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SFST Southern First Bancshares

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period EndedMarch 31, 2020
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period from          to
Commission file number 000-27719
 
Southern First Bancshares, Inc.
(Exact name of registrant as specified in its charter)

South Carolina     58-2459561
(State or other jurisdiction of incorporation or organization)(I.R.S. Employer Identification No.)
 
100 Verdae Boulevard, Suite 100
Greenville, S.C.29607
(Address of principal executive offices)(Zip Code)

864-679-9000
(Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address, and former fiscal year, if changed since last report)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class     Trading Symbol(s)     Name of each exchange on which registered
Common StockSFSTThe Nasdaq Global Market

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐

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

Large accelerated filer          Accelerated filer          
Non-accelerated filerSmaller Reporting Company
Emerging growth company

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 7,717,582 shares of common stock, par value $0.01 per share, were issued and outstanding as of April 28, 2020.


SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY
March 31, 2020 Form 10-Q

INDEX

PART I – CONSOLIDATED FINANCIAL INFORMATION     Page
 
Item 1.    Consolidated Financial Statements
 
Consolidated Balance Sheets3
 
Consolidated Statements of Income4
 
Consolidated Statements of Comprehensive Income5
 
Consolidated Statements of Shareholders’ Equity6
 
Consolidated Statements of Cash Flows7
 
Notes to Unaudited Consolidated Financial Statements8
 
Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations26
 
Item 3.Quantitative and Qualitative Disclosures about Market Risk42
 
Item 4.Controls and Procedures42
 
PART II – OTHER INFORMATION
 
Item 1.Legal Proceedings42
 
Item 1A.Risk Factors42
 
Item 2.Unregistered Sales of Equity Securities and Use of Proceeds44
 
Item 3.Defaults upon Senior Securities44
 
Item 4.Mine Safety Disclosures44
 
Item 5.Other Information44
 
Item 6.Exhibits44

2


PART I. CONSOLIDATED FINANCIAL INFORMATION
Item 1. CONSOLIDATED FINANCIAL STATEMENTS

SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS

March 31,December 31,
(dollars in thousands, except share data)20202019
     (Unaudited)     (Audited)
ASSETS
Cash and cash equivalents:

Cash and due from banks

$     17,52119,196

Federal funds sold

40,27789,256

Interest-bearing deposits with banks

83,31419,364

Total cash and cash equivalents

141,112127,816
Investment securities:

Investment securities available for sale

70,50767,694

Other investments

5,3416,948

Total investment securities

75,84874,642
Mortgage loans held for sale34,94827,046
Loans2,030,261       1,943,525

Less allowance for loan losses

(22,462)(16,642)

Loans, net

2,007,7991,926,883
Bank owned life insurance40,28140,011
Property and equipment, net58,65658,478
Deferred income taxes4,0874,275
Other assets9,5188,044

Total assets

$2,372,2492,267,195
LIABILITIES
Deposits$2,025,6981,876,124
Federal Home Loan Bank advances and other borrowings65,000110,000
Subordinated debentures35,91735,890
Other liabilities35,15939,321

Total liabilities

2,161,7742,061,335
SHAREHOLDERS’ EQUITY
Preferred stock, par value $.01 per share, 10,000,000 shares authorized--
Common stock, par value $.01 per share, 10,000,000 shares authorized, 7,717,582 and 7,672,678 shares issued and outstanding at March 31, 2020 and December 31, 2019, respectively7777
Nonvested restricted stock(1,105)(803)
Additional paid-in capital107,529106,152
Accumulated other comprehensive income (loss)410(298)
Retained earnings103,564100,732

Total shareholders’ equity

210,475205,860

Total liabilities and shareholders’ equity

$2,372,2492,267,195

See notes to consolidated financial statements that are an integral part of these consolidated statements.

3


SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)

 
For the three months
ended March 31,
(dollars in thousands, except share data)     2020     2019
Interest income

Loans

$     23,36720,889

Investment securities

396549

Federal funds sold and interest-bearing deposits with banks

103174

Total interest income

23,86621,612
Interest expense

Deposits

5,1745,375

Borrowings

594419

Total interest expense

5,7685,794

Net interest income

18,09815,818

Provision for loan losses

6,000300

Net interest income after provision for loan losses

12,09815,518
Noninterest income

Mortgage banking income

2,6681,857

Service fees on deposit accounts

262265

ATM and debit card income

398380

Income from bank owned life insurance

270216

Other income

318276

Total noninterest income

3,9162,994
Noninterest expenses

Compensation and benefits

7,8716,783

Occupancy

1,5361,339

Outside service and data processing costs

1,192960

Insurance

320318

Professional fees

497439

Marketing

258260

Other

698549

Total noninterest expenses

12,37210,648

Income before income tax expense

3,6427,864
Income tax expense8101,855
Net income available to common shareholders$2,8326,009
Earnings per common share

Basic

$0.370.81

Diluted

0.360.78
Weighted average common shares outstanding

Basic

7,678,5987,459,342

Diluted

7,827,1737,741,860

See notes to consolidated financial statements that are an integral part of these consolidated statements.

4


SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)

   
     For the three months
ended March 31,
(dollars in thousands)2020     2019
Net income$     2,8326,009
Other comprehensive income:
Unrealized gain on securities available for sale:
Unrealized holding gain arising during the period, pretax895684
Tax expense(187)(143)
Reclassification of realized gain-(4)
Tax expense-1
Other comprehensive income708538
Comprehensive income$3,5406,547

See notes to consolidated financial statements that are an integral part of these consolidated statements.

5


SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
FOR THE THREE MONTHS ENDED MARCH 31, 2020 AND 2019
(Unaudited)

  
 Accumulated
 Nonvested Additionalother
Common stockPreferred stock restricted paid-incomprehensiveRetained
(dollars in thousands, except share data)Shares Amount Shares  Amountstock   capital loss earnings Total
December 31, 20187,466,48175--(741)102,625(917)72,874173,916
Net income-------6,0096,009
Proceeds from exercise of stock options28,455----322--322
Issuance of restricted stock10,700---(347)347---
Compensation expense related to restricted stock, net of tax----95---95
Compensation expense related to stock options, net of tax-----306--306
Other comprehensive income------538-538
 
March 31, 20197,505,636$75-$-$(993) $103,600$(379) $78,883$181,186
December 31, 20197,672,67877--(803)106,152(298)100,732205,860
Net income-------2,8322,832
Proceeds from exercise of stock options35,404----741--741
Issuance of restricted stock9,500---(406)406---
Compensation expense related to restricted stock, net of tax----104---104
Compensation expense related to stock options, net of tax-----230--230
Other comprehensive income------708-708
 
March 31, 20207,717,582$   77-$-$   (1,105)$   107,529$                 410$   103,564$   210,475

See notes to consolidated financial statements that are an integral part of these consolidated statements.

6


SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

      
For the three months ended
      March 31,
(dollars in thousands)20202019
Operating activities
Net income$        2,8326,009
Adjustments to reconcile net income to cash provided by (used for) operating activities:
Provision for loan losses6,000300
Depreciation and other amortization549453
Accretion and amortization of securities discounts and premium, net11683
Net change in operating leases55447
Compensation expense related to stock options and restricted stock grants334401
Gain on sale of loans held for sale(2,778)(1,775)
Loans originated and held for sale(95,423)     (55,178)
Proceeds from sale of loans held for sale90,29956,801
Increase in cash surrender value of bank owned life insurance(270)(216)
Decrease in deferred tax asset-1
Increase in other assets, net(1,490)(400)
Increase (decrease) in other liabilities(3,782)5,978
Net cash provided by (used for) operating activities(3,558)12,904
Investing activities
Increase (decrease) in cash realized from:
Increase in loans, net(86,916)(56,643)
Purchase of property and equipment(1,119)(266)
Purchase of investment securities:
Available for sale(6,302)-
Payments and maturities, calls and repayments of investment securities:
Available for sale4,2692,205
Other investments1,607812
Net cash used for investing activities(88,461)(53,892)
Financing activities
Increase (decrease) in cash realized from:
Increase in deposits, net149,574110,099
Decrease in Federal Home Loan Bank advances and other borrowings, net(45,000)(25,000)
Proceeds from the exercise of stock options and warrants741322
Net cash provided by financing activities105,31585,421
Net increase in cash and cash equivalents13,29644,433
Cash and cash equivalents at beginning of the period127,81672,873
Cash and cash equivalents at end of the period$141,112117,306
Supplemental information
Cash paid for
Interest$7,1035,570
Income taxes--
Schedule of non-cash transactions
Unrealized gain on securities, net of income taxes708541
Right-of-use assets obtained in exchange for lease obligations:
Operating leases-15,395

See notes to consolidated financial statements that are an integral part of these consolidated statements.

7


SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 – Nature of Business and Basis of Presentation

Business Activity
Southern First Bancshares, Inc.(the “Company”) is a South Carolina corporation that owns all of the capital stock of Southern First Bank (the “Bank”) and all of the stock of Greenville First Statutory Trusts I and II (collectively, the “Trusts”). The Trusts are special purpose non-consolidated entities organized for the sole purpose of issuing trust preferred securities. The Bank's primary federal regulator is the Federal Deposit Insurance Corporation (the “FDIC”). The Bank is also regulated and examined by the South Carolina Board of Financial Institutions. The Bank is primarily engaged in the business of accepting demand deposits and savings deposits insured by the FDIC, and providing commercial, consumer and mortgage loans to the general public.

Basis of Presentation
The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three-month period ended March 31, 2020 are not necessarily indicative of the results that may be expected for the year ending December 31, 2020. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019 as filed with the Securities and Exchange Commission (“SEC”) on March 2, 2020. The consolidated financial statements include the accounts of the Company and the Bank. In accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 810, “Consolidation,” the financial statements related to the Trusts have not been consolidated.

Business Segments
In determining proper segment definition, the Company considers the materiality of a potential segment and components of the business about which financial information is available and regularly evaluated, relative to a resource allocation and performance assessment. The Company accounts for intersegment revenues and expenses as if the revenue/expense transactions were generated to third parties, that is, at current market prices. Please refer to “Note 10 – Reportable Segments” for further information on the reporting for the Company’s three business segments.

Use of Estimates
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, or GAAP, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amount of income and expenses during the reporting periods. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, real estate acquired in the settlement of loans, fair value of financial instruments, evaluating other-than-temporary-impairment of investment securities and valuation of deferred tax assets.

Risks and Uncertainties
In December 2019, a novel strain of coronavirus (“COVID-19”) was reported to have surfaced in China, and has since spread to a number of other countries, including the United States. In March 2020, the World Health Organization declared COVID-19 a global pandemic and the United States declared a National Public Health Emergency. The COVID-19 pandemic has severely restricted the level of economic activity in the Bank’s markets. In response to the COVID-19 pandemic, the governments of the states in which the Bank has retail offices, and of most other states, have taken preventative or protective actions, such as imposing restrictions on travel and business operations, advising or requiring individuals to limit or forego their time outside of their homes, and ordering temporary closures of businesses that have been deemed to be non-essential.

8


The impact of the COVID-19 pandemic is fluid and continues to evolve, adversely affecting many of the Bank’s clients. The COVID-19 pandemic and its associated impacts on trade (including supply chains and export levels), travel, employee productivity, unemployment, consumer spending, and other economic activities has resulted in less economic activity, lower equity market valuations and significant volatility and disruption in financial markets, and has had an adverse effect on the Company’s business, financial condition and results of operations. The ultimate extent of the impact of the COVID-19 pandemic on the Company’s business, financial condition and results of operations is currently uncertain and will depend on various developments and other factors, including, among others, the duration and scope of the pandemic, as well as governmental, regulatory and private sector responses to the pandemic, and the associated impacts on the economy, financial markets and our clients, employees and vendors.

The Company’s business, financial condition and results of operations generally rely upon the ability of the Bank’s borrowers to repay their loans, the value of collateral underlying the Bank’s secured loans, and demand for loans and other products and services the Bank offers, which are highly dependent on the business environment in the Bank’s primary markets where it operates and in the United States as a whole.

On March 3, 2020, the Federal Reserve reduced the target federal funds rate by 50 basis points, followed by an additional reduction of 100 basis points on March 16, 2020. These reductions in interest rates and other effects of the COVID-19 pandemic may adversely affect the Company’s financial condition and results of operations. As a result of the spread of COVID-19, economic uncertainties have arisen which are likely to negatively impact net interest income, provision for loan losses, and noninterest income. Other financial impact could occur though such potential impact is unknown at this time.

As of March 31, 2020, the Company and Bank capital ratios were in excess of all regulatory requirements. While management believes that we have sufficient capital to withstand an extended economic recession brought about by the COVID-19 pandemic, our reported and regulatory capital ratios could be adversely impacted by further credit losses.

The Company maintains access to multiple sources of liquidity, including a $15.0 million holding company line of credit with another bank which could be used to support capital ratios at the subsidiary bank. As of April 21, 2020, the entire $15.0 million line was being utilized by the Company.

As of March 31, 2020, over 400 of our clients had requested loan payment deferrals or payments of interest only on loans totaling $380.2 million, of which 93.3% were commercial loans. In accordance with interagency guidance issued in March 2020, these short-term deferrals are not considered troubled debt restructurings (“TDRs”) unless the borrower was previously experiencing financial difficulty; however, three client relationships, with loans totaling $2.9 million, were granted short-term loan modifications which were considered TDRs due to the client experiencing financial difficulty prior to the pandemic.

In addition, the risk-rating on COVID-19 modified loans did not change, and these loans will not be considered past due until after the deferral period is over and scheduled payments resume. The credit quality of these loans will be reevaluated after the deferral period ends. The table below provides a breakdown of loan modification requests due to the COVID-19 pandemic by type of concession.

