FIRST NORTHERN COMMUNITY BANCORP
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2019 and 2018 and December 31, 2018
The accompanying unaudited condensed consolidated financial statements of First Northern Community Bancorp (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information and with the instructions to Form 10-Q and Articles 9 and 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation have been included. The results of operations for any interim period are not necessarily indicative of results expected for the full year. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018 as filed with the Securities and Exchange Commission. The preparation of financial statements in conformity with GAAP requires management 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 financial statements as well as reported amounts of revenue and expense during the reporting period. Actual results could differ from those estimates. All material intercompany balances and transactions have been eliminated in consolidation.
The most significant accounting policies followed by the Company are presented in Note 1 to the audited consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, Management has identified the allowance for loan losses accounting to be the accounting area requiring the most subjective or complex judgments, and as such the accounting area that could be most subject to revision as new information becomes available. A discussion of the factors affecting accounting for the allowance for loan losses is included in the “Asset Quality” and “Allowance for Loan Losses” discussions below. Certain amounts in prior periods have been reclassified to conform to the current presentation.
Application of these principles requires the Company to make certain estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain accounting policies inherently have a greater reliance on the use of estimates, assumptions and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment writedown or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available.
Recently Adopted Accounting Standards:
In February 2016, the Financial Accounting Standards Board (FASB) issued ASU 2016-02, Leases (Topic 842). The Company adopted ASU 2016-02 on January 1, 2019. The Company adopted the new guidance using the optional transition method provided in ASU 2018-11, Leases (Topic 842): Targeted Improvements. This modified transition method allowed the Company to initially apply the new leases standard at the adoption date and allowed the Company to continue reporting comparative periods presented in the financial statements in accordance with legacy guidance in ASC 840. See FN (11), Leases.
Recently Issued Accounting Pronouncements:
In June 2016, FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The amendments in ASU 2016-13, 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, ASU 2016-13 amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. The amendments are effective for public companies for annual periods beginning after December 15, 2019. Early application will be permitted for all organizations for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. We are currently evaluating the potential impact of ASU 2016-13 on our financial statements. In that regard, we have formed a cross-functional working group, under the direction of our Chief Financial Officer and our Chief Credit Officer. The working group is comprised of individuals from various functional areas including credit risk, finance and information technology, among others. We are currently working through our implementation plan which includes assessment and documentation of processes, internal controls and data sources; model development and documentation; and system configuration, among other things. We are also in the process of implementing a third-party vendor solution to assist us in the application of ASU 2016-13. The adoption of ASU 2016-13 could result in an increase in the allowance for loan losses as a result of changing from an “incurred loss” model, which encompasses allowances for current known and inherent losses within the portfolio, to an “expected loss” model, which encompasses allowances for losses expected to be incurred over the life of the portfolio. Furthermore, ASU 2016-13 will necessitate that we establish an allowance for expected credit losses for certain debt securities and other financial assets. While we are currently unable to reasonably estimate the impact of adopting ASU 2016-13, we expect that the impact of adoption will be significantly influenced by the composition, characteristics and quality of our loan and securities portfolios as well as the prevailing economic conditions and forecasts as of the adoption date.
In November 2018, FASB issued ASU 2018-19, Codification Improvements to Topic 326, Financial Instruments – Credit Losses. The guidance clarifies that receivables arising from operating leases are not within the scope of the credit losses standard, but rather should be accounted for in accordance with the leases standard. The effective date and transition requirements are the same as the effective dates and transition requirements in the credit losses standard, ASU 2016-13. The Company does not expect the adoption of this update to have a significant impact on its consolidated financial statements.
In March 2019, FASB issued ASU 2019-01, Leases (Topic 842): Codification Improvements. These amendments align the guidance for fair value of the underlying asset by lessors that are not manufacturers or dealers in Topic 842 with that of existing guidance (Issue 1). This ASU also requires lessors within the scope of Topic 942, Financial Services - Depository and Lending, to present all "principal payments received under leases" within investing activities (Issue 2). Finally, this ASU exempts both lessees and lessors from having to provide certain interim disclosures in the fiscal year in which a company adopts the new leases standard (Issue 3). Issue 1 and Issue 2 are effective for public companies for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. Issue 3 is effective for public companies for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company adopted Issue 3 of ASU 2019-01 on January 1, 2019, which did not have a significant impact on its consolidated financial statements. See FN (11), Leases.
3. INVESTMENT SECURITIES
The amortized cost, unrealized gains and losses and estimated fair values of investments in debt and other securities at March 31, 2019 are summarized as follows:
| (in thousands) | | Amortized cost | | | Unrealized gains | | | Unrealized losses | | | Estimated fair value | |
| | | | | | | | | | | | | |
| Investment securities available-for-sale: | | | | | | | | | | | | |
| U.S. Treasury Securities | | $ | 43,402 | | | $ | 258 | | | $ | (100 | ) | | $ | 43,560 | |
| Securities of U.S. government agencies and corporations | | | 33,670 | | | | 109 | | | | (154 | ) | | | 33,625 | |
| Obligations of states and political subdivisions | | | 22,663 | | | | 272 | | | | (72 | ) | | | 22,863 | |
| Collateralized mortgage obligations | | | 66,511 | | | | 67 | | | | (1,447 | ) | | | 65,131 | |
| Mortgage-backed securities | | | 135,755 | | | | 295 | | | | (2,580 | ) | | | 133,470 | |
| Total debt securities | | $ | 302,001 | | | $ | 1,001 | | | $ | (4,353 | ) | | $ | 298,649 | |
The amortized cost, unrealized gains and losses and estimated fair values of investments in debt and other securities at December 31, 2018 are summarized as follows:
| (in thousands) | | Amortized cost | | | Unrealized gains | | | Unrealized losses | | | Estimated fair value | |
| | | | | | | | | | | | | |
| Investment securities available-for-sale: | | | | | | | | | | | | |
| U.S. Treasury Securities | | $ | 50,825 | | | $ | 14 | | | $ | (157 | ) | | $ | 50,682 | |
| Securities of U.S. government agencies and corporations | | | 42,215 | | | | 89 | | | | (228 | ) | | | 42,076 | |
| Obligations of states and political subdivisions | | | 19,110 | | | | 181 | | | | (123 | ) | | | 19,168 | |
| Collateralized mortgage obligations | | | 65,615 | | | | 34 | | | | (1,850 | ) | | | 63,799 | |
| Mortgage-backed securities | | | 142,297 | | | | 147 | | | | (3,532 | ) | | | 138,912 | |
| Total debt securities | | $ | 320,062 | | | $ | 465 | | | $ | (5,890 | ) | | $ | 314,637 | |
The Company had $17,000,000 and $11,115,000 proceeds from calls and maturities of available-for-sale securities for the three months ended March 31, 2019 and March 31, 2018, respectively. There were no gross realized gains from sales/calls of available-for-sale securities for each of the three months ended March 31, 2019 and March 31, 2018. There were no gross realized losses from sales/calls of available-for-sale securities for each of the three months ended March 31, 2019 and March 31, 2018.
The amortized cost and estimated market value of debt and other securities at March 31, 2019, by contractual and expected maturity, are shown in the following table:
| (in thousands) | | Amortized cost | | | Estimated fair value | |
| | | | | | | |
| Maturity in years: | | | | | | |
| Due in one year or less | | $ | 37,748 | | | $ | 37,645 | |
| Due after one year through five years | | | 51,955 | | | | 52,120 | |
| Due after five years through ten years | | | 5,097 | | | | 5,303 | |
| Due after ten years | | | 4,935 | | | | 4,980 | |
| Subtotal | | | 99,735 | | | | 100,048 | |
| MBS & CMO | | | 202,266 | | | | 198,601 | |
| Total | | $ | 302,001 | | | $ | 298,649 | |
Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. In addition, factors such as prepayments and interest rates may affect the yield on the carrying value of mortgage-related securities.
An analysis of gross unrealized losses of the available-for-sale investment securities portfolio as of March 31, 2019, follows:
| | | Less than 12 months | | | 12 months or more | | | Total | |
| (in thousands) | | Fair Value | | | Unrealized losses | | | Fair Value | | | Unrealized losses | | | Fair Value | | | Unrealized losses | |
| | | | | | | | | | | | | | | | | | | |
| U.S. Treasury securities | | $ | 4,996 | | | $ | (2 | ) | | $ | 15,407 | | | $ | (98 | ) | | $ | 20,403 | | | $ | (100 | ) |
| Securities of U.S. government agencies and corporations | | | 998 | | | | (1 | ) | | | 20,576 | | | | (153 | ) | | | 21,574 | | | | (154 | ) |
| Obligations of states and political subdivisions | | | 698 | | | | (1 | ) | | | 8,591 | | | | (71 | ) | | | 9,289 | | | | (72 | ) |
| Collateralized Mortgage obligations | | | 2,048 | | | | (2 | ) | | | 51,133 | | | | (1,445 | ) | | | 53,181 | | | | (1,447 | ) |
| Mortgage-backed securities | | | 1,929 | | | | (14 | ) | | | 106,343 | | | | (2,566 | ) | | | 108,272 | | | | (2,580 | ) |
| Total | | $ | 10,669 | | | $ | (20 | ) | | $ | 202,050 | | | $ | (4,333 | ) | | $ | 212,719 | | | $ | (4,353 | ) |
No decline in value was considered “other-than-temporary” during the first three months of 2019. Twenty securities, all considered investment grade, which had a fair value of $10,669,000 and a total unrealized loss of $20,000 have been in an unrealized loss position for less than twelve months as of March 31, 2019. Two hundred five securities, all considered investment grade, which had a fair value of $202,050,000 and a total unrealized loss of $4,333,000 have been in an unrealized loss position for more than twelve months as of March 31, 2019. The unrealized losses on the Company's investment securities were caused by market conditions for these types of investments, particularly changes in risk-free interest rates. The Company does not intend to sell the securities and has concluded it is not more likely than not that we will be required to sell these securities prior to recovery of their anticipated cost basis. Therefore, the Company does not consider these investments to be other than temporarily impaired as of March 31, 2019.
The fair value of investment securities could decline in the future if the general economy deteriorates, inflation increases, credit ratings decline, the issuer's financial condition deteriorates, or the liquidity for securities declines. As a result, other than temporary impairments may occur in the future.
An analysis of gross unrealized losses of the available-for-sale investment securities portfolio as of December 31, 2018, follows:
| | | Less than 12 months | | | 12 months or more | | | Total | |
| (in thousands) | | Fair Value | | | Unrealized losses | | | Fair Value | | | Unrealized losses | | | Fair Value | | | Unrealized losses | |
| | | | | | | | | | | | | | | | | | | |
| U.S. Treasury Securities | | $ | 37,805 | | | $ | (67 | ) | | $ | 5,951 | | | $ | (90 | ) | | $ | 43,756 | | | $ | (157 | ) |
| Securities of U.S. government agencies and corporations | | | 16,959 | | | | (39 | ) | | | 13,540 | | | | (189 | ) | | | 30,499 | | | | (228 | ) |
| Obligations of states and political subdivisions | | | 847 | | | | (2 | ) | | | 9,134 | | | | (121 | ) | | | 9,981 | | | | (123 | ) |
| Collateralized Mortgage obligations | | | 2,217 | | | | (6 | ) | | | 53,217 | | | | (1,844 | ) | | | 55,434 | | | | (1,850 | ) |
| Mortgage-backed securities | | | 16,358 | | | | (123 | ) | | | 105,361 | | | | (3,409 | ) | | | 121,719 | | | | (3,532 | ) |
| Total | | $ | 74,186 | | | $ | (237 | ) | | $ | 187,203 | | | $ | (5,653 | ) | | $ | 261,389 | | | $ | (5,890 | ) |
Investment securities carried at $34,363,000 and $36,781,000 at March 31, 2019 and December 31, 2018, respectively, were pledged to secure public deposits or for other purposes as required or permitted by law.
4. LOANS
The composition of the Company’s loan portfolio, by loan class, as of March 31, 2019 and December 31, 2018 was as follows:
| ($ in thousands) | | March 31, 2019 | | | December 31, 2018 | |
| | | | | | | |
| Commercial | | $ | 113,575 | | | $ | 125,177 | |
| Commercial Real Estate | | | 419,540 | | | | 420,106 | |
| Agriculture | | | 109,749 | | | | 123,626 | |
| Residential Mortgage | | | 51,682 | | | | 51,064 | |
| Residential Construction | | | 17,626 | | | | 20,124 | |
| Consumer | | | 31,435 | | | | 35,397 | |
| | | | 743,607 | | | | 775,494 | |
| Allowance for loan losses | | | (12,746 | ) | | | (12,822 | ) |
| Net deferred origination fees and costs | | | 744 | | | | 721 | |
| Loans, net | | $ | 731,605 | | | $ | 763,393 | |
The Company manages asset quality and credit risk by maintaining diversification in its loan portfolio and through review processes that include analysis of credit requests and ongoing examination of outstanding loans and delinquencies, with particular attention to portfolio dynamics and loan mix. The Company strives to identify loans experiencing difficulty early enough to correct the problems, to record charge-offs promptly based on realistic assessments of collectability and current collateral values and to maintain an adequate allowance for loan losses at all times. Asset quality reviews of loans and other non-performing assets are administered using credit risk rating standards and criteria similar to those employed by state and federal banking regulatory agencies.
