hmnf20180930_10q.htm
 

 

Table of Contents

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

[X]

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

 

For the quarterly period ended September 30, 2018

OR

 

[   ]

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

 

For the transition period from _________ to _________

 

Commission File Number 0-24100

 

HMN FINANCIAL, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

41-1777397

(State or other jurisdiction of incorporation or organization)

 

(I.R.S. Employer Identification No.)

     

1016 Civic Center Drive N.W., Rochester, MN

 

55901

(Address of principal executive offices)

 

(Zip Code)

     

Registrant's telephone number, including area code:

 

(507) 535-1200

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes ☒                 No ☐

 

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).

Yes ☒                 No ☐ 

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer ☐          Accelerated filer ☐           Non-accelerated filer ☐          Smaller reporting company ☒          Emerging growth company ☐

 

If an emerging growth company, indicate by checkmark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

 

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

Yes ☐                 No ☒

 

Indicate the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date.

 

Class

 

Outstanding at October 26, 2018

Common stock, $0.01 par value

 

4,824,413

 

1

 

 

HMN FINANCIAL, INC.

 

CONTENTS

 

 

Page

   
PART I - FINANCIAL INFORMATION  

 

 

 

Item 1:

Financial Statements

3

 

 

 

 

Consolidated Balance Sheets at September 30, 2018 and December 31, 2017

3

 

 

 

 

Consolidated Statements of Comprehensive Income for the Three Months and Nine Months Ended September 30, 2018 and 2017

4

 

 

 

 

Consolidated Statement of Stockholders' Equity for the Nine-Month Period Ended September 30, 2018

5

 

 

 

 

Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2018 and 2017

6

 

 

 

 

Notes to Consolidated Financial Statements

7

 

 

 

Item 2:

Management's Discussion and Analysis of Financial Condition and Results of Operations

25

 

 

 

Item 3:

Quantitative and Qualitative Disclosures about Market Risk

34

 

 

 

Item 4:

Controls and Procedures

34

 

 

 

PART II - OTHER INFORMATION

 

 

 

 

Item 1:

Legal Proceedings

35

 

 

 

Item 1A:

Risk Factors

35

 

 

 

Item 2:

Unregistered Sales of Equity Securities and Use of Proceeds

35

 

 

 

Item 3:

Defaults Upon Senior Securities

35

 

 

 

Item 4:

Mine Safety Disclosures

35

 

 

 

Item 5:

Other Information

35

 

 

 

Item 6:

Exhibits

36

 

 

 

Signatures

37

 

2

 

 

Part I – FINANCIAL INFORMATION

Item 1: Financial Statements

 

 HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

 

   

September 30,

   

December 31,

 

(Dollars in thousands)

 

2018

   

2017

 
   

(unaudited)

         

Assets

               

Cash and cash equivalents

  $ 48,076       37,564  

Securities available for sale:

               

Mortgage-backed and related securities (amortized cost $8,593 and $5,148)

    8,207       5,068  

Other marketable securities (amortized cost $73,367 and $73,653)

    71,397       72,404  
      79,604       77,472  
                 

Loans held for sale

    2,109       1,837  

Loans receivable, net

    586,092       585,931  

Accrued interest receivable

    2,225       2,344  

Real estate, net

    414       627  

Federal Home Loan Bank stock, at cost

    867       817  

Mortgage servicing rights, net

    1,845       1,724  

Premises and equipment, net

    9,754       8,226  

Goodwill

    802       802  

Core deposit intangible

    280       355  

Prepaid expenses and other assets

    1,418       1,314  

Deferred tax asset, net

    3,959       3,672  

Total assets

  $ 737,445       722,685  
                 

Liabilities and Stockholders’ Equity

               

Deposits

  $ 651,429       635,601  

Accrued interest payable

    279       146  

Customer escrows

    2,187       1,147  

Accrued expenses and other liabilities

    3,556       4,973  

Total liabilities

    657,451       641,867  

Commitments and contingencies

               

Stockholders’ equity:

               

Serial preferred stock ($.01 par value): authorized 500,000 shares; issued and outstanding shares 0

    0       0  

Common stock ($.01 par value): authorized 16,000,000; issued shares 9,128,662

    91       91  

Additional paid-in capital

    42,578       50,623  

Retained earnings, subject to certain restrictions

    97,402       91,448  

Accumulated other comprehensive loss

    (1,697 )     (957 )

Unearned employee stock ownership plan shares

    (1,885 )     (2,030 )

Treasury stock, at cost 4,519,222 and 4,631,124 shares

    (56,495 )     (58,357 )

Total stockholders’ equity

    79,994       80,818  

Total liabilities and stockholders’ equity

  $ 737,445       722,685  
                 

 

See accompanying notes to consolidated financial statements.

 

3

 

 

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

(unaudited)

 

   

Three Months Ended
September 30,

   

Nine Months Ended
September 30,

 

(Dollars in thousands, except per share data)

 

2018

   

2017

   

2018

   

2017

 
Interest income:                                

Loans receivable

  $ 7,441       6,930       21,225       19,991  

Securities available for sale:

                               

Mortgage-backed and related

    52       16       148       29  

Other marketable

    285       270       842       821  

Other

    192       39       369       72  

Total interest income

    7,970       7,255       22,584       20,913  
                                 

Interest expense:

                               

Deposits

    587       413       1,581       1,035  

Advances and other borrowings

    0       80       2       327  

Total interest expense

    587       493       1,583       1,362  

Net interest income

    7,383       6,762       21,001       19,551  

Provision for loan losses

    (652 )     (581 )     (482 )     (582 )

Net interest income after provision for loan losses

    8,035       7,343       21,483       20,133  
                                 

Non-interest income:

                               

Fees and service charges

    870       848       2,421       2,517  

Loan servicing fees

    343       299       941       906  

Gain on sales of loans

    489       521       1,612       1,528  

Other

    234       241       792       744  

Total non-interest income

    1,936       1,909       5,766       5,695  
                                 

Non-interest expense:

                               

Compensation and benefits

    3,574       3,642       11,076       11,366  

Occupancy and equipment

    1,073       1,050       3,242       3,115  

Data processing

    310       243       939       795  

Professional services

    326       307       873       983  

Other

    931       1,017       2,951       2,786  

Total non-interest expense

    6,214       6,259       19,081       19,045  

Income before income tax expense

    3,757       2,993       8,168       6,783  

Income tax expense

    1,045       1,213       2,284       2,766  

Net income

    2,712       1,780       5,884       4,017  

Other comprehensive (loss) income, net of tax

    (218 )     (4 )     (670 )     357  

Comprehensive income available to common shareholders

  $ 2,494       1,776       5,214       4,374  

Basic earnings per share

  $ 0.62       0.42       1.37       0.95  

Diluted earnings per share

  $ 0.59       0.37       1.24       0.83  
                                 

 

See accompanying notes to consolidated financial statements.

 

4

 

 

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statement of Stockholders' Equity

For the Nine-Month Period Ended September 30, 2018

(unaudited)

 

                                   

 

Unearned

                 
                                   

Employee

                 
                           

Accumulated

   

Stock

           

Total

 
           

Additional

           

Other

   

Ownership

           

Stock-

 
   

Common

   

Paid-in

   

Retained

   

Comprehensive

   

Plan

   

Treasury

   

Holders’

 

(Dollars in thousands)

 

Stock

   

Capital

   

Earnings

   

Loss

   

Shares

   

Stock

   

Equity

 

Balance, December 31, 2017

  $ 91       50,623       91,448       (957 )     (2,030 )     (58,357 )     80,818  

Net income

                    5,884                               5,884  

Amounts reclassified from accumulated other comprehensive loss

                    70       (70 )                     0  

Other comprehensive loss

                            (670 )                     (670 )

Stock warrants purchased

            (6,453 )                                     (6,453 )

Exercise of stock warrants

            (1,674 )                             1,674       0  

Stock compensation expense

            13                                       13  

Restricted stock awards

            (188 )                             188       0  

Amortization of restricted stock awards

            104                                       104  

Earned employee stock ownership plan shares

            153                       145               298  

Balance, September 30, 2018

  $ 91       42,578       97,402       (1,697 )     (1,885 )     (56,495 )     79,994  
                                                         

 

See accompanying notes to consolidated financial statements.

 

5

 

 

HMN FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(unaudited)

 

   

Nine Months Ended

September 30,

 

(Dollars in thousands)

 

2018

   

2017

 

Cash flows from operating activities:

               

Net income

  $ 5,884       4,017  

Adjustments to reconcile net income to cash provided by operating activities:

               

Provision for loan losses

    (482 )     (582 )

Depreciation

    806       704  

Amortization of (discounts) premiums, net

    20       (1 )

Amortization of deferred loan fees

    (254 )     (192 )

Amortization of core deposit intangible

    75       75  

Amortization of other purchased fair value adjustments

    (63 )     (74 )

Amortization of mortgage servicing rights

    412       411  

Capitalized mortgage servicing rights

    (533 )     (461 )

Securities losses, net

    12       0  

Gain on sale of premises and equipment

    0       (8 )

Gain on sales of real estate

    (80 )     (72 )

Gain on sales of loans

    (1,612 )     (1,528 )

Proceeds from sales of loans held for sale

    68,590       63,449  

Disbursements on loans held for sale

    (59,079 )     (54,551 )

Amortization of restricted stock awards

    104       109  

Amortization of unearned Employee Stock Ownership Plan shares

    145       145  

Earned Employee Stock Ownership Plan shares priced above original cost

    153       108  

Stock option compensation expense

    13       31  

Decrease in accrued interest receivable

    119       46  

Increase (decrease) in accrued interest payable

    133       (124 )

(Increase) decrease in other assets

    (101 )     376  

Increase (decrease) in other liabilities

    (1,434 )     57  

Other, net

    (2 )     51  

Net cash provided by operating activities

    12,826       11,986  

Cash flows from investing activities:

               

Principal collected on securities available for sale

    1,478       636  

Proceeds collected on maturities of securities available for sale

    310       20,100  

Purchases of securities available for sale

    (4,888 )     (20,035 )

Purchase of Federal Home Loan Bank stock

    (322 )     (3,999 )

Redemption of Federal Home Loan Bank stock

    272       3,952  

Proceeds from sales of real estate

    367       309  

Net increase in loans receivable

    (7,614 )     (39,044 )

Proceeds from sale of premises and equipment

    0       8  

Purchases of premises and equipment

    (2,333 )     (772 )

Net cash used by investing activities

    (12,730 )     (38,845 )

Cash flows from financing activities:

               

Increase in deposits

    15,829       36,165  

Warrants purchased

    (6,453 )     0  

Stock awards withheld for tax withholding

    0       (54 )

Proceeds from borrowings

    6,800       99,200  

Repayment of borrowings

    (6,800 )     (106,200 )

Increase in customer escrows

    1,040       787  

Net cash provided by financing activities

    10,416       29,898  

Increase in cash and cash equivalents

    10,512       3,039  

Cash and cash equivalents, beginning of period

    37,564       27,561  

Cash and cash equivalents, end of period

  $ 48,076       30,600  

Supplemental cash flow disclosures:

               

Cash paid for interest

  $ 1,448       1,485  

Cash paid for income taxes

    3,395       1,817  

Supplemental noncash flow disclosures:

               

Loans transferred to loans held for sale

    8,187       8,144  

Loans held for sale transferred to loans

    0       164  

Transfer of loans to real estate

    74       40  
                 

 

See accompanying notes to consolidated financial statements.