                
March 31, 2020
(dollars in thousands)# LoansAmount% of Total Portfolio
Payment deferrals252$208,555             10.3%
Interest only170168,7238.3%
Financial difficulty (TDR)62,9250.1%
428$380,20318.7%

9


Through April 21, 2020, we have modified more than 750 loans totaling $591.8 million which remain predominately in the commercial loan categories.

While most industries have and will continue to experience adverse impacts as a result of the COVID-19 pandemic, we have identified nine loan categories considered to be “at-risk” of significant impact. The table below identifies these segments as well as the outstanding, committed and modified loan balances for each industry.

   
March 31, 2020
% of
% of TotalTotalCommittedTotal
BalanceLoansCommittedBalanceModified
(dollars in thousands)   Outstanding   Outstanding   Balance   Outstanding   Balance   % Modified
Religious organizations$     56,3062.8%$     88,42263.6%$     1,5392.7%
Entertainment facilities4,6050.2%9,46448.7%2555.5%
Hotels82,2274.1%104,15578.9%6,0507.4%
Personal care businesses1,3490.1%1,38597.4%13710.2%
Restaurants48,3522.4%53,52690.3%3,6737.6%
Sports facilities22,2291.1%22,88297.1%6833.1%
Travel related businesses3,3280.2%4,08581.5%55516.7%
Private healthcare facilities36,4621.8%41,89987.0%12,53134.4%
Non-essential retail154,4507.6%160,70296.1%13,8439.0%
Total$409,30820.2%$486,52084.1%$39,2669.6%

As of April 21, 2020, the total outstanding balance within these nine portfolios was $413.4 million with approximately 48% of the balances having been modified.

We continue to monitor unfunded commitments through the pandemic, including home equity lines of credit, for evidence of increased credit exposure as borrowers utilize these lines for liquidity purposes.

Reclassifications
Certain amounts, previously reported, have been reclassified to state all periods on a comparable basis and had no effect on shareholders’ equity or net income.

Subsequent Events
Subsequent events are events or transactions that occur after the balance sheet date but before financial statements are issued. Recognized subsequent events are events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements. Non-recognized subsequent events are events that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date.

Newly Issued, But Not Yet Effective Accounting Standards
In June 2016, the FASB issued ASU 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments”. Among other things, ASU 2016-13 requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to form their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. In addition, ASU 2016-13 amends the accounting for credit losses on debt securities and purchased financial assets with credit deterioration. ASU 2016-13 was originally effective for all annual and interim periods beginning after December 31, 2019, with early adoption permitted for fiscal years beginning after December 15, 2018. Adoption will be applied through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective.

In November 2019, the FASB issued guidance that addresses issues raised by stakeholders during the implementation of ASU 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments”. The amendments affect a variety of Topics in the Accounting Standards Codification. For public business entities that meet the definition of a smaller reporting company, such as the Company, the amendments are effective for fiscal years beginning after December 15, 2022 including interim periods within those fiscal years. Early adoption is permitted in any interim period as long as the Company has adopted to amendments in ASU 2016-13. Currently, the Company does not expect to adopt the ASU before the effective period.

10


Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on the consolidated financial statements upon adoption.

NOTE 2 – Investment Securities

The amortized costs and fair value of investment securities are as follows:

   
March 31, 2020
Amortized     Gross UnrealizedFair
(dollars in thousands)     CostGains     Losses     Value
Available for sale
US government agencies$     500-1499
SBA securities519-18501
State and political subdivisions9,38529519,679
Asset-backed securities12,929-64312,286
Mortgage-backed securities
FHLMC10,034270410,300
FNMA33,05770213533,624
GNMA3,56553-3,618
Total mortgage-backed securities46,6561,02513947,542
Total investment securities available for sale$69,9891,32080270,507
 
December 31, 2019
AmortizedGross UnrealizedFair
     Cost     Gains        Losses     Value
Available for sale
US government agencies$     500-1499
SBA securities550-19531
State and political subdivisions4,2053244,184
Asset-backed securities13,351-18413,167
Mortgage-backed securities
FHLMC10,609141510,608
FNMA35,2753416935,140
GNMA3,5815213,565
Total mortgage-backed securities49,4655320549,313
Total$68,0715643367,694

Contractual maturities and yields on the Company’s investment securities at March 31, 2020 and December 31, 2019 are shown in the following table. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

11



   
March 31, 2020
Less than one yearOne to five yearsFive to ten yearsOver ten yearsTotal
(dollars in thousands)AmountYieldAmountYieldAmountYieldAmountYieldAmountYield
Available for sale                    
US government agencies$     --4991.11%----4991.11%
SBA securities------5012.39%5012.39%
State and political subdivisions----9722.65%8,7072.86%9,6792.84%
Asset-backed securities----1,4022.22%10,8842.45%12,2862.43%
Mortgage-backed securities--3,2241.80%8,2632.05%36,0552.34%47,5422.25%
Total$--3,7231.71%10,6372.13%56,1472.44%70,5072.36%
 
December 31, 2019
Less than one yearOne to five yearsFive to ten yearsOver ten yearsTotal
(dollars in thousands)AmountYieldAmountYieldAmountYieldAmountYieldAmountYield
Available for sale
US government agencies$--4991.97%----4991.97%
SBA securities------5312.62%5312.62%
State and political subdivisions--8082.81%1,2832.96%2,0932.67%4,1842.79%
Asset-backed securities----1,4932.34%11,6742.61%13,1672.58%
Mortgage-backed securities--3,3681.78%7,6382.00%38,3072.24%49,3132.17%
Total$--4,6751.98%10,4142.17%52,6052.34%67,6942.29%

The tables below summarize gross unrealized losses on investment securities and the fair market value of the related securities at March 31, 2020 and December 31, 2019, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position.

   
March 31, 2020
Less than 12 months12 months or longerTotal
FairUnrealizedFair UnrealizedFairUnrealized
(dollars in thousands)   #   value   losses   #   value   losses   #   value   losses
Available for sale
US government agencies1$     499$     1-$     -$     -1$     499$     1
SBA securities---150118150118
State and political subdivisions15051---15051
Asset-backed securities55,48936556,7972781012,286643
Mortgage-backed securities
FHLMC12584---12584
FNMA---42,77813542,778135
Total8$6,751$37110$10,076$43118$16,827$802
 
December 31, 2019
Less than 12 months12 months or longerTotal
Fair UnrealizedFair UnrealizedFairUnrealized
(dollars in thousands)#valuelosses#valuelosses#valuelosses
Available for sale
US government agencies1$499$1-$-$-1$499$1
SBA securities---153119153119
State and political subdivisions22,09324---22,09324
Asset-backed securities55,9216857,2461161013,167184
Mortgage-backed securities
FHLMC43,842242,3231386,16515
FNMA1415,50067119,4621022524,962169
GNMA22,240617341532,97421
Total28$30,095$16822$20,296$26550$50,391$433

At March 31, 2020, the Company had eight individual investments with a fair market value of $6.8 million that were in an unrealized loss position for less than 12 months and ten individual investments with a fair market value of $10.1 million that were in an unrealized loss position for 12 months or longer. The unrealized losses were primarily attributable to changes in interest rates, rather than deterioration in credit quality. The individual securities are each investment grade securities. The Company considers the length of time and extent to which the fair value of available-for-sale debt securities have been less than cost to conclude that such securities are not other-than-temporarily impaired. The Company also considers other factors such as the financial condition of the issuer including credit ratings and specific events affecting the operations of the issuer, volatility of the security, underlying assets that collateralize the debt security, and other industry and macroeconomic conditions.

12


As the Company has no intent to sell securities with unrealized losses and it is not more-likely-than-not that the Company will be required to sell these securities before recovery of amortized cost, the Company has concluded that these securities are not impaired on an other-than-temporary basis.

Other investments are comprised of the following and are recorded at cost which approximates fair value.

 
(dollars in thousands)     March 31, 2020     December 31, 2019
Federal Home Loan Bank stock$     4,8036,386
Other investments135159
Investment in Trust Preferred securities403403
Total other investments$5,3416,948

The Company has evaluated the Federal Home Loan Bank (“FHLB”) stock for impairment and determined that the investment in the FHLB stock is not other than temporarily impaired as of March 31, 2020 and that ultimate recoverability of the par value of this investment is probable. All of the FHLB stock is used to collateralize advances with the FHLB.

NOTE 3 – Mortgage Loans Held for Sale

Mortgage loans originated and intended for sale in the secondary market are reported as loans held for sale and carried at fair value under the fair value option with changes in fair value recognized in current period earnings. At the date of funding of the mortgage loan held for sale, the funded amount of the loan, the related derivative asset or liability of the associated interest rate lock commitment, less direct loan costs becomes the initial recorded investment in the loan held for sale. Such amount approximates the fair value of the loan. At March 31, 2020, mortgage loans held for sale totaled $34.9 million compared to $27.0 million at December 31, 2019. The $7.9 million increase in mortgage loans held for sale during the first quarter of 2020 was driven by an increase in volume of mortgage loans originated and sold in the favorable mortgage rate environment.

Mortgage loans held for sale are considered de-recognized, or sold, when the Company surrenders control over the financial assets. Control is considered to have been surrendered when the transferred assets have been isolated from the Company, beyond the reach of the Company and its creditors; the purchaser obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets; and the Company does not maintain effective control over the transferred assets through an agreement that both entitles and obligates the Company to repurchase or redeem the transferred assets before their maturity or the ability to unilaterally cause the holder to return specific assets.

Gains and losses from the sale of mortgage loans are recognized based upon the difference between the sales proceeds and carrying value of the related loans upon sale and are recorded in mortgage banking income in the statement of income. Mortgage banking income also includes the unrealized gains and losses associated with the loans held for sale and the realized and unrealized gains and losses from derivatives.

Mortgage loans sold to investors by the Company, and which were believed to have met investor and agency underwriting guidelines at the time of sale, may be subject to repurchase or indemnification in the event of specific default by the borrower or subsequent discovery that underwriting standards were not met. The Company may, upon mutual agreement, agree to repurchase the loans or indemnify the investor against future losses on such loans. In such cases, the Company bears any subsequent credit loss on the loans. As appropriate, the Company establishes mortgage repurchase reserves related to various representations and warranties that reflect management’s estimate of losses.

13


NOTE 4 – Loans and Allowance for Loan Losses

The following table summarizes the composition of our loan portfolio. Total gross loans are recorded net of deferred loan fees and costs, which totaled $3.6 million as of March 31, 2020 and $3.3 million as of December 31, 2019.

 
March 31, 2020December 31, 2019
(dollars in thousands)     Amount     % of Total     Amount     % of Total
Commercial
Owner occupied RE$     422,12420.8%$     407,85121.0%
Non-owner occupied RE534,84626.3%501,87825.8%
Construction74,7583.7%80,4864.1%
Business317,70215.7%308,12315.9%
Total commercial loans1,349,43066.5%1,298,33866.8%
Consumer
Real estate427,69721.1%398,24520.5%
Home equity183,0999.0%179,7389.3%
Construction45,2402.2%41,4712.1%
Other24,7951.2%25,7331.3%
Total consumer loans680,83133.5%645,18733.2%
Total gross loans, net of deferred fees2,030,261100.0%1,943,525100.0%
Less—allowance for loan losses(22,462)(16,642)
Total loans, net$2,007,799$1,926,883

Maturities and Sensitivity of Loans to Changes in Interest Rates

The information in the following tables summarizes the loan maturity distribution by type and related interest rate characteristics based on the contractual maturities of individual loans, including loans which may be subject to renewal at their contractual maturity. Renewal of such loans is subject to review and credit approval, as well as modification of terms upon maturity. Actual repayments of loans may differ from the maturities reflected below, because borrowers have the right to prepay obligations with or without prepayment penalties.

 
March 31, 2020
After one
One yearbut withinAfter five
(dollars in thousands)     or less     five years     years     Total
Commercial
Owner occupied RE$     35,613143,626242,885422,124
Non-owner occupied RE53,806276,462204,578534,846
Construction12,17828,28034,30074,758
Business86,055151,28180,366317,702
Total commercial loans187,652599,649562,1291,349,430
Consumer
Real estate15,96974,920336,808427,697
Home equity8,20726,334148,558183,099
Construction14,6981,12129,42145,240
Other5,69614,7634,33624,795
Total consumer loans44,570117,138519,123680,831
Total gross loans, net of deferred fees$232,222716,7871,081,2522,030,261
Loans maturing after one year with:
Fixed interest rates$     1,425,015
Floating interest rates373,024

14



 
December 31, 2019
After one
One yearbut withinAfter five
(dollars in thousands)     or less     five years     years     Total
Commercial
Owner occupied RE$     40,476147,945219,430407,851
Non-owner occupied RE55,187267,879178,812501,878
Construction31,03519,27830,17380,486
Business84,452146,05177,620308,123
Total commercial loans211,150581,153506,0351,298,338
Consumer
Real estate16,66382,445299,137398,245
Home equity9,92125,828143,989179,738
Construction13,4051,22226,84441,471
Other6,42215,0224,28925,733
Total consumer46,411124,517474,259645,187
Total gross loan, net of deferred fees$257,561705,670980,2941,943,525
Loans maturing after one year with:
Fixed interest rates$     1,310,744
Floating interest rates375,220

Portfolio Segment Methodology

Commercial
Commercial loans are assessed for estimated losses by grading each loan using various risk factors identified through periodic reviews. The Company applies historic grade-specific loss factors to each loan class. In the development of statistically derived loan grade loss factors, the Company observes historical losses over 20 quarters for each loan grade. These loss estimates are adjusted as appropriate based on additional analysis of external loss data or other risks identified from current economic conditions and credit quality trends. The allowance also includes an amount for the estimated impairment on nonaccrual commercial loans and commercial loans modified in a troubled debt restructuring (“TDR”), whether on accrual or nonaccrual status.