Commercial loans, whether secured or unsecured, generally are made to support the short-term operations and other needs of small businesses. These loans are generally secured by the receivables, equipment, and other real property of the business and are susceptible to the related risks described above. Problem commercial loans are generally identified by periodic review of financial information that may include financial statements, tax returns, and payment history of the borrower. Based on this information, the Company may decide to take any of several courses of action, including demand for repayment, requiring the borrower to provide a significant principal payment and/or additional collateral or requiring similar support from guarantors. Notwithstanding, when repayment becomes unlikely based on the borrower's income and cash flow, repossession or foreclosure of the underlying collateral may become necessary. Collateral values may be determined by appraisals obtained through Bank-approved, licensed appraisers, qualified independent third parties, purchase invoices, or other appropriate documentation.
Commercial real estate loans generally fall into two categories, owner-occupied and non-owner occupied. Loans secured by owner-occupied real estate are primarily susceptible to changes in the market conditions of the related business. This may be driven by, among other things, industry changes, geographic business changes, changes in the individual financial capacity of the business owner, general economic conditions and changes in business cycles. These same risks apply to Commercial loans whether secured by equipment, receivables or other personal property or unsecured. Problem commercial real estate loans are generally identified by periodic review of financial information that may include financial statements, tax returns, payment history of the borrower, and site inspections. Based on this information, the Company may decide to take any of several courses of action, including demand for repayment, requiring the borrower to provide a significant principal payment and/or additional collateral or requiring similar support from guarantors. Notwithstanding, when repayment becomes unlikely based on the borrower's income and cash flow, repossession or foreclosure of the underlying collateral may become necessary. Losses on loans secured by owner occupied real estate, equipment, or other personal property generally are dictated by the value of underlying collateral at the time of default and liquidation of the collateral. When default is driven by issues related specifically to the business owner, collateral values tend to provide better repayment support and may result in little or no loss. Alternatively, when default is driven by more general economic conditions, underlying collateral generally has devalued more and results in larger losses due to default. Loans secured by non-owner occupied real estate are primarily susceptible to risks associated with swings in occupancy or vacancy and related shifts in lease rates, rental rates or room rates. Most often, these shifts are a result of changes in general economic or market conditions or overbuilding and resulting over-supply of space. Losses are dependent on the value of underlying collateral at the time of default. Values are generally driven by these same factors and influenced by interest rates and required rates of return as well as changes in occupancy costs. Collateral values may be determined by appraisals obtained through Bank-approved, licensed appraisers, qualified independent third parties, sales invoices, or other appropriate means.
Agricultural loans, whether secured or unsecured, generally are made to producers and processors of crops and livestock. Repayment is primarily from the sale of an agricultural product or service. Agricultural loans are generally secured by inventory, receivables, equipment, and other real property. Agricultural loans primarily 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 such as drought or floods. Problem agricultural loans are generally identified by periodic review of financial information that may include financial statements, tax returns, crop budgets, payment history, and crop inspections. Based on this information, the Company may decide to take any of several courses of action, including demand for repayment, requiring the borrower to provide a significant principal payment and/or additional collateral or requiring similar support from guarantors. Notwithstanding, when repayment becomes unlikely based on the borrower's income and cash flow, repossession or foreclosure of the underlying collateral may become necessary.
Residential mortgage loans, which are secured by real estate, are primarily susceptible to four risks; non-payment due to diminished or lost income, over-extension of credit, a lack of borrower's cash flow to sustain payments, and shortfalls in collateral value. In general, non-payment is usually due to loss of employment and follows general economic trends in the economy, particularly the upward movement in the unemployment rate, loss of collateral value, and demand shifts.
Construction loans, whether owner-occupied or non-owner occupied residential development loans, are not only susceptible to the related risks described above but the added risks of construction, including cost over-runs, mismanagement of the project, or lack of demand and market changes experienced at time of completion. Losses are primarily related to underlying collateral value and changes therein as described above. Problem construction loans are generally identified by periodic review of financial information that may include financial statements, tax returns and payment history of the borrower. Based on this information, the Company may decide to take any of several courses of action, including demand for repayment, requiring the borrower to provide a significant principal payment and/or additional collateral or requiring similar support from guarantors, or repossession or foreclosure of the underlying collateral. Collateral values may be determined by appraisals obtained through Bank-approved, licensed appraisers, qualified independent third parties, purchase invoices, or other appropriate documentation.
Consumer loans, whether unsecured or secured, are primarily susceptible to four risks: non-payment due to diminished or lost income, over-extension of credit, a lack of borrower's cash flow to sustain payments, and shortfall in collateral value. In general, non-payment is usually due to loss of employment and will follow general economic trends in the economy, particularly the upward movements in the unemployment rate, loss of collateral value, and demand shifts.
Collateral values may be determined by appraisals obtained through Bank-approved, licensed appraisers, qualified independent third parties, purchase invoices, or other appropriate documentation. Collateral valuations are obtained at origination of the credit and periodically thereafter (generally annually but may be more frequent depending on the collateral type), once repayment is questionable, and the loan has been deemed classified.
As of March 31, 2019, approximately 15% in principal amount of the Company's loans were for general commercial uses, including professional, retail and small businesses. Approximately 57% in principal amount of the Company’s loans were secured by commercial real estate, consisting primarily of loans secured by commercial properties and construction and land development loans. Approximately 15% in principal amount of the Company's loans were for agriculture, approximately 7% in principal amount of the Company’s loans were residential mortgage loans, approximately 2% in principal amount of the Company’s loans were residential construction loans and approximately 4% in principal amount of the Company’s loans were consumer loans.
Once a loan becomes delinquent or repayment becomes questionable, a Company collection officer will address collateral shortfalls with the borrower and attempt to obtain additional collateral or a principal payment. If this is not forthcoming and payment of principal and interest in accordance with the contractual terms of the loan agreement becomes unlikely, the Company will consider the loan to be impaired and will estimate its probable loss, using the present value of future cash flows discounted at the loan's effective interest rate, the loan's observable market price, or the fair value of the collateral if the loan is collateral dependent. For collateral dependent loans, the Company will utilize a recent valuation of the underlying collateral less estimated costs of sale, and charge-off the loan down to the estimated net realizable amount. Depending on the length of time until final collection, the Company may periodically revalue the estimated loss and take additional charge-offs or specific reserves as warranted. Revaluations may occur as often as every 3-12 months depending on the underlying collateral and volatility of values. Final charge-offs or recoveries are taken when the collateral is liquidated and the actual loss is confirmed. Unpaid balances on loans after or during collection and liquidation may also be pursued through legal action and attachment of wages or judgment liens on the borrower's other assets.
At March 31, 2019 and December 31, 2018, all loans were pledged under a blanket collateral lien to secure actual and potential borrowings from the Federal Home Loan Bank (“FHLB”).
Non-accrual and Past Due Loans
The Company’s loans by delinquency and non-accrual status, as of March 31, 2019 and December 31, 2018, were as follows:
| ($ in thousands) | | Current & Accruing | | | 30-59 Days Past Due & Accruing | | | 60-89 Days Past Due & Accruing | | | 90 Days or more Past Due & Accruing | | | Nonaccrual | | | Total Loans | |
| March 31, 2019 | | | | | | | | | | | | | | | | | | |
| Commercial | | $ | 111,929 | | | $ | 771 | | | $ | — | | | $ | 662 | | | $ | 213 | | | $ | 113,575 | |
| Commercial Real Estate | | | 419,173 | | | | — | | | | — | | | | — | | | | 367 | | | | 419,540 | |
| Agriculture | | | 104,791 | | | | 180 | | | | — | | | | — | | | | 4,778 | | | | 109,749 | |
| Residential Mortgage | | | 51,408 | | | | 177 | | | | — | | | | — | | | | 97 | | | | 51,682 | |
| Residential Construction | | | 17,626 | | | | — | | | | — | | | | — | | | | — | | | | 17,626 | |
| Consumer | | | 30,983 | | | | 150 | | | | 110 | | | | — | | | | 192 | | | | 31,435 | |
| Total | | $ | 735,910 | | | $ | 1,278 | | | $ | 110 | | | $ | 662 | | | $ | 5,647 | | | $ | 743,607 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2018 | | | | | | | | | | | | | | | | | | | | | | | | |
| Commercial | | $ | 123,765 | | | $ | 662 | | | $ | — | | | $ | — | | | $ | 750 | | | $ | 125,177 | |
| Commercial Real Estate | | | 419,725 | | | | — | | | | — | | | | — | | | | 381 | | | | 420,106 | |
| Agriculture | | | 118,639 | | | | 157 | | | | — | | | | — | | | | 4,830 | | | | 123,626 | |
| Residential Mortgage | | | 50,964 | | | | — | | | | — | | | | — | | | | 100 | | | | 51,064 | |
| Residential Construction | | | 20,124 | | | | — | | | | — | | | | — | | | | — | | | | 20,124 | |
| Consumer | | | 35,054 | | | | 114 | | | | 38 | | | | — | | | | 191 | | | | 35,397 | |
| Total | | $ | 768,271 | | | $ | 933 | | | $ | 38 | | | $ | — | | | $ | 6,252 | | | $ | 775,494 | |
Non-accrual loans amounted to $5,647,000 at March 31, 2019 and were comprised of one commercial loan totaling $213,000, two commercial real estate loans totaling $367,000, five agriculture loans totaling $4,778,000, two residential mortgage loans totaling $97,000 and two consumer loans totaling $192,000. The Company had one commercial loan totaling $662,000 that was 90 days or more past due and still accruing at March 31, 2019. Non-accrual loans amounted to $6,252,000 at December 31, 2018 and were comprised of two commercial loans totaling $750,000, two commercial real estate loans totaling $381,000, five agriculture loans totaling $4,830,000, two residential mortgage loans totaling $100,000, and one consumer loan totaling $191,000. All non-accrual loans are measured for impairment based upon the present value of future cash flows discounted at the loan's effective interest rate, the loan's observable market price, or the fair value of collateral, if the loan is collateral dependent. If the measurement of the non-accrual loan is less than the recorded investment in the loan, an impairment is recognized through the establishment of a specific reserve sufficient to cover expected losses and/or a charge-off against the allowance for loan losses. If the loan is considered to be collateral dependent, it is generally the Company's policy to charge-off the portion of any non-accrual loan that the Company does not expect to collect by writing the loan down to the estimated net realizable value of the underlying collateral. There were no commitments to lend additional funds to borrowers whose loans were on non-accrual status at March 31, 2019.
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 amounts due according to the contractual terms of the loan agreement, including scheduled interest payments. Loans to be considered for impairment include non-accrual loans, troubled debt restructurings and loans with a risk rating of 5 (special mention) or worse and an aggregate exposure of $500,000 or more. Once identified, impaired loans are measured individually for impairment using one of three methods: present value of expected cash flows discounted at the loan's effective interest rate; the loan's observable market price; or fair value of collateral if the loan is collateral dependent. In general, any portion of the recorded investment in a collateral dependent loan in excess of the fair value of the collateral that can be identified as uncollectible, and is, therefore, deemed a confirmed loss, is promptly charged-off against the allowance for loan losses.
Impaired loans, segregated by loan class, as of March 31, 2019 and December 31, 2018 were as follows:
| ($ in thousands) | | Unpaid Contractual Principal Balance | | | Recorded Investment with no Allowance | | | Recorded Investment with Allowance | | | Total Recorded Investment | | | Related Allowance | |
| March 31, 2019 | | | | | | | | | | | | | | | |
| Commercial | | $ | 2,930 | | | $ | 213 | | | $ | 1,961 | | | $ | 2,174 | | | $ | 37 | |
| Commercial Real Estate | | | 767 | | | | 367 | | | | 258 | | | | 625 | | | | 21 | |
| Agriculture | | | 4,779 | | | | 4,779 | | | | — | | | | 4,779 | | | | — | |
| Residential Mortgage | | | 1,471 | | | | 96 | | | | 1,255 | | | | 1,351 | | | | 267 | |
| Residential Construction | | | 743 | | | | — | | | | 743 | | | | 743 | | | | 48 | |
| Consumer | | | 400 | | | | 192 | | | | 191 | | | | 383 | | | | 2 | |
| Total | | $ | 11,090 | | | $ | 5,647 | | | $ | 4,408 | | | $ | 10,055 | | | $ | 375 | |
| | | | | | | | | | | | | | | | | | | | | |
| December 31, 2018 | | | | | | | | | | | | | | | | | | | | |
| Commercial | | $ | 3,591 | | | $ | 300 | | | $ | 2,602 | | | $ | 2,902 | | | $ | 496 | |
| Commercial Real Estate | | | 780 | | | | 381 | | | | 261 | | | | 642 | | | | 21 | |
| Agriculture | | | 4,830 | | | | 4,830 | | | | — | | | | 4,830 | | | | — | |
| Residential Mortgage | | | 1,669 | | | | 100 | | | | 1,451 | | | | 1,551 | | | | 287 | |
| Residential Construction | | | 560 | | | | — | | | | 560 | | | | 560 | | | | 49 | |
| Consumer | | | 403 | | | | 191 | | | | 198 | | | | 389 | | | | 2 | |
| Total | | $ | 11,833 | | | $ | 5,802 | | | $ | 5,072 | | | $ | 10,874 | | | $ | 855 | |
The average recorded investment in impaired loans and the amount of interest income recognized on impaired loans during the three months ended March 31, 2019 and March 31, 2018 was as follows:
| ($ in thousands) | | Three Months Ended March 31, 2019 | | | Three Months Ended March 31, 2018 | |
| | | Average Recorded Investment | | | Interest Income Recognized | | | Average Recorded Investment | | | Interest Income Recognized | |
| Commercial | | $ | 2,538 | | | $ | 42 | | | $ | 3,425 | | | $ | 46 | |
| Commercial Real Estate | | | 634 | | | | 4 | | | | 1,971 | | | | 4 | |
| Agriculture | | | 4,804 | | | | — | | | | — | | | | — | |
| Residential Mortgage | | | 1,451 | | | | 12 | | | | 2,234 | | | | 15 | |
| Residential Construction | | | 652 | | | | 9 | | | | 647 | | | | 9 | |
| Consumer | | | 386 | | | | 3 | | | | 470 | | | | 3 | |
| Total | | $ | 10,465 | | | $ | 70 | | | $ | 8,747 | | | $ | 77 | |
Troubled Debt Restructurings
The Company's loan portfolio includes certain loans that have been modified in a Troubled Debt Restructuring ("TDR"), which are loans on which concessions in terms have been granted because of the borrowers' financial difficulties and, as a result, the Company receives less than the current market-based compensation for the loan. These concessions may include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance, or other actions. Certain TDRs are placed on non-accrual status at the time of restructure and may be returned to accruing status after considering the borrower's sustained repayment performance for a reasonable period, generally six months.
