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FSBW FS Bancorp

Filed: 16 Mar 21, 3:54pm
0001530249us-gaap:FairValueInputsLevel3Memberus-gaap:FairValueMeasurementsNonrecurringMember2019-12-31

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark one)

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

For the fiscal year ended December 31, 2020         OR

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

Commission File Number: 001-35589

FS BANCORP, INC.

(Exact name of registrant as specified in its charter)

Washington

45-4585178

(State or other jurisdiction of incorporation or organization)

(I.R.S. Employer Identification Number)

6920 220th Street SW, Mountlake Terrace, Washington

98043

(Address of principal executive offices)

(Zip Code)

Registrant’s telephone number, including area code:

(425) 771-5299

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 Stock, $0.01 par value per share

FSBW

The NASDAQ Stock Market LLC

Securities Registered Pursuant to Section 12(g) of the Act: None

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes    No

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes    No

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

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

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

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller reporting company

Emerging growth company

If an emerging growth company, indicate by 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 has filed a report on and attestation to its management’s assessment of the effectiveness of

its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report.

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

As of March 5, 2021, there were 4,233,040 shares of the Registrant’s common stock outstanding. The aggregate market value of the common stock held by non-affiliates of the Registrant was $147,557,403, based on the closing sales price of $38.57 per share of the Registrant’s common stock as quoted on the NASDAQ Stock Market LLC on June 30, 2020. For purposes of this calculation, common stock held by executive officers and directors of the Registrant is considered to be held by affiliates.

DOCUMENTS INCORPORATED BY REFERENCE

1.

Portions of the definitive Proxy Statement for the 2021 Annual Meeting of Shareholders (“Proxy Statement”) are incorporated by reference into Part III.

FS Bancorp, Inc.

Table of Contents

Page

PART I

Item 1.

Business:

5

General

5

Market Area

6

Lending Activities

8

Loan Originations, Servicing, Purchases and Sales

18

Asset Quality

21

Allowance for Loan Losses

24

Investment Activities

28

Deposit Activities and Other Sources of Funds

30

Subsidiary and Other Activities

34

Competition

34

Employees

35

How We Are Regulated

39

Taxation

47

Item 1A.

Risk Factors

48

Item 1B.

Unresolved Staff Comments

63

Item 2.

Properties

63

Item 3.

Legal Proceedings

63

Item 4.

Mine Safety Disclosures

63

PART II

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

64

Item 6.

Selected Financial Data

66

Item 7.

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

68

Overview

68

Critical Accounting Policies and Estimates

71

Our Business and Operating Strategy and Goals

73

Comparison of Financial Condition at December 31, 2020 and December 31, 2019

74

Average Balances, Interest and Average Yields/Costs

78

Rate/Volume Analysis

79

Comparison of Results of Operations for the Years Ended December 31, 2020 and December 31, 2019

79

Asset and Liability Management and Market Risk

83

Liquidity

85

Commitments and Off-Balance Sheet Arrangements

86

Capital Resources

86

Recent Accounting Pronouncements

87

Item 7A.

Quantitative and Qualitative Disclosures about Market Risk

87

Item 8.

Financial Statements and Supplementary Data

87

Item 9.

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

142

Item 9A.

Controls and Procedures

142

Item 9B.

Other Information

143

i

Page

PART III

Item 10.

Directors, Executive Officers and Corporate Governance

143

Item 11.

Executive Compensation

144

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

144

Item 13.

Certain Relationships and Related Transactions, and Director Independence

145

Item 14.

Principal Accounting Fees and Services

145

PART IV

Item 15.

Exhibits and Financial Statement Schedules

146

Item 16.

Form 10-K Summary

147

SIGNATURES

148

As used in this report, the terms “we,” “our,” “us,” “Company”, and “FS Bancorp” refer to FS Bancorp, Inc. and its consolidated subsidiary, 1st Security Bank of Washington, unless the context indicates otherwise. When we refer to “Bank” in this report, we are referring to 1st Security Bank of Washington, the wholly owned subsidiary of FS Bancorp.

ii

Forward-Looking Statements

This Form 10-K contains forward-looking statements, which can be identified by the use of words such as “believes,” “expects,” “anticipates,” “estimates” or similar expressions. Forward-looking statements include, but are not limited to:

statements of our goals, intentions and expectations;
statements regarding our business plans, prospects, growth, and operating strategies;
statements regarding the quality of our loan and investment portfolios; and
estimates of our risks and future costs and benefits.

These forward-looking statements are subject to significant risks and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:

the effect of the COVID-19 pandemic, including on the Company’s credit quality and business operations, as well as its impact on general economic and financial market conditions and other uncertainties resulting from the COVID-19 pandemic, such as the extent and duration of the impact on public health, the U.S. and global economies, and consumer and corporate customers, including economic activity, employment levels and market liquidity;
general economic conditions, either nationally or in our market area, that are worse than expected;
the credit risks of lending activities, including changes in the level and trend of loan delinquencies, write offs, changes in our allowance for loan losses, and provision for loan losses that may be impacted by deterioration in the housing and commercial real estate markets;
secondary market conditions and our ability to originate loans for sale and sell loans in the secondary market;
fluctuations in the demand for loans, the number of unsold homes, land and other properties, and fluctuations in real estate values in our market area;
staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges;
the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation;
changes in the interest rate environment that reduce our interest margins or reduce the fair value of financial instruments;
uncertainty regarding the future of the London Interbank Offered Rate (“LIBOR”), and the potential transition away from LIBOR toward new interest rate benchmarks;
increased competitive pressures among financial services companies;
our ability to execute our plans to grow our residential construction lending, our home lending operations, our warehouse lending, and the geographic expansion of our indirect home improvement lending;
our ability to attract and retain deposits;
our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we may in the future acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames and any goodwill charges related thereto;

iii

our ability to control operating costs and expenses;
our ability to retain key members of our senior management team;
changes in consumer spending, borrowing, and savings habits;
our ability to successfully manage our growth;
legislative or regulatory changes that adversely affect our business, including the effect of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd Frank Act”), changes in regulation policies and principles, an increase in regulatory capital requirements or change in the interpretation of regulatory capital or other rules, including as a result of Basel III;
adverse changes in the securities markets;
changes in accounting policies and practices, as may be adopted by the bank regulatory agencies, the Public Company Accounting Oversight Board, or the Financial Accounting Standards Board (“FASB”), including as a result of the Coronavirus Aid, Relief, and Economic Security Act of 2020 (“CARES Act”) and the Consolidated Appropriations Act, 2021 (“CAA 2021”);
costs and effects of litigation, including settlements and judgments;
disruptions, security breaches, or other adverse events, failures, or interruptions in, or attacks on, our information technology systems or on the third-party vendors who perform several of our critical processing functions;
inability of key third-party vendors to perform their obligations to us; and
other economic, competitive, governmental, regulatory, and technical factors affecting our operations, pricing, products, and services, including as a result of the CARES Act and the CAA 2021 and recent COVID-19 vaccination efforts, and other risks described elsewhere in this Form 10-K and our other reports filed with the U.S. Securities and Exchange Commission (“SEC”).

Any of the forward-looking statements made in this Form 10-K and in other public statements may turn out to be wrong because of inaccurate assumptions we might make, because of the factors illustrated above or because of other factors that we cannot foresee. Forward-looking statements are based upon management’s beliefs and assumptions at the time they are made. The Company undertakes no obligation to update or revise any forward-looking statement included in this report or to update the reasons why actual results could differ from those contained in such statements, whether as a result of new information, future events or otherwise. In light of these risks, uncertainties and assumptions, the forward-looking statements discussed in this report might not occur and you should not put undue reliance on any forward-looking statements.

Available Information

The Company provides a link on its investor information page at www.fsbwa.com to filings with the SEC for purposes of providing copies of its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to these reports, as soon as reasonably practicable after we have electronically filed such material with, or furnished such material to the SEC. Other than an investor’s own internet access charges, these filings are free of charge and available through the SEC’s website at www.sec.gov. The information contained on the Company’s website is not included as part of, or incorporated by reference into, this Annual Report on Form 10-K.

iv

PART 1

Item 1. Business

General

FS Bancorp, Inc. (“FS Bancorp” or the “Company”), a Washington corporation, was organized in September 2011 for the purpose of becoming the holding company of 1st Security Bank of Washington (“1st Security Bank of Washington” or  the “Bank”) upon the Bank’s conversion from a mutual to a stock savings bank (“Conversion”). The Conversion was completed on July 9, 2012. At December 31, 2020, the Company had consolidated total assets of $2.11 billion, total deposits of $1.67 billion, and stockholders’ equity of $230.0 million. The Company has not engaged in significant activity other than holding the stock of the Bank. Accordingly, the information set forth in this Annual Report on Form 10-K (“Form 10-K”), including the consolidated financial statements and related data, relates primarily to the Bank.

1st Security Bank of Washington is a relationship-driven community bank. The Bank delivers banking and financial services to local families, local and regional businesses and industry niches within distinct Puget Sound area communities. The Bank emphasizes long-term relationships with families and businesses within the communities served, working with them to meet their financial needs. The Bank is also actively involved in community activities and events within these market areas, which further strengthens relationships within these markets. The Bank has been serving the Puget Sound area since 1907. Originally chartered as a credit union, and known as Washington’s Credit Union, the Bank served various select employment groups. On April 1, 2004, the Bank converted from a credit union to a Washington state-chartered mutual savings bank. Upon completion of the Conversion in July 2012, 1st Security Bank of Washington became a Washington state-chartered stock savings bank and the wholly owned subsidiary of the Company.

At December 31, 2020, the Bank maintained the headquarters office that produces loans and accepts deposits located in Mountlake Terrace, Washington, and an administrative office in Aberdeen, Washington, as well as 21 full-service bank branches and nine home loan production offices in suburban communities in the greater Puget Sound area. The Bank also has one home loan production office in the Tri-Cities, Washington.  

The Company is a diversified lender with a focus on the origination of one-to-four-family, commercial real estate, consumer, including indirect home improvement (“fixture secured loans”),  solar and marine lending, commercial business and second mortgage or home equity loans. Historically, consumer loans, in particular fixture secured loans represented the largest portion of the Company’s loan portfolio and the mainstay of the Company’s lending strategy.  In recent years, the Company has placed more of an emphasis on real estate lending products, such as one-to-four-family, commercial real estate, including speculative residential construction, as well as commercial business loans, while growing the current size of the consumer loan portfolio. The Company reintroduced in-house originations of residential mortgage loans in 2012, primarily for sale into the secondary market, through a mortgage banking program. The Company’s lending strategies are intended to take advantage of: (1) the Company’s historical strength in indirect consumer lending, (2) recent market consolidation that has created new lending opportunities, and (3) relationship lending. Retail deposits will continue to serve as an important funding source. For more information regarding the business and operations of 1st Security Bank of Washington, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-K.

In March 2020, the outbreak of COVID-19 was recognized as a pandemic by the World Health Organization. The spread of COVID-19 has created a global public health crisis that has resulted in unprecedented uncertainty, volatility and disruption in financial markets and in governmental, commercial and consumer activity in the United States and globally, including the markets that we serve. Governmental responses to the pandemic have included orders to close businesses not deemed essential and directing individuals to restrict their movements, observe social distancing and shelter in place. These actions, together with responses to the pandemic by businesses and individuals, have resulted in rapid decreases in commercial and consumer activity, both temporary and permanent and closures of many businesses, a rapid increase in unemployment, material decreases in business valuations, disrupted global supply chains, market downturns and volatility, changes in consumer behavior related to pandemic fears, related emergency response legislation and an expectation that the Board of Governors of the Federal Reserve System (“Federal Reserve”) will maintain a low interest rate environment for the foreseeable future. Although financial markets have rebounded from significant declines that

5

occurred earlier in the pandemic and global economic conditions showed signs of improvement beginning during the second quarter of 2020, many of the effects that arose or became more pronounced after the onset of the COVID-19 pandemic have persisted through the end of the year. These changes have had and are likely to continue to have a significant adverse effect on the markets in which we conduct our business and the demand for our products and services. See "Risk Factors - Risks Related to Macroeconomic Conditions-The COVID-19 pandemic has impacted the way we conduct business which may adversely impact our financial results and those of our customers. The ultimate impact will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic.”

During the year ended December 31, 2020, the Bank participated in the U.S. Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”), a guaranteed unsecured loan program enacted under the CARES Act, enacted March 27, 2020, to provide near-term relief to help small businesses impacted by COVID-19 sustain operations The deadline for PPP loan applications to the SBA was initially August 8, 2020.  Under this program we funded applications totaling $75.8 million of loans in our market areas and began processing applications for loan forgiveness in the fourth quarter of 2020.  As of December 31, 2020, we had received SBA forgiveness on 66 PPP loans totaling $12.0 million resulting in a remaining 423 PPP loans with an aggregate balance of $62.1 million. The CAA 2021 enacted in December 2020 renewed and extended the PPP until March 31, 2021 by authorizing an additional $284.5 billion for the program for eligible small businesses and nonprofits.  As a result, the Bank began originating PPP loans again in January 2021.

In addition, the Bank is continuing to offer payment and financial relief programs for borrowers impacted by COVID-19. These programs include short-term (e.g. less than six months) modifications such as payment deferrals, interest only payment periods, fee waivers, extensions of repayment terms, or other delays in payment. As of December 31, 2020, the amount of portfolio loans remaining under payment/relief agreements includes commercial real estate loans of $31.2 million, commercial business loans of $12.8 million, a portfolio one-to-four-family loan of $308,000, and consumer loans of $392,000. Since these loans were performing loans that were current on their payments prior to the COVID-19 pandemic, these modifications are not considered to be troubled debt restructurings through December 31, 2020 pursuant to applicable accounting and regulatory guidance.  On December 27, 2020, the CAA 2021was signed into law. Among other purposes, this Act provides additional coronavirus emergency response and relief, including extending relief offered under the CARES Act related to troubled debt restructurings as a result of COVID-19 through January 1, 2022 or 60 days after the end of the national emergency declared by the President, whichever is earlier.  For additional discussion of impacts to our business from the COVID-19 pandemic, see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Highlights in Response to the COVID-19 Pandemic” and “Note 3 - Loans Receivable and Allowance for Loan Losses” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10 K.

1st Security Bank of Washington is examined and regulated by the Washington State Department of Financial Institutions (“DFI”), its primary regulator, and by the Federal Deposit Insurance Corporation (“FDIC”). 1st Security Bank of Washington is required to have certain reserves set by the Federal Reserve and is a member of the Federal Home Loan Bank of Des Moines (“FHLB” or “FHLB of Des Moines”), which is one of the 11 regional banks in the Federal Home Loan Bank System.

The principal executive offices of the Company are located at 6920 220th Street SW, Mountlake Terrace, Washington 98043 and the main telephone number is (425) 771-5299.

Market Area

The Company conducts operations, including loan and/or deposit services, out of its headquarters, nine home loan production offices (four of which stand-alone), and 21 full-service bank branches in the Puget Sound region of Washington, and one stand-alone loan production office in Eastern Washington. The headquarters is located in Mountlake Terrace, in Snohomish County, Washington. The four stand-alone home lending offices in the Puget Sound region are located in Puyallup, in Pierce County, Bellevue, in King County, Port Orchard, in Kitsap County, Everett, in Snohomish County, and the one in Eastern Washington located in the Tri-Cities (Kennewick), in Benton County, Washington. The 21 full-service bank branches are located in the following counties: three in Snohomish, two in King, two in Clallam, two in Jefferson, two in Pierce, five in Grays Harbor, two in Thurston, one in Lewis, and two in Kitsap County.

6

The primary market area for business operations is the Seattle-Tacoma-Bellevue, Washington Metropolitan Statistical Area (the “Seattle MSA”).  Kitsap, Clallam, Jefferson, Thurston, Lewis, and Grays Harbor counties, though not in the Seattle MSA, are also part of the Company’s market area. This overall region is typically known as the Puget Sound region. The population of the Puget Sound region as estimated by Puget Sound Regional Council was 4.3 million in 2020, over half of the state’s population, representing a large population base for potential business. The region has a well-developed urban area in the western portion along Puget Sound, with the north, central and eastern portions containing a mixture of developed residential and commercial neighborhoods and undeveloped, rural neighborhoods.

The Puget Sound region is the largest business center in both the State of Washington and the Pacific Northwest. Currently, key elements of the economy are aerospace, military bases, clean technology, biotechnology, education, information technology, logistics, international trade and tourism. The region is well known for the long presence of The Boeing Corporation and Microsoft, two major industry leaders, and for its leadership in technology. Amazon.com has expanded significantly in the Seattle downtown area. The workforce in general is well-educated and strong in technology. Washington State’s location with regard to the Pacific Rim, along with a deep-water port has made international trade a significant part of the regional economy. Tourism has also developed into a major industry for the area, due to the scenic beauty, temperate climate and easy accessibility.

King County, which includes the city of Seattle, has the largest employment base and overall level of economic activity. Six of the largest employers in the state are headquartered in King County including Microsoft Corporation, University of Washington, Amazon.com, King County Government, Starbucks, and Swedish Health Services. Pierce County is the second most populous county in the state and its economy is also well diversified with the presence of military related government employment (Joint Base Lewis-McChord), along with health care (the Multicare Health System and the Franciscan Health System). In addition, there is a large employment base in the economic sectors of shipping (the Port of Tacoma) and aerospace employment (Boeing). Snohomish County to the north has an economy based on aerospace employment (Boeing), health care (Providence Regional Medical Center), and military (the Everett Naval Station) along with additional employment concentrations in biotechnology, electronics/computers, and wood products.

In 2020, the median household income for King County was $95,000, compared to $74,000 for the State of Washington, and $62,000 for the United States.

The United States Navy is a key element for Kitsap County’s economy. The United States Navy is the largest employer in the county, with installations at Puget Sound Naval Shipyard, Naval Undersea Warfare Center Keyport and Naval Base Kitsap (which comprises former Naval Submarine Base Bangor, and Naval Station Bremerton). The largest private employers in the county are the Harrison Medical Center and Port Madison Enterprises.  Clallam County depends on agriculture, forestry, fishing, outdoor recreation and tourism.  Jefferson County’s largest private employer is Port Townsend Paper Mill and the largest employer overall (private and public) is Jefferson Healthcare.

Thurston County includes Olympia, home of Washington State’s capital and its economic base is largely driven by state government related employment.  In 2020, the median household income for Thurston County was $73,000.

Lewis County is supported by manufacturing, retail trade, local government and industrial services.  Grays Harbor County has been historically dependent on the timber and fishing industries, but also relies on tourism, manufacturing, agriculture, shipping, transportation, and technology.

Unemployment in Washington was an estimated 7.2% at December 31, 2020, closely paralleling national trends as disclosed in the U.S. Bureau of Labor Statistics reflecting the impact of COVID-19 over the prior year. King County’s estimated unemployment rate was 6.8%, an increase from 3.5% in the prior year. The estimated unemployment rate in Snohomish County at year end 2020 was 7.8%, an increase from 2.4% at year end 2019.  Kitsap County’s unemployment rate was 7.8% at December 31, 2020, compared to 4.1% at December 31, 2019.  At December 31, 2020, the estimated unemployment rate in Pierce County was 7.6%, up from 4.8% at December 31, 2019. Grays Harbor County’s, Thurston County’s, and Lewis County’s unemployment rates rose to 10.1%, 6.5%, and 7.4%, respectively at December 31, 2020, compared to 7.0%, 4.4%, and 6.0% at year end 2019, respectively. Outside of the Puget Sound area, the Tri-Cities market includes two counties, Benton and Franklin, and we have two full-service branches in Clallam County and two in Jefferson County. The estimated unemployment rate in Benton County at year end 2020 was 6.4%, up from 5.4% at year end 2019. At December 31, 2020, the estimated unemployment rate in Franklin County was slightly up to 7.4%, from 7.3% at

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December 31, 2019. For Clallam and Jefferson counties, the estimated unemployment rates at December 31, 2020 increased to 8.4% and 8.2%, respectively, compared to 6.3% and 5.3%, respectively at December 31, 2019.

According to the Washington Center for Real Estate Research, home values in the State of Washington continued to improve in 2020. For the quarter ended December 31, 2020, the average home value was $747,000 in King County, $574,000 in Snohomish County, $454,000 in Jefferson County, $439,000 in Pierce County, $438,000 in Kitsap County, $395,000 in Thurston County, $360,000 in Clallam County, $345,000 in both Benton and Franklin counties, $316,000 in Lewis County, and $265,000 in Grays Harbor County. Compared to the statewide average increase in home values of 16.0% in the fourth quarter of 2020, Lewis, Grays Harbor, and Pierce counties outperformed the state average with 24.1%, 22.6%, and 17.0%, respectively, with our remaining counties: Snohomish, Thurston, Kitsap, Benton, Franklin, Clallam, Jefferson, and King counties below the state average increase, with 15.9%, 14.0%, 12.5%, 12.1%, 12.1%, 12.1%, 11.9% and 11.3% increases in average home values, respectively.

For a discussion regarding the competition in the Company’s primary market area, see “Competition.”

Lending Activities

General. Historically, the Company’s primary emphasis was the origination of consumer loans (primarily indirect home improvement loans), one-to-four-family residential first mortgages, and second mortgage/home equity loan products. As a result of the Company’s initial public offering in 2012, while maintaining the active indirect consumer lending program, the Company shifted its lending focus to include non-mortgage commercial business loans, as well as commercial real estate which includes construction and development loans. The Company reintroduced in-house originations of residential mortgage loans in 2012, primarily for sale in the secondary market. While maintaining the Company’s historical strength in consumer lending, the Company has added management and personnel in the commercial and home lending areas to take advantage of the relatively favorable long-term business and economic environments prevailing in the markets.

8

Loan Portfolio Analysis. The following table sets forth the composition of the loan portfolio, excluding loans held for sale (“HFS”) by type of loan at the dates indicated.

