HMN FINANCIAL, INC. The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements and the notes to those financial statements included elsewhere in this annual report. This discussion contains forward-looking statements, which are based on our assumptions about the future of our business. Our actual results will likely differ materially from those contained in the forward-looking statements. Please read the cautionary note under the heading "Forward-Looking Statements" included at the beginning of this Annual Report on Form 10-K for additional information. Overview HMN is the stock savings bank holding company for the Bank, which operates community banking and loan production offices inMinnesota ,Iowa andWisconsin . 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, 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, data processing costs, professional services, deposit insurance, amortization expense on mortgage servicing assets, advertising 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
While our significant accounting policies are described in the notes to our consolidated financial statements, we believe the following discussion addresses our most critical accounting estimates, which are those estimates made in accordance withU.S. generally accepted accounting principles (GAAP) that involve a significant level of estimation uncertainty and have had or are reasonably likely to have a material impact on our financial condition or results of operations. The Company has identified the following critical accounting estimates 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. 38
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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, regional and
local economic conditions such as unemployment data, loan delinquencies, 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 and 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 other qualitative factors 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 any adjustments 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, the actual loss experience and
other qualitative factors. 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
current year activity resulted in an increase in the allowance and a charge to
the loan loss provision. 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.
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The Company maintains significant net deferred tax assets for deductible temporary differences, the two largest relating to the net unrealized loss on securities available for sale and the allowance for loan losses. For tax purposes, the net unrealized losses on securities available for sale are not recognized unless the securities are sold and the loss becomes realized. For book purposes, the unrealized losses, net of income taxes, are reported as a separate component of stockholders' equity until realized. For the allowance for loan losses, only the net charge-offs are deductible while the entire provision for loan losses is used to determine book income. A deferred tax asset for both of these items is created because of the timing difference of when the expense is recognized for book and tax purposes. Under GAAP, 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 positive evidence considered 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 Comparison of 2022 with 2021 Net income was$8.0 million for 2022, a decrease of$5.6 million , or 40.7%, compared to net income of$13.6 million for 2021. Diluted earnings per share for the year endedDecember 31, 2022 was$1.83 , a decrease of$1.18 per share, compared to diluted earnings per share of$3.01 for the year endedDecember 31, 2021 . The decrease in net income between the periods was primarily because of a$4.2 million decrease in the gain on sales of loans due to a decrease in mortgage loan originations and sales due primarily to an increase in mortgage interest rates between the periods. The provision for loan losses increased$3.2 million between the periods primarily because of the growth experienced in the loan portfolio and also because of an increase in qualitative reserves due to the perceived negative impact on borrower finances from inflation and rising interest rates. Net income was also negatively impacted by a$1.3 million decrease in other non-interest income primarily because of a decrease in the gains that were realized on the sale of real estate owned between the periods. Compensation and benefits expense increased$1.1 million primarily because of a decrease in the direct loan origination compensation costs that were deferred as a result of the decreased mortgage loan originations. These decreases in net income were partially offset by a$2.1 million decrease in income tax expense as a result of the decrease in pre-tax income between the periods. Net interest income increased$2.1 million primarily due to an increase in interest earning assets and the yields earned on those assets as a result of the increase in the prime interest rate between the periods
Net Interest Income
Net interest income was$32.3 million for 2022, an increase of$2.1 million , or 6.8%, from$30.2 million for 2021. Interest income was$34.3 million for 2022, an increase of$2.5 million , or 7.9%, from$31.8 million for 2021. Interest income increased primarily because of the$78.7 million increase in the average interest-earning assets between the periods. The average yield earned on interest-earning assets was 3.33% for 2022, a decrease of 1 basis point from 3.34% for 2021. The decrease in the average yield was primarily related to the$2.2 million decrease in the yield enhancements recognized on loans made under the Paycheck Protection Program (PPP) between the periods that was not entirely offset by the higher rates earned on interest-earning assets as a result of the prime rate increases that occurred during 2022. 40
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Interest expense was$2.0 million for 2022, an increase of$0.4 million , or 28.7%, from$1.6 million for 2021. Interest expense increased primarily because of the increase in the average interest rate paid on interest-bearing liabilities between the periods. Interest expense also increased because of the$76.6 million increase in the average interest-bearing liabilities and non-interest bearing deposits between the periods. The average interest rate paid on interest-bearing liabilities and non-interest bearing deposits was 0.21% for 2022, an increase of 3 basis points from 0.18% for 2021. The increase in the average rate paid was primarily related to the increase in market interest rates as a result of the 4.25% increase in the federal funds rate between the periods. It is anticipated that the average interest rates paid on interest-bearing liabilities will increase in 2023 because of an increase in the market rates for deposits as a result of the increases in the federal funds rate that have and are expected to occur.
The following table presents the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. Non-accruing loans have been included in the average outstanding loan balance in the table as loans carrying a zero yield.