When a loan is modified, it is measured based upon the present value of future cash flows discounted at the contractual interest rate of the original loan agreement, or the fair value of collateral less selling costs if the loan is collateral dependent. If the value of the modified loan is less than the recorded investment in the loan, impairment is recognized through a specific allowance or a charge-off of the loan.
The Company had $4,591,000 and $4,813,000 in TDR loans as of March 31, 2019 and December 31, 2018, respectively. Specific reserves for TDR loans totaled $375,000 and $405,000 as of March 31, 2019 and December 31, 2018, respectively. TDR loans performing in compliance with modified terms totaled $4,408,000 and $4,622,000 as of March 31, 2019 and December 31, 2018, respectively. There were no commitments to advance additional funds on existing TDR loans as of March 31, 2019.
Loans modified as TDRs during the three months ended March 31, 2019 were as follows:
| | | Three Months Ended March 31, 2019 | |
| | | Number of Contracts | | | Pre-modification outstanding recorded investment | | | Post-modification outstanding recorded investment | |
| | | | | | | | | | | | |
| | | | | | | | | | | | |
There were no loans modified as TDRs during the three months ended March 31, 2018.
Loan modifications generally involve reductions in the interest rate, payment extensions, forgiveness of principal, or forbearance. There were no loans modified as a TDR within the previous twelve months and for which there was a payment default during the three months ended March 31, 2019 and March 31, 2018.
Credit Quality Indicators
All loans are rated using the credit risk ratings and criteria adopted by the Company. Risk ratings are adjusted as future circumstances warrant. All credits risk rated 1, 2, 3 or 4 equate to a Pass as indicated by Federal and State bank regulatory agencies; a 5 equates to a Special Mention; a 6 equates to Substandard; a 7 equates to Doubtful; and an 8 equates to a Loss. For the definitions of each risk rating, see Note 4 to our consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2018.
The following table presents the risk ratings by loan class as of March 31, 2019 and December 31, 2018:
| ($ in thousands) | | Pass | | | Special Mention | | | Substandard | | | Doubtful | | | Loss | | | Total | |
| March 31, 2019 | | | | | | | | | | | | | | | | | | |
| Commercial | | $ | 110,899 | | | $ | 510 | | | $ | 2,166 | | | $ | — | | | $ | — | | | $ | 113,575 | |
| Commercial Real Estate | | | 396,130 | | | | 14,753 | | | | 8,657 | | | | — | | | | — | | | | 419,540 | |
| Agriculture | | | 89,670 | | | | 13,139 | | | | 6,940 | | | | — | | | | — | | | | 109,749 | |
| Residential Mortgage | | | 51,121 | | | | — | | | | 561 | | | | — | | | | — | | | | 51,682 | |
| Residential Construction | | | 17,626 | | | | — | | | | — | | | | — | | | | — | | | | 17,626 | |
| Consumer | | | 30,595 | | | | 538 | | | | 302 | | | | — | | | | — | | | | 31,435 | |
| Total | | $ | 696,041 | | | $ | 28,940 | | | $ | 18,626 | | | $ | — | | | $ | — | | | $ | 743,607 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2018 | | | | | | | | | | | | | | | | | | | | | | | | |
| Commercial | | $ | 121,848 | | | $ | 66 | | | $ | 2,813 | | | $ | 450 | | | $ | — | | | $ | 125,177 | |
| Commercial Real Estate | | | 395,436 | | | | 14,272 | | | | 10,398 | | | | — | | | | — | | | | 420,106 | |
| Agriculture | | | 104,809 | | | | 11,750 | | | | 7,067 | | | | — | | | | — | | | | 123,626 | |
| Residential Mortgage | | | 50,149 | | | | — | | | | 915 | | | | — | | | | — | | | | 51,064 | |
| Residential Construction | | | 19,372 | | | | 752 | | | | — | | | | — | | | | — | | | | 20,124 | |
| Consumer | | | 34,272 | | | | 590 | | | | 535 | | | | — | | | | — | | | | 35,397 | |
| Total | | $ | 725,886 | | | $ | 27,430 | | | $ | 21,728 | | | $ | 450 | | | $ | — | | | $ | 775,494 | |
Allowance for Loan Losses
The following tables detail activity in the allowance for loan losses and the amount allocated to individually and collectively evaluated for impairment by loan class for the three months ended March 31, 2019 and March 31, 2018:
| Three months ended March 31, 2019 | |
| ($ in thousands) | | Commercial | | | Commercial Real Estate | | | Agriculture | | | Residential Mortgage | | | Residential Construction | | | Consumer | | | Unallocated | | | Total | |
| Balance as of December 31, 2018 | | $ | 3,198 | | | $ | 5,890 | | | $ | 1,632 | | | $ | 643 | | | $ | 318 | | | $ | 279 | | | $ | 862 | | | $ | 12,822 | |
| Provision for (reversal of) loan losses | | | (568 | ) | | | 496 | | | | 202 | | | | (197 | ) | | | (102 | ) | | | — | | | | 169 | | | | — | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Charge-offs | | | (150 | ) | | | — | | | | — | | | | — | | | | — | | | | (7 | ) | | | — | | | | (157 | ) |
| Recoveries | | | 19 | | | | — | | | | — | | | | 56 | | | | 1 | | | | 5 | | | | — | | | | 81 | |
| Net charge-offs | | | (131 | ) | | | — | | | | — | | | | 56 | | | | 1 | | | | (2 | ) | | | — | | | | (76 | ) |
| Balance as of March 31, 2019 | | $ | 2,499 | | | $ | 6,386 | | | $ | 1,834 | | | $ | 502 | | | $ | 217 | | | $ | 277 | | | $ | 1,031 | | | $ | 12,746 | |
| Period-end amount allocated to: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Loans individually evaluated for impairment | | | 37 | | | | 21 | | | | — | | | | 267 | | | | 48 | | | | 2 | | | | — | | | | 375 | |
| Loans collectively evaluated for impairment | | | 2,462 | | | | 6,365 | | | | 1,834 | | | | 235 | | | | 169 | | | | 275 | | | | 1,031 | | | | 12,371 | |
| Balance as of March 31, 2019 | | $ | 2,499 | | | $ | 6,386 | | | $ | 1,834 | | | $ | 502 | | | $ | 217 | | | $ | 277 | | | $ | 1,031 | | | $ | 12,746 | |
| Three months ended March 31, 2018 | |
| ($ in thousands) | | Commercial | | | Commercial Real Estate | | | Agriculture | | | Residential Mortgage | | | Residential Construction | | | Consumer | | | Unallocated | | | Total | |
| Balance as of December 31, 2017 | | $ | 2,625 | | | $ | 5,460 | | | $ | 1,547 | | | $ | 628 | | | $ | 360 | | | $ | 342 | | | $ | 171 | | | $ | 11,133 | |
| Provision for (reversal of) loan losses | | | (85 | ) | | | (46 | ) | | | (124 | ) | | | (1 | ) | | | (13 | ) | | | (68 | ) | | | 862 | | | | 525 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Charge-offs | | | — | | | | — | | | | — | | | | — | | | | — | | | | (6 | ) | | | — | | | | (6 | ) |
| Recoveries | | | 9 | | | | — | | | | — | | | | 16 | | | | 1 | | | | 37 | | | | — | | | | 63 | |
| Net recoveries | | | 9 | | | | — | | | | — | | | | 16 | | | | 1 | | | | 31 | | | | — | | | | 57 | |
| Balance as of March 31, 2018 | | $ | 2,549 | | | $ | 5,414 | | | $ | 1,423 | | | $ | 643 | | | $ | 348 | | | $ | 305 | | | $ | 1,033 | | | $ | 11,715 | |
| Period-end amount allocated to: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Loans individually evaluated for impairment | | | 47 | | | | 36 | | | | — | | | | 309 | | | | 71 | | | | 4 | | | | — | | | | 467 | |
| Loans collectively evaluated for impairment | | | 2,502 | | | | 5,378 | | | | 1,423 | | | | 334 | | | | 277 | | | | 301 | | | | 1,033 | | | | 11,248 | |
| Balance as of March 31, 2018 | | $ | 2,549 | | | $ | 5,414 | | | $ | 1,423 | | | $ | 643 | | | $ | 348 | | | $ | 305 | | | $ | 1,033 | | | $ | 11,715 | |
The following table details activity in the allowance for loan losses and the amount allocated to loans individually and collectively evaluated for impairment by loan class as of and for the period ended December 31, 2018.
| Year ended December 31, 2018 | |
| ($ in thousands) | | Commercial | | | Commercial Real Estate | | | Agriculture | | | Residential Mortgage | | | Residential Construction | | | Consumer | | | Unallocated | | | Total | |
| Balance as of December 31, 2017 | | $ | 2,625 | | | $ | 5,460 | | | $ | 1,547 | | | $ | 628 | | | $ | 360 | | | $ | 342 | | | $ | 171 | | | $ | 11,133 | |
| Provision for (reversal of) loan losses | | | 1,036 | | | | 572 | | | | 85 | | | | (19 | ) | | | (173 | ) | | | (92 | ) | | | 691 | | | | 2,100 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Charge-offs | | | (509 | ) | | | (142 | ) | | | — | | | | — | | | | — | | | | (34 | ) | | | — | | | | (685 | ) |
| Recoveries | | | 46 | | | | — | | | | — | | | | 34 | | | | 131 | | | | 63 | | | | — | | | | 274 | |
| Net charge-offs | | | (463 | ) | | | (142 | ) | | | — | | | | 34 | | | | 131 | | | | 29 | | | | — | | | | (411 | ) |
| Ending Balance | | | 3,198 | | | | 5,890 | | | | 1,632 | | | | 643 | | | | 318 | | | | 279 | | | | 862 | | | | 12,822 | |
| Period-end amount allocated to: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Loans individually evaluated for impairment | | | 496 | | | | 21 | | | | — | | | | 287 | | | | 49 | | | | 2 | | | | — | | | | 855 | |
| Loans collectively evaluated for impairment | | | 2,702 | | | | 5,869 | | | | 1,632 | | | | 356 | | | | 269 | | | | 277 | | | | 862 | | | | 11,967 | |
| Balance as of December 31, 2018 | | $ | 3,198 | | | $ | 5,890 | | | $ | 1,632 | | | $ | 643 | | | $ | 318 | | | $ | 279 | | | $ | 862 | | | $ | 12,822 | |
The Company’s investment in loans as of March 31, 2019, March 31, 2018, and December 31, 2018 related to each balance in the allowance for loan losses by loan class and disaggregated on the basis of the Company’s impairment methodology was as follows:
| ($ in thousands) | | Commercial | | | Commercial Real Estate | | | Agriculture | | | Residential Mortgage | | | Residential Construction | | | Consumer | | | Total | |
| March 31, 2019 | |
| Loans individually evaluated for impairment | | $ | 2,174 | | | $ | 625 | | | $ | 4,779 | | | $ | 1,351 | | | $ | 743 | | | $ | 383 | | | $ | 10,055 | |
| Loans collectively evaluated for impairment | | | 111,401 | | | | 418,915 | | | | 104,970 | | | | 50,331 | | | | 16,883 | | | | 31,052 | | | | 733,552 | |
| Ending Balance | | $ | 113,575 | | | $ | 419,540 | | | $ | 109,749 | | | $ | 51,682 | | | $ | 17,626 | | | $ | 31,435 | | | $ | 743,607 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| March 31, 2018 | |
| Loans individually evaluated for impairment | | $ | 3,191 | | | $ | 1,946 | | | $ | — | | | $ | 2,192 | | | $ | 644 | | | $ | 523 | | | $ | 8,496 | |
| Loans collectively evaluated for impairment | | | 127,558 | | | | 391,964 | | | | 104,104 | | | | 42,596 | | | | 20,110 | | | | 36,407 | | | | 722,739 | |
| Ending Balance | | $ | 130,749 | | | $ | 393,910 | | | $ | 104,104 | | | $ | 44,788 | | | $ | 20,754 | | | $ | 36,930 | | | $ | 731,235 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2018 | |
| Loans individually evaluated for impairment | | $ | 2,902 | | | $ | 642 | | | $ | 4,830 | | | $ | 1,551 | | | $ | 560 | | | $ | 389 | | | $ | 10,874 | |
| Loans collectively evaluated for impairment | | | 122,275 | | | | 419,464 | | | | 118,796 | | | | 49,513 | | | | 19,564 | | | | 35,008 | | | | 764,620 | |
| Ending Balance | | $ | 125,177 | | | $ | 420,106 | | | $ | 123,626 | | | $ | 51,064 | | | $ | 20,124 | | | $ | 35,397 | | | $ | 775,494 | |
5. MORTGAGE OPERATIONS
Transfers and servicing of financial assets and extinguishments of liabilities are accounted for and reported based on consistent application of a financial-components approach that focuses on control. Transfers of financial assets that are sales are distinguished from transfers that are secured borrowings. Retained interests (mortgage servicing rights) in loans sold are measured by allocating the previous carrying amount of the transferred assets between the loans sold and retained interests, if any, based on their relative fair value at the date of transfer. Fair values are estimated using discounted cash flows based on a current market interest rate.
