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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2021

 

OR

 

o 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 001-40379

 

FIVE STAR BANCORP

(Exact name of Registrant as specified in its charter)

 

California   75-3100966
(State or other jurisdiction of incorporation or organization)   (IRS Employer Identification No.)

 

3100 Zinfandel Drive Suite 100 Rancho Cordova CA   95670
(Address of principal executive office)   (Zip Code)

 

Registrant’s telephone number, including area code: (916) 626-5000

 

Not Applicable

(Former name, former address and formal fiscal year, if changed since last report)

 

Securities registered pursuant to 12(b) of the Act:
 
Title of each class Trading symbol Name of each exchange on which registered
Common stock, no par value per share FSBC The Nasdaq Stock Market LLC

 

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.

Yes x No o

 

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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).

Yes x No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a 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.

 

Large accelerated filer o Accelerated filer o
Non-accelerated Filer x Smaller reporting company x
Emerging growth company x    

 

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. o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No x

 

As of November 5, 2021, there were 17,223,808 shares of the registrant’s common stock, no par value, outstanding.

1
 

TABLE OF CONTENTS

 

PART  I FINANCIAL INFORMATION 5
     
ITEM 1. Financial Statements 5
     
  Consolidated Balance Sheets 5
     
  Consolidated Statements of Income 6
     
  Consolidated Statements of Comprehensive Income 7
     
  Consolidated Statements of Changes in Shareholders’ Equity 8
     
  Consolidated Statements of Cash Flows 10
     
  Notes to Consolidated Financial Statements 11
     
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 33
     
ITEM 3. Quantitative and Qualitative Disclosure About Market Risk 67
     
ITEM 4. Controls and Procedures 67
     
PART II OTHER INFORMATION 68
     
ITEM 1. Legal Proceedings 68
     
ITEM 1A. Risk Factors 68
     
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds 98
     
ITEM 3. Defaults Upon Senior Securities 98
     
ITEM 4. Mine Safety Disclosures 98
     
ITEM 5. Other Information 98
     
ITEM 6. Exhibits 99
     
SIGNATURES 100
2
 

Cautionary Note Regarding Forward-Looking Statements

 

This report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements represent plans, estimates, objectives, goals, guidelines, expectations, intentions, projections, and statements of our beliefs concerning future events, business plans, objectives, expected operating results, and the assumptions upon which those statements are based. Forward-looking statements include, without limitation, any statement that may predict, forecast, indicate, or imply future results, performance, or achievements, and are typically identified with words such as “may,” “could,” “should,” “will,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “aim,” “intend,” “plan,” or words or phases of similar meaning. We caution that the forward-looking statements are based largely on our expectations and are subject to a number of known and unknown risks and uncertainties that are subject to change based on factors which are, in many instances, beyond our control. Such forward-looking statements are based on various assumptions (some of which may be beyond our control) and are subject to risks and uncertainties, which change over time, and other factors which could cause actual results to differ materially from those currently anticipated. Such risks and uncertainties include, but are not limited to:

 

  uncertain market conditions and economic trends nationally, regionally, and particularly in Northern California and California, including as a result of the coronavirus, and variants thereof, including the Delta variant (“COVID-19”), pandemic;

 

  risks related to the concentration of our business in California, and specifically within Northern California, including risks associated with any downturn in the real estate sector;

 

  the occurrence or impact of climate change, natural or man-made disasters or calamities, such as wildfires, droughts and earthquakes;

 

  risks related to the impact of the COVID-19 pandemic on our business and operations;

 

  changes in market interest rates that affect the pricing of our loans and deposits and our net interest income;

 

  risks related to our strategic focus on lending to small to medium-sized businesses;

 

  the sufficiency of the assumptions and estimates we make in establishing reserves for potential loan losses and the value of loan collateral and securities;

 

  our ability to attract and retain executive officers and key employees and their customer and community relationships;

 

  the risks associated with our loan portfolios, and specifically with our commercial real estate loans;

 

  our level of nonperforming assets and the costs associated with resolving problem loans, if any, and complying with government-imposed foreclosure moratoriums;

 

  our ability to maintain adequate liquidity and to maintain capital necessary to fund our growth strategy and operations and to satisfy minimum regulatory capital levels;

 

  the effects of increased competition from a wide variety of local, regional, national, and other providers of financial and investment services;

 

  risks associated with unauthorized access, cyber-crime, and other threats to data security;

 

  our ability to comply with various governmental and regulatory requirements applicable to financial institutions, including supervisory actions by federal and state banking agencies;

 

  the impact of recent and future legislative and regulatory changes, including changes in banking, securities, and tax laws and regulations and their application by our regulators, and economic stimulus programs;

 

  governmental monetary and fiscal policies, including the policies of the Board of Governors of the Federal Reserve System;
     
  changes in the U.S. economy, including an economic slowdown, inflation, deflation, housing prices, employment levels, rate of growth, and general business conditions;
3
 
  our ability to implement, maintain, and improve effective internal controls; and

 

  other factors that are discussed in the sections entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors.”

 

The foregoing factors should not be considered exhaustive and should be read together with other cautionary statements that are included in this report, including those discussed in the section entitled “Risk Factors.” Additional factors that could cause results or performance to materially differ from those expressed in our forward-looking statements are detailed in the section entitled “Risk Factors” of our Registration Statement on Form S-1, which was declared effective by the U.S. Securities and Exchange Commission (“SEC”) on May 4, 2021, and our Quarterly Report on Form 10-Q for the quarter ended June 30, 2021, and other filings we may make with the SEC, copies of which are available from us at no charge. New risks and uncertainties may emerge from time to time, and it is not possible for us to predict their occurrence or how they will affect us. If one or more of the factors affecting our forward-looking information and statements proves incorrect, then our actual results, performance, or achievements could differ materially from those expressed in, or implied by, forward-looking information and statements contained in this Quarterly Report on Form 10-Q. Therefore, we caution you not to place undue reliance on our forward-looking information and statements. We disclaim any duty to revise or update the forward-looking statements, whether written or oral, to reflect actual results or changes in the factors affecting the forward-looking statements, except as specifically required by law.