(Dollars in thousands)

December 31, 2020

December 31, 2019

December 31, 2018

December 31, 2017

December 31, 2016

    

Amount

    

Percent

Amount

    

Percent

Amount

    

Percent

    

Amount

    

Percent

    

Amount

    

Percent

REAL ESTATE LOANS

Commercial

$

222,719

 

14.15

%  

$

210,749

 

15.59

%

$

204,699

 

15.43

%  

$

63,611

 

8.22

%  

$

55,871

9.23

%

Construction and development

 

216,975

 

13.78

 

179,654

 

13.29

 

247,306

 

18.65

 

143,068

 

18.50

 

94,462

15.60

Home equity

 

43,093

 

2.74

 

38,167

 

2.82

 

40,258

 

3.04

 

25,289

 

3.27

 

20,081

3.32

One-to-four-family (excludes HFS)

 

311,093

 

19.76

 

261,539

 

19.34

 

249,397

 

18.80

 

163,655

 

21.16

 

124,009

20.48

Multi-family

 

131,601

 

8.36

 

133,931

 

9.91

 

104,663

 

7.89

 

44,451

 

5.75

 

37,527

6.20

Total real estate loans

 

925,481

 

58.79

 

824,040

 

60.95

 

846,323

 

63.81

 

440,074

 

56.90

 

331,950

54.83

CONSUMER LOANS

Indirect home improvement

 

286,020

 

18.17

 

254,691

 

18.84

 

212,226

 

16.00

 

171,225

 

22.14

 

144,262

23.83

Marine

 

85,740

 

5.44

 

67,179

 

4.97

 

57,822

 

4.36

 

35,397

 

4.58

 

28,549

4.71

Other consumer

 

3,418

 

0.22

 

4,340

 

0.32

 

5,425

 

0.41

 

2,046

 

0.26

 

1,915

0.32

Total consumer loans

 

375,178

 

23.83

 

326,210

 

24.13

 

275,473

 

20.77

 

208,668

 

26.98

 

174,726

28.86

COMMERCIAL BUSINESS LOANS

Commercial and industrial

 

224,476

 

14.26

 

140,531

 

10.40

 

138,686

 

10.46

 

83,306

 

10.77

 

65,841

10.88

Warehouse lending

 

49,092

 

3.12

 

61,112

 

4.52

 

65,756

 

4.96

 

41,397

 

5.35

 

32,898

5.43

Total commercial business loans

 

273,568

 

17.38

 

201,643

 

14.92

 

204,442

 

15.42

 

124,703

 

16.12

 

98,739

16.31

Total loans receivable, gross

 

1,574,227

 

100.00

%  

 

1,351,893

 

100.00

%

 

1,326,238

 

100.00

%  

 

773,445

 

100.00

%  

 

605,415

100.00

%

Allowance for loan losses

 

(26,172)

 

(13,229)

(12,349)

(10,756)

(10,211)

Deferred costs and fees, net

 

(4,017)

 

(3,273)

 

(2,907)

 

(2,708)

 

(1,887)

Premiums on purchased loans, net

 

943

 

955

 

1,537

 

1,577

 

Total loans receivable, net

$

1,544,981

$

1,336,346

$

1,312,519

$

761,558

$

593,317

9

The following table shows the composition of the loan portfolio by fixed- and adjustable-rate loans, excluding HFS at the dates indicated.

December 31, 

2020

2019

2018

2017

2016

(Dollars in thousands)

    

Amount

    

Percent

    

Amount

    

Percent

    

Amount

    

Percent

    

Amount

    

Percent

    

Amount

    

Percent

Fixed-rate loans:

Real estate loans

Commercial

$

94,324

 

5.99

%  

$

65,913

 

4.88

%  

$

58,037

 

4.37

%  

$

32,430

 

4.19

%  

$

30,445

 

5.03

%

Construction and development

 

8,082

 

0.51

 

3,749

 

0.28

 

25,613

 

1.93

 

286

 

0.04

 

 

Home equity

 

17,403

 

1.11

 

11,292

 

0.83

 

14,134

 

1.07

 

2,649

 

0.34

 

1,644

 

0.27

One-to-four-family (excludes HFS)

 

113,465

 

7.21

 

51,583

 

3.80

 

45,126

 

3.40

 

11,804

 

1.53

 

10,267

 

1.69

Multi-family

 

46,627

 

2.96

 

36,985

 

2.74

 

41,832

 

3.15

 

14,453

 

1.87

 

4,538

 

0.75

Total real estate loans

 

279,901

 

17.78

 

169,522

 

12.53

 

184,742

 

13.92

 

61,622

 

7.97

 

46,894

 

7.74

Consumer loans

 

373,221

 

23.71

 

323,633

 

23.94

 

272,279

 

20.53

 

207,671

 

26.85

 

174,041

 

28.75

Commercial business loans

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

Commercial and industrial

 

114,025

 

7.24

 

53,329

 

3.95

 

59,195

 

4.46

 

32,835

 

4.24

 

26,901

 

4.45

Warehouse lending

 

 

 

 

 

 

 

673

 

0.09

 

 

Total commercial business loans

 

114,025

 

7.24

 

53,329

 

3.95

 

59,195

 

4.46

 

33,508

 

4.33

 

26,901

 

4.45

Total fixed-rate loans

 

767,147

 

48.73

 

546,484

 

40.42

 

516,216

 

38.91

 

302,801

 

39.15

 

247,836

 

40.94

Adjustable-rate loans:

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

Real estate loans

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

Commercial

 

128,395

 

8.16

 

144,836

 

10.71

 

146,662

 

11.06

 

31,181

 

4.03

 

25,426

 

4.20

Construction and development

 

208,893

 

13.27

 

175,905

 

13.01

 

221,693

 

16.72

 

142,782

 

18.46

 

94,462

 

15.60

Home equity

 

25,690

 

1.63

 

26,875

 

1.99

 

26,124

 

1.97

 

22,640

 

2.93

 

18,437

 

3.05

One-to-four-family (excludes HFS)

 

197,628

 

12.55

 

209,956

 

15.54

 

204,271

 

15.40

 

151,851

 

19.63

 

113,742

 

18.79

Multi-family

 

84,974

 

5.40

 

96,946

 

7.17

 

62,831

 

4.74

 

29,998

 

3.88

 

32,989

 

5.45

Total real estate loans

 

645,580

 

41.01

 

654,518

 

48.42

 

661,581

 

49.89

 

378,452

 

48.93

 

285,056

 

47.09

Consumer loans

 

1,957

 

0.12

 

2,577

 

0.19

 

3,194

 

0.24

 

997

 

0.13

 

685

 

0.11

Commercial business loans

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

Commercial and industrial

 

110,451

 

7.02

 

87,202

 

6.45

 

79,491

 

6.00

 

50,471

 

6.53

 

38,940

 

6.43

Warehouse lending

 

49,092

 

3.12

 

61,112

 

4.52

 

65,756

 

4.96

 

40,724

 

5.26

 

32,898

 

5.43

Total commercial business loans

 

159,543

 

10.14

 

148,314

 

10.97

 

145,247

 

10.96

 

91,195

 

11.79

 

71,838

 

11.86

Total adjustable-rate loans

 

807,080

 

51.27

 

805,409

 

59.58

 

810,022

 

61.09

 

470,644

 

60.85

 

357,579

 

59.06

Total loans receivable, gross

 

1,574,227

 

100.00

%  

 

1,351,893

 

100.00

%  

 

1,326,238

 

100.00

%  

 

773,445

 

100.00

%  

 

605,415

 

100.00

%

Less:

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

Allowance for loan losses

 

(26,172)

 

  

 

(13,229)

 

  

 

(12,349)

 

  

 

(10,756)

 

  

 

(10,211)

 

  

Deferred costs and fees, net

(4,017)

(3,273)

(2,907)

(2,708)

(1,887)

Premiums on purchased loans

 

943

 

  

 

955

 

  

 

1,537

 

  

 

1,577

 

  

 

 

  

Total loans receivable, net

$

1,544,981

 

  

$

1,336,346

 

  

$

1,312,519

 

  

$

761,558

 

  

$

593,317

 

  

10

The total amount of loans due after December 31, 2021, which have fixed interest rates is $728.0 million, while the total amount of loans due after this date which have floating or adjustable interest rates is $354.7 million.

Loan Maturity and Repricing. The following table sets forth certain information at December 31, 2020, regarding the dollar amount and current note rates of interest for the loans maturing or repricing in the portfolio based on their contractual terms to maturity but does not include scheduled payments or potential prepayments. Loan balances do not include undisbursed loan proceeds, unearned discounts, unearned income, and allowance for loan losses.

Real Estate

 

(Dollars in

Construction and

Commercial

 

thousands)

Commercial

Development

Home Equity

One-to-Four-Family (2)

Multi-family

Consumer

Business

Total

 

Due During

    

    

Weighted

    

    

Weighted

    

    

Weighted

    

    

Weighted

    

    

Weighted

    

    

Weighted

    

    

Weighted

    

    

Weighted

 

Years Ending

Average

Average

Average

Average

Average

Average

Average

Average

 

December 31, 

Amount

Rate

Amount

Rate

Amount

Rate

Amount

Rate

Amount

Rate

Amount

Rate

Amount

Rate

Amount

Rate

 

2021 (1)

$

49,995

 

4.18

%  

$

212,052

 

5.47

%  

$

27,006

 

4.50

%  

$

21,295

 

4.85

%  

$

15,432

 

4.21

%  

$

2,828

 

9.57

%  

$

162,958

 

4.45

%  

$

491,566

 

4.89

%

2022

 

23,857

 

4.93

 

989

 

3.80

 

55

 

7.03

 

15,165

 

4.72

 

1,578

 

5.03

 

2,079

 

6.70

 

70,381

 

1.65

(3)

 

114,104

 

2.90

2023

 

38,665

 

4.87

 

44

 

3.50

 

287

 

5.35

 

17,034

 

4.87

 

7,465

 

4.88

 

4,734

 

6.34

 

6,881

 

4.66

 

75,110

 

4.94

2024 and 2025

 

50,376

 

4.43

 

2,666

 

5.66

 

123

 

5.98

 

73,106

 

4.20

 

57,511

 

4.03

 

14,030

 

6.34

 

8,453

 

4.11

(4)

 

206,265

 

4.37

2026 to 2030

 

52,029

 

4.35

 

958

 

3.25

 

820

 

5.70

 

101,081

 

4.05

 

41,646

 

4.13

 

75,874

 

6.26

 

15,323

 

3.92

 

287,731

 

4.70

2031 to 2035

 

7,605

 

4.75

 

 

 

2,259

 

5.40

 

3,503

 

5.16

 

6,172

 

6.89

 

201,588

 

6.48

 

3,424

 

4.77

 

224,551

 

6.37

2036 and following

 

192

 

5.00

 

266

 

6.55

 

12,543

 

4.06

 

79,909

 

3.96

 

1,797

 

5.40

 

74,045

 

6.53

 

6,148

 

4.51

 

174,900

 

5.09

Total

$

222,719

 

4.50

%  

$

216,975

 

5.45

%  

$

43,093

 

4.46

%  

$

311,093

 

4.21

%  

$

131,601

 

4.29

%  

$

375,178

 

6.45

%  

$

273,568

 

3.70

%  

$

1,574,227

 

4.88

%

________________________

(1)Includes demand loans, loans having no stated maturity and overdraft loans.
(2)Excludes loans held for sale.
(3)Includes PPP loans of $60.8 million with contractual interest rates of 1.00%.
(4)Includes PPP loans of $1.3 million with contractual interest rates of 1.00%.

11

Lending Authority. The Chief Credit Officer has the authority to approve multiple loans to one borrower up to $15.0 million in aggregate.  All loans that are approved over $5.0 million are reported to the asset quality committee (“AQC”) at each AQC meeting. Loans in excess of $15.0 million and up to $25.0 million require additional approval from management’s senior loan committee. Loans in excess of $25.0 million require AQC approval.  The Chief Credit Officer may delegate lending authority to other individuals at levels consistent with their responsibilities.

The Board of Directors has implemented a lending limit policy that it believes matches the Washington State legal lending limit, or $44.6 million as of December 31, 2020. The Bank’s largest lending relationship at December 31, 2020, consisted of a commercial line of credit to one company having a total available commitment of $28.0 million, with the Bank’s total potential commitment of $19.0 million, and two other banks participating in the remaining $9.0 million. This line of credit is secured by notes for 16 properties. The outstanding balance of this line of credit at December 31, 2020 was $18.4 million for the Bank. The second largest lending relationship consisted of one multi-family construction loan with the Bank’s total potential commitment of $15.7 million, of which $1.7 million was drawn at December 31, 2020, and one other bank participating in the remaining $2.5 million, one permanent multi-family loan, and one permanent one-to-four-family loan having combined commitments of $27.5 million to three related limited liability companies. All of these loans are secured by properties located in the Seattle metropolitan area of Washington State.  The outstanding balance of these three loans at December 31, 2020 was $10.9 million. The third largest lending relationship consisted of a mix of construction and permanent real estate secured loans having combined commitments of $21.6 million, to three related limited liability companies and/or individuals.  All of these loans are secured by real estate located in the Seattle metropolitan area of Washington State.  The outstanding balance of these loans at December 31, 2020 was $19.1 million.  At December 31, 2020, all of the borrowers listed above were in compliance with the original repayment terms of their respective loans.

At December 31, 2020, the Company had $66.0 million in approved commercial construction warehouse lending lines for four companies, with the Bank’s total potential commitment of $57.0 million, and two other banks participating in the remaining $9.0 million.  The commitments range from $8.0 million to $19.0 million for the Bank with $33.0 million outstanding at December 31, 2020.  At December 31, 2019, the Bank had $70.0 million approved in commercial construction warehouse lending lines for six companies with $48.2 million outstanding.  In addition, the Company had $36.0 million approved in mortgage warehouse lending lines for four companies. The commitments ranged from $5.0 million to $15.0 million. At December 31, 2020, there was $16.1 million in mortgage warehouse lending lines outstanding, compared to $25.0 million approved in mortgage warehouse lending lines with $12.9 million outstanding at December 31, 2019.  At December 31, 2020, all of these warehouse lines were in compliance with the original repayment terms of their respective lending lines.

Commercial Real Estate Lending. The Company offers a variety of commercial real estate loans. Most of these loans are secured by income producing properties, including multi-family residences, retail centers, warehouses and office buildings located in the market areas. At December 31, 2020, commercial real estate loans (including $131.6 million of multi-family residential loans) totaled $354.3 million, or 22.5%, of the gross loan portfolio.

The Company’s loans secured by commercial real estate are originated with a fixed or variable interest rate for up to a 15-year maturity and a 30-year amortization. The variable rate loans are indexed to the prime rate of interest or a short-term LIBOR rate, or five or seven-year FHLB rate, with rates equal to the prevailing index rate to 5.0% above the prevailing rate. Loan-to-value ratios on the Company’s commercial real estate loans typically do not exceed 80% of the appraised value of the property securing the loan. In addition, personal guarantees are typically obtained from a principal of the borrower on substantially all credits.

Loans secured by commercial real estate are generally underwritten based on the net operating income of the property and the financial strength of the borrower. The net operating income, which is the income derived from the operation of the property less all operating expenses, must be sufficient to cover the payments related to the outstanding debt plus an additional coverage requirement. The Company generally requires an assignment of rents or leases in order to be assured that the cash flow from the project will be sufficient to repay the debt. Appraisals on properties securing commercial real estate loans are performed by independent state certified or licensed fee appraisers. The Company does not generally maintain insurance or tax escrows for loans secured by commercial real

12

estate. In order to monitor the adequacy of cash flows on income-producing properties, the borrower is required to provide financial information on at least an annual basis.

Loans secured by commercial real estate properties generally involve a greater degree of credit risk than one-to-four-family residential mortgage loans. These loans typically involve large balances to single borrowers or groups of related borrowers. Because payments on loans secured by commercial and multi-family real estate properties are often dependent on the successful operation or management of the properties, repayment of these loans may be subject to adverse conditions in the real estate market or the economy. If the cash flow from the project is reduced, or if leases are not obtained or renewed, the borrower’s ability to repay the loan may be impaired. Commercial and multi-family loans also expose a lender to greater credit risk than loans secured by one-to-four-family because the collateral securing these loans typically cannot be sold as easily as one-to-four-family. In addition, most of our commercial and multi-family loans are not fully amortizing and include balloon payments upon maturity. Balloon payments may require the borrower to either sell or refinance the underlying property in order to make the payment, which may increase the risk of default or non-payment. The largest single commercial or multi-family real estate loan at December 31, 2020 was a performing $8.8 million loan secured by a fully-leased apartment building built in 2019 (which includes a 1,200 square foot retail space, currently leased to a well-established and locally-owned coffee shop) located in Seattle, Washington.  

The Company intends to continue to emphasize commercial real estate lending and has hired experienced commercial loan officers to support the Company’s commercial real estate lending objectives. As the commercial real estate loan portfolio expands, the Company intends to bring in additional experienced personnel in the areas of loan analysis and commercial deposit relationship management.

Construction and Development Lending. The Company expanded its residential construction lending team in 2011 with a focus on vertical, in-city one-to-four-family development in our market area. This team has over 60 years of combined experience and expertise in acquisition, development and construction (“ADC”) lending in the Puget Sound market area. The Company has implemented this strategy to take advantage of what is believed to be a strong demand for construction and ADC loans to experienced, successful and relationship driven builders in our market area after many other banks abandoned this segment because of previous overexposure. At December 31, 2020, outstanding construction and development loans totaled $217.0 million, or 13.8%, of the gross loan portfolio and consisted of 253 loans, compared to $179.7 million and 216 loans at December 31, 2019. The construction and development loans at December 31, 2020, consisted of loans for residential and commercial construction projects primarily for vertical construction and $15.1 million of land acquisition and development loans for finished lots. Total committed, including unfunded construction and development loans at December 31, 2020, was $360.6 million. At December 31, 2020, $133.0 million, or 61.4% of our outstanding construction and development loan portfolio was comprised of speculative one-to-four-family construction loans. Approximately $12.8 million of our residential construction loans at December 31, 2020 were made to finance the custom construction of owner-occupied homes and are structured to be converted to permanent loans at the end of the construction phase.  Approximately 54.0% of these custom home loans consisted of custom manufactured homes.  In addition, included in commercial business loans, the Company had four commercial secured lines of credit, secured by notes to residential construction borrowers with guarantees from principals with experience in the construction re-lending market. These loans had combined commitments of $57.0 million, and an outstanding balance of $33.0 million at December 31, 2020.

The Company’s residential construction lending program includes loans for the purpose of constructing both speculative and pre-sold one-to-four-family residences, the acquisition of in-city lots with and without existing improvements for later development of one-to-four-family residences, the acquisition of land to be developed, and loans for the acquisition and development of land for future development of single family residences. The Company generally limits these types of loans to known builders and developers in the market area. Construction loans generally provide for the payment of interest-only during the construction phase, which is typically up to 12 months. At the end of the construction phase, the construction loan is generally paid off through the sale of the newly constructed home and a permanent loan from another lender, although commitments to convert to a permanent loan may be made by us. Construction loans are generally made with a maximum loan amount of the lower of 95% of cost or 75% of appraised value at completion. During the term of construction, the accumulated interest on the loan is typically added to the principal balance of the loan through an interest reserve of 3% to 5.5% of the loan commitment amount.

13

Commitments to fund construction loans generally are made subject to an appraisal of the property by an independent licensed appraiser. The Company also reviews and has a licensed third-party inspect each property before disbursement of funds during the term of the construction loan. Loan proceeds are disbursed after inspection by a third-party inspector based on the percentage of completion method.

The Company may also make land acquisition and development loans to builders or residential lot developers on a limited basis. These loans involve a higher degree of credit risk, similar to commercial construction loans. At December 31, 2020, included in the $217.0 million of construction and development loans, were seven residential land acquisition and development loans for finished lots totaling $15.1 million, with total commitments of $18.5 million. These land loans also involve additional risks because the loan amount is based on the projected value of the lots after development. Loans are made for up to 75% of the estimated value with a term of up to two years. These loans are required to be paid on an accelerated basis as the lots are sold, so that the Company is repaid before all the lots are sold. Construction financing is generally considered to involve a higher degree of credit risk than longer-term financing on improved, owner-occupied real estate.

Construction and development lending contains the inherent difficulty in estimating both a property’s value at completion of the project and the estimated cost (including interest) of the project. Changes in the demand, such as for new housing and higher than anticipated building costs may cause actual results to vary significantly from those estimated. If the estimate of construction cost proves to be inaccurate, we may be required to advance funds beyond the amount originally committed to permit completion of the project. This type of lending also typically involves higher loan principal amounts and is often concentrated with a small number of builders. In addition, during the term of most of our construction loans, an interest reserve is created at origination and is added to the principal of the loan through the construction phase. If the estimate of value upon completion proves to be inaccurate, we may be confronted at, or prior to, the maturity of the loan with a project, the value of which is insufficient to assure full repayment. Because construction loans require active monitoring of the building process, including cost comparisons and on-site inspections, these loans are more difficult and costly to monitor.

Increases in market rates of interest may have a more pronounced effect on construction loans by rapidly increasing the end-purchasers’ borrowing costs, thereby reducing the overall demand for the project. Properties under construction are often difficult to sell and typically must be completed in order to be successfully sold which also complicates the process of working out problem construction loans. This may require us to advance additional funds and/or contract with another builder to complete construction. Furthermore, speculative construction loans to a builder are often associated with homes that are not pre-sold, and thus pose a greater potential risk than construction loans to individuals on their personal residences as there is the added risk associated with identifying an end-purchaser for the finished project. Loans on land under development or held for future construction pose additional risk because of the lack of income being produced by the property and the potential illiquid nature of the collateral. These risks can be significantly impacted by supply and demand. As a result, this type of lending often involves the disbursement of substantial funds with repayment dependent on the success of the ultimate project and the ability of the borrower to sell or lease the property, rather than the ability of the borrower or guarantor themselves to repay principal and interest.

The Company seeks to address the forgoing risks associated with construction development lending by developing and adhering to underwriting policies, disbursement procedures, and monitoring practices. Specifically, the Company (i) seeks to diversify the number of loans and projects in the market area, (ii) evaluate and document the creditworthiness of the borrower and the viability of the proposed project, (iii) limit loan-to-value ratios to specified levels, (iv) control disbursements on construction loans on the basis of on-site inspections by a licensed third-party,  (v) monitor economic conditions and the housing inventory in each market, and (iv) typically obtains personal guarantees from a principal of the borrower on substantially all credits. No assurances, however, can be given that these practices will be successful in mitigating the risks of construction development lending.

Home Equity Lending. The Company has been active in second lien mortgage and home equity lending, with the focus of this lending being conducted in the Company’s primary market area. The home equity lines of credit generally have adjustable rates tied to the prime rate of interest with a draw term of 10 years plus and a term to maturity of 15 years. Monthly payments are based on 1.0% of the outstanding balance with a maximum combined loan-to-value ratio of up to 90%, including any underlying first mortgage. Fixed second lien mortgage home equity loans are

14

typically amortizing loans with terms of up to 30 years. Total second lien mortgage/home equity loans totaled $43.1 million, or 2.7% of the gross loan portfolio, at December 31, 2020, $25.7 million of which were adjustable rate home equity lines of credit. Unfunded commitments on home equity lines of credit at December 31, 2020, was $52.5 million.

Residential. The Company originates loans secured by first mortgages on one-to-four-family residences primarily in the market area. The Company originates one-to-four-family residential mortgage loans through referrals from real estate agents, financial planners, builders, and from existing customers. Retail banking customers are also important referral sources of the Company’s loan originations. The Company originated $1.87 billion of one-to-four-family mortgages (including $10.1 million of loans brokered to other institutions) and sold $1.64 billion to investors in 2020. Of the loans sold to investors, $1.48 billion were sold to the Federal National Mortgage Association (“Fannie Mae”), the Government National Mortgage Association (“Ginnie Mae”), the FHLB, and/or the Federal Home Loan Mortgage Corporation (“Freddie Mac”) with servicing rights retained in order to further build the relationship with the customer. At December 31, 2020, one-to-four-family residential mortgage loans totaled $311.1 million, or 19.8%, of the gross loan portfolio, excluding loans held for sale of $166.4 million. In addition, the Company originates residential loans through its commercial lending channel, secured by single family rental homes in Washington, with an outstanding balance of $72.7 million at December 31, 2020.