Year Ended December 31,
2022 2021
Average Interest Average Average Interest Average
Outstanding Earned/ Yield/ Outstanding Earned/ Yield/
(Dollars in thousands) Balance Paid Rate Balance Paid Rate
Interest-earning assets:
Securities available for
sale(1):
Mortgage-backed and
related securities $ 238,128 2,801 1.18 % $ 167,759 1,864 1.11 %
Other marketable
securities 52,161 428 0.82 42,878 282 0.66
Loans held for sale 2,418 115 4.75 5,335 159 2.98
Loans receivable, net(1)
(2) 699,365 30,333 4.34 631,969 29,290 4.63
Cash equivalents and
other earning assets 36,692 578 1.58 102,146 166 0.16
Total interest-earning
assets $ 1,028,764 34,255 3.33 $ 950,087 31,761 3.34
Interest-bearing
liabilities:
Checking accounts $ 159,509 220 0.14 % $ 157,857 182 0.12 %
Savings accounts 123,786 75 0.06 113,314 69 0.06
Money market accounts 271,750 882 0.32 245,409 557 0.23
Certificate accounts 81,528 555 0.68 93,650 745 0.80
Customer escrows 803 16 2.00 0 0 0.00
FHLB advances and other
borrowings 6,665 251 3.77 0 0 0.00
Total interest-bearing
liabilities $ 644,041 $ 610,230
Noninterest checking 300,394 257,549
Other
noninterest-bearing
liabilities 2,455 2,490
Total interest-bearing
liabilities and
noninterest-bearing
deposits $ 946,890 1,999 0.21 % $ 870,269 1,553 0.18 %
Net interest income 32,256 $ 30,208
Net interest rate spread 3.12 % 3.16 %
Net earning assets $ 81,874 $ 79,818
Net interest margin 3.14 % 3.18 %
Average interest-earning
assets to average
interest-bearing
liabilities and
noninterest-bearing
deposits 108.65 % 109.17 %
(1) Tax exempt income was not material; therefore, the yield was not presented
on a tax equivalent basis for any of the years presented.
(2) Calculated net of deferred loan costs, loan discounts, loans in process and
loss reserves.
Net interest margin (net interest income divided by average interest-earning
assets) for 2022 was 3.14%, a decrease of 4 basis points, compared to 3.18% for
2021. The decrease in the net interest margin was primarily because of the
decrease in the average yield related to the $2.2 million decrease in the yield
enhancements recognized on PPP loans between the periods that was not entirely
offset by the higher rates earned on interest-earning assets as a result of the
prime rate increases of 4.25% that occurred during 2022.
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The following table presents the dollar amount of changes in interest income and
interest expense for major components of interest-earning assets and
interest-bearing liabilities. It quantifies the changes in interest income and
interest expense related to changes in the average outstanding balances (volume)
and those changes caused by fluctuating interest rates. For each category of
interest-earning assets and interest-bearing liabilities, information is
provided on changes attributable to (i) changes in volume (i.e. changes in
volume multiplied by old rate) and (ii) changes in rate (i.e. changes in rate
multiplied by current volume).
Year Ended December 31,
2022 vs. 2021
Increase (Decrease)
Due to
Total
Increase
(Dollars in thousands) Volume (1) Rate(1) (Decrease)
Interest-earning assets:
Securities available for sale:
Mortgage-backed and related securities $ 782 155 937
Other marketable securities 61 85 146
Loans held for sale (87 ) 43 (44 )
Loans receivable, net 2,873 (1,830 ) 1,043
Cash equivalents and other earning assets (73 ) 485 412
Total interest-earning assets $ 3,556 (1,062 ) 2,494
Interest-bearing liabilities:
Checking accounts $ (3 ) 41 38
Savings accounts 7 (1 ) 6
Money market accounts 71 254 325
Certificate accounts (132 ) (58 ) (190 )
Customer escrows 0 16 16
FHLB advances and other borrowings 244 7 251
Total interest-bearing liabilities$ 187 259
446
Increase (decrease) in net interest income
2,048
(1) For purposes of this table, changes attributable to both rate and volume
which cannot be segregated have been allocated proportionately to the change
due to volume and the change due to rate.
The following table sets forth the weighted average yields on the Company's
interest-earning assets, the weighted average interest rates on interest-bearing
liabilities and the interest rate spread between the weighted average yields and
rates as of the date indicated. Non-accruing loans have been included in the
average outstanding loan balances in the table as loans carrying a zero yield.
At December 31, 2022
Weighted average yield on: Weighted average rate on:
Securities available for
sale:
Mortgage-backed and related
securities 1.22 % Checking accounts 0.38 %
Other marketable securities 0.98 Savings accounts 0.08
Loans held for sale 6.44 Money market accounts 0.73
Loans receivable, net 5.11 Certificate accounts 2.59
FHLB stock and other
interest-earning assets 4.03 Customer escrows 2.00
Combined weighted average Combined weighted average
yield on interest-earning rate on interest-bearing
assets 4.17 liabilities 0.61
Interest rate spread 3.56
Provision for Loan Losses
The provision for loan losses was $1.1 million for 2022, an increase of $3.2
million from the ($2.1) million credit provision for loan losses for 2021. The
provision for loan losses increased between the periods primarily because of the
loan portfolio growth and also because of an increase in qualitative reserves,
during 2022, due to the perceived potential negative impact on borrowers from
inflation and rising interest rates. The credit provision recorded in 2021 was
primarily the result of improvements in the underlying operations supporting
many of the loans that were initially negatively impacted by the COVID-19
pandemic in 2020.