4
 

PART I FINANCIAL INFORMATION

 

ITEM 1. Financial Statements

 

FIVE STAR BANCORP AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
As of September 30, 2021 and December 31, 2020
(Unaudited)
(In thousands, except share and per share data)

 

   September 30,   December 31, 
   2021   2020 
         
ASSETS          
           
Cash and due from financial institutions  $89,951   $46,028 
Interest-bearing deposits in banks   440,881    244,465 
Cash and cash equivalents   530,832    290,493 
           
Time deposits in banks   17,204    23,705 
Securities available-for-sale, at fair value   153,821    114,949 
Securities held-to-maturity, at amortized cost (fair value of $5,211 and $8,755 at September 30, 2021 and December 31, 2020, respectively)   4,955    7,979 
Loans held for sale   5,267    4,820 
Loans, net of allowance for loan losses of $21,848 and $22,189 at September 30, 2021 and December 31, 2020, respectively   1,682,868    1,480,970 
Federal Home Loan Bank of San Francisco (“FHLB”) stock   6,723    6,232 
Premises and equipment, net   1,630    1,663 
Bank owned life insurance   11,142    8,662 
Interest receivable and other assets   20,051    14,292 
Assets  $2,434,493   $1,953,765 
           
LIABILITIES AND SHAREHOLDERS’ EQUITY          
           
Deposits          
Non-interest-bearing  $895,468   $695,687 
Interest-bearing   1,272,926    1,088,314 
Total deposits   2,168,394    1,784,001 
           
Subordinated notes, net   28,370    28,320 
Interest payable and other liabilities   11,091    7,669 
Total liabilities   2,207,855    1,819,990 
           
Commitments and contingencies (Note 10)          
           
Shareholders’ equity          
Preferred stock, no par value; 10,000,000 shares authorized; zero issued and outstanding at September 30, 2021 and December 31, 2021        
Common stock, no par value; 100,000,000 shares authorized; 17,223,808 shares issued and outstanding at September 30, 2021; 11,000,273 shares issued and outstanding at December 31, 2020   218,216    110,082 
Retained earnings   8,442    22,348 
Accumulated other comprehensive (loss) income, net   (20)   1,345 
Total shareholders’ equity   226,638    133,775 
Liabilities and Shareholders’ Equity  $2,434,493   $1,953,765 

 

The accompanying notes are an integral part of these consolidated financial statements (unaudited).

5
 

FIVE STAR BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
(In thousands, except share and per share data)

 

   For the three months
ended September 30,
   For the nine months
ended September 30,
 
   2021   2020   2021   2020 
Interest and dividend income                    
Loans, including fees  $20,086   $17,734   $57,325   $51,318 
Taxable securities   377    347    974    1,062 
Nontaxable securities   194    154    627    285 
Interest-bearing deposits in other banks   175    199    404    1,073 
Interest and dividend income   20,832    18,434    59,330    53,738 
Interest expense                    
Deposits   480    1,764    1,747    6,390 
Subordinated notes   443    443    1,330    1,330 
Interest expense   923    2,207    3,077    7,720 
                     
Net interest income   19,909    16,227    56,253    46,018 
                     
Provision for loan losses       1,850    200    6,000 
                     
Net interest income after provision for loan losses   19,909    14,377    56,053    40,018 
                     
Non-interest income                    
Service charges on deposit accounts   112    93    308    269 
Net gain on sale of securities available-for-sale   435    275    709    1,241 
Gain on sale of loans   988    1,194    3,010    2,635 
Loan-related fees   87    710    420    1,875 
FHLB stock dividends   100    74    270    227 
Earnings on bank owned life insurance   68    59    180    174 
Other   238    130    593    341 
Noninterest Income   2,028    2,535    5,490    6,762 
Non-interest expense                    
Salaries and employee benefits   4,980    3,969    14,616    10,444 
Occupancy and equipment   502    447    1,394    1,239 
Data processing and software   611    529    1,838    1,433 
Federal deposit insurance   110    320    540    867 
Professional services   505    447    3,348    1,154 
Advertising and promotional   366    264    801    766 
Loan-related expenses   462    185    909    510 
Other operating expenses   1,105    1,073    3,579    2,933 
Noninterest expense   8,641    7,234    27,025    19,346 
                     
Income before provision for income taxes   13,296    9,678    34,518    27,434 
                     
Provision for income taxes   2,270    341    3,386    968 
                     
Net income  $11,026   $9,337   $31,132   $26,466 
                     
Basic earnings per share  $0.64   $0.94   $2.18   $2.72 
Diluted earnings per share  $0.64   $0.94   $2.18   $2.72 

 

The accompanying notes are an integral part of these consolidated financial statements (unaudited).

6
 

FIVE STAR BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
(In thousands, except share and per share data)

 

   For the three months
ended September 30,
   For the nine months
ended September 30,
 
   2021   2020   2021   2020 
Net income  $11,026   $9,337   $31,132   $26,466 
                     
Net unrealized holding (loss) gain on securities available-for-sale during the period   (4)   (83)   (713)   2,129 
Reclassification adjustment for net realized gains included in net income   (435)   (275)   (709)   (1,241)
                     
Income tax (benefit) expense related to other comprehensive income (loss)   (131)   (12)   (57)   32 
                     
Other comprehensive (loss) income   (308)   (346)   (1,365)   856 
                     
Total comprehensive income  $10,718   $8,991   $29,767   $27,322 

 

The accompanying notes are an integral part of these consolidated financial statements (unaudited).

7
 

FIVE STAR BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

For the three months ended September 30, 2021 and 2020
(Unaudited)
(In thousands, except share and per share data)

 

               Accumulated     
           Other     
               Comprehensive     
   Common Stock   Retained   Income (Loss),     
   Shares   Amount   Earnings   Net of Taxes   Total 
For the three months ended September 30, 2020                                        
Balance at June 30, 2020   9,683,023   $96,243   $18,304   $1,176   $115,723 
Net income           9,337        9,337 
Other comprehensive loss               (346)   (346)
Stock offering   1,250,000    12,500            12,500 
Stock issued under stock award plans   1,250                 
Stock compensation expense       123            123 
Stock issued to directors   16,000    252            252 
Common stock issued   50,000    900            900 
Cash dividends paid ($0.75 per share)           (7,276)       (7,276)
Balance at September 30, 2020   11,000,273   $110,018   $20,365   $830   $131,213 
                          
For the three months ended September 30, 2021                         
Balance at June 30, 2021   17,225,508   $218,026   $   $288   $218,314 
Net income           11,026        11,026 
Other comprehensive loss               (308)   (308)
Stock compensation expense       190            190 
Stock forfeitures   (1,700)                
Cash dividends paid ($0.15 per share)           (2,584)       (2,584)
Balance at September 30, 2021   17,223,808   $218,216   $8,442   $(20)  $226,638 

 

The accompanying notes are an integral part of these consolidated financial statements (unaudited).

