Notes to Condensed Consolidated Financial Statements (Unaudited)
(All dollar amounts presented in the tables, except per share amounts, are in thousands)
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
See the Glossary of Defined Terms at the beginning of this Report for terms used throughout the unaudited condensed consolidated financial statements and related notes of this Form 10-Q.
Nature of Operations – Orrstown Financial Services, Inc. is a financial holding company that operates Orrstown Bank, a commercial bank providing banking and financial advisory services in Berks, Cumberland, Dauphin, Franklin, Lancaster, Perry and York Counties, Pennsylvania, and in Anne Arundel, Baltimore, Howard and Washington Counties, Maryland. The Company operates in the community banking segment and engages in lending activities, including commercial, residential, commercial mortgages, construction, municipal, and various forms of consumer lending, and deposit services, including checking, savings, time, and money market deposits. The Company also provides fiduciary, investment advisory, insurance and brokerage services. The Company and the Bank are subject to regulation by certain federal and state agencies and undergo periodic examinations by such regulatory authorities.
Basis of Presentation – The accompanying unaudited condensed consolidated financial statements include the accounts of Orrstown Financial Services, Inc. and its wholly owned subsidiary, the Bank. The Company has prepared these unaudited condensed consolidated financial statements in accordance with GAAP for interim financial information, SEC rules that permit reduced disclosure for interim periods, and Article 10 of Regulation S-X. In the opinion of management, all adjustments (all of which are of a normal recurring nature) that are necessary for a fair statement are reflected in the unaudited condensed consolidated financial statements. The December 31, 2021 consolidated balance sheet information contained in this Quarterly Report on Form 10-Q was derived from the Company's 2021 audited consolidated financial statements. The unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements, including the notes thereto, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2021. Operating results for the six months ended June 30, 2022 are not necessarily indicative of the results that may be expected for the year ending December 31, 2022. All significant intercompany transactions and accounts have been eliminated.
The Company's management has evaluated all activity of the Company and concluded that subsequent events are properly reflected in the Company's unaudited condensed consolidated financial statements and notes as required by GAAP.
To prepare financial statements in conformity with GAAP, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and actual results could differ.
Derivatives - FASB ASC 815, Derivatives and Hedging (“ASC 815”), provides the disclosure requirements for derivatives and hedging activities with the intent to provide users of financial statements with an enhanced understanding of: (a) how and why an entity uses derivative instruments, (b) how the entity accounts for derivative instruments and related hedged items, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. Further, qualitative disclosures are required that explain the Company’s objectives and strategies for using derivatives, as well as quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.
As required by ASC 815, the Company records all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge.
The Company may enter into derivative contracts that are intended to economically hedge certain of its risk, even though hedge accounting does not apply or the Company elects not to apply hedge accounting. The Company's objectives in using interest rate derivatives are to add stability to interest income and to manage its exposure to interest rate movements. To accomplish this objective, the Company uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of fixed amounts from a counterparty in exchange for the Company making variable-rate payments over the life of the agreements without exchange of the underlying notional amount.
Changes to the fair value of derivatives designated and that qualify as cash flow hedges are recorded in AOCI and are subsequently reclassified into earnings in the period that the hedged transaction affects earnings. The Company discontinues cash flow hedge accounting if it is probable the forecasted hedged transactions will not occur in the initially identified time period due to circumstances, such as the impact of the COVID-19 pandemic. Upon discontinuance, the associated gains and losses deferred in AOCI are reclassified immediately into earnings and subsequent changes in the fair value of the cash flow hedge are recognized in earnings. At June 30, 2022 and December 31, 2021, the Company had no interest rate derivatives designated as a hedging instrument.
Derivatives not designated as hedges are not speculative and result from a service the Company provides to certain customers. The Company executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies. Those interest rate swaps are simultaneously hedged by offsetting derivatives that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions. As the interest rate derivatives associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer derivatives and the offsetting derivatives are recognized directly in earnings. At June 30, 2022 and December 31, 2021, the Company had interest rate swaps not designated as hedges with a total notional value of $183.5 million and $75.8 million, respectively.
The Company also may enter into risk participation agreements with a financial institution counterparty for an interest rate derivative contract related to a loan in which the Company may be a participant or the agent bank. The risk participation agreement provides credit protection to the agent bank should the borrower fail to perform on its interest rate derivative contracts with the agent bank. The Company manages its credit risk on risk participation agreements by monitoring the creditworthiness of the borrower, which follows the same credit review process as derivative instruments entered into directly with the borrower. The notional amount of a risk participation agreement reflects the Company's pro-rata share of the derivative instrument, consistent with its share of the related participated loan. Changes in the fair value of the risk participation agreement are recognized directly into earnings. At June 30, 2022 and December 31, 2021, the Company had a risk participation with sold protection with a notional value of $15.9 million for both periods, and a risk participation with purchased protection with a notional value of $5.0 million and zero at June 30, 2022 and December 31, 2021, respectively.
Leases - The Company evaluates its contracts at inception to determine if an arrangement either is a lease or contains one. Operating lease ROU assets are included in other assets and operating lease liabilities in accrued interest payable and other liabilities in the unaudited condensed consolidated balance sheets. The Company had no finance leases at June 30, 2022 and December 31, 2021.
ROU assets represent the right to use an underlying asset for the lease term, and lease liabilities represent an obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. The Company's leases do not provide an implicit rate, so the Company's incremental borrowing rate is used, which approximates its fully collateralized borrowing rate, based on the information available at commencement date in determining the present value of lease payments. The incremental borrowing rate is reevaluated upon lease modification. The operating lease ROU asset also includes any initial direct costs and prepaid lease payments made less any lease incentives. In calculating the present value of lease payments, the Company may include options to extend the lease when it is reasonably certain that it will exercise that option.
In accordance with ASU 2016-02, “Leases (Topic 842)” (“ASU 2016-02”), the Company keeps leases with an initial term of 12 months or less off of the balance sheet. The Company recognizes these lease payments in the unaudited condensed consolidated statements of income on a straight-line basis over the lease term. The Company has lease agreements with lease and non-lease components and has elected the practical expedient to account for them as a single lease component.
The Company's operating leases relate primarily to bank branches and office space. The difference between the lease asset and lease liabilities primarily consists of deferred rent liabilities reclassified upon adoption to reduce the measurement of the lease assets. The standard does not materially impact the Company's unaudited condensed consolidated statements of income.
Recent Accounting Pronouncements - ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments ("ASU 2016-13"). The amendments in this update require an organization to measure all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. Organizations will continue to use judgment to determine which loss estimation method is appropriate for their circumstances. Additionally, the amendments in this update amend the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. For certain public companies, this update was effective for interim and
annual periods beginning after December 15, 2019. The implementation deadline of ASU 2016-13 was extended for smaller reporting and other companies until the fiscal year and interim periods beginning after December 15, 2022. The Company will implement ASU 2016-13 effective January 1, 2023.
ASU No. 2019-10, Financial Instruments—Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842): Effective Dates ("ASU 2019-10"), extended the implementation deadline of ASU 2016-13 for smaller reporting and other companies until the fiscal year and interim periods beginning after December 15, 2022. The Company meets the requirements to be considered a smaller reporting company under SEC Regulation S-K and SEC Rule 405, and will adopt ASU 2016-13 effective January 1, 2023. The Company is evaluating the impact of the adoption of ASU 2016-13, and is working with a third-party vendor solution to assist with the application of ASU 2016-13 and finalizing the loss estimation models to be used. Once management finalizes which methods will be utilized, another third party vendor will be contracted to perform a model validation prior to adoption. The Company expects to recognize a one-time cumulative-effect adjustment to the allowance for credit losses as of the date of adoption of the new standard. While the Company anticipates the allowance for loan losses will increase under its current assumptions, it expects the impact of adopting ASU 2016-13 will be influenced by the composition, characteristics and quality of its loan and investment securities portfolios, as well as general economic conditions and forecasts at the adoption date. The other provisions of ASU 2019-10 were not applicable to the Company.
In March 2020, the FASB issued ASU No. 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting ("ASU 2020-04"). ASU 2020-04 contains optional expedients and exceptions for applying generally accepted accounting principles to contract modifications and hedging relationships, subject to meeting certain criteria, that reference LIBOR or another reference rate expected to be discontinued. The optional expedients apply consistently to all contracts or transactions within the scope of this topic, while the optional expedients for hedging relationships can be elected on an individual basis. The Company has formed a cross-functional working group to lead the transition from LIBOR to a planned adoption of an alternate index. The Company currently plans to replace LIBOR with the 30-Day Average SOFR or Term SOFR in its loan agreements. The Company implemented fallback language for loans with maturities after 2021. The Company expects to adopt the LIBOR transition relief allowed under this standard, and is currently evaluating the potential impact of this guidance on its financial statements.
In March 2022, the FASB issued ASU No. 2022-02, Financial Instruments – Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures (“ASU 2022-02”). ASU 2022-02 eliminates the troubled debt restructuring accounting model. This change will require all loan modifications to be accounted for under the general loan modification guidance in Subtopic 310-20, Receivables – Nonrefundable Fees and Other Costs, and subject entities to new disclosure requirements on loan modifications to borrowers experiencing financial difficulty. For entities that have adopted Topic 326, ASU 2022-02 is effective for periods beginning after December 15, 2022. For entities adopting Topic 326 in periods after December 15, 2022, ASU 2022-02 is effective when the company adopts Topic 326. The Company will implement ASU 2022-02 effective January 1, 2023, and is evaluating the impact.
NOTE 2. INVESTMENT SECURITIES
At June 30, 2022 and December 31, 2021, all investment securities were classified as AFS. The following table summarizes amortized cost and fair value of investment securities, and the corresponding amounts of gross unrealized gains and losses recognized in AOCI, at June 30, 2022 and December 31, 2021: | | | | | | | | | | | | | | | | | | | | | | | |
| Amortized Cost | | Gross Unrealized
Gains | | Gross Unrealized
Losses | | Fair Value |
| June 30, 2022 | | | | | | | |
| U.S. Treasury securities | $ | 20,077 | | | $ | — | | | $ | 2,108 | | | $ | 17,969 | |
| | | | | | | |
| | | | | | | |
| States and political subdivisions | 255,144 | | | 768 | | | 22,385 | | | 233,527 | |
| GSE residential MBSs | 65,370 | | | — | | | 3,812 | | | 61,558 | |
| GSE residential CMOs | 73,881 | | | 217 | | | 4,407 | | | 69,691 | |
| Non-agency CMOs | 21,993 | | | 3 | | | 1,298 | | | 20,698 | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| Asset-backed | 113,012 | | | — | | | 4,156 | | | 108,856 | |
| Other | 399 | | | — | | | — | | | 399 | |
| Totals | $ | 549,876 | | | $ | 988 | | | $ | 38,166 | | | $ | 512,698 | |
| December 31, 2021 | | | | | | | |
| U.S. Treasury securities | $ | 20,084 | | | $ | — | | | $ | 382 | | | $ | 19,702 | |
| | | | | | | |
| | | | | | | |
| States and political subdivisions | 185,437 | | | 8,606 | | | 673 | | | 193,370 | |
| GSE residential MBSs | 41,260 | | | 44 | | | 578 | | | 40,726 | |
| GSE residential CMOs | 66,430 | | | 436 | | | 944 | | | 65,922 | |
| Non-agency CMOs | 30,676 | | | — | | | 978 | | | 29,698 | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| Asset-backed | 122,520 | | | 401 | | | 300 | | | 122,621 | |
| Other | 399 | | | — | | | — | | | 399 | |
| Totals | $ | 466,806 | | | $ | 9,487 | | | $ | 3,855 | | | $ | 472,438 | |
The following table summarizes investment securities with unrealized losses at June 30, 2022 and December 31, 2021, aggregated by major investment security type and the length of time in a continuous unrealized loss position. | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Less Than 12 Months | | 12 Months or More | | Total |
| # of Securities | | Fair Value | | Unrealized
Losses | | # of Securities | | Fair Value | | Unrealized
Losses | | # of Securities | | Fair Value | | Unrealized
Losses |
| June 30, 2022 | | | | | | | | | | | | | | | | | |
| U.S. Treasury securities | 3 | | | $ | 17,969 | | | $ | 2,108 | | | — | | | $ | — | | | $ | — | | | 3 | | | $ | 17,969 | | | $ | 2,108 | |
| | | | | | | | | | | | | | | | | |
| States and political subdivisions | 35 | | | 186,442 | | | 22,385 | | | — | | | — | | | — | | | 35 | | | 186,442 | | | 22,385 | |
| GSE residential MBSs | 15 | | | 61,558 | | | 3,812 | | | — | | | — | | | — | | | 15 | | | 61,558 | | | 3,812 | |
| GSE residential CMOs | 8 | | | 45,599 | | | 3,245 | | | 5 | | | 18,803 | | | 1,162 | | | 13 | | | 64,402 | | | 4,407 | |
| Non-agency CMOs | 3 | | | 16,222 | | | 1,298 | | | — | | | — | | | — | | | 3 | | | 16,222 | | | 1,298 | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| Asset-backed | 13 | | | 79,365 | | | 3,168 | | | 3 | | | 29,491 | | | 988 | | | 16 | | | 108,856 | | | 4,156 | |
| Totals | 77 | | | $ | 407,155 | | | $ | 36,016 | | | 8 | | | $ | 48,294 | | | $ | 2,150 | | | 85 | | | $ | 455,449 | | | $ | 38,166 | |
| December 31, 2021 | | | | | | | | | | | | | | | | | |
| U.S. Treasury securities | 3 | | | $ | 19,702 | | | $ | 382 | | | — | | | $ | — | | | $ | — | | | 3 | | | $ | 19,702 | | | $ | 382 | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| States and political subdivisions | 12 | | | 45,522 | | | 673 | | | — | | | — | | | — | | | 12 | | | 45,522 | | | 673 | |
| GSE residential MBSs | 9 | | | 37,899 | | | 578 | | | — | | | — | | | — | | | 9 | | | 37,899 | | | 578 | |
| GSE residential CMOs | 7 | | | 41,163 | | | 944 | | | — | | | — | | | — | | | 7 | | | 41,163 | | | 944 | |
| Non-agency CMOs | 3 | | | 24,661 | | | 978 | | | — | | | — | | | — | | | 3 | | | 24,661 | | | 978 | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| Asset-backed | 3 | | | 21,245 | | | 138 | | | 3 | | | 34,180 | | | 162 | | | 6 | | | 55,425 | | | 300 | |
| Totals | 37 | | | $ | 190,192 | | | $ | 3,693 | | | 3 | | | $ | 34,180 | | | $ | 162 | | | 40 | | | $ | 224,372 | | | $ | 3,855 | |
The Company determines whether unrealized losses are temporary in nature in accordance with FASB ASC 320-10, Investments - Overall, (“FASB ASC 320-10”) and FASB ASC 325-40, Investments – Beneficial Interests in Securitized Financial Assets, when applicable. The evaluation is based upon factors such as the creditworthiness of the underlying borrowers, performance of the underlying collateral, if applicable, and the level of credit support in the security structure.