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Table of Contents Non-Interest Income
Non-interest income was
The following table presents the components of non-interest income:
Year Ended December 31, Percentage
(Dollars in thousands) 2022 2021 Change
Fees and service charges $ 3,222 3,125 3.1 %
Loan servicing fees 1,590 1,555 2.3
Gain on sales of loans 2,393 6,566 (63.6 )
Other non-interest income 1,682 3,017 (44.2 )
Total non-interest income $ 8,887 14,263 (37.7 )
Gain on sales of loans decreased $4.2 million between the periods primarily
because of a decrease in single family loan originations and sales due to an
increase in mortgage interest rates between the periods. Other non-interest
income decreased $1.3 million primarily because of a decrease in the gains that
were realized on the sale of real estate owned between the periods. These
decreases were partially offset by a $0.1 million increase in fees and service
charges between the periods due primarily to an increase in aggregate overdraft
fees. Loan servicing fees increased slightly between the periods due to an
increase in the aggregate balances of single family mortgage loans that were
being serviced for others.
Non-Interest Expense
Non-interest expense was
Year Ended December 31, Percentage
(Dollars in thousands) 2022 2021 Change
Compensation and benefits $ 17,211 16,114 6.8 %
Occupancy and equipment 3,812 4,372 (12.8 )
Data processing 1,948 1,445 34.8
Professional services 1,386 1,438 (3.6 )
Other 4,444 4,292 3.5
Total non-interest expense $ 28,801 27,661 4.1
Compensation and benefits expense increased $1.1 million primarily because of a
decrease in the direct loan origination compensation costs that were deferred as
a result of the decreased mortgage loan production between the periods. Data
processing expenses increased $0.5 million between the periods primarily because
of the change to an outsourced data processing relationship at the end of the
first quarter of 2022. Other non-interest expense increased $0.2 million between
the periods primarily because of an increase in fraud losses on deposit accounts
and increases in marketing expenses. These increases in non-interest expense
were partially offset by a $0.6 million decrease in occupancy and equipment
expense due primarily to a decrease in rent expense between the periods as a
result of purchasing the combined corporate and branch location in Rochester,
Minnesota in the fourth quarter of 2021. Professional services expense decreased
$0.1 million between the periods primarily because of a decrease in legal
expenses relating to a bankruptcy litigation claim that was settled during the
first quarter of 2022.
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Table of Contents Income Taxes The Company considers the calculation of current and deferred income taxes to be a critical accounting policy that is subject to significant estimates. Income tax expense was$3.2 million for 2022, a decrease of$2.2 million from$5.4 million for 2021. The decrease in income tax expense between the periods was primarily the result of a decrease in pre-tax income. Financial Condition Loans Receivable, Net The following table sets forth the information on the Company's loan portfolio in dollar amounts and percentages before deductions for deferred costs/fees and discounts and the allowance for losses as of the dates indicated: December 31, 2022 2021 (Dollars in thousands) Amount Percent Amount Percent Real Estate Loans: Single family$ 205,890 26.13 %$ 163,322 24.67 % Multi-family 53,885 6.84 43,140 6.51 Commercial 370,915 47.08 306,490 46.30 Construction and development 46,545 5.91 47,238 7.14 Total real estate loans 677,235 85.96 560,190 84.62 Non-Real Estate Loans: Consumer Loans: Home equity line 17,551 2.23 17,467 2.64 Home equity 10,865 1.38 7,557 1.14 Recreational vehicles 7,870 1.00 10,985 1.66 Other 8,531 1.08 5,636 0.85 Total consumer loans 44,817 5.69 41,645 6.29 Commercial business loans 65,835 8.35 60,165 9.09 Total non-real estate loans 110,652 14.04 101,810 15.38 Total loans$ 787,887 100.00 %$ 662,000 100.00 % Less: Unamortized discounts 13 10 Net deferred loan fees 519 209 Allowance for losses 10,277 9,279 Total loans receivable, net$ 777,078 $ 652,502 The growth in the loan portfolio in 2022 was primarily because of the growth experienced in commercial real estate, single family, multi-family, commercial business, and consumer loans that was partially offset by a decrease in construction and development loans. Based on current economic conditions and the projected loan origination and prepayment amounts, it is anticipated that the overall growth in the loan portfolio will be limited in 2023. Single family real estate loans were$205.9 million atDecember 31, 2022 , an increase of$42.6 million , compared to$163.3 million atDecember 31, 2021 . The single family loan portfolio increased in 2022 primarily because of an increase in the amount of adjustable rate mortgage loans that were originated and placed into the loan portfolio. The loan portfolio also increased because of a decrease in loan payoffs. The increase in adjustable rate loan originations and the decrease in loan payoffs was primarily the result of the increase in mortgage rates in 2022. Multi-family real estate loans were$53.9 million atDecember 31, 2022 , an increase of$10.8 million , compared to$43.1 million atDecember 31, 2021 . The increase in multi-family real estate loans in 2022 is primarily the result of new loan originations and transfers in from other loan types, partially offset by loans that were repaid during the year. 44
