance for loan losses.
For a more detailed discussion of the Company's year-to-date performance, see "Net Interest Income,” “Provision for Loan Losses,” "Noninterest Income," "Noninterest Expense" and "Income Taxes" below.
Non-GAAP Financial Measures
This report refers to the efficiency ratio, which is computed by dividing noninterest expense, excluding amortization of intangibles and net gains on disposal of premises and equipment, by the sum of net interest income on a tax-equivalent basis and noninterest income, excluding securities gains. This is a non-GAAP financial measure that the Company believes provides investors with important information regarding operational efficiency. Such information is not prepared in accordance with U.S. generally accepted accounting principles (GAAP) and should not be construed as such. Management believes, however, such financial information is meaningful to the reader in understanding operating performance, but cautions that such information not be viewed as a substitute for GAAP. The Company, in referring to its net income, is referring to income under GAAP. The components of the efficiency ratio calculation are summarized in the following table (dollars in thousands).
| Efficiency Ratio |
||||||||||||||||
| Three Months Ended |
Nine Months Ended |
|||||||||||||||
| September 30, 2020 |
September 30, 2019 |
September 30, 2020 |
September 30, 2019 |
|||||||||||||
| Noninterest expense |
$ | 6,135 | $ | 6,186 | $ | 17,892 | $ | 18,514 | ||||||||
| Subtract: amortization of intangibles |
(33 | ) | (71 | ) | (127 | ) | (241 | ) | ||||||||
| Add: gains on disposal of premises and equipment, net |
— | — | 9 | — | ||||||||||||
| $ | 6,102 | $ | 6,115 | $ | 17,774 | $ | 18,273 | |||||||||
| Tax-equivalent net interest income |
$ | 7,623 | $ | 7,123 | $ | 22,158 | $ | 21,091 | ||||||||
| Noninterest income |
2,201 | 2,191 | 6,073 | 6,211 | ||||||||||||
| Subtract: securities gains, net | (38 | ) | — | (38 | ) | — | ||||||||||
| $ | 9,786 | $ | 9,314 | $ | 28,193 | $ | 27,302 | |||||||||
| Efficiency ratio |
62.35 | % | 65.65 | % | 63.04 | % | 66.93 | % | ||||||||
This report also refers to net interest margin, which is calculated by dividing tax equivalent net interest income by total average earning assets. Because a portion of interest income earned by the Company is nontaxable, the tax equivalent net interest income is considered in the calculation of this ratio. Tax equivalent net interest income is calculated by adding the tax benefit realized from interest income that is nontaxable to total interest income then subtracting total interest expense. The tax rate utilized in calculating the tax benefit for both 2020 and 2019 is 21%. The reconciliation of tax equivalent net interest income, which is not a measurement under GAAP, to net interest income, is reflected in the table below (in thousands).
| Reconciliation of Net Interest Income to Tax-Equivalent Net Interest Income |
||||||||||||||||
| Three Months Ended |
Nine Months Ended |
|||||||||||||||
| September 30, 2020 |
September 30, 2019 |
September 30, 2020 |
September 30, 2019 |
|||||||||||||
| GAAP measures: |
||||||||||||||||
| Interest income – loans |
$ | 7,568 | $ | 7,429 | $ | 22,187 | $ | 21,625 | ||||||||
| Interest income – investments and other |
775 | 925 | 2,569 | 2,966 | ||||||||||||
| Interest expense – deposits |
(541 | ) | (1,089 | ) | (2,179 | ) | (3,062 | ) | ||||||||
| Interest expense – federal funds purchased | — | (1 | ) | — | (1 | ) | ||||||||||
| Interest expense – subordinated debt |
(160 | ) | (90 | ) | (341 | ) | (269 | ) | ||||||||
| Interest expense – junior subordinated debt |
(68 | ) | (103 | ) | (225 | ) | (322 | ) | ||||||||
| Interest expense – other borrowings |
— | — | — | (2 | ) | |||||||||||
| Total net interest income |
$ | 7,574 | $ | 7,071 | $ | 22,011 | $ | 20,935 | ||||||||
| Non-GAAP measures: |
||||||||||||||||
| Tax benefit realized on non-taxable interest income – loans |
$ | 8 | $ | 9 | $ | 26 | $ | 30 | ||||||||
| Tax benefit realized on non-taxable interest income – municipal securities |
41 | 43 | 121 | 126 | ||||||||||||
| Total tax benefit realized on non-taxable interest income |
$ | 49 | $ | 52 | $ | 147 | $ | 156 | ||||||||
| Total tax-equivalent net interest income |
$ | 7,623 | $ | 7,123 | $ | 22,158 | $ | 21,091 | ||||||||
Critical Accounting Policies
General
The Company’s consolidated financial statements and related notes are prepared in accordance with GAAP. The financial information contained within the statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset, or relieving a liability. The Bank uses historical losses as one factor in determining the inherent loss that may be present in the loan portfolio. Actual losses could differ significantly from the historical factors used. In addition, GAAP itself may change from one previously acceptable method to another. Although the economics of transactions would be the same, the timing of events that would impact transactions could change.
Presented below is a discussion of those accounting policies that management believes are the most important (Critical Accounting Policies) to the portrayal and understanding of the Company’s financial condition and results of operations. The Critical Accounting Policies require management’s most difficult, subjective, and complex judgments about matters that are inherently uncertain. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.
Allowance for Loan Losses
The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management determines that the loan balance is uncollectible. Subsequent recoveries, if any, are credited to the allowance. For further information about the Company’s loans and the allowance for loan losses, see Notes 3 and 4 to the Consolidated Financial Statements included in this Form 10-Q.
The allowance for loan losses is evaluated on a quarterly basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
The Company performs regular credit reviews of the loan portfolio to review credit quality and adherence to underwriting standards. The credit reviews consist of reviews by its internal credit administration department and reviews performed by an independent third party. Upon origination, each loan is assigned a risk rating ranging from one to nine, with loans closer to one having less risk. This risk rating scale is the Company's primary credit quality indicator. The Company has various committees that review and ensure that the allowance for loans losses methodology is in accordance with GAAP and loss factors used appropriately reflect the risk characteristics of the loan portfolio.
The allowance represents an amount that, in management’s judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. Management’s judgment in determining the level of the allowance is based on evaluations of the collectability of loans while taking into consideration such factors as trends in delinquencies and charge-offs, changes in the nature and volume of the loan portfolio, current economic conditions that may affect a borrower’s ability to repay and the value of the collateral, overall portfolio quality, and review of specific potential losses. The evaluation also considers the following risk characteristics of each loan portfolio class:
| • |
1-4 family residential mortgage loans carry risks associated with the continued creditworthiness of the borrower and changes in the value of the collateral. |
| • |
Real estate construction and land development loans carry risks that the project may not be finished according to schedule, the project may not be finished according to budget, and the value of the collateral may, at any point in time, be less than the principal amount of the loan. Construction loans also bear the risk that the general contractor, who may or may not be a loan customer, may be unable to finish the construction project as planned because of financial pressure or other factors unrelated to the project. |
| • |
Other real estate loans carry risks associated with the successful operation of a business or a real estate project, in addition to other risks associated with the ownership of real estate, because repayment of these loans may be dependent upon the profitability and cash flows of the business or project. |
| • |
Commercial and industrial loans carry risks associated with the successful operation of a business because repayment of these loans may be dependent upon the profitability and cash flows of the business. In addition, there is risk associated with the value of collateral other than real estate which may depreciate over time and cannot be appraised with as much reliability. |
| • |
Consumer and other loans carry risk associated with the continued creditworthiness of the borrower and the value of the collateral, if any. Consumer loans are typically either unsecured or secured by rapidly depreciating assets such as automobiles. These loans are also likely to be immediately and adversely affected by job loss, divorce, illness, personal bankruptcy, or other changes in circumstances. Other loans included in this category include loans to states and political subdivisions. |
The allowance for loan losses consists of specific and general components. The specific component relates to loans that are classified as impaired, and is established when the discounted cash flows, fair value of collateral less estimated costs to sell, or observable market price of the impaired loan is lower than the carrying value of that loan. For collateral dependent loans, an updated appraisal is ordered if a current one is not on file. Appraisals are typically performed by independent third-party appraisers with relevant industry experience. Adjustments to the appraised value may be made based on recent sales of like properties or general market conditions among other considerations.
The general component covers loans that are not considered impaired and is based on historical loss experience adjusted for qualitative factors. The historical loss experience is calculated by loan type and uses an average loss rate during the preceding twelve quarters. The qualitative factors are assigned by management based on delinquencies and asset quality, national and local economic trends, effects of the changes in the value of underlying collateral, trends in volume and nature of loans, effects of changes in the lending policy, the experience and depth of management, concentrations of credit, quality of the loan review system, and the effect of external factors such as competition and regulatory requirements. The factors assigned differ by loan type. The general allowance estimates losses whose impact on the portfolio has yet to be recognized by a specific allowance. Allowance factors and the overall size of the allowance may change from period to period based on management’s assessment of the above described factors and the relative weights given to each factor. For further information regarding the allowance for loan losses, see Note 4 to the Consolidated Financial Statements included in this Form 10-Q.