Consumer
For consumer loans, the Company determines the allowance on a collective basis utilizing historical losses over 20 quarters to represent its best estimate of inherent loss. The Company pools loans, generally by loan class with similar risk characteristics. The allowance also includes an amount for the estimated impairment on nonaccrual consumer loans and consumer loans modified in a TDR, whether on accrual or nonaccrual status.

Credit Quality Indicators

Commercial
We manage a consistent process for assessing commercial loan credit quality by monitoring its loan grading trends and past due statistics. All loans are subject to individual risk assessment. Our risk categories include Pass, Special Mention, Substandard, and Doubtful, each of which is defined by our banking regulatory agencies. Delinquency statistics are also an important indicator of credit quality in the establishment of our allowance for loan losses.

We categorize our loans into risk categories based on relevant information about the ability of the borrower to service their debt such as current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. A description of the general characteristics of the risk grades is as follows:

Pass—These loans range from minimal credit risk to average credit risk; however, still have acceptable credit risk.

15



Special mention—A special mention loan has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or the institution’s credit position at some future date.

  

Substandard—A substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness, or weaknesses, that may jeopardize the liquidation of the debt. A substandard loan is characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

  

Doubtful—A doubtful loan has all of the weaknesses inherent in one classified as substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of the currently existing facts, conditions and values, highly questionable and improbable.

The following tables provide past due information for outstanding commercial loans and include loans on nonaccrual status as well as accruing TDRs.

 
March 31, 2020
OwnerNon-owner
(dollars in thousands)     occupied RE     occupied RE     Construction     Business     Total
Current$     419,978531,11974,758315,5621,341,417
30-59 days past due1,5953,275-1,9096,779
60-89 days past due-264--264
Greater than 90 Days551188-231970
$422,124534,84674,758317,7021,349,430
 
December 31, 2019
OwnerNon-owner
occupied REoccupied REConstructionBusinessTotal
Current$406,594501,67680,486307,7101,296,466
30-59 days past due706151-1781,035
60-89 days past due-----
Greater than 90 Days55151-235837
$407,851501,87880,486308,1231,298,338

As of March 31, 2020 and December 31, 2019, loans 30 days or more past due represented 0.60% and 0.23% of the Company’s total loan portfolio, respectively. Commercial loans 30 days or more past due were 0.39% and 0.10% of the Company’s total loan portfolio as of March 31, 2020 and December 31, 2019, respectively.

The tables below provide a breakdown of outstanding commercial loans by risk category.

 
March 31, 2020
OwnerNon-owner
(dollars in thousands)     occupied RE     occupied RE     Construction     Business     Total
Pass$     418,504525,92774,758310,9531,330,142
Special mention1,321865-3,2715,457
Substandard2,2998,054-3,47813,831
Doubtful-----
$422,124534,84674,758317,7021,349,430
 
December 31, 2019
OwnerNon-owner
occupied REoccupied REConstructionBusinessTotal
Pass$404,237492,94180,486301,5041,279,168
Special mention1,312744-3,1085,164
Substandard2,3028,193-3,51114,006
Doubtful-----
$407,851501,87880,486308,1231,298,338

16


Consumer
The Company manages a consistent process for assessing consumer loan credit quality by monitoring its loan grading trends and past due statistics. All loans are subject to individual risk assessment. The Company’s categories include Pass, Special Mention, Substandard, and Doubtful, which are defined above. Delinquency statistics are also an important indicator of credit quality in the establishment of the allowance for loan losses.

The following tables provide past due information for outstanding consumer loans and include loans on nonaccrual status as well as accruing TDRs.

 
March 31, 2020
(dollars in thousands)     Real estate     Home equity     Construction     Other     Total
Current$     426,127180,48645,24024,790676,643
30-59 days past due5591,527-52,091
60-89 days past due-886--886
Greater than 90 Days1,011200--1,211
$427,697183,09945,24024,795680,831
 
December 31, 2019
(dollars in thousands)Real estateHome equityConstructionOtherTotal
Current$396,445179,05141,47125,650642,617
30-59 days past due799369-831,251
60-89 days past due-118--118
Greater than 90 Days1,001200--1,201
$398,245179,73841,47125,733645,187

Consumer loans 30 days or more past due were 0.21% and 0.13% of total loans as of March 31, 2020 and December 31, 2019, respectively.

The tables below provide a breakdown of outstanding consumer loans by risk category.

 
March 31, 2020
(dollars in thousands)     Real estate     Home equity     Construction     Other     Total
Pass$     420,588178,52045,24024,487668,835
Special mention3,7171,097-2425,056
Substandard3,3923,482-666,940
Doubtful-----
$427,697183,09945,24024,795680,831
 
December 31, 2019
(dollars in thousands)Real estateHome equityConstructionOtherTotal
Pass$392,572176,53241,47125,421635,996
Special mention2,267775-2613,303
Substandard3,4062,431-515,888
Doubtful-----
$398,245179,73841,47125,733645,187

Nonperforming assets

The following table shows the nonperforming assets and the related percentage of nonperforming assets to total assets and gross loans. Generally, a loan is placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when the Company believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the contractual principal or interest on the loan is doubtful. A payment of interest on a loan that is classified as nonaccrual is recognized as a reduction in principal when received.

17


Following is a summary of our nonperforming assets, including nonaccruing TDRs.

 
(dollars in thousands)     March 31, 2020     December 31, 2019
Commercial
Owner occupied RE$       --
Non-owner occupied RE3,268188
Construction--
Business231235
Consumer
Real estate1,8211,829
Home equity427431
Construction--
Other--
Nonaccruing troubled debt restructurings4,1864,111
Total nonaccrual loans, including nonaccruing TDRs9,9336,794
Other real estate owned--
Total nonperforming assets$9,9336,794
Nonperforming assets as a percentage of:
Total assets0.42%0.30%
Gross loans0.49%0.35%
Total loans over 90 days past due$2,1812,038
Loans over 90 days past due and still accruing--
Accruing troubled debt restructurings7,939              5,219

Impaired Loans

The table below summarizes key information for impaired loans. The Company’s impaired loans include loans on nonaccrual status and loans modified in a TDR, whether on accrual or nonaccrual status. These impaired loans may have estimated impairment which is included in the allowance for loan losses. The Company’s commercial and consumer impaired loans are evaluated individually to determine the related allowance for loan losses.

 
March 31, 2020
Recorded investment
Impaired loansImpaired loans
Unpaidwith no relatedwith relatedRelated
PrincipalImpairedallowance forallowance forallowance for
(dollars in thousands)     Balance     loans     loan losses     loan losses     loan losses
Commercial
Owner occupied RE$     2,7872,7222,26845476
Non-owner occupied RE7,5867,0855,4851,600486
Construction-----
Business2,6282,5395401,999824
Total commercial13,00112,3468,2934,0531,386
Consumer
Real estate3,0363,0301,9661,064362
Home equity2,4032,3522,17417865
Construction-----
Other144144-14415
Total consumer5,5835,5264,1401,386442
Total$18,58417,87212,4335,4391,828

18



 
December 31, 2019
Recorded investment
Impaired loansImpaired loans
Unpaidwith no relatedwith relatedRelated
PrincipalImpairedallowance forallowance forallowance for
(dollars in thousands)     Balance     loans     loan losses     loan losses     loan losses
Commercial
Owner occupied RE$     2,7912,7262,27045675
Non-owner occupied RE4,5124,0512,4191,632465
Construction-----
Business1,6201,531558973452
Total commercial8,9238,3085,2473,061992
Consumer
Real estate2,7272,7201,6381,082364
Home equity88583845937966
Construction-----
Other147147-14716
Total consumer3,7593,7052,0971,608446
Total$12,68212,0137,3444,6691,438

The following table provides the average recorded investment in impaired loans and the amount of interest income recognized on impaired loans after impairment by portfolio segment and class.

 
Three months endedThree months endedYear ended
March 31, 2020March 31, 2019December 31, 2019
AverageRecognizedAverageRecognizedAverageRecognized
recordedinterestrecordedinterestrecordedinterest
(dollars in thousands)     investment     income     investment     income     investment     income
Commercial
Owner occupied RE$     2,725182,757302,739128
Non-owner occupied RE7,108622,977494,161255
Construction------
Business2,553282,567401,58279
Total commercial12,3861088,3011198,482462
Consumer
Real estate3,036262,761252,771131
Home equity2,355121,6773085342
Construction------
Other145115711535
Total consumer5,536394,595563,777178
Total$17,92214712,89617512,259640

Allowance for Loan Losses

The allowance for loan loss is management’s estimate of credit losses inherent in the loan portfolio. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

19


The Company has an established process to determine the adequacy of the allowance for loan losses that assesses the losses inherent in the portfolio. While the Company attributes portions of the allowance to specific portfolio segments, the entire allowance is available to absorb credit losses inherent in the total loan portfolio. The Company’s process involves procedures to appropriately consider the unique risk characteristics of the commercial and consumer loan portfolio segments. For each portfolio segment, impairment is measured individually for each impaired loan. The Company’s allowance levels are influenced by loan volume, loan grade or delinquency status, historic loss experience and other economic conditions.

The following table summarizes the activity related to the allowance for loan losses by commercial and consumer portfolio segments:

 
Three months ended March 31, 2020
CommercialConsumer
    Owner    Non-owner                            
occupiedoccupiedRealHome
(dollars in thousands)REREConstructionBusinessEstateequityConstructionOtherTotal
Balance, beginning of period$2,8354,3045413,6923,2781,44726827716,642
Provision for loan losses     1,1701,7111531,0061,3263811471066,000
Loan charge-offs-(221)-----(45)(266)
Loan recoveries---16268--86
Net loan charge-offs-(221)-16268-(45)(180)
Balance, end of period$4,005        5,7946944,714     4,6061,896415   33822,462
Net charge-offs to average loans (annualized)0.04%
Allowance for loan losses to gross loans1.11%
Allowance for loan losses to nonperforming loans226.14%

Three months ended March 31, 2019
CommercialConsumer
    Owner    Non-owner                            
occupiedoccupiedRealHome
(dollars in thousands)REREConstructionBusinessEstateequityConstruction   OtherTotal
Balance, beginning of period$     2,7263,811               6153,616 3,0811,348275   29015,762
Provision for loan losses5774(43)171(56)61729300
Loan charge-offs-------(41)(41)
Loan recoveries-1-9161-330
Net loan charge-offs-1-9161-(38)(11)
Balance, end of period$2,7833,8865723,796    3,0411,41028228116,051
Net charge-offs to average loans (annualized)0.00%
Allowance for loan losses to gross loans0.93%
Allowance for loan losses to nonperforming loans265.35%

The following table disaggregates the allowance for loan losses and recorded investment in loans by impairment methodology.

 
March 31, 2020
Allowance for loan lossesRecorded investment in loans
(dollars in thousands)     Commercial     Consumer     Total     Commercial     Consumer     Total
Individually evaluated$1,3864421,82812,3465,52617,872
Collectively evaluated     13,8226,81220,6341,337,084675,3052,012,389
Total$15,2087,25422,4621,349,430680,8312,030,261
 
December 31, 2019
Allowance for loan lossesRecorded investment in loans
(dollars in thousands)CommercialConsumerTotalCommercialConsumerTotal
Individually evaluated$9924461,4388,3083,70512,013
Collectively evaluated10,3804,82415,2041,290,030641,4821,931,512
Total$11,3725,27016,6421,298,338645,1871,943,525

20


NOTE 5 – Troubled Debt Restructurings

At March 31, 2020, the Company had 24 loans totaling $12.1 million compared to 19 loans totaling $9.3 million at December 31, 2019, which were considered as TDRs. The Company considers a loan to be a TDR when the debtor experiences financial difficulties and the Company grants a concession to the debtor that it would not normally consider. Concessions can relate to the contractual interest rate, maturity date, or payment structure of the note. As part of the workout plan for individual loan relationships, the Company may restructure loan terms to assist borrowers facing financial challenges in the current economic environment. In accordance with interagency guidance, short term deferrals granted due to the COVID-19 pandemic are not considered TDRs unless the borrower was experiencing financial difficulty prior to the pandemic; however, three client relationships, with loans totaling $2.9 million, were granted short-term loan modifications which were considered TDRs due to the client experiencing financial difficulty prior to the pandemic.

The following table summarizes the concession at the time of modification and the recorded investment in the Company’s TDRs before and after their modification for the three months ended March 31, 2020. There were no loans determined to be a TDR during the three months ended March 31, 2019.

 
For the three months ended March 31, 2020
Pre-Post-
   modificationmodification
RenewalsReducedConvertedMaturityTotaloutstandingoutstanding
     deemed a     or deferred     to interest     date     Number     recorded     recorded
(dollars in thousands)concessionpaymentsonlyextensionsof loansinvestmentinvestment
Commercial
Business11$     1,037$     1,037
Consumer
Real estate11322322
Home equity3---31,5221,522
Total loans5---5$2,881$2,881

As of March 31, 2020 and 2019, there were no loans modified as a TDR for which there was a payment default (60 days past due) within 12 months of the restructuring date.

NOTE 6 – Derivative Financial Instruments

The Company utilizes derivative financial instruments primarily to hedge its exposure to changes in interest rates. All derivative financial instruments are recognized as either assets or liabilities and measured at fair value. The Company accounts for all of its derivatives as free-standing derivatives and does not designate any of these instruments for hedge accounting. Therefore, the gain or loss resulting from the change in the fair value of the derivative is recognized in the Company’s statement of income during the period of change.