 

6

 

HMN FINANCIAL, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(unaudited)

September 30, 2018 and 2017

 

 

(1)

HMN Financial, Inc.

HMN Financial, Inc. (HMN or the Company) is a stock savings bank holding company that owns 100 percent of Home Federal Savings Bank (the Bank). The Bank has a community banking philosophy and operates retail banking and loan production facilities in Minnesota, Iowa, and Wisconsin. The Bank has two wholly owned subsidiaries, Osterud Insurance Agency, Inc. (OIA), which does business as Home Federal Investment Services and offers financial planning products and services, and HFSB Property Holdings, LLC (HPH), which is currently inactive but has acted in the past as an intermediary for the Bank in holding and operating certain foreclosed properties.

 

The consolidated financial statements included herein are for HMN, the Bank, OIA and HPH. All significant intercompany accounts and transactions have been eliminated in consolidation.

 

Certain amounts in the consolidated financial statements for the prior year have been reclassified to conform to the current year presentation.

 

 

(2)

Basis of Preparation

The accompanying unaudited consolidated financial statements were prepared in accordance with instructions for Form 10-Q and, therefore, do not include all disclosures necessary for a complete presentation of the consolidated balance sheets, consolidated statements of comprehensive income, consolidated statement of stockholders' equity and consolidated statements of cash flows in conformity with U.S. generally accepted accounting principles (GAAP). However, all normal recurring adjustments which are, in the opinion of management, necessary for the fair presentation of the interim financial statements have been included. The results of operations for the nine month period ended September 30, 2018 are not necessarily indicative of the results which may be expected for the entire year.

 

 

(3)

New Accounting Standards

In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, Leases (Topic 842). The amendments in the ASU create Topic 842, Leases, and supersede the lease requirements in Topic 840, Leases. The objective of this ASU is to establish the principles that lessees and lessors shall apply to report useful information to users of financial statements about the amount, timing, and uncertainty of cash flows arising from a lease. The main difference between previous GAAP and this ASU is the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous GAAP. The amendment requires a lessee to recognize in the statement of financial position a liability to make lease payments (the lease liability) and the right-of-use asset representing its right to use the underlying asset for the lease term. The accounting applied by a lessor is largely unchanged from that applied under previous GAAP. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The modified retrospective approach includes a number of optional practical expedients that entities may elect to apply that will, in effect, continue to account for leases that commence before the effective date in accordance with previous GAAP unless the lease is modified. As entities started to implement the new leases standard, many preparers were encountering some unanticipated costs and complexities associated with the modified retrospective transition method, particularly the comparative period reporting requirements. In response to these issues, the FASB in July of 2018 issued ASU 2018-11. The amendments in this ASU provide lessors with an additional (and optional) transition method to adopt the new leases standard. Under this new transition method, an entity initially applies the new leases standard at the adoption date and recognizes a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. The amendments in these ASU’s, for public business entities, are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The adoption of these ASU’s in the first quarter of 2019 is not anticipated to have a material impact on the Company’s consolidated financial statements.

 

 

In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The amendments in this ASU affect all entities that measure credit losses on financial instruments including loans, debt securities, trade receivables, net investments in leases, off-balance sheet credit exposures, reinsurance receivables, and any other financial asset that has a contractual right to receive cash that is not specifically excluded. The main objective of this ASU is to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. To achieve this objective, the amendments in this ASU replace the incurred loss impairment methodology required in current GAAP with a methodology that reflects expected credit losses that requires consideration of a broader range of reasonable and supportable information to estimate credit losses. The amendments in this ASU will affect entities to varying degrees depending on the credit quality of the assets held by the entity, the duration of the assets held, and how the entity applies the current incurred loss methodology. The amendments in this ASU, for public business entities that are filers with the Securities and Exchange Commission, are effective for fiscal years beginning after December 15, 2019, including interim periods within those annual periods. All entities may adopt the amendments in the ASU early as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Amendments should be applied using a modified retrospective transition method by means of a cumulative-effect adjustment to equity as of the beginning of the period in which the guidance is adopted. Management has accumulated the charge off information necessary to calculate the appropriate life of loan loss percentages for the various loan categories, has identified several key metrics to help identify and project anticipated changes in the credit quality of our loan portfolio upon enactment, and is in the process of evaluating the determination of potential qualitative reserve amounts and the impact that the adoption of this ASU in the first quarter of 2020 will have on the Company’s consolidated financial statements.

 

In March 2017, the FASB issued ASU 2017-08, Receivables – Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. The amendments in this ASU shorten the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount, as discounts continue to be amortized to maturity. This ASU is intended to more closely align the amortization period of premiums and discounts to expectations incorporated in market pricing on the underlying securities. In most cases, market participants price securities to the call date that produces the worst yield when the coupon is above current market rates and price securities to maturity when the coupon is below market rates. As a result, the amendments more closely align interest income recorded on bonds held at a premium or a discount with the economics of the underlying instrument. This ASU is intended to reduce diversity in practice and is effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018 with early adoption permitted. Upon adoption, the amendments should be applied using a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. Additionally, in the period of adoption, an entity should provide disclosures about a change in accounting principles. The adoption of this ASU in the first quarter of 2019 is not anticipated to have a material impact on the Company’s consolidated financial statements.

 

In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820), Disclosure Framework – Changes to the Disclosure Requirements for Fair Value Measurement. The Amendments in this ASU apply to all entities that are required, under existing GAAP, to make disclosures about recurring or nonrecurring fair value measurements and modify the disclosure requirements on fair value measurements in Topic 820, Fair Value Measurement, including the consideration of costs and benefits. The ASU removed, modified, and added various disclosure requirements in Topic 820. The amendments also eliminate at a minimum from the phrase an entity shall disclose at a minimum to promote the appropriate exercise of discretion by entities when considering fair value measurement disclosures and to clarify that materiality is an appropriate consideration of entities and their auditor when evaluating disclosure requirements. The amendments in the ASU are effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. An entity is permitted to early adopt the implementation of any removed or modified disclosures upon issuance of the ASU and delay adoption of the additional disclosures until their effective date. The Company has not opted to early adopt any portion of this ASU and the adoption in the first quarter of 2020 is not anticipated to have a material impact on the Company’s consolidated financial statements.

 

 

 

(4)

Fair Value Measurements

ASC 820, Fair Value Measurements, establishes a framework for measuring the fair value of assets and liabilities using a hierarchy system consisting of three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

 

Level 1 - Valuation is based upon quoted prices for identical instruments traded in active markets that the Company has the ability to access.

 

Level 2 - Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which significant assumptions are observable in the market.

 

Level 3 – Valuation is generated from model-based techniques that use significant assumptions not observable in the market and are used only to the extent that observable inputs are not available. These unobservable assumptions reflect our own estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

 

The following table summarizes the assets and liabilities of the Company for which fair values are determined on a recurring basis as of September 30, 2018 and December 31, 2017.

 

   

Carrying value at September 30, 2018

 

 

(Dollars in thousands)

 

Total

   

Level 1

   

Level 2

   

Level 3

 

Securities available for sale

  $ 79,604       0       79,604       0  

Mortgage loan commitments

    13       0       13       0  

Total

  $ 79,617       0       79,617       0  

 

   

Carrying value at December 31, 2017

 

 

(Dollars in thousands)

 

Total

   

Level 1

   

Level 2

   

Level 3

 

Securities available for sale

  $ 77,472       0       77,472       0  

Mortgage loan commitments

    28       0       28       0  

Total

  $ 77,500       0       77,500       0  
                                 

 

There were no transfers between Levels 1, 2, or 3 during the three or nine month periods ended September 30, 2018.

 

The Company may also be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis in accordance with GAAP. These adjustments to fair value usually result from the application of the lower-of-cost-or-market accounting or write-downs of individual assets. For assets measured at fair value on a nonrecurring basis that were held at December 31, 2017 and at September 30, 2018, the following table provides the level of valuation assumptions used to determine each adjustment and the carrying value of the related individual assets or portfolios at September 30, 2018 and December 31, 2017.

 

   

Carrying value at September 30, 2018

                 

 

 

(Dollars in thousands)

 

Total

   

Level 1

   

Level 2

   

Level 3

   

Three months ended

September 30, 2018

total losses

   

Nine months ended

September 30, 2018

total losses

 

Loans held for sale

  $ 2,109     0       2,109     0       (46 )     (30 )

Mortgage servicing rights

    1,845     0       1,845     0       0       0  

Loans (1)

    5,352     0       5,352     0       (252 )     (332 )

Real estate, net (2)

    414     0       414     0       0       0  

Total

  $ 9,720     0       9,720     0       (298 )     (362 )
                                             

 

   

Carrying value at December 31, 2017

           

 

 

(Dollars in thousands)

 

Total

   

Level 1

   

Level 2

   

Level 3

   

Year ended

December 31, 2017

total gains (losses)

   

Loans held for sale

  $ 1,837     0       1,837     0       1    

Mortgage servicing rights

    1,724     0       1,724     0       0    

Loans (1)

    3,201     0       3,201     0       (413 )  

Real estate, net (2)

    627     0       627     0       0    

Total

  $ 7,389     0       7,389     0       (412 )  
                                       

(1)

Represents the carrying value and related specific reserves on loans for which adjustments are based on the appraised value of the collateral. The carrying value of loans fully charged-off is zero.

(2)

Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as foreclosed assets.

 

 

 

(5)

Fair Value of Financial Instruments

Generally accepted accounting principles require interim reporting period disclosure about the fair value of financial instruments, including assets, liabilities and off-balance sheet items for which it is practicable to estimate fair value. The fair value hierarchy level for each asset and liability, as defined in Note 4, have been included in the following table for September 30, 2018 and December 31, 2017. The fair value estimates are made based upon relevant market information, if available, and upon the characteristics of the financial instruments themselves. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based upon judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. The estimated fair value of the Company’s financial instruments as of September 30, 2018 and December 31, 2017 are shown in the following table.