Lending Policies
General
In an effort to manage risk, the Bank’s loan policy gives loan amount approval limits to individual loan officers based on their position within the Bank and level of experience. The Management Loan Committee can approve new loans up to their authority. The Board Loan Committee approves all loans which exceed the authority of the Management Loan Committee. The full Board of Directors must approve loans which exceed the authority of the Board Loan Committee, up to the Bank’s legal lending limit. The Board Loan Committee currently consists of five directors, four of which are non-management directors. The Board Loan Committee approves the Bank’s Loan Policy and reviews risk management reports, including watch list reports and concentrations of credit. The Board Loan Committee meets on a monthly basis and the Chairman of the Committee then reports to the Board of Directors.
Residential loan originations are primarily generated by mortgage loan officer solicitations and referrals by employees, real estate professionals, and customers. Commercial real estate loan originations and commercial and industrial loan originations are primarily obtained through direct solicitation and additional business from existing customers. All completed loan applications are reviewed by the Bank’s loan officers. As part of the application process, information is obtained concerning the income, financial condition, employment, and credit history of the applicant. The Bank also participates in commercial real estate loans and commercial and industrial loans originated by other financial institutions that are typically outside its market area. In addition, the Bank has purchased consumer loans originated by other financial institutions that are typically outside its market area. Loan quality is analyzed based on the Bank’s experience and credit underwriting guidelines depending on the type of loan involved. Except for loan participations with other financial institutions, real estate collateral is valued by independent appraisers who have been pre-approved by the Board Loan Committee.
As part of the ongoing monitoring of the credit quality of the Company’s loan portfolio, certain appraisals are analyzed by management or by an outsourced appraisal review specialist throughout the year in order to ensure standards of quality are met. The Company also obtains an independent review of loans within the portfolio on an annual basis to analyze loan risk ratings and validate specific reserves on impaired loans.
In the normal course of business, the Bank makes various commitments and incurs certain contingent liabilities which are disclosed but not reflected in its financial statements, including commitments to extend credit. At September 30, 2020, commitments to extend credit, stand-by letters of credit, and rate lock commitments totaled $138.0 million.
Construction and Land Development Lending
The Bank makes local construction loans, including residential and land acquisition and development loans. These loans are secured by the property under construction and the underlying land for which the loan was obtained. The majority of these loans mature in one year. Construction lending entails significant additional risks, compared with residential mortgage lending. Construction and land development loans sometimes involve larger loan balances concentrated with single borrowers or groups of related borrowers. Another risk involved in construction and land development lending is the fact that loan funds are advanced upon the security of the land or property under construction, which value is estimated based on the completion of construction. Thus, there is risk associated with failure to complete construction and potential cost overruns. To mitigate the risks associated with this type of lending, the Bank generally limits loan amounts relative to the appraised value and/or cost of the collateral, analyzes the cost of the project and the creditworthiness of its borrowers, and monitors construction progress. The Bank typically obtains a first lien on the property as security for its construction loans, typically requires personal guarantees from the borrower’s principal owners, and typically monitors the progress of the construction project during the draw period.
1-4 Family Residential Real Estate Lending
1-4 family residential lending activity may be generated by Bank loan officer solicitations and referrals by real estate professionals and existing or new bank customers. Loan applications are taken by a Bank loan officer. As part of the application process, information is gathered concerning income, employment, and credit history of the applicant. Residential mortgage loans generally are made on the basis of the borrower’s ability to make payments from employment and other income and are secured by real estate whose value tends to be readily ascertainable. In addition to the Bank’s underwriting standards, loan quality may be analyzed based on guidelines issued by a secondary market investor. The valuation of residential collateral is generally provided by independent fee appraisers who have been approved by the Board Loan Committee. In addition to originating mortgage loans with the intent to sell to correspondent lenders or broker to wholesale lenders, the Bank also originates and retains certain mortgage loans in its loan portfolio.
Commercial Real Estate Lending
Commercial real estate loans are secured by various types of commercial real estate typically in the Bank’s market area, including multi-family residential buildings, office and retail buildings, hotels, industrial buildings, and religious facilities. Commercial real estate loan originations are primarily obtained through direct solicitation of customers and potential customers. The valuation of commercial real estate collateral is provided by independent appraisers who have been approved by the Board Loan Committee. Commercial real estate lending entails significant additional risk, compared with residential mortgage lending. Commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the payment experience on loans secured by income producing properties is typically dependent on the successful operation of a business or a real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or in the economy in general. The Bank’s commercial real estate loan underwriting criteria require an examination of debt service coverage ratios, the borrower’s creditworthiness, prior credit history, and reputation. The Bank typically requires personal guarantees of the borrowers’ principal owners and considers the valuation of the real estate collateral.
Commercial and Industrial Lending
Commercial and industrial loans generally have a higher degree of risk than loans secured by real estate, but typically have higher yields. Commercial and industrial loans typically are made on the basis of the borrower’s ability to make repayment from cash flow from its business. The loans may be unsecured or secured by business assets, such as accounts receivable, equipment, and inventory. As a result, the availability of funds for the repayment of commercial business loans is substantially dependent on the success of the business itself. Furthermore, any collateral for commercial business loans may depreciate over time and generally cannot be appraised with as much reliability as real estate.
Consumer Lending
Loans to individual borrowers may be secured or unsecured, and include unsecured consumer loans and lines of credit, automobile loans, deposit account loans, and installment and demand loans. These consumer loans may entail greater risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured or secured by rapidly depreciating assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss, or depreciation. Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness, or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.
The underwriting standards employed by the Bank for consumer loans include a determination of the applicant’s payment history on other debts and an assessment of ability to meet existing obligations and payments on a proposed loan. The stability of the applicant’s monthly income may be determined by verification of gross monthly income from primary employment, and additionally from any verifiable secondary income.
Also included in this category are loans purchased through a third-party lending program. These portfolios include consumer loans and carry risks associated with the borrower, changes in the economic environment, and the vendor itself. The Company manages these risks through policies that require minimum credit scores and other underwriting requirements, robust analysis of actual performance versus expected performance, as well as ensuring compliance with the Company's vendor management program.
Results of Operations
General
Net interest income represents the primary source of earnings for the Company. Net interest income equals the amount by which interest income on interest-earning assets, predominantly loans and securities, exceeds interest expense on interest-bearing liabilities, including deposits, other borrowings, subordinated debt, and junior subordinated debt. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, are the components that impact the level of net interest income. The net interest margin is calculated by dividing tax-equivalent net interest income by average earning assets. The provision for loan losses, noninterest income, and noninterest expense are the other components that determine net income. Noninterest income and expense primarily consists of income from service charges on deposit accounts, revenue from wealth management services, ATM and check card income, revenue from other customer services, income from bank owned life insurance, general and administrative expenses, amortization expense, and other real estate owned expense.
Net Interest Income
For the three months ended September 30, 2020, net interest income increased $503 thousand, or 7%, to $7.6 million, compared to $7.1 million for the third quarter of 2019. The increase resulted from a $514 thousand, or 40%, decrease in total interest expense, which was partially offset by an $11 thousand decrease in total interest and dividend income. The net interest margin decreased 46 basis points to 3.41% for the third quarter of 2020. The decrease in the net interest margin was offset by growth in average earning assets of $158.3 million, or 22%, and resulted in an increase in net interest income.
The decrease in interest expense was primarily a result of a $548 thousand, or 50%, decrease in interest expense on deposits, which was attributable to reduced interest rates paid on deposits. The impact of an $83.6 million, or 17%, increase in average interest-bearing deposits was offset by a 49 basis point decrease in the cost of interest-bearing deposits. A 59 basis point reduction in the cost of interest-bearing checking accounts and a 103 basis point reduction in the cost of money market accounts made the largest contributions to the decrease in interest expense.
The decrease in total interest and dividend income resulted from an 81 basis point decrease in the yield on earning assets, which was partially offset by a $158.3 million, or 22%, increase in average earning assets. The decrease in the yield on earning assets resulted from a 19 basis point decrease in the yield on securities, a 48 basis point decrease in the yield on loans, and a 206 basis point decrease in the yield on interest-bearing deposits in banks. The loan yield was negatively impacted by PPP loans earning a 1.00% interest rate. Additionally, the mix of earning assets had an unfavorable impact on the yield on average earning assets as lower yielding interest-bearing deposits in banks increased from 2% to 12% of average earning assets.