The Company enters into commitments to originate residential mortgage loans held for sale, at specified interest rates and within a specified period of time, with clients who have applied for a loan and meet certain credit and underwriting criteria (interest rate lock commitments). These interest rate lock commitments (“IRLCs”) meet the definition of a derivative financial instrument and are reflected in the balance sheet at fair value with changes in fair value recognized in current period earnings. Unrealized gains and losses on the IRLCs are recorded as derivative assets and derivative liabilities, respectively, and are measured based on the value of the underlying mortgage loan, quoted mortgage-backed securities (“MBS”) prices and an estimate of the probability that the mortgage loan will fund within the terms of the interest rate lock commitment, net of estimated commission expenses.

The Company manages the interest rate and price risk associated with its outstanding IRLCs and mortgage loans held for sale by entering into derivative instruments such as forward sales of MBS. Management expects these derivatives will experience changes in fair value opposite to changes in fair value of the IRLCs and mortgage loans held for sale, thereby reducing earnings volatility. The Company takes into account various factors and strategies in determining the portion of the mortgage pipeline (IRLCs and mortgage loans held for sale) it wants to economically hedge.

21


The following table summarizes the Company’s outstanding financial derivative instruments at March 31, 2020 and December 31, 2019.

  
March 31, 2020
               Fair Value
(dollars in thousands)NotionalBalance Sheet LocationAsset/(Liability)
Mortgage loan interest rate lock commitments$109,337Other assets$1,649
MBS forward sales commitments63,000Other liabilities(1,087)
Total derivative financial instruments$172,337$562
 
December 31, 2019
Fair Value
(dollars in thousands)NotionalBalance Sheet LocationAsset/(Liability)
Mortgage loan interest rate lock commitments$     26,446Other assets$            344
MBS forward sales commitments20,500Other liabilities(39)
Total derivative financial instruments$46,946$305

NOTE 7 – Fair Value Accounting

FASB ASC 820, “Fair Value Measurement and Disclosures,” defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an 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. FASB ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1 – Quoted market price in active markets

Quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities include certain debt and equity securities that are traded in an active exchange market.

Level 2 – Significant other observable inputs

Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include fixed income securities and mortgage-backed securities that are held in the Company’s available-for-sale portfolio and valued by a third-party pricing service, as well as certain impaired loans.

Level 3 – Significant unobservable inputs

Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. These methodologies may result in a significant portion of the fair value being derived from unobservable data.

The methods of determining the fair value of assets and liabilities presented in this note are consistent with our methodologies disclosed in Note 14 of the Company’s 2019 Annual Report on Form 10-K. The Company’s loan portfolio is initially fair valued using a segmented approach, using the eight categories of loans as disclosed in Note 4 – Loans and Allowance for Loan Losses. Loans are considered a Level 3 classification.

22


Assets and Liabilities Recorded at Fair Value on a Recurring Basis

The tables below present the recorded amount of assets and liabilities measured at fair value on a recurring basis as of March 31, 2020 and December 31, 2019.

 
March 31, 2020
(dollars in thousands)     Level 1     Level 2     Level 3     Total
Assets
Securities available for sale
US government agencies        -499-499
SBA securities-501-501
State and political subdivisions-9,679-9,679
Asset-backed securities-12,286-12,286
Mortgage-backed securities-47,542-47,542
Mortgage loans held for sale-34,948-34,948
Mortgage loan interest rate lock commitments-1,649-1,649
Total assets measured at fair value on a recurring basis$-107,104-107,104
 
Liabilities
MBS forward sales commitments$-1,087-1,087
Total liabilities measured at fair value on a recurring basis$-1,087-1,087
 
December 31, 2019
(dollars in thousands)Level 1Level 2Level 3Total
Assets
Securities available for sale:
US government agencies$-499-499
SBA securities-531-531
State and political subdivisions-4,184-4,184
Asset-backed securities-13,167-13,167
Mortgage-backed securities-49,313-49,313
Mortgage loans held for sale-27,046-27,046
Mortgage loan interest rate lock commitments-344-344
Total assets measured at fair value on a recurring basis$-95,084-95,084
          
Liabilities
MBS forward sales commitments$-39-39
Total liabilities measured at fair value on a recurring basis$-39-39

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

The tables below present the recorded amount of assets and liabilities measured at fair value on a nonrecurring basis as of March 31, 2020 and December 31, 2019.

 
As of March 31, 2020
(dollars in thousands)     Level 1     Level 2     Level 3     Total
Assets
Impaired loans$       -10,5525,49216,044
Total assets measured at fair value on a nonrecurring basis$-10,5525,49216,044
 
As of December 31, 2019
(dollars in thousands)Level 1Level 2Level 3Total
Assets
Impaired loans$-5,6344,94110,575
Total assets measured at fair value on a nonrecurring basis$-5,6344,94110,575

The Company had no liabilities carried at fair value or measured at fair value on a nonrecurring basis.

23


Fair Value of Financial Instruments

Financial instruments require disclosure of fair value information, whether or not recognized in the consolidated balance sheets, when it is practical to estimate the fair value. A financial instrument is defined as cash, evidence of an ownership interest in an entity or a contractual obligation which requires the exchange of cash. Certain items are specifically excluded from the disclosure requirements, including the Company’s common stock, premises and equipment and other assets and liabilities.

The estimated fair values of the Company’s financial instruments at March 31, 2020 and December 31, 2019 are as follows:

 
March 31, 2020
CarryingFair
(dollars in thousands)     Amount     Value     Level 1     Level 2     Level 3
Financial Assets:
Other investments, at cost$5,3415,341--5,341
Loans1  1,989,9271,942,206--1,942,206
Financial Liabilities:
Deposits2,025,6981,947,258-1,947,258-
FHLB and other borrowings65,00065,021-65,021-
Subordinated debentures35,91731,989-31,989-
 
December 31, 2019
CarryingFair
(dollars in thousands)AmountValueLevel 1Level 2Level 3
Financial Assets:
Other investments, at cost$6,9486,948--6,948
Loans11,914,8701,900,216--1,900,216
Financial Liabilities:
Deposits1,876,1241,772,121-1,772,121-
FHLB and other borrowings110,000109,737-109,737-
Subordinated debentures35,89033,250-33,250-

1Carrying amount is net of the allowance for loan losses and previously presented impaired loans.

NOTE 8 – Leases

Effective January 1, 2019, the Company adopted ASU 2016-02, “Leases (Topic 842)”. As of March 31, 2020, we lease seven of our offices under various operating lease agreements. The lease agreements have maturity dates ranging from February 2022 to October 2029, some of which include options for multiple five-year extensions. The weighted average remaining life of the lease term for these leases was 7.78 years as of March 31, 2020.

The discount rate used in determining the lease liability for each individual lease was the FHLB fixed advance rate which corresponded with the remaining lease term as of January 1, 2019 for leases that existed at adoption and as of the lease commencement date for leases subsequently entered in to. The weighted average discount rate for leases was 2.86% as of March 31, 2020.

The total operating lease costs were $596,000 and $528,000 for the three months ended March 31, 2020 and 2019, respectively. The ROU asset, included in property and equipment, and lease liabilities, included in other liabilities, were $19.1 million and $19.7 million as of March 31, 2020, respectively, compared to $19.5 million and $20.1 million as of December 31, 2019, respectively. The ROU asset and lease liability are recognized at lease commencement by calculating the present value of lease payments over the lease term.

24


Maturities of lease liabilities as of March 31, 2020 were as follows:

 
(dollars in thousands)     Operating
Leases
2020 $1,581
20212,152
20221,400
20231,273
20241,305
Thereafter17,405
Total undiscounted lease payments25,116
Discount effect of cash flows5,407
Total lease liability $19,709

NOTE 9 – Earnings Per Common Share

The following schedule reconciles the numerators and denominators of the basic and diluted earnings per share computations for the three-month periods ended March 31, 2020 and 2019. Dilutive common shares arise from the potentially dilutive effect of the Company’s stock options that were outstanding at March 31, 2020. The assumed conversion of stock options can create a difference between basic and dilutive net income per common share. At March 31, 2020 and 2019, there were 288,053 and 271,034 options, respectively, that were not considered in computing diluted earnings per common share because they were anti-dilutive.

 
     Three months ended
March 31,
(dollars in thousands, except share data)2020     2019
Numerator:
Net income available to common shareholders   $2,8326,009
Denominator:
Weighted-average common shares outstanding – basic7,678,5987,459,342
Common stock equivalents148,575282,518
Weighted-average common shares outstanding – diluted7,827,1737,741,860
Earnings per common share:
Basic$0.370.81
Diluted$0.360.78

NOTE 10 – Reportable Segments

The Company’s reportable segments represent the distinct product lines the Company offers and are viewed separately for strategic planning purposes by management. The three segments include Commercial and Retail Banking, Mortgage Banking, and Corporate. The following schedule presents financial information for each reportable segment.

25



Three months ended
March 31, 2020
Three months ended
March 31, 2019
(dollars in thousands)  Commercial
and Retail
Banking
  Mortgage
Banking
  Corporate  Elimin-
ations
  Consol-
idated
  Commercial
and Retail
Banking
   Mortgage
Banking
  Corporate   Elimin-
ation
  Consol-
idated
Interest income$23,6701964(4)23,866$21,519933(3)21,612
Interest expense5,333-439(4)5,7685,631-166(3)5,794
Net interest income (loss)18,337196(435)-18,09815,88893(163)-15,818
Provision for loan losses6,000---6,000300---300
Noninterest income1,2482,668--3,9161,1371,857--2,994
Noninterest expense10,4991,80766-12,3729,4651,12360-10,648
Net income (loss) before taxes3,0861,057(501)-3,6427,260827(223)-7,864
Income tax provision (benefit)693222(105)-8101,728174(47)-1,855
Net income (loss)$2,393835(396)-2,832$5,532653(176)-6,009
Total assets$2,335,16036,577246,424(245,912) 2,372,249$2,002,95711,003194,671(194,205)2,014,426

Commercial and retail banking.The Company’s primary business is to provide traditional deposit and lending products and services to its commercial and retail banking clients.

Mortgage banking.The mortgage banking segment provides mortgage loan origination services for loans that will be sold in the secondary market to investors.

Corporate.Corporate is comprised primarily of compensation and benefits for certain members of management and interest on parent company debt.

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following discussion reviews our results of operations for the three month period ended March 31, 2020 as compared to the three month period ended March 31, 2019 and assesses our financial condition as of March 31, 2020 as compared to December 31, 2019. You should read the following discussion and analysis in conjunction with the accompanying consolidated financial statements and the related notes and the consolidated financial statements and the related notes for the year ended December 31, 2019 included in our Annual Report on Form 10-K for that period. Results for the three month period ended March 31, 2020 are not necessarily indicative of the results for the year ending December 31, 2020 or any future period.

Unless the context requires otherwise, references to the “Company,” “we,” “us,” “our,” or similar references mean Southern First Bancshares, Inc. and its subsidiaries.

CAUTIONARYWARNINGREGARDING FORWARD-LOOKING STATEMENTS

This report, including information included or incorporated by reference in this report, contains statements which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). Forward-looking statements may relate to our financial condition, results of operations, plans, objectives, or future performance. These statements are based on many assumptions and estimates and are not guarantees of future performance. Our actual results may differ materially from those anticipated in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors which are beyond our control. The words “may,” “would,” “could,” “should,” “will,” “expect,” “anticipate,” “predict,” “project,” “potential,” “believe,” “continue,” “assume,” “intend,” “plan,” and “estimate,” as well as similar expressions, are meant to identify such forward-looking statements. Potential risks and uncertainties that could cause our actual results to differ from those anticipated in any forward-looking statements include, but are not limited to, those described under Item 1A. Risk Factors of our Annual Report on Form 10-K for the year ended December 31, 2019, as well as the following:

Restrictions or conditions imposed by our regulators on our operations;
Increases in competitive pressure in the banking and financial services industries;
Changes in access to funding or increased regulatory requirements with regard to funding;

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Changes in deposit flows;
Credit losses as a result of declining real estate values, increasing interest rates, increasing unemployment, changes in payment behavior or other factors;
Credit losses due to loan concentration;
Changes in the amount of our loan portfolio collateralized by real estate and weaknesses in the real estate market;
Our ability to successfully execute our business strategy;
Our ability to attract and retain key personnel;
The success and costs of our expansion into the Greensboro, North Carolina, Raleigh, North Carolina and Atlanta, Georgia markets and into potential new markets;
Changes in the interest rate environment which could reduce anticipated or actual margins;
Changes in political conditions or the legislative or regulatory environment, including governmental initiatives affecting the financial services industry, including, but not limited to, the Coronavirus Aid, Relief, and Economic Security Act, or the CARES Act;
Changes in economic conditions in the United States and the strength of the local economies in which we conduct our operations, including, but not limited to, due to the negative impacts and disruptions resulting from the recent outbreak of COVID-19 on the economies and communities we serve, which may have an adverse impact on our business, operations and performance, and could have a negative impact on our credit portfolio, share price, borrowers, and on the economy as a whole, both domestically and globally;
Changes occurring in business conditions and inflation;
Increased cybersecurity risk, including potential business disruptions or financial losses;
Changes in technology;
The adequacy of the level of our allowance for loan losses and the amount of loan loss provisions required in future periods;
Examinations by our regulatory authorities, including the possibility that the regulatory authorities may, among other things, require us to increase our allowance for loan losses or write-down assets;
Changes in monetary and tax policies;
The rate of delinquencies and amounts of loans charged-off;
The rate of loan growth in recent years and the lack of seasoning of a portion of our loan portfolio;
Our ability to maintain appropriate levels of capital and to comply with our capital ratio requirements;
Adverse changes in asset quality and resulting credit risk-related losses and expenses;
Changes in accounting policies, practices or guidelines;
Adverse effects of failures by our vendors to provide agreed upon services in the manner and at the cost agreed;
The potential effects of events beyond our control that may have a destabilizing effect on financial markets and the economy, such as epidemics and pandemics, including the potential effects of coronavirus on trade (including supply chains and export levels, travel, employee activity and other economic activities), war or terrorist activities, essential utility outages or trade disputes and related tariffs; and
Other risks and uncertainties detailed in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2019, in Part II, Item 1A of this Quarterly Report on Form 10-Q, and from time to time in our other filings with the SEC.