 

   

September 30, 2018

 

December 31, 2017

 
               

Fair value hierarchy

             

Fair value hierarchy

     

(Dollars in thousands)

 

Carrying

amount

   

Estimated

fair value

 

Level 1

 

Level 2

 

Level 3

 

Contract

amount

 

Carrying

amount

 

Estimated

fair value

 

 

Level 1

 

 

Level 2

 

Level 3

 

Contract amount

 
Financial assets:                                                      

Cash and cash equivalents

  $ 48,076     48,076   48,076               37,564   37,564   37,564              

Securities available for sale

    79,604     79,604       79,604           77,472   77,472       77,472          

Loans held for sale

    2,109     2,109       2,109           1,837   1,837       1,837          

Loans receivable, net

    586,092     578,676       578,676           585,931   585,494       585,494          

Federal Home Loan Bank stock

    867     867       867           817   817       817          

Accrued interest receivable

    2,225     2,225       2,225           2,344   2,344       2,344          

Financial liabilities:

                                                     

Deposits

    651,429     645,417       645,417           635,601   635,905       635,905          

Accrued interest payable

    279     279       279           146   146       146          

Off-balance sheet financial instruments:

                                                     

Commitments to extend credit

    13     13               225,242   28   28               173,645  

Commitments to sell loans

    18     18               8,334   (11 ) (11 )             5,629  

 

Cash and Cash Equivalents

The carrying amount of cash and cash equivalents approximates their fair value.

 

Securities Available for Sale

The fair values of securities were based upon quoted market prices for identical or similar instruments in active markets.

 

Loans Held for Sale

The fair values of loans held for sale were based upon quoted market prices for loans with similar interest rates and terms to maturity.

 

Loans Receivable, net

The fair value of the loan portfolio, with the exception of the adjustable rate portfolio, was calculated by discounting the scheduled cash flows through the estimated maturity using anticipated prepayment speeds and using discount rates that reflect the credit and interest rate risk inherent in each loan portfolio. The fair value of the adjustable loan portfolio was estimated by grouping the loans with similar characteristics and comparing the characteristics of each group to the prices quoted for similar types of loans in the secondary market. The fair value disclosures for both the fixed and adjustable rate portfolios were adjusted to reflect the exit price amount anticipated to be received from the sale of the portfolio in an open market transaction as required upon adoption of ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10) Recognition and Measurement of Financial Assets and Financial Liabilities beginning in the first quarter of 2018.

 

Federal Home Loan Bank Stock

The carrying amount of Federal Home Loan Bank (FHLB) stock approximates its fair value.

 

Accrued Interest Receivable

The carrying amount of accrued interest receivable approximates its fair value since it is short-term in nature and does not present unanticipated credit concerns.

 

Deposits

The fair value of demand deposits, savings accounts and certain money market account deposits is the amount payable on demand at the reporting date. The fair value of fixed maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. The fair value disclosures for all of the deposits were adjusted to reflect the exit price amount anticipated to be received from the sale of the deposits in an open market transaction as required upon adoption of ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10) Recognition and Measurement of Financial Assets and Financial Liabilities beginning in the first quarter of 2018.

 

 

Accrued Interest Payable

The carrying amount of accrued interest payable approximates its fair value since it is short-term in nature.

 

Commitments to Extend Credit

The fair values of commitments to extend credit are estimated using the fees normally charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counter parties.

 

Commitments to Sell Loans

The fair values of commitments to sell loans are estimated using the quoted market prices for loans with similar interest rates and terms to maturity.

 

 

(6)

Other Comprehensive Income (Loss)

Other comprehensive income (loss) is defined as the change in equity during a period from transactions and other events from nonowner sources. Comprehensive income is the total of net income and other comprehensive income (loss), which for the Company is comprised of unrealized gains and losses on securities available for sale. The components of other comprehensive income (loss) and the related tax effects were as follows:

 

   

For the three months ended September 30,

 

(Dollars in thousands)

 

2018

   

2017

 

Securities available for sale:

 

Before tax

   

Tax effect

   

Net of tax

   

Before tax

   

Tax effect

   

Net of tax

 

Net unrealized losses arising during the period

  $ (303 )     (85 )     (218 )     (7 )     (3 )     (4 )

Other comprehensive loss

  $ (303 )     (85 )     (218 )     (7 )     (3 )     (4 )

 

   

For the nine months ended September 30,

 

(Dollars in thousands)

 

2018

   

2017

 

Securities available for sale:

 

Before tax

   

Tax effect

   

Net of tax

   

Before tax

   

Tax effect

   

Net of tax

 

Net unrealized (losses) gains arising during the period

  $ (928 )     (258 )     (670 )     593       236       357  

Other comprehensive (loss) income

  $ (928 )     (258 )     (670 )     593       236       357  
                                                 

 

 

(7)

Securities Available For Sale

The following table shows the gross unrealized losses and fair value for the securities available for sale portfolio, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at September 30, 2018 and December 31, 2017.

 

   

Less Than Twelve Months

   

Twelve Months or More

   

Total

 

(Dollars in thousands)

 

# of Investments

   

Fair Value

   

Unrealized Losses

   

# of Investments

   

Fair Value

   

Unrealized Losses

   

Fair Value

   

Unrealized

Losses

 

September 30, 2018

                                                           

Mortgage-backed securities:

                                                           

Federal National Mortgage Association (FNMA)

  0     $ 0       0     2     $ 3,846       (250 )   $ 3,846       (250 )

Federal Home Loan Mortgage Corporation (FHLMC)

  2       4,171       (123 )   0       0       0       4,171       (123 )

Collateralized mortgage obligations:

                                                           

FNMA

  0       0       0     1       190       (13 )     190       (13 )
                                                             

Other marketable securities:

                                                           

U.S. Government agency obligations

  0       0       0     14       68,125       (1,844 )     68,125       (1,844 )

Municipal obligations

  12       2,058       (21 )   0       0       0       2,058       (21 )

Corporate obligations

  1       172       (1 )   0       0       0       172       (1 )

Corporate preferred stock

  0       0       0     1       595       (105 )     595       (105 )

Total temporarily impaired securities

  15     $ 6,401       (145 )   18     $ 72,756       (2,212 )   $ 79,157       (2,357 )
                                                             

 

 

   

Less Than Twelve Months

   

Twelve Months or More

   

Total

 

(Dollars in thousands)

 

# of Investments

   

Fair Value

   

Unrealized Losses

   

# of Investments

   

Fair Value

   

Unrealized Losses

   

Fair Value

   

Unrealized Losses

 

December 31, 2017

                                                           

Mortgage-backed securities:

                                                           

FNMA

  2     $ 4,703       (78 )   0     $ 0       0     $ 4,703       (78 )

Collateralized mortgage obligations:

                                                           

FNMA

  1       218       (5 )   0       0       0       218       (5 )
                                                             

Other marketable securities:

                                                           

U.S. Government agency obligations

  2       9,819       (163 )   12       58,942       (1,038 )     68,761       (1,201 )

Municipal obligations

  14       2,268       (8 )   0       0       0       2,268       (8 )

Corporate obligations

  1       233       (1 )   0       0       0       233       (1 )

Corporate preferred stock

  0       0       0     1       560       (140 )     560       (140 )

Total temporarily impaired securities

  20     $ 17,241       (255 )   13     $ 59,502       (1,178 )   $ 76,743       (1,433 )
                                                             

 

We review our investment portfolio on a quarterly basis for indications of impairment. This review includes analyzing the length of time and the extent to which the fair value has been lower than the cost, the market liquidity for the investment, the financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer, and our intent and ability to hold the investment for a period of time sufficient to recover the temporary loss.

 

The unrealized losses on impaired securities other than the corporate preferred stock are the result of changes in interest rates. The unrealized losses reported for the corporate preferred stock at September 30, 2018 relates to a single trust preferred security that was issued by the holding company of a small community bank. As of September 30, 2018 all payments were current on the trust preferred security and the issuer’s subsidiary bank was considered to be “well capitalized” based on its most recent regulatory filing. Based on a review of the issuer, it was determined that the trust preferred security was not other-than-temporarily impaired at September 30, 2018. The Company does not intend to sell the preferred stock and has the intent and ability to hold it for a period of time sufficient to recover the temporary loss. Management believes that the Company will receive all principal and interest payments contractually due on the security and that the decrease in the market value is primarily due to a lack of liquidity in the market for trust preferred securities. Management will continue to monitor the credit risk of the issuer and may be required to recognize other-than-temporary impairment charges on this security in future periods.

 

A summary of securities available for sale at September 30, 2018 and December 31, 2017 is as follows:

 

 

(Dollars in thousands)

 

Amortized cost

   

Gross unrealized gains

   

Gross unrealized losses

   

Fair value

 

September 30, 2018:

                               

Mortgage-backed securities:

                               

FNMA

  $ 4,096       0       (250 )     3,846  

FHLMC

    4,294       0       (123 )     4,171  

Collateralized mortgage obligations:

                               

FNMA

    203       0       (13 )     190  
      8,593       0       (386 )     8,207  

Other marketable securities:

                               

U.S. Government agency obligations

    69,969       0       (1,844 )     68,125  

Municipal obligations

    2,381       1       (21 )     2,361  

Corporate debt

    173       0       (1 )     172  

Corporate preferred stock

    700       0       (105 )     595  

Corporate equity

    144       0       0       144  
      73,367       1       (1,971 )     71,397  
    $ 81,960       1       (2,357 )     79,604  
                                 

 

 

 

(Dollars in thousands)

 

Amortized cost

   

Gross unrealized gains

   

Gross unrealized losses

   

Fair value

 

December 31, 2017

                               

Mortgage-backed securities:

                               

FNMA

  $ 4,834       1       (78 )     4,757  

FHLMC

    91       2       0       93  

Collateralized mortgage obligations:

                               

FNMA

    223       0       (5 )     218  
      5,148       3       (83 )     5,068  

Other marketable securities:

                               

U.S. Government agency obligations

    69,962       0       (1,201 )     68,761  

Municipal obligations

    2,699       2       (8 )     2,693  

Corporate obligations

    234       0       (1 )     233  

Corporate preferred stock

    700       0       (140 )     560  

Corporate equity

    58       99       0       157  
      73,653       101       (1,350 )     72,404  
    $ 78,801       104       (1,433 )     77,472  
                                 

 

The following table indicates amortized cost and estimated fair value of securities available for sale at September 30, 2018 based upon contractual maturity adjusted for scheduled repayments of principal and projected prepayments of principal based upon current economic conditions and interest rates.

 

(Dollars in thousands)

 

Amortized

Cost

   

Fair

Value

 

Due less than one year

  $ 1,844       1,777  

Due after one year through five years

    76,425       74,370  

Due after five years through ten years

    2,767       2,643  

Due after ten years

    780       670  

No stated maturity

    144       144  

Total

  $ 81,960       79,604  
                 

 

The allocation of mortgage-backed securities in the table above is based upon the anticipated future cash flow of the securities using estimated mortgage prepayment speeds. The allocation of other marketable securities that have call features is based on the anticipated cash flows to the call date if it is anticipated that the security will be called, or to the maturity date if it is not anticipated to be called.

