MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward-looking Information
Safe Harbor Statement
This quarterly report and other reports filed by the Company with the Securities Exchange Commission (SEC) may contain forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are often identified by such forward-looking terminology as “expect,” “intend,” “look,” “believe,” “anticipate,” “estimate,” “project,” “seek,” “may,” “will,” “would,” “could,” “should,” “trend,” “target,” and “goal” or similar statements or variations of such terms and include, but are not limited to, those relating to growing our core deposit relationships and loan balances, enhancing the financial performance of our core banking operations, maintaining credit quality, maintaining net interest margins, reducing non-performing assets, and generating improved financial results (including profitability); the adequacy and amount of available liquidity and capital resources to the Bank; the Company’s liquidity and capital requirements; our expectations for core capital and our strategies and potential strategies for maintenance thereof; improvements in loan production; changes in the size of the Bank’s loan portfolio; the amount of the Bank’s non-performing assets and the appropriateness of the allowance therefor; anticipated future levels of the provision for loan losses; future losses on non-performing assets; the amount and composition of interest-earning assets; the amount of yield enhancements relating to non-accruing and purchased loans; the amount and composition of non-interest and interest-bearing liabilities; the availability of alternate funding sources; the payment of dividends by HMN; the future outlook for the Company; the amount of deposits that will be withdrawn from checking and money market accounts and how the withdrawn deposits will be replaced; the projected changes in net interest income based on rate shocks; the range that interest rates may fluctuate over the next twelve months; the net market risk of interest rate shocks; the future outlook for the issuer of the trust preferred securities held by the Bank; the anticipated results of litigation and our assessment of the impact on our financial statements; the ability of the Bank to pay dividends to HMN; the ability to remain well capitalized; the impact of new accounting pronouncements; and compliance by the Bank with regulatory standards generally (including the Bank’s status as “well-capitalized”) and other supervisory directives or requirements to which the Company or the Bank are or may become expressly subject, specifically, and possible responses of the Office of the Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve System (FRB), the Bank, and the Company to any failure to comply with any such regulatory standard, directive or requirement.
A number of factors could cause actual results to differ materially from the Company’s assumptions and expectations. These include but are not limited to the adequacy and marketability of real estate and other collateral securing loans to borrowers; federal and state regulation and enforcement; possible legislative and regulatory changes, including changes to regulatory capital rules; the ability of the Bank to comply with other applicable regulatory capital requirements; enforcement activity of the OCC and FRB in the event of our non-compliance with any applicable regulatory standard or requirement; adverse economic, business and competitive developments such as continued shrinking interest margins, reduced collateral values, deposit outflows, changes in credit or other risks posed by the Company’s loan and investment portfolios; changes in costs associated with traditional and alternate funding sources, including changes in collateral advance rates and policies of the Federal Home Loan Bank (FHLB); technological, computer-related or operational difficulties; results of litigation; reduced demand for financial services and loan products; changes in accounting policies and guidelines, or monetary and fiscal policies of the federal government or tax laws; domestic and international economic developments; the Company’s access to and adverse changes in securities markets; the market for credit related assets; the future operating results, financial condition, cash flow requirements and capital spending priorities of the Company and the Bank; the availability of internal and, as required, external sources of funding; our ability to attract and retain employees; or other significant uncertainties. Additional factors that may cause actual results to differ from the Company’s assumptions and expectations include those set forth in the Company’s most recent filings on Forms 10-K and 10-Q with the SEC. All forward-looking statements are qualified by, and should be considered in conjunction with, such cautionary statements. For additional discussion of the risks and uncertainties applicable to the Company, see the “Risk Factors” sections of the Company’s Annual Report on Form 10-K for the year ended December 31, 2018 and Part II, Item 1A of its subsequently filed quarterly reports on Form 10-Q. All statements in this Form 10-Q, including forward-looking statements, speak only as of the date they are made, and we undertake no duty to update any of the forward-looking statements after the date of this quarterly report on Form 10-Q.
