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UNTY Unity Bancorp

Filed: 6 Aug 20, 1:25pm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2020

OR

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

For the transition period from ____ to ____.

Commission File Number 1-12431

Graphic

Unity Bancorp, Inc.

(Exact name of registrant as specified in its charter)

New Jersey

22-3282551

(State or other jurisdiction of incorporation or organization)

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

64 Old Highway 22, Clinton, NJ

08809

(Address of principal executive offices)

(Zip Code)

Registrant’s telephone number, including area code (908) 730-7630

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

Title of each class

Trading Symbol(s)

Name of each exchange on which registered

Common stock

UNTY

NASDAQ

Securities registered pursuant to Section 12(g) of the Exchange Act: None

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, as amended, 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 and post such files). Yes     No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company (as defined in Rule 12b-2 of the Exchange Act):

Large accelerated filer  

Accelerated filer  

Nonaccelerated 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 is a shell company as defined in Rule 12b-2 of the Exchange Act:    Yes     No 

The number of shares outstanding of each of the registrant’s classes of common equity stock, as of July 31, 2020 common stock, no par value: 10,678,794 shares outstanding.

Table of Contents

    

Page #

PART I

CONSOLIDATED FINANCIAL INFORMATION

ITEM 1

Consolidated Financial Statements (Unaudited)

3

Consolidated Balance Sheets at June 30, 2020 and December 31, 2019

3

Consolidated Statements of Income for the three and six months ended June 30, 2020 and 2019

4

Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2020 and 2019

5

Consolidated Statements of Changes in Shareholders’ Equity for the three and six months ended June 30, 2020 and 2019

7

Consolidated Statements of Cash Flows for the six months ended June 30, 2020 and 2019

8

Notes to the Consolidated Financial Statements

9

ITEM 2

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

46

ITEM 3

Quantitative and Qualitative Disclosures about Market Risk

69

ITEM 4

Controls and Procedures

69

PART II

OTHER INFORMATION

69

ITEM 1

Legal Proceedings

69

ITEM 1A

Risk Factors

69

ITEM 2

Unregistered Sales of Equity Securities and Use of Proceeds

71

ITEM 3

Defaults upon Senior Securities

71

ITEM 4

Mine Safety Disclosures

72

ITEM 5

Other Information

72

ITEM 6

Exhibits

73

SIGNATURES

74

EXHIBIT INDEX

75

Exhibit 31.1

Exhibit 31.2

Exhibit 32.1

2

PART I        CONSOLIDATED FINANCIAL INFORMATION

ITEM 1        Consolidated Financial Statements (Unaudited)

Unity Bancorp, Inc.

Consolidated Balance Sheets

(Unaudited)

(In thousands)

    

June 30, 2020

    

December 31, 2019

ASSETS

Cash and due from banks

$

24,066

$

21,106

Federal funds sold and interest-bearing deposits

 

162,617

 

136,910

Cash and cash equivalents

 

186,683

 

158,016

Securities:

Debt securities available for sale (amortized cost of $52,288 in 2020 and $63,883 in 2019)

 

53,102

 

64,275

Equity securities with readily determinable fair values (amortized cost of $2,112 in 2020 and $2,218 in 2019)

 

1,786

 

2,289

Total securities

 

54,888

 

66,564

Loans:

 

  

 

  

SBA loans held for sale

 

10,602

 

13,529

SBA loans held for investment

 

36,966

 

35,767

SBA PPP loans

136,039

Commercial loans

 

792,752

 

765,032

Residential mortgage loans

 

469,987

 

467,706

Consumer loans

 

146,161

 

143,524

Total loans

 

1,592,507

 

1,425,558

Allowance for loan losses

 

(20,234)

 

(16,395)

Net loans

 

1,572,273

 

1,409,163

Premises and equipment, net

 

20,751

 

21,315

Bank owned life insurance ("BOLI")

 

26,435

 

26,323

Deferred tax assets

 

7,274

 

5,559

Federal Home Loan Bank ("FHLB") stock

 

11,629

 

14,184

Accrued interest receivable

 

11,039

 

6,984

Other real estate owned ("OREO")

 

711

 

1,723

Goodwill

 

1,516

 

1,516

Prepaid expenses and other assets

 

7,575

 

7,595

Total assets

$

1,900,774

$

1,718,942

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

  

 

  

Liabilities:

 

  

 

  

Deposits:

 

  

 

  

Noninterest-bearing demand

$

429,899

$

279,793

Interest-bearing demand

 