The Company recognizes a gain and a related asset for the fair value of the rights to service loans for others when loans are sold. The Company sold substantially its entire portfolio of conforming long-term residential mortgage loans originated during the three months ended March 31, 2019 for cash proceeds equal to the fair value of the loans. At March 31, 2019, and December 31, 2018, the Company serviced real estate mortgage loans for others totaling $211,229,000 and $211,845,000, respectively.
The recorded value of mortgage servicing rights is amortized in proportion to, and over the period of, estimated net servicing revenues. The Company assesses capitalized mortgage servicing rights for impairment based upon the fair value of those rights at each reporting date. For purposes of measuring impairment, the rights are stratified based upon the product type, term and interest rates. Fair value is determined by discounting estimated net future cash flows from mortgage servicing activities using discount rates that approximate current market rates and estimated prepayment rates, among other assumptions. The amount of impairment recognized, if any, is the amount by which the capitalized mortgage servicing rights for a stratum exceeds their fair value. Impairment, if any, is recognized through a valuation allowance for each individual stratum. Changes in the carrying amount of mortgage servicing rights are reported in earnings under other operating income on the condensed consolidated statements of income.
Key assumptions used in measuring the fair value of mortgage servicing rights as of March 31, 2019 and December 31, 2018 were as follows:
| | March 31, 2019 | | December 31, 2018 |
| | | | |
| Constant prepayment rate | | 9.00% | | | 8.58% |
| Discount rate | | 10.01% | | | 10.01% |
| Weighted average life (years) | | 6.60 | | | 6.79 |
The following table summarizes the Company’s mortgage servicing rights assets as of March 31, 2019 and December 31, 2018. Mortgage servicing rights are included in Interest Receivable and Other Assets on the condensed consolidated balance sheets:
| | | (in thousands) | |
| | | December 31, 2018 | | | Additions | | | Reductions | | | March 31, 2019 | |
| | | | | | | | | | | | | |
| Mortgage servicing rights | | $ | 1,579 | | | $ | 25 | | | $ | (68 | ) | | $ | 1,536 | |
| Valuation allowance | | | — | | | | — | | | | — | | | | — | |
| Mortgage servicing rights, net of valuation allowance | | $ | 1,579 | | | $ | 25 | | | $ | (68 | ) | | $ | 1,536 | |
At March 31, 2019 and December 31, 2018, the estimated fair market value of the Company’s mortgage servicing rights asset was $1,953,000 and $2,091,000, respectively.
The Company received contractually specified servicing fees of $133,000 and $139,000 for the three months ended March 31, 2019 and March 31, 2018, respectively. Contractually specified servicing fees are included in non-interest income on the condensed consolidated statements of income, net of the amortization of the mortgage servicing rights asset.
6. FAIR VALUE MEASUREMENTS
The Company utilizes fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Securities available-for-sale and trading securities are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a non-recurring basis, such as loans held-for-sale, loans held-for-investment and certain other assets. These non-recurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets. Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally corresponds with the Company’s quarterly valuation process.
Assets Recorded at Fair Value on a Recurring Basis
The table below presents the recorded amount of assets and liabilities measured at fair value on a recurring basis as of March 31, 2019:
| | | (in thousands) | |
| March 31, 2019 | | Fair Value | | | Quoted Prices in Active Markets for Identical Assets (Level 1) | | | Significant Other Observable Inputs (Level 2) | | | Significant Unobservable Inputs (Level 3) | |
| U.S. Treasury securities | | $ | 43,560 | | | $ | 43,560 | | | $ | — | | | $ | — | |
| Securities of U.S. government agencies and corporations | | | 33,625 | | | | — | | | | 33,625 | | | | — | |
| Obligations of states and political subdivisions | | | 22,863 | | | | — | | | | 22,863 | | | | — | |
| Collateralized mortgage obligations | | | 65,131 | | | | — | | | | 65,131 | | | | — | |
| Mortgage-backed securities | | | 133,470 | | | | — | | | | 133,470 | | | | — | |
| Total investments at fair value | | $ | 298,649 | | | $ | 43,560 | | | $ | 255,089 | | | $ | — | |
There were no transfers of assets measured at fair value on a recurring basis between level 1 and level 2 of the fair value hierarchy.
The table below presents the recorded amount of assets and liabilities measured at fair value on a recurring basis as of December 31, 2018:
| | | (in thousands) | |
| December 31, 2018 | | Fair Value | | | Quoted Prices in Active Markets for Identical Assets (Level 1) | | | Significant Other Observable Inputs (Level 2) | | | Significant Unobservable Inputs (Level 3) | |
| U.S. Treasury securities | | $ | 50,682 | | | $ | 50,682 | | | $ | — | | | $ | — | |
| Securities of U.S. government agencies and corporations | | | 42,076 | | | | — | | | | 42,076 | | | | — | |
| Obligations of states and political subdivisions | | | 19,168 | | | | — | | | | 19,168 | | | | — | |
| Collateralized mortgage obligations | | | 63,799 | | | | — | | | | 63,799 | | | | — | |
| Mortgage-backed securities | | | 138,912 | | | | — | | | | 138,912 | | | | — | |
| Total investments at fair value | | $ | 314,637 | | | $ | 50,682 | | | $ | 263,955 | | | $ | — | |
Assets Recorded at Fair Value on a Non-Recurring Basis
Assets measured at fair value on a non-recurring basis are included in the table below by level within the fair value hierarchy as of March 31, 2019 and December 31, 2018:
| | | (in thousands) | |
| March 31, 2019 | | Carrying Value | | | Level 1 | | | Level 2 | | | Level 3 | |
| Other real estate owned | | $ | 1,092 | | | $ | — | | | $ | — | | | $ | 1,092 | |
| Total assets at fair value | | $ | 1,092 | | | $ | — | | | $ | — | | | $ | 1,092 | |
| | | (in thousands) | |
| December 31, 2018 | | Carrying Value | | | Level 1 | | | Level 2 | | | Level 3 | |
| Impaired loans | | $ | 300 | | | $ | — | | | $ | — | | | $ | 300 | |
| Other real estate owned | | | 1,092 | | | | — | | | | — | | | | 1,092 | |
| Total assets at fair value | | $ | 1,392 | | | $ | — | | | $ | — | | | $ | 1,392 | |
There were no liabilities measured at fair value on a recurring or non-recurring basis as of March 31, 2019 and December 31, 2018.
Key methods and assumptions used in measuring the fair value of impaired loans and other real estate owned as of December 31, 2018 were as follows:
| | Method | Assumption Inputs |
| | | |
| Impaired loans | Collateral, market, income, enterprise, liquidation and discounted Cash Flows | External appraised values, management assumptions regarding market trends or other relevant factors, selling costs generally ranging from 6% to 10%, or the amount and timing of cash flows based on the loan's effective interest rate. |
| Other real estate owned | Collateral | External appraised values, management assumptions regarding market trends or other relevant factors, selling costs generally ranging from 6% to 10%. |
The following section describes the valuation methodologies used for assets and liabilities recorded at fair value.
Investment Securities Available-for-Sale
Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, if available. If quoted market prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions, and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets where valuations include significant unobservable assumptions.
Impaired Loans
The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, the Company measures impairment. The fair value of impaired loans is estimated using one of several methods, including the present value of expected cash flows discounted at the loan's effective interest rate, the loan's observable market price, or the fair value of the collateral if the loan is collateral dependent. Those impaired loans not requiring charge-off or specific allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans.
At December 31, 2018, certain impaired loans were considered collateral dependent and were evaluated based on the fair value of the underlying collateral securing the loan. Impaired loans where a charge-off is recorded based on the fair value of collateral require classification in the fair value hierarchy. When a loan is evaluated based on the fair value of the underlying collateral securing the loan, the Company records the impaired loan as non-recurring Level 3 given the valuation includes significant unobservable assumptions.
Other Real Estate Owned
Other real estate assets (“OREO”) acquired through, or in lieu of, foreclosure are held-for-sale and are initially recorded at the lower of cost or fair value, less selling costs. Any write-downs to fair value at the time of transfer to OREO are charged to the allowance for loan losses. Appraisals or evaluations are then done periodically thereafter charging any additional write-downs or valuation allowances to the appropriate expense accounts. Values are derived from appraisals of underlying collateral and discounted cash flow analysis. OREO is classified within Level 3 of the hierarchy given the valuation includes significant unobservable assumptions.
Disclosures about Fair Value of Financial Instruments
The estimated fair values of the Company’s financial instruments for the periods ended March 31, 2019 and December 31, 2018 were approximately as follows:
| | | | | | March 31, 2019 | | | December 31, 2018 | |
| | | Level | | | Carrying amount | | | Fair value | | | Carrying amount | | | Fair value | |
| | | | | | | | | | | | | | | | |
| Financial assets: | | | | | | | | | | | | | | | |
| Cash and cash equivalents | | | 1 | | | $ | 128,094 | | | $ | 128,094 | | | $ | 116,032 | | | $ | 116,032 | |
| Certificates of deposit | | | 2 | | | | 10,045 | | | | 10,118 | | | | 7,595 | | | | 7,573 | |
| Stock in Federal Home Loan Bank and other equity securities | | | 3 | | | | 6,019 | | | | 6,019 | | | | 6,019 | | | | 6,019 | |
| Loans receivable: | | | | | | | | | | | | | | | | | | | | |
| Net loans | | | 3 | | | | 731,605 | | | | 692,053 | | | | 763,393 | | | | 726,179 | |
| Loans held-for-sale | | | 2 | | | | 2,407 | | | | 2,462 | | | | 2,295 | | | | 2,345 | |
| Interest receivable | | | 2 | | | | 4,410 | | | | 4,410 | | | | 4,158 | | | | 4,158 | |
| Mortgage servicing rights | | | 3 | | | | 1,536 | | | | 1,953 | | | | 1,579 | | | | 2,091 | |
| Financial liabilities: | | | | | | | | | | | | | | | | | | | | |
| Deposits | | | 3 | | | | 1,086,228 | | | | 947,551 | | | | 1,124,612 | | | | 966,464 | |
| Interest payable | | | 2 | | | | 90 | | | | 90 | | | | 74 | | | | 74 | |
Limitations
Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument and expected exit prices. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
Fair value estimates are based on existing on- and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Other significant assets and liabilities that are not considered financial assets or liabilities include deferred tax liabilities and premises and equipment. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in many of the estimates.
7. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit in the form of loans or through standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the balance sheet. The contract amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
The Bank’s exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
Financial instruments, whose contract amounts represent credit risk at the indicated periods, were as follows:
| (in thousands) | | March 31, 2019 | | | December 31, 2018 | |
| | | | | | | |
| Undisbursed loan commitments | | $ | 204,184 | | | $ | 201,983 | |
| Standby letters of credit | | | 2,447 | | | | 2,974 | |
| Commitments to sell loans | | | 1,078 | | | | 570 | |
| | | $ | 207,709 | | | $ | 205,527 | |
Commitments to extend credit 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. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties.
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank issues both financial and performance standby letters of credit. The financial standby letters of credit are primarily to guarantee payment to third parties. At March 31, 2019 and December 31, 2018, there were no financial standby letters of credit outstanding. The performance standby letters of credit are typically issued to municipalities as specific performance bonds. Performance standby letters of credit totaled $2,447,000 and $2,974,000 at March 31, 2019 and December 31, 2018, respectively. The Bank has experienced no draws on these letters of credit, resulting in no related liability included on its balance sheet; however, should a triggering event occur, the Bank either has collateral in excess of the letter of credit or imbedded agreements of recourse from the customer. The Bank has set aside a reserve for unfunded commitments in the amount of $880,000 and $800,000 at March 31, 2019 and December 31, 2018, respectively, which is recorded in “interest payable and other liabilities” on the Condensed Consolidated Balance Sheets.
Commitments to extend credit and standby letters of credit bear similar credit risk characteristics as outstanding loans. As of March 31, 2019 and December 31, 2018, the Company had no off-balance sheet derivatives requiring additional disclosure.
Mortgage loans sold to investors may be sold with servicing rights retained, for which the Company makes only standard legal representations and warranties as to meeting certain underwriting and collateral documentation standards. In the past two years, the Company has not had to repurchase any loans due to deficiencies in underwriting or loan documentation. Management believes that any liabilities that may result from such recourse provisions are not significant.
8. STOCK PLANS
On January 24, 2019, the Board of Directors of the Company declared a 5% stock dividend payable on March 29, 2019 to shareholders of record as of February 28, 2019. All stock options and restricted stock outstanding have been adjusted to give retroactive effect to stock dividends.