General
HMN Financial, Inc. (HMN or the Company) is the stock savings bank holding company for Home Federal Savings Bank (the Bank), which operates community banking and loan production offices in Minnesota, Iowa and Wisconsin. The earnings of the Company are primarily dependent on the Bank's net interest income, which is the difference between interest earned on loans and investments, and the interest paid on interest-bearing liabilities such as deposits and other borrowings. The difference between the average rate of interest earned on assets and the average rate paid on liabilities is the "interest rate spread". Net interest income is produced when interest-earning assets equal or exceed interest-bearing liabilities and there is a positive interest rate spread. Net interest income and net interest rate spread are affected by changes in interest rates, the volume and composition of interest-earning assets and interest-bearing liabilities, and the level of non-performing assets. The Company's net earnings are also affected by the generation of non-interest income, which consists primarily of gains from the sale of loans and real estate owned, fees for servicing loans, commissions on the sale of uninsured investment products, and service charges on deposit accounts. The Bank incurs expenses in addition to interest expense in the form of compensation and benefits, occupancy and equipment expenses, provisions for loan losses, professional services, data processing costs, other non-interest expenses and income taxes. The earnings of financial institutions, such as the Bank, are also significantly affected by prevailing economic and competitive conditions, particularly changes in interest rates, government monetary and fiscal policies, and regulations of various regulatory authorities. Lending activities are influenced by the demand for and supply of business credit, single family and commercial properties, competition among lenders, the level of interest rates and the availability of funds. Deposit flows and costs of deposits are influenced by prevailing market rates of interest on competing investments, account maturities and the levels of personal income and savings.
Critical Accounting Estimates
Critical accounting policies are those policies that the Company's management believes are the most important to understanding the Company’s financial condition and operating results. These critical accounting policies often involve estimates and assumptions that could have a material impact on the Company’s financial statements. The Company has identified the following critical accounting policies that management believes involve the most difficult, subjective, and/or complex judgments that are inherently uncertain. Therefore, actual financial results could differ significantly depending upon the estimates, assumptions and other factors used.
Allowance for Loan Losses and Related Provision
The allowance for loan losses is based on periodic analysis of the loan portfolio and is maintained at an amount considered to be appropriate by management to provide for probable losses inherent in the loan portfolio as of the balance sheet dates. In this analysis, management considers factors including, but not limited to, specific occurrences of loan impairment, actual and anticipated changes in the size of the portfolios, national and regional economic conditions such as unemployment data, loan delinquencies, local economic conditions, demand for single family homes, demand for commercial real estate and building lots, loan portfolio composition, historical loss experience and observations made by the Company's ongoing internal audit and regulatory exam processes. Loans are charged off to the extent they are deemed to be uncollectible. The Company has established separate processes to determine the appropriateness of the loan loss allowance for its homogeneous single family and consumer loan portfolios and its non-homogeneous loan portfolios. The determination of the allowance on the homogeneous single family and consumer loan portfolios is calculated on a pooled basis with individual determination of the allowance for all non-performing loans. The determination of the allowance for the non-homogeneous commercial, commercial real estate and multi-family loan portfolios involves assigning standardized risk ratings and loss factors that are periodically reviewed. The loss factors are estimated based on the Company's own loss experience and are assigned to all loans without identified credit weaknesses. For each non-performing loan, the Company also performs an individual analysis of impairment that is based on the expected cash flows or the value of the assets collateralizing the loans and establishes any necessary reserves or charges off all loans, or portions thereof, that are deemed uncollectible.
The appropriateness of the allowance for loan losses is dependent upon management’s estimates of variables affecting valuation, appraisals of collateral, evaluations of performance and status, and the amounts and timing of future cash flows expected to be received on impaired loans. Such estimates, appraisals, evaluations and cash flows may be subject to adjustments due to changing economic prospects of borrowers or properties. The fair market value of collateral dependent loans is typically based on the appraised value of the property less estimated selling costs. The estimates are reviewed periodically and adjustments, if any, are recorded in the provision for loan losses in the periods in which the adjustments become known. Because of the size of some loans, changes in estimates can have a significant impact on the loan loss provision. The allowance is allocated to individual loan categories based upon the relative risk characteristics of the loan portfolios and the actual loss experience. The Company increases its allowance for loan losses by charging the provision for loan losses against income and by receiving recoveries of previously charged off loans. The Company decreases its allowance by crediting the provision for loan losses and recording loan charge-offs. The methodology for establishing the allowance for loan losses takes into consideration probable losses that have been identified in connection with specific loans as well as losses in the loan portfolio that have not been specifically identified. Although management believes that based on current conditions the allowance for loan losses is maintained at an appropriate amount to provide for probable loan losses inherent in the portfolio as of the balance sheet dates, future conditions may differ substantially from those anticipated in determining the allowance for loan losses and adjustments may be required in the future.
Income Taxes
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. These calculations are based on many complex factors including estimates of the timing of reversals of temporary differences, the interpretation of federal and state income tax laws, and a determination of the differences between the tax and the financial reporting basis of assets and liabilities. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax assets and liabilities.