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Commercial real estate loans were$370.9 million atDecember 31, 2022 , an increase of$64.4 million , compared to$306.5 million atDecember 31, 2021 . The outstanding commercial real estate loans increased as a result of$80.4 million increase in originations between the periods due, in part, to an increase in the number of people on the commercial lending staff during the year. Construction and development loans were$46.5 million atDecember 31, 2022 , a decrease of$0.7 million , compared to$47.2 million atDecember 31, 2021 . The decrease in construction and development loans resulted primarily from$14.6 million in paid off loans and$26.3 million where the projects were completed and the loans were moved to a permanent classification. These decreases were partially offset by$24.0 million in new construction loan originations and$16.2 in advances on existing loans. Home equity lines of credit were$17.6 million atDecember 31, 2022 , an increase of$0.1 million , compared to$17.5 million atDecember 31, 2021 . The open-end home equity lines are generally written with an adjustable rate and a two to ten year draw period which requires interest only payments followed by a ten year repayment period which fully amortizes the outstanding balance. Home equity loans were$10.9 million atDecember 31, 2022 , an increase of$3.3 million , compared to$7.6 million atDecember 31, 2021 . Closed-end home equity loans are written with fixed or adjustable rates with terms up to fifteen years. The overall increase in the open-end equity lines and closed-end equity loans is related primarily to an increase in new equity loans, as fewer borrowers chose to refinance their home mortgage due to rising interest rates on conventional mortgage loans. Recreational vehicle loans were$7.9 million atDecember 31, 2022 , a decrease of$3.1 million , compared to$11.0 million atDecember 31, 2021 . These loans were made primarily to finance the recreational vehicle sales of a single dealer within the Bank's market area. The decrease in the outstanding balance between the periods was primarily due to existing loans being paid off, as the recreational vehicle loan program was discontinued in 2021 and no new recreational vehicle loans are being originated. Commercial business loans were$65.8 million atDecember 31, 2022 , an increase of$5.6 million , compared to$60.2 million atDecember 31, 2021 . The increase in commercial business loans in 2022 was primarily because of an increase in the draws on established commercial business lines of credit between the periods. Allowance for Loan Losses The determination of the allowance for loan losses and the related provision is a critical accounting policy of the Company that is subject to significant estimates. The allowance for loan losses is made up of general reserves on the entire loan portfolio and specific reserves on impaired loans. The general reserve amount includes quantitative reserves based on the size and risk characteristics of the portfolio and past loan loss history and qualitative reserves for other items determined to have a potential impact on future loan losses. The general reserves increased during the year primarily because of the loan portfolio growth and because of an increase in the required qualitative reserves. The other qualitative reserves were increased in 2022 due to a perceived deterioration of economic conditions, including the elevated inflation rate, and enacted and expected increases in the federal funds rate. These qualitative reserve increases were partially offset by a reduction in the qualitative reserves for loan losses related to the disruption in business activity as a result of the COVID-19 pandemic because of a perceived reduction in this risk due to improving conditions during 2022. The current level of the allowance for loan losses is a result of management's assessment of the risks within the portfolio based on the information obtained through the credit evaluation process. The Company utilizes a risk-rating system on non-homogeneous commercial real estate and commercial business loans that includes regular credit reviews to identify and quantify the risk in the commercial portfolio. Management conducts quarterly reviews of the entire loan portfolio and evaluates the need to adjust the allowance balance on the basis of these reviews. Management actively monitors asset quality and, when appropriate, charges off loans against the allowance for loan losses. Although management believes it uses the best information available to make determinations with respect to the allowance for loan losses, future adjustments may be necessary if economic conditions differ substantially from the economic conditions in the assumptions used to determine the size of the allowance for loan losses. 45
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The allowance for loan losses was$10.3 million , or 1.30% of gross loans atDecember 31, 2022 , compared to$9.3 million , or 1.40% of gross loans atDecember 31, 2021 . The allowance for loan losses increased in 2022 primarily because of growth in the portfolio and also because of an increase in qualitative reserves related to the perceived negative impact on borrowers from inflation and rising interest rates. The allowance as a percentage of gross loans decreased due to the improvement in the credit risk of the loans held in the portfolio between the periods. The following table reflects the activity in the allowance for loan losses and selected statistics: December 31, (Dollars in thousands) 2022 2021 Balance at beginning of year$ 9,279 10,699 Provision for loan losses 1,071 (2,119 ) Charge-offs: Commercial real estate (91 ) (36 ) Consumer (24 ) (42 ) Recoveries 42 777 Net (charge-offs) recoveries (73 ) 699 Balance at end of year$ 10,277 9,279 Year-end allowance for loan losses as a percent of year end gross loan balance 1.30 % 1.40 % Ratio of net loan (charge-offs) recoveries to average loans outstanding (0.01 )
0.11
Allowance as a percent of total assets at year
end 0.94 0.87
The following table presents information related to net (charge-offs) recoveries
by loan category:
2022 2021
Ratio of Net Ratio of Net
(Charge-offs) (Charge-offs)
Net Recoveries to Net Recoveries to
(Charge-offs) Average Loans (Charge-offs) Average Loans
(Dollars in thousands) Recoveries Outstanding Recoveries Outstanding
Single family $ 1 0.00 % $ 0 0.00 %
Commercial real estate (91 ) (0.02 ) 617 0.16
Consumer (17 ) (0.04 ) 16 0.03