The following table presents the activity related to stock options for the three months ended March 31, 2019:
| | | Number of Shares | | | Weighted Average Exercise Price | | | Aggregate Intrinsic Value | | | Weighted Average Remaining Contractual Term (in years) | |
| Options outstanding at Beginning of Period | | | 329,160 | | | $ | 8.23 | | | | | | | |
| Granted | | | 77,666 | | | $ | 10.86 | | | | | | | |
| Expired | | | — | | | $ | — | | | | | | | |
| Cancelled / Forfeited | | | (1,689 | ) | | | 12.41 | | | | | | | |
| Exercised | | | — | | | $ | — | | | | | | | |
| Options outstanding at End of Period | | | 405,137 | | | $ | 8.72 | | | $ | 1,192,539 | | | | 7.16 | |
| Exercisable (vested) at End of Period | | | 224,595 | | | $ | 6.95 | | | $ | 1,038,576 | | | | 5.71 | |
The weighted average grant date fair value per share of options granted during the three months ended March 31, 2019 was $1.82 per share.
The intrinsic value of options exercised was $0 and $88,000 during the three months ended March 31, 2019 and March 31, 2018, respectively. The fair value of awards vested was $141,000 and $114,000 during the three months ended March 31, 2019 and March 31, 2018, respectively.
As of March 31, 2019, there was $365,000 of total unrecognized compensation cost related to non-vested stock options. This cost is expected to be recognized over a weighted average period of approximately 2.74 years.
There was $35,000 of recognized compensation cost related to stock options granted for the three months ended March 31, 2019.
A summary of the weighted average assumptions used in valuing stock options during the three months ended March 31, 2019 is presented below:
| | Three Months Ended March 31, 2019 |
| Risk Free Interest Rate | | 2.47 % |
| | | |
| Expected Dividend Yield | | 0.00 % |
| | | |
| Expected Life in Years | | 5 |
| | | |
| Expected Price Volatility | | 11.86 % |
The following table presents the activity related to non-vested restricted stock for the three months ended March 31, 2019:
| | | Number of Shares | | | Weighted Average Grant - Date Fair Value
| | | Aggregate Intrinsic Value | | | Weighted Average Remaining Contractual Term (in years) | |
Non-vested Restricted stock outstanding at Beginning of Period
| | | 118,391 | | | $ | 8.94 | | | | | | | |
| Granted | | | 42,262
| | | $ | 10.86 | | | | | | | |
| Cancelled / Forfeited | | | — |
| | | — | | | | | | | |
| Exercised/Released/Vested | | | (33,922
| )
| | $ | 6.64
| | | | | | | |
Non-vested restricted stock outstanding at End of Period
| | | 126,731
| | | $ | 10.19
| | | $ | 1,457,407 | | | | 3.13
| |
The weighted average fair value of restricted stock granted during the three months ended March 31, 2019 was $10.86 per share.
As of March 31, 2019, there was $871,000 of total unrecognized compensation cost related to non-vested restricted stock. This cost is expected to be recognized over a weighted average period of approximately 3.13 years.
There was $69,000 of recognized compensation cost related to restricted stock awards for the three months ended March 31, 2019.
The Company has an Employee Stock Purchase Plan (“ESPP”). There are 295,277 shares authorized under the ESPP. The total number of shares authorized has been adjusted to give retroactive effect to stock dividends and stock splits, including the 5% stock dividend declared on January 24, 2019, payable March 29, 2019 to shareholders of record as of February 28, 2019. The ESPP will expire on March 16, 2026.
The ESPP is implemented by participation periods of not more than twenty-seven months each. The Board of Directors determines the commencement date and duration of each participation period. The Board of Directors approved the current participation period of November 24, 2018 to November 23, 2019. An eligible employee is one who has been continually employed for at least 90 days prior to commencement of a participation period. Under the terms of the ESPP, employees can choose to have up to 10 percent of their compensation withheld to purchase the Company’s common stock each participation period. The purchase price of the stock is 85 percent of the lower of the fair value on the last trading day before the date of participation or the fair value on the last trading day during the participation period.
As of March 31, 2019, there was $19,000 of unrecognized compensation cost related to ESPP issuances. This cost is expected to be recognized over a weighted average period of approximately 0.75 years.
There was $6,000 of recognized compensation cost related to ESPP issuances for the three months ended March 31, 2019.
The weighted average fair value at issuance date during the three months ended March 31, 2019 was $2.57.
A summary of the weighted average assumptions used in valuing ESPP issuances during the three months ended March 31, 2019 is presented below:
| | Three Months Ended March 31, 2019 |
| Risk Free Interest Rate | | 2.67% |
| | | |
| Expected Dividend Yield | | 0.00% |
| | | |
| Expected Life in Years | | 1.00 |
| | | |
| Expected Price Volatility | | 8.47% |
9. ACCUMULATED OTHER COMPREHENSIVE LOSS
The following table details activity in accumulated other comprehensive income (loss) for the three months ended March 31, 2019:
| ($ in thousands) | | Unrealized Gains (losses) on Securities | | | Officers’ retirement plan | | | Directors’ retirement plan | | | Accumulated Other Comprehensive Loss | |
| Balance as of December 31, 2018 | | $ | (3,867 | ) | | $ | (1,198 | ) | | $ | 29 | | | $ | (5,036 | ) |
| Current period other comprehensive income/(loss) | | | 1,478 | | | | — | | | | — | | | | 1,478 | |
| Balance as of March 31, 2019 | | $ | (2,389 | ) | | $ | (1,198 | ) | | $ | 29 | | | $ | (3,558 | ) |
The following table details activity in accumulated other comprehensive income (loss) for the three months ended March 31, 2018:
| ($ in thousands) | | Unrealized Gains (losses) on Securities | | | Officers’ retirement plan | | | Directors’ retirement plan | | | Accumulated Other Comprehensive Loss | |
| Balance as of December 31, 2017 | | $ | (2,997 | ) | | $ | (1,403 | ) | | $ | 3 | | | $ | (4,397 | ) |
| Current period other comprehensive income/(loss) | | | (1,811 | ) | | | — | | | | — | | | | (1,811 | ) |
| Balance as of March 31, 2018 | | $ | (4,808 | ) | | $ | (1,403 | ) | | $ | 3 | | | $ | (6,208 | ) |
10. OUTSTANDING SHARES AND EARNINGS PER SHARE
On January 24, 2019, the Board of Directors of the Company declared a 5% stock dividend payable on March 29, 2019 to shareholders of record as of February 28, 2019. All income per share amounts have been adjusted to give retroactive effect to stock dividends.
Earnings Per Share (EPS)
Basic EPS includes no dilution and is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding for the respective period. Diluted EPS is computed by dividing net income available to common shareholders by the weighted average number of shares outstanding plus dilutive shares for the quarter. Diluted shares include all common stock equivalents (“in-the-money” stock options, unvested restricted stock, stock units, warrants and rights, convertible bonds and preferred stock), which reflects the potential dilution of securities that could share in the earnings of the Company.
The following table presents a reconciliation of basic and diluted EPS for the three months ended March 31, 2019 and 2018 (dollars in thousands except per share amounts):
| | | Three months ended March 31, | |
| | | 2019 | | | 2018 | |
| Basic earnings per share: | | | | | | |
| Net income | | $ | 3,985 | | | $ | 2,733 | |
| | | | | | | | | |
| Weighted average common shares outstanding | | | 12,141,752 | | | | 12,111,999 | |
| Basic EPS | | $ | 0.33 | | | $ | 0.23 | |
| | | | | | | | | |
| Diluted earnings per share: | | | | | | | | |
| Net income | | $ | 3,985 | | | $ | 2,733 | |
| | | | | | | | | |
| Weighted average common shares outstanding | | | 12,141,752 | | | | 12,111,999 | |
| Effect of dilutive shares | | | 143,308 | | | | 170,787 | |
| Adjusted weighted average common shares outstanding | | | 12,285,060 | | | | 12,282,786 | |
| Diluted EPS | | $ | 0.32 | | | $ | 0.22 | |
Stock options which were not included in the computation of diluted earnings per share because they would have had an anti-dilutive effect amounted to 215,415 shares and 139,445 shares for the three months ended March 31, 2019 and March 31, 2018, respectively.
11. LEASES
The Company adopted ASU 2016-02, Leases (Topic 842) on January 1, 2019. As a result, the Company recognized a right-of-use asset of $4,417,000 included in Interest receivable and other assets and lease liabilities of $4,812,000 included in Interest payable and other liabilities on the Balance Sheet. The recognition of a cumulative-effect adjustment to the opening balance of retained earnings was not necessary as prior to the adoption of this ASU, the Company recognized lease expense on a straight-line basis over the life of the lease term. As such, the difference between the right-of-use asset and lease liabilities was offset by accrued rent and tenant improvement receivables as of January 1, 2019.
The Bank leases nine branch and administrative locations. Leases with an initial term of 12 months or less are not recorded on the balance sheet and lease expense is recognized on a straight-line basis over the lease term. For lease agreements entered into or reassessed after the adoption of Topic 842, the Bank combines lease and nonlease components. As of March 31, 2019, all of the Bank’s leases are operating leases.
Most leases include options to renew, with renewal terms that can extend the lease term from 3 to 10 years. The exercise of lease renewal options is at the Bank’s sole discretion. Most leases are currently in the extension period. For the remaining leases with options to renew, the Bank has not included the extended lease terms in the calculation of lease liabilities as the options are not reasonably certain of being exercised. Certain lease agreements include rental payments that are adjusted periodically for inflation. The Bank's lease agreements do not contain any residual value guarantees or restrictive covenants.
The Bank uses its FHLB advance fixed rates, which are the Bank’s incremental borrowing rates for secured borrowings, as the discount rates to calculate lease liabilities.
As of March 31, 2019, the Company had right-of use assets and lease liabilities totaling $4,225,000 and $4,618,000, respectively. For the three months ended March 31, 2019, the Company recognized lease expense totaling $223,000, which includes expenses related to short-term leases totaling $29,000 and a reduction of $21,000 for the recognition of deferred gain on sale-leaseback. Lease expense is included in Occupancy and equipment expense on the Income Statement.
The table below summarizes the maturity of remaining lease liabilities:
| (in thousands) | | March 31, 2019 | |
| 2019 | | $ | 656 | |
| 2020 | | | 858 | |
| 2021 | | | 802 | |
| 2022 | | | 738 | |
| 2023 | | | 669 | |
| After 2023 | | | 1,387 | |
| Total lease payments | | | 5,110 | |
| Less: interest | | | (492 | ) |
| Present value of lease liabilities | | $ | 4,618 | |
The table below summarizes other information related to our operating leases:
| (in thousands except for percent and period data) | | Three Months Ended March 31, 2019 | |
| Cash paid for amounts included in the measurement of lease liabilities | | | |
| Operating cash flows from operating leases | | $ | 217 | |
| Right-of-use assets obtained in exchange for new operating lease liabilities | | | 4,417 | |
| Weighted-average remaining lease term - operating leases, in years | | | 6.41 | |
| Weighted-average discount rate - operating leases | | | 3.03 | % |
FIRST NORTHERN COMMUNITY BANCORP
ITEM 2. – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
This report may include forward-looking statements, which may include forecasts of our financial results and condition, expectations for our operations and business, and our assumptions for those forecasts and expectations. Do not rely unduly on forward-looking statements. Actual results might differ significantly compared to our forecasts and expectations. See Part I, Item 1A. “Risk Factors,” and the other risks described in our 2018 Annual Report on Form 10-K and Part II, Item 1A "Risk Factors" in this Quarterly Report on Form 10-Q and the other risks described in our Quarterly Reports on Form 10-Q for factors to be considered when reading any forward-looking statements in this filing.
This report and other reports or statements which we may release may include forward-looking statements, which are subject to the “safe harbor” created by section 27A of the Securities Act of 1933, as amended, and section 21E of the Securities Exchange Act of 1934, as amended. We may make forward-looking statements in our Securities and Exchange Commission (SEC) filings, press releases, news articles and when we are speaking on behalf of the Company. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include the words “believe,” “expect,” “target,” “anticipate,” “intend,” “plan,” “seek,” “strive,” “estimate,” “potential,” “project,” or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” or “may.” These forward-looking statements are intended to provide investors with additional information with which they may assess our future potential. All of these forward-looking statements are based on assumptions about an uncertain future and are based on information available to us at the date of these statements. We do not undertake to update forward-looking statements to reflect facts, circumstances, assumptions or events that occur after the date any forward-looking statements are made.