The Company generally underwrites the one-to-four-family loans based on the applicant’s ability to repay. This includes employment and credit history and the appraised value of the subject property. The Company will lend up to 100% of the lesser of the appraised value or purchase price for one-to-four-family first mortgage loans. For first mortgage loans with a loan-to-value ratio in excess of 80%, the Company generally requires either private mortgage insurance or government sponsored insurance in order to mitigate the higher risk level associated with higher loan-to-value loans. Fixed-rate loans secured by one-to-four-family residences have contractual maturities of up to 30 years and are generally fully amortizing, with payments due monthly. Adjustable-rate mortgage loans generally pose different credit risks than fixed-rate loans, primarily because as interest rates rise the borrower’s payments rise, increasing the potential for default. Properties securing the one-to-four-family loans are appraised by independent fee appraisers who are selected in accordance with industry and regulatory standards. The Company requires borrowers to obtain title and hazard insurance, and flood insurance, if necessary. Loans are generally underwritten to the secondary market guidelines with overlays as determined by the internal underwriting department.

Consumer Lending. Consumer lending represents a significant and important historical activity for the Company, primarily reflecting the indirect lending through home improvement contractors and dealers. At December 31, 2020, consumer loans totaled $375.2 million, or 23.8% of the gross loan portfolio.

The Company’s indirect home improvement loans, also referred to as fixture secured loans, represent the largest portion of the consumer loan portfolio and have traditionally been the mainstay of the Company’s consumer lending strategy. These loans totaled $286.0 million, or 18.2% of the gross loan portfolio, and 76.2% of total consumer loans, at December 31, 2020. Indirect home improvement loans are originated through a network of 143 home improvement contractors and dealers located in Washington, Oregon, California, Idaho, Colorado, Arizona, Nevada, and Minnesota. Four dealers are responsible for 39.2% of the loan volume. These fixture secured loans consist of loans for a wide variety of products, such as replacement windows, siding, roofs, HVAC systems, pools, and other home fixture installations, including solar related home improvement projects.

In connection with fixture secured loans, the Company receives loan applications from the dealers, and originates the loans based on pre-defined lending criteria. These loans are processed through the loan origination software, with approximately 40% of the loan applications receiving an automated approval based on the information provided, and the remaining loans are processed by the Company’s credit analysts. The Company follows the internal underwriting guidelines in evaluating loans obtained through the indirect dealer program, including using a Fair Isaac and Company, Incorporated (“FICO”) credit score to approve loans. A FICO score is a principal measure of credit quality and is one of the significant criteria we rely upon in our underwriting in addition to the borrower’s debt to income.

The Company’s fixture secured loans generally range in amounts from $2,500 to $100,000, and generally carry terms of 8 to 20 years with fixed rates of amortizing payments and interest. In some instances, the participating

15

dealer may pay a fee to buy down the borrower’s interest rate to a rate below the Company’s published rate. Fixture secured loans are secured by the personal property installed in, on or at the borrower’s real property, and may be perfected with a financing statement under the Uniform Commercial Code (“UCC-2”) filed in the county of the borrower’s residence. The Company generally files a UCC-2 financing statement to perfect the security interest in the personal property in situations where the borrower’s credit score is below 720 or the home improvement loan is for an amount in excess of $5,000. Perfection gives the Company a claim to the collateral that is superior to someone that obtains a lien through the judicial process subsequent to the perfection of a security interest. The failure to perfect a security interest does not render the security interest unenforceable against the borrower. However, failure to perfect a security interest risks avoidance of the security interest in bankruptcy or subordination to the claims of third parties.

The Company also offers consumer marine loans secured by boats. At December 31, 2020, the marine loan portfolio totaled $85.7 million, or 5.4% of total loans. Marine loans are originated with borrowers on both a direct and indirect basis, and generally carry terms of up to 20 years with fixed rates of interest. The Company generally requires a 10% down payment, and the loan amount may be up to the lesser of 120% of factory invoice or 90% of the purchase price.

The Company originates other consumer loans which totaled $3.4 million at December 31, 2020.  These loans primarily include personal lines of credit, credit cards, automobile, direct home improvement, loans on deposit, and recreational loans.

In evaluating any consumer loan application, a borrower’s FICO score is utilized as an important indicator of credit risk. The FICO score represents the creditworthiness of a borrower based on the borrower’s credit history, as reported by an independent third party. A higher FICO score typically indicates a greater degree of creditworthiness. Over the last several years the Company has emphasized originations of loans to consumers with higher credit scores. This has resulted in a lower level of loan charge-offs in recent periods.  At December 31, 2020, 78.5% of the consumer loan portfolio was originated with borrowers having a FICO score over 720 at the time of origination, and 20.0% was originated with borrowers having a FICO score between 660 and 720 at the time of origination.  Generally, a FICO score of 660 or higher indicates the borrower has an acceptable credit reputation. A consumer credit score at the time of loan origination of less than 660 is associated as “subprime” by federal banking regulators and these loans comprised just 1.5% of our consumer loan portfolio at December 31, 2020. Consideration for loans with FICO scores below 660 require additional management oversight and approval.

Consumer loans generally have shorter average lives with faster prepayment, which reduces the Company’s exposure to changes in interest rates. In addition, management believes that offering consumer loan products helps to expand and create stronger ties to existing customer base by increasing the number of customer relationships and providing cross-marketing opportunities.

Consumer and other loans generally entail greater risk than do one-to-four-family residential mortgage loans, particularly in the case of consumer loans that are secured by rapidly depreciable assets, such as boats, automobiles and other recreational vehicles. In these cases, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance. As a result, consumer loan collections are dependent on the borrower’s continuing financial stability and, thus, are more likely to be adversely affected by job loss, divorce, illness, or personal bankruptcy. In the case of fixture secured loans, it is very difficult to repossess the personal property securing these loans as they are typically attached to the borrower’s personal residence. Accordingly, if a borrower defaults on a fixture secured loan the only practical recourse is to wait until the borrower wants to sell or refinance the home, at which time if there is a perfected security interest the Company generally will be able to collect a portion of the loan previously charged off.

Commercial Business Lending. The Company originates commercial business loans and lines of credit to local small- and mid-sized businesses in the Puget Sound market area that are secured by accounts receivable, inventory, or personal/business property, plant and equipment. Consistent with management’s objectives to expand commercial business lending, in 2009, the Company commenced a mortgage warehouse lending program through which the Company funds third-party residential mortgage bankers. Under this program the Company provides short-term funding to the mortgage banking companies for the purpose of originating residential mortgage loans for sale

16

into the secondary market. The Company’s warehouse lending lines are secured by the underlying notes associated with one-to-four-family mortgage loans made to borrowers by the mortgage banking company and generally require guarantees from the principal shareholder(s) of the mortgage banking company. These loans are repaid when the note is sold by the mortgage bank into the secondary market, with the proceeds from the sale used to pay down the outstanding loan before being dispersed to the mortgage bank. The Company had $36.0 million approved in residential mortgage warehouse lending lines for four companies at December 31, 2020. The commitments ranged from $5.0 million to $15.0 million. At December 31, 2020, there was $16.1 million in residential warehouse lines outstanding, compared to $25.0 million in approved residential warehouse lending lines with $12.9 million outstanding at December 31, 2019. During the year ended December 31, 2020, we processed approximately 870 loans and funded approximately $323.1 million in total under our mortgage warehouse lending program.

The Company also has commercial construction warehouse lending lines secured by notes on construction loans and typically guaranteed by principals with experience in construction lending. In April 2013, we commenced an expansion of our mortgage warehouse lending program to include construction re-lending warehouse lines. These lines are secured by notes provided to construction lenders and are typically guaranteed by a principal of the borrower with experience in construction lending.  Terms for the underlying notes can be up to 18 months and the Bank will lend a percentage (typically 70 - 80%) of the underlying note which may have a loan-to-value ratio up to 75%.  Combined, the loan-to-value ratio on the underlying note would be up to 60% with additional credit support provided by the guarantor. At December 31, 2020, the Company had $66.0 million in approved commercial construction warehouse lending lines for four companies, with the Bank’s total potential commitment of $57.0 million, and two other banks participating in the remaining $9.0 million. The commitments range from $8.0 million to $19.0 million. At December 31, 2020, there was $33.0 million outstanding, compared to $70.0 million approved in commercial warehouse lending lines for six companies with $48.2 million outstanding at December 31, 2019.

Beginning in the second quarter of 2020, the Bank began to offer PPP loans which are fully guaranteed by the SBA, to existing and new customers as a result of the COVID-19 pandemic. These PPP loans are subject to the provisions of the CARES Act as well as complex and evolving rules and guidance issued by the SBA and the U.S. Department of the Treasury. The entire principal amount of the borrower's PPP loan, including any accrued interest, is eligible to be forgiven and repaid by the SBA if the borrower meets the PPP conditions. Under this program, as of December 31, 2020, there were 423 PPP loans outstanding totaling $62.1 million. The CAA 2021 renewed and extended the PPP until March 31, 2021 by authorizing an additional $284.5 billion for the program.  As a result, in January 2021, the Bank began accepting and processing loan applications under this second PPP program. The Bank earns 1% interest on PPP loans as well as a fee from the SBA to cover processing costs, which is amortized over the life of the loan. The Bank expects that the great majority of its PPP borrowers will seek full or partial forgiveness of their loan obligations. For additional information regarding these loans, see Item 1A. Risk Factors - “Risks Related to Our Lending - Loans originated under the SBA Paycheck Protection Program subject us to credit, forgiveness and guarantee risk.”

Commercial business loans may be fixed-rate but are usually adjustable-rate loans indexed to the prime rate of interest, plus a margin. Some of these commercial business loans, such as those made pursuant to the warehouse lending program, are structured as lines of credit with terms of 12 months and interest-only payments required during the term, while other loans may reprice on an annual basis and amortize over a two to five year period. Due to the current interest rate environment, these loans and lines of credit are generally originated with a floor, which is set between 2.0% and 7.0%. Loan fees are generally charged at origination depending on the credit quality and account relationships of the borrower. Advance rates on these types of lines are generally limited to 80% of accounts receivable and 50% of inventory. The Company also generally requires the borrower to establish a deposit relationship as part of the loan approval process. At December 31, 2020, the commercial business loan portfolio totaled $273.6 million, or 17.4%, of the gross loan portfolio including warehouse lending loans and PPP loans.

At December 31, 2020, most of the commercial business loans were secured. The Company’s commercial business lending policy includes credit file documentation and analysis of the borrower’s background, capacity to repay the loan, the adequacy of the borrower’s capital and collateral, as well as an evaluation of other conditions affecting the borrower. Analysis of the borrower’s past, present, and future cash flows is also an important aspect of credit analysis. The Company generally requires personal guarantees on these commercial business loans.

17

Nonetheless, commercial business loans are believed to carry higher credit risk than residential mortgage loans. The largest commercial business lending relationships at December 31, 2020, consisted of a participating commercial line of credit having a commitment of $19.0 million from the Bank.  This line of credit is secured by residential construction projects located primarily in Seattle, Washington.  The outstanding balance of this line of credit at December 31, 2020 was $18.4 million. The next largest commercial business lending relationship totaled $13.8 million and consisted of two commercial lines of credit of up to $12.0 million, of which the Bank has disbursed $8.9 million, a commercial term loan of $1.5 million, and a PPP loan of $3.4 million.  With the exception of the PPP loan, these loans are secured by a mix of assets of the borrower and guarantor.  

Unlike residential mortgage loans, commercial business loans, particularly unsecured loans, are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business and, therefore, are of higher risk. The Company makes commercial business loans secured by business assets, such as accounts receivable, inventory, equipment, real estate and cash as collateral with loan-to-value ratios in most cases up to 80%, based on the type of collateral. This collateral depreciates over time, may be difficult to appraise and may fluctuate in value based on the specific type of business and equipment used. As a result, the availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself (which, in turn, is often dependent in part upon general economic conditions).

Loan Originations, Servicing, Purchases and Sales

The Company originates both fixed-rate and adjustable-rate loans. The ability to originate loans, however, is dependent upon customer demand for loans in the market areas. From time to time to supplement our loan originations and based on our asset/liability objectives we will also purchase bulk loans or pools of loans from other financial institutions.

Over the past few years, the Company has continued to originate consumer loans, and increased emphasis on commercial real estate loans, including construction and development lending, as well as commercial business loans. Demand is affected by competition and the interest rate environment. In periods of economic uncertainty, the ability of financial institutions, including the Bank, to originate large dollar volumes of commercial business and real estate loans may be substantially reduced or restricted, with a resultant decrease in interest income. In addition to interest earned on loans and loan origination fees, the Company receives fees for loan commitments, late payments, and other miscellaneous services. The fees vary from time to time, generally depending on the supply of funds and other competitive conditions in the market.  In addition to the 1.0% interest earned on PPP loans, the SBA pays processing fees for PPP loans of either 1%, 3%, or 5%, based on the size of the loan. Banks may not collect any fees from the PPP loan applicants.

The Company will sell long-term, fixed-rate residential real estate loans in the secondary market to mitigate interest rate risk.  Gains and losses from the sale of these loans are recognized based on the difference between the sales proceeds and carrying value of the loans at the time of the sale. Some residential real estate loans originated as Federal Housing Administration or FHA, U.S. Department of Veterans Affairs or VA, or United States Department of Agriculture or USDA Rural Housing loans were sold by the Company as servicing released loans to other companies. A majority of residential real estate loans sold by the Company were sold with servicing retained at a specified servicing fee. The Company earned gross mortgage servicing fees of $4.4 million for the year ended December 31, 2020.  The Company was servicing $2.17 billion of one-to-four-family loans at December 31, 2020, for Fannie Mae, Freddie Mac, Ginnie Mae, the FHLB, and another financial institution. These mortgage servicing rights (“MSRs”) constituted an $12.6 million asset on our books on that date, which is amortized in proportion to and over the period of the net servicing income. These MSRs are periodically evaluated for impairment based on their fair value, which takes into account the rates and potential prepayments of those sold loans being serviced. The fair value of our MSRs at December 31, 2020 was $12.8 million. See “Note 4 - Servicing Rights” and “Note 15 - Fair Value Measurements” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.

18

The following table presents the notional balance activity during the year ended December 31, 2020, related to loans serviced for others.

    

(In thousands)

Beginning balance at January 1, 2020

One-to-four-family

$

1,463,732

Consumer

 

591

Subtotal

 

1,464,323

Additions

 

  

One-to-four-family

 

1,480,110

Repayments

 

  

One-to-four-family

 

(771,341)

Consumer

 

(225)

Subtotal

 

(771,566)

Ending balance at December 31, 2020

 

  

One-to-four-family

 

2,172,501

Consumer

 

366

Total

$

2,172,867

19

The following table shows total loans originated, purchased, sold and repaid during the years indicated.

Year Ended December 31, 

(In thousands)

    

2020

    

2019

Originations by type:

Fixed-rate:

Commercial

$

36,307

$

23,110

Construction and development

17,886

3,641

Home equity

 

13,522

 

6,163

One-to-four-family (1)

 

66,796

 

23,426

Loans held for sale (one-to-four-family)

 

1,723,884

 

778,866

Multi-family

 

17,118

 

2,886

Consumer

 

188,587

 

161,269

Commercial business (2) (5)

 

98,646

 

5,903

Total fixed-rate

 

2,162,746

 

1,005,264

Adjustable-rate:

 

  

 

  

Commercial

 

25,218

 

30,679

Construction and development

 

297,883

 

243,000

Home equity

 

18,079

 

20,199

One-to-four-family (1)

 

59,188

 

81,457

Loans held for sale (one-to-four-family)

 

6,781

 

25,753

Multi-family

 

14,074

 

44,803

Consumer

 

1,176

 

2,216

Commercial business (2)

 

113,546

 

338,859

Warehouse lines, net

 

(12,020)

 

(4,644)

Total adjustable-rate

 

523,925

 

782,322

Total loans originated

 

2,686,671

 

1,787,586

Purchases by type

 

  

 

  

Fixed-rate:

 

  

 

  

Commercial

Home equity

One-to-four-family (1) (4)

272

321

Multi-family

Consumer

Construction and development

Commercial business (2)

 

 

1,798

Adjustable-rate:

 

  

 

  

Commercial

 

Home equity

One-to-four-family (1)

28,057

 

Multi-family

 

Consumer

Construction and development

Commercial business (2) (3)

 

3,727

 

Total loans purchased

 

32,056

 

2,119

Sales and repayments:

 

  

 

  

One-to-four-family (1)

 

 

Loans held for sale (one-to-four-family)

 

(1,641,880)

 

(785,438)

Commercial business (2)

 

 

(8,365)

Total loans sold

 

(1,641,880)

 

(793,803)

Total principal repayments

 

(757,764)

 

(951,743)

Total reductions

 

(2,399,644)

 

(1,745,546)

Net increase

$

319,083

$

44,159

20

_____________________________

(1)One-to-four-family portfolio loans.
(2)Excludes warehouse lines.
(3)Includes USDA/ SBA guaranteed loans purchased at a premium.
(4)Loan repurchased, previously sold.
(5)Includes $75.8 million of PPP loans.

Sales of whole and participations in real estate loans can be beneficial to the Bank since these sales systematically generate income at the time of sale, produce future servicing income on loans where servicing is retained, provide funds for additional lending and other investments, and increase liquidity.

From time to time we also sell whole consumer loans, specifically long term consumer loans, which can be beneficial to us since these sales generate income at the time of sale, can potentially create future servicing income where servicing is retained, and provide a mitigation of interest rate risk associated with holding 15-20 year maturity consumer loans.

Asset Quality

When a borrower fails to make a required payment on a residential real estate loan, the Company attempts to cure the delinquency by contacting the borrower. In the case of loans secured by residential real estate, a late notice typically is sent 16 days after the due date, and the borrower is contacted by phone within 16 to 25 days after the due date. When the loan is 30 days past due, an action plan is formulated for the credit under the direction of the mortgage loan control manager. Generally, a delinquency letter is mailed to the borrower. All delinquent accounts are reviewed by a loan control representative who attempts to cure the delinquency by contacting the borrower once the loan is 30 days past due. If the account becomes 60 days delinquent and an acceptable repayment plan has not been agreed upon, a Loan Control representative will generally refer the account to legal counsel with instructions to prepare a notice of intent to foreclose. The notice of intent to foreclose allows the borrower up to 30 days to bring the account current. Between 90 - 120 days past due, a value is obtained for the loan collateral. At that time, a mortgage analysis is completed to determine the loan-to-value ratio and any collateral deficiency. If foreclosed, the Company customarily takes title to the property and sells it directly through a real estate broker.

Delinquent consumer loans are handled in a similar manner. Appropriate action is taken in the form of phone calls and notices to collect any loan payment that is delinquent more than 16 days. Once the loan is 90 days past due, it is classified as nonaccrual. Generally, credits are charged off if past due 120 days, unless the collections department provides support for a customer repayment plan. Bank procedures for repossession and sale of consumer collateral are subject to various requirements under the applicable consumer protection laws as well as other applicable laws and the determination by us that it would be beneficial from a cost basis.

Delinquent commercial business loans and loans secured by commercial real estate are handled by the loan officer in charge of the loan, who is responsible for contacting the borrower. The loan officer works with outside counsel and, in the case of real estate loans, a third-party consultant to resolve problem loans. In addition, management meets as needed and reviews past due and classified loans, as well as other loans that management feels may present possible collection problems, which are reported to the AQC and the board on a monthly basis. If an acceptable workout of a delinquent commercial loan cannot be agreed upon, the Company customarily will initiate foreclosure or repossession proceedings on any collateral securing the loan.

21

The following table shows delinquent loans by the type of loan and number of days delinquent at December 31, 2020.  Categories not included in the table below did not have any delinquent loans at December 31, 2020.  Loans that were modified in accordance with the CARES Act and related regulatory guidance are not considered delinquent.

Loans Delinquent For:

 

Total Loans Delinquent

60-89 Days

90 Days or More

60 Days or More

Percent of

Percent of

Percent of

Loan

Loan

Loan

(Dollars in thousands)

    

Number

    

Amount

    

Category

    

Number

    

Amount

    

Category

    

Number

    

Amount

    

Category

Real estate loans

Home equity

2

$

137

0.32

%  

4

$

219

0.51

%  

6

$

356

0.83

%

One-to-four-family

2

404

0.13

4

512

0.16

6

916

0.29

Total real estate loans

4

541

0.06

8

731

0.08

12

1,272

0.14

Consumer loans

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

Indirect home improvement

 

24

 

331

 

0.12

 

22

 

325

 

0.11

 

46

 

656

 

0.23

Marine

2

77

0.09

1

22

0.03

3

99

0.12

Other consumer

 

6

 

22

 

0.64

 

 

 

 

6

 

22

 

0.64

Total consumer loans

 

32

 

430

 

0.11

 

23

 

347

 

0.09

 

55

 

777

 

0.21

Commercial business loans

Commercial and industrial

1

1,204

0.54

1

1,204

0.54

Total commercial business loans

1

1,204

0.44

1

1,204

0.44

Total

 

37

$

2,175

 

0.14

%  

31

$

1,078

 

0.07

%  

68

$

3,253

 

0.21

%

22

Nonperforming Assets. The following table sets forth information with respect to the Company’s nonperforming assets.

December 31, 

(Dollars in thousands)

    

2020

    

2019

    

2018

    

2017

    

2016

Nonaccruing loans:

Real estate loans

Commercial

$

$

1,086

$

$

$

Home equity

636

190

229

151

210

One-to-four-family

 

644

 

1,264

 

1,552

 

142

 

Total real estate loans

 

1,280

 

2,540

 

1,781

 

293

 

210

Consumer loans

 

  

 

  

 

  

 

  

 

  

Indirect home improvement

 

826

 

468

 

408

 

195

 

504

Marine

 

44

 

 

18

 

 

Other consumer

 

1

 

25

 

2

 

 

7

Total consumer loans

 

871

 

493

 

428

 

195

 

511

Commercial business loans

 

  

 

  

 

  

 

  

 

  

Commercial and industrial

 

5,610

 

 

1,685

 

551

 

Total commercial business loans

 

5,610

 

 

1,685

 

551

 

Total nonaccruing loans

 

7,761

 

3,033

 

3,894

 

1,039

 

721

Accruing loans contractually past due 90 days or more

 

 

 

11

 

 

Other real estate owned

 

90

 

168

 

689

 

 

Repossessed assets

 

 

10

 

 

 

15

Total nonperforming assets

$

7,851

$

3,211

$

4,594

$

1,039

$

736

TDR loans

$

$

$

$

55

$

57

Total nonperforming assets as a percentage of total assets

 

0.37

%  

 

0.19

%  

 

0.28

%  

 

0.11

%  

 

0.09

%

For the year ended December 31, 2020, gross interest income, which would have been recorded had the nonaccruing loans been current in accordance with their original terms was $335,000.  Prior to nonaccrual status, the amount of interest income included in net income for the year ended December 31, 2020 was $304,000 for these loans.