Management also evaluates other factors and circumstances that may be indicative of an OTTI condition. This includes, but is not limited to, an evaluation of the type of security, length of time and extent to which the fair value has been less than cost and near-term prospects of the issuer.
FASB ASC 320-10 requires the Company to assess if an OTTI exists by considering whether the Company has the intent to sell the security or it is more likely than not that it will be required to sell the security before recovery. If either of these situations applies, the guidance requires the Company to record an OTTI charge to earnings on debt securities for the difference between the amortized cost basis of the security and the fair value of the security. If neither of these situations applies, the Company is required to assess whether it is expected to recover the entire amortized cost basis of the security. If the Company is not expected to recover the entire amortized cost basis of the security, the guidance requires the Company to bifurcate the identified OTTI into a credit loss component and a component representing loss related to other factors. A discount rate is applied which equals the effective yield of the security. The difference between the present value of the expected flows and the amortized book value is considered a credit loss, which would be recorded through earnings as an OTTI charge. When a market price is not readily available, the market value of the security is determined using the same expected cash flows; the discount rate is a rate the Company determines from the open market and other sources as appropriate for the security. The difference between the market value and the present value of cash flows expected to be collected is recognized in AOCI on the unaudited condensed consolidated statements of financial condition.
U.S. Treasury Securities. The unrealized losses presented in the table above have been caused by an increase in rates from the time these securities were purchased. Management considers the full faith and credit of the U.S. government in determining whether a security is OTTI. Because the Company does not intend to sell these securities and it is not more likely than not that the Company will be required to sell them before recovery of their amortized cost basis, which may be maturity, the Company does not consider these securities to be OTTI at June 30, 2022 or December 31, 2021.
States and Political Subdivisions. The unrealized losses presented in the table above have been caused by a rise in interest rates from the time these securities were purchased. Management considers the investment rating, the state of the issuer of the security and other credit support in determining whether the security is OTTI. Because the Company does not intend to sell these securities and it is not more likely than not that the Company will be required to sell them before recovery of their amortized cost basis, which may be maturity, the Company does not consider these securities to be OTTI at June 30, 2022 or December 31, 2021.
GSE Residential CMOs and GSE Residential MBS. The unrealized losses presented in the table above have been caused by a widening of spreads and a rise in interest rates from the time these securities were purchased. The contractual terms of these securities do not permit the issuer to settle the securities at a price less than its par value basis. Because the Company does not intend to sell these securities and it is not more likely than not that the Company will be required to sell them before recovery of their amortized cost basis, which may be maturity, the Company does not consider these securities to be OTTI at June 30, 2022 or December 31, 2021.
Non-Agency CMOs. The unrealized losses presented in the table above were caused by a widening of spreads and a rise in interest rates from the time the securities were purchased. Because the Company does not intend to sell these securities and it is not more likely than not that the Company will be required to sell them before recovery of their amortized cost basis, which may be maturity, the Company does not consider these securities to be OTTI at June 30, 2022 or December 31, 2021.
Asset-backed. The unrealized losses presented in the table above were caused by a widening of spreads from the time the securities were purchased. Management considers the investment rating and other credit support in determining whether a security is OTTI. Because the Company does not intend to sell these securities and it is not more likely than not that the Company will be required to sell them before recovery of their amortized cost basis, which may be maturity, the Company does not consider these securities to be OTTI at June 30, 2022 or December 31, 2021.
The following table summarizes amortized cost and fair value of investment securities by contractual maturity at June 30, 2022. Expected maturities may differ from contractual maturities if borrowers have the right to call or prepay obligations with
or without call or prepayment penalties. Securities not due at a single maturity date are shown separately. | | | | | | | | | | | |
| Amortized Cost | | Fair Value |
| Due in one year or less | $ | 249 | | | $ | 249 | |
| Due after one year through five years | 3,122 | | | 3,191 | |
| Due after five years through ten years | 85,322 | | | 79,065 | |
| Due after ten years | 186,927 | | | 169,390 | |
| CMOs and MBSs | 161,244 | | | 151,947 | |
| Asset-backed | 113,012 | | | 108,856 | |
| Totals | $ | 549,876 | | | $ | 512,698 | |
The following table summarizes proceeds from sales of investment securities and gross gains and gross losses for the three and six months ended June 30, 2022 and 2021: | | | | | | | | | | | | | | | | | | | | | | | |
| Three months ended June 30, | | Six months ended June 30, |
| 2022 | | 2021 | | 2022 | | 2021 |
| Proceeds from sale of investment securities | $ | — | | | $ | — | | | $ | 3,075 | | | $ | 75,719 | |
| Gross gains | — | | | 11 | | | 25 | | | 1,362 | |
| Gross losses | 3 | | | — | | | 3 | | | 1,206 | |
During the three and six months ended June 30, 2022, the Company recorded net investment security losses of $3 thousand and net investment security gains of $22 thousand, respectively, compared to net gains of $11 thousand and $156 thousand for the three and six months ended June 30, 2021, respectively. A non-agency CMO was called, which resulted in a loss of $171 thousand for the six months ended June 30, 2022. During the six months ended June 30, 2022, a partial sale of one security with a principal balance of $3.1 million was sold for proceeds of $3.1 million compared to 14 securities with a principal balance of $75.6 million that were sold for proceeds of $75.7 million during the six months ended June 30, 2021. There were no securities sold during the three months ended June 30, 2022 and 2021. Investment securities with a fair value of $341.9 million and $295.6 million at June 30, 2022 and December 31, 2021, respectively, were pledged to secure public funds and for other purposes as required or permitted by law.
NOTE 3. LOANS AND ALLOWANCE FOR LOAN LOSSES
Consistent with ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Loan Losses, the Company’s loan portfolio is grouped into segments which are further broken down into classes to allow management to monitor the performance by the borrower and to monitor the yield on the portfolio.
The risks associated with lending activities differ among the various loan classes and are subject to the impact of changes in interest rates, market conditions of collateral securing the loans, and general economic conditions. All of these factors may adversely impact both the borrower’s ability to repay its loans and associated collateral.
The Company has various types of commercial real estate loans, which have differing levels of credit risk. Owner occupied commercial real estate loans are generally dependent upon the successful operation of the borrower’s business, with the cash flows generated from the business being the primary source of repayment of the loan. If the business suffers a downturn in sales or profitability, the borrower’s ability to repay the loan could be in jeopardy.
Non-owner occupied and multi-family commercial real estate loans and non-owner occupied residential loans present a different credit risk to the Company than owner occupied commercial real estate loans, as the repayment of the loan is dependent upon the borrower’s ability to generate a sufficient level of occupancy to produce rental income that exceeds debt service requirements and operating expenses. Lower occupancy or lease rates may result in a reduction in cash flows, which hinders the ability of the borrower to meet debt service requirements, and may result in lower collateral values. The Company generally recognizes that greater risk is inherent in these credit relationships compared to owner occupied loans mentioned above.
Acquisition and development loans consist of 1-4 family residential construction and commercial and land development loans. The risk of loss on these loans is largely dependent on the Company’s ability to assess the property’s value at the completion of the project, which should exceed the property’s construction costs. During the construction phase, a number of
factors could potentially negatively impact the collateral value, including cost overruns, delays in completing the project, competition, and real estate market conditions, which may change based on the supply of similar properties in the area. In the event the collateral value at the completion of the project is not sufficient to cover the outstanding loan balance, the Company must rely upon other repayment sources, if any, including the guarantors of the project or other collateral securing the loan.
On March 27, 2020, the Coronavirus Aid, Relief and Economic Security (“CARES”) Act was enacted. The CARES Act established the SBA PPP. The SBA PPP is intended to provide economic relief to small businesses nationwide adversely impacted under the COVID-19 Emergency Declaration issued on March 13, 2020. The SBA PPP, which began on April 3, 2020, provided small businesses with funds to cover up to 24 weeks of payroll costs and other expenses, including benefits. It also provides for forgiveness of up to the full principal amount of qualifying loans. In total, the Bank closed and funded almost 6,500 loans for a total gross loan amount of $699.4 million through December 31, 2021.
Commercial and industrial loans include advances to local and regional businesses for general commercial purposes and include permanent and short-term working capital, machinery and equipment financing, and may be either in the form of lines of credit or term loans. Although commercial and industrial loans may be unsecured to our highest-rated borrowers, the majority of these loans are secured by the borrower’s accounts receivable, inventory and machinery and equipment. In a significant number of these loans, the collateral also includes the business real estate or the business owner’s personal real estate or assets. Commercial and industrial loans present credit exposure to the Company, as they are more susceptible to risk of loss during a downturn in the economy as borrowers may have greater difficulty in meeting their debt service requirements and the value of the collateral may decline. The Company attempts to mitigate this risk through its underwriting standards, including evaluating the creditworthiness of the borrower and, to the extent available, credit ratings on the business. Additionally, monitoring of the loans through annual renewals and meetings with the borrowers are typical. However, these procedures cannot eliminate the risk of loss associated with commercial and industrial lending. At June 30, 2022 and December 31, 2021, commercial and industrial loans include $30.2 million and $189.9 million, respectively, of loans, net of deferred fees and costs, originated through the SBA PPP. At June 30, 2022, the Bank has $758 thousand of net deferred SBA PPP fees remaining to be recognized through net interest income over the remaining life of the loans. The timing of the recognition of these fees is dependent upon the loan forgiveness process established by the SBA. As these loans are 100% guaranteed by the SBA, there is no associated ALL at June 30, 2022.
Municipal loans consist of extensions of credit to municipalities and school districts within the Company’s market area. These loans generally present a lower risk than commercial and industrial loans, as they are generally secured by the municipality’s full taxing authority, by revenue obligations, or by its ability to raise assessments on its clients for a specific utility.
The Company originates loans to its retail clients, including fixed-rate and adjustable first lien mortgage loans, with the underlying 1-4 family owner occupied residential property securing the loan. The Company’s risk exposure is minimized in these types of loans through the evaluation of the creditworthiness of the borrower, including credit scores and debt-to-income ratios, and underwriting standards, which limit the loan-to-value ratio to generally no more than 80% upon loan origination, unless the borrower obtains private mortgage insurance.
Home equity loans, including term loans and lines of credit, present a slightly higher risk to the Company than 1-4 family first liens, as these loans can be first or second liens on 1-4 family owner occupied residential property, but can have loan-to-value ratios of no greater than 85% of the value of the real estate taken as collateral. The creditworthiness of the borrower is also considered, including credit scores and debt-to-income ratios.
Installment and other loans’ credit risk is mitigated through prudent underwriting standards, including evaluation of the creditworthiness of the borrower through credit scores and debt-to-income ratios and, if secured, the collateral value of the assets. These loans can be unsecured or secured by assets the value of which may depreciate quickly or may fluctuate, and may present a greater risk to the Company than 1-4 family residential loans.
The following table presents the loan portfolio by segment and class, excluding residential mortgage LHFS, at June 30, 2022 and December 31, 2021: | | | | | | | | | | | |
| June 30, 2022 | | December 31, 2021 |
| Commercial real estate: | | | |
| Owner occupied | $ | 287,825 | | | $ | 238,668 | |
| Non-owner occupied | 559,309 | | | 551,783 | |
| Multi-family | 116,110 | | | 93,255 | |
| Non-owner occupied residential | 109,141 | | | 106,112 | |
| Acquisition and development: | | | |
| 1-4 family residential construction | 22,650 | | | 12,279 | |
| Commercial and land development | 134,947 | | | 93,925 | |
Commercial and industrial (1) | 379,729 | | | 485,728 | |
| Municipal | 12,957 | | | 14,989 | |
| Residential mortgage: | | | |
| First lien | 202,787 | | | 198,831 | |
| Home equity - term | 5,996 | | | 6,081 | |
| Home equity - lines of credit | 171,269 | | | 160,705 | |
| Installment and other loans | 14,909 | | | 17,630 | |
| Total loans | $ | 2,017,629 | | | $ | 1,979,986 | |
(1) This balance includes $30.2 million and $189.9 million of SBA PPP loans, net of deferred fees and costs, at June 30, 2022 and December 31, 2021, respectively.
In order to monitor ongoing risk associated with its loan portfolio and specific loans within the segments, management uses an internal grading system. The first several rating categories, representing the lowest risk to the Bank, are combined and given a “Pass” rating. Management generally follows regulatory definitions in assigning criticized ratings to loans, including "Special Mention," "Substandard," "Doubtful" or "Loss." The Special Mention category includes loans that have potential weaknesses that may, if not monitored or corrected, weaken the asset or inadequately protect the Bank's position at some future date. These assets pose elevated risk, but their weakness does not yet justify a more severe, or classified rating. Substandard loans are classified as they have a well-defined weakness, or weaknesses that jeopardize liquidation of the debt. These loans are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Substandard loans include loans that management has determined not to be impaired, as well as loans considered to be impaired. A Doubtful loan has a high probability of total or substantial loss, but because of specific pending events that may strengthen the asset, its classification as Loss is deferred. Loss loans are considered uncollectible, as the borrowers are often in bankruptcy, have suspended debt repayments, or have ceased business operations. Once a loan is classified as Loss, there is little prospect of collecting the loan’s principal or interest and it is charged-off.