For the nine months ended September 30, 2020, net interest income increased $1.1 million, or 5%, to $22.0 million, compared to $20.9 million for the same period in 2019. The increase resulted from a $911 thousand, or 25%, decrease in total interest expense and a $165 thousand, or 1%, increase in total interest and dividend income. The net interest margin decreased 33 basis points to 3.58% for the nine months ended September 30, 2020. The decrease in the net interest margin was offset by growth in average earning assets of $105.3 million, or 15%, and resulted in an increase in net interest income.
The decrease in total interest expense resulted primarily from a $883 thousand, or 29%, decrease in interest expense on deposits, which was attributable to reduced interest rates paid on deposits. The impact of a $58.1 million, or 12%, increase in average interest-bearing deposits was offset by a 30 basis point decrease in the cost of interest-bearing deposits. A 49 basis point reduction in the cost of interest-bearing checking accounts and a 65 basis point reduction in the cost of money market accounts made the largest contributions to the decrease in interest expense.
The increase in total interest and dividend income resulted from a $105.3 million, or 15%, increase in average earning assets, which was partially offset by a 56 basis point decrease in the yield on earning assets. The decrease in the yield on earning assets resulted from a 22 basis point decrease in the yield on securities, a 36 basis point decrease in the yield on loans, and a 189 basis point decrease in the yield on interest-bearing deposits in banks. The loan yield was negatively impacted by PPP loans earning a 1.00% interest rate. Additionally, the mix of earning assets had an unfavorable impact on the yield on average earning assets as lower yielding interest-bearing deposits in banks increased from 3% to 8% of average earning assets.
COVID-19 Pandemic Impact on Net Interest Income
Net interest income was negatively impacted by higher levels of nonaccrual loans. Loans to customers who are not able to make their loan payments to the Bank are placed on nonaccrual status, which causes a reversal of accrued interest receivable and interest income on loans. Recognition of interest on the loans will not resume until the borrowers can once again demonstrate their ability to repay.
Net interest income may be negatively impacted in future periods by unfavorable changes in the earning asset composition and the impact of recent decreases in market rates on earning asset yields in future periods. An unfavorable change in the Company’s earning asset composition could occur if a decrease in loan demand causes a reduction in loan balances, the Bank’s highest yielding asset category, while balances of securities and interest-bearing deposits in banks, the Bank’s lower yielding asset categories, increase.
The ability of loan customers to make loan payments and the potential of decreasing loan demand may depend on the length of time and extent the Bank’s loan customers experience business interruptions from the pandemic. The Bank implemented a loan payment deferral program to provide customers with temporary payment relief. The loan deferral program could delay or make it difficult to identify the extent that asset quality may worsen during the fourth quarter of 2020 until the program ends and loan customers demonstrate their ability or inability to resume loan payments.
The following tables show interest income on earning assets and related average yields as well as interest expense on interest-bearing liabilities and related average rates paid for the periods indicated (dollars in thousands):
Average Balances, Income and Expenses, Yields and Rates (Taxable Equivalent Basis)
| Three Months Ended |
||||||||||||||||||||||||
| September 30, 2020 |
September 30, 2019 |
|||||||||||||||||||||||
| Average Balance | Interest Income/Expense | Yield/Rate | Average Balance | Interest Income/Expense | Yield/Rate | |||||||||||||||||||
| Assets |
||||||||||||||||||||||||
| Securities: |
||||||||||||||||||||||||
| Taxable |
$ | 106,852 | $ | 575 | 2.14 | % | $ | 108,336 | $ | 645 | 2.36 | % | ||||||||||||
| Tax-exempt (1) |
26,994 | 193 | 2.83 | % | 27,555 | 200 | 2.87 | % | ||||||||||||||||
| Restricted |
1,848 | 23 | 5.07 | % | 1,786 | 26 | 5.93 | % | ||||||||||||||||
| Total securities |
$ | 135,694 | $ | 791 | 2.32 | % | $ | 137,677 | $ | 871 | 2.51 | % | ||||||||||||
| Loans: (2) |
||||||||||||||||||||||||
| Taxable |
$ | 644,259 | $ | 7,537 | 4.65 | % | $ | 571,105 | $ | 7,392 | 5.13 | % | ||||||||||||
| Tax-exempt (1) |
3,476 | 39 | 4.51 | % | 4,139 | 46 | 4.47 | % | ||||||||||||||||
| Total loans |
$ | 647,735 | $ | 7,576 | 4.65 | % | $ | 575,244 | $ | 7,438 | 5.13 | % | ||||||||||||
| Interest-bearing deposits with other institutions |
105,698 | 25 | 0.09 | % | 17,944 | 97 | 2.15 | % | ||||||||||||||||
| Total earning assets |
$ | 889,127 | $ | 8,392 | 3.75 | % | $ | 730,865 | $ | 8,406 | 4.56 | % | ||||||||||||
| Less: allowance for loan losses |
(6,323 | ) | (4,965 | ) | ||||||||||||||||||||
| Total non-earning assets |
61,586 | 54,476 | ||||||||||||||||||||||
| Total assets |
$ | 944,390 | $ | 780,376 | ||||||||||||||||||||
| Liabilities and Shareholders’ Equity |
||||||||||||||||||||||||
| Interest bearing deposits: |
||||||||||||||||||||||||
| Checking |
$ | 203,790 | $ | 139 | 0.27 | % | $ | 161,880 | $ | 352 | 0.86 | % | ||||||||||||
| Regular savings |
114,202 | 16 | 0.06 | % | 104,880 | 17 | 0.06 | % | ||||||||||||||||
| Money market accounts |
157,769 | 110 | 0.27 | % | 118,144 | 388 | 1.30 | % | ||||||||||||||||
| Time deposits: |
||||||||||||||||||||||||
| $100,000 and over |
50,864 | 166 | 1.30 | % | 51,752 | 199 | 1.52 | % | ||||||||||||||||
| Under $100,000 |
58,861 | 110 | 0.74 | % | 65,002 | 131 | 0.80 | % | ||||||||||||||||
| Brokered |
592 | — | 0.27 | % | 852 | 2 | 0.99 | % | ||||||||||||||||
| Total interest-bearing deposits |
$ | 586,078 | $ | 541 | 0.37 | % | $ | 502,510 | $ | 1,089 | 0.86 | % | ||||||||||||
| Federal funds purchased |
— | — | — | % | 119 | 1 | 2.59 | % | ||||||||||||||||
| Subordinated debt |
9,984 | 160 | 6.37 | % | 4,976 | 90 | 7.23 | % | ||||||||||||||||
| Junior subordinated debt |
9,279 | 68 | 2.92 | % | 9,279 | 103 | 4.43 | % | ||||||||||||||||
| Total interest-bearing liabilities |
$ | 605,341 | $ | 769 | 0.51 | % | $ | 516,884 | $ | 1,283 | 0.99 | % | ||||||||||||
| Non-interest bearing liabilities |
||||||||||||||||||||||||
| Demand deposits |
253,597 | 187,306 | ||||||||||||||||||||||
| Other liabilities |
3,558 | 1,895 | ||||||||||||||||||||||
| Total liabilities |
$ | 862,496 | $ | 706,085 | ||||||||||||||||||||
| Shareholders’ equity |
81,894 | 74,291 | ||||||||||||||||||||||
| Total liabilities and Shareholders’ equity |
$ | 944,390 | $ | 780,376 | ||||||||||||||||||||
| Net interest income |
$ | 7,623 | $ | 7,123 | ||||||||||||||||||||
| Interest rate spread |
3.24 | % | 3.57 | % | ||||||||||||||||||||
| Cost of funds |
0.36 | % | 0.72 | % | ||||||||||||||||||||
| Interest expense as a percent of average earning assets |
0.34 | % | 0.70 | % | ||||||||||||||||||||
| Net interest margin |
3.41 | % | 3.87 | % | ||||||||||||||||||||
| (1) |
Income and yields are reported on a taxable-equivalent basis assuming a federal tax rate of 21%. The tax-equivalent adjustment was $49 and $52 thousand for the three months ended September 30, 2020 and 2019, respectively. |
| (2) |
Loans on non-accrual status are reflected in the balances. |
Average Balances, Income and Expenses, Yields and Rates (Taxable Equivalent Basis)
| Nine Months Ended |
||||||||||||||||||||||||
| September 30, 2020 |
September 30, 2019 |
|||||||||||||||||||||||
| Average Balance |
Interest Income/Expense |
Yield/Rate |
Average Balance |
Interest Income/Expense |
Yield/Rate |
|||||||||||||||||||
| Assets |
||||||||||||||||||||||||
| Securities: |
||||||||||||||||||||||||
| Taxable |