Other Real Estate Owned. Real estate acquired by the Company as a result of foreclosure or by deed-in-lieu of foreclosure is classified as real estate owned until it is sold. When the property is acquired, it is recorded at the lower of its cost, which is the unpaid principal balance of the related loan plus foreclosure costs, or the fair market value of the property less selling costs. The Company had one real estate owned property as of December 31, 2020.

Restructured Loans. According to generally accepted accounting principles in the United States of America  (“U.S. GAAP”), the Company is required to account for certain loan modifications or restructuring as a “troubled debt restructuring” or “TDR”.  In general, the modification or restructuring of a debt is considered a TDR if the Company, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrowers that would not otherwise be considered.  The Company had no TDRs at December 31, 2020. In late March 2020, the Bank announced loan modification programs to support and provide relief for its borrowers during the COVID-19 pandemic. The Company has followed the CARES Act and interagency guidance from the federal banking agencies when determining if a borrower's modification is subject to TDR classification. For a discussion on loans that qualified for deferral or forbearance agreements under the CARES Act and related guidance, see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Highlights in Response to the COVID-19 Pandemic” and “Note 3 - Loans Receivable and Allowance for Loan Losses.” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.

Other Assets Especially Mentioned. At December 31, 2020, there was $7.1 million of loans with respect to which known information about the possible credit problems of the borrowers caused management to have doubts as

23

to the ability of the borrowers to comply with present loan repayment terms and which may result in the future inclusion of such items in the nonperforming asset categories.  

Classified Assets. Federal regulations provide for the classification of lower quality loans and other assets (such as other real estate owned and repossessed property), debt and equity securities, as substandard, doubtful or loss. An asset is considered substandard if it is inadequately protected by the current net worth and pay capacity of the borrower or of any collateral pledged. Substandard assets include those characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. Assets classified as doubtful have all the weaknesses inherent in those classified substandard with the added characteristic that the weaknesses present make collection or liquidation in full highly questionable and improbable, on the basis of currently existing facts, conditions, and values. Assets classified as loss are those considered uncollectible and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted.

When the Company classifies problem assets as either substandard or doubtful, a specific allowance may be established in an amount deemed prudent to address specific impairments. General allowances represent loss allowances which have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets. When an insured institution classifies problem assets as a loss, it is required to charge off those assets in the period in which they are deemed uncollectible. The Company’s determination as to the classification of assets and the amount of valuation allowances is subject to review by the FDIC and the DFI, which can order the establishment of additional loss allowances. Assets which do not currently expose the Company to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses are required to be designated as special mention.

In connection with the filing of periodic reports with the FDIC and in accordance with the Company’s classification of assets policy, the Company regularly reviews the problem assets in the portfolio to determine whether any assets require classification in accordance with applicable regulations. On the basis of the review of the Company’s assets, at December 31, 2020, the Company had classified $17.6 million of assets as substandard. The $17.6 million of classified assets represented 7.7% of equity and 0.84% of total assets at December 31, 2020. The Company had $7.1 million of assets classified as special mention at December 31, 2020, not included in classified assets reported above.

Allowance for Loan Losses

The Company maintains an allowance for loan losses to absorb probable incurred credit losses in the loan portfolio. The allowance is based on ongoing monthly assessments of the estimated probable incurred losses in the loan portfolio. Ultimate losses may vary from these estimates. In evaluating the level of the allowance for loan losses, management considers the types of loans and the amount of loans in the loan portfolio, peer group information, historical loss experience, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. The Company also considers qualitative factors such as changes in the lending policies and procedures, changes in the local/national economy, changes in volume or type of

credits, changes in volume/severity of problem loans, quality of loan review and board of director oversight and concentrations of credit. The qualitative factors have been established based on certain assumptions made as a result

of the current economic conditions and are adjusted as conditions change to be directionally consistent with these changes. Large groups of smaller balance homogeneous loans, such as residential real estate, small commercial real estate, home equity and consumer loans, are evaluated in the aggregate using historical loss factors and peer group data adjusted for current economic conditions. More complex loans, such as commercial real estate loans and commercial business loans, are evaluated individually for impairment, primarily through the evaluation of net operating income and available cash flow and their possible impact on collateral values.

When determining the appropriate allowance for loan losses during 2020, management took into consideration the impact of the COVID-19 pandemic on such additional qualitative factors as the national and state unemployment rates and related trends, national and state unemployment benefit claim levels and related trends, the amount of and timing of financial assistance provided by the government, consumer spending levels and trends,

24

industries significantly impacted by the COVID-19 pandemic, a review of the Bank's largest commercial loan relationships, and the Bank's COVID-19 loan modification program.

Management increased qualitative factors during 2020 due to the deterioration of economic conditions as a result of the COVD-19 pandemic. The increase in the factors resulted in a significant increase in the allowance for loan losses during the current year. Management will continue to closely monitor economic conditions and will work with borrowers as necessary to assist them through this challenging economic climate. If economic conditions worsen or do not improve in the near term, and if future government programs, if any, do not provide adequate relief to borrowers, it is possible the Bank's allowance for loan losses will need to increase in future periods. Uncertainties relating to our allowance for loan losses  are heightened as a result of the risks surrounding the COVID-19 pandemic as described in further detail in Item 1A. Risk Factors - “Risks Related to Macroeconomic Conditions-The COVID-19 pandemic has impacted the way we conduct business which may adversely impact our financial results and those of our customers. The ultimate impact will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic.”

The allowance is increased by the provision for loan losses, which is charged against current period earnings and decreased by the amount of actual loan charge-offs, net of recoveries.

The provision for loan losses was $13.0 million for the year ended December 31, 2020 as compared to $2.9 million for the year ended December 31, 2019, due primarily to the incurred but not yet reported probable loan losses reflecting credit deterioration due to the adverse impact of the COVID-19 pandemic and the increase in the loan portfolio due to organic growth. The $62.1 million balance of PPP loans was omitted from the calculation of the allowance for loan losses at December 31, 2020 as these loans are fully guaranteed by the SBA and management expects that the great majority of PPP borrowers will seek full or partial forgiveness of their loan obligations from the SBA within a short time frame, which will in turn reimburse the Bank for the amount forgiven. In addition, the provision for loan losses also reflects risk rating downgrades on $103.3 million of loans that are considered at risk due to the COVID-19 pandemic. The majority of the downgrades were to a “Watch” grade and therefore were not classified as either special mention or other assets especially mentioned.

The allowance for loan losses was $26.2 million, or 1.66% of gross loans receivable at December 31, 2020, as compared to $13.2 million, or 0.98% of gross loans receivable outstanding at December 31, 2019.  In accordance with acquisition accounting, loans acquired in the Anchor Bank acquisition in November 2018 (“Anchor Acquisition”) were recorded at their estimated fair value, which resulted in a net discount to the contractual amounts of the loans, of which a portion reflects a discount for possible credit losses. Credit discounts are included in the determination of fair value and as a result, no allowance for loan losses is recorded for acquired loans at the acquisition date. Although the discount recorded on the acquired loans is not reflected in the allowance for loan losses, or related allowance coverage ratios, we believe it should be considered when comparing the current ratios to similar ratios in periods prior to the acquisition. The remaining fair value discount on loans purchased in the Anchor Acquisition was $1.5 million, on $132.6 million of gross loans at December 31, 2020.  Management will continue to review the adequacy of the allowance for loan losses and make adjustments to the provision for loan losses based on loan growth, economic conditions, charge-offs and portfolio composition.  A further decline in national and local economic conditions, as a result of the COVID-19 pandemic or other factors, could result in a material increase in the allowance for loan losses and may adversely affect the Company's financial condition and results of operations.

Assessing the allowance for loan losses is inherently subjective as it requires making material estimates, including the amount and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. In the opinion of management, the allowance, when taken as a whole, reflects probable incurred loan losses in the loan portfolio. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Comparison of Results of Operations for the Years Ended December 31, 2020 and 2019 - Provision for Loan Losses” and “Notes 1- Basis of Presentation and Summary of Significant Accounting Policies” and “Note 3 - Loans Receivable and Allowance for Loan Losses” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.

25

The following table summarizes the distribution of the allowance for loan losses by loan category.

December 31,

2020

2019

2018

2017

2016

    

    

Percent

    

    

    

Percent

    

    

    

Percent

    

    

    

Percent

    

    

    

Percent

    

of

of

of

of

of

loan

loan

loan

loan

loan

balance

Allowance

balance

Allowance

balance

Allowance

balance

Allowance

balance

Allowance

 in each  

 for loan

 in each  

 for loan

 in each  

 for loan

 in each  

 for loan

 in each  

 for loan

category

losses by

category

losses by

category

losses by

category

losses by

category

losses by

Loan

to

loan

Loan

to

loan

Loan

to

loan

Loan

to

loan

Loan

to

loan

(Dollars in thousands)

balance

total loans

category

balance

total loans

category

balance

total loans

category

balance

total loans

category

balance

total loans

category

Allocated at end of year to:

Real estate loans

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

Commercial

$

152,131

 

9.66

%  

$

3,366

$

114,015

 

8.43

%  

$

1,524

$

74,039

 

5.58

%  

$

985

$

63,611

 

8.22

%  

$

868

$

55,871

 

9.23

%  

$

708

Construction and development

 

215,962

 

13.72

 

3,528

 

175,567

 

12.99

 

1,988

 

196,815

 

14.84

 

2,677

 

143,068

 

18.50

 

2,146

 

94,462

 

15.60

 

1,273

Home equity

 

37,096

 

2.36

 

691

 

29,606

 

2.19

 

343

 

27,295

 

2.06

 

320

 

25,289

 

3.27

 

263

 

20,081

 

3.32

 

244

One-to-four-family

 

290,036

 

18.42

 

3,494

 

224,967

 

16.64

 

1,349

 

194,343

 

14.65

 

1,288

 

163,655

 

21.16

 

1,004

 

124,009

 

20.48

 

947

Multi-family

 

102,894

 

6.54

 

1,276

 

91,975

 

6.80

 

987

 

49,125

 

3.71

 

491

 

44,451

 

5.75

 

489

 

37,527

 

6.20

 

375

Total real estate loans

 

798,119

 

50.70

 

12,355

 

636,130

 

47.05

 

6,191

 

541,617

 

40.84

 

5,761

 

440,074

 

56.90

 

4,770

 

331,950

 

54.83

 

3,547

Consumer loans

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

Indirect home improvement

 

286,020

 

18.17

 

5,271

 

254,616

 

18.84

 

3,073

 

212,226

 

16.00

 

2,731

 

171,225

 

22.14

 

2,374

 

144,262

 

23.83

 

1,811

Marine

 

85,740

 

5.45

 

1,356

 

67,179

 

4.97

 

663

 

57,822

 

4.36

 

586

 

35,397

 

4.58

 

405

 

28,549

 

4.71

 

229

Other consumer

 

1,913

 

0.12

 

41

 

2,038

 

0.15

 

30

 

2,012

 

0.15

 

34

 

2,046

 

0.26

 

35

 

1,915

 

0.32

 

42

Total consumer loans

 

373,673

 

23.74

 

6,668

 

323,833

 

23.96

 

3,766

 

272,060

 

20.51

 

3,351

 

208,668

 

26.98

 

2,814

 

174,726

 

28.86

 

2,082

Commercial business loans

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

Commercial and industrial

 

220,978

 

14.04

 

4,123

 

135,565

 

10.03

 

2,503

 

119,910

 

9.04

 

2,435

 

83,306

 

10.77

 

1,531

 

65,841

 

10.88

 

2,297

Warehouse lending

 

49,092

 

3.12

 

712

 

61,112

 

4.52

 

751

 

65,756

 

4.96

 

756

 

41,397

 

5.35

 

483

 

32,898

 

5.43

 

378

Total commercial business loans

 

270,070

 

17.16

 

4,835

 

196,677

 

14.55

 

3,254

 

185,666

 

14.00

 

3,191

 

124,703

 

16.12

 

2,014

 

98,739

 

16.31

 

2,675

Anchor Acquisition loans at fair value

132,365

8.40

1,623

195,253

14.44

15

326,895

24.65

Unallocated reserve

 

 

 

691

 

 

 

3

 

 

 

46

 

 

 

1,158

 

 

 

1,907

Total

$

1,574,227

 

100.00

%  

$

26,172

$

1,351,893

 

100.00

%  

$

13,229

$

1,326,238

 

100.00

%  

$

12,349

$

773,445

 

100.00

%  

$

10,756

$

605,415

 

100.00

%  

$

10,211

26

The following table sets forth an analysis of the allowance for loan losses at the dates and or the years indicated.

Year Ended December 31, 

(Dollars in thousands)

    

2020

    

2019

    

2018

    

2017

    

2016

Balance at beginning of year

 

$

13,229

 

$

12,349

 

$

10,756

 

$

10,211

 

$

7,785

Charge-offs:

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

Real estate loans

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

Commercial

 

 

 

 

 

 

 

 

 

 

One-to-four-family

2

Home equity

 

 

 

 

3

 

 

4

 

 

65

 

 

65

Total real estate loans

 

 

 

 

5

 

 

4

 

 

65

 

 

65

Consumer loans

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

Indirect home improvement

 

 

875

 

 

850

 

 

899

 

 

781

 

 

872

Marine

 

 

161

 

 

122

 

 

35

 

 

23

 

 

81

Other consumer

 

 

65

 

 

68

 

 

2

 

 

28

 

 

49

Total consumer loans

 

 

1,101

 

 

1,040

 

 

936

 

 

832

 

 

1,002

Commercial business loans

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

Commercial and industrial

 

 

22

 

 

1,583

 

 

 

 

33

 

 

Total commercial business loans

 

 

22

 

 

1,583

 

 

 

 

33

 

 

Total charge-offs

 

 

1,123

 

 

2,628

 

 

940

 

 

930

 

 

1,067

Recoveries:

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

Real estate loans

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

Commercial

 

 

 

 

 

 

 

 

 

 

Home equity

 

 

 

 

10

 

 

20

 

 

35

 

 

68

One-to-four-family

 

 

18

 

 

1

 

 

22

 

 

 

 

48

Total real estate loans

 

 

18

 

 

11

 

 

42

 

 

35

 

 

116

Consumer loans

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

Indirect home improvement

 

 

616

 

 

523

 

 

908

 

 

611

 

 

780

Marine

 

 

25

 

 

56

 

 

17

 

 

27

 

 

29

Other consumer

 

 

18

 

 

38

 

 

22

 

 

42

 

 

81

Total consumer loans

 

 

659

 

 

617

 

 

947

 

 

680

 

 

890

Commercial business loans

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

Commercial and industrial

 

 

353

 

 

 

 

4

 

 

10

 

 

87

Total commercial business loans

 

 

353

 

 

 

 

4

 

 

10

 

 

87

Total recoveries

 

 

1,030

 

 

628

 

 

993

 

 

725

 

 

1,093

Net charge-offs (recoveries)

 

 

93

 

 

2,000

 

 

(53)

 

 

205

 

 

(26)

Additions charged to operations

 

 

13,036

 

 

2,880

 

 

1,540

 

 

750

 

 

2,400

Balance at end of year

 

$

26,172

 

$

13,229

 

$

12,349

 

$

10,756

 

$

10,211

Net charge-offs to average loans outstanding

 

 

0.01

%  

 

0.15

%  

 

%  

 

0.03

%  

 

%

Net charge-offs (recoveries) to average nonperforming assets

 

 

1.68

%  

 

51.24

%  

 

(1.90)

%  

 

23.10

%  

 

(3.00)

%

Allowance as a percentage of nonperforming loans

 

 

337.22

%  

 

436.17

%  

 

317.13

%  

 

1,035.23

%  

 

1,416.23

%

Allowance as a percentage of gross loans receivable (end of year)  

 

 

1.66

%  

 

0.98

%  

 

0.93

%  

 

1.39

%  

 

1.69

%

While management believes that the estimates and assumptions used in its determination of the adequacy of the allowance for loan losses are reasonable, there can be no assurance that such estimates and assumptions will not be proven incorrect in the future, or that the actual amount of future provisions will not exceed the amount of past provisions or that any increased provisions that may be required will not adversely impact the Company’s financial condition and results of operations. In addition, the determination of the amount of the Bank’s allowance for loan losses is subject to review by

27

bank regulators as part of the routine examination process, which may result in the adjustment of reserves based upon their judgment of information available to them at the time of their examination.

Investment Activities

General. Under Washington law, savings banks are permitted to invest in various types of liquid assets, including U.S. Treasury obligations, securities of various federal agencies, certain certificates of deposit of insured banks and savings institutions, banker’s acceptances, repurchase agreements, federal funds (“Fed Funds”), commercial paper, investment grade corporate debt securities, and obligations of states and their political subdivisions.

The Chief Financial Officer has the responsibility for the management of the Company’s investment portfolio, subject to consultation with the Chief Executive Officer, and the direction and guidance of the Board of Directors. Various factors are considered when making investment decisions, including the marketability, maturity and tax consequences of the proposed investment. The maturity structure of investments will be affected by various market conditions, including the current and anticipated slope of the yield curve, the level of interest rates, the trend of new deposit inflows, and the anticipated demand for funds via deposit withdrawals and loan originations and purchases.

The general objectives of the Company’s investment portfolio will be to provide liquidity when loan demand is high, to assist in maintaining earnings when loan demand is low and to maximize earnings while satisfactorily managing risk, including credit risk, reinvestment risk, liquidity risk, and interest rate risk. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management and Market Risk” of this Form 10-K.

As a member of the FHLB of Des Moines, the Bank had $7.4 million in stock at December 31, 2020. For the year ended December 31, 2020, the Bank received $394,000 in dividends.

The table below sets forth information regarding the composition of the securities portfolio and other investments at the dates indicated. At December 31, 2020, the securities portfolio did not contain securities of any issuer with an aggregate book value in excess of 10% of equity capital, excluding those issued by the United States Government or its agencies.

December 31, 

2020

2019

2018

    

Amortized

    

Fair

    

Amortized

    

Fair

    

Amortized

    

Fair

(In thousands)

Cost

Value

Cost

Value

Cost

Value

Securities available-for-sale

U.S. agency securities

$

7,940

$

8,105

$

8,986

$

9,066

$

16,052

$

15,887

Corporate securities

 

11,885

 

11,000

 

10,525

 

10,570

 

7,074

 

6,865

Municipal bonds

 

69,572

 

71,857

 

20,516

 

21,120

 

14,446

 

14,194

Mortgage-backed securities

 

65,722

 

68,187

 

62,745

 

62,850

 

45,827

 

44,836

U.S. Small Business Administration securities

 

18,441

 

18,869

 

22,281

 

22,451

 

15,690

 

15,423

Total securities available-for-sale

173,560

178,018

125,053

126,057

99,089

97,205

Securities held-to-maturity

Corporate securities

7,500

7,556

Total securities

$

181,060

$

185,574

$

125,053

$

126,057

$

99,089

$

97,205

28

The composition and contractual maturities of the investment portfolio at December 31, 2020, excluding FHLB stock, are indicated in the following table. The yields on municipal bonds have not been computed on a tax equivalent basis.

December 31, 2020

1 year or less

Over 1 year to 5 years

Over 5 to 10 years

Over 10 years

Total Securities

    

    

Weighted

    

    

Weighted

    

    

Weighted

    

    

Weighted

    

    

Weighted

    

Amortized

Average

Amortized

Average

Amortized

Average

Amortized

Average

Amortized

Average

Fair

(Dollars in thousands)

Cost

 

Yield

Cost

 

Yield

Cost

 

Yield

Cost

 

Yield

Cost

 

Yield

Value

Securities available-for-sale

U.S. agency securities

$

 

%  

$

978

 

2.75

%  

$

1,000

 

3.15

%  

$

5,962

 

1.19

%  

$

7,940

 

1.63

%  

$

8,105

Corporate securities

 

2,392

 

2.39

 

3,493

 

1.44

 

4,000

 

3.25

 

2,000

 

2.05

 

11,885

 

2.34

 

11,000

Municipal bonds

 

101

 

2.24

 

3,749

 

2.71

 

7,994

 

2.22

 

57,728

 

2.04

 

69,572

 

2.10

 

71,857

Mortgage-backed securities:

 

 

 

 

 

 

 

 

 

 

 

Federal National Mortgage Association

3,903

3.11

19,944

2.53

23,828

2.45

47,675

2.54

50,005

Federal Home Loan Mortgage Corporation

602

2.09

11,223

1.95

11,825

1.95

11,913

Government National Mortgage Association

1,176

2.86

5,046

1.83

6,222

2.03

6,269

U.S. Small Business Administration securities

 

 

 

2,266

 

2.76

 

8,097

 

2.20

 

8,078

 

1.50

 

18,441

 

1.96

 

18,869

Total securities available-for-sale

2,493

 

2.38

14,389

 

2.52

42,813

 

2.12

113,865

 

2.02

173,560

 

2.09

178,018

Securities held-to-maturity

Corporate securities

7,500

5.06

7,500

5.06

7,556

Total securities

$

2,493

2.38

%  

$

14,389

2.52

%  

$

50,313

2.56

%  

$

113,865

2.02

%  

$

181,060

2.24

%  

$

185,574

29

Deposit Activities and Other Sources of Funds

General. Deposits, borrowings, and loan repayments are the major sources of funds for lending and other investment purposes. Scheduled loan repayments are a relatively stable source of funds, while deposit inflows and outflows and loan prepayments are influenced significantly by general interest rates and market conditions. Borrowings from the FHLB of Des Moines are used to supplement the availability of funds from other sources and also as a source of term funds to assist in the management of interest rate risk.

The Company’s deposit composition reflects a mixture with certificates of deposit (including brokered) accounting for 30.02% of the total deposits at December 31, 2020, and interest and noninterest-bearing checking, savings and money market accounts comprising the balance of total deposits. The Company relies on marketing activities, convenience, customer service and the availability of a broad range of deposit products and services to attract and retain customer deposits. The Company had $201.4 million of brokered deposits, or 12.03% of total deposits at December 31, 2020.  As a wholesale funding alternative, brokered deposits have competitive rates that are comparable to FHLB borrowings and local certificates of deposit.

Deposits. Deposits are attracted from within the market area through the offering of a broad selection of deposit instruments, including checking accounts, money market deposit accounts, savings accounts, and certificates of deposit with a variety of rates. Deposit account terms vary according to the minimum balance required, the time periods the funds must remain on deposit, and the interest rate, among other factors. In determining the terms of the Company’s deposit accounts, the Company considers the development of long-term profitable customer relationships, current market interest rates, current maturity structure and deposit mix, customer preferences, and the profitability of acquiring customer deposits compared to alternative sources.

The following table sets forth total deposit activities for the years indicated.

Year Ended December 31, 

(Dollars in thousands)

    

2020

    

2019

    

2018

Beginning balance

$

1,392,408

$

1,274,219

$

829,842

Net deposits before interest credited

 

269,683

(1)(2)  

 

102,027

(1)(2)  

 

437,056

(1)(2)  

Interest credited

 

11,980

 

16,162

 

7,321

Ending balance

$

1,674,071

$

1,392,408

$

1,274,219

Net increase in deposits

$

281,663

$

118,189

$

444,377

Percent increase

 

20.23

%  

 

9.28

%  

 

53.55

%

_______________________

(1)On January 22, 2016, the Company purchased four retail bank branches from Bank of America, N.A (the “Branch Purchase”) and acquired approximately $186.4 million in deposits. At December 31, 2020, 2019, and 2018, approximately $129.5 million, $117.1 million, and $120.0 million of the acquired deposits, respectively, remained with the Bank. These branches also attracted new deposits. At December 31, 2020, they had an aggregated total of $343.2 million in deposits, including public funds.
(2)On November 15, 2018, the Company completed the Anchor Acquisition and acquired approximately $357.9 million in deposits.  At December 31, 2020 and 2019, approximately $286.5 million and approximately $299.0 million of the acquired deposits remained with the Bank, respectively.