The Company has a loan review policy and program, which is designed to identify and monitor risk in the lending function. The Management ERM Committee, comprised of executive officers, senior officers and loan department personnel, is charged with the oversight of overall credit quality and risk exposure of the Company's loan portfolio. This includes the monitoring of the lending activities of all Company personnel with respect to underwriting and processing new loans and the timely follow-up and corrective action for loans showing signs of deterioration in quality. A loan review program provides the Company with an independent review of the commercial loan portfolio on an ongoing basis. Generally, consumer and residential mortgage loans are included in the Pass categories unless a specific action, such as extended delinquencies, bankruptcy, repossession or death of the borrower occurs, which heightens awareness as to a possible credit event.
Internal loan reviews are completed annually on all commercial relationships with a committed loan balance in excess of $1.0 million, which includes confirmation of risk rating by an independent credit officer. In addition, all commercial relationships greater than $500 thousand rated Substandard, Doubtful or Loss are reviewed quarterly and corresponding risk ratings are reaffirmed by the Company's Problem Loan Committee, with subsequent reporting to the Management ERM Committee and the Board of Directors.
The following table summarizes the Company’s loan portfolio ratings based on its internal risk rating system at June 30, 2022 and December 31, 2021: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Pass | | Special Mention | | Non-Impaired Substandard | | Impaired - Substandard | | Doubtful | | PCI Loans | | Total |
| June 30, 2022 | | | | | | | | | | | | | |
| Commercial real estate: | | | | | | | | | | | | | |
| Owner occupied | $ | 274,188 | | | $ | 6,086 | | | $ | 2,375 | | | $ | 2,910 | | | $ | — | | | $ | 2,266 | | | $ | 287,825 | |
| Non-owner occupied | 547,382 | | | 9,221 | | | 2,409 | | | — | | | — | | | 297 | | | 559,309 | |
| Multi-family | 107,779 | | | 8,082 | | | 249 | | | — | | | — | | | — | | | 116,110 | |
| Non-owner occupied residential | 105,680 | | | 2,261 | | | 503 | | | 98 | | | — | | | 599 | | | 109,141 | |
| Acquisition and development: | | | | | | | | | | | | | |
| 1-4 family residential construction | 22,650 | | | — | | | — | | | — | | | — | | | — | | | 22,650 | |
| Commercial and land development | 133,264 | | | 1,683 | | | — | | | — | | | — | | | — | | | 134,947 | |
| Commercial and industrial | 365,407 | | | 5,877 | | | 6,266 | | | 62 | | | — | | | 2,117 | | | 379,729 | |
| Municipal | 12,957 | | | — | | | — | | | — | | | — | | | — | | | 12,957 | |
| Residential mortgage: | | | | | | | | | | | | | |
| First lien | 195,674 | | | — | | | 221 | | | 2,448 | | | — | | | 4,444 | | | 202,787 | |
| Home equity - term | 5,974 | | | — | | | — | | | 6 | | | — | | | 16 | | | 5,996 | |
| Home equity - lines of credit | 170,834 | | | — | | | 46 | | | 389 | | | — | | | — | | | 171,269 | |
| Installment and other loans | 14,861 | | | — | | | — | | | 42 | | | — | | | 6 | | | 14,909 | |
| $ | 1,956,650 | | | $ | 33,210 | | | $ | 12,069 | | | $ | 5,955 | | | $ | — | | | $ | 9,745 | | | $ | 2,017,629 | |
| | | | | | | | | | | | | |
| December 31, 2021 | | | | | | | | | | | | | |
| Commercial real estate: | | | | | | | | | | | | | |
| Owner occupied | $ | 219,250 | | | $ | 7,239 | | | $ | 6,087 | | | $ | 3,763 | | | $ | — | | | $ | 2,329 | | | $ | 238,668 | |
| Non-owner occupied | 528,010 | | | 23,297 | | | 166 | | | — | | | — | | | 310 | | | 551,783 | |
| Multi-family | 84,414 | | | 8,238 | | | 603 | | | — | | | — | | | — | | | 93,255 | |
| Non-owner occupied residential | 102,588 | | | 1,065 | | | 1,153 | | | 122 | | | — | | | 1,184 | | | 106,112 | |
| Acquisition and development: | | | | | | | | | | | | | |
| 1-4 family residential construction | 12,279 | | | — | | | — | | | — | | | — | | | — | | | 12,279 | |
| Commercial and land development | 92,049 | | | 1,385 | | | 491 | | | — | | | — | | | — | | | 93,925 | |
| Commercial and industrial | 470,579 | | | 7,917 | | | 4,720 | | | 250 | | | — | | | 2,262 | | | 485,728 | |
| Municipal | 14,989 | | | — | | | — | | | — | | | — | | | — | | | 14,989 | |
| Residential mortgage: | | | | | | | | | | | | | |
| First lien | 191,386 | | | — | | | 225 | | | 2,635 | | | — | | | 4,585 | | | 198,831 | |
| Home equity - term | 6,058 | | | — | | | — | | | 7 | | | — | | | 16 | | | 6,081 | |
| Home equity - lines of credit | 160,203 | | | 20 | | | 46 | | | 436 | | | — | | | — | | | 160,705 | |
| Installment and other loans | 17,584 | | | — | | | — | | | 40 | | | — | | | 6 | | | 17,630 | |
| $ | 1,899,389 | | | $ | 49,161 | | | $ | 13,491 | | | $ | 7,253 | | | $ | — | | | $ | 10,692 | | | $ | 1,979,986 | |
For commercial real estate, acquisition and development and commercial and industrial loans, a loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by
management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Generally, loans that are more than 90 days past due are deemed impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed to determine if the loan should be placed on nonaccrual status. Nonaccrual loans in the commercial and commercial real estate portfolios and any TDRs are, by definition, deemed to be impaired. Impairment is measured on a loan-by-loan basis for commercial, construction and restructured loans by either the present value of the expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. A loan is collateral dependent if the repayment of the loan is expected to be provided solely by the underlying collateral. For loans that are deemed to be impaired for extended periods of time, periodic updates on fair values are obtained, which may include updated appraisals. Updated fair values are incorporated into the impairment analysis in the next reporting period.
Loan charge-offs, which may include partial charge-offs, are taken on an impaired loan that is collateral dependent if the loan’s carrying balance exceeds its collateral’s appraised value, the loan has been identified as uncollectible, and it is deemed to be a confirmed loss. Typically, impaired loans with a charge-off or partial charge-off will continue to be considered impaired, unless the note is split into two, and management expects the performing note to continue to perform and is adequately secured. The second, or non-performing note, would be charged-off. Generally, an impaired loan with a partial charge-off may continue to have an impairment reserve on it after the partial charge-off, if factors warrant.
At June 30, 2022 and December 31, 2021, except for TDRs, all of the Company’s loan impairments were measured based on the estimated fair value of the collateral securing the loan. By definition, TDRs are considered impaired. All TDR impairment analyses are initially based on discounted cash flows for those loans. For real estate loans, collateral generally consists of commercial real estate, but in the case of commercial and industrial loans, it could also consist of accounts receivable, inventory, equipment or other business assets. Commercial and industrial loans may also have real estate collateral.
Updated appraisals are generally required every 18 months for classified commercial loans in excess of $250 thousand. The “as is" value provided in the appraisal is often used as the fair value of the collateral in determining impairment, unless circumstances, such as subsequent improvements, approvals, or other circumstances, dictate that another value than that provided by the appraiser is more appropriate.
Generally, impaired commercial loans secured by real estate, other than performing TDRs, are measured at fair value using certified real estate appraisals that had been completed within the last 18 months. Appraised values are discounted for estimated costs to sell the property and other selling considerations to arrive at the property’s fair value. In those situations in which it is determined an updated appraisal is not required for loans individually evaluated for impairment, fair values are based on either an existing appraisal or a discounted cash flow analysis as determined by management. The approaches are discussed below:
•Existing appraisal – if the existing appraisal provides a strong loan-to-value ratio (generally 70% or lower) and, after consideration of market conditions and knowledge of the property and area, it is determined by the Credit Administration staff that there has not been a significant deterioration in the collateral value, the existing certified appraised value may be used. Discounts to the appraised value, as deemed appropriate for selling costs, are factored into the fair value.
•Discounted cash flows – in limited cases, discounted cash flows may be used on projects in which the collateral is liquidated to reduce the borrowings outstanding, and is used to validate collateral values derived from other approaches.
Collateral on certain impaired loans is not limited to real estate, and may consist of accounts receivable, inventory, equipment or other business assets. Estimated fair values are determined based on borrowers’ financial statements, inventory ledgers, accounts receivable aging or appraisals from individuals with knowledge in the business. Stated balances are generally discounted for the age of the financial information or the quality of the assets. In determining fair value, liquidation discounts are applied to this collateral based on existing loan evaluation policies.
The Company distinguishes substandard loans on both an impaired and non-impaired basis, as it places less emphasis on a loan’s classification, and increased reliance on whether the loan was performing in accordance with the contractual terms. A substandard classification does not automatically meet the definition of impaired. Loss potential, while existing in the aggregate amount of substandard loans, does not have to exist in individual extensions of credit classified as substandard. As a result, the Company’s methodology includes an evaluation of certain accruing commercial real estate, acquisition and development, and commercial and industrial loans rated substandard to be collectively evaluated for impairment. Although the Company believes
these loans meet the definition of substandard, they are generally performing and management has concluded that it is likely the Company will be able to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement.
Larger groups of smaller balance homogeneous loans are collectively evaluated for impairment. Generally, the Company does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement due to financial difficulties of the borrower.
The following table, which excludes accruing PCI loans, summarizes impaired loans by segment and class, segregated by those for which a specific allowance was required and those for which a specific allowance was not required at June 30, 2022 and December 31, 2021. The recorded investment in loans excludes accrued interest receivable due to insignificance. Related allowances established generally pertain to those loans in which loan forbearance agreements were in the process of being negotiated or updated appraisals were pending, and any partial charge-off will be recorded when final information is received.
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Impaired Loans with a Specific Allowance | | Impaired Loans with No Specific Allowance |
| Recorded Investment (Book Balance) | | Unpaid Principal Balance (Legal Balance) | | Related Allowance | | Recorded Investment (Book Balance) | | Unpaid Principal Balance (Legal Balance) |
| June 30, 2022 | | | | | | | | | |
| Commercial real estate: | | | | | | | | | |
| Owner-occupied | $ | — | | | $ | — | | | $ | — | | | $ | 2,910 | | | $ | 3,862 | |
| | | | | | | | | |
| | | | | | | | | |
| Non-owner occupied residential | — | | | — | | | — | | | 98 | | | 212 | |
| | | | | | | | | |
| | | | | | | | | |
| | | | | | | | | |
| Commercial and industrial | — | | | — | | | — | | | 62 | | | 336 | |
| Residential mortgage: | | | | | | | | | |
| First lien | 181 | | | 181 | | | 28 | | | 2,267 | | | 3,103 | |
| Home equity—term | — | | | — | | | — | | | 6 | | | 9 | |
| Home equity—lines of credit | — | | | — | | | — | | | 389 | | | 619 | |
| Installment and other loans | — | | | — | | | — | | | 42 | | | 42 | |
| $ | 181 | | | $ | 181 | | | $ | 28 | | | $ | 5,774 | | | $ | 8,183 | |
| December 31, 2021 | | | | | | | | | |
| Commercial real estate: | | | | | | | | | |
| Owner-occupied | $ | — | | | $ | — | | | $ | — | | | $ | 3,763 | | | $ | 4,902 | |
| | | | | | | | | |
| | | | | | | | | |
| Non-owner occupied residential | — | | | — | | | — | | | 122 | | | 259 | |
| | | | | | | | | |
| | | | | | | | | |
| | | | | | | | | |
| Commercial and industrial | — | | | — | | | — | | | 250 | | | 547 | |
| Residential mortgage: | | | | | | | | | |
| First lien | 341 | | | 341 | | | 28 | | | 2,294 | | | 3,337 | |
| Home equity—term | — | | | — | | | — | | | 7 | | | 10 | |
| Home equity—lines of credit | — | | | — | | | — | | | 436 | | | 653 | |
| Installment and other loans | — | | | — | | | — | | | 40 | | | 40 | |
| $ | 341 | | | $ | 341 | | | $ | 28 | | | $ | 6,912 | | | $ | 9,748 | |
The following table, which excludes accruing PCI loans, summarizes the average recorded investment in impaired loans and related recognized interest income for the three and six months ended June 30, 2022 and 2021:
| | | | | | | | | | | | | | | | | | | | | | | |
| 2022 | | 2021 |
| Average
Impaired
Balance | | Interest
Income
Recognized | | Average
Impaired
Balance | | Interest
Income
Recognized |
| Three Months Ended June 30, | | | | | | | |
| Commercial real estate: | | | | | | | |
| Owner-occupied | $ | 3,006 | | | $ | — | | | $ | 4,072 | | | $ | — | |
| | | | | | | |
| | | | | | | |
| Non-owner occupied residential | 99 | | | — | | | 259 | | | — | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| Commercial and industrial | 117 | | | — | | | 3,302 | | | — | |
| Residential mortgage: | | | | | | | |
| First lien | 2,310 | | | 8 | | | 2,542 | | | 10 | |
| Home equity – term | 6 | | | — | | | 18 | | | — | |
| Home equity - lines of credit | 408 | | | — | | | 547 | | | — | |
| Installment and other loans | 49 | | | — | | | 13 | | | — | |
| $ | 5,995 | | | $ | 8 | | | $ | 10,753 | | | $ | 10 | |
| Six Months Ended June 30, | | | | | | | |
| Commercial real estate: | | | | | | | |
| Owner occupied | $ | 3,236 | | | $ | — | | | $ | 3,726 | | | $ | 1 | |
| | | | | | | |
| Multi-family | — | | | — | | | 11 | | | — | |
| Non-owner occupied residential | 103 | | | — | | | 263 | | | — | |
| Acquisition and development: | | | | | | | |
| | | | | | | |
| Commercial and land development | — | | | — | | | 351 | | | — | |
| Commercial and industrial | 168 | | | — | | | 3,049 | | | — | |
| Residential mortgage: | | | | | | | |
| First lien | 2,369 | | | 15 | | | 2,593 | | | 21 | |
| Home equity - term | 6 | | | — | | | 14 | | | — | |
| Home equity - lines of credit | 419 | | | — | | | 581 | | | — | |
| Installment and other loans | 46 | | | — | | | 12 | | | — | |
| $ | 6,347 | | | $ | 15 | | | $ | 10,600 | | | $ | 22 | |
The following table presents impaired loans that are TDRs, with the recorded investment at June 30, 2022 and December 31, 2021:
| | | | | | | | | | | | | | | | | | | | | | | |
| June 30, 2022 | | December 31, 2021 |
| Number of
Contracts | | Recorded
Investment | | Number of
Contracts | | Recorded
Investment |
| Accruing: | | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| Residential mortgage: | | | | | | | |
| First lien | 7 | | | $ | 568 | | | 8 | | | $ | 804 | |
| | | | | | | |
| 7 | | | 568 | | | 8 | | | 804 | |
| Nonaccruing: | | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| Residential mortgage: | | | | | | | |
| First lien | 6 | | | 264 | | | 5 | | | 285 | |
| Installment and other loans | 1 | | | 4 | | | — | | | — | |
| 7 | | | 268 | | | 5 | | | 285 | |
| 14 | | | $ | 836 | | | 13 | | | $ | 1,089 | |
There were one and two new TDRs, both on non-accrual status, of $4 thousand and $6 thousand, for the three and six months ended June 30, 2022, respectively. There were no new TDRs in 2021.