The Company maintains significant net deferred tax assets for deductible temporary differences, the largest of which relates to the allowance for loan and real estate losses. For tax purposes only the net charge-offs are deductible while the entire provision for loan losses is used to determine book income. A deferred tax asset is created because of the timing difference of when the expense is recognized for book and tax purposes. Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is “more likely than not” that the deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon management’s judgment and evaluation of both positive and negative evidence, including the forecasts of future income, tax planning strategies, and assessments of the current and future economic and business conditions. The Company considers both positive and negative evidence regarding the ultimate realizability of deferred tax assets. Positive evidence includes the Company’s cumulative net income in the prior three year period, the ability to implement tax planning strategies to accelerate taxable income recognition, and the probability that taxable income will be generated in future periods. The Company could not currently identify any negative evidence. It is possible that future conditions may differ substantially from those anticipated in determining that no valuation allowance was required on deferred tax assets, and adjustments may be required in the future.
Determining the ultimate settlement of any tax position requires significant estimates and judgments in arriving at the amount of tax benefits to be recognized in the financial statements. It is possible that the tax benefits realized upon the ultimate resolution of a tax position may result in tax benefits that are significantly different from those estimated.
RESULTS OF OPERATIONS FOR THE THREE AND NINE MONTH PERIODS ENDED SEPTEMBER 30, 2019 COMPARED TO THE SAME PERIODS ENDED SEPTEMBER 30, 2018
Net Income
Net income was $2.1 million for the third quarter of 2019, a decrease of $0.6 million, compared to net income of $2.7 million for the third quarter of 2018. Diluted earnings per share for the third quarter of 2019 was $0.45, a decrease of $0.14 per share, compared to diluted earnings per share of $0.59 for the third quarter of 2018. The decrease in net income between the periods was primarily because of a $0.5 million increase in non-interest expenses primarily related to increased compensation and professional services costs, a $0.3 million decrease in net interest income due to an increase in the average rates paid on deposits, and a $0.3 million increase in the loan loss provision. These decreases in net income were partially offset by a $0.4 million increase in the gain on sales of loans between the periods and a $0.1 million decrease in income tax expense as a result of the decreased pre-tax income between the periods.
Net income was $6.6 million for the nine month period ended September 30, 2019, an increase of $0.7 million, or 11.4%, compared to net income of $5.9 million for the nine month period ended September 30, 2018. Diluted earnings per share for the nine month period ended September 30, 2019 was $1.41, an increase of $0.17 per share, compared to diluted earnings per share of $1.24 for the same period in 2018. The increase in net income between the periods was primarily because of a $1.0 million decrease in the provision for loan losses, a $0.6 million increase in net interest income, and a $0.2 million increase in the gain on sales of loans. These increases in net income were partially offset by a $0.4 million increase in compensation expense related to the increased mortgage loan production and annual salary increases, a $0.4 million increase in income tax expense as a result of the increased pre-tax income, and a $0.2 million increase in professional services expenses between the periods.
Net Interest Income
Net interest income was $7.1 million for the third quarter of 2019, a decrease of $0.3 million, or 3.9%, from $7.4 million for the third quarter of 2018. Interest income was $8.0 million for the third quarter of 2019, the same as for the third quarter of 2018. Interest income remained flat despite the increase in the average federal funds rate between the periods as competitive pricing in our markets did not allow for increased loan rates when the federal funds rate increased in the fourth quarter of 2018. The average yield earned on interest-earning assets was 4.47% for the third quarter of 2019, the same as for the third quarter of 2018.
Interest expense was $0.9 million for the third quarter of 2019, an increase of $0.3 million, or 54.3%, from $0.6 million for the third quarter of 2018. The average interest rate paid on interest-bearing liabilities and non-interest-bearing deposits was 0.56% for the third quarter of 2019, an increase of 20 basis points from 0.36% for the third quarter of 2018. The increase in the interest paid on interest-bearing liabilities was primarily because of the increase in the average federal funds rate between the periods which increased the cost of deposits between the periods.
Net interest margin (net interest income divided by average interest-earning assets) for the third quarter of 2019 was 3.97%, a decrease of 17 basis points, compared to 4.14% for the third quarter of 2018. The decrease in the net interest margin is primarily related to the increase in interest expense as a result of an increase in the average federal funds rate between the periods while rates on interest earning assets remained flat.
Net interest income was $21.6 million for the first nine months of 2019, an increase of $0.6 million, or 2.9%, from $21.0 million for the same period in 2018. Interest income was $24.0 million for the nine month period ended September 30, 2019, an increase of $1.4 million, or 6.4%, from $22.6 million for the same nine month period in 2018. Interest income increased primarily because of the higher interest amounts earned on interest-earning assets as a result of the increase in the average federal funds rate between the periods. Interest income also increased $0.3 million because of an increase in the amount of yield enhancements recognized between the periods on non-accruing loans that were paid off. The average yield earned on interest-earning assets was 4.60% for the nine month period ended September 30, 2019, an increase of 28 basis points from 4.32% for the same nine month period in 2018. The average yield earned on the average interest-earning assets increased 5 basis points as a result of the change in yield enhancements recognized between the periods.