$ | 112,166 | $ | 1,881 | 2.24 | % | $ | 111,652 | $ | 2,078 | 2.49 | % | ||||||||||||
| Tax-exempt (1) |
26,651 | 575 | 2.88 | % | 27,109 | 598 | 2.95 | % | ||||||||||||||||
| Restricted |
1,835 | 75 | 5.48 | % | 1,726 | 76 | 5.93 | % | ||||||||||||||||
| Total securities |
$ | 140,652 | $ | 2,531 | 2.40 | % | $ | 140,487 | $ | 2,752 | 2.62 | % | ||||||||||||
| Loans: (2) |
||||||||||||||||||||||||
| Taxable |
$ | 614,439 | $ | 22,088 | 4.80 | % | $ | 556,410 | $ | 21,509 | 5.17 | % | ||||||||||||
| Tax-exempt (1) |
3,737 | 125 | 4.49 | % | 4,365 | 146 | 4.49 | % | ||||||||||||||||
| Total loans |
$ | 618,176 | $ | 22,213 | 4.80 | % | $ | 560,775 | $ | 21,655 | 5.16 | % | ||||||||||||
| Federal funds sold | 6 | — | 0.10 | % | — | — | — | % | ||||||||||||||||
| Interest-bearing deposits with other institutions |
68,406 | 159 | 0.31 | % | 20,637 | 340 | 2.20 | % | ||||||||||||||||
| Total earning assets |
$ | 827,240 | $ | 24,903 | 4.02 | % | $ | 721,899 | $ | 24,747 | 4.58 | % | ||||||||||||
| Less: allowance for loan losses |
(5,591 | ) | (4,951 | ) | ||||||||||||||||||||
| Total non-earning assets |
62,092 | 53,829 | ||||||||||||||||||||||
| Total assets |
$ | 883,741 | $ | 770,777 | ||||||||||||||||||||
| Liabilities and Shareholders’ Equity |
||||||||||||||||||||||||
| Interest bearing deposits: |
||||||||||||||||||||||||
| Checking |
$ | 187,755 | $ | 569 | 0.40 | % | $ | 162,389 | $ | 1,082 | 0.89 | % | ||||||||||||
| Regular savings |
109,600 | 49 | 0.06 | % | 108,332 | 53 | 0.07 | % | ||||||||||||||||
| Money market accounts |
145,530 | 649 | 0.60 | % | 109,888 | 1,031 | 1.25 | % | ||||||||||||||||
| Time deposits: |
||||||||||||||||||||||||
| $100,000 and over |
52,533 | 555 | 1.41 | % | 50,497 | 545 | 1.44 | % | ||||||||||||||||
| Under $100,000 |
60,675 | 356 | 0.78 | % | 66,838 | 347 | 0.69 | % | ||||||||||||||||
| Brokered |
575 | 1 | 0.26 | % | 586 | 4 | 0.91 | % | ||||||||||||||||
| Total interest-bearing deposits |
$ | 556,668 | $ | 2,179 | 0.52 | % | $ | 498,530 | $ | 3,062 | 0.82 | % | ||||||||||||
| Federal funds purchased |
1 | — | 1.61 | % | 41 | 1 | 2.59 | % | ||||||||||||||||
| Subordinated debt |
6,701 | 341 | 6.79 | % | 4,972 | 269 | 7.23 | % | ||||||||||||||||
| Junior subordinated debt |
9,279 | 225 | 3.25 | % | 9,279 | 322 | 4.65 | % | ||||||||||||||||
| Other borrowings |
— | — | — | % | 55 | 2 | 6.21 | % | ||||||||||||||||
| Total interest-bearing liabilities |
$ | 572,649 | $ | 2,745 | 0.64 | % | $ | 512,877 | $ | 3,656 | 0.95 | % | ||||||||||||
| Non-interest bearing liabilities |
||||||||||||||||||||||||
| Demand deposits |
228,042 | 184,964 | ||||||||||||||||||||||
| Other liabilities |
2,822 | 1,788 | ||||||||||||||||||||||
| Total liabilities |
$ | 803,513 | $ | 699,629 | ||||||||||||||||||||
| Shareholders’ equity |
80,228 | 71,148 | ||||||||||||||||||||||
| Total liabilities and Shareholders’ equity |
$ | 883,741 | $ | 770,777 | ||||||||||||||||||||
| Net interest income |
$ | 22,158 | $ | 21,091 | ||||||||||||||||||||
| Interest rate spread |
3.38 | % | 3.63 | % | ||||||||||||||||||||
| Cost of funds |
0.46 | % | 0.70 | % | ||||||||||||||||||||
| Interest expense as a percent of average earning assets |
0.44 | % | 0.68 | % | ||||||||||||||||||||
| Net interest margin |
3.58 | % | 3.91 | % | ||||||||||||||||||||
| (1) |
Income and yields are reported on a taxable-equivalent basis assuming a federal tax rate of 21%. The tax-equivalent adjustment was $147 and $156 thousand for the nine months ended September 30, 2020 and 2019, respectively. |
| (2) |
Loans on non-accrual status are reflected in the balances. |
Provision for Loan Losses
The Bank recorded a provision for loan losses of $1.5 million for the third quarter of 2020, which resulted in a total allowance for loan losses of $7.8 million, or 1.20% of total loans, at September 30, 2020. Excluding PPP loans, which the Company understands are fully guaranteed by the U.S. government, the allowance for loan losses totaled 1.34% of total loans at September 30, 2020. This compared to no provision for loan losses for the third quarter of 2019 and an allowance for loan losses of $4.9 million, or 0.86% of total loans, at September 30, 2019. The allowance for loan losses totaled $4.9 million, or 0.86% of total loans, at December 31, 2019.
The provision for loan losses for the third quarter of 2020 was primarily attributable to an increase in the specific reserve component of the allowance for loan losses, which was partially offset by a decrease in the general reserve component. The increase in the specific reserve component of the allowance for loan losses included reserves placed on newly identified impaired loans and an increase in a reserve on a loan evaluated in a prior period. The general reserve component of the allowance for loan losses decreased primarily from adjustments to qualitative factors, which resulted from the Bank's observation of improved economic conditions and a reduction in the number and amount of loans participating in the Bank's loan payment deferral program. Net charge offs on loans also contributed to the provision for loan losses, which totaled $19 thousand for the third quarter of 2020, compared to $83 thousand for the same period one year ago.
A provision for loan losses was not recorded for the third quarter of 2019 as net charge-offs on loans were offset by decreases in the specific and general reserve components of the allowance for loan losses. The specific reserve decreased during the third quarter of 2019 primarily from principal payments received on impaired loans. The decrease in the general reserve resulted from the impact of a decrease in loan balances during the quarter and improvements in the historical loss rate of the loan portfolio, which were partially offset by changes in qualitative adjustments.
For the nine months ended September 30, 2020, the Bank recorded a provision for loan losses of $3.2 million, which was attributable to increases in both the general and specific reserve components of the allowance for loan losses. The general reserve component of the allowance for loan losses increased primarily from adjustments to qualitative factors, which resulted from the Bank’s observation of recent unfavorable changes in economic indicators impacted by the pandemic, consideration of risks associated with loans participating in the Bank's loan payment deferral program, and an increase in substandard loan amounts. The increase in the specific reserve component of the allowance for loan losses included reserves placed on newly identified impaired loans and an increase in a reserve on a loan evaluated in a prior period. Net charge offs on loans also contributed to the provision for loan losses, which totaled $357 thousand for the first nine months of 2020, compared to $297 thousand for the same period one year ago.
The Bank recorded a provision for loan losses of $200 thousand for the nine months ended September 30, 2019 as net charge-offs on loans and an increase in the general component of the allowance for loan losses were partially offset by a decrease in the specific reserve component. The increase in the general reserve resulted primarily from the impact of loan growth during the first nine months of 2019 and changes in qualitative adjustments. The specific reserve decreased from improvements in collateral positions on impaired loans, principal payments received, and the resolution of certain impaired loans.
COVID-19 Pandemic Impact on Provision for Loan Losses
The Bank may continue to experience a higher provision for loan losses in future periods from factors including higher specific reserves on newly identified impaired loans, higher levels of net charge-offs, and additional adjustments to qualitative factors in the general reserve component of the allowance for loan losses. The Bank believes the length of time and extent that the Bank’s customers experience business interruptions from the pandemic will impact the amount of provision for loan losses in future periods.