8
 

FIVE STAR BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

For the nine months ended September 30, 2021 and 2020
(Unaudited)
(In thousands, except share and per share data)

  

               Accumulated     
           Other     
               Comprehensive     
   Common Stock   Retained   Income (Loss),     
   Shares   Amount   Earnings   Net of Taxes   Total 
For the nine months ended September 30, 2020                                        
Balance at December 31, 2019   9,674,875   $96,114   $12,789   $(26)  $108,877 
Net income           26,466        26,466 
Other comprehensive income               856    856 
Stock offering   1,250,000    12,500            12,500 
Stock issued under stock award plans   9,398                 
Stock compensation expense       252            252 
Stock issued to directors   16,000    252            252 
Common stock issued   50,000    900            900 
Cash dividends paid ($1.95 per share)           (18,890)       (18,890)
Balance at September 30, 2020   11,000,273   $110,018   $20,365   $830   $131,213 
                          
For the nine months ended September 30, 2021                         
Balance at December 31, 2020   11,000,273   $110,082   $22,348   $1,345   $133,775 
Net income           31,132        31,132 
Other comprehensive loss               (1,365)   (1,365)
Stock offering   6,054,750    111,243            111,243 
Stock issued under stock award plans   132,707                 
Stock compensation expense       402            402 
Stock issued to directors   40,500    810            810 
Stock forfeitures   (4,422)                
Reclassification of retained deficit       (4,321)   4,321         
Cash dividends paid ($4.40 per share)           (49,359)       (49,359)
Balance at September 30, 2021   17,223,808   $218,216   $8,442   $(20)  $226,638 

 

The accompanying notes are an integral part of these consolidated financial statements (unaudited).

9
 

  FIVE STAR BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the nine months ended September 30, 2021 and 2020
(Unaudited)
(In thousands, except share and per share data)

 

   September 30,
2021
   September 30,
2020
 
Cash flows from operating activities:          
Net income  $31,132   $26,466 
Adjustments to reconcile net income to net cash provided by operating activities:          
Provision for loan losses   200    6,000 
Loans originated for sale   (34,211)   (60,188)
Gain on sale of loans   (3,010)   (2,635)
Proceeds from sales of loans   31,954    48,958 
Net gain on sale of securities available-for-sale   (709)   (1,241)
Earnings on bank owned life insurance   (180)   (174)
Stock compensation expense   402    252 
Director stock compensation expense   810    252 
Change in deferred loan fees   (997)   5,932 
Amortization and accretion of security premiums and discounts   1,120    744 
Amortization of subordinated notes issuance costs   50    50 
Depreciation and amortization   408    333 
Net changes in:          
Interest receivable and other assets   (5,702)   (3,939)
Interest payable and other liabilities   3,422    318 
Net cash provided by operating activities   24,689    21,128 
Cash flows from investing activities:          
Proceeds from sale of securities available-for-sale   40,772    39,940 
Maturities, prepayments, and calls of securities available-for-sale   13,639    11,804 
Purchases of securities available-for-sale   (92,093)   (82,571)
Increase (decrease) in time deposits in banks   6,501    (2,255
Loan originations, net of repayments   (196,280)   (371,499)
Purchase of premises and equipment   (375)   (714)
Purchase of FHLB stock   (491)   (1,152)
Purchase of bank owned life insurance   (2,300)    
Net cash used in investing activities   (230,627)   (406,447)
Cash flows from financing activities:          
Net change in deposits   384,393    579,835 
Proceeds from issuance of stock   111,243    13,400 
FHLB repayment       (25,000)
Cash dividends paid   (49,359)   (18,890)
Net cash provided by financing activities   446,277    549,345 
Net change in cash and cash equivalents   240,339    164,026 
Cash and cash equivalents at beginning of period   290,493    177,366 
Cash and cash equivalents at end of period  $530,832   $341,392 
Supplemental disclosure of cash flow information:          
Interest paid  $3,090   $8,181 
Income taxes paid  $5,150   $1,045 
Supplemental disclosure of noncash investing and financing activities:          
Transfer from loans held for investment to loans held for sale  $4,820   $6,527 
Unrealized (loss) gain on securities  $(1,365)  $856 

 

The accompanying notes are an integral part of these consolidated financial statements (unaudited).

10
 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

Note 1: Basis of Presentation

 

Nature of Operations and Principles of Consolidation

 

Five Star Bank (the “Bank”) was chartered on October 26, 1999 and began operations on December 20, 1999. Five Star Bancorp (“Bancorp” or the “Company”) was incorporated on September 16, 2002 and subsequently obtained approval from the Board of Governors of the Federal Reserve System (“Federal Reserve”) to be a bank holding company in connection with its acquisition of the Bank. The Company became the sole shareholder of the Bank on June 2, 2003 in a statutory merger, pursuant to which each outstanding share of the Bank’s common stock was exchanged for one share of common stock of the Company.

 

The Company, through the Bank, provides financial services to customers who are predominately small and middle-market businesses, professionals, and individuals residing in the Northern California region. Its primary loan products are commercial real estate loans, land development loans, construction loans, and operating lines of credit; and its primary deposit products are checking accounts, savings accounts, money market accounts, and term certificate accounts. The Bank currently has seven branch offices in Roseville, Natomas, Rancho Cordova, Redding, Elk Grove, Chico, and Yuba City, and two loan production offices in Santa Rosa and Sacramento.

 

The Company terminated its status as a Subchapter S corporation as of May 5, 2021, in connection with the Company’s Initial Public Offering (“IPO”) and became a taxable C Corporation. Prior to that date, as an S Corporation, the Company had no U.S. federal income tax expense.

 

On April 9, 2021, the Company publicly filed a Registration Statement on Form S-1 with the U.S. Securities and Exchange Commission (“SEC”) in connection with its IPO  (the “Registration Statement”), which was subsequently amended on April 26, 2021 and May 3, 2021. The Registration Statement was declared effective by the SEC on May 4, 2021. In connection with the IPO, the Company issued 6,054,750 shares of common stock, no par value, which included 789,750 shares sold pursuant to the underwriters’ exercise of their option to purchase additional shares. The securities were sold to the public at a price of $20.00 per share and began trading on the Nasdaq Stock Market LLC on May 5, 2021. On May 7, 2021, the closing date of the IPO, the Company received total net proceeds of $111.2 million. The net proceeds less other related expenses, including audit fees, legal fees, listing fees, and other expenses, totaled $109.1 million.