Interest expense was $2.4 million for the first nine months of 2019, an increase of $0.8 million, or 53.2%, compared to $1.6 million in the first nine months of 2018. The average interest rate paid on interest-bearing liabilities and non-interest-bearing deposits was 0.51% for the first nine months of 2019, an increase of 18 basis points from 0.33% for the first nine months of 2018. The increase in the interest paid on non-interest and interest-bearing liabilities was primarily because of the increase in the average federal funds rate between the periods which increased the cost of deposits.
Net interest margin (net interest income divided by average interest-earning assets) for the first nine months of 2019 was 4.14%, an increase of 12 basis points, compared to 4.02% for the first nine months of 2018. The increase in the net interest margin is primarily related to the increase in interest income between the periods as a result of the increase in the average federal funds rate.
A summary of the Company’s net interest margin for the three and nine month periods ended September 30, 2019 and 2018 is as follows:
|
|
For the three-month period ended
|
|
|
|
September 30, 2019
|
|
|
September 30, 2018
|
|
(Dollars in thousands)
|
|
Average
Outstanding
Balance
|
|
|
Interest
Earned/
Paid
|
|
|
Yield/
Rate
|
|
|
Average
Outstanding
Balance
|
|
|
Interest
Earned/
Paid
|
|
|
Yield/
Rate
|
|
Interest-earning assets:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Securities available for sale
|
|
$
|
80,286
|
|
|
|
365
|
|
|
|
1.80
|
%
|
|
$
|
79,755
|
|
|
|
337
|
|
|
|
1.68
|
%
|
Loans held for sale
|
|
|
3,557
|
|
|
|
43
|
|
|
|
4.72
|
|
|
|
1,757
|
|
|
|
24
|
|
|
|
5.45
|
|
Single family loans, net
|
|
|
115,844
|
|
|
|
1,236
|
|
|
|
4.23
|
|
|
|
112,221
|
|
|
|
1,154
|
|
|
|
4.08
|
|
Commercial loans, net
|
|
|
398,674
|
|
|
|
5,229
|
|
|
|
5.20
|
|
|
|
399,517
|
|
|
|
5,349
|
|
|
|
5.31
|
|
Consumer loans, net
|
|
|
73,788
|
|
|
|
920
|
|
|
|
4.95
|
|
|
|
72,257
|
|
|
|
914
|
|
|
|
5.02
|
|
Other
|
|
|
37,355
|
|
|
|
205
|
|
|
|
2.18
|
|
|
|
42,344
|
|
|
|
192
|
|
|
|
1.80
|
|
Total interest-earning assets
|
|
$
|
709,504
|
|
|
|
7,998
|
|
|
|
4.47
|
|
|
$
|
707,851
|
|
|
|
7,970
|
|
|
|
4.47
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest-bearing liabilities and non-interest-bearing deposits:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Checking accounts
|
|
|
93,024
|
|
|
|
23
|
|
|
|
0.10
|
|
|
|
84,491
|
|
|
|
19
|
|
|
|
0.09
|
|
Savings accounts
|
|
|
80,269
|
|
|
|
16
|
|
|
|
0.08
|
|
|
|
78,191
|
|
|
|
16
|
|
|
|
0.08
|
|
Money market accounts
|
|
|
173,606
|
|
|
|
303
|
|
|
|
0.69
|
|
|
|
204,599
|
|
|
|
221
|
|
|
|
0.43
|
|
Certificates
|
|
|
127,888
|
|
|
|
564
|
|
|
|
1.75
|
|
|
|
115,620
|
|
|
|
331
|
|
|
|
1.14
|
|
Total interest-bearing liabilities
|
|
$
|
474,787
|
|
|
|
|
|
|
|
|
|
|
$
|
482,901
|
|
|
|
|
|
|
|
|
|
Non-interest checking
|
|
|
166,972
|
|
|
|
|
|
|
|
|
|
|
|
160,410
|
|
|
|
|
|
|
|
|
|
Other non-interest bearing deposits
|
|
|
2,415
|
|
|
|
|
|
|
|
|
|
|
|
1,709
|
|
|
|
|
|
|
|
|
|
Total interest-bearing liabilities and non-interest-bearing deposits
|
|
$
|
644,174
|
|
|
|
906
|
|
|
|
0.56
|
|
|
$
|
645,020
|
|
|
|
587
|
|
|
|
0.36
|
|
Net interest income
|
|
|
|
|
|
|
7,092
|
|
|
|
|
|
|
|
|
|
|
|
7,383
|
|
|
|