In this document and in other SEC filings or other public statements, for example, we make forward-looking statements relating to the following topics, among others:
| ● |
| Our business objectives, strategies and initiatives, our organizational structure, the growth of our business and our competitive position and prospects, and the effect of competition on our business and strategies |
| ● | | Our assessment of significant factors and developments that have affected or may affect our results |
| ● | | Pending and recent legal and regulatory actions, and future legislative and regulatory developments, including the effects of the Dodd-Frank Wall Street Reform and Protection Act (the “Dodd-Frank Act”) and other legislation and governmental measures introduced in response to the financial crisis which began in 2008 affecting the banking system, financial markets and the U.S. economy |
| ● | | Regulatory and compliance controls, processes and requirements and their impact on our business |
| ● | | The costs and effects of legal or regulatory actions |
| ● | | Expectations regarding draws on performance letters of credit and liabilities that may result from recourse provisions in standby letters of credit |
| ● |
| Our intent to sell or hold, and the likelihood that we would be required to sell, various investment securities |
| ● | | Our regulatory capital requirements, including the capital rules after the financial crisis by the U.S. federal banking agencies |
| ● | | Expectations regarding our non-payment of a cash dividend on our common stock in the foreseeable future |
| ● | | Credit quality and provision for credit losses and management of asset quality and credit risk, and expectations regarding collections |
| ● | | Our allowances for credit losses, including the conditions we consider in determining the unallocated allowance and our portfolio credit quality, the adequacy of the allowance for loan losses, underwriting standards, and risk grading |
| ● | | Our assessment of economic conditions and trends and credit cycles and their impact on our business |
| ● | | The seasonal nature of our business |
| ● | | The impact of changes in interest rates and our strategy to manage our interest rate risk profile and the possible effect of increases in residential mortgage interest rates on new originations and refinancing of existing residential mortgage loans |
| ● | | Loan portfolio composition and risk grade trends, expected charge-offs, portfolio credit quality, our strategy regarding troubled debt restructurings (“TDRs”), delinquency rates and our underwriting standards |
| ● | | Our deposit base including renewal of time deposits |
| ● | | The impact on our net interest income and net interest margin from the current interest rate environment |
| ● |
| Possible changes in the initiatives and policies of the federal bank regulatory agencies |
| ● | | Tax rates and the impact of changes in the U.S. tax laws, including the Tax Cuts and Jobs Act |
| ● | | Our pension and retirement plan costs |
| ● | | Critical accounting policies and estimates, the impact or anticipated impact of recent accounting pronouncements or changes in accounting principles |
| ● | | Expected rates of return, maturities, loss exposure, growth rates, yields and projected results |
| ● | | The possible impact of weather related conditions, including drought, fire or flooding, seismic events, and related governmental responses, on economic conditions, especially in the agricultural sector |
| ● | | Maintenance of insurance coverages appropriate for our operations |
| ● | | Threats to the banking sector and our business due to cybersecurity issues and attacks and regulatory expectations related to cybersecurity |
| ● | | Descriptions of assumptions underlying or relating to any of the foregoing |
Readers of this document should not rely on any forward-looking statements, which reflect only our management’s belief as of the date of this report. There are numerous risks and uncertainties that could and will cause actual results to differ materially from those discussed in our forward-looking statements. Many of these factors are beyond our ability to control or predict and could have a material adverse effect on our financial condition and results of operations or prospects. Such risks and uncertainties include, but are not limited to those listed in Item 1A “Risk Factors” of Part II of this Form 10-Q, Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of Part I of this Form 10-Q and "Risk Factors" and “Supervision and Regulation” in our 2018 Annual Report on Form 10-K, and in our other reports to the SEC.
INTRODUCTION
This overview of Management’s Discussion and Analysis highlights selected information in this report and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources and critical accounting estimates, you should carefully read this entire report and any other reports to the Securities and Exchange Commission (“SEC”), together with our Consolidated Financial Statements and the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2018.
Our subsidiary, First Northern Bank of Dixon (the “Bank”), is a California state-chartered bank that derives most of its revenues from lending and deposit taking in the Sacramento Valley region of Northern California. Interest rates, business conditions and customer confidence all affect our ability to generate revenues. In addition, the regulatory and compliance environment and competition can present challenges to our ability to generate those revenues.
Significant results and developments during the first quarter and year-to-date 2019 included:
| ● | | Net income of $4.0 million for the three months ended March 31, 2019, up 45.8% from $2.7 million earned for the same period last year. |
| ● | | Diluted earnings per share of $0.32 for the three months ended March 31, 2019, up 45.5% from diluted earnings per share of $0.22 in the same period last year. |
| ● | | Net interest income of $11.7 million for the three months ended March 31, 2019, up 11.1% from $10.5 million in the same period last year. |
| ● |
| Net interest margin of 4.09% for the three months ended March 31, 2019, up 9.4% from 3.74% for the same period last year. |
| ● | | No provision for loan losses for the three months ended March 31, 2019, compared to $0.5 million provision for the same period last year. |
| ● | | Total assets of $1.22 billion as of March 31, 2019, down 2.5% from $1.25 billion as of December 31, 2018. |
| ● | | Total net loans (including loans held-for-sale) of $734.0 million as of March 31, 2019, down 4.1% from $765.7 million as of December 31, 2018. |
| ● | | Total investment securities of $298.6 million as of March 31, 2019, down 5.1% from $314.6 million as of December 31, 2018. |
| ● | | Total deposits of $1.09 billion as of March 31, 2019, down 3.4% from $1.12 billion as of December 31, 2018. |
SUMMARY
The Company recorded net income of $3,985,000 for the three months ended March 31, 2019, representing an increase of $1,252,000 from net income of $2,733,000 for the same period in 2018.
The following tables present a summary of the results for the three months ended March 31, 2019 and 2018, and a summary of our financial condition at March 31, 2019 and December 31, 2018:
| | | Three months ended March 31, 2019 | | | Three months ended March 31, 2018 | |
| | | | | | | |
| (in thousands except for per share amounts) | | | | |
| For the Period: | | | | | | |
| Net Income | | $ | 3,985 | | | $ | 2,733 | |
| Basic Earnings Per Common Share | | $ | 0.33 | | | $ | 0.23 | |
| Diluted Earnings Per Common Share | | $ | 0.32 | | | $ | 0.22 | |
| Net Income to Average Assets (annualized) | | | 1.30 | % | | | 0.91 | % |
| Net Income to Average Equity (annualized) | | | 13.84 | % | | | 10.85 | % |
| Average Equity to Average Assets | | | 9.41 | % | | | 8.39 | % |
| | | | | | | | | |
| | | March 31, 2019 | | | December 31, 2018 | |
| | | | | | | |
| (in thousands except for ratios) | | | | |
| At Period End: | | | | | | |
| Total Assets | | $ | 1,218,968 | | | $ | 1,249,845 | |
| Total Investment Securities | | $ | 298,649 | | | $ | 314,637 | |
| Total Loans, Net (including loans held-for-sale) | | $ | 734,012 | | | $ | 765,688 | |
| Total Deposits | | $ | 1,086,228 | | | $ | 1,124,612 | |
| Loan-To-Deposit Ratio | | | 67.6 | % | | | 68.1 | % |
FIRST NORTHERN COMMUNITY BANCORP
Distribution of Average Statements of Condition and Analysis of Net Interest Income
(in thousands, except percentage amounts)
| | | Three months ended March 31, 2019 | | | Three months ended March 31, 2018 | |
| | | Average Balance | | | Interest | | | Yield/ Rate (4) | | | Average Balance | | | Interest | | | Yield/ Rate (4) | |
| Assets | | | | | | | | | | | | | | | | | | |
| Interest-earning assets: | | | | | | | | | | | | | | | | | | |
| Loans (1) | | $ | 744,045 | | | $ | 9,612 | | | | 5.24 | % | | $ | 717,675 | | | $ | 8,806 | | | | 4.98 | % |
| Certificates of deposit | | | 8,994 | | | | 66 | | | | 2.98 | % | | | 1,984 | | | | 6 | | | | 1.23 | % |
| Interest bearing due from banks | | | 87,772 | | | | 575 | | | | 2.66 | % | | | 123,235 | | | | 511 | | | | 1.68 | % |
| Investment securities, taxable | | | 299,866 | | | | 1,633 | | | | 2.21 | % | | | 280,552 | | | | 1,308 | | | | 1.89 | % |
| Investment securities, non-taxable (2) | | | 10,621 | | | | 50 | | | | 1.91 | % | | | 12,259 | | | | 39 | | | | 1.29 | % |
| Other interest earning assets | | | 6,019 | | | | 115 | | | | 7.75 | % | | | 5,567 | | | | 105 | | | | 7.65 | % |
| Total average interest-earning assets | | | 1,157,317 | | | | 12,051 | | | | 4.22 | % | | | 1,141,272 | | | | 10,775 | | | | 3.83 | % |
| Non-interest-earning assets: | | | | | | | | | | | | | | | | | | | | | | | | |
| Cash and due from banks | | | 26,606 | | | | | | | | | | | | 24,267 | | | | | | | | | |
| Premises and equipment, net | | | 6,557 | | | | | | | | | | | | 6,154 | | | | | | | | | |
| Other real estate owned | | | 1,092 | | | | | | | | | | | | — | | | | | | | | | |
| Interest receivable and other assets | | | 32,587 | | | | | | | | | | | | 29,683 | | | | | | | | | |
| Total average assets | | | 1,224,159 | | | | | | | | | | | | 1,201,376 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Liabilities and Stockholders’ Equity: | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing liabilities: | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing transaction deposits | | | 309,859 | | | | 127 | | | | 0.17 | % | | | 303,755 | | | | 67 | | | | 0.09 | % |
| Savings and MMDA’s | | | 329,563 | | | | 162 | | | | 0.20 | % | | | 337,901 | | | | 129 | | | | 0.15 | % |
| Time, $250,000 and under | | | 44,759 | | | | 56 | | | | 0.51 | % | | | 52,184 | | | | 47 | | | | 0.37 | % |
| Time, over $250,000 | | | 16,594 | | | | 26 | | | | 0.64 | % | | | 18,841 | | | | 20 | | | | 0.43 | % |
| Total average interest-bearing liabilities | | | 700,775 | | | | 371 | | | | 0.21 | % | | | 712,681 | | | | 263 | | | | 0.15 | % |
| Non-interest-bearing liabilities: | | | | | | | | | | | | | | | | | | | | | | | | |
| Non-interest-bearing demand deposits | | | 395,329 | | | | | | | | | | | | 376,428 | | | | | | | | | |
| Interest payable and other liabilities | | | 12,920 | | | | | | | | | | | | 11,486 | | | | | | | | | |
| Total liabilities | | | 1,109,024 | | | | | | | | | | | | 1,100,595 | | | | | | | | | |
| Total average stockholders’ equity | | | 115,135 | | | | | | | | | | | | 100,781 | | | | | | | | | |
| Total average liabilities and stockholders’ equity | | $ | 1,224,159 | | | | | | | | | | | $ | 1,201,376 | | | | | | | | | |
| Net interest income and net interest margin (3) | | | | | | $ | 11,680 | | | | 4.09 | % | | | | | | $ | 10,512 | | | | 3.74 | % |
(1) Average balances for loans include loans held-for-sale and non-accrual loans and are net of the allowance for loan losses, but non-accrued interest is excluded. Loan interest income includes loan fees of approximately $(9) and $28 for the three months ended March 31, 2019 and 2018, respectively.
(2) Interest income and yields on tax-exempt securities are not presented on a taxable equivalent basis.
(3) Net interest margin is computed by dividing net interest income by total average interest-earning assets.
(4) For disclosure purposes, yield/rates are annualized by dividing the number of days in the reported period by 365.
FIRST NORTHERN COMMUNITY BANCORP
Distribution of Average Statements of Condition and Analysis of Net Interest Income
(in thousands, except percentage amounts)
| | | Three months ended March 31, 2019 | | | Three months ended December 31, 2018 | |
| | | Average Balance | | | Interest | | | Yield/ Rate (4) | | | Average Balance | | | Interest | | | Yield/ Rate (4) | |
| Assets | | | | | | | | | | | | | | | | | | |
| Interest-earning assets: | | | | | | | | | | | | | | | | | | |
| Loans (1) | | $ | 744,045 | | | $ | 9,612 | | | | 5.24 | % | | $ | 764,464 | | | $ | 9,589 | | | | 4.98 | % |
| Certificates of deposit | | | 8,994 | | | | 66 | | | | 2.98 | % | | | 6,192 | | | | 44 | | | | 2.82 | % |
| Interest bearing due from banks | | | 87,772 | | | | 575 | | | | 2.66 | % | | | 118,042 | | | | 629 | | | | 2.11 | % |
| Investment securities, taxable | | | 299,866 | | | | 1,633 | | | | 2.21 | % | | | 291,535 | | | | 1,518 | | | | 2.07 | % |
| Investment securities, non-taxable (2) | | | 10,621 | | | | 50 | | | | 1.91 | % | | | 8,932 | | | | 38 | | | | 1.69 | % |
| Other interest earning assets | | | 6,019 | | | | 115 | | | | 7.75 | % | | | 6,019 | | | | 205 | | | | 13.51 | % |
| Total average interest-earning assets | | | 1,157,317 | | | | 12,051 | | | | 4.22 | % | | | 1,195,184 | | | | 12,023 | | | | 3.99 | % |
| Non-interest-earning assets: | | | | | | | | | | | | | | | | | | | | | | | | |
| Cash and due from banks | | | 26,606 | | | | | | | | | | | | 26,581 | | | | | | | | | |
| Premises and equipment, net | | | 6,557 | | | | | | | | | | | | 5,995 | | | | | | | | | |
| Other real estate owned | | | 1,092 | | | | | | | | | | | | 736 | | | | | | | | | |
| Interest receivable and other assets | | | 32,587 | | | | | | | | | | | | 31,292 | | | | | | | | | |
| Total average assets | | | 1,224,159 | | | | | | | | | | | | 1,259,788 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Liabilities and Stockholders’ Equity: | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing liabilities: | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing transaction deposits | | | 309,859 | | | | 127 | | | | 0.17 | % | | | 315,644 | | | | 144 | | | | 0.18 | % |
| Savings and MMDA’s | | | 329,563 | | | | 162 | | | | 0.20 | % | | | 341,631 | | | | 162 | | | | 0.19 | % |
| Time, $250,000 and under | | | 44,759 | | | | 56 | | | | 0.51 | % | | | 47,281 | | | | 57 | | | | 0.48 | % |
| Time, over $250,000 | | | 16,594 | | | | 26 | | | | 0.64 | % | | | 16,131 | | | | 20 | | | | 0.49 | % |
| Total average interest-bearing liabilities | | | 700,775 | | | | 371 | | | | 0.21 | % | | | 720,687 | | | | 383 | | | | 0.21 | % |
| Non-interest-bearing liabilities: | | | | | | | | | | | | | | | | | | | | | | | | |
| Non-interest-bearing demand deposits | | | 395,329 | | | | | | | | | | | | 417,473 | | | | | | | | | |
| Interest payable and other liabilities | | | 12,920 | | | | | | | | | | | | 12,883 | | | | | | | | | |
| Total liabilities | | | 1,109,024 | | | | | | | | | | | | 1,151,043 | | | | | | | | | |
| Total average stockholders’ equity | | | 115,135 | | | | | | | | | | | | 108,745 | | | | | | | | | |
| Total average liabilities and stockholders’ equity | | $ | 1,224,159 | | | | | | | | | | | $ | 1,259,788 | | | | | | | | | |
| Net interest income and net interest margin (3) | | | | | | $ | 11,680 | | | | 4.09 | % | | | | | | $ | 11,640 | | | | 3.86 | % |
(1) Average balances for loans include loans held-for-sale and non-accrual loans and are net of the allowance for loan losses, but non-accrued interest is excluded. Loan interest income includes loan fees of approximately $(9) and $(173) for the three months ended March 31, 2019 and December 31, 2018, respectively.