 

 

(8)

Loans Receivable, Net

A summary of loans receivable at September 30, 2018 and December 31, 2017 is as follows:

 

 

(Dollars in thousands)

 

September 30,

2018

   

December 31,

2017

 

Single family

  $ 108,493       107,005  

Commercial real estate:

               

Real estate rental and leasing

    187,373       175,177  

Other

    145,130       158,940  
      332,503       334,117  

Consumer

    74,521       73,767  

Commercial business

    78,882       79,909  

Total loans

    594,399       594,798  

Less:

               

Unamortized discounts

    18       19  

Net deferred loan costs

    (543 )     (463 )

Allowance for loan losses

    8,832       9,311  

Total loans receivable, net

  $ 586,092       585,931  
                 

 

 

 

(9)

Allowance for Loan Losses and Credit Quality Information

The allowance for loan losses is summarized as follows:

 

 

(Dollars in thousands)

 

Single Family

   

Commercial

Real Estate

   

Consumer

   

Commercial Business

   

Total

 
For the three months ended September 30, 2018:                                        

Balance, June 30, 2018

  $ 881       5,242       1,623       1,582       9,328  

Provision for losses

    (10 )     (287 )     61       (416 )     (652 )

Charge-offs

    0       0       (16 )     (15 )     (31 )

Recoveries

    0       0       5       182       187  

Balance, September 30, 2018

  $ 871       4,955       1,673       1,333       8,832  
                                         
For the nine months ended September 30, 2018:                                        

Balance, December 31, 2017

  $ 900       5,073       1,630       1,708       9,311  

Provision for losses

    (6 )     (316 )     169       (329 )     (482 )

Charge-offs

    (24 )     0       (141 )     (270 )     (435 )

Recoveries

    1       198       15       224       438  

Balance, September 30, 2018

  $ 871       4,955       1,673       1,333       8,832  
                                         

Allocated to:

                                       

Specific reserves

  $ 192       441       263       177       1,073  

General reserves

    708       4,632       1,367       1,531       8,238  

Balance, December 31, 2017

  $ 900       5,073       1,630       1,708       9,311  
                                         

Allocated to:

                                       

Specific reserves

  $ 104       688       187       82       1,061  

General reserves

    767       4,267       1,486       1,251       7,771  

Balance, September 30, 2018

  $ 871       4,955       1,673       1,333       8,832  
                                         

Loans receivable at December 31, 2017:

                                       

Individually reviewed for impairment

  $ 1,523       1,364       880       507       4,274  

Collectively reviewed for impairment

    105,482       332,753       72,887       79,402       590,524  

Ending balance

  $ 107,005       334,117       73,767       79,909       594,798  
                                         

Loans receivable at September 30, 2018:

                                       

Individually reviewed for impairment

  $ 1,407       3,689       946       371       6,413  

Collectively reviewed for impairment

    107,086       328,814       73,575       78,511       587,986  

Ending balance

  $ 108,493       332,503       74,521       78,882       594,399  
                                         

 

 

(Dollars in thousands)

 

Single Family

   

Commercial Real Estate

   

Consumer

   

Commercial Business

   

Total

 

For the three months ended September 30, 2017:

                                       

Balance, June 30, 2017

  $ 1,004       5,490       1,544       2,007       10,045  

Provision for losses

    (63 )     (509 )     141       (150 )     (581 )

Charge-offs

    (6 )     0       (45 )     (300 )     (351 )

Recoveries

    0       32       6       126       164  

Balance, September 30, 2017

  $ 935       5,013       1,646       1,683       9,277  
                                         

For the nine months ended September 30, 2017:

                                       

Balance, December 31, 2016

  $ 1,186       4,953       1,613       2,151       9,903  

Provision for losses

    (245 )     (147 )     257       (447 )     (582 )

Charge-offs

    (6 )     0       (263 )     (300 )     (569 )

Recoveries

    0       207       39       279       525  

Balance, September 30, 2017

  $ 935       5,013       1,646       1,683       9,277  
                                         

 

 

The following table summarizes the amount of classified and unclassified loans at September 30, 2018 and December 31, 2017:

 

   

September 30, 2018

 
   

Classified

   

Unclassified

         

(Dollars in thousands)

 

Special Mention

   

Substandard

   

Doubtful

   

Loss

   

Total

   

Total

   

Total Loans

 

Single family

  $ 257       2,119       42       0       2,418       106,075       108,493  

Commercial real estate:

                                                       

Real estate rental and leasing

    5,312       4,881       0       0       10,193       177,180       187,373  

Other

    2,896       7,535       0       0       10,431       134,699       145,130  

Consumer

    0       765       42       128       935       73,586       74,521  

Commercial business

    5,744       2,834       0       0       8,578       70,304       78,882  
    $ 14,209       18,134       84       128       32,555       561,844       594,399  

 

   

December 31, 2017

 
   

Classified

   

Unclassified

         

(Dollars in thousands)

 

Special Mention

   

Substandard

   

Doubtful

   

Loss

   

Total

   

Total

   

Total Loans

 

Single family

  $ 77       2,154       44       0       2,275       104,730       107,005  

Commercial real estate:

                                                       

Real estate rental and leasing

    5,022       3,813       0       0       8,835       166,342       175,177  

Other

    9,135       4,257       0       0       13,392       145,548       158,940  

Consumer

    0       631       119       130       880       72,887       73,767  

Commercial business

    5,781       5,506       0       0       11,287       68,622       79,909  
    $ 20,015       16,361       163       130       36,669       558,129       594,798  
                                                         

 

Classified loans represent special mention, substandard (performing and non-performing), and non-performing loans categorized as doubtful and loss. Loans classified as special mention are loans that have potential weaknesses that, if left uncorrected, may result in deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future date. Loans classified as substandard are loans that are generally inadequately protected by the current net worth and paying capacity of the obligor, or by the collateral pledged, if any. Loans classified as substandard have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. Substandard loans are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loans classified as doubtful have the weaknesses of those classified as substandard, with additional characteristics that make collection in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. A loan classified as loss is essentially uncollateralized and/or considered uncollectible and of such little value that continuance as an asset on the balance sheet may not be warranted. Loans classified as substandard or doubtful require the Bank to perform an analysis of the individual loan and charge off any loans, or portion thereof, that are deemed uncollectible.

 

 

The aging of past due loans at September 30, 2018 and December 31, 2017 is summarized as follows:

 

 

 

 

(Dollars in thousands)

 

30-59 Days Past Due

   

60-89 Days Past Due

   

90 Days

or More

Past Due

   

Total

Past Due

   

Current

Loans

   

Total

Loans

   

Loans 90 Days

or More Past

Due and Still Accruing

 

September 30, 2018

                                                       

Single family

  $ 897       0       222       1,119       107,374       108,493       0  

Commercial real estate:

                                                       

Real estate rental and leasing

    0       0       210       210       187,163       187,373       0  

Other

    0       2,227       0       2,227       142,903       145,130       0  

Consumer

    324       115       335       774       73,747       74,521       0  

Commercial business

    30       24       33       87       78,795       78,882          
    $ 1,251       2,366       800       4,417       589,982       594,399       0  

December 31, 2017

                                                       

Single family

  $ 727       294       669       1,690       105,315       107,005       0  

Commercial real estate:

                                                       

Real estate rental and leasing

    0       0       0       0       175,177       175,177       0  

Other

    0       0       0       0       158,940       158,940       0  

Consumer

    734       117       235       1,086       72,681       73,767       0  

Commercial business

    34       0       180       214       79,695       79,909       0  
    $ 1,495       411       1,084       2,990       591,808       594,798       0  
                                                         

 

Impaired loans include loans that are non-performing (non-accruing) and loans that have been modified in a troubled debt restructuring (TDR). The following table summarizes impaired loans and related allowances as of September 30, 2018 and December 31, 2017:

 

   

September 30, 2018

   

December 31, 2017

 

 

 

 

(Dollars in thousands)

 

Recorded

Investment

   

Unpaid

Principal

Balance

   

Related

Allowance

   

Recorded

Investment

   

Unpaid

Principal

Balance

   

Related

Allowance

 

Loans with no related allowance recorded:

                                               

Single family

  $ 605       605       0       415       415       0  

Commercial real estate:

                                               

Real estate rental and leasing

    33       33       0       35       51       0  

Other

    25       1,681       0       25       1,682       0  

Consumer

    608       608       0       414       414       0  

Loans with an allowance recorded:

                                               

Single family

    802       802       104       1,108       1,108       192  

Commercial real estate:

                                               

Real estate rental and leasing

    210       210       22       0       0       0  

Other

    3,421       3,421       666       1,304       1,304       441  

Consumer

    338       355       187       466       483       263  

Commercial business

    371       922       82       507       1,358       177  

Total:

                                               

Single family

    1,407       1,407       104       1,523       1,523       192  

Commercial real estate:

                                               

Real estate rental and leasing

    243       243       22       35       51       0  

Other

    3,446       5,102       666       1,329       2,986       441  

Consumer

    946       963       187       880       897       263  

Commercial business

    371       922       82       507       1,358       177  
    $ 6,413       8,637       1,061       4,274       6,815       1,073  
                                                 

 

 

The following tables summarize average recorded investment and interest income recognized on impaired loans during the three and nine months ended September 30, 2018 and 2017.