30

The following table sets forth the dollar amount of savings deposits in the various types of deposit programs the Company offered at the dates indicated.

December 31, 

2020

2019

(Dollars in thousands)

    

Amount

    

Percent of Total

    

Amount

    

Percent of Total

Transactions and Savings Deposits

Noninterest-bearing checking

$

348,421

 

20.81

%  

$

260,131

 

18.68

%

Interest-bearing checking

 

226,282

 

13.52

 

177,972

 

12.78

Savings

 

152,842

 

9.13

 

118,845

 

8.53

Money market

 

429,548

 

25.66

 

270,489

 

19.43

Escrow accounts related to mortgages serviced

 

14,432

 

0.86

 

13,471

 

0.97

Total transaction and savings deposits

 

1,171,525

 

69.98

 

840,908

 

60.39

Certificates

 

  

 

  

 

  

 

  

0.00 - 1.99%

 

406,551

 

24.29

 

297,118

 

21.34

2.00 - 3.99%

 

95,995

 

5.73

 

254,382

 

18.27

Total certificates

 

502,546

 

30.02

 

551,500

 

39.61

Total deposits

$

1,674,071

 

100.00

%  

$

1,392,408

 

100.00

%

The following table sets forth the rate and maturity information of time deposit certificates at December 31, 2020.

Rate

 

    

0.00 -

    

2.00 -

    

    

Percent

 

(Dollars in thousands)

1.99%

3.99%

Total

 

of Total

Certificate accounts maturing in quarter ending:

 

  

 

  

 

  

 

  

March 31, 2021

$

153,501

$

184

$

153,685

 

30.58

%

June 30, 2021

 

40,144

 

13,545

53,689

 

10.68

September 30, 2021

 

60,645

 

15,840

76,485

 

15.22

December 31, 2021

 

43,221

 

13,787

57,008

 

11.34

March 31, 2022

 

8,261

 

8,483

16,744

 

3.33

June 30, 2022

 

13,540

 

16,242

29,782

 

5.93

September 30, 2022

 

17,401

 

4,453

21,854

 

4.35

December 31, 2022

 

15,192

 

4,957

20,149

 

4.01

March 31, 2023

 

5,905

 

3,005

8,910

 

1.77

June 30, 2023

 

4,493

 

1,142

5,635

 

1.12

September 30, 2023

 

339

 

1,917

2,256

 

0.45

December 31, 2023

 

403

 

2,787

3,190

 

0.64

Thereafter

 

43,506

 

9,653

53,159

 

10.58

Total

$

406,551

$

95,995

$

502,546

 

100.00

%

Percent of total

 

80.90

%  

 

19.10

%  

 

100.00

%  

  

The following table indicates the amount of jumbo certificates of deposit by time remaining until maturity at December 31, 2020. Jumbo certificates of deposit are certificates in amounts of $100,000 or more.

Maturity

 

    

    

Over

    

Over

    

    

3 Months

3 to 6

6 to 12

Over

(In thousands)

or Less

Months

Months

12 Months

Total

Certificates of deposit of less than $100,000(1)

$

123,620

$

19,237

$

58,230

$

98,070

$

299,157

Certificates of deposit of $100,000 to less than $250,000

 

22,246

 

20,615

 

55,318

 

37,722

 

135,901

Certificates of deposit of $250,000 and over

 

7,819

 

13,837

 

19,945

 

25,887

 

67,488

Total certificates of deposit

$

153,685

$

53,689

$

133,493

$

161,679

$

502,546

__________________________

(1)Includes $186.4 million of brokered certificates of deposit at December 31, 2020.

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The Federal Reserve requires the Bank to maintain reserves on transaction accounts or non-personal time deposits. These reserves may be in the form of cash or noninterest-bearing deposits with the Federal Reserve Bank of San Francisco (“Federal Reserve Bank”). Negotiable order of withdrawal (“NOW”) accounts and other types of accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to the reserve requirements, as are any non-personal time deposits at a savings bank. Effective March 26, 2020, the Federal Reserve lowered the reserve requirement to zero percent.  There was no required reserve balance at December 31, 2020.

Debt. Although customer deposits are the primary source of funds for lending and investment activities, the Company uses various borrowings such as advances and warehouse lines of credit from the FHLB of Des Moines, and to a lesser extent Fed Funds purchased to supplement the supply of lendable funds, to meet short-term deposit withdrawal requirements and also to provide longer term funding to better match the duration of selected loan and investment maturities.

As one of the Company’s capital management strategies, the Company has used advances from the FHLB of Des Moines to fund loan originations in order to increase net interest income. Depending upon the retail banking activity, the Company will consider and may undertake additional leverage strategies within applicable regulatory requirements or restrictions. These borrowings would be expected to primarily consist of FHLB of Des Moines advances.

As a member of the FHLB of Des Moines, the Bank is required to own capital stock in the FHLB of Des Moines and authorized to apply for advances on the security of that stock and certain mortgage loans and other assets (principally securities which are obligations of, or guaranteed by, the U.S. Government) provided certain creditworthiness standards have been met. Advances are individually made under various terms pursuant to several different credit programs, each with its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based on the financial condition of the member institution and the adequacy of collateral pledged to secure the credit. The Bank maintains a committed credit facility with the FHLB of Des Moines that provides for immediately available advances up to an aggregate of $568.2 million at December 31, 2020.  Outstanding advances from the FHLB of Des Moines totaled $102.5 million at December 31, 2020.

During the year ended December 31, 2020, the Company utilized the Federal Reserve's Paycheck Protection Program Liquidity Facility (“PPPLF”), established to bolster the effectiveness of the SBA’s PPP.  Under the PPPLF, the Bank may pledge its PPP loans as collateral at face value to obtain Federal Reserve Bank non-recourse loans.  As of December 31, 2020, the Company had borrowed $63.3 million under the PPPLF, with no additional borrowing capacity.  Advances under the PPPLF incur interest at a per annum rate of 0.35%.  The maturity date of any PPPLF advance (the “Maturity Date”) will be the maturity date of the PPP loan pledged to secure the PPPLF advance.  The Maturity Date of any PPPLF advance will be accelerated on and to the extent of (i) the date of any loan forgiveness reimbursement by the SBA for any PPP loan securing the PPPLF advance; or (ii) the date of purchase by the SBA from the Bank of any PPP loan securing the PPPLF loan advance to realize on the SBA’s guarantee of the PPP loan.

PPPLF loans may be prepaid in full or in part, without penalty.  The Bank shall prepay PPPLF advances (i) on the date and to the extent of the payment by the SBA for the amount of covered loan forgiveness for any PPP loan securing the PPPLF advance; (ii) on the date of purchase by the SBA from the Bank of a PPP loan securing the PPPLF advances to realize on the SBA’s guarantee of such PPP loans; or (iii) on the date and to the extent a borrower under a PPP loan repays or prepays such PPP loans, in each case, so that the amount of any PPPLF advances outstanding does not exceed the outstanding amount of PPP loans pledged to secure such PPPLF advances. No new borrowings will be made under the PPPLF after March 31, 2021 unless the Federal Reserve Board and the U.S. Department of the Treasury determine to extend the PPPLF.

As of December 31, 2020, the Company also had $179.6 million of additional short-term borrowing capacity with the Federal Reserve Bank. The Bank also had an aggregate of $101.0 million in unsecured Fed Funds lines of credit with other financial institutions of which none was outstanding at December 31, 2020.

On October 15, 2015, FS Bancorp, Inc. closed on a third-party loan commitment by the issuance of an unsecured subordinated term note in the aggregate principal amount of $10.0 million due October 1, 2025 (the “Subordinated Note”). The Subordinated Note’s maturity date was October 1, 2025, but the Company redeemed the Subordinated Note with prior regulatory approval on January 4, 2021.

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On February 10, 2021, FS Bancorp, Inc. completed the private placement of $50.0 million of its 3.75% fixed-to-floating rate subordinated notes due 2031 (the “Notes”) at an offering price equal to 100% of the aggregate principal amount of the Notes, resulting in net proceeds, after placement agent fees and offering expenses, of approximately $49.3 million.  FS Bancorp intends to use the net proceeds it received from the sale of the Notes for general corporate purposes, including providing capital to support the organic growth of the Bank and for potential share repurchase activities and acquisition opportunities. The Notes were issued under an Indenture, dated February 10, 2021(the “Indenture”), by and between the Company and U.S. Bank National Association, as trustee.  From and including the original issue date to, but excluding, February 15, 2026 or the date of earlier redemption, FS Bancorp will pay interest on the Notes semi-annually in arrears on February 15 and August 15 of each year, commencing on August 15, 2021, at a fixed annual interest rate equal to 3.75%. From and including February 15, 2026 to but excluding the maturity date or the date of earlier redemption, the floating interest rate per annum will be equal to a benchmark rate, which is expected to be Three-Month Term SOFR (as defined in the Indenture) plus a spread of 337 basis points, payable quarterly in arrears on February 15, May 15, August 15 and November 15 of each year, commencing on May 15, 2026. Notwithstanding the foregoing, in the event that the benchmark rate is less than zero, the benchmark rate shall be deemed to be zero. The Notes will mature on February 15, 2031.

On or after February 15, 2026, FS Bancorp may redeem the Notes, in whole or in part, at an amount equal to 100% of the outstanding principal amount being redeemed plus accrued interest.  The Notes are not redeemable by FS Bancorp prior to February 15, 2026 except in the event that (i) the Notes no longer qualify as Tier 2 capital, (ii) the interest on the Notes is determined by law to be not deductible for Federal Income Tax reporting or (iii) FS Bancorp is considered an investment company pursuant to the Investment Company Act of 1940. The Notes are not subject to redemption by the noteholder.

The Notes are unsecured obligations and are subordinated in right of payment to all existing and future indebtedness, deposits and other liabilities of the Company's current and future subsidiaries, including the Banks’ deposits as well as the Company's subsidiaries' liabilities to general creditors and liabilities arising during the ordinary course of business. The Notes may be included in Tier 2 capital for the Company under current regulatory guidelines and interpretations.

In connection with the sale and issuance of the Notes, FS Bancorp also entered into a Registration Rights Agreement (the “Registration Rights Agreement”) with the purchasers of the Notes. Under the terms of the Registration Rights Agreement, FS Bancorp has agreed to take certain actions to provide for the exchange of the Notes for subordinated notes that are registered with SEC under the Securities Act of 1933, as amended and that have substantially the same terms as the Notes. Under certain circumstances, if FS Bancorp fails to meet its obligations under the Registration Rights Agreement, it would be required to pay additional interest to the holders of the Notes. For additional information related to borrowings, see “Note 9 - Debt” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10 K.  

33

The following tables set forth information regarding both long- and short-term borrowings at the years indicated.

Year Ended December 31, 

 

(Dollars in thousands)

 

2020

 

2019

 

2018

Maximum balance:

Federal Home Loan Bank advances and Fed Funds

    

$

159,114

    

$

186,401

    

$

180,025

Federal Reserve Bank

40,000

5,000

Fed Funds lines of credit

865

5,000

21,016

Subordinated note (excluding unamortized debt issuance cost)

10,000

10,000

10,000

Paycheck Protection Program Liquidity Facility

74,112

Average balances:

 

  

 

  

 

  

Federal Home Loan Bank advances and Fed Funds

$

99,773

$

93,653

$

96,044

Federal Reserve Bank

1,096

167

Fed Funds lines of credit

3

318

5,286

Subordinated note (excluding unamortized debt issuance cost)

10,000

10,000

10,000

Paycheck Protection Program Liquidity Facility

46,965

Cost of borrowing:

 

 

 

Federal Home Loan Bank advances and Fed Funds

 

1.80

%  

 

2.61

%  

 

2.02

%

Fed Funds

 

0.25

 

2.96

 

Fed Funds lines of credit

 

0.36

 

2.09

 

1.93

Subordinated note (excluding unamortized debt issuance cost)

 

7.76

 

6.88

 

6.89

Paycheck Protection Program Liquidity Facility

 

0.35

 

 

At December 31, 

 

(Dollars in thousands)

    

2020

    

2019

    

2018

Balance outstanding at end of year:

Federal Home Loan Bank advances

$

102,528

$

84,864

$

137,149

Paycheck Protection Program Liquidity Facility

63,281

Subordinated note

10,000

10,000

10,000

Weighted average interest rate of:

 

  

 

  

 

  

Federal Home Loan Bank advances, at end of year

 

1.68

%  

 

2.29

%  

 

2.38

%

Paycheck Protection Program Liquidity Facility

0.35

Subordinated note

6.50

6.50

6.50

Subsidiary and Other Activities

The Company has one active subsidiary, which is the Bank, and the Bank has one inactive subsidiary. The Bank had no capital investment in its inactive subsidiary at December 31, 2020.

Competition

The Company faces strong competition in attracting deposits. Competition in originating real estate loans comes primarily from other savings institutions, commercial banks, credit unions, life insurance companies, mortgage bankers, and more recently, financial technology (or “FinTech”) companies. Other savings institutions, commercial banks, credit unions, finance, and FinTech companies provide vigorous competition in consumer lending, including indirect lending. Commercial business competition is primarily from local commercial banks. The Company competes by delivering high-quality, personal service to customers that result in a high level of customer satisfaction.

The Company’s market areas have a high concentration of financial institutions, many of which are branches of large money centers and regional banks that have resulted from the consolidation of the banking industry in Washington and other western states. These include such large national lenders as Wells Fargo, Bank of America, Chase, and others in the Company’s market area that have greater resources and offer services that the Bank does not provide. For example, the Bank does not offer trust services. Customers who seek “one-stop shopping” may be drawn to institutions that offer services that the Bank does not.

34

The Company attracts deposits through the branch office system. Competition for those deposits is principally from other savings institutions, commercial banks and credit unions located in the same community, as well as mutual funds, FinTech companies, and other alternative investments. The Bank competes for these deposits by offering superior service and a variety of deposit accounts at competitive rates. Based on the most recent branch deposit data provided by the FDIC, at June 30, 2020, 1st Security Bank of Washington’s share of aggregate deposits in the market area consisting of the eleven counties where the Company has branches was less than one percent.

Employees

At December 31, 2020, the Company had 506 full-time equivalent employees. Company employees are not represented by any collective bargaining group. The Company considers employee relations to be good.

Set forth below is certain information regarding the executive officers of the Company and the Bank. There are no family relationships among or between the executive officers.

Executive Officers. The following table sets forth information with respect to the executive officers of the Company and the Bank.

Name

    

Age (1)

    

Position with FS Bancorp, Inc.

     

Position with 1st Security Bank of Washington

Joseph C. Adams

61

Director and

Director and

Chief Executive Officer

Chief Executive Officer

Matthew D. Mullet

42

Chief Financial Officer,

Executive Vice President, Chief Financial Officer

Treasurer and Secretary

Robert B. Fuller

61

Chief Credit Officer

Executive Vice President, Chief Credit Officer

Dennis V. O’Leary

53

Executive Vice President, Chief Lending Officer

Lisa A. Cleary

39

Executive Vice President, Chief Operating Officer

Erin M. Burr

43

Executive Vice President, Chief Risk Officer and CRA Officer

Vickie A. Jarman

43

Executive Vice President, Chief Human Resources Officer/WOW! Officer

Donn C. Costa

59

Executive Vice President, Home Lending Production

Kelli B. Nielsen

49

Executive Vice President, Retail Banking and Marketing

___________________________

(1) At December 31, 2020.

Joseph C. Adams, age 61, is a director and has been the Chief Executive Officer of 1st Security Bank of Washington since July 2004.  He has also served in those capacities for FS Bancorp since its formation in September 2011.  He joined 1st Security Bank of Washington in April 2003 as its Chief Financial Officer.  Mr. Adams served as Supervisory Committee Chairperson from 1993 to 1999 when the bank was Washington's Credit Union.  Mr. Adams is a lawyer, having worked for Deloitte as a tax consultant, K&L Gates as a lawyer and then at Univar USA as a lawyer and Director of Regulatory Affairs.  As the Director of Regulatory Affairs for Univar USA, the largest chemical distribution company in the United States, Mr. Adams used his environmental law expertise to ensure Univar stayed in compliance with all relevant local, state and federal environmental laws, rules and regulations.  He is a member of the Board of Directors of the Central Washington University Foundation and the Community Bankers of Washington.  Mr. Adams received a master’s degree equivalent from the Pacific Coast Banking School in 2007.  Mr. Adams' legal and accounting backgrounds, as well as his duties as Chief Executive Officer of 1st Security Bank of Washington, bring a special

35

knowledge of the financial, economic and regulatory challenges faced by the Bank, which makes him well-suited to educating the Board on these matters.

Matthew D. Mullet, age 42, joined 1st Security Bank of Washington in July 2011 and was appointed Chief Financial Officer in September 2011. Mr. Mullet started his banking career in June 2000 as a financial examiner with the Washington State Department of Financial Institutions, Division of Banks, where he worked until October 2004. From October 2004 until August 2010, Mr. Mullet was employed at Golf Savings Bank, Mountlake Terrace, WA, where he served in several financial capacities, including as Chief Financial Officer from May 2007 until August 2010. In August 2010, Golf Savings Bank was merged with Sterling Savings Bank, where Mr. Mullet held the position as Senior Vice President of the Home Loan Division until resigning and commencing work at 1st Security Bank of Washington.

Robert B. Fuller, age 61, joined 1st Security Bank of Washington as Chief Credit Officer in September of 2013. Prior to his employment with the Bank, Mr. Fuller served as Chief Financial Officer/Chief Credit Officer for Blueprint Capital, REIT in 2013, Chief Credit Officer for Core Business Bank during 2012, and Plaza Bank during 2011, and in credit administration at Golf Savings Bank/Sterling Bank during 2009 and 2010. Mr. Fuller also served as Executive Vice President, Chief Operating Officer, and Chief Financial Officer for Golf Savings Bank from March 2001 to September 2006 and was a member of the integration team for the Golf sale to Sterling Savings Bank. Mr. Fuller started his banking career at US Bank of Washington’s mid-market production team and has over 30 years of banking experience.

Dennis V. O’Leary, age 53, joined 1st Security Bank of Washington as Senior Vice President - Consumer, Small Business and Construction Lending in August 2011 and currently holds the position of Chief Lending Officer. Prior to his employment with the Bank, Mr. O’Leary previously was employed by Sterling Savings Bank from July 2006 until August 2011 as Senior Vice President and Puget Sound Regional Director of the residential construction lending division. Sterling Savings Bank acquired Golf Savings Bank in 2006 where Mr. O’Leary had served as Executive Vice President, Commercial Real Estate Lending, having previously served in various senior lending positions at Golf Savings Bank since June 1985.

Lisa A. Cleary, age 39, joined 1st Security Bank of Washington in October 2020 as Chief Operating Officer.  Prior to her employment at the Bank, she served as Chief Credit Officer at First Sound Bank, Vice President and SBA Assistant Manager at Home Street Bank, Seattle, Washington after the merger with Fortune Bank in 2013.  Ms. Cleary has 20 years of experience in the banking industry, including operations, sales, and credit.

Erin M. Burr, age 43, joined 1st Security Bank of Washington in January 2009 and became the Enterprise Risk Manager in 2012.  She was appointed Chief Risk Officer in April 2018.  Ms. Burr started her banking career in July 1999 as a financial examiner with the Washington State Department of Financial Institutions, Division of Banks where she worked until May 2006.  From May 2006 until December 2008, Ms. Burr served as senior underwriter for Builders Capital Mortgage.  Ms. Burr became the CRA Officer in January 2010.  As the Bank’s CRA Officer, she enjoys building relationships with non-profit groups that benefit the communities in which we serve.  As the Chief Risk Officer, she uses her regulatory background to help promote and build risk awareness culture throughout the Bank.

Vickie A. Jarman, age 43, has been a 1st Security Bank of Washington teammate since 2002.  Prior to becoming the Chief Human Resources Officer/WOW! Officer in April 2018, she worked in our indirect lending department.  In 2011, Ms. Jarman became the Director of WOW! and focused on corporate culture.  Since 2012, she has overseen Human Resources, Payroll, Benefits, and Recruiting, as well as continuing her work on corporate culture and core values.  Ms. Jarman ensures that as the organization evolves, core values continue to reflect the personal principles that all employees stand behind and are held accountable.

Donn C. Costa, age 59, Executive Vice President, Home Lending, joined 1st Security Bank of Washington   in October 2011 as Senior Vice President, Home Lending. He previously held the position of Executive Vice President at Sterling Savings Bank, Mountlake Terrace, Washington after the merger with Golf Savings Bank in August 2009, and held the position of Executive Vice President at Golf Savings Bank, Mountlake Terrace, Washington since 2006. With more than 30 years of home lending experience, Mr. Costa began as a loan officer at Lomas and Nettleton Mortgage Company in Mountlake Terrace in 1986.

36

Kelli B. Nielsen, age 49, Executive Vice President, Retail Banking and Marketing, joined 1st Security Bank of Washington in June 2016. Prior to her employment at the Bank, she served as Senior Vice President of Retail Banking and Marketing at Sound Community Bank and prior to that, she was Vice President, Sales and Service Manager of Retail Banking at Cascade Bank and its acquirer Opus Bank. Ms. Nielsen has 29 years of experience in the banking industry and started her banking career at Seafirst Bank and Bank of America. She is a 2016 graduate of the American Bankers Association (“ABA”) Stonier Graduate School of Banking, a master’s equivalent program where she also received a leadership certificate from the Wharton Business School.  Additionally, Ms. Nielsen is a 2016-2020 Capstone Advisor to other third year students at Stonier.  She was named to the Advisory Board of the ABA Stonier Graduate School of Banking for the 2018-2020 term.

Human Capital

FS Bancorp, Inc, and its primary subsidiary 1st Security Bank of Washington, have developed a Vision Statement that guides our ongoing and future strategies.  Our Vision Statement is: To build a truly great place to work and bank.  The Vision Statement is aspirational and dynamic meaning we are aware of our responsibilities to our employees to continue to evolve in order to achieve these values.  The order is purposeful in that we believe building a great place to work will naturally develop a great place to bank.

Employee Compensation and Benefits

Management remains focused on ensuring employees are provided a livable wage in addition to a commitment to a balanced work/life schedule. Besides a competitive salary, the following benefits are available to all full-time employees:

Employee health benefits that have not increased in employee contribution cost since 2014;
401k match of up to the first 5% of contribution for up to 4% of total salary;
An Employee Stock Ownership Plan (“ESOP”) that contributed 25,921 shares in 2020 to employees that have met a minimum threshold of hours worked;
Vacation and sick leave benefits;
Family leave benefits including paid time off for a new child/adopted child;
Education reimbursement of up to $5,000 per year for any accredited program;
Student loan reimbursement of up to $5,000 per year (Provided in 2020 as part of the CARES Act);
Paid volunteer hours (16 hours each year);
Opportunities to participate in development programs through the Washington Bankers Association;
Regular Company provided lunches and treats; and
A pet friendly workplace at the administrative offices.