Management further monitors the performance and credit quality of the loan portfolio by analyzing the length of time a portfolio is past due, by aggregating loans based on its delinquencies. The following table presents the classes of loan portfolio summarized by aging categories of performing loans and nonaccrual loans at June 30, 2022 and December 31, 2021: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Days Past Due | | | | | | |
| Current | | 30-59 | | 60-89 | | 90+
(still accruing) | | Total
Past Due | | Non-
Accrual | | Total
Loans |
| June 30, 2022 | | | | | | | | | | | | | |
| Commercial real estate: | | | | | | | | | | | | | |
| Owner occupied | $ | 282,280 | | | $ | 369 | | | $ | — | | | $ | — | | | $ | 369 | | | $ | 2,910 | | | $ | 285,559 | |
| Non-owner occupied | 558,928 | | | 84 | | | — | | | — | | | 84 | | | — | | | 559,012 | |
| Multi-family | 116,110 | | | — | | | — | | | — | | | — | | | — | | | 116,110 | |
| Non-owner occupied residential | 108,324 | | | 120 | | | — | | | — | | | 120 | | | 98 | | | 108,542 | |
| Acquisition and development: | | | | | | | | | | | | | |
| 1-4 family residential construction | 22,650 | | | — | | | — | | | — | | | — | | | — | | | 22,650 | |
| Commercial and land development | 134,947 | | | — | | | — | | | — | | | — | | | — | | | 134,947 | |
| Commercial and industrial | 376,246 | | | 1,304 | | | — | | | — | | | 1,304 | | | 62 | | | 377,612 | |
| Municipal | 12,957 | | | — | | | — | | | — | | | — | | | — | | | 12,957 | |
| Residential mortgage: | | | | | | | | | | | | | |
| First lien | 195,825 | | | 123 | | | 466 | | | 49 | | | 638 | | | 1,880 | | | 198,343 | |
| Home equity - term | 5,965 | | | 9 | | | — | | | — | | | 9 | | | 6 | | | 5,980 | |
| Home equity - lines of credit | 170,679 | | | 133 | | | 68 | | | — | | | 201 | | | 389 | | | 171,269 | |
| Installment and other loans | 14,734 | | | 103 | | | 24 | | | — | | | 127 | | | 42 | | | 14,903 | |
| Subtotal | 1,999,645 | | | 2,245 | | | 558 | | | 49 | | | 2,852 | | | 5,387 | | | 2,007,884 | |
| Loans acquired with credit deterioration: | | | | | | | | | | | | |
| Commercial real estate: | | | | | | | | | | | | | |
| Owner occupied | 2,266 | | | — | | | — | | | — | | | — | | | — | | | 2,266 | |
| Non-owner occupied | 297 | | | — | | | — | | | — | | | — | | | — | | | 297 | |
| | | | | | | | | | | | | |
| Non-owner occupied residential | 484 | | | — | | | — | | | 115 | | | 115 | | | — | | | 599 | |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | |
| Commercial and industrial | 2,117 | | | — | | | — | | | — | | | — | | | — | | | 2,117 | |
| | | | | | | | | | | | | |
| Residential mortgage: | | | | | | | | | | | | | |
| First lien | 4,164 | | | 10 | | | 112 | | | 158 | | | 280 | | | — | | | 4,444 | |
| Home equity - term | 16 | | | — | | | — | | | — | | | — | | | — | | | 16 | |
| | | | | | | | | | | | | |
| Installment and other loans | 6 | | | — | | | — | | | — | | | — | | | — | | | 6 | |
| Subtotal | 9,350 | | | 10 | | | 112 | | | 273 | | | 395 | | | — | | | 9,745 | |
| $ | 2,008,995 | | | $ | 2,255 | | | $ | 670 | | | $ | 322 | | | $ | 3,247 | | | $ | 5,387 | | | $ | 2,017,629 | |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | |
| | | Days Past Due | | | | | | |
| Current | | 30-59 | | 60-89 | | 90+
(still accruing) | | Total
Past Due | | Non-
Accrual | | Total
Loans |
| December 31, 2021 | | | | | | | | | | | | | |
| Commercial real estate: | | | | | | | | | | | | | |
| Owner occupied | $ | 231,371 | | | $ | 314 | | | $ | — | | | $ | 891 | | | $ | 1,205 | | | $ | 3,763 | | | $ | 236,339 | |
| Non-owner occupied | 551,473 | | | — | | | — | | | — | | | — | | | — | | | 551,473 | |
| Multi-family | 93,255 | | | — | | | — | | | — | | | — | | | — | | | 93,255 | |
| Non-owner occupied residential | 104,645 | | | 161 | | | — | | | — | | | 161 | | | 122 | | | 104,928 | |
| Acquisition and development: | | | | | | | | | | | | | |
| 1-4 family residential construction | 12,279 | | | — | | | — | | | — | | | — | | | — | | | 12,279 | |
| Commercial and land development | 93,793 | | | 132 | | | — | | | — | | | 132 | | | — | | | 93,925 | |
| Commercial and industrial | 483,088 | | | 128 | | | — | | | — | | | 128 | | | 250 | | | 483,466 | |
| Municipal | 14,989 | | | — | | | — | | | — | | | — | | | — | | | 14,989 | |
| Residential mortgage: | | | | | | | | | | | | | |
| First lien | 189,043 | | | 2,995 | | | 281 | | | 96 | | | 3,372 | | | 1,831 | | | 194,246 | |
| Home equity - term | 6,042 | | | 16 | | | — | | | — | | | 16 | | | 7 | | | 6,065 | |
| Home equity - lines of credit | 159,628 | | | 641 | | | — | | | — | | | 641 | | | 436 | | | 160,705 | |
| Installment and other loans | 17,467 | | | 109 | | | 8 | | | — | | | 117 | | | 40 | | | 17,624 | |
| Subtotal | 1,957,073 | | | 4,496 | | | 289 | | | 987 | | | 5,772 | | | 6,449 | | | 1,969,294 | |
| Loans acquired with credit deterioration: | | | | | | | | | | | | |
| Commercial real estate: | | | | | | | | | | | | | |
| Owner occupied | 2,329 | | | — | | | — | | | — | | | — | | | — | | | 2,329 | |
| Non-owner occupied | 310 | | | — | | | — | | | — | | | — | | | — | | | 310 | |
| | | | | | | | | | | | | |
| Non-owner occupied residential | 479 | | | — | | | 587 | | | 118 | | | 705 | | | — | | | 1,184 | |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | |
| Commercial and industrial | 2,262 | | | — | | | — | | | — | | | — | | | — | | | 2,262 | |
| | | | | | | | | | | | | |
| Residential mortgage: | | | | | | | | | | | | | |
| First lien | 3,937 | | | 387 | | | 166 | | | 95 | | | 648 | | | — | | | 4,585 | |
| Home equity - term | 15 | | | — | | | — | | | 1 | | | 1 | | | — | | | 16 | |
| | | | | | | | | | | | | |
| Installment and other loans | 6 | | | — | | | — | | | — | | | — | | | — | | | 6 | |
| Subtotal | 9,338 | | | 387 | | | 753 | | | 214 | | | 1,354 | | | — | | | 10,692 | |
| $ | 1,966,411 | | | $ | 4,883 | | | $ | 1,042 | | | $ | 1,201 | | | $ | 7,126 | | | $ | 6,449 | | | $ | 1,979,986 | |
| | | | | | | | | | | | | |
The Company maintains its ALL at a level management believes adequate for probable incurred credit losses. The ALL is established and maintained through a provision for loan losses charged to earnings. On a quarterly basis, management assesses the adequacy of the ALL utilizing a defined methodology, which considers specific credit evaluation of impaired loans as discussed above, historical loan loss experience, and qualitative factors. Management believes its approach properly addresses relevant accounting guidance for loans individually identified as impaired and for loans collectively evaluated for impairment, and other bank regulatory guidance.
In connection with its quarterly evaluation of the adequacy of the ALL, management reviews its methodology to determine if it properly addresses the current risk in the loan portfolio. For each loan class, general allowances based on quantitative factors, principally historical loss trends, are provided for loans that are collectively evaluated for impairment. An
adjustment to historical loss factors may be incorporated for delinquency and other potential risk not elsewhere defined within the ALL methodology.
In addition to this quantitative analysis, adjustments to the ALL requirements are allocated on loans collectively evaluated for impairment based on additional qualitative factors, including:
Nature and Volume of Loans – including loan growth in the current and subsequent quarters based on the Company’s targeted growth and strategic plan, coupled with the types of loans booked based on risk management and credit culture; the number of exceptions to loan policy; and supervisory loan to value exceptions.
Concentrations of Credit and Changes within Credit Concentrations – including the composition of the Company’s overall portfolio makeup and management's evaluation related to concentration risk management and the inherent risk associated with the concentrations identified.
Underwriting Standards and Recovery Practices – including changes to underwriting standards and perceived impact on anticipated losses; trends in the number of exceptions to loan policy; supervisory loan to value exceptions; and administration of loan recovery practices.
Delinquency Trends – including delinquency percentages noted in the portfolio relative to economic conditions; severity of the delinquencies; and whether the ratios are trending upwards or downwards.
Classified Loans Trends – including internal loan ratings of the portfolio; severity of the ratings; whether the loan segment’s ratings show a more favorable or less favorable trend; and underlying market conditions and impact on the collateral values securing the loans.
Experience, Ability and Depth of Management/Lending staff – including the level of experience of senior and middle management and the lending staff; turnover of the staff; and instances of repeat criticisms.
Quality of Loan Review – including the level of experience of the loan review staff; in-house versus outsourced provider of review; turnover of the staff; and instances of repeat criticisms.
National and Local Economic Conditions – including trends in the consumer price index, unemployment rates, the housing price index, housing statistics compared to the prior year, bankruptcy rates, regulatory and legal environment risks and competition.
All factors noted above were deemed appropriate at June 30, 2022. For the six months ended June 30, 2022, these factors were unchanged, except for a reduction in the National and Local Economic Conditions factor during the first quarter of 2022. This factor had been increased previously for economic concerns in the commercial real estate portfolio associated with the COVID-19 pandemic. The additional allocation was removed at March 31, 2022 as these concerns had subsided.