 

   

For the three months ended

September 30, 2018

   

For the nine months ended

September 30, 2018

 

 

 

(Dollars in thousands)

 

Average

Recorded

Investment

   

Interest

Income

Recognized

   

Average

Recorded

Investment

   

Interest

Income

Recognized

 

Loans with no related allowance recorded:

                               

Single family

  $ 511       6       467       18  

Commercial real estate:

                               

Real estate rental and leasing

    34       15       34       30  

Other

    95       29       95       77  

Consumer

    608       4       508       14  

Loans with an allowance recorded:

                               

Single family

    840       0       882       0  

Commercial real estate:

                               

Real estate rental and leasing

    105       1       53       7  

Other

    2,327       0       1,821       57  

Consumer

    358       4       409       9  

Commercial business

    318       3       406       12  

Total:

                               

Single family

    1,351       6       1,349       18  

Commercial real estate:

                               

Real estate rental and leasing

    139       16       87       37  

Other

    2,422       29       1,916       134  

Consumer

    966       8       917       23  

Commercial business

    318       3       406       12  
    $ 5,196       62       4,675       224  
                                 

 

   

For the three months ended

September 30, 2017

   

For the nine months ended

September 30, 2017

 

 

 

(Dollars in thousands)

 

Average

Recorded

Investment

   

Interest

Income

Recognized

   

Average

Recorded

Investment

   

Interest

Income

Recognized

 

Loans with no related allowance recorded:

                               

Single family

  $ 453       1       414       3  

Commercial real estate:

                               

Real estate rental and leasing

    38       0       39       0  

Other

    26       24       26       72  

Consumer

    500       5       404       9  

Commercial business

    0       0       125       0  

Loans with an allowance recorded:

                               

Single family

    765       8       821       11  

Commercial real estate:

                               

Real estate rental and leasing

    258       0       194       0  

Other

    1,838       16       1,818       23  

Consumer

    375       4       455       8  

Commercial business

    496       6       428       19  

Total:

                               

Single family

    1,218       9       1,235       14  

Commercial real estate:

                               

Real estate rental and leasing

    296       0       233       0  

Other

    1,864       40       1,844       95  

Consumer

    875       9       859       17  

Commercial business

    496       6       553       19  
    $ 4,749       64       4,724       145  
                                 

 

At September 30, 2018 and December 31, 2017, non-accruing loans totaled $5.5 million and $3.1 million, respectively, for which the related allowance for loan losses was $0.9 million and $0.9 million, respectively. All of the interest income that was recognized for non-accruing loans was recognized using the cash basis method of income recognition. Non-accruing loans for which no specific allowance has been recorded, because management determined that the value of the collateral was sufficient to repay the loan, totaled $0.7 million and $0.4 million, at September 30, 2018 and December 31, 2017, respectively. Non-accrual loans also include certain loans that have had terms modified in a TDR.

 

 

The non-accrual loans at September 30, 2018 and December 31, 2017 are summarized as follows:

 

 

(Dollars in thousands)

 

September 30, 2018

   

December 31, 2017

 
                 

Single family

  $ 1,073       949  

Commercial real estate:

               
Real estate rental and leasing     243       35  

Other

    3,446       1,329  

Consumer

    526       553  

Commercial business

    197       278  
    $ 5,485       3,144  
                 

 

At September 30, 2018 and December 31, 2017 there were loans included in loans receivable, net, with terms that had been modified in a TDR totaling $2.4 million and $3.0 million, respectively. The amount of loans restructured in the third quarter of 2018 was not considered meaningful. For the loans that were restructured in the third quarter of 2017, $34,000 were classified but performing, and $0.2 million were non-performing at September 30, 2017.

 

The following table summarizes TDRs at September 30, 2018 and December 31, 2017:

 

   

September 30, 2018

   

December 31, 2017

 

 

(Dollars in thousands)

 

Accrual

   

Non-Accrual

   

Total

   

Accrual

   

Non-Accrual

   

Total

 

Single family

  $ 334       144       478       574       111       685  

Commercial real estate

    0       1,146       1,146       0       1,210       1,210  

Consumer

    420       173       593       327       431       758  

Commercial business

    174       58       232       229       162       391  
    $ 928       1,521       2,449       1,130       1,914       3,044  
                                                 

 

As of September 30, 2018, the Bank had commitments to lend an additional $1.0 million to a borrower who has TDR and non-accrual loans. These additional funds are for the construction of single family homes with a maximum loan-to-value ratio of 75%. These loans are secured by the home under construction. At December 31, 2017, there were commitments to lend additional funds of $0.8 million to this same borrower.

 

TDR concessions can include reduction of interest rates, extension of maturity dates, forgiveness of principal and/or interest due, or acceptance of real estate or other assets in full or partial satisfaction of the debt. Loan modifications are not reported as TDRs after 12 months if the loan was modified at a market rate of interest for comparable risk loans, and the loan is performing in accordance with the terms of the restructured agreement for the entire 12 month period. All loans classified as TDRs are considered to be impaired.

 

When a loan is modified as a TDR, there may be a direct, material impact on the loans within the balance sheet, as principal balances may be partially forgiven. The financial effects of TDRs are presented in the following tables and represent the difference between the outstanding recorded balance pre-modification and post-modification, for the three month and nine month periods ended September 30, 2018 and 2017.

 

 

   

 

Three Months Ended

September 30, 2018

   

Nine Months Ended

September 30, 2018

 

 

 

 

 

(Dollars in thousands)

 

Number of Contracts

   

 

Pre-modification Outstanding Recorded Investment

   

Post-modification Outstanding

Recorded

Investment

   

Number of Contracts

   

Pre-modification Outstanding Recorded Investment

   

Post-modification Outstanding

Recorded

Investment

 

Troubled debt restructurings:

                                               

Single family

    0     $ 0       0       1     $ 55       58  

Commercial real estate:

                                               

Real estate rental and leasing

    0       0       0       1       54       54  

Other

    0       0       0       2       1,518       1,518  

Consumer

    2       2       2       10       335       336  

Commercial business

    0       0       0       1       70       70  

Total

    2     $ 2       2       15     $ 2,032       2,036  
                                                 

 

   

 

Three Months Ended

September 30, 2017

   

Nine Months Ended

September 30, 2017

 

 

 

 

(Dollars in thousands)

 

Number of Contracts

   

 

Pre-modification Outstanding Recorded Investment

   

Post-modification Outstanding

Recorded

Investment

   

Number of Contracts

   

Pre-modification Outstanding Recorded Investment

   

Post-modification Outstanding

Recorded

Investment

 

Troubled debt restructurings:

                                               

Single family

    0     $ 0       0       3     $ 282       514  

Consumer

    6       104       105       13       462       465  

Commercial business

    1       416       116       1       416       116  

Total

    7     $ 520       221       17     $ 1,160       1,095  
                                                 

 

There were no loans that were restructured in the 12 months preceding September 30, 2018 that subsequently defaulted during the three and nine months ended September 30, 2018. The following table summarizes the loans that were restructured in the 12 months preceding September 30, 2017 and subsequently defaulted during the nine months ended September 30, 2017. There were no restructured loans that defaulted in the three months ended September 30, 2017.

 

   

Nine Months Ended

September 30, 2017

 

(Dollars in thousands)

 

Number of

Contracts

   

Outstanding

Recorded

Investment

 

Troubled debt restructurings that subsequently defaulted:

               

Single Family

    2     $ 60  

Total

    2     $ 60  
                 

 

The Company considers a loan to have defaulted when it becomes 90 or more days past due under the modified terms, when it is placed in non-accrual status, when it becomes other real estate owned, or when it becomes non-compliant with some other material requirement of the modification agreement. Loans that were non-accrual prior to modification remain on non-accrual status for at least six months following modification. Non-accrual TDR loans that have performed according to the modified terms for six months may be returned to accrual status. Loans that were accruing prior to modification remain on accrual status after the modification as long as the loan continues to perform under the new terms.

 

TDRs are reviewed for impairment following the same methodology as other impaired loans. For loans that are collateral-dependent, the value of the collateral is reviewed and additional reserves may be added to specific reserves as needed. Loans that are not collateral-dependent may have additional reserves established if deemed necessary. The reserves for TDRs were $0.6 million, or 7.2%, of the total $8.8 million in loan loss reserves at September 30, 2018 and $0.9 million, or 9.8%, of the total $9.3 million in loan loss reserves at December 31, 2017.

 

 

The following is additional information with respect to loans acquired through acquisitions:

 

(Dollars in thousands)

 

Contractual

Principal

Receivable

   

Accretable

Difference

   

Carrying

Amount

 

Purchased performing loans:

                       

Balance at June 30, 2018

  $ 8,556       (206 )     8,350  

Change due to payments/refinances

    (538 )     15       (523 )

Balance at September 30, 2018

  $ 8,018       (191 )     7,827  
                         

 

(Dollars in thousands)

 

Contractual

Principal

Receivable

   

Non-Accretable

Difference

   

Carrying

Amount

 

Purchased credit impaired loans:

                       

Balance at June 30, 2018

  $ 396       (36 )     360  

Change due to payments/refinances

    (210 )     29       (181 )

Balance at September 30, 2018

  $ 186       (7 )     179  
                         

 

As a result of acquisitions, the Company has loans for which there was, at acquisition, evidence of deterioration of credit quality since origination and for which it was probable at acquisition that all contractually required payments would not be collected. The carrying amount of those loans as of September 30, 2018 was $0.2 million.

 

No material provision for loan losses was recognized during the period ended September 30, 2018 related to acquired loans, as there was no significant change to the credit quality of those loans.

 

 

(10)

Intangible Assets

The Company’s intangible assets consist of mortgage servicing rights, core deposit intangibles, and goodwill. A summary of mortgage servicing activity is as follows:

 

 

(Dollars in thousands)

 

Nine Months ended September 30, 2018

   

Twelve Months ended

December 31, 2017

   

Nine Months ended

September 30, 2017

 

Balance, beginning of period

  $ 1,724       1,604       1,604  

Originations

    533       675       461  

Amortization

    (412 )     (555 )     (411 )

Balance, end of period

  $ 1,845       1,724       1,654  

Fair value of mortgage servicing rights

  $ 3,641       3,196       3,003  
                         

 

All of the loans being serviced were single family loans serviced for FNMA under the individual loan sale program.

 

The following is a summary of the risk characteristics of the loans being serviced for FNMA at September 30, 2018.

 

           

Weighted

   

Weighted

         
   

Loan

   

Average

   

Average

         
   

Principal

   

Interest

   

Remaining

   

Number

 

(Dollars in thousands)

 

Balance

   

Rate

   

Term (months)

   

of Loans

 

Original term 30 year fixed rate

  $ 292,980       4.13

%

    307       2,252  

Original term 15 year fixed rate

    98,179       3.16       132       991  

Adjustable rate

    54       4.38       272       2  

 

 

The gross carrying amount of intangible assets and the associated accumulated amortization at September 30, 2018 and 2017 is presented in the following table. No amortization expense relating to goodwill is recorded as generally accepted accounting principles do not allow goodwill to be amortized, but require that it be tested for impairment at least annually, or sooner if there are indications that impairment may exist. Amortization expense for amortizing intangible assets was $0.5 million for both nine month periods ended September 30, 2018 and 2017.