Commercial business 34 0.05 66 0.09
Total $ (73 ) (0.01 ) $ 699 0.11
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The following table reflects the allocation of the allowance for loan losses by
loan category:
December 31,
2022 2021
Allocated Percent of Allocated Percent of
Allowance as a Loans in Each Allowance as a Loans in Each
% of Loan Category to % of Loan Category to
(Dollars in thousands) Category Total Loans Category Total Loans
Single family 0.61 % 26.13 % 0.60 % 24.67 %
Commercial real estate 1.49 59.83 1.61 59.95
Consumer 2.36 5.69 2.35 6.29
Commercial business 1.41 8.35 1.56 9.09
Total 1.30 100.00 % 1.40 100.00 %
The allocated allowance percentages for commercial real estate and commercial
business loans decreased in 2022 primarily because of the improvement in the
credit risk of the loans held in the portfolio between the periods. The increase
in the allowance percentage for single family and consumer loans between the
periods is due to an increase in the qualitative reserves relating to the
perceived negative impact on borrowers from inflation and rising interest rates.
Allowance for Real Estate Losses
Real estate properties acquired or expected to be acquired through loan
foreclosures are initially recorded at fair value less estimated selling costs.
Management periodically performs valuations and an allowance for losses is
established if the carrying value of a property exceeds its fair value less
estimated selling costs. There was no allowance for real estate losses at
Non-performing Assets Loans are reviewed at least quarterly and if the collectability of any loan is doubtful, it is placed on non-accrual status. Loans are placed on non-accrual status when either principal or interest is 90 days or more past due, unless, in the judgment of management, the loan is well collateralized and in the process of collection. Interest accrued and unpaid at the time a loan is placed on non-accrual status is charged against interest income. Subsequent payments are either applied to the outstanding principal balance or recorded as interest income, depending on the assessment of the ultimate collectability of the loan. Restructured loans include the Bank's troubled debt restructurings (TDRs) that involved forgiving a portion of interest or principal or making a loan with terms that the Bank would not normally grant to borrowers whose financial condition had deteriorated. Foreclosed and repossessed assets include assets acquired in settlement of loans. Total non-performing assets were$1.9 million atDecember 31, 2022 , a decrease of$3.0 million , or 61.8%, from$4.9 million atDecember 31, 2021 . Non-performing loans decreased$2.7 million and foreclosed and repossessed assets decreased$0.3 million during 2022. The decrease in non-performing loans is related to a$3.8 million decrease in non-performing commercial real estate loans, primarily because of a$3.1 million loan in the hospitality industry that was reclassified as performing during 2022. Non-performing consumer loans also decreased$0.1 million during the period. These decreases in non-performing loans were partially offset by increases of$0.6 million and$0.5 million in non-performing single family and commercial business loans, respectively. 47
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The following table sets forth the amounts and categories of non-performing assets in the Company's portfolio:
December 31,
(Dollars in thousands) 2022 2021
Non-performing loans:
Single family $ 908 340
Commercial real estate 0 3,757
Consumer 441 517
Commercial business 529 7
Total 1,878 4,621
Foreclosed and repossessed assets:
Commercial real estate 0 290
Total 0 290
Total non-performing assets $ 1,878 4,911
Total as a percentage of total assets 0.17 % 0.46 %
Total as a percentage of total loans receivable 0.24 % 0.70 % Allowance for loan losses to non-performing loans 547.24 % 200.81 %
Gross interest income which would have been recorded had the non-accruing loans been current in accordance with their original terms amounted to$0.1 million and$0.3 million for the years endedDecember 31, 2022 and 2021, respectively. The amount that was included in interest income on a cash basis for these loans for 2022 was not material, and for the year endedDecember 31, 2021 the amount included in interest income was$0.2 million . AtDecember 31, 2022 and 2021, there were loans included in loans receivable, net, with terms that had been modified in a TDR totaling$0.8 million and$1.1 million , respectively. Had these loans been performing in accordance with their original terms throughout 2022 and 2021, the Company would have recorded gross interest income of$0.1 million for both years. During 2022 and 2021, the amount of interest income received on these loans was not material. For the loans that were modified in 2022,$0.1 million were classified and performing, and an immaterial amount were non-performing atDecember 31, 2022 . The decrease in TDRs in 2022 related primarily to a commercial real estate loan that was charged down and paid off during the year. Three loans totaling$0.1 million were modified in 2022 and outstanding atDecember 31, 2022 . One loan was secured by business assets, one loan was secured by a retail single family lot, and one loan was secured by personal property. For the loans that were modified in 2021, none were classified and performing, and$0.3 million were non-performing atDecember 31, 2021 . The decrease in TDRs in 2021 related primarily to a single family first mortgage loan that paid off during the year. Of the loans that were modified in 2021 and outstanding atDecember 31, 2021 ,$0.2 million related to a loan secured by commercial real estate and$0.1 million consisted of two unrelated loans secured by first mortgages on single family properties. 48
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The following table sets forth the amount of TDRs in the Company's portfolio:
December 31,
(Dollars in thousands) 2022 2021
Single family $ 202 254
Commercial real estate 179 355