Noninterest Income
Noninterest income increased $10 thousand to $2.2 million for the three months ended September 30, 2020, compared to the same period of 2019. The increase was primarily attributable to an $83 thousand, or 14%, increase in ATM and check card fees, a $96 thousand, or 20%, increase in wealth management fees, and a $146 thousand, or 82%, increase in fees for other customer services. The increase in ATM and check card fees was primarily attributable to volume related incentive payments received from the Bank's card services provider for customer check card usage. These incentive payments are typically received in the fourth quarter. Wealth management fees increased primarily from higher balances of assets under management during the third quarter of 2020 compared to the same period one year ago. Assets under management increased as a result of new business relationships and from growth in the market values of existing accounts. The increase in fees for other customer services was a result of fee income from brokered mortgage loans to the secondary market. These increases were partially offset by a $311 thousand, or 41%, decrease in service charges on deposit accounts from lower deposit overdraft fees.
For the nine months ended September 30, 2020, noninterest income decreased $138 thousand, or 2%, to $6.1 million, compared to the same period of 2019. The decrease was primarily attributable to a $698 thousand, or 32%, decrease in service charges on deposit accounts from lower deposit overdraft fees. This decrease was partially offset by a $62 thousand, or 4%, increase in ATM and check card fees, a $238 thousand, or 17%, increase in wealth management fees, and a $262 thousand, or 52%, increase in fees for other customer services. The increase in ATM and check card fees was primarily attributable to volume related incentive payments received from the Bank's card services provider for customer check card usage. These incentive payments are typically received in the fourth quarter. Wealth management fees increased primarily from higher balances of assets under management during the nine months ended September 30, 2020 compared to the same period one year ago. Assets under management increased as a result of new business relationships and from growth in the market values of existing accounts. The increase in fees for other customer services was primarily a result of fee income from brokered mortgage loans to the secondary market.
COVID-19 Pandemic Impact on Noninterest Income
The number of customer overdrafts and resulting income from service charges on deposits decreased significantly during the second and third quarters of 2020. The Bank believes this may have resulted from a reduction in consumer spending due to government stay at home orders, social distancing, and an increase in unemployment. The lower amount of overdrafts may have also been impacted by receipt of government stimulus checks and an increase in the average balances of customer deposit accounts. In addition, the Bank suspended certain overdraft fees at the beginning of the second quarter in an effort to provide relief to its customers who may experience financial difficulties related to the pandemic. Service charges on deposits may continue to remain at recent levels, depending on customer spending behaviors and the balance of deposit accounts.
ATM and check card fee revenue may also be lower in future periods as customers may spend and visit ATM machines less during periods of uncertainty. Wealth management revenue may decrease in future periods if the market values of investments decline and mortgage fee income may decrease if the number of home purchases and refinancing activity slows in the Bank's market area.
Noninterest Expense
Noninterest expense decreased $51 thousand, or 1%, to $6.1 million for the three months ended September 30, 2020, compared to the same period of 2019. The decrease was primarily attributable to a $58 thousand, or 2%, decrease in salaries and employee benefits, an $80 thousand, or 56%, decrease in marketing expense, and a $131 thousand, or 17%, decrease in other operating expense. The decrease in salaries and employee benefits resulted from a decrease in the number of employees as certain vacated positions were not replaced. Marketing expense decreased from reduced spending on marketing campaigns. Other operating expense decreased primarily from lower loan collection expense and debit card fraud losses. These decreases were partially offset by a $35 thousand, or 9%, increase in occupancy expense, a $26 thousand, or 30%, increase in supplies expense, and a $58 thousand increase in FDIC assessment. The increases in occupancy and supplies expense were primarily attributable to expenses related to the pandemic. FDIC assessment increased due to small bank assessment credits used during the third quarter of 2019.
For the nine months ended September 30, 2020, noninterest expense decreased $622 thousand, or 3%, to $17.9 million, compared to the same period of 2019. The decrease was primarily attributable to a $265 thousand, or 3%, decrease in salaries and employee benefits, a $280 thousand, or 54%, decrease in marketing expense, and a $326 thousand, or 15%, decrease in other operating expense. The decrease in salaries and employee benefits resulted primarily from the deferral of $535 thousand of salary costs to originate PPP loans during the second and third quarters of 2020. Marketing expense decreased from a combination of reduced spending on marketing campaigns during the nine months ended September 30, 2020 and elevated expenses during the same period of 2019 from the timing of marketing initiatives in the prior year. Other operating expense decreased primarily from lower dues and subscriptions costs, education and training costs, registration and licensing fees, travel costs, debit card fraud losses, and loan servicing costs for purchased loans.
The $535 thousand of deferred salary costs described above were netted against $2.5 million of loan fee income, and are being accreted into earnings evenly over the life of the loans through interest and fees on loans. Approximately 99% of the PPP loan balances mature in the second quarter of 2022 and approximately 1% of loan balances mature in the third quarter of 2025. If loans are paid off prior to their maturity dates, the remaining balance of net deferred loan fees would be recognized during that same period.
COVID-19 Pandemic Impact on Noninterest Expense
If asset quality deteriorates as a result of the pandemic, the Bank may incur an increase in expenses related to the resolution of problem loans including appraisal costs, legal and professional fees, OREO expenses and losses on the sale of OREO. The Bank believes the length of time and extent that the Bank’s customers experience business interruptions from the pandemic will impact the amount of noninterest expense in future periods.
Income Taxes
Income tax expense decreased by $197 thousand for the third quarter of 2020 and decreased by $302 thousand for the nine months ended September 30, 2020, compared to the same periods one year ago. The Company’s income tax expense differed from the amount of income tax determined by applying the U.S. federal income tax rate to pretax income for the three and nine months ended September 30, 2020 and 2019. The difference was a result of net permanent tax deductions, primarily comprised of tax-exempt interest income and income from bank owned life insurance. A more detailed discussion of the Company’s tax calculation is contained in Note 11 to the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019.
Financial Condition
General
Total assets increased $142.7 million to $942.7 million at September 30, 2020, compared to $800.0 million at December 31, 2019. The increase was primarily attributable to a $71.2 million increase in net loans and a $72.7 million increase in interest-bearing deposits in banks. The increase in net loans included $73.7 million of PPP loans at September 30, 2020.
At September 30, 2020, total liabilities increased $137.6 million to $860.5 million compared to $722.8 million at December 31, 2019. The increase was primarily attributable to a $132.0 million increase in total deposits. Proceeds from PPP loan originations and the receipt of government stimulus checks by customers during the second quarter contributed to the increase in deposits. Noninterest-bearing demand deposits and savings and interest-bearing demand deposits increased $67.1 million and $80.8 million, respectively, while time deposits decreased $15.9 million. Subordinated debt also increased during the first nine months of 2020 as the Company issued a 5.50% fixed-to-floating rate $5.0 million subordinated note to an institutional investor.
Total shareholders’ equity increased $5.0 million to $82.3 million at September 30, 2020, compared to $77.2 million at December 31, 2019. The increase was primarily attributable to a $4.1 million increase in retained earnings and a $2.7 million increase in accumulated other comprehensive income. These increases were partially offset by a $1.8 million decrease in common stock and surplus, which resulted primarily from stock repurchases in the first quarter of 2020 under the Company’s stock repurchase plan. Tangible common equity totaled $82.2 million at the end of the third quarter, an increase of 7% compared to $77.0 at December 31, 2019. The Company's capital ratios continued to exceed the minimum capital requirements for regulatory purposes.
Loans
Loans, net of the allowance for loan losses, increased $71.2 million to $640.6 million at September 30, 2020, compared to $569.4 million at December 31, 2019. Commercial and industrial loans increased by $75.1 million during the first nine months of 2020, followed by commercial real estate loans and residential real estate loans that increased by $13.8 million and $4.8 million, respectively. These increases were partially offset by construction loans and consumer loans that decreased by $15.7 million and $3.9 million, respectively. The increase in commercial and industrial loans includes $73.7 million of PPP loans at September 30, 2020.
The Company, through its banking subsidiary, grants mortgage, commercial, and consumer loans to customers. The Bank segments its loan portfolio into real estate loans, commercial and industrial loans, and consumer and other loans. Real estate loans are further divided into the following classes: Construction and Land Development; 1-4 Family Residential; and Other Real Estate Loans. Descriptions of the Company’s loan classes are as follows:
Real Estate Loans – Construction and Land Development: The Company originates construction loans for the acquisition and development of land and construction of commercial buildings, condominiums, townhomes, and one-to-four family residences.
Real Estate Loans – 1-4 Family: This class of loans includes loans secured by one-to-four family homes. In addition to traditional residential mortgage loans secured by a first or junior lien on the property, the Bank offers home equity lines of credit.
Real Estate Loans – Other: This loan class consists primarily of loans secured by various types of commercial real estate typically in the Bank’s market area, including multi-family residential buildings, office and retail buildings, industrial and warehouse buildings, hotels, and religious facilities.
Commercial and Industrial Loans: Commercial loans may be unsecured or secured with non-real estate commercial property. The Company's banking subsidiary makes commercial loans to businesses located within its market area and also to businesses outside of its market area through loan participations with other financial institutions.