The following table presents the activity in the ALL for the three and six months ended June 30, 2022 and 2021: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Commercial | | Consumer | | | | |
| Commercial
Real Estate | | Acquisition
and
Development | | Commercial
and
Industrial | | Municipal | | Total | | Residential
Mortgage | | Installment
and Other | | Total | | Unallocated | | Total |
| Three Months Ended | | | | | | | | | | | | | | | | | | | |
| June 30, 2022 | | | | | | | | | | | | | | | | | | | |
| Balance, beginning of period | $ | 11,546 | | | $ | 2,321 | | | $ | 4,301 | | | $ | 29 | | | $ | 18,197 | | | $ | 2,873 | | | $ | 201 | | | $ | 3,074 | | | $ | 237 | | | $ | 21,508 | |
| Provision for loan losses | 748 | | | 695 | | | 184 | | | (3) | | | 1,624 | | | 127 | | | 24 | | | 151 | | | — | | | 1,775 | |
| | | | | | | | | | | | | | | | | | | |
| Charge-offs | — | | | — | | | (54) | | | — | | | (54) | | | — | | | (5) | | | (5) | | | — | | | (59) | |
| Recoveries | — | | | 8 | | | 40 | | | — | | | 48 | | | 4 | | | 3 | | | 7 | | | — | | | 55 | |
| Balance, end of period | $ | 12,294 | | | $ | 3,024 | | | $ | 4,471 | | | $ | 26 | | | $ | 19,815 | | | $ | 3,004 | | | $ | 223 | | | $ | 3,227 | | | $ | 237 | | | $ | 23,279 | |
| June 30, 2021 | | | | | | | | | | | | | | | | | | | |
| Balance, beginning of period | $ | 10,671 | | | $ | 1,046 | | | $ | 3,714 | | | $ | 38 | | | $ | 15,469 | | | $ | 3,058 | | | $ | 208 | | | $ | 3,266 | | | $ | 232 | | | $ | 18,967 | |
| Provision for loan losses | 806 | | | 197 | | | (223) | | | (9) | | | 771 | | | (142) | | | 19 | | | (123) | | | (23) | | | 625 | |
| Charge-offs | (181) | | | — | | | (112) | | | — | | | (293) | | | (71) | | | (9) | | | (80) | | | — | | | (373) | |
| Recoveries | 19 | | | — | | | 116 | | | — | | | 135 | | | 18 | | | 9 | | | 27 | | | — | | | 162 | |
| Balance, end of period | $ | 11,315 | | | $ | 1,243 | | | $ | 3,495 | | | $ | 29 | | | $ | 16,082 | | | $ | 2,863 | | | $ | 227 | | | $ | 3,090 | | | $ | 209 | | | $ | 19,381 | |
| Six Months Ended | | | | | | | | | | | | | | | | | | | |
| June 30, 2022 | | | | | | | | | | | | | | | | | | | |
| Balance, beginning of period | $ | 12,037 | | | $ | 2,062 | | | $ | 3,814 | | | $ | 30 | | | $ | 17,943 | | | $ | 2,785 | | | $ | 215 | | | $ | 3,000 | | | $ | 237 | | | $ | 21,180 | |
| Provision for loan losses | 225 | | | 953 | | | 684 | | | (4) | | | 1,858 | | | 199 | | | 18 | | | 217 | | | — | | | 2,075 | |
| | | | | | | | | | | | | | | | | | | |
| Charge-offs | — | | | — | | | (115) | | | — | | | (115) | | | (10) | | | (18) | | | (28) | | | — | | | (143) | |
| Recoveries | 32 | | | 9 | | | 88 | | | — | | | 129 | | | 30 | | | 8 | | | 38 | | | — | | | 167 | |
| Balance, end of period | $ | 12,294 | | | $ | 3,024 | | | $ | 4,471 | | | $ | 26 | | | $ | 19,815 | | | $ | 3,004 | | | $ | 223 | | | $ | 3,227 | | | $ | 237 | | | $ | 23,279 | |
| June 30, 2021 | | | | | | | | | | | | | | | | | | | |
| Balance, beginning of period | $ | 11,151 | | | $ | 1,114 | | | $ | 3,942 | | | $ | 40 | | | $ | 16,247 | | | $ | 3,362 | | | $ | 324 | | | $ | 3,686 | | | $ | 218 | | | $ | 20,151 | |
| Provision for loan losses | 312 | | | 128 | | | (277) | | | (11) | | | 152 | | | (431) | | | (87) | | | (518) | | | (9) | | | (375) | |
| Charge-offs | (181) | | | — | | | (566) | | | — | | | (747) | | | (92) | | | (29) | | | (121) | | | — | | | (868) | |
| Recoveries | 33 | | | 1 | | | 396 | | | — | | | 430 | | | 24 | | | 19 | | | 43 | | | — | | | 473 | |
| Balance, end of period | $ | 11,315 | | | $ | 1,243 | | | $ | 3,495 | | | $ | 29 | | | $ | 16,082 | | | $ | 2,863 | | | $ | 227 | | | $ | 3,090 | | | $ | 209 | | | $ | 19,381 | |
The following table summarizes the ending loan balance individually evaluated for impairment based upon loan segment, as well as the related ALL loss allocation for each at June 30, 2022 and December 31, 2021. Accruing PCI loans are excluded from loans individually evaluated for impairment. | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Commercial | | Consumer | | | | |
| Commercial
Real Estate | | Acquisition
and
Development | | Commercial
and
Industrial | | Municipal | | Total | | Residential
Mortgage | | Installment
and Other | | Total | | Unallocated | | Total |
| June 30, 2022 | | | | | | | | | | | | | | | | | | | |
| Loans allocated by: | | | | | | | | | | | | | | | | | | | |
Individually evaluated for impairment | $ | 3,008 | | | $ | — | | | $ | 62 | | | $ | — | | | $ | 3,070 | | | $ | 2,843 | | | $ | 42 | | | $ | 2,885 | | | $ | — | | | $ | 5,955 | |
Collectively evaluated for impairment | 1,069,377 | | | 157,597 | | | 379,667 | | | 12,957 | | | 1,619,598 | | | 377,209 | | | 14,867 | | | 392,076 | | | — | | | 2,011,674 | |
| | | | | | | | | | | | | | | | | | | |
| $ | 1,072,385 | | | $ | 157,597 | | | $ | 379,729 | | | $ | 12,957 | | | $ | 1,622,668 | | | $ | 380,052 | | | $ | 14,909 | | | $ | 394,961 | | | $ | — | | | $ | 2,017,629 | |
ALL allocated by: | | | | | | | | | | | | | | | | | | | |
Individually evaluated for impairment | $ | — | | | $ | — | | | $ | — | | | $ | — | | | $ | — | | | $ | 28 | | | $ | — | | | $ | 28 | | | $ | — | | | $ | 28 | |
Collectively evaluated for impairment | 12,294 | | | 3,024 | | | 4,471 | | | 26 | | | 19,815 | | | 2,976 | | | 223 | | | 3,199 | | | 237 | | | 23,251 | |
| | | | | | | | | | | | | | | | | | | |
| $ | 12,294 | | | $ | 3,024 | | | $ | 4,471 | | | $ | 26 | | | $ | 19,815 | | | $ | 3,004 | | | $ | 223 | | | $ | 3,227 | | | $ | 237 | | | $ | 23,279 | |
| December 31, 2021 | | | | | | | | | | | | | | | | | | | |
| Loans allocated by: | | | | | | | | | | | | | | | | | | | |
Individually evaluated for impairment | $ | 3,885 | | | $ | — | | | $ | 250 | | | $ | — | | | $ | 4,135 | | | $ | 3,078 | | | $ | 40 | | | $ | 3,118 | | | $ | — | | | $ | 7,253 | |
Collectively evaluated for impairment | 985,933 | | | 106,204 | | | 485,478 | | | 14,989 | | | 1,592,604 | | | 362,539 | | | 17,590 | | | 380,129 | | | — | | | 1,972,733 | |
| $ | 989,818 | | | $ | 106,204 | | | $ | 485,728 | | | $ | 14,989 | | | $ | 1,596,739 | | | $ | 365,617 | | | $ | 17,630 | | | $ | 383,247 | | | $ | — | | | $ | 1,979,986 | |
ALL allocated by: | | | | | | | | | | | | | | | | | | | |
Individually evaluated for impairment | $ | — | | | $ | — | | | $ | — | | | $ | — | | | $ | — | | | $ | 28 | | | $ | — | | | $ | 28 | | | $ | — | | | $ | 28 | |
Collectively evaluated for impairment | 12,037 | | | 2,062 | | | 3,814 | | | 30 | | | 17,943 | | | 2,757 | | | 215 | | | 2,972 | | | 237 | | | 21,152 | |
| $ | 12,037 | | | $ | 2,062 | | | $ | 3,814 | | | $ | 30 | | | $ | 17,943 | | | $ | 2,785 | | | $ | 215 | | | $ | 3,000 | | | $ | 237 | | | $ | 21,180 | |
The following table provides activity for the accretable yield on purchased impaired loans for the three and six months ended June 30, 2022 and 2021, respectively: | | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended | | Six Months Ended |
| June 30, 2022 | | June 30, 2021 | | June 30, 2022 | | June 30, 2021 |
| Accretable yield, beginning of period | $ | 2,517 | | | $ | 3,072 | | | $ | 2,661 | | | $ | 3,438 | |
| | | | | | | |
| Accretion of income | (276) | | | (209) | | | (590) | | | (676) | |
| Reclassifications from nonaccretable difference due to improvement in expected cash flows | 102 | | | 74 | | | 345 | | | 118 | |
| Other changes, net | 77 | | | 79 | | | 4 | | | 136 | |
| Accretable yield, end of period | $ | 2,420 | | | $ | 3,016 | | | $ | 2,420 | | | $ | 3,016 | |
| | | | | | | |
NOTE 4. LEASES
A lease provides the lessee the right to control the use of an identified asset for a period of time in exchange for consideration. The Company has primarily entered into operating leases for branches and office space. Most of the Company's leases contain renewal options, which the Company is reasonably certain to exercise. Including renewal options, the Company's
leases range from six to 31 years. Operating lease right-of-use assets and lease liabilities are included in other assets and accrued interest and other liabilities on the Company's unaudited condensed consolidated balance sheets.
The Company uses its incremental borrowing rate to determine the present value of the lease payments, as the rate implicit in the Company's leases is not readily determinable. Lease agreements that contain non-lease components are generally accounted for as a single lease component, while variable costs, such as common area maintenance expenses and property taxes, are expensed as incurred.
The following table summarizes the Company's operating leases at June 30, 2022 and December 31, 2021: | | | | | | | | | | | |
| June 30, 2022 | | December 31, 2021 |
| Operating lease ROU assets | $ | 10,093 | | | $ | 10,515 | |
| Operating lease ROU liabilities | 10,753 | | | 11,119 | |
| Weighted-average remaining lease term (in years) | 14.3 | | 14.6 |
| Weighted-average discount rate | 4.1 | % | | 4.1 | % |
The following table presents information related to the Company's operating leases for the three and six months ended June 30, 2022 and 2021: | | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended | | Six Months Ended |
| June 30, 2022 | | June 30, 2021 | | June 30, 2022 | | June 30, 2021 |
| Cash paid for operating lease liabilities | $ | 295 | | | $ | 318 | | | $ | 589 | | | $ | 616 | |
| Operating lease expense | 349 | | | 388 | | | 743 | | | 791 | |
The following table presents expected future maturities of the Company's lease liabilities as of June 30, 2022: | | | | | |
| Remainder of 2022 | $ | 573 | |
| 2023 | 1,216 | |
| 2024 | 1,246 | |
| 2025 | 1,269 | |
| 2026 | 1,302 | |
| Thereafter | 9,687 | |
| 15,293 | |
| Less: imputed interest | 4,540 | |
| Total lease liabilities | $ | 10,753 | |
NOTE 5. GOODWILL AND OTHER INTANGIBLE ASSETS
At June 30, 2022 and 2021, goodwill was $18.7 million. No impairment charges were recorded in the three and six months ended June 30, 2022 and June 30, 2021. Goodwill is not amortized but is reviewed for potential impairment on at least an annual basis, with testing between annual tests if an event occurs or circumstances change that could potentially reduce the fair value of a reporting unit.
The Company conducted its last annual goodwill impairment test as of November 30, 2021 using generally accepted valuation methods. As a result of that impairment test, no goodwill impairment was identified. No changes occurred that would impact the results of that analysis through June 30, 2022.
The following table presents changes in and components of other intangible assets for the three and six months ended June 30, 2022 and 2021: | | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended June 30, | | Six Months Ended June 30, |
| 2022 | | 2021 | | 2022 | | 2021 |
| Beginning of period | $ | 3,891 | | | $ | 5,124 | | | $ | 4,183 | | | $ | 5,458 | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| Amortization expense | (281) | | | (324) | | | (573) | | | (658) | |
| | | | | | | |
| Balance, end of period | $ | 3,610 | | | $ | 4,800 | | | $ | 3,610 | | | $ | 4,800 | |
No impairment charges were recorded in the three and six months ended June 30, 2022 and June 30, 2021.
The following table presents the components of other identifiable intangible assets at June 30, 2022 and December 31, 2021: | | | | | | | | | | | | | | | | | | | | | | | |
| June 30, 2022 | | December 31, 2021 |
| Gross Amount | | Accumulated
Amortization | | Gross Amount | | Accumulated
Amortization |
| Amortized intangible assets: | | | | | | | |
| Core deposit intangibles | $ | 8,390 | | | $ | 4,781 | | | $ | 8,390 | | | $ | 4,208 | |
| Other customer relationship intangibles | 25 | | | 24 | | | 25 | | | 24 | |
| | | | | | | |
| Total | $ | 8,415 | | | $ | 4,805 | | | $ | 8,415 | | | $ | 4,232 | |
The following table presents future estimated aggregate amortization expense for intangible assets remaining at June 30, 2022: | | | | | |
| |
| Remainder of 2022 | $ | 532 | |
| 2023 | 935 | |
| 2024 | 766 | |
| 2025 | 596 | |
| 2026 | 427 | |
| Thereafter | 354 | |
| $ | 3,610 | |
NOTE 6. SHARE-BASED COMPENSATION PLANS
The Company maintains share-based compensation plans under the shareholder-approved 2011 Plan. The purpose of the share-based compensation plans is to provide officers, employees, and non-employee members of the Board of Directors of the Company with additional incentive to further the success of the Company. At the Company's 2022 Annual Meeting of Shareholders held on April 26, 2022, the Company's shareholders approved an amendment to the 2011 Plan increasing the number of shares available for issuance under the 2011 Plan by 400,000. At June 30, 2022, 1,281,920 shares of the common stock of the Company were reserved, of which 537,611 shares are available to be issued.
The 2011 Plan incentive awards may consist of grants of incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock, deferred stock units and performance shares. All employees and members of the Board of Directors of the Company and its subsidiaries are eligible to participate in the 2011 Plan. The 2011 Plan allows for the Compensation Committee of the Board of Directors to determine the type of incentive to be awarded, its term, manner of exercise, vesting and restrictions on shares. Generally, awards are nonqualified under the IRC, unless the awards are deemed to be incentive awards to employees at the Compensation Committee’s discretion.