Consumer 378 442
Commercial business 31 0
Total $ 790 1,051
TDRs on accrual status $ 262 29
TDRs on non-accrual status 528 1,022
Total $ 790 1,051
The Financial Accounting Standards Board (FASB) issued Accounting Standards
Update (ASU) 2022-02, Financial Instruments-Credit Losses (Topic 326): Troubled
Debt Restructurings and Vintage Disclosures. The amendments in this ASU
eliminate the guidance for troubled debt restructurings (TDRs) by creditors in
Subtopic 310-40, Receivables-Troubled Debt Restructurings by Creditors, while
enhancing disclosure requirements for certain loan refinancing and restructures
by creditors when a borrower is experiencing financial difficulty. See "Note 1
Description of the Business and Summary of Significant Accounting Policies - New
Accounting Pronouncements" in the Notes to Consolidated Financial Statements for
further information on the impact on the Company when it adopted ASU 2022-02 on
January 1, 2023 .
Liquidity and Capital Resources
The Company manages its liquidity position so that the funding needs of borrowers and depositors are met in a timely and cost-effective manner. Asset liquidity is the ability to convert assets to cash through the maturity or sale of the asset. Liability liquidity is the ability of the Bank to obtain retail, commercial, internet, and brokered deposits or to borrow funds from third parties such as the FHLB or theFederal Reserve Bank of Minneapolis . The primary investing activities are the origination of loans and the purchase of securities. Principal and interest payments on loans and securities, along with the proceeds from the sale of loans held for sale, are the primary sources of cash for the Bank. Additional cash can be obtained by selling securities from the available for sale portfolio or by selling loans or mortgage servicing rights. The primary financing activity is the attraction of retail, commercial, internet, and brokered deposits. The Bank also has the ability to borrow funds from the FHLB orFederal Reserve Bank of Minneapolis based on the collateral value of the loans pledged, subject to applicable borrowing base and collateral requirements. See "Note 12Federal Home Loan Bank (FHLB) Advances and Other Borrowings" in the Notes to Consolidated Financial Statements for more information on the advances that could be drawn based upon existing collateral levels with the FHLB and theFederal Reserve Bank of Minneapolis . Unpledged securities could also be pledged and used as collateral for additional borrowings with the FHLB orFederal Reserve Bank of Minneapolis . The Bank's most liquid assets are cash and cash equivalents, which consist of short-term highly liquid investments with original maturities of less than three months that are readily convertible to known amounts of cash, and interest-bearing deposits. The level of these assets is dependent on the operating, financing and investing activities during any given period. 49
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Cash and cash equivalents for the Company atDecember 31, 2022 were$36.3 million , a decrease of$57.8 million , compared to$94.1 million atDecember 31, 2021 . Net cash provided by operating activities during 2022 was$31.3 million . The Company conducted the following investing activities during 2022: purchases of securities available for sale and FHLB stock were$41.9 million ; principal payments and maturity and redemption proceeds received on securities available for sale and FHLB stock were$56.3 million ; and the proceeds from the sale of premises and other real estate were$0.4 million . Net loans receivable increased$139.7 million and the Company purchased premises and equipment of$0.3 million . Net cash used by investing activities during 2022 was$125.2 million . The Company conducted the following major financing activities during 2022: deposits increased$31.2 million ; received proceeds from borrowings of$158.9 million , repaid borrowings of$158.9 million , purchased treasury stock of$2.2 million ; paid dividends to stockholders of$1.0 million , and customer escrows increased$8.0 million . Net cash provided by financing activities was$36.0 million for 2022. The Bank has certificates of deposits from customers with outstanding balances of$72.7 million that mature during 2023. Based upon past experience, management anticipates that the majority of the deposits will renew for another term. The Company believes that deposits that do not renew will be replaced with deposits from other customers, brokers, or FHLB advances. Proceeds from the sale of securities could also be used to fund unanticipated outflows of deposits. The Bank has deposits of$134.2 million in checking and money market accounts of eight customers that have individual relationship balances greater than$5.0 million . These funds may be withdrawn at any time, however, management anticipates that the majority of these deposits will remain on deposit with the Bank over the next twelve months. If these deposits are withdrawn, it is anticipated that they would be funded with available cash, replaced with deposits from other customers, brokers, or with advances from the FHLB. Proceeds from the sale of securities could also be used to fund unanticipated outflows of deposits. Dividends from the Bank have been the Company's primary source of cash. The Bank is restricted under applicable federal banking law from paying dividends to the Company without prior notice to and non-objection of the applicable regulator. During 2022, the Bank paid dividends to the Company of$6.0 million and atDecember 31, 2022 , the Company had an available cash balance of$15.3 million . The Company's primary use of cash is the payment of holding company level expenses including the payment of director and management fees, legal expenses and regulatory costs. The Company may also use cash to repurchase stock or pay any declared dividends. The Company plans to continue to fund its liquidity needs through dividends from the Bank, or if deemed prudent, by obtaining external capital.