If any of these risks or uncertainties materialize, or if any of the assumptions underlying such forward-looking statements proves to be incorrect, our results could differ materially from those expressed in, implied or projected by, such forward-looking statements. For information with respect to factors that could cause actual results to differ from the expectations stated in the forward-looking statements, see “Risk Factors” under Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2019 and “Risk Factors” under Part II, Item 1A of this Quarterly Report on Form 10-Q. We urge investors to consider all of these factors carefully in evaluating the forward-looking statements contained in this Quarterly Report on Form 10-Q. We make these forward-looking statements as of the date of this document and we do not intend, and assume no obligation, to update the forward-looking statements or to update the reasons why actual results could differ from those expressed in, or implied or projected by, the forward-looking statements.

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OVERVIEW

Our business model continues to be client-focused, utilizing relationship teams to provide our clients with a specific banker contact and support team responsible for all of their banking needs. The purpose of this structure is to provide a consistent and superior level of professional service, and we believe it provides us with a distinct competitive advantage. We consider exceptional client service to be a critical part of our culture, which we refer to as "ClientFIRST."

At March 31, 2020, we had total assets of $2.37 billion, a 4.6% increase from total assets of $2.27 billion at December 31, 2019. The largest components of our total assets are loans which were $2.03 billion and $1.94 billion at March 31, 2020 and December 31, 2019, respectively. Our liabilities and shareholders’ equity at March 31, 2020 totaled $2.16 billion and $210.5 million, respectively, compared to liabilities of $2.06 billion and shareholders’ equity of $205.9 million at December 31, 2019. The principal component of our liabilities is deposits which were $2.03 billion and $1.88 billion at March 31, 2020 and December 31, 2019, respectively.

Like most community banks, we derive the majority of our income from interest received on our loans and investments. Our primary source of funds for making these loans and investments is our deposits, on which we pay interest. Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income on our interest-earning assets, such as loans and investments, and the expense on our interest-bearing liabilities, such as deposits and borrowings. Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities, which is called our net interest spread. In addition to earning interest on our loans and investments, we earn income through fees and other charges to our clients.

Our net income to common shareholders was $2.8 million and $6.0 million for the three months ended March 31, 2020 and 2019, respectively. Diluted earnings per share (“EPS”) was $0.36 for the first quarter of 2020 as compared to $0.78 for the same period in 2019. The decrease in net income resulted primarily from a $5.7 million increase in loan loss provision recorded in the first quarter of 2020 compared to the same period in 2019, partially offset by a $2.3 million increase in net interest income and a $922,000 increase in noninterest income.

Economic conditions, competition, and the monetary and fiscal policies of the Federal government significantly affect most financial institutions, including the Bank. Lending and deposit activities and fee income generation are influenced by levels of business spending and investment, consumer income, consumer spending and savings, capital market activities, and competition among financial institutions, as well as customer preferences, interest rate conditions and prevailing market rates on competing products in our market areas.

RECENT EVENTSCOVID-19 PANDEMIC

In December 2019, a novel strain of coronavirus (COVID-19) was reported to have surfaced in China, and has since spread to a number of other countries, including the United States. In March 2020, the World Health Organization declared COVID-19 a global pandemic and the United States declared a National Public Health Emergency. The COVID-19 pandemic has severely restricted the level of economic activity in our markets. In response to the COVID-19 pandemic, the governments of the states in which we have retail offices, and of most other states, have taken preventative or protective actions, such as imposing restrictions on travel and business operations, advising or requiring individuals to limit or forego their time outside of their homes, and ordering temporary closures of businesses that have been deemed to be non-essential.

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The impact of the COVID-19 pandemic is fluid and continues to evolve, adversely affecting many of the Bank’s clients. The COVID-19 pandemic and its associated impacts on trade (including supply chains and export levels), travel, employee productivity, unemployment, consumer spending, and other economic activities has resulted in less economic activity, lower equity market valuations and significant volatility and disruption in financial markets, and has had an adverse effect on our business, financial condition and results of operations. The ultimate extent of the impact of the COVID-19 pandemic on our business, financial condition and results of operations is currently uncertain and will depend on various developments and other factors, including, among others, the duration and scope of the pandemic, as well as governmental, regulatory and private sector responses to the pandemic, and the associated impacts on the economy, financial markets and our customers, employees and vendors.

Our business, financial condition and results of operations generally rely upon the ability of our borrowers to repay their loans, the value of collateral underlying our secured loans, and demand for loans and other products and services we offer, which are highly dependent on the business environment in our primary markets where we operate and in the United States as a whole. The COVID-19 pandemic has begun to have a significant impact on our business and operations. As part of our efforts to exercise social distancing, in March 2020, we closed all of our banking lobbies and are conducting most of our business at this time through drive-thru tellers and through electronic and online means. To support the health and well-being of our employees, approximately 70% of our workforce is working from home. We are focused on servicing the financial needs of our commercial and consumer clients with flexible loan payment arrangements, including short-term loan modifications or forbearance payments and reducing or waiving certain fees on deposit accounts. Future governmental actions may require these and other types of client-related responses.

At March 31, 2020, more than 400 clients, with aggregate outstanding loan principal balances of approximately $380.2 million, have been granted deferrals on loan payments. We are also a small business administration approved lender and have begun processing customer applications under the Paycheck Protection Program (“PPP”), established under the Coronavirus Aid, Relief, and Economic Security Act, or CARES Act.

At March 31, 2020, our non-performing assets were not yet materially impacted by the economic pressures of COVID-19. In addition, as we closely monitor credit risk and our exposure to increased loan losses resulting from the impact of COVID-19 on our commercial clients, we have identified nine portfolios considered to be “at-risk” of significant impact from the pandemic. For additional information on the nine identified portfolios, see Note 1 –Nature of Business and Basis of Presentation, in the accompanying condensed notes to consolidated financial statements included elsewhere in this report.

We are monitoring the impact of the COVID-19 pandemic on the operations and value of our investments. We mark to market our publicly traded investments and will review our investment portfolio for impairment at period end. Because of changing economic and market conditions affecting issuers, we may be required to recognize further impairments on the securities we hold as well as reductions in other comprehensive income. We cannot currently determine the ultimate impact of the pandemic on the long-term value of our portfolio.

As of March 31, 2020, all of our capital ratios, and our subsidiary bank’s capital ratios, were in excess of all regulatory requirements. While we believe that we have sufficient capital to withstand an extended economic recession brought about by the COVID-19 pandemic, our reported and regulatory capital ratios could be adversely impacted by further credit losses.

We maintain access to multiple sources of liquidity, including a $15.0 million holding company line of credit with another bank which could be used to support capital ratios at the subsidiary bank.

RESULTS OF OPERATIONS

Net Interest Income and Margin

Our level of net interest income is determined by the level of earning assets and the management of our net interest margin. Our net interest income was $18.1 million for the three month period ended March 31, 2020, a 14.4% increase over net interest income of $15.8 million for the same period in 2019. In addition, our average earning assets increased 16.3%, or $296.6 million, during the first quarter of 2020 compared to the first quarter of 2019, while our interest-bearing liabilities increased by $210.7 million, or 15.2%, during the same period. The increase in average earning assets was primarily related to an increase in average loans, while the increase in average interest-bearing liabilities was primarily a result of an increase in interest-bearing deposits.

29


We have included a number of tables to assist in our description of various measures of our financial performance. For example, the “Average Balances, Income and Expenses, Yields and Rates” table reflects the average balance of each category of our assets and liabilities as well as the yield we earned or the rate we paid with respect to each category during the three month periods ended March 31, 2020 and 2019. A review of this table shows that our loans typically provide higher interest yields than do other types of interest-earning assets, which is why we direct a substantial percentage of our earning assets into our loan portfolio. Similarly, the “Rate/Volume Analysis” table demonstrates the effect of changing interest rates and changing volume of assets and liabilities on our financial condition during the periods shown. We also track the sensitivity of our various categories of assets and liabilities to changes in interest rates, and we have included tables to illustrate our interest rate sensitivity with respect to interest-earning accounts and interest-bearing accounts.

The following table sets forth information related to our average balance sheets, average yields on assets, and average costs of liabilities. We derived these yields by dividing income or expense by the average balance of the corresponding assets or liabilities. We derived average balances from the daily balances throughout the periods indicated. During the same periods, we had no securities purchased with agreements to resell. All investments owned have an original maturity of over one year. Nonaccrual loans are included in the following tables. Loan yields have been reduced to reflect the negative impact on our earnings of loans on nonaccrual status. The net of capitalized loan costs and fees are amortized into interest income on loans.

Average Balances, Income and Expenses, Yields and Rates
 For the Three Months Ended March 31,
20202019
AverageIncome/Yield/AverageIncome/Yield/
(dollars in thousands)  Balance  Expense  Rate(1)  Balance  Expense  Rate(1)
Interest-earning assets
Federal funds sold and interest-bearing
deposits with banks$46,101$1030.90%$30,656$1742.30%
Investment securities, taxable66,6403812.30%71,8765082.87%
Investment securities, nontaxable(2)3,815192.05%5,427533.98%
Loans(3)2,003,55423,3674.69%1,715,57020,8894.94%
Total interest-earning assets2,120,11023,8704.53%1,823,52921,6244.81%
Noninterest-earning assets111,33886,431
Total assets$2,231,448$1,909,960
Interest-bearing liabilities
NOW accounts$227,6881680.30%$186,070860.19%
Savings & money market956,5883,3691.42%780,1153,3001.72%
Time deposits329,6641,6372.00%371,6941,9892.17%
Total interest-bearing deposits1,513,9405,1741.37%1,337,8795,3751.63%
FHLB advances and other borrowings43,4701581.46%31,3022563.32%
Subordinated debentures35,9004364.88%13,4031634.93%
Total interest-bearing liabilities1,593,3105,7681.46%1,382,5845,7941.70%
Noninterest-bearing liabilities427,992349,988
Shareholders’ equity210,146177,388
Total liabilities and shareholders’ equity$     2,231,448$     1,909,960
Net interest spread3.07%3.11%
Net interest income (tax equivalent) / margin$     18,1023.43%$     15,8303.52%
Less: tax-equivalent adjustment(2)412
Net interest income$18,098$15,818
       (1)       Annualized for the three month period.
(2)The tax-equivalent adjustment to net interest income adjusts the yield for assets earning tax-exempt income to a comparable yield on a taxable basis.
(3)Includes mortgage loans held for sale.

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Our net interest margin, on a tax-equivalent basis (TE), was 3.43% for the three months ended March 31, 2020 compared to 3.52% for the first quarter of 2019. The nine basis point decrease in net interest margin (TE) was driven by the decreased yield on our interest-earning assets, partially offset by the decreased rates on our interest-bearing liabilities as compared to the prior year period. Our average interest-earning assets grew by $296.6 million during the first three months of 2020 as compared to the same period in 2019, while the average yield on these assets decreased by 28 basis points. In addition, our average interest-bearing liabilities grew by $210.7 million during the 2020 period while the rate on these liabilities decreased 24 basis points to 1.46% for the three months ended March 31, 2020.

The increase in average interest-earning assets for the three months ended March 31, 2020 as compared to the same period in 2019 related primarily to an increase of $288.0 million in our average loan balances. The 28 basis point decrease in yield during the same period was driven by a 25 basis point decrease in loan yield due to loans being originated or renewed at market rates which are lower than those in the past. The Federal Reserve reduced interest rates by 225 basis points since August 2019 which resulted in the decreased loan yield as well as a significant decrease in yield on our Federal funds sold and interest bearing deposits and investment securities.

In addition, the increase in our interest-bearing liabilities resulted primarily from a $176.1 million increase in our interest-bearing deposits at an average rate of 1.37%, a 26 basis point decrease from the average rate in the first quarter of 2019. In addition, our average subordinated debentures increased due to the issuance of $23 million on September 30, 2019.

Our net interest spread was 3.07% for the three months ended March 31, 2020 compared to 3.11% for the same period in 2019. The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities. The 28 basis point decrease in yield on our interest-earning assets and the 24 basis point decrease in rate on our interest-bearing liabilities, resulted in the four basis point decrease in our net interest spread for the 2020 period. We anticipate continued pressure on our net interest spread and net interest margin in future periods based on the Federal Reserve’s 225 basis point interest rate decrease since August 2019.

Rate/Volume Analysis
Net interest income can be analyzed in terms of the impact of changing interest rates and changing volume. The following table sets forth the effect which the varying levels of interest-earning assets and interest-bearing liabilities and the applicable rates have had on changes in net interest income for the periods presented.