Consumer and Other Loans: Consumer loans include all loans made to individuals for consumer or personal purposes. They include new and used automobile loans, unsecured loans, and lines of credit. The Company's banking subsidiary makes consumer loans to individuals located within its market area. The Bank has also made loans to individuals outside of its market area through the purchase of loans from another financial institution. Other loans in this category include loans to state and political subdivisions.
A substantial portion of the loan portfolio is represented by residential and commercial loans secured by real estate throughout the Bank's market area. The ability of the Bank’s debtors to honor their contracts may be impacted by the real estate and general economic conditions in this area.
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances less the allowance for loan losses and any deferred fees or costs on originated loans. Interest income is accrued and credited to income based on the unpaid principal balance. Loan origination fees, net of certain origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method.
A loan’s past due status is based on the contractual due date of the most delinquent payment due. Loans are generally placed on non-accrual status when the collection of principal or interest is 90 days or more past due, or earlier, if collection is uncertain based on an evaluation of the net realizable value of the collateral and the financial strength of the borrower. Loans greater than 90 days past due may remain on accrual status if management determines it has adequate collateral to cover the principal and interest. Loans greater than 90 days past due and still accruing totaled $6 thousand at September 30, 2020, compared to $97 thousand at December 31, 2019. For those loans that are carried on non-accrual status, payments are first applied to principal outstanding. A loan may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed. These policies are applied consistently across the loan portfolio.
All interest accrued but not collected for loans that are placed on non-accrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. When a loan is returned to accrual status, interest income is recognized based on the new effective yield to maturity of the loan.
Any unsecured loan that is deemed uncollectible is charged-off in full. Any secured loan that is considered by management to be uncollectible is partially charged-off and carried at the fair value of the collateral less estimated selling costs. This charge-off policy applies to all loan segments.
Impaired Loans
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value (net of selling costs), and the probability of collecting scheduled principal and interest payments when due. Additionally, management generally evaluates substandard and doubtful loans greater than $250 thousand for impairment. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair market value of the collateral, net of selling costs, if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company typically does not separately identify individual consumer, residential, and certain small commercial loans that are less than $250 thousand for impairment disclosures, except for troubled debt restructurings (TDRs) as noted below. The recorded investment in impaired loans totaled $7.0 million and $1.5 million at September 30, 2020 and December 31, 2019, respectively.
Troubled Debt Restructurings (TDR)
In situations where, for economic or legal reasons related to a borrower’s financial condition, management grants a concession to the borrower that it would not otherwise consider, the related loan is classified as a TDR. TDRs are considered impaired loans. Upon designation as a TDR, the Company evaluates the borrower’s payment history, past due status, and ability to make payments based on the revised terms of the loan. If a loan was accruing prior to being modified as a TDR and if the Company concludes that the borrower is able to make such payments, and there are no other factors or circumstances that would cause it to conclude otherwise, the loan will remain on an accruing status. If a loan was on non-accrual status at the time of the TDR, the loan will remain on non-accrual status following the modification and may be returned to accrual status based on the policy for returning loans to accrual status as noted above. There were $6.0 million and $360 thousand in loans classified as TDRs as of September 30, 2020 and December 31, 2019, respectively.
Asset Quality
Management classifies non-performing assets as non-accrual loans and OREO. OREO represents real property taken by the Bank when its customers do not meet the contractual obligation of their loans, either through foreclosure or through a deed in lieu thereof from the borrower and properties originally acquired for branch operations or expansion but no longer intended to be used for that purpose. OREO is recorded at the lower of cost or fair value, less estimated selling costs, and is marketed by the Bank through brokerage channels. The Bank did not have any assets classified as OREO at September 30, 2020 or December 31, 2019.
Non-performing assets totaled $7.0 million and $1.5 million at September 30, 2020 and December 31, 2019, representing approximately 0.74% and 0.18% of total assets, respectively. Non-performing assets consisted only of non-accrual loans at September 30, 2020 and December 31, 2019.
At September 30, 2020, 67% of non-performing assets were commercial real estate loans, 22% were commercial and industrial loans, 7% were residential real estate loans, and 4% were construction and land development loans. Non-performing assets could increase due to other loans identified by management as potential problem loans. Other potential problem loans are defined as performing loans that possess certain risks, including the borrower’s ability to pay and the collateral value securing the loan, that management has identified that may result in the loans not being repaid in accordance with their terms. Other potential problem loans totaled $3.8 million and $3.4 million at September 30, 2020 and December 31, 2019, respectively. The amount of other potential problem loans in future periods may be dependent on economic conditions and other factors influencing a customers’ ability to meet their debt requirements.
Loans greater than 90 days past due and still accruing totaled $6 thousand at September 30, 2020, which was comprised of three purchased consumer loans. Consumer loans purchased at origination are charged-off when they are greater than 120 days past due. Loans that were greater than 90 days past due and still accruing totaled $97 thousand at December 31, 2019.
The allowance for loan losses represents management’s analysis of the existing loan portfolio and related credit risks. The provision for loan losses is based upon management’s current estimate of the amount required to maintain an adequate allowance for loan losses reflective of the risks in the loan portfolio. The allowance for loan losses totaled $7.8 million at September 30, 2020 and $4.9 million at December 31, 2019, representing 1.20% and 0.86% of total loans, respectively. For further discussion regarding the allowance for loan losses, see “Provision for Loan Losses” above.
Recoveries of loan losses of $164 thousand and $30 thousand were recorded in the construction and land development and consumer and other loan classes, respectively, during the nine months ended September 30, 2020. The recovery of loan losses in the construction and land development loan class resulted primarily from a decrease in both the general and specific reserves. The decrease in the general reserve for the construction and land development loan class resulted from the impact of a decrease in loans while the decrease in the specific reserve resulted from improvements in collateral positions on impaired loans and principal payments received. The recovery of loan losses in the consumer and other loan class resulted from a decrease in the general reserve, which was partially offset by net charge offs on loans. The decrease in the general reserve for the consumer and other loan class resulted from the impact of a decrease in loans and improvements in the historical loss rate. These recoveries were offset by provision for loan losses totaling $3.4 million in the 1-4 family residential, other real estate, and commercial and industrial loan classes. For more detailed information regarding the provision for loan losses, see Note 4 to the Consolidated Financial Statements.
Impaired loans totaled $7.0 million and $1.5 million at September 30, 2020 and December 31, 2019, respectively. The related allowance for loan losses provided for these loans totaled $2.3 million and $33 thousand at September 30, 2020 and December 31, 2019, respectively. The average recorded investment in impaired loans during the nine months ended September 30, 2020 and the year ended December 31, 2019 was $2.9 million and $1.9 million, respectively. Included in the impaired loans total are loans classified as TDRs totaling $6.0 million and $360 thousand at September 30, 2020 and December 31, 2019, respectively. Loans classified as TDRs represent situations in which a modification to the contractual interest rate or repayment structure has been granted to address a financial hardship. As of September 30, 2020, none of these TDRs were performing under the restructured terms and all were considered non-performing assets.
Management believes, based upon its review and analysis, that the Bank has sufficient reserves to cover losses inherent within the loan portfolio. For each period presented, the provision for loan losses charged to expense was based on management’s judgment after taking into consideration all factors connected with the collectability of the existing portfolio. Management considers economic conditions, historical loss factors, past due percentages, internally generated loan quality reports, and other relevant factors when evaluating the loan portfolio. There can be no assurance, however, that an additional provision for loan losses will not be required in the future, including as a result of changes in the qualitative factors underlying management’s estimates and judgments, changes in accounting standards, adverse developments in the economy, on a national basis or in the Company’s market area, loan growth, or changes in the circumstances of particular borrowers. For further discussion regarding the allowance for loan losses, see “Critical Accounting Policies” above.
COVID-19 Pandemic Impact on Asset Quality
The Bank anticipates the pandemic to have an unfavorable impact on the financial condition of many of its customers, and as a result, has begun the process of identifying the related credit risk within its loan portfolio with the goal of mitigating the risk and minimizing potential loan charge-offs. Management expects significant pressure on several sectors of the loan portfolio, including those listed in the following table (dollars in thousands).
| September 30, 2020 |
||||||||
| Loan Balance |
Percent of Total Loans |
|||||||
| Industry |
||||||||
| Retail / shopping |
$ | 27,017 | 4.17 | % | ||||
| Lodging |
26,802 | 4.13 | % | |||||
| Leisure |
12,641 | 1.95 | % | |||||
| Total |
$ | 66,460 | 10.25 | % | ||||
The Bank's asset quality was negatively impacted by higher levels of nonaccrual loans. The magnitude of the potential decline in the Bank’s asset quality will likely depend on the severity and length of time and extent that the Bank’s customers experience business interruptions from the pandemic. In addition, the Bank’s loan deferral program, involving $22.6 million, or 3%, of the Bank's total loan balances at September 30, 2020, which included $21.6 million of loans that were provided a second 90 day loan payment deferral period, could delay or make it difficult to identify the extent of asset quality deterioration during the fourth quarter of 2020 until the payment deferral periods have ended and scheduled loan payments become due. Interest income continued to accrue to the Bank on the loans in the program during the deferral periods.