Contractual Obligations and Commercial Commitments
The Company has no off-balance sheet arrangements other than commitments to originate and sell loans in the ordinary course of business. The Company does have certain obligations and commitments to make future payments under existing contracts. See "Note 18 Commitments and Contingencies" in the Notes to Consolidated Financial Statements for further information on the outstanding contractual obligations and commercial commitments atDecember 31, 2022 .
Regulatory Capital Requirements
The Bank is subject to the Basel III regulatory capital requirements. TheBasel III requirements, among other things, (i) apply a set of capital requirements to the Bank, including requirements relating to common equity as a component of core capital, (ii) implement a "capital conservation buffer" against risk and a minimum Tier 1 capital requirement, and (iii) set forth rules for calculating risk-weighted assets for purposes of such requirements. The rules made corresponding revisions to the prompt corrective action framework and include capital ratios and buffer requirements. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of its assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. 50
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The Board of Governors of theFederal Reserve Bank (FRB) amended its Policy Statement, to exempt small bank and savings and loan holding companies with assets less than$3 billion from the above capital requirements. The Company currently meets the qualitative exemption requirements, and therefore, is exempt from the above capital requirements. Quantitative measures established by regulations to ensure capital adequacy require the Bank to maintain minimum amounts and ratios of common equity Tier 1 capital to risk-weighted assets, Tier 1 capital to adjusted total assets, Tier 1 capital to risk-weighted assets and total capital to risk-weighted assets. The Bank must maintain a capital conservation buffer of at least 2.50% composed of common equity Tier 1 capital above its minimum risk-based capital requirements in order to avoid limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers. Management believes that, as ofDecember 31, 2022 , the Bank's capital ratios were in excess of those quantitative capital ratio standards set forth under the current prompt corrective action regulations, including the capital conservation buffer described above. However, there can be no assurance that the Bank will continue to maintain such status in the future. The OCC has extensive discretion in its supervisory and enforcement activities, and can adjust the requirement to be well-capitalized in the future. See "Note 17Regulatory Capital " in the Notes to Consolidated Financial Statements for a table that reflects the Bank's capital compared to these capital requirements.
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, anticipated asset growth, general business practices and other factors. The Company did not make any dividend payments to common stockholders in 2021 and made four quarterly dividend payments of6 cents per share that totaled$1.0 million during 2022. The Company will continue to evaluate the best use of the Company's capital based on the factors identified above. Under applicable federal banking laws and regulations, no dividends can be declared or paid by the Bank to the Company without notice to and non-objection from the applicable banking regulator. There is no assurance that the Bank would satisfy the applicable regulatory requirements necessary to effect any such dividends. The payment of dividends by the Company is dependent upon the Company having adequate cash or other assets that can be converted to cash to pay dividends to its stockholders and is subject to the discretion of the Board of Directors of both the Bank and the Company. The payment of dividends depends upon many factors, including the Company's results of operations, financial condition, capital requirements, regulatory and contractual restrictions, business strategy and other factors deemed relevant by the Board of Directors. InJanuary 2023 , the Company's Board of Directors declared a quarterly dividend of6 cents per share of common stock payable onMarch 8, 2023 to stockholders of record at the close of business onFebruary 15, 2023 . The declaration and amount of any future cash dividends remains subject to the sole discretion of the Board of Directors. New Accounting Pronouncements "Note 1 Description of the Business and Summary of Significant Accounting Policies - New Accounting Pronouncements" in the Notes to Consolidated Financial Statements discusses recently issued accounting pronouncements that the Company will be required to adopt. Also discussed is management's expectation of the impact these new accounting pronouncements will have on the Company's consolidated financial statements. 51
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Table of Contents 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 Management's Discussion and Analysis 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 onDecember 31, 2022 . (Dollars in thousands) Market Value Basis point change in interest rates -200 -100 0 +100 +200 Total market-risk sensitive assets$ 1,070,776 1,046,409 1,022,659 998,862 976,579 Total market-risk sensitive liabilities 877,577 828,037 797,208 774,528 757,172 Off-balance sheet financial instruments 148 79 0 149 286 Net market risk$ 193,051 218,293 225,451 224,185 219,121 Percentage change from current market value (14.37 )% (3.17 )% 0.00 % (0.56 )% (2.81 )% The preceding table was prepared utilizing the following assumptions (the Model Assumptions) regarding prepayment and decay ratios that were determined by management based upon its review of historical prepayment speeds and decay rates. Fixed rate loans were assumed to prepay at annual rates of between 1% and 39%, depending on the note rate and the period to maturity. Adjustable rate mortgages (ARMs) were assumed to prepay at annual rates of between 7% and 43%, depending on the note rate and the period to maturity. Mortgage-backed securities were projected to have prepayments based upon the underlying collateral securing the instrument. All loan prepayments vary based on the note rate and period to maturity of the individual loans. Certificate accounts were assumed not to be withdrawn until maturity. Retail money market demand accounts (MMDAs) and savings accounts were assumed to decay at an annual rate of 26% and 2%, respectively. Retail non-interest and interest-bearing checking accounts were assumed to decay at annual rates of 14% and 21%, respectively. Commercial non-interest and interest-bearing checking accounts were assumed to decay at annual rates of 16% and 36%, respectively. Commercial MMDAs were assumed to decay at annual rates of between 4% and 18%. 52