 

Basis of Financial Statement Presentation and Consolidation

 

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) as contained within the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) and the rules and regulations of the SEC, including the instructions to Regulation S-X. These interim unaudited consolidated financial statements reflect all adjustments (consisting solely of normal recurring adjustments and accruals) which, in the opinion of management, are necessary for a fair presentation of financial position, results of operations and comprehensive income, changes in shareholders’ equity, and cash flows for the interim periods presented. These unaudited consolidated financial statements have been prepared on a basis consistent with, and should be read in conjunction with, the audited consolidated financial statements as of and for the year ended December 31, 2020, and the notes thereto, as filed in the Company’s Registration Statement, which was declared effective by the SEC on May 4, 2021.

 

The unaudited consolidated financial statements include Five Star Bancorp and its wholly owned subsidiary, Five Star Bank. All significant intercompany transactions and balances are eliminated in consolidation.

 

The results of operations for the three and nine months ended September 30, 2021 are not necessarily indicative of the results of operations that may be expected for any other interim period or for the year ending December 31, 2021.

11
 

While the Company’s chief decision-makers monitor the revenue streams of the various products and services, operations are managed, and financial performance is evaluated, on a Company-wide basis. Discrete financial information is not available other than on a Company-wide basis. Accordingly, all of the financial service operations are considered by management to be aggregated in one reportable operating segment.

 

The Company’s accounting and reporting policies conform to GAAP and to general practices within the banking industry.

 

The Company qualifies as an emerging growth company as defined in the Jumpstart Our Business Startups Act of 2012, and, as such, may take advantage of specified reduced reporting requirements and is relieved of other significant requirements that are otherwise generally applicable to other public companies.

 

Use of Estimates

 

Management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. These estimates and assumptions affect the amounts reported in the unaudited consolidated financial statements and the disclosures provided, and actual results could differ. The allowance for loan losses is the most significant accounting estimate reflected in the Company’s consolidated financial statements.

 

Earnings Per Share (“EPS”)

 

Basic EPS is net income divided by the weighted average number of common shares outstanding during the period less average unvested restricted stock awards (“RSAs”). Diluted EPS includes the dilutive effect of additional potential common shares related to unvested RSAs using the treasury stock method. The Company has two forms of outstanding common stock: common stock and unvested RSAs. Holders of unvested RSAs receive non-forfeitable dividends at the same rate as common shareholders and they both share equally in undistributed earnings, and therefore the RSAs are considered participating securities. However, under the two-class method, the difference in EPS is not significant for these participating securities.

 

 

   For the three months ended   For the nine months ended 
(in thousands, except per share data)  September 30,
2021
   September 30,
2020
   September 30,
2021
   September 30,
2020
 
Net income  $11,026   $9,337   $31,132   $26,466 
Weighted average basic common shares outstanding   17,095,957    9,902,952    14,256,993    9,747,896 
Add: Dilutive effects of assumed vesting of restricted stock   27,225        15,538     
Weighted average diluted common shares outstanding   17,123,182    9,902,952    14,272,531    9,747,896 
Income per common share:                    
Basic EPS  $0.64   $0.94   $2.18   $2.72 
Diluted EPS  $0.64   $0.94   $2.18   $2.72 

 

During the three and nine months ended September 30, 2021 and 2020, there were no outstanding stock options. Anti-dilutive shares, which are excluded from the dilutive EPS calculation, were deemed to be immaterial.

 

For the three and nine months ended September 30, 2020, pro forma EPS is calculated by applying a C Corporation effective tax rate of 29.56% to net income before provision for income taxes and using the determined pro forma net income balance to calculate EPS. For the three months ended September 30, 2021, pro forma EPS is actual EPS given that the Company was a C Corporation for the entire three-month period. For the nine months ended September 30, 2021, pro forma EPS is calculated by applying an effective tax rate of 23.25%, which is the actual effective tax rate, excluding the effects of the discrete deferred tax adjustment of $4.6 million, as discussed in Note 8. The following reconciliation table provides a detailed calculation of pro forma EPS:

 

 

   For the three months ended   For the nine months ended 
(in thousands, except per share data)  September 30,
2021
   September 30,
2020
   September 30,
2021
   September 30,
2020
 
Net income before provision for income taxes - GAAP  $13,296   $9,678   $34,518   $27,434 
Actual/pro forma provision for income taxes   (2,270)   (2,861)   (8,024)   (8,109)
Actual/pro forma net income   11,026    6,817    26,494    19,325 
Weighted average basic common shares outstanding   17,095,957    9,902,952    14,256,993    9,747,896 
Add: Dilutive effects of assumed vesting of restricted stock   27,225        15,538     
Weighted average diluted common shares outstanding   17,123,182    9,902,952    14,272,531    9,747,896 
Income per common share:                    
Basic EPS  $0.64   $0.69   $1.86   $1.98 
Diluted EPS  $0.64   $0.69   $1.86   $1.98 

 

Note 2: Recently Issued Accounting Standards

 

The following reflect recent accounting standards that are pending adoption by the Company. As discussed in Note 1, Basis of Presentation, the Company qualifies as an emerging growth company, and as such, has elected to use the extended transition period for complying with new or revised accounting standards and is not subject to the new or revised accounting standards applicable to public companies during the extended transition period. The accounting standards discussed below reflect effective dates for the Company as an emerging growth company with the extended transition period.

12
 

Accounting Standards Not Yet Adopted

 

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). The amendments in this ASU intend to increase transparency and comparability among organizations by recognizing an asset, which represents the right to use the asset for the lease term, and a lease liability, which is a lessee’s obligation to make lease payments measured on a discounted basis. This ASU generally applies to leasing arrangements exceeding a twelve-month term. As amended by ASU 2020-05, ASU 2016-02 is effective for annual periods, including interim periods within those annual periods beginning after December 15, 2021 and requires a modified retrospective method of adoption. In July 2018, the FASB issued two amendments to ASU 2016-02: ASU No. 2018-10, Codification Improvements to Topic 842, Leases, which provides various corrections and clarifications to ASU 2016-02; and ASU No. 2018-11, Leases (Topic 842): Targeted Improvements, which provides a new optional transition method and provides a lessor with practical expedients for separating lease and non-lease components of a lease. In July 2021, the FASB issued ASU No. 2021-05, which amends ASU 2016-02 and requires a lessor to classify a lease with variable lease payments that do not depend on an index or rate as an operating lease on the commencement date of the lease if specified criteria are met. Entities will apply a modified retrospective approach at either the beginning of the earliest period presented or at the beginning of the period of adoption through a cumulative-effect adjustment to retained earnings. The Company is currently evaluating the effect that this ASU will have on its consolidated financial statements.