(2) Interest income and yields on tax-exempt securities are not presented on a taxable equivalent basis.
(3) Net interest margin is computed by dividing net interest income by total average interest-earning assets.
(4) For disclosure purposes, yield/rates are annualized by dividing the number of days in the reported period by 365.
Analysis of Changes
in Interest Income and Interest Expense
(Dollars in thousands)
Following is an analysis of changes in interest income and expense (dollars in thousands) for the three months ended March 31, 2019 over the three months ended March 31, 2018 and the three months ended March 31, 2019 over the three months ended December 31, 2018. Changes not solely due to interest rate or volume have been allocated proportionately to interest rate and volume.
| | | Three Months Ended March 31, 2019 Over Three Months Ended March 31, 2018 | | | Three Months Ended March 31, 2019 Over Three Months Ended December 31, 2018 | |
| | | Volume | | | Interest Rate | | | Change | | | Volume | | | Interest Rate | | | Change | |
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Increase (Decrease) in Interest Income: | | | | | | | | | | | | | | | | | | |
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Investment Securities - Taxable | | | | | | | | | | | | | | | | | | | | | | | | |
Investment Securities - Non-taxable | | | | | | | | | | | | | | | | | | | | | | | | |
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Increase (Decrease) in Interest Expense: | | | | | | | | | | | | | | | | | | | | | | | | |
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Interest-Bearing Transaction Deposits | | | | | | | | | | | | | | | | | | | | | | | | |
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Increase in Net Interest Income: | | | | | | | | | | | | | | | | | | | | | | | | |
CHANGES IN FINANCIAL CONDITION
The assets of the Company set forth in the Unaudited Condensed Consolidated Balance Sheets reflect a $12,062,000 or 10.4% increase in cash and cash equivalents, a $15,988,000 or 5.1% decrease in investment securities available-for-sale, a $31,788,000 or 4.2% decrease in net loans held-for-investment, a $112,000 or 4.9% increase in loans held-for-sale, and a $349,000 or 5.3% decrease in premises & equipment from December 31, 2018 to March 31, 2019. The increase in cash and cash equivalents was due to an increase in non-interest bearing accounts, which was partially offset by a decrease in interest bearing due from Federal Reserve Bank accounts. The decrease in investment securities available-for-sale was primarily the result of maturities of agency, mortgage-backed, U.S. Treasury and municipal securities, which was partially offset by purchases of agency, municipal, collateralized mortgage obligations, and mortgage-backed securities. The decrease in net loans held-for-investment was primarily due to principal paydowns and maturities of loans. The increase in loans held-for-sale was due to timing of sales of loans held-for-sale. The decrease in premises & equipment was primarily due the sale of land during the three months ended March 31, 2019.
The liabilities of the Company set forth in the Unaudited Condensed Consolidated Balance Sheets reflect a decrease in total deposits of $38,384,000 or 3.4% from December 31, 2018 to March 31, 2019. The decrease in deposits was largely due to increased competition for low cost funding as short term rates rose during the period, coupled with seasonal fluctuations.
CHANGES IN RESULTS OF OPERATIONS
Interest Income
The Federal Open Market Committee made no changes to the Federal Funds rate during the three months ended March 31, 2019.
Interest income on loans for the three months ended March 31, 2019 was up 9.2% from the same period in 2018, increasing from $8,806,000 to $9,612,000. The increase in interest income on loans for the three months ended March 31, 2019 as compared to the same period a year ago was primarily due to an increase in average loans and a 26 basis point increase in loan yields. The increase in loan yields was primarily due to the origination of new loans and the repricing of existing loans at higher rates.
Interest income on investment securities available-for-sale for the three months ended March 31, 2019 was up 24.9% from the same period in 2018, increasing from $1,347,000 to $1,683,000. The increase in interest income on investment securities for the three months ended March 31, 2019 as compared to the same period a year ago was primarily due to an increase in average investment securities and a 33 basis point increase in yields on investment securities. The increase in yields on investment securities is primarily due to the reinvestment of cash flows into higher yielding investment securities.
Interest income on certificates of deposit for the three months ended March 31, 2019 was up 1000.0% from the same period in 2018, increasing from $6,000 to $66,000. The increase in interest income on certificates of deposit for the three months ended March 31, 2019 as compared to the same period a year ago was primarily due to an increase in average balance of certificates of deposit and a 175 basis point increase in certificates of deposit yields.
Interest income on interest-bearing due from banks for the three months ended March 31, 2019 was up 12.5% from the same period in 2018, increasing from $511,000 to $575,000. The increase in interest income on interest-bearing due from banks for the three months ended March 31, 2019 as compared to the same period a year ago was due to a 98 basis point increase in interest-bearing due from yields, which was partially offset by a decrease in average interest-bearing due from banks balance.
The Company had no Federal Funds sold balances during the three months ended March 31, 2019 and March 31, 2018.
Interest Expense
Interest expense on deposits for the three months ended March 31, 2019 was up 41.4% from the same period in 2018, increasing from $263,000 to $371,000. The increase in interest expense is primarily due to a 6 basis point increase in average interest-bearing deposits, which was partially offset by a decrease in average deposits.
The Company had no FHLB advances or other borrowing balances during the three months ended March 31, 2019 and March 31, 2018.
Provision for Loan Losses
There was no provision for loan losses for the three months ended March 31, 2019 compared to a provision for loan losses of $525,000 for the same period in 2018. The allowance for loan losses was approximately $12,746,000, or 1.71% of total loans, at March 31, 2019, compared to $12,822,000, or 1.65% of total loans, at December 31, 2018. The allowance for loan losses is maintained at a level considered adequate by management to provide for probable loan losses inherent in the loan portfolio.
Provision for Unfunded Lending Commitment Losses
There was a provision for unfunded lending commitment losses of $80,000 and $0 for the three months ended March 31, 2019 and March 31, 2018, respectively.
Provisions for unfunded lending commitment losses are included in non-interest expense in the Condensed Consolidated Statements of Income.
Non-Interest Income
Non-interest income was up 3.1% for the three months ended March 31, 2019 from the same period in 2018, increasing from $1,804,000 to $1,859,000.
The increase was primarily due to increases on gains on sales of loans held-for-sale, mortgage brokerage income, and gain on sale of land, which were partially offset by decreases in investment and brokerage income, loan servicing income, debit card income and trust income. The increase in gains on sales of loans held-for-sale was primarily due to an increase in originations of loans held-for-sale. The increase in mortgage brokerage income was primarily due to an increase in demand for those services. The Company recognized a gain on sale of land totaling $281,000 during the three months ended March 31, 2019. The decrease in investment and brokerage income was primarily due to a decrease in demand for those services. The decrease in loan servicing income was primarily due to a decrease in mortgage servicing assets recorded. The decrease in debit card income was primarily due to a decrease in volume of transactions. The decrease in trust income was due to the sale of the Company's Trust Department during the fourth quarter of 2018.
Non-Interest Expenses
Total non-interest expenses were up 0.3% for the three months ended March 31, 2019 from the same period in 2018, increasing from $7,994,000 to $8,018,000.
The increase was primarily due to increases in salaries and employee benefits, data processing, and other real estate owned expense, which was partially offset by decreases in occupancy and equipment expense, stationery and supplies, advertising and directors' fees. The increase in salaries and employee benefits was primarily due to an increase in the number of full-time equivalent employees. The increase in data processing expense was primarily due to enhanced IT infrastructure costs. The increase in other real estate owned expense was primarily due to an increase in other real estate owned properties. The decrease in occupancy and equipment expense was primarily due to a decrease in service contracts. The decrease in directors' fees was partially due to a decrease in the number of directors and number of meetings.
The following table sets forth other non-interest expenses by category for the three months ended March 31, 2019 and 2018.
| | | (in thousands) | |
| | | Three months ended March 31, 2019 | | | Three months ended March 31, 2018 | |
| Other non-interest expenses | | | | | | |
| Allowance for unfunded commitments expense | | $ | 80 | | | $ | — | |
| FDIC assessments | | | 90 | | | | 110 | |
| Contributions | | | 66 | | | | 49 | |
| Legal fees | | | 73 | | | | 54 | |
| Accounting and audit fees | | | 110 | | | | 105 | |
| Consulting fees | | | 78 | | | | 96 | |
| Postage expense | | | 28 | | | | 26 | |
| Telephone expense | | | 33 | | | | 30 | |
| Public relations | | | 48 | | | | 61 | |
| Training expense | | | 33 | | | | 27 | |
| Loan origination expense | | | 51 | | | | 51 | |
| Computer software depreciation | | | 32 | | | | 36 | |
| Operational losses | | | 54 | | | | 40 | |
| Loan collection (recovery) expense | | | (52 | ) | | | 12 | |
| Other non-interest expense | | | 434 | | | | 483 | |
| Total other non-interest expenses | | $ | 1,158 | | | $ | 1,180 | |
Income Taxes
The Company’s tax rate, the Company’s income before taxes and the amount of tax relief provided by non-taxable earnings affect the Company’s provision for income taxes. Provision for income taxes increased 44.4% for the three months ended March 31, 2019 from the same period in 2018, increasing from $1,064,000 to $1,536,000 due to an increase in pre-tax income.
Off-Balance Sheet Commitments
The following table shows the distribution of the Company’s undisbursed loan commitments at the dates indicated.
| | | (in thousands) | |
| | | March 31, 2019 | | | December 31, 2018 | |
| | | | | | | |
| Undisbursed loan commitments | | $ | 204,184 | | | $ | 201,983 | |
| Standby letters of credit | | | 2,447 | | | | 2,974 | |
| Commitments to sell loans | | | 1,078 | | | | 570 | |
| | | $ | 207,709 | | | $ | 205,527 | |
The reserve for unfunded lending commitments amounted to $880,000 and $800,000 as of March 31, 2019 and December 31, 2018, respectively. The reserve for unfunded lending commitments is included in other liabilities on the Condensed Consolidated Balance Sheets. See Note 7 of the Notes to Condensed Consolidated Financial Statements of this Form 10-Q, "Financial Instruments with Off-Balance Sheet Risk," for additional information.
Asset Quality
The Company manages asset quality and credit risk by maintaining diversification in its loan portfolio and through review processes that include analysis of credit requests and ongoing examination of outstanding loans and delinquencies, with particular attention to portfolio dynamics and loan mix. The Company strives to identify loans experiencing difficulty early enough to correct the problems, to record charge-offs promptly based on realistic assessments of collectability and current collateral values and to maintain an adequate allowance for loan losses at all times. Asset quality reviews of loans and other non-performing assets are administered using credit risk-rating standards and criteria similar to those employed by state and federal banking regulatory agencies. The federal bank regulatory agencies utilize the following definitions for assets adversely classified for supervisory purposes:
| ● | | Substandard Assets – A substandard asset is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. |
| ● | | Doubtful Assets – An asset classified doubtful has all the weaknesses inherent in one classified 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 or improbable. |
Other Real Estate Owned and loans rated Substandard and Doubtful are deemed "classified assets". This category, which includes both performing and non-performing assets, receives an elevated level of attention regarding collection.
The following tables summarize the Company’s non-accrual loans net of guarantees of the State of California and U.S. Government by loan category at March 31, 2019 and December 31, 2018:
| | | At March 31, 2019 | | | At December 31, 2018 | |
| | | Gross | | | Guaranteed | | | Net | | | Gross | | | Guaranteed | | | Net | |
| (dollars in thousands) | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
| Commercial | | $ | 213 | | | $ | — | | | $ | 213 | | | $ | 750 | | | $ | 300 | | | $ | 450 | |
| Commercial real estate | | | 367 | | | | 53 | | | | 314 | | | | 381 | | | | 56 | | | | 325 | |
| Agriculture | | | 4,778 | | | | 735 | | | | 4,043 | | | | 4,830 | | | | 776 | | | | 4,054 | |
| Residential mortgage | | | 97 | | | | — | | | | 97 | | | | 100 | | | | — | | | | 100 | |
| Residential construction | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | |
| Consumer | | | 192 | | | | — | | | | 192 | | | | 191 | | | | — | | | | 191 | |
| Total non-accrual loans | | $ | 5,647 | | | $ | 788 | | | $ | 4,859 | | | $ | 6,252 | | | $ | 1,132 | | | $ | 5,120 | |
It is generally the Company’s policy to discontinue interest accruals once a loan is past due for a period of 90 days as to interest or principal payments unless the loan is well secured and in process of collection. When a loan is placed on non-accrual, interest accruals cease and uncollected accrued interest is reversed and charged against current income. Payments received on non-accrual loans are applied against principal. A loan may only be restored to an accruing basis when it again becomes well secured and in the process of collection or all past due amounts have been collected or there is an extended period of positive performance and a high probability that the loan will continue to pay according to original terms.