The following table presents a summary of nonvested restricted shares activity for the six months ended June 30, 2022: | | | | | | | | | | | |
| Shares | | Weighted Average Grant Date Fair Value |
| Nonvested shares, beginning of year | 274,697 | | | $ | 20.05 | |
| Granted | 137,449 | | | 24.89 | |
| Forfeited | (26,290) | | | 21.40 | |
| Vested | (76,931) | | | 19.67 | |
| Nonvested shares, at period end | 308,925 | | | $ | 22.18 | |
The following table presents restricted share compensation expense, with tax benefit information, and fair value of shares vested, for the three and six months ended June 30, 2022 and 2021: | | | | | | | | | | | | | | | | | | | | | | | |
| Three months ended June 30, | | Six months ended June 30, |
| 2022 | | 2021 | | 2022 | | 2021 |
| Restricted share award expense | $ | 529 | | | $ | 478 | | | $ | 859 | | | $ | 912 | |
| Restricted share award tax benefit | 111 | | | 126 | | | 180 | | | 218 | |
| Fair value of shares vested | 540 | | | 511 | | | 1,864 | | | 1,539 | |
The unrecognized compensation expense related to the share awards totaled $4.1 million at June 30, 2022 and $2.3 million at December 31, 2021. The unrecognized compensation expense at June 30, 2022 is expected to be recognized over a weighted-average period of 2.0 years.
The Company maintains an employee stock purchase plan to provide its employees with an opportunity to purchase Company common stock. Eligible employees may purchase shares in an amount that does not exceed 10% of their annual salary, at the lower of 95% of the fair market value of the shares on the semi-annual offering date or related purchase date. The purchases occur in March and September of each year. The Company reserved 350,000 shares of its common stock to be issued under the employee stock purchase plan. At June 30, 2022, 147,527 shares were available to be issued under the employee stock purchase plan.
The following table presents information for the employee stock purchase plan for the three and six months ended June 30, 2022 and 2021: | | | | | | | | | | | | | | | | | | | | | | | |
| Three months ended June 30, | | Six months ended June 30, |
| 2022 | | 2021 | | 2022 | | 2021 |
| Shares purchased | — | | | — | | | 3,953 | | | 5,484 | |
| Weighted average price of shares purchased | $ | — | | | $ | — | | | $ | 22.46 | | | $ | 13.44 | |
| Compensation expense recognized | — | | | — | | | 8 | | | 33 | |
| | | | | | | |
The Company issues new shares or treasury shares, depending on market conditions, in its share-based compensation plans.
NOTE 7. DERIVATIVE FINANCIAL INSTRUMENTS
The Company is exposed to certain risks arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, sources, and duration of its assets and liabilities and the use of derivative financial instruments. Specifically, the Company may enter into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. Derivative financial instruments may be used as risk management tools by the Company to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to the Company’s borrowings and are not used for trading or speculative purposes.
The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. The Company, however, discontinues cash flow hedge accounting if it is probable the forecasted hedged transactions will not occur in the initially identified time period due to circumstances, such as the impact
of the COVID-19 pandemic. Upon discontinuance, the associated gains and losses deferred in AOCI are reclassified immediately into earnings and subsequent changes in the fair value of the cash flow hedge are recognized in earnings. At June 30, 2022 and December 31, 2021, the Company had no interest rate derivative designated as a hedging instrument.
The Company enters into interest rate swaps that allow its commercial loan customers to effectively convert a variable-rate commercial loan agreement to a fixed-rate commercial loan agreement. Under these agreements, the Company enters into a variable-rate loan agreement with a customer in addition to an interest rate swap agreement, which serves to effectively swap the customer’s variable-rate loan into a fixed-rate loan. The Company then enters into a corresponding swap agreement with a third party in order to economically hedge its exposure through the customer agreement. The interest rate swaps with both the customers and third parties are not designated as hedges and are marked through earnings. At June 30, 2022, the Company had 17 customer and 17 corresponding third-party broker interest rate derivatives not designated as a hedging instrument with an aggregate notional amount of $183.5 million. The Company had $75.8 million in notional amount of such derivative instruments at December 31, 2021. The Company entered into three new interest rate swaps with its commercial loan customers and recognized swap fee income of $785 thousand during the three months ended June 30, 2022 compared to one new interest rate swap that resulted in swap fee income of $15 thousand during the three months ended June 30, 2021. During the six months ended June 30, 2022 and 2021, the Company recognized swap fee income of $1.7 million from five new interest rate swaps and $68 thousand from two new interest rate swaps, respectively, which are included in noninterest income in the unaudited condensed consolidated statements of income. At June 30, 2022 and December 31, 2021, the Company provided cash collateral of $2.7 million and $260 thousand to the third parties for these derivatives, respectively. At June 30, 2022 and December 31, 2021, the Company was holding cash collateral of $6.1 million and $490 thousand from the third parties for these derivatives, respectively.
The Company also may enter into risk participation agreements with a financial institution counterparty for an interest rate derivative contract related to a loan in which the Company may be a participant or the agent bank. The risk participation agreement provides credit protection to the agent bank should the borrower fail to perform on its interest rate derivative contracts with the agent bank. The Company manages its credit risk on the risk participation agreement by monitoring the creditworthiness of the borrower, which follows the same credit review process as the derivative instruments entered into directly with the borrower. The notional amount of such risk participation agreement reflects the Company’s pro-rata share of the derivative instrument, consistent with its share of the related participated loan. At June 30, 2022 and December 31, 2021, the Company had a risk participation with sold protection with a notional value of $15.9 million for both periods, and a risk participation with purchased protection with a notional value of $5.0 million and zero at June 30, 2022 and December 31, 2021, respectively. For the three and six months ended June 30, 2021, the Company received an upfront fee of zero and $53 thousand, respectively, upon entry into the risk participation agreement with sold protection, which is included in noninterest income in the unaudited condensed consolidated statements of income. There was no upfront fee on the new risk participation during the three and six months ended June 30, 2022.
As a part of its normal residential mortgage operations, the Company will enter into an interest rate lock commitment with a potential borrower. The Company will enter into a corresponding commitment with an investor to sell that loan at a specific price shortly after origination. In accordance with FASB ASC 820, adjustments are recorded through earnings to account for the net change in fair value of these transactions for the held for sale pipeline.
The following table summarizes the fair value of the Company's derivative instruments at June 30, 2022 and December 31, 2021: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| June 30, 2022 | | December 31, 2021 |
| Notional Amount | | Balance Sheet Location | | Fair Value | | Notional Amount | | Balance Sheet Location | | Fair Value |
| | | | | | | | | | | |
| | | | | | | | | | | |
| | | | | | | | | | | |
| | | | | | | | | | | |
| | | | | | | | | | | |
| Derivatives not designated as hedging instruments: | | | | | | | | | | | |
| Interest rate swaps | $ | 91,731 | | | Other assets | | $ | 5,853 | | | $ | 37,915 | | | Other assets | | $ | 764 | |
| Interest rate swaps | 91,731 | | | Other liabilities | | (5,717) | | | 37,915 | | | Other liabilities | | (758) | |
| Risk participation - sold credit protection | 15,855 | | | Other liabilities | | — | | | 15,855 | | | Other liabilities | | (2) | |
| Risk participation - purchased credit protection | 4,992 | | | Other assets | | 28 | | | — | | | Not applicable | | — | |
| Interest rate lock commitments with customers | 7,713 | | | Other assets | | 186 | | | 16,604 | | | Other assets | | 353 | |
| Forward sale commitments | 8,328 | | | Other assets | | 683 | | | 8,665 | | | Other assets | | 52 | |
| Total derivatives not designated as hedging instruments | | | | | $ | 1,033 | | | | | | | $ | 409 | |
The following tables summarize the effect of the Company's derivative financial instruments on OCI and net income for the three and six months ended June 30, 2022 and 2021:
| | | | | | | | | | | | | | | | | | | | | | | |
| Amount of Loss Recognized in OCI on Derivative | | Amount of Gain Recognized in OCI on Derivative |
| Three Months Ended June 30, | | Six Months Ended June 30, |
| 2022 | | 2021 | | 2022 | | 2021 |
| Derivatives in cash flow hedging relationships: | | | | | | |
| Interest rate products | $ | — | | | $ | (83) | | | $ | — | | | $ | 656 | |
| Total | $ | — | | | $ | (83) | | | $ | — | | | $ | 656 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Amount of Loss Reclassified from AOCI into Income | | Amount of Loss Reclassified from AOCI into Income | | Location of Loss Recognized from AOCI into Income |
| Three Months Ended June 30, | | Six Months Ended June 30, | | |
| 2022 | | 2021 | | 2022 | | 2021 | | |
| Derivatives in cash flow hedging relationships: | | | | | | | | |
| Interest rate products | $ | — | | | $ | (89) | | | $ | — | | | $ | (176) | | | Interest expense |
| Total | $ | — | | | $ | (89) | | | $ | — | | | $ | (176) | | | |
During the three months ended September 30, 2021, the Company terminated its interest rate swap designated as a hedging instrument of $50.0 million.
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Amount of Gain (Loss) Recognized in Income | | Amount of Gain (Loss) Recognized in Income | | Location of Gain (Loss) Recognized in Income |
| Three Months Ended June 30, | | Six Months Ended June 30, | | |
| 2022 | | 2021 | | 2022 | | 2021 | | |
| Derivatives not designated as hedging instruments: | | | | | | | | |
| Interest rate products | $ | 93 | | | $ | (16) | | | $ | 130 | | | $ | 37 | | | Other operating expenses |
| Risk participation agreement | 28 | | | — | | | 30 | | | (4) | | | Other operating expenses |
| Interest rate lock commitments with customers | (113) | | | (216) | | | (167) | | | (217) | | | Mortgage banking activities |
| Forward sale commitment | 330 | | | (171) | | | 631 | | | 83 | | | Mortgage banking activities |
| Total | $ | 339 | | | $ | (403) | | | $ | 624 | | | $ | (101) | | | |
NOTE 8. SHAREHOLDERS’ EQUITY AND REGULATORY CAPITAL
Banks and bank holding companies are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action. Under the Basel Committee on Banking Supervision's capital guidelines for U.S. Banks ("Basel III rules"), an entity must hold a capital conservation buffer above the adequately capitalized risk-based capital ratios. The Company and the Bank have elected not to include net unrealized gains or losses included in AOCI in computing regulatory capital.
The consolidated asset limit on small bank holding companies is $3.0 billion and a company with assets under that limit is not subject to the FRB consolidated capital rules, but may file reports that include capital amounts and ratios. The Company has elected to file those reports.
Management believes that the Company and the Bank met all capital adequacy requirements to which they are subject at June 30, 2022 and December 31, 2021.
Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required. At June 30, 2022, the most recent regulatory notifications categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank's classification.
The following table presents capital amounts and ratios at June 30, 2022 and December 31, 2021:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Actual | | For Capital Adequacy Purposes
(includes applicable capital conservation buffer) | | To Be Well
Capitalized Under
Prompt Corrective Action Provisions |
| Amount | | Ratio | | Amount | | Ratio | | Amount | | Ratio |
| June 30, 2022 | | | | | | | | | | | |
| Total risk-based capital: | | | | | | | | | | | |
| Orrstown Financial Services, Inc. | $ | 300,376 | | | 13.5 | % | | $ | 234,163 | | | 10.5 | % | | n/a | | n/a |
| Orrstown Bank | 296,723 | | | 13.3 | % | | 234,096 | | | 10.5 | % | | $ | 222,949 | | | 10.0 | % |
| Tier 1 risk-based capital: | | | | | | | | | | | |
| Orrstown Financial Services, Inc. | 243,470 | | | 10.9 | % | | 189,560 | | | 8.5 | % | | n/a | | n/a |
| Orrstown Bank | 271,811 | | | 12.2 | % | | 189,506 | | | 8.5 | % | | 178,359 | | | 8.0 | % |
| Tier 1 common equity risk-based capital: | | | | | | | | | | | |
| Orrstown Financial Services, Inc. | 243,470 | | | 10.9 | % | | 156,109 | | | 7.0 | % | | n/a | | n/a |
| Orrstown Bank | 271,811 | | | 12.2 | % | | 156,064 | | | 7.0 | % | | 144,917 | | | 6.5 | % |
| Tier 1 leverage capital: | | | | | | | | | | | |
| Orrstown Financial Services, Inc. | 243,470 | | | 8.5 | % | | 114,400 | | | 4.0 | % | | n/a | | n/a |
| Orrstown Bank | 271,811 | | | 9.5 | % | | 114,452 | | | 4.0 | % | | 143,065 | | | 5.0 | % |
| December 31, 2021 | | | | | | | | | | | |
| Total risk-based capital: | | | | | | | | | | | |
| Orrstown Financial Services, Inc. | $ | 297,823 | | | 15.0 | % | | $ | 208,617 | | | 10.5 | % | | n/a | | n/a |
| Orrstown Bank | 278,780 | | | 14.0 | % | | 208,550 | | | 10.5 | % | | $ | 198,619 | | | 10.0 | % |
| Tier 1 risk-based capital: | | | | | | | | | | | |
| Orrstown Financial Services, Inc. | 243,075 | | | 12.2 | % | | 168,880 | | | 8.5 | % | | n/a | | n/a |
| Orrstown Bank | 255,995 | | | 12.9 | % | | 168,826 | | | 8.5 | % | | 158,895 | | | 8.0 | % |
| Tier 1 common equity risk-based capital: | | | | | | | | | | | |
| Orrstown Financial Services, Inc. | 243,075 | | | 12.2 | % | | 139,078 | | | 7.0 | % | | n/a | | n/a |
| Orrstown Bank | 255,995 | | | 12.9 | % | | 139,033 | | | 7.0 | % | | 129,102 | | | 6.5 | % |
| Tier 1 leverage capital: | | | | | | | | | | | |
| Orrstown Financial Services, Inc. | 243,075 | | | 8.5 | % | | 114,384 | | | 4.0 | % | | n/a | | n/a |
| Orrstown Bank | 255,995 | | | 8.9 | % | | 114,470 | | | 4.0 | % | | 143,087 | | | 5.0 | % |
In September 2015, the Board of Directors of the Company authorized a share repurchase program under which the Company may repurchase up to 5% of the Company's outstanding shares of common stock, or approximately 416,000 shares, in accordance with all applicable securities laws and regulations, including Rule 10b-18 of the Exchange Act. On April 19, 2021, the Board of Directors authorized the additional future repurchase of up to 562,000 shares of its outstanding common stock. When and if appropriate, repurchases may be made in the open market or privately negotiated transactions, depending on market conditions, regulatory requirements and other corporate considerations, as determined by management. Share repurchases may not occur and may be discontinued at any time. At June 30, 2022, 823,629 shares had been repurchased at a total cost of $18.8 million, or $22.79 per share. Common stock available for future repurchase totals approximately 154,371 shares, or 1% of the Company's outstanding common stock at June 30, 2022.