 

   

September 30, 2018

 
   

Gross

                 

 

(Dollars in thousands)

 

Carrying

Amount

   

Accumulated

Amortization

   

Unamortized

Amount

 

Mortgage servicing rights

  $ 4,457       (2,612 )     1,845  

Core deposit intangible

    574       (294 )     280  

Goodwill

    802       0       802  

Total

  $ 5,833       (2,906 )     2,927  
                         

 

   

September 30, 2017

 
   

Gross

                 

 

(Dollars in thousands)

 

Carrying

Amount

   

Accumulated

Amortization

   

Unamortized

Amount

 

Mortgage servicing rights

  $ 4,141       (2,487 )     1,654  

Core deposit intangible

    574       (195 )     379  

Goodwill

    802       0       802  

Total

  $ 5,517       (2,682 )     2,835  
                         

 

The following table indicates the estimated future amortization expense for amortizing intangible assets:

 

(Dollars in thousands)

 

Mortgage
Servicing
Rights

   

Core

Deposit
Intangible

   

Total

Amortizing

Intangible

Assets

 

Year ended December 31,

                       

2018

  $ 122       25       147  

2019

    445       99       544  

2020

    371       99       470  

2021

    326       47       373  

2022

    265       10       275  

Thereafter

    316       0       316  

Total

  $ 1,845       280       2,125  
                         

 

Projections of amortization are based on existing asset balances and the existing interest rate environment as of September 30, 2018. The Company's actual experience may be significantly different depending upon changes in mortgage interest rates and other market conditions.

 

 

(11)

Earnings per Common Share

The following table reconciles the weighted average shares outstanding and the earnings available to common shareholders used for basic and diluted earnings per share:

 

   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 

(In thousands, except per share data)

 

2018

   

2017

   

2018

   

2017

 

Weighted average number of common shares outstanding used in basic earnings per share calculation

    4,358       4,220       4,296       4,212  

Net dilutive effect of:

                               

Restricted stock awards, options, and warrants

    252       650       458       651  

Weighted average number of shares outstanding adjusted for effect of dilutive securities

    4,610       4,870       4,754       4,863  

Income available to common shareholders

  $ 2,712       1,780       5,884       4,017  

Basic earnings per common share

  $ 0.62       0.42       1.37       0.95  

Diluted earnings per common share

  $ 0.59       0.37       1.24       0.83  
                                 

 

 

 

(12)

Regulatory Capital and Oversight

The Company and the Bank are subject to the regulatory requirements of the Basel III capital reforms. The Basel III requirements, among other things, (i) apply a strengthened set of capital requirements to the Bank (the Company is exempt, pursuant to the Small Bank Holding Company Policy Statement (Policy Statement) described below), including requirements relating to common equity as a component of core capital, (ii) implement a “capital conservation buffer” against risk and a higher minimum Tier 1 capital requirement, and (iii) revise the 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 which are being phased in incrementally, with full implementation scheduled for January 1, 2019. 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 their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

 

The Board of Governors of the Federal Reserve System (FRB) amended its Policy Statement, to exempt small bank holding companies with assets less than $3 billion from the above capital requirements. The Policy Statement was also expanded to include savings and loan holding companies that meet the Policy Statement’s qualitative requirements for exemption. 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 (set forth in the following table and defined in the regulation) 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’s average total assets for the quarter ended September 30, 2018 were $733.0 million, its adjusted total assets were $731.3 million, and its risk-weighted assets were $606.0 million. The following table presents the Bank’s capital amounts and ratios at September 30, 2018 for actual capital, required capital, and excess capital, including ratios in order to qualify as being well capitalized under the prompt corrective action regulations.

 

   

Actual

   

Required to be

Adequately Capitalized

   

Excess Capital

   

To Be Well Capitalized

Under Prompt Corrective

Action Provisions

 

(Dollars in thousands)

 

Amount

   

Percent of Assets

   

Amount

   

Percent of Assets

   

Amount

   

Percent of Assets

   

Amount

   

Percent of Assets

 

September 30, 2018

                                                               

Common equity tier 1 capital

  $ 76,689       12.65

%

  $ 27,272       4.50

%

  $ 49,417       8.15

%

  $ 39,393       6.50

%

Tier 1 capital leverage

    76,689       10.49       29,252       4.00       47,437       6.49       36,564       5.00  

Tier 1 risk-based capital

    76,689       12.65       36,362       6.00       40,327       6.65       48,483       8.00  

Total risk-based capital

    84,280       13.91       48,483       8.00       35,797       5.91       60,604       10.00  
                                                                 

 

The Bank must maintain a capital conservation buffer 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. For 2018, the capital conservation buffer is 1.875% and in 2019 the buffer amount will increase to 2.50% and be fully phased in. Management believes that, as of September 30, 2018, 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 Office of the Comptroller of the Currency has extensive discretion in its supervisory and enforcement activities, and can adjust the requirement to be “well-capitalized” in the future.

 

 

(13)

Stockholders’ Equity

The Company's certificate of incorporation authorizes the issuance of up to 500,000 shares of preferred stock, and on December 23, 2008, the Company completed the sale of 26,000 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the Preferred Stock) to the U.S. Department of the Treasury (Treasury). The Preferred Stock had a liquidation value of $1,000 per share and a related warrant was also issued to purchase 833,333 shares of HMN common stock at an exercise price of $4.68 per share (the Warrant). The transaction was part of the Treasury’s Capital Purchase Program under the Emergency Economic Stabilization Act of 2008.

 

On February 17, 2015, the Company redeemed the final 10,000 shares of outstanding Preferred Stock. On May 21, 2015, the Treasury sold the Warrant at an exercise price of $4.68 per share to three unaffiliated third party investors for an aggregate purchase price of $5.7 million.

 

 

On May 21, 2018, the Company entered into a warrant repurchase agreement with one of the warrant holders, pursuant to which the Company purchased, at a purchase price of $14.32 per warrant, warrants to purchase 138,888.66 shares of HMN common stock for an aggregate purchase price of $2.0 million. The warrants purchased by the Company were cancelled. Simultaneously with the repurchase, the warrant holder engaged in a cashless exercise of the remainder of its warrant, resulting in the issuance of 104,678 shares of HMN common stock to the warrant holder out of treasury stock.

 

On August 29, 2018, the Company entered into a warrant repurchase agreement with a second warrant holder, pursuant to which the Company purchased, at a purchase price of $16.07 per warrant, warrants to purchase 277,777.67 shares of HMN common stock for an aggregate purchase price of $4.5 million. The warrants purchased by the Company were cancelled.

 

On October 2, 2018, the final warrant holder engaged in a cashless exercise of its warrant, resulting in the issuance of 214,973 shares of HMN common stock to the warrant holder out of treasury stock.

 

As a result of the above transactions, the Company no longer has any obligations under the Warrant.

 

 

(14) Other Borrowings

On December 15, 2014, the Company entered into a Loan Agreement with an unrelated third party, providing for a term loan of up to $10.0 million that was evidenced by a promissory note (the Note) with an interest rate of 6.50% per annum. The principal balance of the loan was payable in consecutive equal annual installments of $1.0 million on each anniversary of the date of the Loan Agreement, commencing on December 15, 2015, with the balance due on December 15, 2021. The Company had the option to voluntarily prepay the Note in whole or in part without penalty. The Company made the scheduled $1.0 million principal payment on December 15, 2015, a $2.0 million payment on December 15, 2016, and on August 31, 2017 paid off the remaining principal balance of $7.0 million. There was no outstanding loan balance at September 30, 2018 or September 30, 2017.

 

 

(15) Commitments and Contingencies

The Bank issues standby letters of credit which guarantee the performance of customers to third parties. The standby letters of credit issued and available at September 30, 2018 were approximately $2.7 million, expire over the next 46 months, and are collateralized primarily with commercial real estate mortgages. Since the conditions under which the Bank is required to fund the standby letters of credit may not materialize, the cash requirements are expected to be less than the total outstanding commitments.

 

 

(16) Business Segments

The Bank has been identified as a reportable operating segment in accordance with the provisions of ASC 280. HMN did not meet the quantitative thresholds for determining reportable segments and, therefore, is included in the “Other” category.

 

The Company evaluates performance and allocates resources based on the segment’s net income, return on average assets and equity. Each corporation is managed separately with its own officers and board of directors, some of whom may overlap between the corporations.

 

 

The following table sets forth certain information about the reconciliation of reported profit and assets for each of the Company’s reportable segments.

 

(Dollars in thousands)  

Home Federal Savings Bank

   

Other

   

Eliminations

   

Consolidated
Total

 

At or for the nine months ended September 30, 2018:

                               

Interest income - external customers

  $ 22,584       0       0       22,584  

Non-interest income - external customers

    5,766       0       0       5,766  

Intersegment non-interest income

    164       6,328       (6,492 )     0  

Interest expense

    1,583       0       0       1,583  

Non-interest expense

    18,703       542       (164 )     19,081  

Income tax expense

    2,382       (98 )     0       2,284  

Net income

    6,328       5,884       (6,328 )     5,884  

Total assets

    737,289       79,228       (79,072 )     737,445  
                                 

At or for the nine months ended September 30, 2017:

                               

Interest income - external customers

  $ 20,913       0       0       20,913  

Non-interest income - external customers

    5,695       0       0       5,695  

Intersegment non-interest income

    158       4,596       (4,754 )     0  

Interest expense

    1,056       306       0       1,362  

Non-interest expense

    18,653       550       (158 )     19,045  

Income tax expense

    3,043       (277 )     0       2,766  

Net income

    4,596       4,017       (4,596 )     4,017  

Total assets

    715,827       79,516       (78,733 )     716,610  
                                 

At or for the quarter ended September 30, 2018:

                               

Interest income - external customers

  $ 7,970       0       0       7,970  

Non-interest income - external customers

    1,936       0       0       1,936  

Intersegment non-interest income

    59       2,864       (2,923 )     0  

Interest expense

    587       0       0       587  

Non-interest expense

    6,087       186       (59 )     6,214  

Income tax expense

    1,079       (34 )     0       1,045  

Net income

    2,864       2,712       (2,864 )     2,712  

Total assets

    737,289       79,228       (79,072 )     737,445  
                                 

At or for the quarter ended September 30, 2017:

                               

Interest income - external customers

  $ 7,255       0       0       7,255  

Non-interest income - external customers

    1,909       0       0       1,909  

Intersegment non-interest income

    53       1,960       (2,013 )     0  

Interest expense

    416       77       0       493  

Non-interest expense

    6,124       188       (53 )     6,259  

Income tax expense

    1,298       (85 )     0       1,213  

Net income

    1,960       1,780       (1,960 )     1,780  

Total assets

    715,827       79,516       (78,733 )     716,610  
                                 

 

 

 

Item 2:

HMN FINANCIAL, INC.

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 and Exchange Commission 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, reducing non-performing assets, and generating improved financial results (including profitability); the extent of the positive impact of the lower federal tax rates on the deferred tax asset balance and future earnings; 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 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 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; 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 Form 10-K and 10-Q with the Securities and Exchange Commission. 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, 2017 and Part II, Item 1A of its subsequently filed quarterly reports on Form 10-Q.

 

25

 

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 fees earned 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, deposit insurance, amortization expense on mortgage servicing assets, data processing costs 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.

 

26

 

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 by charging off loans. 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.