Securities
The securities portfolio plays a primary role in the management of the Company’s interest rate sensitivity and serves as a source of liquidity. The portfolio is used as needed to meet collateral requirements, such as those related to secure public deposits and balances with the Reserve Bank. The investment portfolio consists of held to maturity, available for sale, and restricted securities. Securities are classified as available for sale or held to maturity based on the Company’s investment strategy and management’s assessment of the intent and ability to hold the securities until maturity. Management determines the appropriate classification of securities at the time of purchase. If management has the intent and the Company has the ability at the time of purchase to hold the investment securities to maturity, they are classified as investment securities held to maturity and are stated at amortized cost, adjusted for amortization of premiums and accretion of discounts using the interest method. Investment securities which the Company may not hold to maturity are classified as investment securities available for sale, as management has the intent and ability to hold such investment securities for an indefinite period of time, but not necessarily to maturity. Securities available for sale may be sold in response to changes in market interest rates, changes in prepayment risk, increases in loan demand, general liquidity needs and other similar factors and are carried at estimated fair value. Restricted securities, including Federal Home Loan Bank, Federal Reserve Bank, and Community Bankers’ Bank stock, are generally viewed as long-term investments because there is minimal market for the stock and are carried at cost.
Securities at September 30, 2020 totaled $134.1 million, a decrease of $6.3 million, or 5%, from $140.4 million at December 31, 2019. Investment securities are comprised of U.S. agency and mortgage-backed securities, obligations of state and political subdivisions, corporate debt securities, and restricted securities. As of September 30, 2020, neither the Company nor the Bank held any derivative financial instruments in their respective investment security portfolios. Gross unrealized gains in the available for sale portfolio totaled $4.2 million and $1.3 million at September 30, 2020 and December 31, 2019, respectively. Gross unrealized losses in the available for sale portfolio totaled $14 thousand and $339 thousand at September 30, 2020 and December 31, 2019, respectively. Gross unrealized gains in the held to maturity portfolio totaled $537 thousand and $99 thousand at September 30, 2020 and December 31, 2019, respectively. There were no gross unrealized losses in the held to maturity portfolio at September 30, 2020. Gross unrealized losses in the held to maturity portfolio totaled $80 thousand at December 31, 2019. Investments in an unrealized loss position were considered temporarily impaired at September 30, 2020 and December 31, 2019. The change in the unrealized gains and losses of investment securities from December 31, 2019 to September 30, 2020 was related to changes in market interest rates and was not related to credit concerns of the issuers.
Deposits
At September 30, 2020, deposits totaled $838.4 million, an increase of $132.0 million, from $706.4 million at December 31, 2019. There was a change in the deposit mix when comparing the periods. At September 30, 2020, noninterest-bearing demand deposits, savings and interest-bearing demand deposits, and time deposits composed 31%, 57%, and 12% of total deposits, respectively, compared to 27%, 56%, and 17% at December 31, 2019.
Liquidity
Liquidity represents the ability to meet present and future financial obligations through either the sale or maturity of existing assets or with borrowings from correspondent banks or other deposit markets. The Company classifies cash, interest-bearing and noninterest-bearing deposits with banks, federal funds sold, investment securities, and loans maturing within one year as liquid assets. As part of the Bank’s liquidity risk management, stress tests and cash flow modeling are performed quarterly.
As a result of the Bank’s management of liquid assets and the ability to generate liquidity through liability funding, management believes that the Bank maintains overall liquidity sufficient to satisfy its depositors’ requirements and to meet its customers’ borrowing needs.
At September 30, 2020, cash, interest-bearing and noninterest-bearing deposits with banks, securities, and loans maturing within one year totaled $169.8 million. At September 30, 2020, 7% or $45.8 million of the loan portfolio matured within one year. Non-deposit sources of available funds totaled $226.3 million at September 30, 2020, which included $146.3 million of secured funds available from Federal Home Loan Bank of Atlanta (FHLB), $29.0 million of secured funds available through the Federal Reserve Discount Window, and $51.0 million of unsecured federal funds lines of credit with other correspondent banks.
COVID-19 Pandemic Impact on Liquidity
Although the Bank’s liquidity has not been negatively impacted by the pandemic during the third quarter of 2020, it could be reduced in future periods. Factors that could reduce the Bank’s liquidity include a reduction in cash inflows from loan customers if they would experience financial difficulties and are not able to make contractual payments. Other factors that could reduce liquidity include decreasing customer deposit balances, increasing customer draws on their lines of credit with the Bank, and a reduction in the available lines of credit from correspondent banks. The Bank actively manages and monitors liquidity risk in order to maintain sufficient liquidity to meet the demand from its customers.
Capital Resources
The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to the size, composition, and quality of the Company’s asset and liability levels and consistent with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and absorb potential losses. The Company meets eligibility criteria of a small bank holding company in accordance with the Federal Reserve Board’s Small Bank Holding Company Policy Statement issued in February 2015 and is no longer obligated to report consolidated regulatory capital.
Effective January 1, 2015, the Bank became subject to capital rules adopted by federal bank regulators implementing the Basel III regulatory capital reforms adopted by the Basel Committee on Banking Supervision (the Basel Committee), and certain changes required by the Dodd-Frank Act.
The minimum capital level requirements applicable to the Bank under the final rules are as follows: a new common equity Tier 1 capital ratio of 4.5%; a Tier 1 capital ratio of 6%; a total capital ratio of 8%; and a Tier 1 leverage ratio of 4% for all institutions. The final rules also established a “capital conservation buffer” above the new regulatory minimum capital requirements of 2.5% of risk-weighted assets. This results in the following minimum capital ratios beginning in 2019: a common equity Tier 1 capital ratio of 7.0%, a Tier 1 capital ratio of 8.5%, and a total capital ratio of 10.5%. Under the final rules, institutions are subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions. Management believes, as of September 30, 2020 and December 31, 2019, that the Bank met all capital adequacy requirements to which it is subject, including the capital conservation buffer.
The following table shows the Bank’s regulatory capital ratios at September 30, 2020:
| First Bank |
||||
| Total capital to risk-weighted assets |
15.34 | % | ||
| Tier 1 capital to risk-weighted assets |
14.09 | % | ||
| Common equity Tier 1 capital to risk-weighted assets |
14.09 | % | ||
| Tier 1 capital to average assets |
8.67 | % | ||
| Capital conservation buffer ratio(1) |
7.34 | % | ||
| (1) |
Calculated by subtracting the regulatory minimum capital ratio requirements from the Company’s actual ratio for Common equity Tier 1, Tier 1, and Total risk based capital. The lowest of the three measures represents the Bank’s capital conservation buffer ratio. |
The prompt corrective action framework is designed to place restrictions on insured depository institutions if their capital levels begin to show signs of weakness. Under the prompt corrective action requirements, which are designed to complement the capital conservation buffer, insured depository institutions are required to meet the following capital level requirements in order to qualify as “well capitalized:” a common equity Tier 1 capital ratio of 6.5%; a Tier 1 capital ratio of 8%; a total capital ratio of 10%; and a Tier 1 leverage ratio of 5%. The Bank met the requirements to qualify as "well capitalized" as of September 30, 2020 and December 31, 2019.
On September 17, 2019 the FDIC finalized a rule that introduces an optional simplified measure of capital adequacy for qualifying community banking organizations (i.e., the community bank leverage ratio (CBLR) framework), as required by the Economic Growth Act. The CBLR framework is designed to reduce burden by removing the requirements for calculating and reporting risk-based capital ratios for qualifying community banking organizations that opt into the framework.
In order to qualify for the CBLR framework, a community banking organization must have a tier 1 leverage ratio greater than 9%, have less than $10 billion in total consolidated assets, and limited amounts of off-balance sheet exposures and trading assets and liabilities. The CARES Act temporarily lowered the tier 1 leverage ratio requirement to 8% until December 31, 2020. A qualifying community banking organization that opts into the CBLR framework and meets all requirements under the framework will be considered to have met the "well-capitalized" ratio requirements under the prompt corrective action regulations and will not be required to report or calculate risk-based capital. Although, the Company did not opt into the CBLR framework at September 30, 2020, it may opt into the CBLR framework in a future quarterly period.