Non-accrual loans amounted to $5,647,000 at March 31, 2019 and were comprised of one commercial loan totaling $213,000, two commercial real estate loans totaling $367,000, five agriculture loans totaling $4,778,000, two residential mortgage loans totaling $97,000, and two consumer loans totaling $192,000. Non-accrual loans amounted to $6,252,000 at December 31, 2018 and were comprised of two commercial loans totaling $750,000, two commercial real estate loans totaling $381,000, five agriculture loans totaling $4,830,000, two residential mortgage loans totaling $100,000, and one consumer loan totaling $191,000. If the loan is considered collateral dependent, it is generally the Company’s policy to charge-off the portion of any non-accrual loan that the Company does not expect to collect by writing the loan down to the estimated net realizable value of the underlying collateral.
Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Nonaccrual loans are non-performing impaired loans totaling $5,647,000 and $6,252,000 as of March 31, 2019 and December 31, 2018, respectively. A restructuring of a loan can constitute a TDR if the Company for economic or legal reasons related to the borrower’s financial difficulties grants a concession to the borrower that it would not otherwise consider. A loan that is restructured as a TDR is considered an impaired loan. Performing impaired loans, which consisted of loans modified as TDRs, totaled $4,408,000 and $4,622,000 at March 31, 2019 and December 31, 2018, respectively. The Company expects to collect all principal and interest due from performing impaired loans. These loans are not on non-accrual status. The majority of the non-performing impaired loans, in management's opinion, were adequately collateralized based on recently obtained appraised property values or were guaranteed by a governmental entity. See “Allowance for Loan Losses” below for additional information. No assurance can be given that the existing or any additional collateral will be sufficient to secure full recovery of the obligations owed under these loans.
As the following table illustrates, total non-performing assets, net of guarantees of the State of California and U.S. Government, including its agencies and its government-sponsored agencies, increased $401,000 or 6.5% to $6,613,000 during the first three months of 2019. Non-performing assets, net of guarantees, represented 0.5% of total assets at March 31, 2019.
| | | At March 31, 2019 | | | At December 31, 2018 | |
| | | Gross | | | Guaranteed | | | Net | | | Gross | | | Guaranteed | | | Net | |
| (dollars in thousands) | | | | | | | | | | | | | | | | | | |
| Non-accrual loans | | $ | 5,647 | | | $ | 788 | | | $ | 4,859 | | | $ | 6,252 | | | $ | 1,132 | | | $ | 5,120 | |
| Loans 90 days past due and still accruing | | | 662 | | | | — | | | | 662 | | | | — | | | | — | | | | — | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Total non-performing loans | | | 6,309 | | | | 788 | | | | 5,521 | | | | 6,252 | | | | 1,132 | | | | 5,120 | |
| Other real estate owned | | | 1,092 | | | | — | | | | 1,092 | | | | 1,092 | | | | — | | | | 1,092 | |
| Total non-performing assets | | | 7,401 | | | | 788 | | | | 6,613 | | | | 7,344 | | | | 1,132 | | | | 6,212 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Non-performing loans (net of guarantees) to total loans | | | | | | | | | | | 0.7 | % | | | | | | | | | | | 0.7 | % |
| Non-performing assets (net of guarantees) to total assets | | | | | | | | | | | 0.5 | % | | | | | | | | | | | 0.5 | % |
| Allowance for loan and lease losses to non-performing loans (net of guarantees) | | | | | | | | | | | 230.9 | % | | | | | | | | | | | 250.4 | % |
The Company had one commercial loan totaling $662,000 that was 90 days or more past due and still accruing at March 31, 2019. The Company had no loans 90 days or more past due and still accruing at December 31, 2018.
Excluding the non-performing loans cited previously, loans totaling $12,317,000 and $15,926,000 were classified as substandard or doubtful loans, representing potential problem loans at March 31, 2019 and December 31, 2018, respectively. In Management’s opinion, the potential loss related to these problem loans was sufficiently covered by the Bank’s existing loan loss reserve (Allowance for Loan Losses) at March 31, 2019 and December 31, 2018. The ratio of the Allowance for Loan Losses to total loans at March 31, 2019 and December 31, 2018 was 1.71% and 1.65%, respectively.
Other real estate owned (“OREO”) consists of property that the Company has acquired by deed in lieu of foreclosure or through foreclosure proceedings, and property that the Company does not hold title to but is in actual control of, known as in-substance foreclosure. The estimated fair value of the property is determined prior to transferring the balance to OREO. The balance transferred to OREO is the estimated fair value of the property less estimated cost to sell. Impairment may be deemed necessary to bring the book value of the loan equal to the appraised value. Appraisals or loan officer evaluations are then conducted periodically thereafter charging any additional impairment to the appropriate expense account. The Company had one commercial property classified as OREO totaling $1,092,000 as of March 31, 2019 and December 31, 2018.
Allowance for Loan Losses
The Company's Allowance for Loan Losses is maintained at a level believed by management to be adequate to provide for loan and other credit losses that can be reasonably anticipated. The allowance is increased by provisions charged to operating expense and reduced by net charge-offs. The Company contracts with vendors for credit reviews of the loan portfolio as well as considers current economic conditions, loan loss experience, and other factors in determining the adequacy of the reserve balance. The allowance for loan losses is based on estimates, and actual losses may vary from current estimates.
The following table summarizes the Allowance for Loan Losses of the Company during the three months ended March 31, 2019 and 2018, and for the year ended December 31, 2018:
Analysis of the Allowance for Loan Losses
(Amounts in thousands, except percentage amounts)
| | | Three months ended March 31, | | | Year ended December 31, | |
| | | 2019 | | | 2018 | | | 2018 | |
| | | | | | | | | | |
| Balance at beginning of period | | $ | 12,822 | | | $ | 11,133 | | | $ | 11,133 | |
| Provision for loan losses | | | — | | | | 525 | | | | 2,100 | |
| Loans charged-off: | | | | | | | | | | | | |
| Commercial | | | (150 | ) | | | — | | | | (509 | ) |
| Commercial Real Estate | | | — | | | | — | | | | (142 | ) |
| Agriculture | | | — | | | | — | | | | — | |
| Residential Mortgage | | | — | | | | — | | | | — | |
| Residential Construction | | | — | | | | — | | | | — | |
| Consumer | | | (7 | ) | | | (6 | ) | | | (34 | ) |
| Total charged-off | | | (157 | ) | | | (6 | ) | | | (685 | ) |
| | | | | | | | | | | | | |
| Recoveries: | | | | | | | | | | | | |
| Commercial | | | 19 | | | | 9 | | | | 46 | |
| Commercial Real Estate | | | — | | | | — | | | | — | |
| Agriculture | | | — | | | | — | | | | — | |
| Residential Mortgage | | | 56 | | | | 16 | | | | 34 | |
| Residential Construction | | | 1 | | | | 1 | | | | 131 | |
| Consumer | | | 5 | | | | 37 | | | | 63 | |
| Total recoveries | | | 81 | | | | 63 | | | | 274 | |
| | | | | | | | | | | | | |
| Net charge-offs | | | (76 | ) | | | 57 | | | | (411 | ) |
| | | | | | | | | | | | | |
| Balance at end of period | | $ | 12,746 | | | $ | 11,715 | | | $ | 12,822 | |
| | | | | | | | | | | | | |
| Ratio of net charge-offs (recoveries) to average loans outstanding during the period (annualized) | | | (0.04 | %) | | | 0.03 | % | | | (0.05 | %) |
| Allowance for loan losses | | | | | | | | | | | | |
| To total loans at the end of the period | | | 1.71 | % | | | 1.60 | % | | | 1.65 | % |
| To non-performing loans, net of guarantees at the end of the period | | | 230.9 | % | | | 374.3 | % | | | 250.4 | % |
The allowance for loan losses to non-performing loans, net of guarantees was 230.9% and 374.3% as of March 31, 2019 and March 31, 2018, respectively, and 250.4% as of December 31, 2018. The decrease in the ratio of allowance for loan losses to non-performing loans, net of guarantees from December 31, 2018 to March 31, 2019 was due to various factors which include the payoff of a $450,000 commercial loan that was fully reserved as of December 31, 2018, an increase in unallocated reserves driven by a decrease in loans outstanding primarily driven by seasonal fluctuations associated with agricultural production loans and reductions in commercial loans outstanding.
Deposits
Deposits are one of the Company’s primary sources of funds. At March 31, 2019, the Company had the following deposit mix: 30.4% in savings and MMDA deposits, 5.5% in time deposits, 28.3% in interest-bearing transaction deposits and 35.8% in non-interest-bearing transaction deposits. At December 31, 2018, the Company had the following deposit mix: 29.6% in savings and MMDA deposits, 5.6% in time deposits, 27.8% in interest-bearing transaction deposits and 37.0% in non-interest-bearing transaction deposits. Non-interest-bearing transaction deposits increase the Company’s net interest income by lowering its cost of funds.
The Company obtains deposits primarily from the communities it serves. The Company believes that no material portion of its deposits has been obtained from or is dependent on any one person or industry. The Company accepts deposits in excess of $250,000 from customers. These deposits are priced to remain competitive.
Maturities of time certificates of deposits of over $250,000 or more outstanding at March 31, 2019 and December 31, 2018 are summarized as follows:
| | | (in thousands) | |
| | | March 31, 2019 | | | December 31, 2018 | |
| Three months or less | | $ | 3,492 | | | $ | 3,848 | |
| Over three to twelve months | | | 6,603 | | | | 6,414 | |
| Over twelve months | | | 6,117 | | | | 5,741 | |
| Total | | $ | 16,212 | | | $ | 16,003 | |
Liquidity and Capital Resources
In order to serve our market area, the Company must maintain adequate liquidity and adequate capital. Liquidity is measured by various ratios, in management’s opinion, the most common being the ratio of net loans to deposits (including loans held-for-sale). This ratio was 67.6% on March 31, 2019. In addition, on March 31, 2019, the Company had the following short-term investments (based on remaining maturity and/or next repricing date): $32,725,000 in securities due within one year or less; and $63,605,000 in securities due in one to five years.
To meet unanticipated funding requirements, the Company maintains short-term unsecured lines of credit with other banks which totaled $67,000,000 at March 31, 2019. Additionally, the Company has a line of credit with the FHLB, with a borrowing capacity at March 31, 2019 of $330,553,000; credit availability is subject to certain collateral requirements. The Company had no borrowings outstanding as of March 31, 2019.
The Company’s primary source of liquidity on a stand-alone basis is dividends from the Bank. Dividends from the Bank are subject to regulatory restrictions.
In July 2013, the Federal Reserve Board and the other U.S. federal banking agencies adopted final rules making significant changes to the U.S. regulatory capital framework for U.S. banking organizations and to conform this framework to the guidelines published by the Basel Committee on Banking Supervision (Basel Committee) known as the Basel III Global Regulatory Framework for Capital and Liquidity. These rules adopted by the FRB and the other federal banking agencies (the U.S. Basel III Capital Rules) replaced the federal banking agencies' general risk-based capital rules, advanced approaches rule, market-risk rule, and leverage rules, in accordance with certain transition provisions. The Bank became subject to the new rules on January 1, 2015. The new rules implement higher minimum capital requirements, include a new common equity Tier 1 capital requirement, and establish criteria that instruments must meet in order to be considered common equity Tier 1 capital, additional Tier 1 capital, or Tier 2 capital. When fully phased in by January 1, 2019, the final rules will provide for increased minimum capital ratios as follows: (a) a common equity Tier 1 capital ratio of 4.5%; (b) a Tier 1 capital ratio of 6% (which is an increase from 4.0%); (c) a total capital ratio of 8%; and (d) a Tier 1 leverage ratio to average consolidated assets of 4%. Under the new rules, in order to avoid certain limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers, a banking organization must hold a capital conservation buffer composed of common equity Tier 1 capital above its minimum risk based capital requirements (equal to 2.5% of total risk-weighted assets when fully phased in). The phase-in of the capital conservation buffer began on January 1, 2016, and must be completed by January 1, 2019. The U.S. Basel III Capital Rules also provide for various adjustments and deductions to the definitions of regulatory capital that phased in from January 1, 2014 through December 31, 2017.
As of March 31, 2019, the Bank’s capital ratios exceeded applicable regulatory requirements. The following table presents the capital ratios for the Bank, compared to the regulatory standards for well-capitalized depository institutions, as of March 31, 2019.
| | | (amounts in thousands except percentage amounts) | |
| | | Actual | | | Well Capitalized Ratio Requirement | |
| | | Capital | | | Ratio | |
| Leverage | | $ | 118,367 | | | | 9.65 | % | | | 5.0 | % |
| Common Equity Tier 1 | | $ | 118,367 | | | | 13.81 | % | | | 6.5 | % |
| Tier 1 Risk-Based | | $ | 118,367 | | | | 13.81 | % | | | 8.0 | % |
| Total Risk-Based | | $ | 129,114 | | | | 15.07 | % | | | 10.0 | % |