 

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The standard will replace the “incurred loss” model with a “current expected credit loss” (“CECL”) model. The CECL model will apply to estimated credit losses on loans receivable, held-to-maturity debt securities, unfunded loan commitments, and certain other financial assets measured at amortized cost. The CECL model is based on lifetime expected losses, rather than incurred losses, and requires the recognition of credit loss expense in the consolidated statement of income and a related allowance for credit losses on the consolidated statement of condition at the time of origination or purchase of a loan receivable or held-to-maturity debt security. Likewise, subsequent changes in this estimate are recorded through credit loss expense and related allowance. The CECL model requires the use of not only relevant historical experience and current conditions, but reasonable and supportable forecasts of future events and circumstances, incorporating a broad range of information in developing credit loss estimates, which could result in significant changes to both the timing and amount of credit loss expense and allowance. Under ASU 2016-13, available-for-sale debt securities are evaluated for impairment if fair value is less than amortized cost. Estimated credit losses are recorded through a credit loss expense and an allowance, rather than a write-down of the investment. Changes in fair value that are not credit-related will continue to be recorded in other comprehensive income. The ASU also expands the disclosure requirements regarding assumptions, models, and methods for estimating the allowance for loan losses. In addition, entities will need to disclose the amortized cost balance for each class of financial asset by credit quality indicator, disaggregated by the year of origination. ASU 2016-13 is effective for the Company for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Entities will apply a modified retrospective approach through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective. While the Company believes the change from an incurred loss model to a CECL model has the potential to increase the allowance for loan losses at the adoption date, the Company cannot reasonably quantify the impact of the adoption of the amendments to its financial condition or results of operations at this time due to the complexity and extensive changes from these amendments. The Company is working with its third-party vendor to identify data gaps and determine the appropriate methodologies and resources to utilize in preparation for its transition to the new accounting standard, including but not limited to the use of certain tools to forecast future economic conditions that affect the cash flows of loans over their lifetime.

 

In August 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. The primary objective of the amendments in this update is to simplify the application of hedge accounting. More specifically, the amendments in this update better align an entity’s risk management activities and financial reporting for hedging relationships through changes to both the designation and measurement guidance for qualifying hedging relationships and the presentation of hedge results. Furthermore, the amendments expand and refine hedge accounting for both nonfinancial and financial risk components and align the recognition and presentation of the effects of the hedging instrument and the hedged item in the financial statements. Additionally, amendments in this update require an entity to present the earnings effect of the hedging instrument in the same income statement line item in which the earnings effect of the hedged item is reported. Hedge ineffectiveness is no longer separately measured and reported. The amendments in this update will be effective for fiscal years beginning after December 15, 2020 and interim periods within fiscal years beginning after December 15, 2021. Early adoption is permitted in any interim period. The impact of adopting this ASU is expected to be immaterial to the Company’s consolidated financial statements.

13
 

In March 2020, the FASB issued ASU No. 2020-04, Reference Rate Reform (Topic 848). The amendments in this ASU are elective and provide optional guidance for a limited period of time to ease the potential burden in accounting for (or recognizing the effects of) reference rate reform. The amendments in this ASU provide optional expedients and exceptions for applying GAAP to contracts, hedging relationships, and other transactions that reference the London Inter-Bank Offered Rate (“LIBOR”) or another reference rate expected to be discontinued because of reference rate reform. Additionally, in January 2021, the FASB issued ASU No. 2021-01, Reference Rate Reform (Topic 848), which refines the scope of ASC 848 and clarifies its guidance, permitting entities to elect certain optional expedients and exceptions when accounting for derivative contracts and certain hedging relationships affected by changes in the interest rates used for discounting cash flows, computing variation margin settlements, and calculating price alignment interest in connection with reference rate reform activities under way in global financial markets. The amendments in these ASUs may be elected as of March 12, 2020 through December 31, 2022. An entity may choose to elect the amendments in these updates at an interim period subsequent to March 12, 2020, with adoption methods varying based on transaction type. The Company has not elected to apply these amendments; however, the Company is assessing the applicability of the ASUs and continues to monitor guidance for reference rate reform from FASB and its impact on the Company’s consolidated financial statements.

 

Note 3: Fair Value of Assets and Liabilities

 

Fair Value Hierarchy and Fair Value Measurement

 

Accounting standards require the Company to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

 

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the Company has the ability to access as of the measurement date.

 

Level 2: Significant other observable inputs other than Level 1 prices such as 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.

 

Level 3: Significant unobservable inputs that reflect the Company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

 

The fair values of securities are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs).

14
 

The following table summarizes the Company’s assets and liabilities that were required to be recorded at fair value on a recurring basis.

 

(in thousands)  Carrying
Value
   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   Significant
Other
Observable
Inputs
(Level 2)
   Significant
Unobservable
Inputs
(Level 3)
   Measurement
Categories: Changes
in Fair Value Recorded
In1
 
September 30, 2021                         
Assets:                         
Securities available-for-sale:                         
U.S. government agencies, mortgage-backed securities, obligations of states and political subdivisions, collateralized mortgage obligations, and corporate bonds  $153,821   $   $153,821   $    OCI 
Derivatives – interest rate swap   108        108        NI 
Liabilities:                         
Derivatives – interest rate swap   108        108        NI 
                          
December 31, 2020                         
Assets:                         
Securities available-for-sale:                         
U.S. government agencies, mortgage-backed securities, obligations of states and political subdivisions, and collateralized mortgage obligations  $114,949   $   $114,949   $    OCI 
Derivatives – interest rate swap   149        149        NI 
Liabilities:                         
Derivatives – interest rate swap   149        149   $    NI 

 

1 Other comprehensive income (“OCI”) or net income (“NI”).

 

Available-for-sale securities are recorded at fair value on a recurring basis. When available, quoted market prices (Level 1) are used to determine the fair value of available-for-sale securities. If quoted market prices are not available, management obtains pricing information from a reputable third-party service provider, who may utilize valuation techniques that use current market-based or independently sourced parameters, such as bid/ask prices, dealer-quoted prices, interest rates, benchmark yield curves, prepayment speeds, probability of default, loss severity, and credit spreads (Level 2). Level 2 securities include U.S. agencies or government-sponsored agencies’ debt securities, mortgage-backed securities, government agency issued bonds, privately issued collateralized mortgage obligations, and corporate bonds. As of September 30, 2021 and December 31, 2020, there were no Level 1 or Level 3 securities.