     Three Months Ended
March 31, 2020 vs. 2019March 31, 2019 vs. 2018
Increase (Decrease) Due toIncrease (Decrease) Due to
Rate/Rate/
(dollars in thousands)     Volume     Rate     Volume     Total     Volume     Rate     Volume     Total
Interest income
Loans$3,507(881)(148)2,478$3,1101,0241924,326
Investment securities(49)(114)10(153)699418181
Federal funds sold and interest-bearing
deposits with banks88(106)(53)(71)(124)103(52)(73)
Total interest income3,546(1,101)(191)2,2543,0551,2211584,434
Interest expense
Deposits790(864)(127)(201)4391,8943042,637
FHLB advances and other borrowings100(142)(56)(98)(32)6(1)(27)
Subordinated debentures273--273-48-48
Total interest expense1,163(1,006)(183)(26)4071,9483032,658
Net interest income$     2,383(95)(8)2,280$     2,648(727)(145)1,776

Net interest income, the largest component of our income, was $18.1 million for the three months ended March 31, 2020 and $15.8 million for the three months ended March 31, 2019, a $2.3 million, or 14.4%, increase during the first quarter of 2020. The increase in net interest income is due to a $2.3 million increase in interest income and a $26,000 decrease in interest expense. During the first quarter of 2020, our average interest-earning assets increased $296.6 million as compared to the same period in 2019, resulting in $3.5 million of additional interest income, while lower rates on our interest-earning assets decreased interest income by $1.1 million from the prior year period. In contrast, our interest expense decreased $26,000 during the first quarter of 2020, despite a $210.7 million increase in average interest-bearing liabilities as the lower rates on our deposits and borrowing outweighed the increase in volume.

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Provision for Loan Losses
We have established an allowance for loan losses through a provision for loan losses charged as an expense on our consolidated statements of income. We review our loan portfolio periodically to evaluate our outstanding loans and to measure both the performance of the portfolio and the adequacy of the allowance for loan losses. Please see the discussion included in Note 4 – Loans and Allowance for Loan Losses for a description of the factors we consider in determining the amount of the provision we expense each period to maintain this allowance.

For the three months ended March 31, 2020, we incurred a noncash expense related to the provision for loan losses of $6.0 million, which resulted in an allowance for loan losses of $22.5 million, or 1.11% of gross loans. For the three months ended March 31, 2019, our provision for loan losses of $300,000 resulted in an allowance for loan losses of $16.1 million, or 0.93% of gross loans. The increased provision during the first quarter of 2020 is related primarily to the COVID-19 pandemic and qualitative adjustment factors related to the uncertain economic conditions, as well as a small increase in past due and nonaccrual loans at March 31, 2020.

Noninterest Income
The following table sets forth information related to our noninterest income.

Three months ended
          March 31,
(dollars in thousands)20202019
Mortgage banking income$     2,6681,857
Service fees on deposit accounts262265
ATM and debit card income398380
Income from bank owned life insurance270216
Other income318276
Total noninterest income$3,9162,994

Noninterest income increased $922,000, or 30.8%, for the first quarter of 2020 as compared to the same period in 2019. The increase in total noninterest income during the 2020 period resulted primarily from the following:

Mortgage banking income increased by $811,000, or 43.7%, driven by higher mortgage origination volume during the first quarter of 2020 due to the favorable interest rate environment for mortgage loans.
Income from bank owned life insurance increased $54,000, or 25%, due to $5 million of policy purchases during the second quarter of 2019.

Noninterest expenses
The following table sets forth information related to our noninterest expenses.

Three months ended
     March 31,
(dollars in thousands)2020     2019
Compensation and benefits$     7,8716,783
Occupancy1,5361,339
Outside service and data processing costs1,192960
Insurance320318
Professional fees497439
Marketing258260
Other698549
Total noninterest expense$12,37210,648

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Noninterest expense was $12.4 million for the three months ended March 31, 2020, a $1.7 million, or 16.2%, increase from noninterest expense of $10.6 million for the three months ended March 31, 2019. The increase in noninterest expenses during the 2020 period was driven primarily by the following:

Compensation and benefits expense increased $1.1 million, or 16.0%, relating primarily to increases in base compensation and benefits expenses. The increases were driven by the cost of 18 additional team members which were hired to support client growth.
Occupancy expense increased $197,000, or 14.7%, primarily related to opening new office space in Summerville, SC and Greensboro, NC during the second half of 2019.
Outside service and data processing fees increased by $232,000, or 24.2%, primarily due to increased electronic banking, ATM/debit card related fees and software licensing costs.
Other expenses increased $149,000, or 27.1%, primarily related to higher travel and entertainment, collection expenses and business license and tax costs.

Our efficiency ratio was 56.2% for the first quarter of 2020 compared to 56.6% for the same period in 2019. The efficiency ratio represents the percentage of one dollar of expense required to be incurred to earn a full dollar of revenue and is computed by dividing noninterest expense by the sum of net interest income and noninterest income. The slight improvement during the 2020 period relates primarily to the decrease in noninterest expenses as a percentage of net interest and noninterest income compared to the prior year.

We incurred income tax expense of $810,000 and $1.9 million for the three months ended March 31, 2020 and 2019, respectively. Our effective tax rate was 22.2% and 23.6% for the three months ended March 31, 2020 and 2019, respectively. The lower tax rate for the 2020 period relates to the greater impact of our tax exempt income on our taxable income.

BALANCESHEETREVIEW

Investment Securities
At March 31, 2020, the $75.8 million in our investment securities portfolio represented approximately 3.2% of our total assets.Our available for sale investment portfolio included U.S. government agency securities, SBA securities, state and political subdivisions, asset-backed securities and mortgage-backed securities witha fair value of $70.5 million and an amortized cost of $70.0 million, resulting in an unrealized gain of $518,000. At December 31, 2019, the $74.6 million in our investment securities portfolio represented approximately 3.3% of our total assets. At December 31, 2019, we held investment securities available for sale with a fair value of $67.7 million and an amortized cost of $68.1 million for an unrealized loss of $377,000.

Loans
Since loans typically provide higher interest yields than other types of interest earning assets, a substantial percentage of our earning assets are invested in our loan portfolio. Average loans excluding mortgage loans held for sale for the three months ended March 31, 2020 and 2019 were $1.98 billion and $1.71 billion, respectively. Before the allowance for loan losses, total loans outstanding at March 31, 2020 and December 31, 2019 were $2.03 billion and $1.94 billion, respectively.

The principal component of our loan portfolio is loans secured by real estate mortgages. As of March 31, 2020, our loan portfolio included $1.69 billion, or 83.1%, of real estate loans, compared to $1.61 billion, or 82.8%, of real estate loans at December 31, 2019. Most of our real estate loans are secured by residential or commercial property. We obtain a security interest in real estate, in addition to any other available collateral. This collateral is taken to increase the likelihood of the ultimate repayment of the loan. Generally, we limit the loan-to-value ratio on loans to coincide with the appropriate regulatory guidelines. We attempt to maintain a relatively diversified loan portfolio to help reduce the risk inherent in concentration in certain types of collateral and business types. We do not generally originate traditional long term residential mortgages to hold in our loan portfolio, but we do issue traditional second mortgage residential real estate loans and home equity lines of credit. Home equity lines of credit totaled $183.1 million as of March 31, 2020, of which approximately 44% were in a first lien position, while the remaining balance was second liens, compared to $179.7 million as of December 31, 2019, also of which approximately 44% were in first lien positions with the remaining balance in second liens. The average loan had a balance of approximately $91,000 and a loan to value of 67% as of March 31, 2020, compared to an average loan balance of $90,000 and a loan to value of approximately 68% as of December 31, 2019. Further, 1.4% and 0.4% of our total home equity lines of credit were over 30 days past due as of March 31, 2020 and December 31, 2019, respectively.

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Following is a summary of our loan composition at March 31, 2020 and December 31, 2019. During the first three months of 2020, our loan portfolio increased by $86.7 million, or 4.5%. Our commercial and consumer loan portfolios each experienced growth during the three months ended March 31, 2020 with a 3.9% increase in commercial loans and a 5.5% increase in consumer loans during the period. Of the $86.7 million in loan growth during the first three months of 2020, $78.1 million of the increase was in loans secured by real estate with the remainder in commercial business loans. Our consumer real estate portfolio includes high quality 1-4 family consumer real estate loans. Our average consumer real estate loan currently has a principal balance of $394,000, a term of 15 years, and an average rate of 4.32% as of March 31, 2020, compared to a principal balance of $386,000, a term of 14 years, and an average rate of 4.46% as of December 31, 2019.

March 31, 2020December 31, 2019
(dollars in thousands)Amount% of TotalAmount% of Total
Commercial                    
Owner occupied RE$422,12420.8%$407,85121.0%
Non-owner occupied RE534,84626.3%501,87825.8%
Construction74,7583.7%80,4864.1%
Business317,70215.7%308,12315.9%
Total commercial loans1,349,43066.5%1,298,33866.8%
 
Consumer
Real estate427,69721.1%398,24520.5%
Home equity183,0999.0%179,7389.3%
Construction45,2402.2%41,4712.1%
Other24,7951.2%25,7331.3%
Total consumer loans680,83133.5%645,18733.2%
Total gross loans, net of deferred fees2,030,261100.0%1,943,525   100.0%
Less—allowance for loan losses(22,462)(16,642)
Total loans, net$     2,007,799$     1,926,883

Nonperforming assets
Nonperforming assets include real estate acquired through foreclosure or deed taken in lieu of foreclosure and loans on nonaccrual status. Generally, a loan is placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when we believe, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the contractual principal or interest on the loan is doubtful. A payment of interest on a loan that is classified as nonaccrual is recognized as a reduction in principal when received. Our policy with respect to nonperforming loans requires the borrower to make a minimum of six consecutive payments in accordance with the loan terms and to show capacity to continue performing into the future before that loan can be placed back on accrual status. As of March 31, 2020 and December 31, 2019, we had no loans 90 days past due and still accruing.

Following is a summary of our nonperforming assets, including nonaccruing TDRs.

(dollars in thousands)     March 31, 2020     December 31, 2019
Commercial$3,499423
Consumer2,2482,260
Nonaccruing troubled debt restructurings4,1864,111
Total nonaccrual loans9,9336,794
Other real estate owned--
Total nonperforming assets$9,9336,794

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At March 31, 2020, nonperforming assets were $9.9 million, or 0.42% of total assets and 0.49% of gross loans. Comparatively, nonperforming assets were $6.8 million, or 0.30% of total assets and 0.35% of gross loans at December 31, 2019. Nonaccrual loans increased $3.1 million during the first quarter of 2020 due primarily to two loans put on nonaccrual status. The amount of foregone interest income on the nonaccrual loans in the first three months of 2020 and 2019 was approximately $51,000 and $20,000, respectively.

At March 31, 2020 and 2019, the allowance for loan losses represented 226.1% and 265.4% of the total amount of nonperforming loans, respectively. A significant portion, or approximately 98%, of nonperforming loans at March 31, 2020 was secured by real estate. We have evaluated the underlying collateral on these loans and believe that the collateral on these loans is sufficient to minimize future losses. Based on the level of coverage on nonperforming loans and analysis of our loan portfolio, we believe the allowance for loan losses of $22.5 million as of March 31, 2020 to be adequate.

As a general practice, most of our loans are originated with relatively short maturities of less than ten years. As a result, when a loan reaches its maturity we frequently renew the loan and thus extend its maturity using similar credit standards as those used when the loan was first originated. Due to these loan practices, we may, at times, renew loans which are classified as nonaccrual after evaluating the loan’s collateral value and financial strength of its guarantors. Nonaccrual loans are renewed at terms generally consistent with the ultimate source of repayment and rarely at reduced rates. In these cases, we will generally seek additional credit enhancements, such as additional collateral or additional guarantees to further protect the loan. When a loan is no longer performing in accordance with its stated terms, we will typically seek performance under the guarantee.

In addition, at March 31, 2020, 83.1% of our loans were collateralized by real estate and 91% of our impaired loans were secured by real estate. We utilize third party appraisers to determine the fair value of collateral dependent loans. Our current loan and appraisal policies require us to obtain updated appraisals on an annual basis, either through a new external appraisal or an appraisal evaluation. Impaired loans are individually reviewed on a quarterly basis to determine the level of impairment. As of March 31, 2020, we did not have any impaired real estate loans carried at a value in excess of the appraised value. We typically charge-off a portion or create a specific reserve for impaired loans when we do not expect repayment to occur as agreed upon under the original terms of the loan agreement.

At March 31, 2020, impaired loans totaled $17.9 million, for which $5.4 million of these loans had a reserve of approximately $1.8 million allocated in the allowance. During the first three months of 2020, the average recorded investment in impaired loans was approximately $17.9 million. Comparatively, impaired loans totaled $12.0 million at December 31, 2019 for which $4.7 million of these loans had a reserve of approximately $1.4 million allocated in the allowance. During 2019, the average recorded investment in impaired loans was approximately $12.3 million.

We consider a loan to be a TDR when the debtor experiences financial difficulties and we provide concessions such that we will not collect all principal and interest in accordance with the original terms of the loan agreement. Concessions can relate to the contractual interest rate, maturity date, or payment structure of the note. As part of our workout plan for individual loan relationships, we may restructure loan terms to assist borrowers facing challenges in the current economic environment. As of March 31, 2020, we determined that we had loans totaling $12.1 million that we considered TDRs compared to $9.3 million as of December 31, 2019. The increase during the first quarter of 2020 was driven by three client relationships with loans totaling $2.9 million that were modified due to the COVID-19 pandemic, and considered to be TDRs due to experiencing financial difficulty prior to the COVID-19 pandemic.

Allowance for Loan Losses
The allowance for loan losses was $22.5 million and $16.1 million at March 31, 2020 and 2019, respectively, or 1.11% of outstanding loans at March 31, 2020 and 0.93% of outstanding loans at March 31, 2019. At December 31, 2019, our allowance for loan losses was $16.6 million, or 0.86% of outstanding loans.