During the fourth quarter of 2019, the Board of Directors of the Company authorized a stock repurchase plan pursuant to which the Company may repurchase up to $5.0 million of the Company’s outstanding common stock. The stock repurchase plan was authorized to run through December 31, 2020, unless the entire amount authorized to be repurchased has been acquired before that date. During the first nine months of 2020, the Company repurchased and retired 129,035 shares at an average price paid per share of $16.05, for a total of $2.1 million. The Company did not repurchase any shares of its common stock during 2019.
COVID-19 Pandemic Impact on Capital Resources
The Company will continue to update its enterprise risk assessment and capital plan as the operating environment develops. During the third quarter of 2020, the Company’s stock repurchase plan remained suspended due to the economic uncertainty caused by the pandemic. As a result of the updated capital plan, the Company issued $5.0 million of subordinated debt in June 2020, primarily to further strengthen holding company liquidity and remain a source of strength for the Bank in the event of a severe economic downturn. The Company may also use the proceeds of the issuance for general corporate purposes, including the potential repayment of the Company’s existing subordinated debt, which becomes callable in January 2021. The updated capital plan also required consideration of whether to continue the Company’s cash dividend payments to common shareholders. The Company declared and paid an $0.11 per share dividend during the third quarter, which was unchanged from the dividend paid in the first and second quarters of 2020.
Contractual Obligations
There have been no material changes outside the ordinary course of business to the contractual obligations disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019.
Off-Balance Sheet Arrangements
The Company, through the Bank, is a party to credit related financial instruments with risk not reflected in the consolidated financial statements in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit, and commercial letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The Bank’s exposure to credit loss is represented by the contractual amount of these commitments. The Bank follows the same credit policies in making commitments as it does for on-balance sheet instruments.
Commitments to extend credit, which amounted to $112.2 million at September 30, 2020, and $92.5 million at December 31, 2019, are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for lines of credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Bank, is based on management’s credit evaluation of the customer.
Unfunded commitments under commercial lines of credit, revolving credit lines, and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines of credit are collateralized as deemed necessary and may or may not be drawn upon to the total extent to which the Bank is committed.
Commercial and standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank generally holds collateral supporting those commitments if deemed necessary. At September 30, 2020 and December 31, 2019, the Bank had $10.6 million and $11.0 million in outstanding standby letters of credit, respectively.
At September 30, 2020, the Bank had $15.2 million in locked-rate commitments to originate mortgage loans. Risks arise from the possible inability of counterparties to meet the terms of their contracts. The Bank does not expect any counterparty to fail to meet its obligations.
On April 21, 2020, the Company entered into interest rate swap agreements related to its outstanding junior subordinated debt. The Company uses derivatives to manage exposure to interest rate risk through the use of interest rate swaps. Interest rate swaps involve the exchange of fixed and variable rate interest payments between two parties, based on a common notional principal amount and maturity date with no exchange of underlying principal amounts.
The interest rate swaps qualified and are designated as cash flow hedges. The Company’s cash flow hedges effectively modify the Company’s exposure to interest rate risk by converting variable rates of interest on $9.0 million of the Company’s junior subordinated debt to fixed rates of interest for periods that end between June 2034 and October 2036. The cash flow hedges’ total notional amount is $9.0 million. At September 30, 2020, the cash flow hedges had a fair value of $134 thousand, which is recorded in other assets. The net gain/loss on the cash flow hedges is recognized as a component of other comprehensive income and reclassified into earnings in the same period(s) during which the hedged transactions affect earnings. The Company’s derivative financial instruments are described more fully in Note 16 to the Consolidated Financial Statements.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Not required.
Item 4. Controls and Procedures
The Company maintains disclosure controls and procedures that are designed to provide assurance that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods required by the SEC and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. An evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of September 30, 2020 was carried out under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer. Based on and as of the date of such evaluation, the aforementioned officers concluded that the Company’s disclosure controls and procedures were effective.
The Company’s management is also responsible for establishing and maintaining adequate internal control over financial reporting. There were no changes in the Company’s internal control over financial reporting identified in connection with the evaluation of it that occurred during the Company’s last fiscal quarter that materially affected, or are reasonably likely to materially affect, internal control over financial reporting.
There are no material pending legal proceedings, other than ordinary routine litigation incidental to the Company’s business, to which the Company is a party or to which the property of the Company is subject.
Other than as set forth below, there were no material changes to the Company’s risk factors as disclosed in its Annual Report on Form 10-K for the year ended December 31, 2019.
The ongoing COVID-19 pandemic and measures intended to prevent its spread may adversely affect the Company's business, financial condition and operations; the extent of such impacts are highly uncertain and difficult to predict.
Global health and economic concerns relating to the COVID-19 outbreak and government actions taken to reduce the spread of the virus have had a material adverse impact on the macroeconomic environment, and the outbreak has significantly increased economic uncertainty. The pandemic has resulted in federal, state and local authorities, including those who govern the markets in which we operate, implementing numerous measures to try to contain the virus. These measures, including shelter in place orders and business limitations and shutdowns, have significantly contributed to rising unemployment and negatively impacted consumer and business spending.
The COVID-19 outbreak has adversely impacted and is likely to continue to adversely impact the Company's workforce and operations and the operations of its customers and business partners. In particular, the Company may experience adverse effects due to a number of operational factors impacting it or its customers or business partners, including but not limited to:
| • |
credit losses resulting from financial stress experienced by the Company's borrowers, especially those operating in industries most hard hit by government measures to contain the spread of the virus; |
| • |
operational failures, disruptions or inefficiencies due to changes in the Company's normal business practices necessitated by its internal measures to protect its employees and government-mandated measures intended to slow the spread of the virus; |
| • |
possible business disruptions experienced by the Company's vendors and business partners in carrying out work that supports its operations; |
| • |
decreased demand for the Company's products and services due to economic uncertainty, volatile market conditions and temporary business closures; |
| • |
any financial liability, credit losses, litigation costs or reputational damage resulting from the Company's origination of PPP loans; and |
| • |
heightened levels of cyber and payment fraud, as cyber criminals try to take advantage of the disruption and increased online activity brought about by the pandemic. |
The extent to which the pandemic impacts the Company's business, liquidity, financial condition and operations will depend on future developments, which are highly uncertain and are difficult to predict, including, but not limited to, its duration and severity, the actions to contain it or treat its impact, and how quickly and to what extent normal economic and operating conditions can resume. In addition, the rapidly changing and unprecedented nature of COVID-19 heightens the inherent uncertainty of forecasting future economic conditions and their impact on the Company's loan portfolio, thereby increasing the risk that the assumptions, judgments and estimates used to determine the allowance for loan losses and other estimates are incorrect. Further, the Company's loan deferral program could delay or make it difficult to identify the extent of asset quality deterioration during the 90-day deferral period. As a result of these and other conditions, the ultimate impact of the pandemic is highly uncertain and subject to change, and the Company cannot predict the full extent of the impacts on its business, its operations or the global economy as a whole. To the extent any of the foregoing risks or other factors that develop as a result of COVID-19 materialize, it could exacerbate the risk factors discussed in the Company's Annual Report on Form 10-K for the year ended December 31, 2019, or otherwise materially and adversely affect its business, liquidity, financial condition and results of operations.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Issuer Purchases of Equity Securities
During the fourth quarter of 2019, the Board of Directors of the Company authorized a stock repurchase plan pursuant to which the Company may repurchase up to $5 million of its outstanding common stock. Repurchases under the plan could be made through privately negotiated transactions or in the open market in accordance with Securities and Exchange Commission rules. The Company's Board of Directors authorized the purchase plan through December 31, 2020, unless the entire amount authorized to repurchased has been acquired before that date.
The Company had no purchases of its common stock during the three months ended September 30, 2020 pursuant to the stock repurchase plan.
Item 3. Defaults upon Senior Securities
None
Item 4. Mine Safety Disclosures
None
None
The following documents are attached hereto as Exhibits:
| 31.1 |
Certification of Chief Executive Officer, Section 302 Certification. |
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| 31.2 |
Certification of Chief Financial Officer, Section 302 Certification. |
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| 32.1 |
Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350. |
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| 32.2 |
Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350. |
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| 101 |
The following materials from First National Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2020 formatted in Inline eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Income, (iii) Consolidated Statements of Comprehensive Income (iv) Consolidated Statements of Cash Flows, (v) Consolidated Statements of Shareholders’ Equity, and (vi) Notes to Consolidated Financial Statements. |
| 104 | The cover page from First National Corporation's Quarterly Report on Form 10-Q for the quarter ended September 30, 2020, formatted in Inline XBRL (included with Exhibit 101). |
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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| FIRST NATIONAL CORPORATION |
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| (Registrant) |
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| /s/ Scott C. Harvard |
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November 9, 2020 |
| Scott C. Harvard |
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| President and Chief Executive Officer |
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| /s/ M. Shane Bell |
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November 9, 2020 |
| M. Shane Bell |
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| Executive Vice President and Chief Financial Officer |
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