|
|
Net interest rate spread
|
|
|
|
|
|
|
|
|
|
|
3.91
|
%
|
|
|
|
|
|
|
|
|
|
|
4.11
|
%
|
Net interest margin
|
|
|
|
|
|
|
|
|
|
|
3.97
|
%
|
|
|
|
|
|
|
|
|
|
|
4.14
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
For the nine-month period ended
|
|
|
|
September 30, 2019
|
|
|
September 30, 2018
|
|
(Dollars in thousands)
|
|
Average
Outstanding
Balance
|
|
|
Interest
Earned/
Paid
|
|
|
Yield/
Rate
|
|
|
Average
Outstanding
Balance
|
|
|
Interest
Earned/
Paid
|
|
|
Yield/
Rate
|
|
Interest-earning assets:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Securities available for sale
|
|
$
|
79,163
|
|
|
|
1,051
|
|
|
|
1.77
|
%
|
|
$
|
79,436
|
|
|
|
990
|
|
|
|
1.67
|
%
|
Loans held for sale
|
|
|
2,417
|
|
|
|
82
|
|
|
|
4.51
|
|
|
|
1,739
|
|
|
|
62
|
|
|
|
4.80
|
|
Single family loans, net
|
|
|
115,162
|
|
|
|
3,744
|
|
|
|
4.35
|
|
|
|
112,252
|
|
|
|
3,412
|
|
|
|
4.06
|
|
Commercial loans, net
|
|
|
402,469
|
|
|
|
15,966
|
|
|
|
5.30
|
|
|
|
401,850
|
|
|
|
15,076
|
|
|
|
5.02
|
|
Consumer loans, net
|
|
|
73,384
|
|
|
|
2,805
|
|
|
|
5.11
|
|
|
|
72,238
|
|
|
|
2,675
|
|
|
|
4.95
|
|
Other
|
|
|
24,886
|
|
|
|
381
|
|
|
|
2.05
|
|
|
|
30,964
|
|
|
|
369
|
|
|
|
1.59
|
|
Total interest-earning assets
|
|
$
|
697,481
|
|
|
|
24,029
|
|
|
|
4.60
|
|
|
$
|
698,479
|
|
|
|
22,584
|
|
|
|
4.32
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest-bearing liabilities and non-interest-bearing deposits:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Checking accounts
|
|
|
95,748
|
|
|
|
73
|
|
|
|
0.10
|
|
|
|
87,468
|
|
|
|
41
|
|
|
|
0.06
|
|
Savings accounts
|
|
|
79,599
|
|
|
|
47
|
|
|
|
0.08
|
|
|
|
78,075
|
|
|
|
46
|
|
|
|
0.08
|
|
Money market accounts
|
|
|
174,565
|
|
|
|
878
|
|
|
|
0.67
|
|
|
|
198,149
|
|
|
|
610
|
|
|
|
0.41
|
|
Certificates
|
|
|
120,376
|
|
|
|
1,420
|
|
|
|
1.58
|
|
|
|
114,412
|
|
|
|
884
|
|
|
|
1.03
|
|
Advances and other borrowings
|
|
|
384
|
|
|
|
7
|
|
|
|
2.54
|
|
|
|
188
|
|
|
|
2
|
|
|
|
1.71
|
|
Total interest-bearing liabilities
|
|
$
|
470,672
|
|
|
|
|
|
|
|
|
|
|
$
|
478,292
|
|
|
|
|
|
|
|
|
|
Non-interest checking
|
|
|
159,820
|
|
|
|
|
|
|
|
|
|
|
|
156,026
|
|
|
|
|
|
|
|
|
|
Other non-interest bearing deposits
|
|
|
2,030
|
|
|
|
|
|
|
|
|
|
|
|
1,567
|
|
|
|
|
|
|
|
|
|
Total interest-bearing liabilities and non-interest-bearing deposits
|
|
$
|
632,522
|
|
|
|
2,425
|
|
|
|
0.51
|
|
|
$
|
635,885
|
|
|
|
1,583
|
|
|
|
0.33
|
|
Net interest income
|
|
|
|
|
|
|
21,604
|
|
|
|
|
|
|
|
|
|
|
|
21,001
|
|
|
|
|
|
Net interest rate spread
|
|
|
|
|
|
|
|
|
|
|
4.09
|
%
|
|
|
|
|
|
|
|
|
|
|
3.99
|
%
|
Net interest margin
|
|
|
|
|
|
|
|
|
|
|
4.14
|
%
|
|
|
|
|
|
|
|
|
|
|
4.02
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Provision for Loan Losses
The provision for loan losses was ($0.4) million for the third quarter of 2019, an increase of $0.3 million from the ($0.7) million provision for loan losses for the third quarter of 2018. The credit provision amount for the period was primarily the result of certain adversely classified commercial loans being paid off during the period. These payoffs, combined with the continued improvement in the credit quality of the loan portfolio, resulted in a reduction of the overall allowance for loan losses required between the periods.