172,950

 

176,335

Savings

 

408,416

 

389,795

Time, under $100,000

 

271,974

 

195,446

Time, $100,000 to $250,000

 

113,237

 

126,192

Time, $250,000 and over

 

86,981

 

82,553

Total deposits

 

1,483,457

 

1,250,114

Borrowed funds

 

223,000

 

283,000

Subordinated debentures

 

10,310

 

10,310

Accrued interest payable

 

228

 

455

Accrued expenses and other liabilities

 

17,172

 

14,354

Total liabilities

 

1,734,167

 

1,558,233

Shareholders’ equity:

 

  

 

  

Common stock

91,103

 

90,113

Retained earnings

 

79,253

 

70,442

Treasury stock

(2,991)

Accumulated other comprehensive (loss) income

 

(758)

 

154

Total shareholders’ equity

 

166,607

 

160,709

Total liabilities and shareholders’ equity

$

1,900,774

$

1,718,942

Shares issued

10,939

10,881

Shares outstanding

10,728

10,881

Treasury shares

211

The accompanying notes to the Consolidated Financial Statements are an integral part of these statements.

3

Unity Bancorp, Inc.

Consolidated Statements of Income

(Unaudited)

For the three months ended June 30, 

For the six months ended June 30, 

(In thousands, except per share amounts)

    

2020

    

2019

2020

    

2019

INTEREST INCOME

 

  

 

  

  

 

  

Federal funds sold and interest-bearing deposits

$

23

$

232

$

212

$

453

FHLB stock

 

79

 

77

 

188

 

193

Securities:

 

 

  

 

 

Taxable

 

437

 

461

 

948

 

937

Tax-exempt

 

17

 

27

 

39

 

55

Total securities

 

454

 

488

 

987

 

992

Loans:

 

  

 

  

 

  

 

  

SBA loans

 

709

 

942

 

1,694

 

1,937

SBA PPP loans

723

723

Commercial loans

 

9,815

 

9,357

 

19,748

 

18,426

Residential mortgage loans

 

5,554

 

5,535

 

11,324

 

11,095

Consumer loans

 

1,921

 

2,150

 

3,988

 

4,185

Total loans

 

18,722

 

17,984

 

37,477

 

35,643

Total interest income

 

19,278

 

18,781

 

38,864

 

37,281

INTEREST EXPENSE

 

  

 

  

 

  

 

  

Interest-bearing demand deposits

 

364

 

442

 

842

 

851

Savings deposits

 

512

 

1,188

 

1,363

 

2,306

Time deposits

 

2,454

 

2,437

 

4,900

 

4,445

Borrowed funds and subordinated debentures

 

423

 

504

 

989

 

1,253

Total interest expense

 

3,753

 

4,571

 

8,094

 

8,855

Net interest income

 

15,525

 

14,210

 

30,770

 

28,426

Provision for loan losses

 

2,500

 

350

 

4,000

 

850

Net interest income after provision for loan losses

 

13,025

 

13,860

 

26,770

 

27,576

NONINTEREST INCOME

 

  

 

  

 

  

 

  

Branch fee income

 

207

 

378

 

523

 

746

Service and loan fee income

 

390

 

569

 

766

 

1,011

Gain on sale of SBA loans held for sale, net

 

92

 

238

 

565

 

554

Gain on sale of mortgage loans, net

 

1,553

 

630

 

2,604

 

980

BOLI income

 

154

 

147

 

327

 

297

Net security gains (losses)

 

79

 

98

 

(91)

 

198

Other income

 

336

 

351

 

662

 

647

Total noninterest income

 

2,811

 

2,411

 

5,356

 

4,433

NONINTEREST EXPENSE

 

  

 

  

 

  

 

  

Compensation and benefits

 

5,553

 

5,186

 

10,992

 

10,030

Processing and communications

 

769

 

748

 

1,477

 

1,464

Furniture and equipment

 

641

 

718

 

1,296

 

1,377

Occupancy

 

630

 

653

 

1,253

 

1,346

BSA expenses

488

550

Professional services

 

261

 

277

 

531

 

565

Advertising

 

207

 

374

 

497

 

722

Director fees

 

181

 

164

 

381

 

328

Other loan expenses

 

168

 

67

 

257

 

113

Deposit insurance

 

159

 

134

 

247

 

301

Loan collection and OREO expenses (recoveries)

 

1

 

(10)

 

187

 

57

Other expenses

 

119

 

480

 

833

 

966

Total noninterest expense

 

9,177

 