Management works with employees to provide these benefits whenever possible including a flexible schedule for employees to be able to enjoy full time benefits with a reduced hour schedule when appropriate.

Diversity and Inclusion

One of our core values is diversity.  We celebrate diversity and support equality for all.  The Board and management consider diverse viewpoints, backgrounds, and experiences, as well as gender, age, race, and ethnicity.  We are an inclusive community; all are welcome.  Of the independent directors, 43% are women (three of seven) and then 56% of the executives that report to our CEO are women (five of nine).  Note the CEO is male and part of both the executive team and Board of Directors.

37

The following table outlines gender diversity:

Level

    

Female %

Male %

Individual Contributor

74%

26%

Manager

 

62%

38%

Independent Director*

43%

57%

Executive

 

56%

44%

*Director Pamela Andrews, who joined the Board in January 2021, is included in the above table.

Talent Acquisition

FS Bancorp, Inc. and 1st Security Bank have been a growing organization since 2011 and are regularly looking to fill positions in the markets we serve.  We have an interview process that includes both the manager and teammates when interviewing potential candidates.  The Human Resource team is an advocate for the employee and remains focused on providing a culture of “Wow”.  The head of our human resources team is the EVP of WOW and is focused on hiring employees to build careers that will thrive in our culture.  In 2020, we hired 141 new employees bringing our total employee count to 506 employees as of December 31, 2020.

Operation Safe and Secure 2020

Starting with the pandemic in March 2020, management implemented “Operation Safe and Secure 2020” to provide regular, ongoing updates to employees about how the organization is functioning during the pandemic.  One of the first items to be implemented from our Pandemic Plan was the adjustment to a remote work force.  Based on our plan, 80% of our employees are capable of working remotely.  For those essential employees that were required to be in the retail locations or admin office, we provided safety measures including enhanced cleaning, required mask wearing in open areas, plexiglass screens between cubicles and flexible hours where appropriate.  In retail branch locations, we relied upon the feedback from the community to determine the appropriate level of customer access and safety for employees.  Employee safety remains a top priority with mandatory quarantine requirements post vacation, a negative test required for anyone that may have been exposed or had COVID-19, and paid sick leave for all employees that may have been impacted by COVID-19.

Regarding job security, employees during the pandemic often expressed concern about whether their jobs were secure.  During the pandemic, 1st Security Bank continued to hire and build out our infrastructure.  We are proud to report there were no furloughs and that zero jobs were reduced or eliminated during the pandemic.  As noted above, we added 141 new jobs in 2020 to the communities we serve.

 

The Board also continued our free flu shot program and, in 2020, provided an incentive of a free turkey ($25.00 gift card) for all employees that received the flu shot.

Volunteerism

Our organization has a long history of giving and volunteering in the communities we serve.  During the pandemic, social distancing greatly reduced our available volunteer hours in our communities from 7,140 hours in 2019 to 2,200 in 2020.  To offset this reduction, the Board of Directors approved increased donations to food banks and shelters in our communities for a total of $202,000 in 2020.  Our organization looks forward to physically getting back into our communities to volunteer once a vaccine has been distributed.

Human Capital Metrics

As of December 31, 2020, FS Bancorp, Inc., and its subsidiary bank employee 506 employees.  Of those numbers, 98% are full time employees and 2% are part time including our college intern program.  Our employees are not represented by a collective bargaining agreement.  As of December 31, 2020, 99% of our employees reside in Washington State, 0.34%

38

in Oregon, 0.33% in Texas, and 0.33% in Arizona.  Turnover for employees as measured by terminated/replaced employees was 14.99% in 2020, down from 15.32% in 2019.

HOW WE ARE REGULATED

The following is a brief description of certain laws and regulations applicable to FS Bancorp and 1st Security Bank of Washington. Descriptions of laws and regulations here and elsewhere in this Form 10-K do not purport to be complete and are qualified in their entirety by reference to the actual laws and regulations. Legislation is introduced from time to time in the United States Congress or in the Washington State Legislature that may affect the operations of FS Bancorp and 1st Security Bank of Washington. In addition, the regulations governing the Company and the Bank may be amended from time to time by the FDIC, DFI, Federal Reserve and the Consumer Financial Protection Bureau (“CFPB”). Any such legislation or regulatory changes in the future could adversely affect our operations and financial condition. We cannot predict whether any such changes may occur.

Regulation of 1st Security Bank of Washington

General. 1st Security Bank of Washington, as a state-chartered savings bank, is subject to applicable provisions of Washington law and to regulations and examinations of the DFI. As an insured institution, it also is subject to examination and regulation by the FDIC, which insures the deposits of 1st Security Bank of Washington to the maximum permitted by law. During these state or federal regulatory examinations, the examiners may require 1st Security Bank of Washington to provide for higher general or specific loan loss reserves, which can impact capital and earnings. This regulation of 1st Security Bank of Washington is intended for the protection of depositors and the Deposit Insurance Fund (“DIF”) of the FDIC and not for the purpose of protecting shareholders of 1st Security Bank of Washington or FS Bancorp. 1st Security Bank of Washington is required to maintain minimum levels of regulatory capital and is subject to some limitations on the payment of dividends to FS Bancorp. See below “Regulatory Capital Requirements” and “Restrictions on Dividends and Stock Repurchases.”

Federal and State Enforcement Authority and Actions. As part of its supervisory authority over Washington-chartered savings banks, the DFI may initiate enforcement proceedings to obtain a consent order to cease-and-desist against an institution believed to have engaged in unsafe and unsound practices or to have violated a law, regulation, or other regulatory limit, including a written agreement. The FDIC also has the authority to initiate enforcement actions against insured institutions under its jurisdiction for similar reasons and may terminate the deposit insurance if it determines that an institution has engaged in unsafe or unsound practices or is in an unsafe or unsound condition. Both these agencies may also utilize less formal supervisory tools to address their concerns about the condition, operations or compliance status of a savings bank.

Regulation by the Washington State Department of Financial Institutions. State law and regulations govern 1st Security Bank of Washington’s ability to take deposits and pay interest, to make loans on or invest in residential and other real estate, to make consumer loans, to invest in securities, to offer various banking services to its customers, and to establish branch offices. As a state savings bank, 1st Security Bank of Washington must pay semi-annual assessments, examination costs and certain other charges to the DFI.

Washington law generally provides the same powers for Washington savings banks as federally and other-state chartered savings institutions and banks with branches in Washington, subject to the approval of the DFI. Washington law allows Washington savings banks to charge the maximum interest rates on loans and other extensions of credit to Washington residents which are allowable for a national bank in another state if higher than Washington limits. In addition, the DFI may approve applications by Washington savings banks to engage in an otherwise unauthorized activity, if the DFI determines that the activity is closely related to banking, and 1st Security Bank of Washington is otherwise qualified under the statute. This additional authority, however, is subject to review and approval by the FDIC if the activity is not permissible for national banks.

Insurance of Accounts and Regulation by the FDIC. Through the DIF, the FDIC insures deposit accounts in 1st Security Bank of Washington up to $250,000 per separately insured deposit ownership right or category. As insurer, the

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FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by FDIC-insured institutions.  

Under the FDIC’s rules, the assessment base for a bank is equal to its total average consolidated assets less average tangible equity capital. Currently, the FDIC’s base assessment rates are 3 to 30 basis points and are subject to certain adjustments.  For institutions with less than $10 billion in assets, rates are determined based on supervisory ratings and certain financial ratios. No institution may pay a dividend if it is in default on its federal deposit insurance assessment.  The FDIC has authority to increase insurance assessments, and any significant increases may have an adverse effect on the operating expenses and results of operations of the Company.  Management cannot predict what assessment rates will be in the future. In a banking industry emergency, the FDIC may also impose a special assessment.

The FDIC announced that the DIF reserve ratio surpassed 1.35% as of September 30, 2018 which triggered two changes under the regulations: surcharges on large banks (total consolidated assets of $10 billion or more) ended and small banks (total consolidated assets of less than $10 billion, which includes the Bank) were awarded assessment credits for the portion of their assessments that contributed to the growth in the reserve ratio from 1.15% to 1.35% to be applied when the reserve ratio is at least 1.35%. The Bank applied $320,000 of small bank credits received to its quarterly deposit insurance assessments paid during 2019, reducing the Bank’s FDIC expense for the year to $358,000. The Bank paid $829,000 in FDIC assessments for the year ending December 31, 2020, after using the remaining $26,000 of such credits.

The FDIC conducts examinations of and requires reporting by state non-member banks, such as 1st Security Bank of Washington. The FDIC also may prohibit any insured institution from engaging in any activity determined by regulation or order to pose a serious risk to the DIF.  No institution may pay a dividend if it is in default on its federal deposit insurance assessment. Management is not aware of any existing circumstances which would result in termination of the Bank's deposit insurance.

Capital Requirements. In September 2019, the regulatory agencies, including the FDIC and Federal Reserve adopted a final rule, effective January 1, 2020, creating a community bank leverage ratio ("CBLR") for institutions with total consolidated assets of less than $10 billion, and that meet other qualifying criteria related to off-balance sheet exposures and trading assets and liabilities. The CBLR provides for a simple measure of capital adequacy for qualifying institutions. Management has elected to use the CBLR framework for the Bank. Consolidated regulatory capital requirements identical to those applicable to subsidiary banks generally apply to bank holding companies.  However, the Federal Reserve Board has provided a “Small Bank Holding Company” exception to its consolidated capital requirements, and bank holding companies with less than $3.0 billion of consolidated assets are not subject to the consolidated holding company capital requirements unless otherwise directed by the Federal Reserve Board.

The CBLR is calculated as Tier 1 Capital to average consolidated assets as reported on an institution's regulatory reports. Tier 1 Capital, for the Company and the Bank, generally consists of common stock plus related surplus and retained earnings, adjusted for goodwill and other intangible assets and accumulated and other comprehensive amounts (“AOCI”) related amounts. Qualifying institutions that elect to use the CBLR framework and that maintain a leverage ratio of greater than 9% will be considered to have satisfied the generally applicable risk-based and leverage capital requirements in the regulatory agencies' capital rules, and to have met the well-capitalized ratio requirements. In April 2020, as directed by Section 4012 of the CARES Act, the regulatory agencies introduced temporary changes to the CBLR. These changes, which subsequently were adopted as a final rule, temporarily reduced the CBLR requirement to 8% through the end of 2020. Beginning in 2021, the CBLR requirement will increase to 8.5% for the calendar year before returning to 9% in 2022. A qualifying institution utilizing the CBLR framework whose leverage ratio does not fall more than one percent below the required percentage is allowed a two-quarter grace period in which to increase its leverage ratio back above the required percentage. During the grace period, a qualifying institution will still be considered well capitalized so long as its leverage ratio does not fall more than one percent below the required percentage. If an institution either fails to meet all the qualifying criteria within the grace period or has a leverage ratio that falls more than one percent below the required percentage, it becomes ineligible to use the CBLR framework and must instead comply with generally applicable capital rules, sometimes referred to as Basel III rules. A bank may also opt out of the framework at any time, without restriction, by reverting to the generally applicable capital rules.

At December 31, 2020, 1st Security Bank of Washington was categorized as well capitalized under the prompt corrective action regulations of the FDIC. For a complete description of the Bank’s required and actual capital levels on

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December 31, 2020, see “Note 14 - Regulatory Capital” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data,” of this Form 10 K.

The FASB has adopted a new accounting standard for U.S. GAAP that will be effective for us for our first fiscal year beginning after December 15, 2022. This standard, referred to as Current Expected Credit Loss, or CECL, requires a company to recognize credit losses expected over the life of certain financial assets. Upon adoption of CECL, a banking organization must record a one-time adjustment to its credit loss allowances as of the beginning of the fiscal year of adoption equal to the difference, if any, between the amount of credit loss allowances under the current methodology and the amount required under CECL.  Implementation of CECL may reduce retained earnings and affect other items in a manner that reduces its regulatory capital. The federal banking regulators (the Federal Reserve, the Office of the Comptroller of the Currency and the FDIC) have adopted a rule that gives a banking organization the option to phase in over a three-year period the day-one adverse effects of CECL on its regulatory capital.

The FDIC also has authority to establish individual minimum capital requirements in appropriate cases upon a determination that an institution’s capital level is or may become inadequate in light of particular risks or circumstances. Management of 1st Security Bank of Washington believes that, under the current regulations, 1st Security Bank of Washington will continue to meet its minimum capital requirements in the foreseeable future.

FS Bancorp, Inc. is a bank holding company registered with the Federal Reserve. Bank holding companies are subject to capital adequacy requirements of the Federal Reserve under the Bank Holding Company Act of 1956, as amended, and the regulations of the Federal Reserve.  Bank holding companies with less than $3.0 billion in assets are generally not subject to compliance with the Federal Reserve’s capital regulations, which are generally the same as the capital regulations applicable to the Bank. The Federal Reserve has a policy that a bank holding company is required to serve as a source of financial and managerial strength to the holding company’s subsidiary bank and expects the holding company’s subsidiary bank to be well capitalized under the prompt corrective action regulations. If FS Bancorp, Inc. was subject to regulatory guidelines for bank holding companies with $3.0 billion or more in assets at December 31, 2020, FS Bancorp, Inc. would have exceeded all regulatory capital requirements

Prompt Corrective Action. Federal statutes establish a supervisory framework for FDIC-insured institutions based on five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. An institution’s category generally depends upon where its capital levels are in relation to relevant capital measures, which include risk-based capital measures, a leverage ratio capital measure, and certain other factors.  An institution that is not well capitalized is subject to certain restrictions on brokered deposits, including restrictions on the rates it can offer on its deposits generally. Any institution which is neither well capitalized nor adequately capitalized is considered undercapitalized.  The previously referenced final rule establishing an elective “community bank leverage ratio” regulatory capital framework provides that a qualifying institution whose capital exceeds the community bank leverage ratio and opts to use that framework will be considered “well capitalized” for purposes of prompt corrective action.

Undercapitalized institutions are subject to certain prompt corrective action requirements, regulatory controls and restrictions which become more extensive as an institution becomes more severely undercapitalized. Failure by 1st Security Bank of Washington to comply with applicable capital requirements would, if unremedied, result in progressively more severe restrictions on its activities and lead to enforcement actions, including, but not limited to, the issuance of a capital directive to ensure the maintenance of required capital levels and, ultimately, the appointment of the FDIC as receiver or conservator. Banking regulators will take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements. Additionally, approval of any regulatory application filed for their review may be dependent on compliance with capital requirements.

At December 31, 2020, 1st Security Bank of Washington was categorized as well capitalized under the prompt corrective action regulations of the FDIC. For additional information, see “Note 14 - Regulatory Capital” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data,” of this Form 10-K.

Standards for Safety and Soundness.  Each federal banking agency, including the FDIC, has adopted guidelines establishing general standards relating to internal controls, information and internal audit systems; loan documentation; credit underwriting; interest rate risk exposure; asset growth; asset quality; earnings; and compensation, fees and benefits.

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In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director, or principal shareholder.  If the FDIC determines that an institution fails to meet any of these guidelines, it may require an institution to submit to the FDIC an acceptable plan to achieve compliance.

Federal Home Loan Bank System. The FHLB of Des Moines is one of 11 regional Federal Home Loan Banks that administer the home financing credit function of savings institutions. The Federal Home Loan Banks are subject to the oversight of the Federal Housing Finance Agency and each Federal Home Loan Bank serves as a reserve or central bank for its members within its assigned region. The Federal Home Loan Banks are funded primarily from proceeds derived from the sale of consolidated obligations of the Federal Home Loan Bank System and make loans or advances to members in accordance with policies and procedures established by the Board of Directors of the Federal Home Loan Bank, which are subject to the oversight of the Federal Housing Finance Agency. All advances are required to be fully secured by sufficient collateral as determined by the Federal Home Loan Bank. In addition, members are required to purchase stock equal to 4.0% of advances. That stock may be redeemed if advances are paid down.  See “Business - Deposit Activities and Other Sources of Funds - Debt.” At December 31, 2020, 1st Security Bank of Washington had $7.4 million in FHLB of Des Moines stock, which was in compliance with this requirement.

The FHLB pays dividends quarterly, and 1st Security Bank of Washington received $394,000 in dividends during the year ended December 31, 2020.

The Federal Home Loan Banks continue to contribute to low- and moderately-priced housing programs through direct loans or interest subsidies on advances targeted for community investment and low- and moderate-income housing projects. These contributions have adversely affected the level of Federal Home Loan Bank dividends paid and could continue to do so in the future. These contributions could also have an adverse effect on the value of Federal Home Loan Bank stock in the future. A reduction in value of 1st Security Bank of Washington’s FHLB stock may result in a decrease in net income.

Commercial Real Estate Lending Concentrations. The federal banking agencies have issued guidance on sound risk management practices for concentrations in commercial real estate lending. The particular focus is on exposure to commercial real estate loans that are dependent on the cash flow from the real estate held as collateral and that are likely to be sensitive to conditions in the commercial real estate market (as opposed to real estate collateral held as a secondary source of repayment or as an abundance of caution). The purpose of the guidance is not to limit a bank’s commercial real estate lending but to guide banks in developing risk management practices and capital levels commensurate with the level and nature of real estate concentrations. The guidance directs the FDIC and other federal bank regulatory agencies to focus their supervisory resources on institutions that may have significant commercial real estate loan concentration risk. A bank that has experienced rapid growth in commercial real estate lending, has notable exposure to a specific type of commercial real estate loan, or is approaching or exceeding the following supervisory criteria may be identified for further supervisory analysis with respect to real estate concentration risk:

Total reported loans for construction, land development and other land represent 100% or more of the Bank’s total regulatory capital; or
Total commercial real estate loans (as defined in the guidance) represent 300% or more of the Bank’s total regulatory capital and the outstanding balance of the Bank’s commercial real estate loan portfolio has increased 50% or more during the prior 36 months.

The guidance provides that the strength of an institution’s lending and risk management practices with respect to such concentrations will be taken into account in supervisory guidance on evaluation of capital adequacy. At December 31, 2020, 1st Security Bank of Washington’s aggregate recorded loan balances for construction, land development and land loans were 89.6% of regulatory capital. In addition, at December 31, 2020, 1st Security Bank of Washington’s loans on all commercial real estate, including construction, owner and non-owner occupied commercial real estate, and multi-family lending, as defined by the FDIC, were 253.6% of regulatory capital.

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Activities and Investments of Insured State-Chartered Financial Institutions. Federal law generally limits the activities and equity investments of FDIC insured, state-chartered banks to those that are permissible for national banks. An insured state bank is not prohibited from, among other things, (1) acquiring or retaining a majority interest in a subsidiary, (2) investing as a limited partner in a partnership the sole purpose of which is direct or indirect investment in the acquisition, rehabilitation or new construction of a qualified housing project, provided that such limited partnership investments may not exceed 2% of the bank’s total assets, (3) acquiring up to 10% of the voting stock of a company that solely provides or reinsures directors’ and officers’ liability insurance coverage or bankers’ blanket bond group insurance coverage for insured depository institutions, and (4) acquiring or retaining the voting shares of a depository institution if certain requirements are met.

Dividends. Dividends from 1st Security Bank of Washington constitute a major source of funds for dividends in future periods that may be paid by FS Bancorp to shareholders. The amount of dividends payable by 1st Security Bank of Washington to FS Bancorp depends upon the Bank’s earnings and capital position, and is limited by federal and state laws, regulations and policies. According to Washington law, 1st Security Bank of Washington may not declare or pay a cash dividend on its capital stock if it would cause its net worth to be reduced below (1) the amount required for liquidation accounts or (2) the net worth requirements, if any, imposed by the Director of the DFI. Dividends on 1st Security Bank of Washington’s capital stock may not be paid in an aggregate amount greater than the aggregate retained earnings of 1st Security Bank of Washington, without the approval of the Director of the DFI. The Bank paid $20.9 million in dividends to the holding company in 2020.

The amount of dividends actually paid during any one period will be strongly affected by 1st Security Bank of Washington’s policy of maintaining a strong capital position. Federal law further limits and can prohibit dividends when an institution does not meet the capital conservation buffer requirement and provides that no insured depository institution may pay a cash dividend if it would cause the institution to be “undercapitalized,” as defined in the prompt corrective action regulations. Moreover, the federal bank regulatory agencies also have the general authority to limit the dividends paid by insured banks if such payments are deemed to constitute an unsafe and unsound practice.

Affiliate Transactions. FS Bancorp and 1st Security Bank of Washington are separate and distinct legal entities. FS Bancorp (and any non-bank subsidiary of FS Bancorp) is an affiliate of 1st Security Bank of Washington. Federal laws strictly limit the ability of banks to engage in certain transactions with their affiliates. Transactions deemed to be “covered transactions” under Section 23A of the Federal Reserve Act and between a bank and an affiliate are limited to 10% of the bank subsidiary’s capital and surplus and, with respect to all affiliates, to an aggregate of 20% of the bank’s capital and surplus. Further, covered transactions that are loans and extensions of credit generally are required to be secured by eligible collateral in specified amounts. Federal law also requires that covered transactions and certain other transactions listed in Section 23B of the Federal Reserve Act between a bank and its affiliates be on terms as favorable to the bank as transactions with non-affiliates.

Community Reinvestment Act. 1st Security Bank of Washington is also subject to the provisions of the Community Reinvestment Act of 1977 (“CRA”), which requires the appropriate federal bank regulatory agency to assess a bank’s performance under the CRA in meeting the credit needs of the community serviced by the Bank, including low and moderate income neighborhoods. The regulatory agency’s assessment of a bank’s record is made available to the public. Further, a bank’s CRA performance rating must be considered in connection with a bank’s application to, among other things, establish a new branch office that will accept deposits, relocate an existing office or merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution, and in connection with certain applications by a bank holding company, such as bank acquisitions. An unsatisfactory rating may be the basis for denial of certain applications. 1st Security Bank of Washington received a “satisfactory” rating during its most recent CRA examination.

Privacy Standards. 1st Security Bank of Washington is subject to FDIC regulations implementing the privacy protection provisions of the Gramm-Leach-Bliley Act of 1999. These regulations require 1st Security Bank of Washington to disclose its privacy policy, including informing consumers of its information sharing practices and informing consumers of its rights to opt out of certain practices.

Environmental Issues Associated with Real Estate Lending. The Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”) is a federal statute that generally imposes strict liability on, all prior and

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present “owners and operators” of sites containing hazardous waste. However, Congress asked to protect secured creditors by providing that the term “owner and operator” excludes a person whose ownership is limited to protecting its security interest in the site. Since the enactment of the CERCLA, this “secured creditor exemption” has been the subject of judicial interpretations which have left open the possibility that lenders could be liable for cleanup costs on contaminated property that they hold as collateral for a loan. To the extent that legal uncertainty exists in this area, all creditors, including 1st Security Bank of Washington, that have made loans secured by properties with potential hazardous waste contamination (such as petroleum contamination) could be subject to liability for cleanup costs, which costs often substantially exceed the value of the collateral property.