The provision for loan losses was ($1.5) million for the first nine months of 2019, a decrease of $1.0 million compared to the ($0.5) million provision for loan losses for the first nine months of 2018. The credit provision amount for the period was primarily the result of the increase in net recoveries received during the nine month period ended September 30, 2019 when compared to the same period of 2018. The net recoveries, combined with the continued improvement in the credit quality of the loan portfolio, resulted in a reduction of the overall allowance for loan losses required between the periods.
A reconciliation of the Company’s allowance for loan losses for the three and nine month periods ended September 30, 2019 and 2018 is summarized as follows:
|
|
Three months ended September 30,
|
|
(Dollars in thousands)
|
|
2019
|
|
|
2018
|
|
Balance at June 30,
|
|
$
|
8,624
|
|
|
$
|
9,328
|
|
Provision
|
|
|
(420
|
)
|
|
|
(652
|
)
|
Charge offs:
|
|
|
|
|
|
|
|
|
Single family
|
|
|
(2
|
)
|
|
|
0
|
|
Consumer
|
|
|
(46
|
)
|
|
|
(16
|
)
|
Commercial business
|
|
|
0
|
|
|
|
(15
|
)
|
Recoveries
|
|
|
39
|
|
|
|
187
|
|
Balance at September 30,
|
|
$
|
8,195
|
|
|
$
|
8,832
|
|
|
|
|
|
|
|
|
|
|
Allocated to:
|
|
|
|
|
|
|
|
|
General allowance
|
|
$
|
7,528
|
|
|
$
|
7,771
|
|
Specific allowance
|
|
|
667
|
|
|
|
1,061
|
|
|
|
$
|
8,195
|
|
|
$
|
8,832
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine months ended September 30,
|
|
(Dollars in thousands)
|
|
2019
|
|
|
2018
|
|
Balance at January 1,
|
|
$
|
8,686
|
|
|
$
|
9,311
|
|
Provision
|
|
|
(1,452
|
)
|
|
|
(482
|
)
|
Charge offs:
|
|
|
|
|
|
|
|
|
Single family
|
|
|
(2
|
)
|
|
|
(24
|
)
|
Consumer
|
|
|
(92
|
)
|
|
|
(141
|
)
|
Commercial business
|
|
|
(869
|
)
|
|
|
(270
|
)
|
Recoveries
|
|
|
1,924
|
|
|
|
438
|
|
Balance at September 30,
|
|
$
|
8,195
|
|
|
$
|
8,832
|
|
|
|
|
|
|
|
|
|
|
Non-Interest Income
Non-interest income was $2.2 million for the third quarter of 2019, an increase of $0.3 million, or 15.0%, from $1.9 million for the third quarter of 2018. Gain on sales of loans increased $0.4 million between the periods primarily because of an increase in single family loan sales. Fees and service charges decreased $0.1 million due to a decrease in the loan commitment fees earned between the periods. Loan servicing fees decreased slightly between the periods due to a decrease in the commercial loans servicing fees earned.
Non-interest income was $5.9 million for the first nine months of 2019, an increase of $0.1 million, or 3.0%, from $5.8 million for the same period of 2018. Gain on sales of loans increased $0.2 million between the periods primarily because of an increase in single family loan sales. Other non-interest income increased $0.1 million due primarily to an increase in the gains recognized on equity securities between the periods. Fees and service charges decreased $0.1 million due to a decrease in the loan commitment fees earned between the periods. Loan servicing fees increased slightly between the periods due to an increase in single family loan servicing fees earned.
Non-Interest Expense
Non-interest expense was $6.7 million for the third quarter of 2019, an increase of $0.5 million, or 8.6%, from $6.2 million for the third quarter of 2018. Compensation and benefits expense increased $0.3 million primarily because of annual salary increases and an increase in the compensation paid as a result of the increased mortgage loan production between the periods. Professional services expense increased $0.1 million due primarily to an increase in legal expenses between the periods. Other non-interest expense increased $0.1 million due primarily to an increase in mortgage loan servicing expenses caused by the increase in serviced loans that were refinanced between the periods. Occupancy and equipment costs increased $0.1 million between the periods due to an increase in depreciation and maintenance costs.