On July 18, 2022, the Board of Directors declared a cash dividend of $0.19 per common share, which will be paid on August 8, 2022 to shareholders of record at August 1, 2022.
NOTE 9. EARNINGS PER SHARE
The following table presents earnings per share for the three and six months ended June 30, 2022 and 2021:
| | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended June 30, | | Six Months Ended June 30, |
| 2022 | | 2021 | | 2022 | | 2021 |
| Net income | $ | 8,871 | | | $ | 8,776 | | | $ | 17,239 | | | $ | 18,983 | |
| Weighted average shares outstanding - basic | 10,610 | | | 10,975 | | | 10,735 | | | 10,975 | |
| Dilutive effect of share-based compensation | 134 | | | 137 | | | 140 | | | 118 | |
| Weighted average shares outstanding - diluted | 10,744 | | | 11,112 | | | 10,875 | | | 11,093 | |
| Per share information: | | | | | | | |
| Basic earnings per share | $ | 0.84 | | | $ | 0.80 | | | $ | 1.61 | | | $ | 1.73 | |
| Diluted earnings per share | 0.83 | | | 0.79 | | | 1.59 | | | 1.71 | |
Average outstanding restricted award shares totaling 4,433 and zero for the three months ended June 30, 2022 and 2021, respectively, and 58,328 and zero for the six months ended June 30, 2022 and 2021, respectively, were not included in the computation of earnings per share because the effect was antidilutive. The dilutive effect of share-based compensation in each period above relates principally to restricted stock awards.
NOTE 10. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its clients. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the unaudited condensed consolidated balance sheets. The contract amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The following table presents these contractual, or notional, amounts: | | | | | | | | | | | |
| Contractual or Notional Amount |
| June 30, 2022 | | December 31, 2021 |
| Commitments to fund: | | | |
| Home equity lines of credit | $ | 282,911 | | | $ | 261,580 | |
| 1-4 family residential construction loans | 63,345 | | | 40,348 | |
| Commercial real estate, construction and land development loans | 153,906 | | | 124,488 | |
| Commercial, industrial and other loans | 291,305 | | | 378,996 | |
| Standby letters of credit | 22,322 | | | 19,724 | |
Commitments to extend credit are agreements to lend to a client as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each client’s credit-worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the client. Collateral varies but may include accounts receivable, inventory, equipment, residential real estate, and income-producing commercial properties.
Standby letters of credit and financial guarantees written are conditional commitments issued by the Company to guarantee the performance of a client to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to clients. The Company holds collateral supporting those commitments when deemed necessary by management. The liability at June 30, 2022 and December 31, 2021 for guarantees under standby letters of credit issued was not considered to be material.
The Company maintains a reserve, based on historical loss experience of the related loan class and utilization assumptions, for off-balance sheet credit exposures that currently are not funded, in other liabilities on the unaudited condensed consolidated balance sheets. This reserve totaled approximately $1.6 million at both June 30, 2022 and December 31, 2021.
NOTE 11. FAIR VALUE
Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Certain financial instruments and all non-financial instruments are excluded from disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.
The fair value hierarchy distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity's own assumptions about market participant assumptions based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are:
Level 1 – quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access at the measurement date.
Level 2 – significant other observable inputs other than Level 1 prices such as prices for similar assets and liabilities in active markets; quoted prices for identical or similar instruments in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
Level 3 – at least one significant unobservable input that reflects a company's own assumptions about the assumptions that market participants would use in pricing an asset or liability.
In instances in which multiple levels of inputs are used to measure fair value, hierarchy classification is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company's assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.
The Company used the following methods and significant assumptions to estimate fair value for instruments measured on a recurring basis:
Where quoted prices are available in an active market, investment securities are classified within Level 1 of the valuation hierarchy. Level 1 investment securities include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, investment securities are classified within Level 2 and fair values are estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flow. Level 2 investment securities include U.S. agency securities, MBS, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, investment securities are classified within Level 3 of the valuation hierarchy. The Company’s investment securities are classified as available for sale.
The fair values of interest rate swaps and risk participation derivatives are determined using models that incorporate readily observable market data into a market standard methodology. This methodology nets the discounted future cash receipts and the discounted expected cash payments. The discounted variable cash receipts and payments are based on expectations of future interest rates derived from observable market interest rate curves. In addition, fair value is adjusted for the effect of nonperformance risk by incorporating credit valuation adjustments for the Company and its counterparties. These assets and liabilities are classified as Level 2 fair values, based upon the lowest level of input that is significant to the fair value measurements.
The following table summarizes assets and liabilities measured at fair value on a recurring basis at June 30, 2022 and December 31, 2021: | | | | | | | | | | | | | | | | | | | | | | | |
| Level 1 | | Level 2 | | Level 3 | | Total Fair
Value
Measurements |
| June 30, 2022 | | | | | | | |
| Financial Assets | | | | | | | |
| Investment securities: | | | | | | | |
| U.S. Treasury securities | $ | 17,969 | | | $ | — | | | $ | — | | | $ | 17,969 | |
| | | | | | | |
| | | | | | | |
| States and political subdivisions | — | | | 227,272 | | | 6,255 | | | 233,527 | |
| GSE residential MBSs | — | | | 61,558 | | | — | | | 61,558 | |
| GSE residential CMOs | — | | | 69,691 | | | — | | | 69,691 | |
| Nonagency CMOs | — | | | 20,698 | | | — | | | 20,698 | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| Asset-backed | — | | | 108,856 | | | — | | | 108,856 | |
| Other | 399 | | | — | | | — | | | 399 | |
| Loans held for sale | — | | | 7,824 | | | — | | | 7,824 | |
| Derivatives | — | | | 5,882 | | | 186 | | | 6,068 | |
| | | | | | | |
| Totals | $ | 18,368 | | | $ | 501,781 | | | $ | 6,441 | | | $ | 526,590 | |
| Financial Liabilities | | | | | | | |
| Derivatives | $ | — | | | $ | 5,717 | | | $ | — | | | $ | 5,717 | |
| | | | | | | |
| | | | | | | |
| December 31, 2021 | | | | | | | |
| Financial Assets | | | | | | | |
| Investment securities: | | | | | | | |
| U.S. Treasury securities | $ | 19,702 | | | $ | — | | | $ | — | | | $ | 19,702 | |
| | | | | | | |
| | | | | | | |
| States and political subdivisions | — | | | 183,171 | | | 10,199 | | | 193,370 | |
| GSE residential MBSs | — | | | 40,726 | | | — | | | 40,726 | |
| GSE residential CMOs | — | | | 65,922 | | | — | | | 65,922 | |
| Nonagency CMOs | — | | | 16,750 | | | 12,948 | | | 29,698 | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| Asset-backed | — | | | 122,621 | | | — | | | 122,621 | |
| Other | 399 | | | — | | | — | | | 399 | |
| Loans held for sale | — | | | 8,868 | | | — | | | 8,868 | |
| Derivatives | — | | | 764 | | | 353 | | | 1,117 | |
| | | | | | | |
| Totals | $ | 20,101 | | | $ | 438,822 | | | $ | 23,500 | | | $ | 482,423 | |
| Financial Liabilities | | | | | | | |
| Derivatives | $ | — | | | $ | 760 | | | $ | — | | | $ | 760 | |
| | | | | | | |
| | | | | | | |
The Company had one municipal bond measured at fair value on a recurring basis using significant unobservable inputs (Level 3) at June 30, 2022 and one municipal bond and one non-agency CMO measured at fair value on a recurring basis using significant unobservable inputs (Level 3) at December 31, 2021. During the three months ended June 30, 2022, the non-agency CMO security was called by the issuer. The Level 3 valuation is based on a non-executable broker quote, which is considered a significant unobservable input. Such quotes are updated as available and may remain constant for a period of time for certain broker-quoted securities that do not move with the market or that are not interest rate sensitive as a result of their structure or overall attributes.
The Company’s residential mortgage LHFS are recorded at fair value utilizing Level 2 measurements. This fair value measurement is determined based upon third party quotes obtained on similar loans. For LHFS, for which the fair value option has been elected, the aggregate fair value declined below the aggregate principal balance by $565 thousand as of June 30, 2022, and exceeded the aggregate principal balance by $150 thousand as of December 31, 2021.
The determination of the fair value of interest rate lock commitments on residential mortgages is based on agreed upon pricing with the respective investor on each loan and includes a pull through percentage. The pull through percentage represents an estimate of loans in the pipeline to be delivered to an investor versus the total loans committed for delivery. Significant
changes in this input could result in a significantly higher or lower fair value measurement. As the pull through percentage is a significant unobservable input, this is deemed a Level 3 valuation input. The average pull through percentage, which is based upon historical experience, was 92% as of June 30, 2022. An increase or decrease of 5% in the pull through assumption would result in a positive or negative change of $10 thousand in the fair value of interest rate lock commitments at June 30, 2022.
The following provides details of the Level 3 fair value measurement activity for the periods ended June 30, 2022 and 2021:
Investment securities: | | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended June 30, | | Six Months Ended June 30, |
| 2022 | | 2021 | | 2022 | | 2021 |
| Balance, beginning of period | $ | 18,634 | | | $ | 25,564 | | | $ | 23,147 | | | $ | 31,503 | |
| | | | | | | |
| | | | | | | |
| Unrealized losses included in OCI | (220) | | | 2,096 | | | (1,580) | | | 1,431 | |
| | | | | | | |
| Net (premium amortization) discount accretion | (5) | | | — | | | 66 | | | — | |
| Principal payments and other | — | | | (2,735) | | | — | | | (4,464) | |
| Sales | — | | | — | | | (3,053) | | | (3,545) | |
| Calls | (12,154) | | | — | | | (12,154) | | | — | |
| | | | | | | |
| OTTI | — | | | — | | | (171) | | | — | |
| Balance, end of period | $ | 6,255 | | | $ | 24,925 | | | $ | 6,255 | | | $ | 24,925 | |
Interest rate lock commitments on residential mortgages: | | | | | | | | | | | | | | | | | | | | | | | |
| Three Months Ended June 30, | | Six Months Ended June 30, |
| 2022 | | 2021 | | 2022 | | 2021 |
| Balance, beginning of period | $ | 300 | | | $ | 672 | | | $ | 353 | | | $ | 673 | |
| | | | | | | |
| Total losses included in earnings | (114) | | | (216) | | | (167) | | | (217) | |
| | | | | | | |
| | | | | | | |
| Balance, end of period | $ | 186 | | | $ | 456 | | | $ | 186 | | | $ | 456 | |
Certain financial assets are measured at fair value on a nonrecurring basis. Adjustments to the fair value of these assets usually results from the application of lower of cost or market accounting or write-downs of individual assets. The Company used the following methods and significant assumptions to estimate fair value for these financial assets.
Impaired Loans
Loans are designated as impaired when, in the judgment of management and based on current information and events, it is probable that all amounts due, according to the contractual terms of the loan agreement, will not be collected. The measurement of loss associated with impaired loans for all loan classes can be based on either the observable market price of the loan, the fair value of the collateral, or discounted cash flows using the rate of return implicit in the original loan for TDRs. For collateral-dependent loans, fair value is measured based on the value of the collateral securing the loan, less estimated costs to sell. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The value of the real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral is a house or building in the process of construction, or if management adjusts the appraisal value, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal, if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivable collateral are based on financial statement balances or aging reports (Level 3). Impaired loans with an allocation to the ALL are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the unaudited condensed consolidated statements of income.
Any changes in the fair value of impaired loans still held were not material for the three and six months ended June 30, 2022 and 2021.
Foreclosed Real Estate
OREO property acquired through foreclosure is initially recorded at the fair value of the property at the transfer date less estimated selling cost. Subsequently, OREO is carried at the lower of its carrying value or the fair value less estimated selling cost. Fair value is usually determined based upon an independent third-party appraisal of the property or occasionally upon a recent sales offer. The Company had no OREO balances at June 30, 2022 and December 31, 2021.
Mortgage Servicing Rights
The MSR fair value is estimated to be equal to its carrying value, unless the quarterly valuation model calculates the present value of the estimated net servicing income is less than its carrying value, in which case an impairment charge is taken. Fair value adjustments on the MSR only occur if there is impairment. At June 30, 2022 and December 31, 2021, an impairment reserve of zero and $79 thousand, respectively, existed on the MSR portfolio. For the three months ended June 30, 2022 and 2021, impairment valuation allowance reversals of $47 thousand and $45 thousand were included, respectively, in mortgage banking activities on the unaudited condensed consolidated statements of income. For the six months ended June 30, 2022 and 2021, impairment valuation allowance reversals of $79 thousand and $651 thousand, respectively, were included in mortgage banking activities on the unaudited condensed consolidated statements of income. The reversals in the three and six months ended June 30, 2022 and 2021 were due to increases in market rates, which increased the MSR fair value.