Federal Reserve System. The Federal Reserve requires that all depository institutions maintain reserves on transaction accounts or non-personal time deposits. These reserves may be in the form of cash or noninterest-bearing deposits with the regional Federal Reserve Bank. NOW accounts and other types of accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to the reserve requirements, as are any non-personal time deposits at a savings bank. On March 15, 2020, the Federal Reserve reduced reserve requirement ratios to zero percent, effective March 26, 2020, thereby eliminating reserve requirements for all depository institutions.

Other Consumer Protection Laws and Regulations. The Dodd-Frank Act established the CFPB and empowered it to exercise broad regulatory, supervisory and enforcement authority with respect to both new and existing consumer financial protection laws. 1st Security Bank of Washington is subject to consumer protection regulations issued by the CFPB, but as a financial institution with assets of less than $10 billion, 1st Security Bank of Washington is generally subject to supervision and enforcement by the FDIC and the DFI with respect to compliance with federal and state consumer financial protection laws and regulations.

1st Security Bank of Washington is subject to a broad array of federal and state consumer protection laws and regulations that govern almost every aspect of its business relationships with consumers. While the list set forth below is not exhaustive, these include the Truth in Lending Act, the Truth in Savings Act, the Electronic Fund Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Real Estate Settlement Procedures Act, the Home Mortgage Disclosure Act, the Fair Credit Reporting Act, the Fair Debt Collection Practices Act, the Right to Financial Privacy Act, the Home Ownership and Equity Protection Act, the Consumer Leasing Act, the Fair Credit Billing Act, the Homeowners Protection Act, the Check Clearing for the 21st Century Act, laws governing flood insurance, laws governing consumer protections in connection with the sale of insurance, federal and state laws prohibiting unfair and deceptive business practices, and various regulations that implement the foregoing. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits, making loans, collecting loans, and providing other services. In addition, The USA PATRIOT Act, requires banks to, among other things, establish broadened anti-money laundering compliance programs, and due diligence policies and controls to ensure the detection and reporting of money laundering. Such required compliance programs are intended to supplement existing compliance requirements that also apply to financial institutions under the Bank Secrecy Act and the Office of Foreign Assets Control regulations. Failure to comply with these laws and regulations can subject 1st Security Bank of Washington to various penalties, including but not limited to, enforcement actions, injunctions, fines, civil liability, criminal penalties, punitive damages, and the loss of certain contractual rights.

Regulation and Supervision of FS Bancorp

General. FS Bancorp is a bank holding company registered with the Federal Reserve and is the sole shareholder of 1st Security Bank of Washington. Bank holding companies are subject to comprehensive regulation by the Federal Reserve under the Bank Holding Company Act of 1956, as amended (“BHCA”), and the regulations promulgated there under. This regulation and oversight is generally intended to ensure that FS Bancorp limits its activities to those allowed by law and that it operates in a safe and sound manner without endangering the financial health of 1st Security Bank of Washington.

As a bank holding company, FS Bancorp is required to file quarterly and annual reports with the Federal Reserve and any additional information required by the Federal Reserve and is subject to regular examinations by the Federal Reserve. The Federal Reserve also has extensive enforcement authority over bank holding companies, including the ability to assess civil money penalties, to issue cease and desist or removal orders, and to require that a holding company divest

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subsidiaries (including its bank subsidiaries). In general, enforcement actions may be initiated for violations of law and regulations and unsafe or unsound practices.

The Bank Holding Company Act. Under the BHCA, FS Bancorp is supervised by the Federal Reserve. The Federal Reserve has a policy that a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, the Dodd-Frank Act provides that a bank holding company should serve as a source of strength to its subsidiary banks by having the ability to provide financial assistance to its subsidiary banks during periods of financial stress to the bank. A bank holding company’s failure to meet its obligation to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve to be an unsafe and unsound banking practice or a violation of the Federal Reserve’s regulations or both. No regulations have yet been proposed by the Federal Reserve to implement the source of strength doctrine required by the Dodd-Frank Act. FS Bancorp and any subsidiaries that it may control are considered “affiliates” of 1st Security Bank of Washington within the meaning of the Federal Reserve Act, and transactions between 1st Security Bank of Washington and its affiliates are subject to numerous restrictions. With some exceptions, FS Bancorp and its subsidiaries are prohibited from tying the provision of various services, such as extensions of credit, to other services offered by FS Bancorp or its subsidiaries.

Acquisitions. The BHCA prohibits a bank holding company, with certain exceptions, from acquiring ownership or control of more than 5% of the voting shares of any company that is not a bank or bank holding company and from engaging in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. Under the BHCA, the Federal Reserve may approve the ownership of shares by a bank holding company in any company, the activities of which the Federal Reserve has determined to be so closely related to the business of banking or managing or controlling banks as to be a proper incident thereto. These activities include:  operating a savings institution, mortgage company, finance company, credit card company or factoring company; performing certain data processing operations; providing certain investment and financial advice; underwriting and acting as an insurance agent for certain types of credit-related insurance; leasing property on a full-payout, non-operating basis; selling money orders, travelers’ checks, and U.S. Savings Bonds; real estate and personal property appraising; providing tax planning and preparation services; and, subject to certain limitations, providing securities brokerage services for customers.

Regulatory Capital Requirements. As discussed above, pursuant to the “Small Bank Holding Company” exception, effective August 30, 2018, bank holding companies with less than $3 billion in consolidated assets were generally no longer subject to the Federal Reserve’s capital regulations, which are generally the same as the capital regulations applicable to 1st Security Bank of Washington. At the time of this change, FS Bancorp was considered “well capitalized” (as defined for a bank holding company), and was not subject to an individualized order, directive or agreement under which the Federal Reserve requires it to maintain a specific capital level.

For additional information, see “Note 14 - Regulatory Capital” of the Notes to the Consolidated Financial Statements contained in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.

Interstate Banking. The Federal Reserve may approve an application of a bank holding company to acquire control of, or acquire all, or substantially all of the assets of a bank located in a state other than the holding company’s home state, without regard to whether the transaction is prohibited by the laws of any state. The Federal Reserve may not approve the acquisition of a bank that has not been in existence for the minimum time period, not exceeding five years, specified by the law of the host state. Nor may the Federal Reserve approve an application if the applicant controls or would control more than 10% of the insured deposits in the United States or 30% or more of the deposits in the target bank’s home state or in any state in which the target bank maintains a branch. Federal law does not affect the authority of states to limit the percentage of total insured deposits in the state that may be held or controlled by a bank holding company to the extent such limitation does not discriminate against out-of-state banks or bank holding companies. Individual states may also waive the 30% state-wide concentration limit contained in the federal law.

The federal banking agencies are generally authorized to approve interstate merger transactions without regard to whether the transaction is prohibited by the law of any state.  Interstate acquisitions of branches will be permitted only if the law of the state in which the branch is located permits such acquisitions. Interstate mergers and branch acquisitions are also subject to the nationwide and statewide insured deposit concentration amounts described above.

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Restrictions on Dividends and Stock Repurchases. FS Bancorp’s ability to declare and pay dividends is subject to the Federal Reserve limits and Washington law, and may depend on its ability to receive dividends from 1st Security Bank of Washington.

Federal Reserve policy limits the payment of a cash dividend by a bank holding company if the holding company’s net income for the past year is not sufficient to cover both the cash dividend and a rate of earnings retention that is consistent with capital needs, asset quality and overall financial condition. A bank holding company that does not meet any applicable capital standard would not be able to pay any cash dividends under this policy. A bank holding company not subject to consolidated capital requirements is expected not to pay dividends unless its debt-to-equity ratio is less than 1:1, and it meets certain additional criteria. The Federal Reserve also has indicated that it would be inappropriate for a company experiencing serious financial problems to borrow funds to pay dividends.

Except for a company that meets the applicable standard to be considered a well capitalized and well-managed bank holding company and is not subject to any unresolved supervisory issues, a bank holding company is required to give the Federal Reserve prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of the company’s consolidated net worth. The Federal Reserve may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe or unsound practice or would violate any law, regulation or regulatory order, condition, or written agreement.

Under Washington corporate law, FS Bancorp generally may not pay dividends if after that payment it would not be able to pay its liabilities as they become due in the usual course of business, or its total assets would be less than the sum of its total liabilities.

Federal Securities Law. The stock of FS Bancorp is registered with the SEC under the Securities Exchange Act of 1934, as amended. As a result, FS Bancorp is subject to the information, proxy solicitation, insider trading restrictions, and other requirements under the Securities Exchange Act of 1934.

FS Bancorp stock held by persons who are affiliates of FS Bancorp may not be resold without registration unless sold in accordance with certain resale restrictions. Affiliates are generally considered to be officers, directors, and principal shareholders. If FS Bancorp meets specified current public information requirements, each affiliate of FS Bancorp will be able to sell in the public market, without registration, a limited number of shares in any three-month period.

Recent Regulatory Reform

In response to the COVID-19 pandemic, the United States Congress, through the enactment of the CARES Act and the Consolidated Appropriations Act (“CAA 2021”), and the federal banking agencies, though rulemaking, interpretive guidance and modifications to agency policies and procedures, have taken a series of actions to provide national emergency economic relief measures including, among others, the following:

The CARES Act, as amended by the CAA 2021, allows banks to elect to suspend requirements under GAAP for loan modifications related to the COVID-19 pandemic (for loans that were not more than 30 days past due as of December 31, 2019) that would otherwise be categorized as a TDR, including impairment for accounting purposes, until the earlier of 60 days after the termination date of the national emergency or, January 1, 2022.  The suspension of GAAP is applicable for the entire term of the modification. The federal banking agencies also issued guidance to encourage banks to make loan modifications for borrowers affected by COVID-19 by providing that short-term modifications made in response to COVID-19, such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant related to the loans in which the borrower is less than 30 days past due on its contractual payments at the time a modification is implemented is not a TDR.  The Bank is applying this guidance to qualifying COVID-19 modifications. See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - COVID-19 Related Information” for further information about the COVID-19 modifications completed by the Bank.

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The CARES Act amended the SBA’s loan program, in which the Bank participates, to create a guaranteed, unsecured loan program, the PPP, to fund payroll and operational costs of eligible businesses, organizations and self-employed persons during COVID-19. The loans are provided through participating financial institutions, such as the Bank, that process loan applications and service the loans and are eligible for SBA repayment and loan forgiveness if the borrower meets the PPP conditions. The application period for a PPP loan closed on August 8, 2020. The SBA began approving PPP forgiveness applications and remitting forgiveness payments to PPP lenders on October 2, 2020. The CAA 2021 which was signed into law on December 27, 2020, renews and extends the PPP until March 31, 2021.  As a result, as a participating lender, the Bank began originating PPP loans again in January 2021 and will continue to monitor legislative, regulatory, and supervisory developments related to the PPP.
Pursuant to the CARES Act, the federal banking agencies authorities adopted in April 2020 an interim rule, effective until the earlier of the termination of the coronavirus emergency declaration by the President and December 31, 2020, to (i) reduce the minimum CBLR  from 9% to 8% percent and (ii) give community banks two-quarter grace period to satisfy such ratio if such ratio falls out of compliance by no more than 1%. Effective October 1, 2020, the final rule adopted by the federal banking agencies authorities lowers the CBLR as set forth in the interim rule and provides a gradual transition back to the prior level. Under the final rule the  CBLR was 8% for 2020, and will be 8.5% for 2021, and 9% beginning January 1, 2022. The final rule also retains the grace period. A community banking organization that falls below the CBRL will still be deemed to be well capitalized during a two-quarter grace period so long as the banking organization maintains a CBRL greater than 7.5% during 2021, and greater than 8% thereafter.

As the on-going COVID-19 pandemic evolves, federal regulatory authorities continue to issue additional guidance with respect to the implementation, lifecycle, and eligibility requirements for the various CARES Act programs as well as industry-specific recovery procedures for COVID-19. In addition, it is possible that the United States Congress will enact supplementary COVID-19 response legislation. The Company continues to assess the impact of the CARES Act and other statues, regulations and supervisory guidance related to the COVID-19 pandemic.

TAXATION

Federal Taxation

General. FS Bancorp and 1st Security Bank of Washington are subject to federal income taxation in the same general manner as other corporations, with some exceptions discussed below. The following discussion of federal taxation is intended only to summarize certain pertinent federal income tax matters and is not a comprehensive description of the tax rules applicable to FS Bancorp. 1st Security Bank of Washington is no longer subject to U.S. federal income tax examinations by tax authorities for years ended before 2017, and income tax returns have not been audited for the past eight years, 2013 to 2020.  

FS Bancorp files a consolidated federal income tax return with 1st Security Bank of Washington. Accordingly, any cash distributions made by FS Bancorp to its shareholders would be considered to be taxable dividends and not as a non-taxable return of capital to shareholders for federal and state tax purposes. For additional information, see “Note 11- Income Taxes” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10 K.

Method of Accounting. For federal income tax purposes, FS Bancorp currently reports its income and expenses on the accrual method of accounting and uses a fiscal year ending on December 31 for filing its federal income tax return.

Net Operating Loss Carryovers.  At December 31, 2020, the Company had a remaining NOL of approximately $2.4 million, which begins to expire in 2035.

Corporate Dividends-Received Deduction. FS Bancorp may eliminate from its income dividends received from 1st Security Bank of Washington as a wholly owned subsidiary of FS Bancorp if it elects to file a consolidated return with 1st Security Bank of Washington. The corporate dividends-received deduction is 100%, or 80%, in the case of dividends

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received from corporations with which a corporate recipient does not file a consolidated tax return, depending on the level of stock ownership of the payor of the dividend. Corporations which own less than 20% of the stock of a corporation distributing a dividend may deduct 70% of dividends received or accrued on their behalf.

Washington Taxation

The Company and the Bank are subject to a business and occupation tax which is imposed under Washington law at the rate of 1.75% of gross receipts. Interest received on loans secured by mortgages or deeds of trust on residential properties, residential mortgage-backed securities, and certain U.S. Government and agency securities are not subject to this tax.

Item 1A. Risk Factors

An investment in our common stock is subject to risks inherent in our business. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included in this report and our other filings with the SEC. In addition to the risks and uncertainties described below, other risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially and adversely affect our business, financial condition, capital levels, cash flows, liquidity, results of operations, and prospects. The market price of our common stock could decline significantly due to any of these identified or other risks, and you could lose some or all of your investment. The risks discussed below also include forward-looking statements, and our actual results may differ substantially from those discussed in these forward-looking statements. This report is qualified in its entirety by these risk factors.

Risks Related to Macroeconomic Conditions

The COVID-19 pandemic has adversely impacted our ability to conduct business and is expected to adversely impact our financial results and those of our customers. The ultimate impact will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic.

The worldwide COVID-19 pandemic has caused major economic disruption and volatility in the financial markets both in the United States and globally and has negatively affected our operations and the banking and financial services we provide our customers.  In our market areas, stay-at-home orders, social distancing and travel restrictions, and similar orders imposed across the United States to restrict the spread of COVID-19, resulted in significant business and operational disruptions, including business closures, supply chain disruptions, and significant layoffs and furloughs. While the stay-at-home orders have terminated or been phased-out along with reopening of businesses in certain markets, many localities in the western states in which we operate still apply capacity restrictions and health and safety recommendations that encourage continued social distancing and working remotely, limiting the ability of businesses to return to pre-pandemic levels of activity. As an essential business, we continue to provide banking and financial services to our customers at our branch locations. All of our branches are open and we continue to remain flexible as to branch operations based on the guidance provided for the communities in which we operate. In addition, we continue to provide access to banking and financial services through online banking, ATMs and by telephone. To further the well-being of staff and customers, we have implemented measures to allow employees to work from home to the extent practicable. Despite these efforts, if the COVID-19 pandemic worsens it could limit, or disrupt, our ability to provide banking and financial services to our customers.

The majority of our employees continue to work remotely where feasible to enable us to continue to provide banking services to our customers.  Heightened cybersecurity, information security and operational risks may result from these remote work-from-home arrangements. We also could be adversely affected if key personnel or a significant number of employees were to become unavailable due to the effects and restrictions of the COVID-19 pandemic.  We also rely upon our third-party vendors to conduct business and to process, record and monitor transactions. If any of these vendors are unable to continue to provide us with these services, it could negatively impact our ability to serve our customers. Although we have business continuity plans and other safeguards in place, there is no assurance that such plans and safeguards will be effective.

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To date, the COVID-19 pandemic has resulted in declines in loan demand and loan originations other than through government sponsored programs such as the PPP and has impacted both deposit availability and  market interest rates and negatively impacted many of our business and consumer borrowers’ ability to make their loan payments. Because the length of the pandemic and the efficacy of the extraordinary measures being put in place to address the economic consequences are unknown, including a continued low targeted federal funds rate, until the pandemic subsides, we expect our net interest income and net interest margin will continue to be adversely affected.

The impact of the pandemic is expected to continue to adversely affect us during 2021 as the ability of many of our borrowers to make loan payments has been significantly affected.  Many of our borrowers have become unemployed or may face unemployment, and certain businesses are at risk of insolvency as their revenues decline precipitously, especially in businesses related to travel, hospitality, leisure and physical personal services. Businesses may ultimately not reopen as there is a significant level of uncertainty regarding the level of economic activity that will return to our markets over time, the impact of governmental assistance, the speed of economic recovery, the resurgence of COVID-19 in subsequent seasons and changes to demographic and social norms that will take place.

Consistent with guidance provided by banking regulators, we have modified loans by providing various loan payment deferral options to our borrowers affected by the COVID-19 pandemic. Notwithstanding these modifications, these borrowers may not be able to resume making full payments on their loans once the COVID-19 pandemic is resolved.

In accordance with U.S. GAAP, we record assets acquired and liabilities assumed at their fair value with the excess of the purchase consideration over the net assets acquired resulting in the recognition of goodwill. If adverse economic conditions or the recent decrease in our stock price and market capitalization as a result of the pandemic were to be deemed sustained rather than temporary, it may significantly affect the fair value of our goodwill and may trigger impairment charges. Any impairment charge could have a material adverse effect on our results of operations and financial condition.

The ultimate impact of the COVID-19 pandemic on our business, results of operations and financial condition, as well as our regulatory capital and liquidity ratios, will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic, including recent vaccination efforts. Even after the COVID-19 pandemic subsides, the U.S. economy may experience a recession and we anticipate our business would be materially and adversely affected by a prolonged recession. To the extent the COVID-19 pandemic adversely affects our business, financial condition, liquidity or results of operations, it may also have the effect of heightening many of the other risk factors described in this section.

Our business may be adversely affected by downturns in the national economy and in the economies in our market areas.

Our primary market areas are in the Puget Sound region of Washington and Kitsap, Clallam, Jefferson, Grays Harbor, Thurston, Lewis, and Benton counties. Our business is directly affected by market conditions, trends in industry and finance, legislative and regulatory changes, and changes in governmental monetary and fiscal policies, and inflation, all of which are beyond our control. General economic conditions, including inflation, unemployment and money supply fluctuations, also may affect our profitability adversely. Weakness in the global economy has adversely affected many businesses operating in our markets that are dependent upon international trade and it is not known how changes in tariffs being imposed on international trade may also affect these businesses. Changes in agreements or relationships between the United States and other countries may also affect these businesses.  

A deterioration in economic conditions in the market areas we serve could result in loan losses beyond that which is provided for in our allowance for loan losses and could result in the following consequences, any of which could have a material adverse effect on the business, financial condition, and results of operations:

demand for our products and services may decline, possibly resulting in a decrease in our total loans or assets;
loan delinquencies, problem assets and foreclosures may increase;
we may increase our allowance for loan losses;

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collateral for our loans may further decline in value, in turn reducing customer’s borrowing power, reducing the value of assets and collateral associated with existing loans;
the net worth and liquidity of loan guarantors may decline, impairing their ability to honor commitments to us; and
the amount of our low-cost or noninterest-bearing deposits may decrease.

A decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose real estate loan portfolios are geographically diverse. Many of the loans in our portfolio are secured by real estate or fixtures attached to real estate. Deterioration in the real estate markets where collateral for a mortgage loan is located could negatively affect the borrower’s ability to repay the loan and the value of the collateral securing the loan. Real estate values are affected by various other factors, including changes in general or regional economic conditions, governmental rules or policies, and natural disasters such as earthquakes. If we are required to liquidate a significant amount of collateral during a period of reduced real estate values, our financial condition and profitability could be adversely affected.

Adverse changes in the regional and general economy could reduce our growth rate, impair our ability to collect loans, and generally have a negative effect on our financial condition and results of operations.

Risks Related to our Lending Activities

Our loan portfolio possesses increased risk due to a large percentage of consumer loans.

Our consumer loans accounted for $375.2 million, or 23.8% of our total gross loan portfolio as of December 31, 2020, of which $286.0 million (76.2% of total consumer loans) consisted of indirect home improvement loans (some of which were not secured by a lien on the real property), $85.7 million (22.9% of total consumer loans) consisted of marine loans secured by boats, and $3.4 million (0.9% of total consumer loans) consisted of other consumer loans, which includes personal lines of credit, credit cards, automobile, direct home improvement, loans on deposit, and recreational loans. Generally, we consider these types of loans to involve a higher degree of risk compared to first mortgage loans on owner-occupied, one-to-four-family residential properties. As a result of our large portfolio of consumer loans, it may become necessary to increase the level of provision for our loan losses, which would reduce profits. Consumer loans generally entail greater risk than do one-to-four-family residential mortgage loans, particularly in the case of loans that are secured by rapidly depreciable assets, such as automobiles and boats. In these cases, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance.

Most of our consumer loans are originated indirectly by or through third parties, which presents greater risk than our direct lending products which involves direct contact between us and the borrower. Unlike a direct loan where the borrower makes an application directly to us, in these loans the dealer, who has a direct financial interest in the loan transaction, assists the borrower in preparing the loan application. Although we disburse the loan proceeds directly to the dealer upon receipt of a “completion certificate” signed by the borrower, because we do not have direct contact with the borrower, these loans may be more susceptible to a material misstatement on the loan application or having the loan proceeds being misused by the borrower or the dealer. In addition, if the work is not properly performed, the borrower may cease payment on the loan until the problem is rectified. Although we file a UCC-2 financing statement to perfect the security interest in the personal property collateral for most fixture loans, there are no guarantees on our ability to collect on that security interest or that the repossessed collateral for a defaulted fixture loan will provide an adequate source of repayment for the outstanding loan given the limited stand-alone value of the collateral.

Indirect home improvement and marine loans totaled $371.8 million, or 23.6% of our total gross loan portfolio at December 31, 2020, and are originated through a network of 143 home improvement contractors and dealers located in Washington, Oregon, California, Idaho, Colorado, Arizona, Nevada, and Minnesota.  In addition, we rely on four dealers for 39.2% of our loan volume so the loss of one of these dealers can have a significant effect on our loan origination volume. See “Item 1. Business - Lending Activities - Consumer Lending” and “- Asset Quality.”