Non-interest expense was $19.8 million for the first nine months of 2019, an increase of $0.7 million, or 3.6%, from $19.1 million for the same period of 2018. Compensation and benefits expense increased $0.4 million primarily because of annual salary increases and an increase in the compensation paid as a result of the increased mortgage loan production between the periods. Professional services expense increased $0.2 million due primarily to an increase in legal expenses between the periods. Other non-interest expense increased slightly due to an increase in mortgage loan servicing expenses caused by the increase in serviced loans that were refinanced between the periods. Occupancy and equipment costs increased slightly between the periods due to an increase in depreciation and maintenance costs.
Income Taxes
Income tax expense was $0.9 million for the third quarter of 2019, a decrease of $0.1 million from $1.0 million for the third quarter of 2018. Income tax expense was $2.7 million for the first nine months of 2019, an increase of $0.4 million from $2.3 million for the first nine months of 2018. The change in income tax expense between the periods is primarily the result of a change in pre-tax income.
FINANCIAL CONDITION
Non-Performing Assets
The following table summarizes the amounts and categories of non-performing assets in the Bank’s portfolio and loan delinquency information as of the end of the two most recently completed quarters and December 31, 2018.
|
|
September 30,
|
|
|
June 30,
|
|
|
December 31,
|
|
(Dollars in thousands)
|
|
2019
|
|
|
2019
|
|
|
2018
|
|
Non-Performing Loans:
|
|
|
|
|
|
|
|
|
|
|
|
|
Single family
|
|
$
|
574
|
|
|
$
|
854
|
|
|
$
|
730
|
|
Commercial real estate
|
|
|
293
|
|
|
|
1,212
|
|
|
|
1,311
|
|
Consumer
|
|
|
513
|
|
|
|
458
|
|
|
|
489
|
|
Commercial business
|
|
|
99
|
|
|
|
144
|
|
|
|
148
|
|
Total
|
|
|
1,479
|
|
|
|
2,668
|
|
|
|
2,678
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Foreclosed and Repossessed Assets:
|
|
|
|
|
|
|
|
|
|
|
|
|
Single family
|
|
|
166
|
|
|
|
30
|
|
|
|
0
|
|
Commercial real estate
|
|
|
414
|
|
|
|
414
|
|
|
|
414
|
|
Consumer
|
|
|
0
|
|
|
|
12
|
|
|
|
0
|
|
Total non-performing assets
|
|
$
|
2,059
|
|
|
$
|
3,124
|
|
|
$
|
3,092
|
|
Total as a percentage of total assets
|
|
|
0.27
|
%
|
|
|
0.43
|
%
|
|
|
0.43
|
%
|
Total non-performing loans
|
|
$
|
1,479
|
|
|
$
|
2,668
|
|
|
$
|
2,678
|
|
Total as a percentage of total loans receivable, net
|
|
|
0.25
|
%
|
|
|
0.45
|
%
|
|
|
0.46
|
%
|
Allowance for loan losses to non-performing loans
|
|
|
554.16
|
%
|
|
|
323.18
|
%
|
|
|
324.27
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Delinquency Data:
|
|
|
|
|
|
|
|
|
|
|
|
|
Delinquencies (1)
|
|
|
|
|
|
|
|
|
|
|
|
|
30+ days
|
|
$
|
2,541
|
|
|
$
|
1,991
|
|
|
$
|
1,453
|
|
90+ days
|
|
|
0
|
|
|
|
0
|
|
|
|
0
|
|
Delinquencies as a percentage of loan portfolio (1)
|
|
|
|
|
|
|
|
|
|
|
|
|
30+ days
|
|
|
0.42
|
%
|
|
|
0.33
|
%
|
|
|
0.24
|
%
|
90+ days
|
|
|
0.00
|
%
|
|
|
0.00
|
%
|
|
|
0.00
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(1) Excludes non-accrual loans.
Total non-performing assets were $2.1 million at September 30, 2019, a decrease of $1.0 million, or 34.1%, from $3.1 million at June 30, 2019 and a decrease of $1.0 million, or 33.4%, from $3.1 million at December 31, 2018. Non-performing loans decreased $1.2 million and foreclosed and repossessed assets increased $0.2 million for both the three and nine month periods of 2019. The decrease in the non-performing loans was primarily related to a $1.3 million non-performing loan relationship that was reclassified as an accruing loan during the third quarter of 2019.
Dividends
The declaration of dividends is subject to, among other things, the Company's financial condition and results of operations, the Bank's compliance with regulatory capital requirements and other regulatory restrictions, tax considerations, industry standards, economic conditions, general business practices and other factors. The Company has not made any dividend payments to common stockholders during the three year period ended September 30, 2019.