 

27

 

RESULTS OF OPERATIONS FOR THE THREE AND NINE MONTH PERIODS ENDED SEPTEMBER 30, 2018 COMPARED TO THE SAME PERIODS ENDED SEPTEMBER 30, 2017

 

Net Income

Net income was $2.7 million for the third quarter of 2018, an increase of $0.9 million, compared to net income of $1.8 million for the third quarter of 2017. Diluted earnings per share for the third quarter of 2018 was $0.59, an increase of $0.22, compared to diluted earnings per share of $0.37 for the third quarter of 2017. The increase in net income between the periods was primarily because of a $0.6 million increase in net interest income primarily because of an increase in the average interest-earning assets, a $0.2 million decrease in income tax expense as a result of the reduced federal corporate income tax rate for 2018, and a $0.1 million decrease in other non-interest expense primarily related to decreases in advertising and compensation and benefit expenses between the periods.

 

Net income was $5.9 million for the nine month period ended September 30, 2018, an increase of $1.9 million, or 46.5%, compared to net income of $4.0 million for the nine month period ended September 30, 2017. Diluted earnings per share for the nine month period ended September 30, 2018 was $1.24, an increase of $0.41 per share compared to diluted earnings per share of $0.83 for the same period in 2017. The increase in net income between the periods was primarily because of a $1.4 million increase in net interest income primarily due to an increase in the average interest-earning assets and a $0.5 million decrease in income tax expense as a result of the reduced federal corporate income tax rate for 2018.

 

Net Interest Income

Net interest income was $7.4 million for the third quarter of 2018, an increase of $0.6 million, or 9.2%, from $6.8 million for the third quarter of 2017. Interest income was $8.0 million for the third quarter of 2018, an increase of $0.7 million, or 9.9%, from $7.3 million for the same period in 2017. Interest income increased between the periods primarily because of an increase in the average interest-earning assets, a change in the composition of the average interest-earning assets, and an increase in the federal funds rate between the periods which resulted in higher earnings on loan, cash, and investment balances. While the average interest-earning assets increased $23.7 million between the periods, the average interest-earning assets held in higher yielding loans decreased $3.3 million, and the amount of average interest-earning assets held in lower yielding cash and investments increased $27.0 million between the periods. The decrease in the average outstanding loans between the periods was primarily the result of a decrease in the commercial loan portfolio, which occurred because of an increase in loan payoffs between the periods. The average yield earned on interest-earning assets was 4.47% for the third quarter of 2018, an increase of 26 basis points from 4.21% for the third quarter of 2017.

 

Interest expense was $0.6 million for the third quarter of 2018, an increase of $0.1 million, or 19.1%, from $0.5 million for the third quarter of 2017. The average interest rate paid on interest-bearing liabilities and non-interest-bearing deposits was 0.36% for the third quarter of 2018, an increase of 5 basis points from 0.31% for the third quarter of 2017. The average interest rate paid increased between the periods due to an increase in the rates paid on certain money market accounts and certificates of deposit and a change in the composition of the average interest-bearing liabilities and non-interest-bearing deposits held between the periods. While the average interest-bearing liabilities and non-interest-bearing deposits increased $18.3 million between the periods, the average amount held in higher rate premium money market accounts increased $16.8 million, the average amount held in lower rate checking, savings, and money market accounts decreased $0.5 million, and the average amount held in higher rate borrowings and certificates of deposit increased $2.0 million between the periods.

 

Net interest margin (net interest income divided by average interest-earning assets) for the third quarter of 2018 was 4.14%, an increase of 22 basis points, compared to 3.92% for the third quarter of 2017.

 

28

 

Net interest income was $21.0 million for the first nine months of 2018, an increase of $1.4 million, or 7.4%, from $19.6 million for the same period in 2017. Interest income was $22.6 million for the nine month period ended September 30, 2018, an increase of $1.7 million, or 8.0%, from $20.9 million for the same nine month period in 2017. Interest income increased between the periods primarily because of an increase in the average interest-earning assets, a change in the composition of the average interest-earning assets, and an increase in the federal funds rate between the periods which resulted in higher earnings on loan, cash, and investment balances. While the average interest-earning assets increased $34.5 million between the periods, the average interest-earning assets held in higher yielding loans increased $15.3 million and the amount of average interest-earning assets held in lower yielding cash and investments increased $19.2 million between the periods. The increase in the average outstanding loans between the periods was primarily the result of an increase in the commercial loan portfolio, which occurred because of a reduction in loan payoffs between the periods. The average yield earned on interest-earning assets was 4.32% for the first nine months of 2018, an increase of 11 basis points from 4.21% for the first nine months of 2017.

 

Interest expense was $1.6 million for the first nine months of 2018, an increase of $0.2 million, or 16.2%, compared to $1.4 million in the first nine months of 2017. The average interest rate paid on interest-bearing liabilities and non-interest-bearing deposits was 0.33% for the first nine months of 2018, an increase of 3 basis points from 0.30% for the first nine months of 2017. The average interest rate paid increased between the periods due to an increase in the rates paid on certain money market accounts and certificates of deposit and a change in the composition of the average interest-bearing liabilities and non-interest-bearing deposits held between the periods. While the average interest-bearing liabilities and non-interest-bearing deposits increased $27.4 million between the periods, the average amount held in higher rate premium money market accounts increased $19.3 million, the average amount held in lower rate checking, savings, and money market accounts increased $6.3 million, and the average amount held in higher rate borrowings and certificates of deposit increased $1.8 million between the periods.

 

Net interest margin (net interest income divided by average interest-earning assets) for the first nine months of 2018 was 4.02%, an increase of 8 basis points, compared to 3.94% for the first nine months of 2017.

 

A summary of the Company’s net interest margin for the nine month periods ended September 30, 2018 and 2017 is as follows:

 

   

For the nine-month period ended

 
   

September 30, 2018

   

September 30, 2017

 

(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

  $ 79,436       991       1.67

%

  $ 76,695       850       1.48

%

Loans held for sale

    1,739       62       4.80       1,863       69       4.95  

Single family loans, net

    112,252       3,412       4.06       113,372       3,411       4.02  

Commercial loans, net

    401,850       15,075       5.02       384,321       13,885       4.83  

Consumer loans, net

    72,238       2,675       4.95       73,270       2,626       4.79  

Cash equivalents

    30,105       349       1.55       13,564       64       0.63  

Federal Home Loan Bank stock

    859       20       3.10       892       8       1.20  

Total interest-earning assets

  $ 698,479       22,584       4.32     $ 663,977       20,913       4.21  
                                                 

Interest-bearing liabilities and non-interest-bearing deposits:

                                               

NOW accounts

    87,468       41       0.06       87,783       66       0.10  

Savings accounts

    78,075       46       0.08       77,015       47       0.08  

Money market accounts

    198,149       610       0.41       175,388       390       0.30  

Certificates

    114,412       884       1.03       104,362       532       0.68  

Advances and other borrowings

    188       2       1.71       8,469       327       5.16  

Total interest-bearing liabilities

  $ 478,292                     $ 453,017                  

Non-interest checking

    156,026                       154,085                  

Other non-interest bearing deposits

    1,567                       1,361                  

Total interest-bearing liabilities and non-interest- bearing deposits

  $ 635,885       1,583       0.33     $ 608,463       1,362       0.30  

Net interest income

            21,001                       19,551          

Net interest rate spread

                    3.99

%

                    3.91

%

Net interest margin

                    4.02

%

                    3.94

%

                                                 

 

Provision for Loan Losses

The provision for loan losses was ($0.7) million for the third quarter of 2018, a decrease of $0.1 million from the ($0.6) million provision for loan losses for the third quarter of 2017. The provision for loan losses was ($0.5) million for the first nine months of 2018, an increase of $0.1 million compared to the ($0.6) million provision for loan losses for the first nine months of 2017. The changes in the provision for loan losses relate primarily to changes in the payments received on certain adversely classified commercial loans between the periods.

 

29

 

A reconciliation of the Company’s allowance for loan losses for the three and nine month periods ended September 30, 2018 and September 30, 2017 is summarized as follows:

 

   

Three months ended September 30,

 

(Dollars in thousands)

 

2018

   

2017

 

Balance at June 30,

  $ 9,328     $ 10,045  

Provision

    (652 )     (581 )

Charge offs:

               

Single family

    0       (6 )

Consumer

    (16 )     (45 )

Commercial business

    (15 )     (300 )

Recoveries

    187       164  

Balance at September 30,

  $ 8,832     $ 9,277  
                 

Allocated to:

               

Specific allowance

  $ 1,061     $ 1,138  

General allowance

    7,771       8,139  
    $ 8,832     $ 9,277  
                 

 

   

Nine months ended September 30,

 

(Dollars in thousands)

 

2018

   

2017

 

Balance at January 1,

  $ 9,311     $ 9,903  

Provision

    (482 )     (582 )

Charge offs:

               

Single family

    (24 )     (6 )

Consumer

    (141 )     (263 )

Commercial business

    (270 )     (300 )

Recoveries

    438       525  

Balance at September 30,

  $ 8,832     $ 9,277  
                 

 

Non-Interest Income

Non-interest income was $1.9 million for the third quarter of 2018, the same as the third quarter of 2017. Loan servicing fees increased slightly between the periods due primarily to an increase in commercial loan servicing fees. Fees and service charges increased slightly due to an increase in the loan commitment fees earned between the periods. These increases in non-interest income were offset by slight decreases in the gain on sales of loans and other non-interest income.

 

Non-interest income was $5.8 million for the first nine months of 2018, an increase of $0.1 million, or 1.2%, from $5.7 million for the first nine months of 2017. Gain on sales of loans increased $0.1 million between the periods primarily because of an increase in single family loan sales. Other non-interest income increased slightly due to an increase in the sales of uninsured investment products between the periods. Loan servicing fees increased slightly between the periods primarily because of an increase in mortgage loan servicing fees. These increases in non-interest income were partially offset by a $0.1 million decrease in fees and service charges earned between the periods due primarily to a decrease in overdraft fees.

 

Non-Interest Expense

Non-interest expense was $6.2 million for the third quarter of 2018, a decrease of $0.1 million, or 0.7%, from $6.3 million for the third quarter of 2017. Other non-interest expense decreased $0.1 million due to a decrease in advertising expense, and compensation and benefits expense decreased $0.1 million primarily because of a decrease in employees between the periods. These decreases in non-interest expense were partially offset by a $0.1 million increase in data processing expense primarily related to an increase in mobile banking and on-line banking costs between the periods. Occupancy and equipment costs increased slightly between the periods due to an increase in depreciation and real estate taxes. Professional services expense increased slightly due primarily to an increase in legal expenses between the periods.