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Our business could suffer if we are unsuccessful in making, continuing, and growing relationships with home improvement contractors and dealers.

Our indirect home improvement lending, which is the largest component of our consumer loan portfolio, is reliant on our relationships with home improvement contractors and dealers. In particular, our indirect home improvement loan operations depend in large part upon our ability to establish and maintain relationships with reputable contractors and dealers who originate loans at the point of sale. Our indirect home improvement contractor/dealer network is currently comprised of 143 active contractors and dealers with businesses located throughout Washington, Oregon, California, Idaho, Colorado, Arizona, Nevada, and Minnesota with approximately ten contractors/dealers responsible for more than half of this loan volume. Indirect home improvement totaled $286.0 million, or 18.2% of our total gross loan portfolio, at December 31, 2020, reflecting approximately 19,400 loans with an average balance of approximately $15,000.

We have relationships with home improvement contractors/dealers, however, the relationships generally are not exclusive, some of them are newly established and they may be terminated at any time. If there is another economic downturn and contraction of credit to both contractors/dealers and their customers, there could be an increase in business closures and our existing contractor/dealer base could experience decreased sales and loan volume, which may have an adverse effect on our business, results of operations and financial condition. In addition, if a competitor were to offer better service or more attractive loan products to our contractor/dealer partners, it is possible that our partners would terminate their relationships with us or recommend customers to our competitors. If we are unable to continue to grow our existing relationships and develop new relationships, our results of operations and financial condition could be adversely affected.

A significant portion of our business involves commercial real estate lending which is subject to various risks that could adversely impact our results of operations and financial condition.

At December 31, 2020, our loan portfolio included $354.3 million of commercial real estate loans, including $147.1 million secured by non-owner occupied commercial real estate properties, and $131.6 million of multi-family real estate loans, or 22.5% of our total gross loan portfolio, compared to $344.7 million, or 25.5%, at December 31, 2019. We have been increasing and intend to continue to increase, subject to market demand, the origination of commercial and multi-family real estate loans. The credit risk related to these types of loans is considered to be greater than the risk related to one-to-four-family residential loans because the repayment of commercial and multi-family real estate loans typically is dependent on the successful operation and income stream of the property securing the loan and the value of the real estate securing the loan as collateral, which can be significantly affected by economic conditions.

Our focus on these types of loans will increase the risk profile relative to traditional one-to-four-family lenders as we continue to implement our business strategy. Although commercial and multi-family real estate loans are intended to enhance the average yield of the earning assets, they do involve a different, and possibly higher, level of risk of delinquency or collection than generally associated with one-to-four-family loans for a number of reasons. Among other factors, these loans involve larger balances to a single borrower or groups of related borrowers. Since commercial real estate and multi-family real estate loans generally have large balances, if we make any errors in judgment in the collectability of these loans, we may need to significantly increase the provision for loan losses since any resulting charge-offs will be larger on a per loan basis. Consequently, this could materially adversely affect our future earnings.

Collateral evaluation for these types of loans also requires a more detailed analysis at the time of loan underwriting and on an ongoing basis. In addition, most of our commercial and multi-family loans are not fully amortizing and include balloon payments upon maturity. Balloon payments may require the borrower to either sell or refinance the underlying property in order to make the payment, which may increase the risk of default or non-payment. Finally, if foreclosure occurs on a commercial real estate loan, the holding period for the collateral, if any, typically is longer than for a one-to-four-family residence because the secondary market for most types of commercial and multi-family real estate is not readily liquid, so we have less opportunity to mitigate credit risk by selling part or all of our interest in these assets. See “Item 1. Business - Lending Activities - Commercial Real Estate Lending” of this Form 10-K.

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Repayment of our commercial business loans is often dependent on the cash flows of the borrower, which may be unpredictable, and the collateral securing these loans may fluctuate in value.

At December 31, 2020, our commercial business loan portfolio included commercial and industrial loans of $224.5 million, or 14.3%, and warehouse lending of $49.1 million, or 3.1%, of our total gross loan portfolio compared to commercial and industrial loans of $140.5 million, or 10.4%, and warehouse lending of $61.1 million, or 4.5% at December 31, 2019.  Commercial business lending involves risks that are different from those associated with residential and commercial real estate lending. Real estate lending is generally considered to be collateral-based lending with loan amounts based on predetermined loan to collateral values and liquidation of the underlying real estate collateral being viewed as the primary source of repayment in the event of borrower default.  Our commercial and industrial business loans are primarily made based on the cash flow of the borrower and secondarily on the underlying collateral provided by the borrower.  The borrowers’ cash flow may be unpredictable and collateral securing these loans may fluctuate in value.  This collateral may consist of equipment, inventory, accounts receivable, or other business assets.  In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.  Other collateral securing these loans may depreciate over time, may be difficult to appraise, may be illiquid, and may fluctuate in value based on the specific type of business and equipment.  As a result, the availability of funds for the repayment of commercial and industrial business loans may be substantially dependent on the success of the business itself, which, in turn, is often dependent in part upon general economic conditions and secondarily on the underlying collateral provided by the borrower. For additional information related to the risks of warehouse lending, see “Our residential mortgage warehouse lending and construction warehouse lending programs are subject to various risks that could adversely impact our results of operations and financial condition.”

We continue to focus on residential construction lending which is subject to various risks that could adversely impact our results of operations and financial condition.

We make real estate construction loans to individuals and builders, primarily for the construction of residential properties. We originate these loans whether or not the collateral property underlying the loan is under contract for sale. At December 31, 2020, construction and development loans totaled $217.0 million, or 13.8% of our total gross loan portfolio (excluding $143.7 million of unfunded construction loan commitments), of which $162.0 million were for residential real estate projects. This compares to construction and development loans of $179.7 million, or 13.3% of our total loan portfolio at December 31, 2019, or an increase of 20.8% during the past year. In addition to these construction and development loans, the Company had four commercial note-secured lines of credit to residential construction re-lenders with combined commitments of $66.0 million, and an outstanding balance of $33.0 million at December 31, 2020. The underlying collateral risks associated with our commercial construction warehouse lines are similar to the risks related to our residential construction and development loans.

Construction financing is generally considered to involve a higher degree of credit risk than longer term financing on improved, owner-occupied real estate. Construction lending involves additional risks when compared with permanent residential lending because funds are advanced upon the collateral for the project based on an estimate of costs that will produce a future value at completion. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the complete project and the effects of governmental regulation on real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the completed project loan-to-value ratio. Changes in demand for new housing and higher than anticipated building costs may cause actual results to vary significantly from those estimated. For these reasons, this type of lending also typically involves higher loan principal amounts and may be concentrated with a small number of builders. A downturn in housing, or the real estate market, could increase delinquencies, defaults and foreclosures, and significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. Some of the builders we deal with have more than one loan outstanding with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss. In addition, during the term of most of our construction loans, no payment from the borrower is required since the accumulated interest is added to the principal of the loan through an interest reserve. As a result, these loans often involve the disbursement of funds with repayment substantially dependent on the success of the ultimate project and the ability of the borrower to sell or lease the property or obtain permanent take-out financing, rather than the ability of the borrower or guarantor to repay principal and interest. If our appraisal of the value of a completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project and may incur

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a loss. Because construction loans require active monitoring of the building process, including cost comparisons and on-site inspections, these loans are more difficult and costly to monitor.

Increases in market rates of interest may have a more pronounced effect on construction loans by rapidly increasing the end-purchaser’s borrowing costs, thereby possibly reducing the homeowner's ability to finance the home upon completion or the overall demand for the project. Properties under construction are often difficult to sell and typically must be completed in order to be successfully sold which also complicates the process of working out problem construction loans. This may require us to advance additional funds and/or contract with another builder to complete construction and assume the market risk of selling the project at a future market price, which may or may not enable us to fully recover unpaid loan funds and associated construction and liquidation costs. Furthermore, in the case of speculative construction loans, there is the added risk associated with identifying an end-purchaser for the finished project.  At December 31, 2020, outstanding construction and development loans totaled $217.0 million of which $133.0 million was comprised of speculative one-to-four-family construction loans and $15.7 million of land acquisition and development loans. Total committed, including unfunded construction and development loans at December 31, 2020 was $360.6 million. Loans on land under development or held for future construction pose additional risks because of the lack of income being produced by the property and the potential illiquid nature of the collateral. These risks can be significantly impacted by supply and demand. As a result, this type of lending often involves the disbursement of substantial funds with repayment dependent on the success of the ultimate project and the ability of the borrower to sell or lease the property, rather than the ability of the borrower or guarantor themselves to repay principal and interest. No real estate construction and development loans were nonperforming at December 31, 2020. A material increase in our nonperforming construction and development loans could have a material adverse effect on our financial condition and results of operation.

Our residential mortgage warehouse lending program is subject to various risks that could adversely impact our results of operations and financial condition.

The Company has a residential mortgage warehouse lending program that focuses on four Pacific Northwest mortgage banking companies. Short-term funding is provided to the mortgage banking companies for the purpose of originating residential mortgage loans for sale into the secondary market. Our warehouse lending lines are secured by the underlying notes associated with mortgage loans made to borrowers by the mortgage banking company and we generally require guarantees from the principal shareholder(s) of the mortgage banking company. Because these loans are repaid when the note is sold by the mortgage bank into the secondary market, with the proceeds from the sale used to pay down our outstanding loan before being dispersed to the mortgage bank, interest rate fluctuation is also a key risk factor affecting repayment. At December 31, 2020, we had approved residential warehouse lending lines in varying amounts from $5.0 million to $15.0 million with each of the four companies, for an aggregate amount of $36.0 million. At December 31, 2020, there was $16.1 million in residential warehouse lines outstanding, compared to $12.9 million outstanding at December 31, 2019.  

There are numerous risks associated with residential mortgage warehouse lending, which include, without limitation, (i) credit risks relating to the mortgage bankers that borrow from us, (ii) the risk of intentional misrepresentation or fraud by any of these mortgage bankers, (iii) changes in the market value of mortgage loans originated by the mortgage banker, the sale of which is the expected source of repayment of the borrowings under the warehouse line of credit, due to changes in interest rates during the time in warehouse, (iv) unsalable or impaired mortgage loans originated, which could lead to decreased collateral value and the failure of a purchaser of the mortgage loan to purchase the loan from the mortgage banker, and (v) the volatility of mortgage loan originations.

The underlying collateral risks associated with our residential mortgage warehouse lines are similar to the risks related to our one-to-four-family residential mortgage loans. Additionally, the impact of interest rates on our residential mortgage warehouse lending business is similar to the impact on our mortgage banking operations as discussed below under “Revenue from mortgage banking operations are sensitive to changes in economic conditions, decreased economic activity, a slowdown in the housing market, higher interest rates or new legislation and may adversely impact our financial condition and results of operations.”

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Loans originated under the SBA Paycheck Protection Program subject us to credit, forgiveness and guarantee risk.

As of December 31, 2020, we hold and service a portfolio of 423 loans originated under the PPP with a balance of $62.1 million. The PPP loans are subject to the provisions of the CARES Act and CAA 2021 and to complex and evolving rules and guidance issued by the SBA and other government agencies. We expect that the great majority of our PPP borrowers will seek full or partial forgiveness of their loan obligations. We have credit risk on PPP loans if the SBA determines that there is a deficiency in the manner in which we originated, funded or serviced loans, including any issue with the eligibility of a borrower to receive a PPP loan. We could face additional risks in our administrative capabilities to service our PPP loans, and risk with respect to the determination of loan forgiveness, depending on the final procedures for determining loan forgiveness. 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 we originated, funded or serviced a PPP loan, the SBA may deny its liability under the guaranty, reduce the amount of the guaranty or, if the SBA has already paid under the guaranty, seek recovery of any loss related to the deficiency from us.

If our allowance for loan losses is not sufficient to cover actual loan losses, our earnings could be reduced.

Our business depends on the creditworthiness of our customers. As with most financial institutions, we maintain an allowance for loan losses to reflect potential defaults and nonperformance, which represents management's best estimate of probable loans losses inherent in the loan portfolio. The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. In determining the amount of the allowance for loan losses, we review loans and our historical loss and delinquency experience and evaluate economic conditions. Management also recognizes that significant new growth in loan portfolios, new loan products, and the refinancing of existing loans can result in portfolios comprised of unseasoned loans that may not perform in a historical or projected manner and will increase the risk that our allowance may be insufficient to absorb losses without significant additional provisions. If our assumptions are incorrect, our allowance for loan losses may not be sufficient to cover actual losses, resulting in additional provisions for loan losses to replenish the allowance for loan losses. Deterioration in economic conditions, new information regarding existing loans, identification of additional problem loans or relationships, and other factors, both within and outside of our control, may increase our loan charge-offs and/or otherwise require an increase in our provision for loan losses.

In addition, the FASB has adopted a new accounting standard referred to as Current Expected Credit Loss, or CECL, which will require financial institutions to determine periodic estimates of lifetime expected credit losses on loans, and recognize the expected credit losses as allowances for credit losses. This will change the current method of providing allowances for credit losses only when they have been incurred and are probable, which may require us to increase our allowance for loan losses, and may greatly increase the types of data we would need to collect and review to determine the appropriate level of the allowance for credit losses. This accounting pronouncement is expected to be applicable to us for our first fiscal year after December 15, 2022. We are evaluating the impact the CECL accounting model will have on our accounting, but expect to recognize a one-time cumulative-effect adjustment to the allowance for loan losses as of the beginning of the first reporting period in which the new standard is effective. We cannot yet determine the magnitude of any such one-time cumulative adjustment or of the overall impact of the new standard on our financial condition or results of operations. The federal banking regulators, including the Federal Reserve and the FDIC, have adopted a rule that gives a banking organization the option to phase in over a three-year period the day-one adverse effects of CECL on its regulatory capital. Any increase in our allowance for loan losses or expenses incurred to determine the appropriate level of the allowance for loan losses may have a material adverse effect on our financial condition and results of operations.  For more on this new accounting standard, see “Note 1- Basis of Presentation and Summary” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.

In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs based on their judgment about information available to them at the time of their examination. Any increases in the provision for loan losses will result in a decrease in net income and may have a material adverse effect on our financial condition, results of operations, and capital.

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Our business may be adversely affected by credit risk associated with residential property.

At December 31, 2020, $311.1 million, excluding loans held for sale of $166.4 million, or 19.8% of our total loan portfolio was secured by first liens on one-to-four-family residential loans and our home equity lines of credit totaled $43.1 million, or 2.7% of our total loan portfolio. These types of loans are generally sensitive to regional and local economic conditions that significantly impact the ability of borrowers to meet their loan payment obligations, making loss levels difficult to predict. A decline in residential real estate values resulting from a downturn in the Washington housing markets in which our loans are concentrated may reduce the value of the real estate collateral securing these types of loans and increase our risk of loss if borrowers default on their loans. A decline in economic conditions or in the volume of real estate sales and/or the sales prices coupled with elevated unemployment rates may result in higher than expected loan delinquencies or problem assets, and a decline in demand for our products and services. In addition, residential loans with high combined loan-to-value ratios will be more sensitive to the fluctuation of property values than those with lower combined loan-to-value ratios and therefore may experience a higher incidence of default and severity of losses. Further, the majority of our home equity lines of credit consist of second mortgage loans. For those home equity lines secured by a second mortgage, it is unlikely that we will be successful in recovering all or a portion of our loan proceeds in the event of default unless we are prepared to repay the first mortgage loan and such repayment and the costs associated with a foreclosure are justified by the value of the property. For these reasons, we may experience higher rates of delinquencies, defaults and losses which would adversely affect our net income.

Risk Related to Changes in Market Interest Rates

Changes in interest rates may reduce our net interest income and may result in higher defaults in a rising rate environment.

Our earnings and cash flows are largely dependent upon our net interest income. Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Reserve Board.  After steadily increasing the targeted federal funds rate in 2018 and 2017, the Federal Reserve decreased the targeted federal funds rate 25 basis points three times during 2019 to 1.50% - 1.75% at December 31, 2019, in response to some recent weakness in economic data and indicated possible further decreases, subject to economic conditions.  In March 2020, in response to the COVID-19 pandemic, the Federal Open Market Committee (“FOMC”) of the Federal Reserve System, lowered the target range for the federal funds rate 150 basis points to a range of 0.00% to 0.25%.  The FOMC expects to maintain this target until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.  Future increases in the targeted federal funds rate, may negatively impact both the housing markets by reducing refinancing activity and new home purchases and the U.S. economy. In addition, deflationary pressures, while possibly lowering our operating costs, could have a significant negative effect on our borrowers, especially our business borrowers, and the values of collateral securing loans, which could negatively affect our financial performance.

We principally manage interest rate risk by managing our volume and mix of our earning assets and funding liabilities.  Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and investments and the amount of interest we pay on deposits and borrowings, but these changes could also affect (i) our ability to originate and/or sell loans and obtain deposits, (ii) the fair value of our financial assets and liabilities, which could negatively impact shareholders’ equity, and our ability to realize gains from the sale of such assets, (iii) our ability to obtain and retain deposits in competition with other available investment alternatives, (iv) the ability of our borrowers to repay adjustable or variable rate loans, and (v) the average duration of our investment securities portfolio and other interest-earning assets.  If the interest rates paid on deposits and borrowings increase at a faster rate than the interest rates received on loans and other investments, our net interest income, and therefore earnings, could be adversely affected.  In a changing interest rate environment, we may not be able to manage this risk effectively.  If we are unable to manage interest rate risk effectively, our business, financial condition, and results of operations could be materially affected.

Changes in interest rates could also have a negative impact on our results of operations by reducing the ability of borrowers to repay their current loan obligations or by reducing our margins and profitability.  Our net interest margin is the difference between the yield we earn on our assets and the interest rate we pay for deposits and our other sources of funding.  Changes in interest rates-up or down-could adversely affect our net interest margin and, as a result, our net interest income.  Although the yield we earn on our assets and our funding costs tend to move in the same direction in

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response to changes in interest rates, one can rise or fall faster than the other, causing our net interest margin to expand or contract.  Our liabilities tend to be shorter in duration than our assets, so they may adjust faster in response to changes in interest rates.  As a result, when interest rates rise, our funding costs may rise faster than the yield we earn on our assets, causing our net interest margin to contract until the yields on interest-earning assets catch up.

Changes in the slope of the “yield curve”, or the spread between short-term and long-term interest rates could also reduce our net interest margin.  Normally, the yield curve is upward sloping, meaning short-term rates are lower than long-term rates.  Because our liabilities tend to be shorter in duration than our assets, when the yield curve flattens or even inverts, we could experience pressure on our net interest margin as our cost of funds increases relative to the yield we can earn on our assets.  Also, interest rate decreases can lead to increased prepayments of loans and mortgage-backed securities as borrowers refinance their loans to reduce borrowing costs.  Under these circumstances, we are subject to reinvestment risk as we may have to redeploy such repayment proceeds into lower yielding investments, which would likely hurt our income.

A sustained increase in market interest rates could adversely affect our earnings.  As is the case with many financial institutions, our emphasis on increasing the development of core deposits, those deposits bearing no or a relatively low rate of interest with no stated maturity date, has resulted in an increasing percentage of our deposits being comprised of deposits bearing no or a relatively low rate of interest and having a shorter duration than our assets. At December 31, 2020, we had $340.9 million in certificates of deposit that mature within one year and $1.17 billion in noninterest bearing, NOW checking, savings and money market accounts. We would incur a higher cost of funds to retain these deposits in a rising interest rate environment.  If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, our net interest income, and therefore earnings, could be adversely affected. In addition, a substantial amount of our residential mortgage loans and home equity lines of credit have adjustable interest rates. As a result, these loans may experience a higher rate of default in a rising interest rate environment. Our net income can also be reduced by the impact that changes in interest rates can have on the fair value of our capitalized mortgage servicing rights (“MSRs”).  At December 31, 2020, we serviced $2.17 billion of loans sold to third parties, and the servicing rights associated with such loans had an amortized cost of $12.6 million and an estimated fair value, at that date, of $12.8 million. Because the estimated life and estimated income to be derived from servicing the underlying loans generally increase with rising interest rates and decrease with falling interest rates, the value of MSRs generally increases as interest rates rise and decreases as interest rates fall. For example, a decrease in mortgage interest rates typically increases the prepayment speeds of MSRs and therefore decreases the fair value of the MSRs.  Future decreases in mortgage interest rates could decrease the fair value of our MSRs below their recorded amount, which would decrease our earnings. Changes in interest rates also affect the value of our interest-earning assets and in particular, our investment securities portfolio.  Generally, the fair value of fixed-rate securities fluctuates inversely with changes in interest rates. Unrealized gains and losses on securities available for sale are reported as a separate component of equity, net of tax. Decreases in the fair value of securities available for sale resulting from increases in interest rates could have an adverse effect on stockholders’ equity.

Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on our results of operations, any substantial, unexpected, or prolonged change in market interest rates could have a material adverse effect on our financial condition and results of operations. Also, our interest rate risk modeling techniques and assumptions likely may not fully predict or capture the impact of actual interest rate changes on our balance sheet or projected operating results. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management and Market Risk” of this Form 10-K.

Revenue from mortgage banking operations are sensitive to changes in economic conditions, decreased economic activity, a slowdown in the housing market, higher interest rates or new legislation and may adversely impact our financial condition and results of operations.

Our mortgage banking operations provide a significant portion of our noninterest income.  We generate mortgage banking revenues primarily from gains on the sale of one-to-four-family mortgage loans.  The one-to-four-family mortgage loans are sold pursuant to programs currently offered by Fannie Mae, Freddie Mac, Ginnie Mae, FHA, VA, USDA Rural Housing, the FHLB, and non-Government Sponsored Enterprise (“GSE”) investors.  These entities account for a substantial portion of the secondary market in residential one-to-four-family mortgage loans.  Any future changes in the

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one-to-four-family programs, our eligibility to participate in these programs, the criteria for loans to be accepted or laws that significantly affect the activity of such entities, could, in turn, materially adversely affect our results of operations.  Mortgage banking is generally considered a volatile source of income because it depends largely on the level of loan volume which, in turn, depends largely on prevailing market interest rates.  In a rising or higher interest rate environment, our originations of mortgage loans may decrease, resulting in fewer loans that are available to be sold to investors.  This would result in a decrease in mortgage banking revenues and a corresponding decrease in noninterest income.  In addition, our results of operations are affected by the amount of noninterest expense associated with mortgage banking activities, such as salaries and employee benefits, occupancy, equipment and data processing expense, and other operating costs.  During periods of reduced loan demand, our results of operations may be adversely affected to the extent that we are unable to reduce expenses commensurate with the decline in loan originations.  In addition, although we sell loans into the secondary market without recourse, we are required to give customary representations and warranties about the loans to the buyers.  If we breach those representations and warranties, the buyers may require us to repurchase the loans and we may incur a loss on the repurchase.

Our securities portfolio may be negatively impacted by fluctuations in market value, changes in the tax code, and interest rates.

Factors beyond our control can significantly influence the fair value of securities in our portfolio and can cause potential adverse changes to the fair value of these securities. These factors include, but are not limited to, rating agency actions in respect of the securities, defaults by, or other adverse events affecting, the issuer or with respect to the underlying securities, and changes in market interest r