LIQUIDITY AND CAPITAL RESOURCES
For the nine months ended September 30, 2019, the net cash provided by operating activities was $8.1 million. The Company received $10.4 million from maturing or called securities, $1.3 million from principal repayments on securities, $1.1 million from the redemption of FHLB stock, and $0.2 million from the sale of premises and equipment. The Company purchased $1.0 million in FHLB stock and paid $1.7 million for the purchase of premises and equipment. Net loans receivable decreased $1.0 million, customer escrows increased $1.5 million, and the Company had a net increase in deposit balances of $36.3 million. The Company also received and repaid $26.0 million in borrowings.
The Company has certificates of deposits with outstanding balances of $80.3 million that mature over the next 12 months. Based upon past experience, management anticipates that the majority of the deposits will renew for another term. The Company believes that cash outflow from certificates that do not renew will be replaced with other deposits or FHLB advances. Federal Reserve Bank borrowings or proceeds from the sale of securities could also be used to fund unanticipated outflows of certificates of deposits.
The Company had four deposit customers that individually had aggregate deposits greater than $5.0 million as of September 30, 2019. The $45.9 million in funds held by these customers may be withdrawn at any time, but management believes that the majority of these deposits will not be withdrawn from the Bank over the next twelve months. If these deposits are withdrawn, it is anticipated that they would be replaced with deposits from other customers or FHLB advances. Federal Reserve Bank borrowings or proceeds from the sale of securities could also be used to replace unanticipated outflows of large checking and money market deposits.
The Company had the ability to borrow $187.0 million from the FHLB at September 30, 2019, based on the collateral value of the loans pledged. The credit policy of the FHLB relating to the collateral value of the loans collateralizing the available line of credit with the FHLB may change such that the current collateral pledged to secure future advances is no longer acceptable or the formulas for determining the excess pledged collateral may change. The FHLB could also reduce the amount of funds it will lend to the Bank. It is not anticipated that the Bank will need to find alternative funding sources in the next twelve months to replace the available borrowings from the FHLB. However, if needed, excess collateral currently pledged to the FHLB could be pledged to the Federal Reserve Bank and the Bank could borrow additional funds from the Federal Reserve Bank based on the increased collateral levels or obtain additional deposits.
The Company’s primary source of cash is dividends from the Bank. At September 30, 2019, the Company had $7.7 million in cash and other assets that could readily be turned into cash. The primary use of cash by the Company is the payment of operating expenses.
The Company also serves as a source of capital, liquidity, and financial support to the Bank. Depending upon the operating performance of the Bank and the Company’s other liquidity and capital needs, including Company level expenses, the Company may find it prudent, subject to prevailing capital market conditions and other factors, to raise additional capital through issuance of its common stock or other equity securities. Additional capital would also potentially permit the Company to implement a strategy of growing Bank assets. Depending on the circumstances, if it were to raise capital, the Company may deploy it to the Bank for general banking purposes, or may retain some or all of it for use by the Company.
If the Company were to raise capital through the issuance of additional shares of common stock or other equity securities, it would dilute the ownership interests of existing stockholders, and, if issued at a price less than the Company’s book value, would dilute the per share book value of the Company’s common stock, and could result in a change in control of the Company and the Bank. New investors may also have rights, preferences and privileges senior to the Company’s current stockholders, which may adversely impact the Company’s current stockholders. The Company’s ability to raise additional capital through the issuance of equity securities, if deemed prudent, will depend on, among other factors, conditions in the capital markets at that time, which are outside of its control, and on the Company’s financial performance and plans.
Market Risk
Market risk is the risk of loss from adverse changes in market prices and rates. The Company’s market risk arises primarily from interest rate risk inherent in its investing, lending and deposit taking activities. Management actively monitors and manages its interest rate risk exposure.
The Company’s profitability is affected by fluctuations in interest rates. A sudden and substantial change in interest rates may adversely impact the Company’s earnings to the extent that the interest rates borne by assets and liabilities do not change at the same speed, to the same extent, or on the same basis. The Company monitors the projected changes in net interest income that occur if interest rates were to suddenly change up or down. The Rate Shock Table located in the following Asset/Liability Management section of this report discloses the Company’s projected changes in net interest income based upon immediate interest rate changes called rate shocks. The Company utilizes a model that uses the discounted cash flows from its interest-earning assets and its interest-bearing liabilities to calculate the current market value of those assets and liabilities. The model also calculates the changes in market value of the interest-earning assets and interest-bearing liabilities under different interest rate changes.
The following table discloses the projected changes in market value to the Company’s interest-earning assets and interest-bearing liabilities based upon incremental 100 basis point changes in interest rates from interest rates in effect on September 30, 2019.