 

On a recurring basis, derivative financial instruments are recorded at fair value, which is based on the income approach using observable Level 2 market inputs, reflecting market expectations of future interest rates as of the measurement date. Standard valuation techniques are used to calculate the present value of the future expected cash flows assuming an orderly transaction. Valuation adjustments may be made to reflect both the Company’s credit risk and the counterparties’ credit risk in determining the fair value of the derivatives. A similar credit risk adjustment, correlated to the credit standing of the counterparty, is made when collateral posted by the counterparty does not fully cover their liability to the Company. For further discussion on the Company’s methodology in valuing its derivative financial instruments, refer to Note 11, Derivative Financial Instruments and Hedging Activities.

 

Certain financial assets may be measured at fair value on a non-recurring basis. These assets are subject to fair value adjustments that result from the application of the lower of cost or fair value accounting or write-downs of individual assets, such as impaired loans that are collateral dependent and other real estate owned (“OREO”). As of September 30, 2021 and December 31, 2020, the Company did not carry any assets measured at fair value on a non-recurring basis.

15
 

Disclosures about Fair Value of Financial Instruments

 

The table below is a summary of fair value estimates for financial instruments as of September 30, 2021 and December 31, 2020. The carrying amounts in the following table are recorded in the consolidated balance sheets under the indicated captions. Further, management has not disclosed the fair value of financial instruments specifically excluded from disclosure requirements such as bank owned life insurance policies (“BOLI”).

 

 

   September 30, 2021   December 31, 2020 
(in thousands)  Carrying
Amounts
   Fair
Value
   Fair Value
Hierarchy
   Carrying
Amounts
   Fair
Value
   Fair Value
Hierarchy
 
Financial assets (recorded at amortized cost)                              
Cash and cash equivalents  $530,832   $530,832    Level 1   $290,493   $290,493    Level 1 
Time deposits in banks   17,204    17,204    Level 1    23,705    23,705    Level 1 
Securities available-for-sale   153,821    153,821    Level 2    114,949    114,949    Level 2 
Securities held-to-maturity   4,955    5,211    Level 3    7,979    8,755    Level 3 
Loans held for sale   5,267    5,507    Level 2    4,820    5,012    Level 2 
Loans held for investment   1,682,868    1,689,036    Level 3    1,480,970    1,464,794    Level 3 
Interest receivable   5,170    5,170    Level 2    5,422    5,422    Level 2 
Financial liabilities (recorded at amortized cost)                             
Deposits   2,168,394    2,120,785    Level 2    1,784,001    1,785,944    Level 2 
Interest payable   19    19    Level 2    75    75    Level 2 
Subordinated notes   28,370    28,370    Level 3    28,320    28,320    Level 3 

 

The following methods and assumptions were used by the Company to estimate the fair value of its financial instruments at September 30, 2021 and December 31, 2020:

 

Cash and cash equivalents and time deposits in banks: The carrying amount is estimated to be fair value due to the liquid nature of the assets and their short-term maturities.

 

Investment securities: See discussion above for the methods and assumptions used by the Company to estimate the fair value of investment securities.

 

Loans held for sale: For loans held for sale, the fair value is based on what secondary markets are currently offering for portfolios with similar characteristics.

 

Loans held for investment: For variable-rate loans that reprice frequently with no significant change in credit risk, fair values are based on carrying values. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates being offered at each reporting date for loans with similar terms to borrowers of comparable creditworthiness without considering widening credit spreads due to market illiquidity, which approximates the exit price notion. The allowance for loan losses is considered to be a reasonable estimate of loan discount for credit quality concerns.

 

Interest receivable and payable: For interest receivable and payable, the carrying amount is estimated to be fair value.

 

Derivatives - interest rate swap: See above for a discussion of the methods and assumptions used by the Company to estimate the fair value of derivatives.

16
 

Deposits: The fair values for demand deposits are, by definition, equal to the amount payable on demand at the reporting date represented by their carrying amount. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flow analysis that uses interest rates being offered at each reporting date by the Company for certificates with similar remaining maturities. For variable rate time deposits, cost approximates fair value.

 

Subordinated Notes: The fair value is estimated by discounting the future cash flow using the current 3-month LIBOR rate. Both notes are not registered securities and were issued through private placements, resulting in a Level 3 classification. Both notes are recorded at carrying value.

 

Note 4: Investment Securities

 

The Company’s investment securities portfolio includes obligations of states and political subdivisions, securities issued by U.S. federal government agencies such as Government National Mortgage Association (“GNMA”) and Small Business Administration (“SBA”), and securities issued by U.S. government-sponsored enterprises (“GSEs”), such as Federal National Mortgage Association (“FNMA”), Federal Home Loan Mortgage Corporation (“FHLMC”), and Federal Home Loan Bank of San Francisco (“FHLB”). The Company also invests in residential and commercial mortgage-backed securities (“MBS” and “CMBS”, respectively), collateralized mortgage obligations (“CMOs”) issued or guaranteed by the GSEs, and corporate bonds, as reflected in the following tables.

 

A summary of the amortized cost and fair value related to securities held-to-maturity as of September 30, 2021 and December 31, 2020 is presented below.

 

 

       Gross Unrealized     
(in thousands)  Amortized
Cost
   Gains   (Losses)   Fair
Value
 
September 30, 2021                    
Obligations of states and political subdivisions   4,955    256        5,211 
Total held-to-maturity  $4,955   $256   $   $5,211 
December 31, 2020                    
Obligations of states and political subdivisions   7,979    776        8,755 
Total held-to-maturity  $7,979   $776   $   $8,755 

 

For securities issued by states and political subdivisions, management considers (i) issuer and/or guarantor credit ratings, (ii) historical probability of default and loss given default rates for given bond ratings and remaining maturity, (iii) whether issuers continue to make timely principal and interest payments under the contractual terms of the securities, (iv) internal credit review of the financial information, and (v) whether or not such securities have credit enhancements such as guarantees, contain a defeasance clause, or are pre-refunded by the issuers.