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During the three months ended March 31, 2020, we charged-off $266,000 of loans and recorded $86,000 of recoveries on loans previously charged-off, for net charge-offs of $180,000. Comparatively, we charged-off $41,000 of loans and recorded $30,000 of recoveries on loans previously charged-off, resulting in net charge-offs of $11,000 for the first three months of 2019. The $5.8 million increase in the allowance for loan losses during the first three months of 2020 is driven by the impact of the COVID-19 pandemic and qualitative adjustment factors related to the uncertain economic conditions, as well as an increase in past due and nonaccrual loans at March 31, 2020. We expect economic uncertainty to continue for the next few months which may result in a significant increase to the allowance for loan losses for the second quarter of 2020.

Following is a summary of the activity in the allowance for loan losses.

      
Three months ended   
March 31,Year ended
(dollars in thousands)20202019December 31, 2019
Balance, beginning of period     $     16,642     15,762     15,762
Provision6,0003002,300
Loan charge-offs(266)(41)(1,515)
Loan recoveries863095
Net loan charge-offs(180)(11)(1,420)
Balance, end of period$22,46216,051              16,642

Deposits and Other Interest-Bearing Liabilities
Our primary source of funds for loans and investments is our deposits and advances from the FHLB. In the past, we have chosen to obtain a portion of our certificates of deposits from areas outside of our market in order to obtain longer term deposits than are readily available in our local market. Our internal guidelines regarding the use of brokered CDs limit our brokered CDs to 20% of total deposits. In addition, we do not obtain time deposits of $100,000 or more through the Internet. These guidelines allow us to take advantage of the attractive terms that wholesale funding can offer while mitigating the related inherent risk.

Our retail deposits represented $1.94 billion, or 95.8% of total deposits at March 31, 2020, while our out-of-market, or brokered, deposits represented $84.1 million, or 4.2% of our total deposits at March 31, 2020. At December 31, 2019, retail deposits represented $1.81 billion, or 96.4% of our total deposits, and brokered CDs were $67.4 million, representing 3.6% of our total deposits. Our loan-to-deposit ratio was 100% at March 31, 2020 and 104% at December 31, 2019.

The following is a detail of our deposit accounts:

     
March 31,December 31,
(dollars in thousands)20202019
Non-interest bearing     $     437,855     397,331
Interest bearing:
NOW accounts260,320228,680
Money market accounts979,861898,923
Savings19,56316,258
Time, less than $100,00043,59647,941
Time and out-of-market deposits, $100,000 and over284,503286,991
Total deposits$2,025,6981,876,124

During the past 12 months, we continued our focus on increasing core deposits, which exclude out-of-market deposits and time deposits of $250,000 or more, in order to provide a relatively stable funding source for our loan portfolio and other earning assets. Our core deposits were $1.79 billion and $1.66 billion at March 31, 2020, and December 31, 2019, respectively.

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The following table shows the average balance amounts and the average rates paid on deposits.

   
Three months ended
March 31,
20202019
(dollars in thousands)AmountRateAmountRate
Noninterest-bearing demand deposits     $    391,761     -%     $    323,800     -%
Interest-bearing demand deposits227,6880.30%186,0700.19%
Money market accounts938,8081.44%764,6381.75%
Savings accounts17,7800.05%15,4770.05%
Time deposits less than $100,00048,7751.61%62,3711.85%
Time deposits greater than $100,000280,8892.06%309,3232.24%
Total deposits$1,905,7011.09%$1,661,6791.31%

During the three months ended March 31, 2020, our average transaction account balances increased by $286.1 million, or 22.2%, from the three months ended March 31, 2019, while our average time deposit balances decreased by $42.0 million, or 11.3%, during the same three-month period.

All of our time deposits are certificates of deposits. The maturity distribution of our time deposits of $100,000 or more at March 31, 2020 was as follows:

   
(dollars in thousands)March 31, 2020
Three months or less     $    56,241
Over three through six months54,008
Over six through twelve months142,352
Over twelve months31,902
Total$284,503

Included in time deposits of $100,000 or more at March 31, 2020 is $84.1 million of wholesale CDs scheduled to mature within the next 12 months at a weighted average rate of 1.90%. Time deposits that meet or exceed the FDIC insurance limit of $250,000 at March 31, 2020 and December 31, 2019 were $236.8 million and $220.1 million, respectively.

Liquidity and Capital Resources

Liquidity represents the ability of a company to convert assets into cash or cash equivalents without significant loss, and the ability to raise additional funds by increasing liabilities. Liquidity management involves monitoring our sources and uses of funds in order to meet our day-to-day cash flow requirements while maximizing profits. Liquidity management is made more complicated because different balance sheet components are subject to varying degrees of management control. For example, the timing of maturities of our investment portfolio is fairly predictable and subject to a high degree of control at the time investment decisions are made. However, net deposit inflows and outflows are far less predictable and are not subject to the same degree of control. We have not experienced any unusual pressure on our deposit balances or our liquidity position as a result of the COVID-19 pandemic.

At March 31, 2020 and December 31, 2019, cash and cash equivalents amounted to $141.1 million and $127.8 million, respectively, or 5.9% and 5.6% of total assets, respectively. Our investment securities at March 31, 2020 and December 31, 2019 amounted to $75.8 million and $74.6 million, respectively, or 3.2% and 3.3% of total assets, respectively.Investment securities traditionally provide a secondary source of liquidity since they can be converted into cash in a timely manner.

Our ability to maintain and expand our deposit base and borrowing capabilities serves as our primary source of liquidity. We plan to meet our future cash needs through the liquidation of temporary investments, the generation of deposits, loan payoffs, and from additional borrowings. In addition, we will receive cash upon the maturity and sale of loans and the maturity of investment securities. We maintain four federal funds purchased lines of credit with correspondent banks totaling $72.0 million for which there were no borrowings against the lines of credit at March 31, 2020.

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We are also a member of the FHLB, from which applications for borrowings can be made. The FHLB requires that securities, qualifying mortgage loans, and stock of the FHLB owned by the Bank be pledged to secure any advances from the FHLB. The unused borrowing capacity currently available from the FHLB at March 31, 2020 was $385.9 million, based on the Bank’s $4.8 million investment in FHLB stock, as well as qualifying mortgages available to secure any future borrowings. However, we are able to pledge additional securities to the FHLB in order to increase our available borrowing capacity. In addition, at March 31, 2020 and December 31, 2019 we had $229.3 million and $238.1 million, respectively, of letters of credit outstanding with the FHLB to secure client deposits.

We also have a line of credit with another financial institution for $15.0 million, which was unused at March 31, 2020. The line of credit bears interest at LIBOR plus 2.50% and matures on June 30, 2020. As noted in Note 1 – Nature of Business and Basis of Presentation, we have utilized $15.0 million of the line subsequent to March 31, 2020.

We believe that our existing stable base of core deposits, federal funds purchased lines of credit with correspondent banks, and borrowings from the FHLB will enable us to successfully meet our long-term liquidity needs. However, as short-term liquidity needs arise, we have the ability to sell a portion of our investment securities portfolio to meet those needs.

Total shareholders’ equity was $210.5 million at March 31, 2020 and $205.9 million at December 31, 2019. The $4.6 million increase from December 31, 2019 is primarily related to net income of $2.8 million during the first three months of 2020, stock option exercises and expenses of $1.1 million, and $708,000 in other comprehensive income.

The following table shows the return on average assets (net income divided by average total assets), return on average equity (net income divided by average equity), equity to assets ratio (average equity divided by average assets), and tangible common equity ratio (total equity less preferred stock divided by total assets) annualized for the three months ended March 31, 2020 and the year ended December 31, 2019. Since our inception, we have not paid cash dividends.

     
March 31, 2020December 31, 2019
Return on average assets     0.51%     1.35%
Return on average equity5.42%14.72%
Return on average common equity5.42%14.72%
Average equity to average assets ratio9.42%9.16%
Tangible common equity to assets ratio          8.87%               9.08%

Under the capital adequacy guidelines, regulatory capital is classified into two tiers. These guidelines require an institution to maintain a certain level of Tier 1 and Tier 2 capital to risk-weighted assets. Tier 1 capital consists of common shareholders’ equity, excluding the unrealized gain or loss on securities available for sale, minus certain intangible assets. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, are multiplied by a risk-weight factor of 0% to 100% based on the risks believed to be inherent in the type of asset. Tier 2 capital consists of Tier 1 capital plus the general reserve for loan losses, subject to certain limitations. We are also required to maintain capital at a minimum level based on total average assets, which is known as the Tier 1 leverage ratio.

Regulatory capital rules adopted in July 2013 and fully-phased in as of January 1, 2019, which we refer to Basel III, impose minimum capital requirements for bank holding companies and banks. The Basel III rules apply to all national and state banks and savings associations regardless of size and bank holding companies and savings and loan holding companies other than “small bank holding companies,” generally holding companies with consolidated assets of less than $3 billion (such as the Company). In order to avoid restrictions on capital distributions or discretionary bonus payments to executives, a covered banking organization must maintain a “capital conservation buffer” on top of our minimum risk-based capital requirements. This buffer must consist solely of common equity Tier 1, but the buffer applies to all three measurements (common equity Tier 1, Tier 1 capital and total capital). The capital conservation buffer consists of an additional amount of CET1 equal to 2.5% of risk-weighted assets.

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To be considered “well-capitalized” for purposes of certain rules and prompt corrective action requirements, the Bank must maintain a minimum total risked-based capital ratio of at least 10%, a total Tier 1 capital ratio of at least 8%, a common equity Tier 1 capital ratio of at least 6.5%, and a leverage ratio of at least 5%. As of March 31, 2020, our capital ratios exceed these ratios and we remain “well capitalized.”

The following table summarizes the capital amounts and ratios of the Bank and the regulatory minimum requirements.

   
March 31, 2020
For capitalTo be well capitalized
adequacy purposesunder prompt
minimum plus thecorrective
capital conservationaction provisions
Actualbufferminimum
(dollars in thousands)AmountRatioAmountRatioAmountRatio
Total Capital (to risk weighted assets)    $259,896    13.16%    158,033    10.50%    197,542    10.00%
Tier 1 Capital (to risk weighted assets)237,43312.02%118,5258.50%158,0338.00%
Common Equity Tier 1 Capital (to risk weighted assets)237,43312.02%88,8947.00%128,4026.50%
Tier 1 Capital (to average assets)237,43310.64%89,2554.00%111,5695.00%
 
               
  December 31, 2019
For capitalTo be well capitalized
adequacy purposesunder prompt
minimum plus thecorrective
capital conservationaction provisions
Actualbufferminimum
(dollars in thousands)AmountRatioAmountRatioAmountRatio
Total Capital (to risk weighted assets)$     250,84713.31%$     150,80710.50%$        188,51010.00%
Tier 1 Capital (to risk weighted assets)234,20512.42%113,1068.50%150,8078.00%
Common Equity Tier 1 Capital (to risk weighted assets)234,20512.42%84,8297.00%122,5316.50%
Tier 1 Capital (to average assets)234,20510.80%86,7724.00%108,4655.00%

The following table summarizes the capital amounts and ratios of the Company and the minimum regulatory requirements.

              
March 31, 2020
For capitalTo be well capitalized
adequacy purposesunder prompt
minimum plus thecorrective
capital conservationaction provisions
Actualbuffer(1)minimum
(dollars in thousands)AmountRatioAmountRatioAmountRatio
Total Capital (to risk weighted assets)    $268,528    13.59%            158,033    10.50%    N/A    N/A
Tier 1 Capital (to risk weighted assets)223,06511.29%118,5258.50%N/AN/A
Common Equity Tier 1 Capital (to risk weighted assets)210,06510.63%88,8947.00%N/AN/A
Tier 1 Capital (to average assets)223,06510.00%89,2554.00%                    N/AN/A

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December 31, 2019
For capitalTo be well capitalized
adequacy purposesunder prompt
minimumcorrective
plus the capitalaction provisions
Actualconservation buffer(1)minimum
(dollars in thousands)AmountRatioAmountRatioAmountRatio
Total Capital (to risk weighted assets)    $258,800    13.73%    $150,807    10.50%    N/A    N/A
Tier 1 Capital (to risk weighted assets)219,15811.63%113,1068.50%N/AN/A
Common Equity Tier 1 Capital (to risk weighted assets)206,15810.94%84,8297.00%N/AN/A
Tier 1 Capital (to average assets)219,15810.10%86,7724.00%                  N/AN/A
       (1)       

Under the Federal Reserve’s Small Bank Holding Company Policy Statement, the Company is not subject to the minimum capital adequacy and capital conservation buffer capital requirements at the holding company level, unless otherwise advised by the Federal Reserve (such capital requirements are applicable only at the Bank level). Although the minimum regulatory capital requirements are not applicable to the Company, we calculate these ratios for our own planning and monitoring purposes.

The ability of the Company to pay cash dividends is dependent upon receiving cash in the form of dividends from the Bank. The dividends that may be paid by the Bank to the Company are subject to legal limitations and regulatory capital requirements. Since our inception, we have not paid cash dividends.

Effect of Inflation and Changing Prices

The effect of relative purchasing power over time due to inflation has not been taken into account in our consolidated financial statements. Rather, our financial statements have been prepared on an historical cost basis in accordance with generally accepted accounting principles.

Unlike most industrial companies, our assets and liabilities are primarily monetary in nature. Therefore, the effect of changes in interest rates will have a more significant impact on our performance than will the effect of changing prices and inflation in general. In addition, interest rates may generally increase as the rate of inflation increases, although not necessarily in the same magnitude. As discussed previously, we seek to manage the relationships between interest sensitive assets and liabilities in order to protect against wide rate fluctuations, including those resulting from inflation.