 

Non-interest expense was $19.1 million for the first nine months of 2018, an increase of $0.1 million, or 0.2%, from $19.0 million for the same period of 2017. Other non-interest expense increased $0.2 million due primarily to increases in deposit insurance costs and the losses incurred on deposit accounts between the periods. Data processing expense increased $0.1 million primarily related to an increase in mobile and on-line banking costs between the periods. Occupancy and equipment costs increased $0.1 million between the periods due to an increase in depreciation and maintenance costs. These increases in non-interest expense were partially offset by a $0.3 million decrease in compensation and benefits expense primarily because of a decrease in employees between the periods and a $0.1 million decrease in professional services expense due to a decrease in legal expenses between the periods.

 

30

 

Income Taxes

Income tax expense was $1.0 million for the third quarter of 2018, a decrease of $0.2 million from $1.2 million for the third quarter of 2017. Income tax expense was $2.3 million for the first nine months of 2018, a decrease of $0.5 million from $2.8 million for the first nine months of 2017. Income tax expense decreased between the periods, despite an increase in pre-tax income, because of the decrease in the federal corporate income tax rate as a result of the tax law changes enacted in the fourth quarter of 2017.

 

 

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, 2017.

 

   

September 30,

   

June 30,

   

December 31,

 

(Dollars in thousands)

 

2018

   

2018

   

2017

 

Non-Performing Loans:

                       

Single family

  $ 1,073     $ 960     $ 949  

Commercial real estate

    3,689       1,432       1,364  

Consumer

    526       551       553  

Commercial business

    197       73       278  

Total

    5,485       3,016       3,144  
                         

Foreclosed and Repossessed Assets:

                       

Single family

    0       74       0  

Commercial real estate

    414       627       627  

Consumer

    0       15       0  

Total non-performing assets

  $ 5,899     $ 3,732     $ 3,771  

Total as a percentage of total assets

    0.80

%

    0.51

%

    0.52

%

Total non-performing loans

  $ 5,485     $ 3,016     $ 3,144  

Total as a percentage of total loans receivable, net

    0.94

%

    0.51

%

    0.54

%

Allowance for loan losses to non-performing loans

    161.02

%

    309.31

%

    296.11

%

                         

Delinquency Data:

                       

Delinquencies (1)

                       

30+ days

  $ 1,298     $ 1,585     $ 1,789  

90+ days

    0       0       0  

Delinquencies as a percentage of loan portfolio (1)

                       

30+ days

    0.22

%

    0.26

%

    0.30

%

90+ days

    0.00

%

    0.00

%

    0.00

%

                         

(1) Excludes non-accrual loans.

 

Total non-performing assets were $5.9 million at September 30, 2018, an increase of $2.2 million, or 58.1%, from $3.7 million at June 30, 2018. Non-performing loans increased $2.5 million and foreclosed and repossessed assets decreased $0.3 million during the third quarter of 2018. The increase in the non-performing loans was primarily related to a $2.2 million commercial loan relationship that was downgraded during the third quarter of 2018.

 

Total non-performing assets were $5.9 million at September 30, 2018, an increase of $2.1 million, or 56.4%, from $3.8 million at December 31, 2017. Non-performing loans increased $2.3 million and foreclosed and repossessed assets decreased $0.2 million during the first nine months of 2018. The increase in the non-performing loans was primarily related to a $2.2 million commercial loan relationship that was downgraded during the third quarter of 2018.

 

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 growth, 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, 2018.

 

31

 

LIQUIDITY AND CAPITAL RESOURCES

For the nine months ended September 30, 2018, the net cash provided by operating activities was $12.8 million. The Company collected $0.3 million from the maturities of securities, $1.5 million from principal repayments on securities, $0.3 million from the redemption of FHLB stock, and $0.4 million in proceeds from the sale of real estate. The Company purchased securities of $4.9 million, purchased $0.3 million of FHLB stock, and paid out $2.3 million for premises and equipment. Net loans receivable also increased $7.6 million. The Company had a net increase in deposit balances of $15.8 million and customer escrows increased $1.0 million. The Company also received $6.8 million in proceeds from borrowings, repaid borrowings of $6.8 million, and paid $6.5 million to repurchase outstanding warrants.

 

The Company has certificates of deposits with outstanding balances of $72.3 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 five deposit customers that individually had aggregate deposits greater than $5.0 million as of September 30, 2018. The $73.8 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 $174.6 million from the FHLB at September 30, 2018, 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, 2018, the Company had $2.4 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.

 

32

 

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, 2018.

 

   

 

Market Value

 

(Dollars in thousands)

Basis point change in interest rates

 

-100

   

0

   

+100

   

+200

 

Total market risk sensitive assets

  $ 731,450       719,082       706,828       694,523  

Total market risk sensitive liabilities

    621,098       584,526       553,049       526,250  

Off-balance sheet financial instruments

    (194 )     0       (58 )     (87 )

Net market risk

  $ 110,546       134,556       153,837       168,360  

Percentage change from current market value

    (17.84 )%     0.00 %     14.33 %     25.12 %
                                 

 

The preceding table was prepared utilizing a model using the following assumptions (the Model Assumptions) regarding prepayment and decay ratios that were determined by management based upon their review of historical prepayment speeds and future prepayment projections. Fixed rate loans were assumed to prepay at annual rates of between 2% to 34%, depending on the note rate and the period to maturity. Adjustable rate mortgages (ARMs) were assumed to prepay at annual rates of between 5% and 50%, 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. Certificate accounts were assumed not to be withdrawn until maturity. Passbook accounts and retail money market accounts were assumed to decay at an annual rate of 3% and 1%, respectively. Retail checking accounts were assumed to decay at an annual rate of 9%. Commercial checking and money market accounts were assumed to decay at annual rates of 28% and 32%, respectively. Callable investments were projected to be called at the first call date where the projected interest rate on similar remaining term instruments is less than the interest rate on the callable advance or investment.

 

Certain shortcomings are inherent in the method of analysis presented in the above 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 which 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 could be different from the values disclosed 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 sustained increase in interest rates.

 

33

 

Asset/Liability Management

The Company’s management reviews the impact that changing interest rates will have on the Company’s net interest income projected for the next twelve months 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 ending September 30, 2019 of immediate interest rate changes called rate shocks.

 

(Dollars in thousands)

 

Rate Shock in

Basis Points

   

Projected

Change in Net

Interest Income

   

Percentage

Change

 

+200

    $ 2,808       9.76

%

+100

    $ 1,402       4.87  
0     $ 0       0.00  
-100     $ (1,526 )     (5.30 )

 

The preceding table was prepared utilizing the Model Assumptions. Certain shortcomings are inherent in the method of analysis presented in the foregoing 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 foregoing 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 primarily because there are more adjustable rate loans that would re-price to higher interest rates than there are deposits that would re-price in the next twelve months.

 

In an attempt to manage the Company’s exposure to changes in interest rates, management closely monitors interest rate risk. The Bank has an Asset/Liability Committee that meets frequently to discuss changes in the interest rate risk position and projected profitability. This 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.

 

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 restructure its balance sheet in order to better match the maturities of its assets and liabilities. In the past, more long-term fixed rate loans were placed into the single family loan portfolio. In recent years, the Bank has continued to focus its 30 year fixed rate single family residential lending program on 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. A significant portion of the Bank’s commercial loan production continues to be in adjustable rate loans that reprice every one, two, or three years.

 

Off-Balance Sheet Arrangements

The Company has no off-balance sheet arrangements other than commitments to originate, fund, and sell loans in the ordinary course of business.

 

Item 3: Quantitative and Qualitative Disclosures about Market Risk

Not applicable.

 

Item 4: Controls and Procedures

Evaluation of disclosure controls and procedures. As of the end of the period covered by this report, the Company conducted an evaluation, under the supervision and with the participation of the Company’s management, including the principal executive officer and principal financial officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the Exchange Act)). Based on this evaluation, the principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

 

Changes in internal controls. There was no change in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) during the Company’s most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

34

 

HMN FINANCIAL, INC.

PART II - OTHER INFORMATION

 

ITEM 1.           Legal Proceedings.

 

From time to time, the Company is party to legal proceedings arising out of its lending and deposit operations. The Company is, and expects to become, engaged in a number of foreclosure proceedings and other collection actions as part of its collection activities. Based on its current understanding of these pending legal proceedings, management does not believe that judgments or settlements, if any and if determined adversely to the Company, arising from pending legal matters individually or in the aggregate, would have a material adverse effect on the consolidated financial position, operating results or cash flows of the Company. Litigation is often unpredictable and the actual results of litigation cannot be determined with any certainty.

 

ITEM 1A.      Risk Factors.

 

There have been no material changes to the Company’s risk factors contained in its Annual Report on Form 10-K for the year ended December 31, 2017. For a further discussion of our Risk Factors, see Part I, Item 1A. of the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

 

ITEM 2.     Unregistered Sales of Equity Securities and Use of Proceeds.


(a) Not applicable.
(b) Not applicable.
(c) Not applicable.

 

ITEM 3.     Defaults Upon Senior Securities.


None.
 

ITEM 4.     Mine Safety Disclosures.


Not applicable.

 

ITEM 5.     Other Information.


None.

 

35

 

ITEM 6.     Exhibits.

 

INDEX TO EXHIBITS

 

Exhibit

 

Filing

Number

Exhibit

Status

     

10.1

Warrant Repurchase Agreement by and between the Company and Arbiter Partners QP, LP, dated August 29, 2018

Incorporated by Reference (1)

     

31.1

Rule 13a-14(a)/15d-14(a) Certification of CEO

Filed Electronically

     

31.2

Rule 13a-14(a)/15d-14(a) Certification of CFO

Filed Electronically

     

32

Section 1350 Certifications of CEO and CFO

Filed Electronically

     

101

Financial statements from the Quarterly Report on Form 10-Q of the Company for the period ended September 30, 2018, filed with the Securities and Exchange Commission on November 2, 2018, formatted in Extensible Business Reporting Language (XBRL); (i) the Consolidated Balance Sheets at September 30, 2018 and December 31, 2017, (ii) the Consolidated Statements of Comprehensive Income for the Three Month and Nine Month Periods Ended September 30, 2018 and 2017, (iii) the Consolidated Statement of Stockholders’ Equity for the Nine Month Period Ended September 30, 2018, (iv) the Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2018 and 2017, and (v) Notes to Consolidated Financial Statements.

Filed Electronically

 

(1) Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated August 29, 2018, filed on August 30, 2018. (File No. 000-24100).

 

36

 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

HMN FINANCIAL, INC.

Registrant

   
   
Date: November 2, 2018 By: /s/ Bradley Krehbiel
   

Bradley Krehbiel, President and Chief Executive Officer

(Principal Executive Officer)

   
   
   
Date: November 2, 2018 By: /s/ Jon Eberle
   

Jon Eberle,

Senior Vice President, Chief Financial Officer, and Treasurer

(Principal Financial Officer)

 

37