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A summary of the amortized cost and fair value related to securities available-for-sale as of September 30, 2021 and December 31, 2020 is presented below.

 

       Gross Unrealized     
(in thousands)  Amortized
Cost
   Gains   (Losses)   Fair
Value
 
September 30, 2021                    
U.S. government agencies  $21,780   $108   $(234)  $21,654 
Mortgage-backed securities   78,301    198    (572)   77,927 
Collateralized mortgage obligations   580    12        592 
Obligations of states and political subdivisions   51,189    661    (197)   51,653 
Corporate bonds   2,000        (5)   1,995 
Total available-for-sale  $153,850   $979   $(1,008)  $153,821 
December 31, 2020                    
U.S. government agencies  $32,069   $111   $(352)  $31,828 
Mortgage-backed securities   23,601    338    (7)   23,932 
Collateralized mortgage obligations   748    21        769 
Obligations of states and political subdivisions   57,137    1,291    (8)   58,420 
Total available-for-sale  $113,555   $1,761   $(367)  $114,949 

 

The amortized cost and fair value of investment debt securities by contractual maturity at September 30, 2021 and December 31, 2020 are shown below. Expected maturities may differ from contractual maturities if the issuers of the securities have the right to call or prepay obligations with or without call or prepayment penalties.

 

   September 30, 2021   December 31, 2020 
   Held-to-Maturity   Available-for-Sale   Held-to-Maturity   Available-for-Sale 
(in thousands)  Amortized
Cost
   Fair Value   Amortized
Cost
   Fair Value   Amortized
Cost
   Fair Value   Amortized
Cost
   Fair Value 
Within one year  $795   $836   $   $   $494   $543   $   $ 
After one but within five years   2,700    2,840    508    528    2,143    2,351    1,141    1,206 
After five years through ten years   1,460    1,535    4,488    4,610    2,755    3,023    8,340    8,599 
After ten years           46,193    46,515    2,587    2,838    47,656    48,615 
                                         
Investment securities not due at a single maturity date:                                        
U.S. government agencies           21,780    21,654            32,069    31,828 
Mortgage-backed securities           78,301    77,927            23,601    23,932 
Collateralized mortgage obligations           580    592            748    769 
Corporate bonds           2,000    1,995                 
Total  $4,955   $5,211   $153,850   $153,821   $7,979   $8,755   $113,555   $114,949 

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Sales of investment securities and gross gains and losses are shown in the following table:

 

   For the three months ended   For the nine months ended 
(in thousands)  September 30,
2021
   September 30,
2020
   September 30,
2021
   September 30,
2020
 
Available-for-sale:                   
Sales proceeds  $24,590   $7,706   $40,772   $39,940 
Gross realized gains   435    275    709    1,241 

 

Pledged investment securities are shown in the following table:

 

(in thousands)  September 30,
2021
   December 31,
2020
 
Pledged to the State of California:        
Secure deposits of public funds and borrowings  $68,050   $52,897 
Total pledged investment securities  $68,050   $52,897 

 

The following table details the gross unrealized losses and fair values aggregated by investment category and length of time that individual available-for-sale securities have been in a continuous unrealized loss position at September 30, 2021 and December 31, 2020:

 

(in thousands)  < 12 continuous months   ≥ 12 continuous months   Total securities
in a loss position
 
   Fair Value   Unrealized Loss   Fair Value   Unrealized Loss   Fair Value   Unrealized Loss 
September 30, 2021                              
U.S. government agencies  $   $   $14,866   $(234)  $14,866   $(234)
Mortgage-backed securities   56,020    (530)   1,421    (42)   57,441    (572)
Obligations of states and political subdivisions   20,846    (184)   1,063    (13)   21,909    (197)
Corporate bonds   995    (5)           995    (5)
Total temporarily impaired securities  $77,861   $(719)  $17,350   $(289)  $95,211   $(1,008)
                               
December 31, 2020                              
U.S. government agencies  $10,800   $(56)  $15,195   $(296)  $25,995   $(352)
Mortgage-backed securities   1,786    (7)           1,786    (7)
Obligations of states and political subdivisions   3,922    (8)           3,922    (8)
Total temporarily impaired securities  $16,508   $(71)  $15,195   $(296)  $31,703   $(367)

 

There were 93 and 31 securities in unrealized loss positions at September 30, 2021 and December 31, 2020, respectively, which were all classified as available-for-sale. As of September 30, 2021, the investment portfolio included 18 investment securities that had been in a continuous loss position for twelve months or more and 75 investment securities that had been in a loss position for less than twelve months.

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The Company periodically evaluates each available-for-sale investment security in an unrealized loss position to determine if the impairment is temporary or other than temporary and has determined that no investment security is other than temporarily impaired. The unrealized losses are due primarily to interest rate changes. The Company does not intend, and it is more likely than not that the Company will not be required to, sell the securities before the earlier of the forecasted recovery or the maturity of the underlying debt security.

 

There were no held-to-maturity securities in a continuous loss position at September 30, 2021 or December 31, 2020.

 

Obligations issued or guaranteed by government agencies such as GNMA and SBA or GSEs under conservatorship such as FNMA and FHLMC are guaranteed or sponsored by agencies of the U.S. government and have strong credit profiles. The Company therefore expects to receive all contractual interest payments on time and believes the risk of credit losses on these securities is remote.

 

The Company’s investment in obligations of states and political subdivisions are deemed credit worthy after management’s comprehensive analysis of the issuers’ latest financial information, credit ratings by major credit agencies, and/or credit enhancements.

 

Non-Marketable Securities Included in Other Assets

 

FHLB capital stock: As a member of the FHLB, the Company is required to maintain a minimum investment in FHLB capital stock determined by the board of directors of the FHLB. The minimum investment requirements can increase in the event the Company increases its total asset size or borrowings with the FHLB. Shares cannot be purchased or sold except between the FHLB and its members at the $100 per share par value. The Company held $6.7 million and $6.2 million of FHLB stock at September 30, 2021 and December 31, 2020, respectively. The carrying amounts of these investments are reasonable estimates of fair value because the securities are restricted to member banks and do not have a readily determinable market value. Based on management’s analysis of the FHLB’s financial condition and certain qualitative factors, management determined that the FHLB stock was not impaired at September 30, 2021 and December 31, 2020. On July 29, 2021, FHLB announced a cash dividend for the second quarter of 2021 at an annualized dividend rate of 6.00%, which was paid on August 10, 2021. For the three and nine months ended September 30, 2021, cash dividends received on FHLB capital stock in the amount of $0.1 million and $0.3 million, respectively, were recorded as non-interest income on the consolidated statements of income.