Off-Balance Sheet Risk

Commitments to extend credit are agreements to lend money to a client as long as the client has not violated any material condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee. At March 31, 2020, unfunded commitments to extend credit were $458.7 million, of which $137.6 million were at fixed rates and $321.1 million were at variable rates. At December 31, 2019, unfunded commitments to extend credit were $426.6 million, of which approximately $105.0 million were at fixed rates and $321.7 million were at variable rates. A significant portion of the unfunded commitments related to consumer equity lines of credit. We evaluate each client’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by us upon extension of credit, is based on our credit evaluation of the borrower. The type of collateral varies but may include accounts receivable, inventory, property, plant and equipment, and commercial and residential real estate.

At March 31, 2020 and December 31, 2019, there were commitments under letters of credit for $9.3 million and $9.9 million, respectively. The credit risk and collateral involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Since most of the letters of credit are expected to expire without being drawn upon, they do not necessarily represent future cash requirements.

Except as disclosed in this report, we are not involved in off-balance sheet contractual relationships, unconsolidated related entities that have off-balance sheet arrangements or transactions that could result in liquidity needs or other commitments that significantly impact earnings.

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Market Risk and Interest Rate Sensitivity

Market risk is the risk of loss from adverse changes in market prices and rates, which principally arises from interest rate risk inherent in our lending, investing, deposit gathering, and borrowing activities. Other types of market risks, such as foreign currency exchange rate risk and commodity price risk, do not generally arise in the normal course of our business.

We actively monitor and manage our interest rate risk exposure in order to control the mix and maturities of our assets and liabilities utilizing a process we call asset/liability management. The essential purposes of asset/liability management are to ensure adequate liquidity and to maintain an appropriate balance between interest sensitive assets and liabilities in order to minimize potentially adverse impacts on earnings from changes in market interest rates. Our asset/liability management committee (“ALCO”) monitors and considers methods of managing exposure to interest rate risk. We have both an internal ALCO consisting of senior management that meets at various times during each month and a board ALCO that meets monthly. The ALCOs are responsible for maintaining the level of interest rate sensitivity of our interest sensitive assets and liabilities within board-approved limits.

As of March 31, 2020, the following table summarizes the forecasted impact on net interest income using a base case scenario given upward and downward movements in interest rates of 100, 200, and 300 basis points based on forecasted assumptions of prepayment speeds, nominal interest rates and loan and deposit repricing rates. Estimates are based on current economic conditions, historical interest rate cycles and other factors deemed to be relevant. However, underlying assumptions may be impacted in future periods which were not known to management at the time of the issuance of the Consolidated Financial Statements. Therefore, management’s assumptions may or may not prove valid. No assurance can be given that changing economic conditions and other relevant factors impacting our net interest income will not cause actual occurrences to differ from underlying assumptions. In addition, this analysis does not consider any strategic changes to our balance sheet which management may consider as a result of changes in market conditions.

Interest rate scenario     Change in net interest
income from base
Up 300 basis points2.87%
Up 200 basis points1.31%
Up 100 basis points0.12%
Base-
Down 100 basis points1.58%
Down 200 basis points4.68%
Down 300 basis points                  5.60%

Critical Accounting Policies

We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States and with general practices within the banking industry in the preparation of our financial statements. Our significant accounting policies are described in the footnotes to our audited consolidated financial statements as of December 31, 2019, as filed in our Annual Report on Form 10-K.

Certain accounting policies involve significant judgments and assumptions by us that have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgment and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Our Critical Accounting Policies are the allowance for loan losses, fair value of financial instruments and income taxes. Because of the nature of the judgment and assumptions we make, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of our assets and liabilities and our results of operations. A brief discussion of each of these areas appears in our 2019 Annual Report on Form 10-K. During the first three months of 2020, we did not significantly alter the manner in which we applied our Critical Accounting Policies or developed related assumptions and estimates.

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Accounting, Reporting, and Regulatory Matters

See Note 1 – Nature of Business and Basis of Presentation in the accompanying condensed notes to consolidated financial statements included elsewhere in this report for details of recently issued accounting pronouncements and their expected impact on our consolidated financial statements.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on the consolidated financial statements upon adoption.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
As a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide information required by this Item.

Item 4. CONTROLS AND PROCEDURES.
Evaluation of Disclosure Controls and Procedures

Management, including our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports we file and submit under the Exchange Act is (i) recorded, processed, summarized and reported as and when required and (ii) accumulated and communicated to our management, including our Chief Executive Officer and the Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

There has been no change in the Company’s internal control over financial reporting during the three months ended March 31, 2020, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS.
We are a party to claims and lawsuits arising in the course of normal business activities. Management is not aware of any material pending legal proceedings against the Company which, if determined adversely, would have a material adverse impact on the company’s financial position, results of operations or cash flows.

Item 1A. RISK FACTORS.
Investing in shares of our common stock involves certain risks, including those identified and described in Item 1A. of our Annual Report on Form 10-K for the fiscal year ended December 31, 2019, as well as cautionary statements contained in this Quarterly Report on Form 10-Q, including those under the caption “Cautionary Warning Regarding Forward-Looking Statements” set forth in Part I, Item 2 of this Quarterly Report on Form 10-Q, risks and matters described elsewhere in this Quarterly Report on Form 10-Q and in our other filings with the SEC.

We are providing this additional risk factor to supplement the risk factors contained in Item 1A. of our Annual Report on Form 10-K for the year ended December 31, 2019.

The COVID-19 pandemic has adversely affected our business, financial condition and results of operations, and the ultimate impacts of the pandemic on our business, financial condition and results of operations will depend on future developments and other factors that are highly uncertain and will be impacted by the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic.

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The ongoing COVID-19 global and national health emergency has caused significant disruption in the international and United States economies and financial markets and has had an adverse effect on our business, financial condition and results of operations. The spread of COVID-19 has caused illness, quarantines, cancellation of events and travel, business and school shutdowns, reduction in business activity and financial transactions, supply chain interruptions and overall economic and financial market instability. In response to the COVID-19 pandemic, the governments of the states in which we have retail offices, and of most other states, have taken preventative or protective actions, such as imposing restrictions on travel and business operations, advising or requiring individuals to limit or forego their time outside of their homes, and ordering temporary closures of businesses that have been deemed to be non-essential. These restrictions and other consequences of the pandemic have resulted in significant adverse effects for many different types of businesses, including, among others, those in the travel, hospitality and food and beverage industries, and have resulted in a significant number of layoffs and furloughs of employees nationwide and in the regions in which we operate.

The ultimate effects of COVID-19 on the broader economy and the markets that we serve are not known nor is the ultimate length of the restrictions described above and any accompanying effects. Moreover, the Federal Reserve has taken action to lower the Federal Funds rate, which may negatively affect our interest income and, therefore, earnings, financial condition and results of operation. Additional impacts of COVID-19 on our business could be widespread and material, and may include, or exacerbate, among other consequences, the following:

employees contracting COVID-19;
reductions in our operating effectiveness as our employees work from home;
a work stoppage, forced quarantine, or other interruption of our business;
unavailability of key personnel necessary to conduct our business activities;
effects on key employees, including operational management personnel and those charged with preparing, monitoring and evaluating our financial reporting and internal controls;
sustained closures of our branch lobbies or the offices of our customers;
declines in demand for loans and other banking services and products;
reduced consumer spending due to both job losses and other effects attributable to COVID-19;
unprecedented volatility in United States financial markets;
volatile performance of our investment securities portfolio;
decline in the credit quality of our loan portfolio, owing to the effects of COVID-19 in the markets we serve, leading to a need to increase our allowance for loan losses;
declines in value of collateral for loans, including real estate collateral;
declines in the net worth and liquidity of borrowers and loan guarantors, impairing their ability to honor commitments to us; and
declines in demand resulting from businesses being deemed to be “non-essential” by governments in the markets we serve, and from “non-essential” and “essential” businesses suffering adverse effects from reduced levels of economic activity in our markets.

These factors, together or in combination with other events or occurrences that may not yet be known or anticipated, may materially and adversely affect our business, financial condition and results of operations.

The ongoing COVID-19 pandemic has resulted in meaningfully lower stock prices for many companies, as well as the trading prices for many other securities. The further spread of the COVID-19 outbreak, as well as ongoing or new governmental, regulatory and private sector responses to the pandemic, may materially disrupt banking and other economic activity generally and in the areas in which we operate. This could result in further decline in demand for our banking products and services, and could negatively impact, among other things, our liquidity, regulatory capital and our growth strategy. Any one or more of these developments could have a material adverse effect on our business, financial condition and results of operations.

We are taking precautions to protect the safety and well-being of our employees and customers. However, no assurance can be given that the steps being taken will be adequate or deemed to be appropriate, nor can we predict the level of disruption which will occur to our employee’s ability to provide customer support and service. If we are unable to recover from a business disruption on a timely basis, our business, financial condition and results of operations could be materially and adversely affected. We may also incur additional costs to remedy damages caused by such disruptions, which could further adversely affect our business, financial condition and results of operations.

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As a participating lender in the SBA Paycheck Protection Program (“PPP”), the Company and the Bank are subject to additional risks of litigation from the Bank’s clients or other parties regarding the Bank’s processing of loans for the PPP and risks that the SBA may not fund some or all PPP loan guaranties.

On March 27, 2020, President Trump signed the CARES Act, which included a $349 billion loan program administered through the SBA referred to as the PPP. Under the PPP, small businesses and other entities and individuals can apply for loans from existing SBA lenders and other approved regulated lenders that enroll in the program, subject to numerous limitations and eligibility criteria. The Bank is participating as a lender in the PPP. The PPP opened on April 3, 2020; however, because of the short timeframe between the passing of the CARES Act and the opening of the PPP, there is some ambiguity in the laws, rules and guidance regarding the operation of the PPP, which exposes the Company to risks relating to noncompliance with the PPP. On or about April 16, 2020, the SBA notified lenders that the $349 billion earmarked for the PPP was exhausted. Congress has approved additional funding for the PPP and President Trump signed the new legislation on April 24, 2020. Since the opening of the PPP, several other larger banks have been subject to litigation regarding the process and procedures that such banks used in processing applications for the PPP. The Company and the Bank may be exposed to the risk of litigation, from both clients and non-clients that approached the Bank regarding PPP loans, regarding its process and procedures used in processing applications for the PPP. If any such litigation is filed against the Company or the Bank and is not resolved in a manner favorable to the Company or the Bank, it may result in significant financial liability or adversely affect the Company’s reputation. In addition, litigation can be costly, regardless of outcome. Any financial liability, litigation costs or reputational damage caused by PPP related litigation could have a material adverse impact on our business, financial condition and results of operations.

The Bank also has credit risk on PPP loans if a determination is made by the SBA that there is a deficiency in the manner in which the loan was originated, funded, or serviced by the Bank, such as an issue with the eligibility of a borrower to receive a PPP loan, which may or may not be related to the ambiguity in the laws, rules and guidance regarding the operation of the PPP. In the event of a loss resulting from a default on a PPP loan and a determination by the SBA that there was a deficiency in the manner in which the PPP loan was originated, funded, or serviced by the Company, the SBA may deny its liability under the guaranty, reduce the amount of the guaranty, or, if it has already paid under the guaranty, seek recovery of any loss related to the deficiency from the Company.

Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

(a)

Not applicable.

(b)

Not applicable.

(c)

Issuer Purchases of Registered Equity Securities

The following table reflects share repurchase activity during the first quarter of 2020:

(d) Maximum
(c) TotalNumber (or
Number ofApproximate
Shares (orDollar Value) of
Units)Shares (or
(a) TotalPurchased asUnits) that May
Number ofPart of PubliclyYet Be
Shares (or(b) AverageAnnouncedPurchased
Units)Price Paid perPlans orUnder the Plans
Period     Purchased     Share (or Unit)     Programs     or Programs
January 1 - January 31-$---
February 1 - February 29----
March 1 - March 31---383,650
Total--       383,650*

*On March 11, 2020, the Company announced a share repurchase plan allowing us to repurchase up to 383,650 shares of our common stock (the “Repurchase Plan”). As of March 31, 2020, we have not repurchased any of the shares authorized for repurchase under the Repurchase Plan. The Company is not obligated to purchase any such shares under the Repurchase Plan, and the Repurchase Plan may be discontinued, suspended or restarted at any time; however, repurchases under the Repurchase Plan after December 31, 2020 would require additional approval of our Board of Directors and the Federal Reserve.

Item 3. DEFAULTS UPON SENIOR SECURITIES.
None.

Item 4. MINE SAFETY DISCLOSURES.
Not applicable.

Item 5. OTHER INFORMATION.
None.

Item 6. EXHIBITS.
The exhibits required to be filed as part of this Quarterly Report on Form 10-Q are listed in the Index to Exhibits attached hereto and are incorporated herein by reference.

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INDEX TO EXHIBITS

Exhibit
Number
     Description
31.1Rule 13a-14(a) Certification of the Principal Executive Officer.
 
31.2Rule 13a-14(a) Certification of the Principal Financial Officer.
 
32Section 1350 Certifications.
 
101The following materials from the Quarterly Report on Form 10-Q of Southern First Bancshares, Inc. for the quarter ended March 31, 2020, formatted in eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Income, (iii) Consolidated Statements of Comprehensive Income, (iv) Consolidated Statement of Changes in Shareholders’ Equity, (v) Consolidated Statements of Cash Flows and (vi) Notes to Unaudited Consolidated Financial Statements.

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SIGNATURES

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

SOUTHERN FIRST BANCSHARES, INC.
Registrant
 
Date: April 28, 2020/s/R. Arthur Seaver, Jr.                    
R. Arthur Seaver, Jr.
Chief Executive Officer (Principal Executive Officer)
 
Date: April 28, 2020/s/Michael D. Dowling                    
Michael D. Dowling
Chief Financial Officer (Principal Financial and Accounting Officer)

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