The following table summarizes assets measured at fair value on a nonrecurring basis at June 30, 2022 and December 31, 2021: | | | | | | | | | | | | | | | | | | | | | | | |
| Level 1 | | Level 2 | | Level 3 | | Total
Fair Value
Measurements |
| June 30, 2022 | | | | | | | |
| Impaired Loans | | | | | | | |
| Commercial real estate: | | | | | | | |
| Owner occupied | $ | — | | | $ | — | | | $ | 130 | | | $ | 130 | |
| | | | | | | |
| | | | | | | |
| Non-owner occupied residential | — | | | — | | | 16 | | | 16 | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| Residential mortgage: | | | | | | | |
| First lien | — | | | — | | | 328 | | | 328 | |
| | | | | | | |
| Home equity - lines of credit | — | | | — | | | 65 | | | 65 | |
| | | | | | | |
| Total impaired loans | $ | — | | | $ | — | | | $ | 539 | | | $ | 539 | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| Mortgage servicing rights | $ | — | | | $ | — | | | $ | — | | | $ | — | |
| | | | | | | |
| December 31, 2021 | | | | | | | |
| Impaired Loans | | | | | | | |
| Commercial real estate: | | | | | | | |
| Owner occupied | $ | — | | | $ | — | | | $ | 751 | | | $ | 751 | |
| | | | | | | |
| | | | | | | |
| Non-owner occupied residential | — | | | — | | | 24 | | | 24 | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| Residential mortgage: | | | | | | | |
| First lien | — | | | — | | | 545 | | | 545 | |
| | | | | | | |
| Home equity - lines of credit | — | | | — | | | 72 | | | 72 | |
| | | | | | | |
| Total impaired loans | $ | — | | | $ | — | | | $ | 1,392 | | | $ | 1,392 | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| Mortgage servicing rights | $ | — | | | $ | — | | | $ | 322 | | | $ | 322 | |
The following table presents additional qualitative information about assets measured on a nonrecurring basis and for which the Company has utilized Level 3 inputs to determine fair value: | | | | | | | | | | | | | | | | | | | | | | | |
| Fair Value
Estimate | | Valuation
Techniques | | Unobservable Input | | Range |
| June 30, 2022 | | | | | | | |
| Impaired loans | $ | 539 | | | Appraisal of collateral | | Management adjustments on appraisals for property type and recent activity | | 0% - 25% discount |
| | | | | - Management adjustments for liquidation expenses | | 6.08% - 17.93% discount |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| December 31, 2021 | | | | | | | |
| Impaired loans | $ | 1,392 | | | Appraisal of collateral | | Management adjustments on appraisals for property type and recent activity | | 10% - 25% discount |
| | | | | - Management adjustments for liquidation expenses | | 6.08% - 17.93% discount |
| | | | | | | |
| | | | | | | |
| Mortgage servicing rights | $ | 322 | | | Discounted cash flows | | Weighted average CPR | | 12.60% |
| | | | | - Weighted average discount rate | | 9.03% |
Fair values of financial instruments
GAAP requires disclosure of the fair value of financial assets and liabilities, including those that are not measured and reported at fair value on a recurring or nonrecurring basis. The following table presents carrying amounts and estimated fair values of the financial assets and liabilities at June 30, 2022 and December 31, 2021: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Carrying
Amount | | Fair Value | | Level 1 | | Level 2 | | Level 3 |
| June 30, 2022 | | | | | | | | | |
| Financial Assets | | | | | | | | | |
| Cash and due from banks | $ | 25,825 | | | $ | 25,825 | | | $ | 25,825 | | | $ | — | | | $ | — | |
| Interest-bearing deposits with banks | 86,081 | | | 86,081 | | | 86,081 | | | — | | | — | |
| | | | | | | | | |
| Restricted investments in bank stock | 6,500 | | | n/a | | n/a | | n/a | | n/a |
| Investment securities | 512,698 | | | 512,698 | | | 18,368 | | | 488,075 | | | 6,255 | |
| Loans held for sale | 7,824 | | | 7,824 | | | — | | | 7,824 | | | — | |
| Loans, net of allowance for loan losses | 1,994,350 | | | 1,904,407 | | | — | | | — | | | 1,904,407 | |
| | | | | | | | | |
| Derivatives | 6,068 | | | 6,068 | | | — | | | 5,882 | | | 186 | |
| Accrued interest receivable | 8,425 | | | 8,425 | | | — | | | 3,490 | | | 4,935 | |
| | | | | | | | | |
| Financial Liabilities | | | | | | | | | |
| Deposits | 2,478,616 | | | 2,477,314 | | | — | | | 2,477,314 | | | — | |
| Securities sold under agreements to repurchase | 24,287 | | | 24,287 | | | — | | | 24,287 | | | — | |
| FHLB advances and other borrowings | 1,678 | | | 1,724 | | | — | | | 1,724 | | | — | |
| Subordinated notes | 31,994 | | | 32,092 | | | — | | | 32,092 | | | — | |
| Derivatives | 5,717 | | | 5,717 | | | — | | | 5,717 | | | — | |
| Accrued interest payable | 203 | | | 203 | | | — | | | 203 | | | — | |
| Off-balance sheet instruments | — | | | — | | | — | | | — | | | — | |
| | | | | | | | | |
| December 31, 2021 | | | | | | | | | |
| Financial Assets | | | | | | | | | |
| Cash and due from banks | $ | 21,217 | | | $ | 21,217 | | | $ | 21,217 | | | $ | — | | | $ | — | |
| Interest-bearing deposits with banks | 187,493 | | | 187,493 | | | 187,493 | | | — | | | — | |
| | | | | | | | | |
| Restricted investments in bank stock | 7,252 | | | n/a | | n/a | | n/a | | n/a |
| Investment securities | 472,438 | | | 472,438 | | | 20,101 | | | 429,190 | | | 23,147 | |
| Loans held for sale | 8,868 | | | 8,868 | | | — | | | 8,868 | | | — | |
| Loans, net of allowance for loan losses | 1,958,806 | | | 1,946,365 | | | — | | | — | | | 1,946,365 | |
| | | | | | | | | |
| Derivatives | 1,117 | | | 1,117 | | | — | | | 764 | | | 353 | |
| Accrued interest receivable | 8,234 | | | 8,235 | | | — | | | 2,203 | | | 6,032 | |
| | | | | | | | | |
| Financial Liabilities | | | | | | | | | |
| Deposits | 2,464,929 | | | 2,466,191 | | | — | | | 2,466,191 | | | — | |
| Securities sold under agreements to repurchase | 23,301 | | | 23,301 | | | — | | | 23,301 | | | — | |
| FHLB advances and other borrowings | 1,896 | | | 2,035 | | | — | | | 2,035 | | | — | |
| Subordinated notes | 31,963 | | | 31,815 | | | — | | | 31,815 | | | — | |
| Derivatives | 760 | | | 760 | | | — | | | 760 | | | — | |
| Accrued interest payable | 154 | | | 154 | | | — | | | 154 | | | — | |
| Off-balance sheet instruments | — | | | — | | | — | | | — | | | — | |
In accordance with the Company's adoption of ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, the methods utilized to measure the fair value of financial instruments at June 30, 2022 and December 31, 2021 represent an approximation of exit price; however, an actual exit price may differ.
NOTE 12. CONTINGENCIES
The nature of the Company’s business generates a certain amount of litigation involving matters arising out of the ordinary course of business. Except as described below, in the opinion of management, there are no legal proceedings that might have a material effect on the results of operations, liquidity, or the financial position of the Company at this time.
On May 25, 2012, SEPTA filed a putative class action complaint in the U.S. District Court for the Middle District of Pennsylvania against the Company, the Bank and certain current and former directors and officers (collectively, the “Orrstown Defendants”). The complaint alleged, among other things, that (i) in connection with the Company’s Registration Statement on Form S-3 dated February 23, 2010 and its Prospectus Supplement dated March 23, 2010, and (ii) during the purported class period of March 24, 2010 through October 27, 2011, the Company issued materially false and misleading statements regarding the Company’s lending practices and financial results, including misleading statements concerning the stringent nature of the Bank’s credit practices and underwriting standards, the quality of its loan portfolio, and the intended use of the proceeds from the Company’s March 2010 public offering of common stock. The complaint asserted claims under Sections 11, 12(a) and 15 of the Securities Act, Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 promulgated thereunder, and sought class certification, unspecified money damages, interest, costs, fees and equitable or injunctive relief. Under the Private Securities Litigation Reform Act of 1995, the Court appointed SEPTA Lead Plaintiff on August 20, 2012.
On March 4, 2013, SEPTA filed an amended complaint. The amended complaint expanded the list of defendants in the action to include the Company’s former independent registered public accounting firm, Smith Elliott Kearns & Company, LLC (“SEK”), and the underwriters of the Company’s March 2010 public offering of common stock. In addition, among other things, the amended complaint extended the purported Exchange Act class period from March 15, 2010 through April 5, 2012.
On June 22, 2015, in a 96-page Memorandum, the Court dismissed without prejudice SEPTA’s amended complaint against all defendants, finding that SEPTA failed to state a claim under either the Securities Act, or the Exchange Act. On February 8, 2016, the Court granted SEPTA’s motion for leave to amend again and SEPTA filed its second amended complaint that same day.
On December 7, 2016, the Court issued an Order and Memorandum granting in part and denying in part defendants’ motions to dismiss SEPTA’s second amended complaint. The Court granted the motions to dismiss the Securities Act claims against all defendants, and granted the motions to dismiss the Exchange Act Section 10(b) and Rule 10b-5 claims against all defendants except Orrstown Financial Services, Inc., Orrstown Bank, Thomas R. Quinn, Jr., Bradley S. Everly, and Jeffrey W. Embly. The Court also denied the motions to dismiss the Exchange Act Section 20(a) claims against Quinn, Everly, and Embly.
On December 15, 2017, the Orrstown Defendants and SEPTA exchanged expert reports in opposition to and in support of class certification, respectively. On January 15, 2018, the parties exchanged expert rebuttal reports. SEPTA has not yet filed a motion for class certification.
On August 9, 2018, SEPTA filed a motion to compel the production of Confidential Supervisory Information (CSI) of non-parties the FRB and the Pennsylvania Department of Banking and Securities, in the possession of Orrstown and third parties. On August 30, 2018, the FRB filed an unopposed motion to intervene in the Action for the purpose of opposing SEPTA’s motion to compel. On February 12, 2019, the Court denied SEPTA’s motion to compel the production of CSI on the ground that SEPTA had failed to exhaust its administrative remedies.
On April 11, 2019, SEPTA filed a motion for leave to file a third amended complaint. The proposed third amended complaint seeks to reassert the Securities Act claims that the Court dismissed as to all defendants on December 7, 2016, when the Court granted in part and denied in part defendants’ motions to dismiss SEPTA’s second amended complaint. The proposed third amended complaint also seeks to reassert the Exchange Act claims against those defendants that the Court dismissed from the case on December 7, 2016.
On June 13, 2019, Orrstown filed a motion for protective order to stay discovery pending resolution of SEPTA’s motion for leave to file a third amended complaint. On July 17, 2019, the Court entered an Order partially granting Orrstown’s motion for protective order, ruling that all deposition discovery in the case was stayed pending a decision on SEPTA’s motion for leave to file a third amended complaint. Party and non-party document discovery in the case has largely been completed.
On February 14, 2020, the Court issued an Order and Memorandum granting SEPTA’s motion for leave to file a third amended complaint. The third amended complaint is now the operative complaint. It reinstates the Orrstown Defendants, as well as SEK and the underwriter defendants, previously dismissed from the case on December 7, 2016. The third amended complaint also revives the previously dismissed Securities Act claim against the Orrstown Defendants, SEK, and the underwriter defendants. Defendants filed their motions to dismiss the third amended complaint on April 24, 2020. SEPTA’s opposition was filed on July 8, 2020, and Orrstown’s reply brief was filed on August 12, 2020.
Additionally, on February 24, 2020, the Orrstown Defendants, and the underwriter defendants and SEK, separately filed motions under 28 U.S.C. § 1292(b) asking the District Court to certify its February 14, 2020 Order granting leave to file the third amended complaint for interlocutory appeal to the Third Circuit Court of Appeals. The District Court granted those motions on July 17, 2020, and defendants filed their Petition for Permission to Appeal with the Third Circuit on July 27, 2020. The Third Circuit granted permission to appeal the Order pursuant to 28 U.S.C. § 1292(b) on August 13, 2020. Defendants filed their joint Opening Brief in the Third Circuit on November 2, 2020, asking the Court to reverse the district court’s Order. SEPTA filed its responsive brief on December 2, 2020 and defendants filed their reply brief on December 23, 2020. Oral argument was held on February 10, 2021. On September 2, 2021, the Third Circuit affirmed the District Court's February 14, 2020 Order granting SEPTA leave to file a third amended complaint. Defendants' motions to dismiss the third amended complaint are still pending in the District Court.
The Company believes that SEPTA’s allegations and claims against the defendants are without merit, and the Company intends to defend itself vigorously against those claims. It is not possible at this time to reasonably estimate possible losses, or even a range of reasonably possible losses, in connection with the litigation.
On March 25, 2022, a customer of the Bank filed a putative class action complaint against the Bank in the Court of Common Pleas of Cumberland County, Pennsylvania in a case captioned Alleman, on behalf of himself and all others similarly situated, v. Orrstown Bank. The complaint alleges, among other things, that the Bank breached its account agreements by charging certain overdraft fees. The complaint seeks a refund of all allegedly improper fees, damages in an amount to be proven at trial, attorneys’ fees and costs, and an injunction against the Bank’s allegedly improper overdraft practices. This lawsuit is similar to lawsuits recently filed against other financial institutions pertaining to overdraft fee disclosures. The Company filed a preliminary objection to the complaint on May 16, 2022. The plaintiff filed a brief in opposition to the Company's preliminary objection on June 16, 2022, and the Company filed its reply brief on June 30, 2022. The Bank believes that the allegations and claims against the Bank are without merit, and intends to defend itself vigorously against those claims. Based on information available at present, it is not possible at this time to reasonably estimate possible losses, or even a range of reasonably possible losses, in connection with the litigation. Accordingly, the Company has not recognized any liability associated with this action.