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Certain shortcomings are inherent in the method of analysis presented in the foregoing table. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates. The model assumes that the difference between the current interest rate being earned or paid compared to a treasury instrument or other interest index with a similar term to maturity (the interest spread) will remain constant over the interest changes disclosed in the table. Changes in interest spread could impact projected market value changes. Certain assets, such as ARMs, have features that restrict changes in interest rates on a short-term basis and over the life of the assets. The market value of the interest-bearing assets that are approaching their lifetime interest rate caps or floors could be different from the values calculated in the table. Certain liabilities, such as certificates of deposit, have fixed rates that restrict interest rate changes until maturity. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the foregoing table. The ability of many borrowers to service their debt may also decrease in the event of a substantial increase in interest rates.
Asset/Liability Management
The Company's management reviews the impact that changing interest rates will have on the net interest income projected for the twelve months followingDecember 31, 2022 to determine if its current level of interest rate risk is acceptable. The following table projects the estimated impact on net interest income during the twelve month period endingDecember 31, 2023 of immediate interest rate changes called rate shocks:
(Dollars in thousands)
Rate Shock Net Interest Percent
in Basis Points Change Change
+200 $ 904 2.66 %
+100 461 1.36
0 0 0.00
-100 (419 ) (1.23 )
-200 (1,760 ) (5.17 )
The preceding table was prepared utilizing the Model Assumptions. Certain
shortcomings are inherent in the method of analysis presented in the preceding
table. In the event of a change in interest rates, prepayment and early
withdrawal levels would likely deviate significantly from those assumed in
calculating the preceding table. The ability of many borrowers to service their
debt may decrease in the event of a substantial increase in interest rates and
could impact net interest income. The increase in interest income in a rising
rate environment is because there are more interest earning assets that are
anticipated to reprice to higher interest rates in that environment in the next
twelve months than there are deposits that would reprice based on the
composition of deposits and the estimated lag in repricing certain deposits.
In managing the Company's exposure to changes in interest rates, management
closely monitors interest rate risk. The Company has an Asset/Liability
Committee that meets frequently to discuss changes in the interest rate risk
position and projected profitability. The Committee makes adjustments to the
asset/liability position of the Bank that are reviewed by the Board of Directors
of the Bank. This Committee also reviews the Bank's portfolio, formulates
investment strategies and oversees the timing and implementation of transactions
as intended to assure attainment of the Bank's objectives in an effective
manner. In addition, each quarter the Board reviews the Bank's asset/liability
position, including simulations of the effect on the Bank's capital of various
interest rate scenarios.
In managing its asset/liability composition, the Bank may, at times, depending
on the relationship between long-term and short-term interest rates, market
conditions and consumer preference, place more emphasis on managing net interest
margin than on better matching the interest rate sensitivity of its assets and
liabilities in an effort to enhance net interest income. Management believes
that the increased net interest income resulting from a mismatch in the maturity
of its asset and liability portfolios can, in certain situations, provide high
enough returns to justify the increased exposure to sudden and unexpected
changes in interest rates.
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To the extent consistent with its interest rate spread objectives, the Bank attempts to manage its interest rate risk and has taken a number of steps to structure its balance sheet to better match the maturities of its assets and liabilities. The Bank sells almost all of its originated 30-year fixed rate single family residential loans that are saleable to third parties and generally places only adjustable rate or shorter-term fixed rate loans that meet certain risk characteristics into its loan portfolio. In addition, a significant portion of the Bank's commercial loans that are placed into the portfolio are adjustable rate loans or fixed rate loans that reprice in five years or less.
Other Financial Data
The following tables set forth certain information as to the Bank's FHLB advances and other borrowings.
Year Ended December 31,
(Dollars in thousands) 2022 2021
Maximum Balance:
FHLB advances and other borrowings $ 72,500 1
FHLB short-term advances and other borrowings 72,500
1
Average Balance: FHLB advances and other borrowings 6,762
0
FHLB short-term advances and other borrowings 6,762 0 See "Note 12Federal Home Loan Bank (FHLB) Advances and Other Borrowings" in the Notes to Consolidated Financial Statements for more information on FHLB advances and other borrowings.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable.
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