 

Note 5: Loans and Allowance for Loan Losses

 

The Company’s loan portfolio is its largest class of earning assets and typically provides higher yields than other types of earning assets. Associated with the higher yields is an inherent amount of credit risk which the Company attempts to mitigate with strong underwriting. As of September 30, 2021 and December 31, 2020, the carrying value of total loans held for investment amounted to $1.7 billion and $1.5 billion, respectively. The following table presents the balance of each major product type within the Company’s portfolio as of the dates indicated.

 

(in thousands)  September 30,
2021
   December 31,
2020
 
Real estate:          
Commercial  $1,317,060   $1,002,497 
Commercial land and development   15,726    10,600 
Commercial construction   47,511    91,760 
Residential construction   8,438    11,914 
Residential   29,354    30,431 
Farmland   55,077    50,164 
Commercial:          
Secured   137,165    138,676 
Unsecured   21,655    17,526 
Paycheck Protection Program (“PPP”)   61,499    147,965 
Consumer and other   13,528    4,921 
Subtotal   1,707,013    1,506,454 
Less: Net deferred loan fees   2,297    3,295 
Less: Allowance for loan losses   21,848    22,189 
Total loans, net  $1,682,868   $1,480,970 

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Underwriting

 

Commercial loans: Commercial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and prudently expand its business. Underwriting standards are designed to promote relationship banking rather than transactional banking. Once it is determined that the borrower’s management possesses sound ethics and solid business acumen, the Company’s management examines current and projected cash flows to determine the ability of the borrower to repay its obligations as agreed. Commercial loans are primarily made based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected, and the collateral securing these loans may fluctuate in value. Most commercial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.

 

Real estate loans: Real estate loans are subject to underwriting standards and processes similar to commercial loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts, and the repayment of these loans is generally largely dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected than other loans by conditions in the real estate markets or in the general economy. The properties securing the Company’s commercial real estate portfolio are diverse in terms of type and geographic location. This diversity helps reduce the Company’s exposure to adverse economic events that affect any single market or industry. Management monitors and evaluates commercial real estate loans based on collateral, geography, and risk grade criteria.

 

Construction loans: With respect to construction loans that the Company may originate from time to time, the Company generally requires the borrower to have had an existing relationship with the Company and have a proven record of success. Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates, and financial analysis of the developers and property owners. Construction loans are generally based upon estimates of costs and value associated with the complete project. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment substantially dependent on the ultimate success of the project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property, or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are generally considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions, and the availability of long-term financing.

 

Residential real estate loans: Residential real estate loans are underwritten based upon the borrower’s income, credit history, and collateral. To monitor and manage residential loan risk, policies and procedures are developed and modified, as needed. This activity, coupled with relatively small loan amounts that are spread across many individual borrowers, minimizes risk. Underwriting standards for home loans are heavily influenced by statutory requirements, which include, but are not limited to, a maximum loan-to-value percentage, collection remedies, the number of such loans a borrower can have at one time, and documentation requirements.

21
 

Farmland loans: Farmland loans are generally made to producers and processors of crops and livestock. Repayment is primarily from the sale of an agricultural product or service. Farmland loans are secured by real property and are susceptible to changes in market demand for specific commodities. This may be exacerbated by, among other things, industry changes, changes in the individual financial capacity of the business owner, general economic conditions, and changes in business cycles, as well as adverse weather conditions.

 

Consumer loans: The Company purchased consumer loans underwritten utilizing credit scoring analysis to supplement the underwriting process. To monitor and manage consumer loan risk, policies and procedures are developed and modified, as needed. This activity, coupled with relatively small loan amounts that are spread across many individual borrowers, minimizes risk. Underwriting standards for home equity loans are heavily influenced by statutory requirements, which include, but are not limited to, a maximum loan-to-value percentage, collection remedies, the number of such loans a borrower can have at one time, and documentation requirements.

 

Credit Quality Indicators

 

The Company has established a loan risk rating system to measure and monitor the quality of the loan portfolio. All loans are assigned a risk rating from the inception of the loan until the loan is paid off. The primary loan grades are as follows:

 

Loans rated pass: These are loans to borrowers with satisfactory financial support, repayment capacity, and credit strength. Borrowers in this category demonstrate fundamentally sound financial positions, repayment capacity, credit history, and management expertise. Loans in this category must have an identifiable and stable source of repayment and meet the Company’s policy regarding debt service coverage ratios. These borrowers are capable of sustaining normal economic, market, or operational setbacks without significant financial impacts. Financial ratios and trends are acceptable. Negative external industry factors are generally not present. The loan may be secured, unsecured, or supported by non-real estate collateral for which the value is more difficult to determine and/or marketability is more uncertain.

 

Loans rated watch: These are loans which have deficient loan quality and potentially significant issues, but losses do not appear to be imminent, and the issues are expected to be temporary in nature. The significant issues are typically: (a) a history of losses or events that threaten the borrower’s viability, (b) a property with significant depreciation and/or marketability concerns, or (c) poor or deteriorating credit, occasional late payments, and/or limited reserves but loan is generally kept current. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the Company’s credit position at some future date.

 

Loans rated substandard: These are loans which are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged (if any). Loans so classified exhibit a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. Loans are characterized by the distinct possibility that the Company may sustain some loss if the deficiencies are not corrected. The substandard loan category includes loans that management has determined not to be impaired, as well as loans that are impaired.

 

Loans rated doubtful: These are loans for which the collection or liquidation of the entire debt is highly questionable or improbable. Typically, the possibility of loss is extremely high. The losses on these loans are deferred until all pending factors have been addressed.

22
 

The following table summarizes the credit quality indicators related to the Company’s loans by class as of September 30, 2021:

 

  

(in thousands)  Pass   Watch   Substandard   Doubtful   Total 
Real estate:                         
Commercial  $1,266,349   $15,223   $35,488   $   $1,317,060 
Commercial land and development   15,726                15,726 
Commercial construction   41,611    5,900            47,511 
Residential construction   8,438                8,438 
Residential   29,175        179        29,354 
Farmland   55,077                55,077 
                          
Commercial:                         
Secured   136,011        1,154        137,165 
Unsecured   21,655                21,655 
PPP