8,791

 

18,501

 

17,269

Income before provision for income taxes

 

6,659

 

7,480

 

13,625

 

14,740

Provision for income taxes

 

1,488

 

1,646

 

3,086

 

3,166

Net income

$

5,171

$

5,834

$

10,539

$

11,574

Net income per common share - Basic

$

0.48

$

0.54

$

0.97

$

1.07

Net income per common share - Diluted

$

0.47

$

0.53

$

0.96

$

1.05

Weighted average common shares outstanding – Basic

 

10,792

 

10,843

 

10,838

 

10,822

Weighted average common shares outstanding – Diluted

 

10,888

 

11,026

 

10,962

 

11,011

The accompanying notes to the Consolidated Financial Statements are an integral part of these statements.

4

Unity Bancorp, Inc.

Consolidated Statements of Comprehensive Income

(Unaudited)

For the three months ended

June 30, 2020

June 30, 2019

    

    

Income tax

    

    

Income tax

    

Before tax

expense

Net of tax

Before tax

expense

Net of tax

(In thousands)

amount

(benefit)

amount

     

amount

(benefit)

amount

Net income

$

6,659

$

1,488

$

5,171

$

7,480

$

1,646

$

5,834

Other comprehensive income

Debt securities available for sale:

 

  

 

  

 

  

 

  

 

  

 

  

Unrealized holding gains on securities arising during the period

 

497

 

135

 

362

 

874

 

243

 

631

Less: reclassification adjustment for gains on securities included in net income

 

79

 

17

 

62

 

98

 

21

��

77

Total unrealized gains on securities available for sale

 

418

 

118

 

300

 

776

 

222

 

554

Adjustments related to defined benefit plan:

 

  

 

  

 

  

 

  

 

  

 

  

Amortization of prior service cost

 

21

 

6

 

15

 

21

 

6

 

15

Total adjustments related to defined benefit plan

 

21

 

6

 

15

 

21

 

6

 

15

Net unrealized losses from cash flow hedges:

 

  

 

  

 

  

 

  

 

  

 

  

Unrealized holding losses on cash flow hedges arising during the period

 

(340)

 

(99)

 

(241)

 

(584)

 

(169)

 

(415)

Total unrealized losses on cash flow hedges

 

(340)

 

(99)

 

(241)

 

(584)

 

(169)

 

(415)

Total other comprehensive income

 

99

 

25

 

74

 

213

 

59

 

154

Total comprehensive income

$

6,758

$

1,513

$

5,245

$

7,693

$

1,705

$

5,988

The accompanying notes to the Consolidated Financial Statements are an integral part of these statements.

5

Unity Bancorp, Inc.

Consolidated Statements of Comprehensive Income

(Unaudited)

For the six months ended

June 30, 2020

June 30, 2019

    

    

Income tax

    

    

Income tax

    

Before tax

expense

Net of tax

Before tax

expense

Net of tax

(In thousands)

amount

(benefit)

amount

amount

(benefit)

amount

Net income

$

13,625

$

3,086

$

10,539

$

14,740

$

3,166

$

11,574

Other comprehensive income

 

  

 

  

 

  

 

  

 

  

 

  

Debt securities available for sale:

 

  

 

  

 

  

 

  

 

  

 

  

Unrealized holding gains on securities arising during the period

 

331

 

100

 

231

 

1,187

 

316

 

871

Less: reclassification adjustment for (losses) gains on securities included in net income

 

(91)

 

(19)

 

(72)

 

198

 

42

 

156

Total unrealized gains on securities available for sale

 

422

 

119

 

303

 

989

 

274

 

715

Adjustments related to defined benefit plan:

 

  

 

  

 

  

 

  

 

  

 

  

Amortization of prior service cost

 

42

 

12

 

30

 

42

 

(64)

 

106

Total adjustments related to defined benefit plan

 

42

 

12

 

30

 

42

 

(64)

 

106

Net unrealized losses from cash flow hedges:

 

  

 

  

 

  

 

  

 

  

 

  

Unrealized holding losses on cash flow hedges arising during the period

 

(1,750)

 

(505)

 

(1,245)

 

(992)

 

(275)

 

(717)

Total unrealized losses on cash flow hedges

 

(1,750)

 

(505)

 

(1,245)

 

(992)

 

(275)

 

(717)

Total other comprehensive (loss) income

 

(1,286)

 

(374)

 

(912)

 

39

 

(65)

 

104

Total comprehensive income

$

12,339

$

2,712

$

9,627

$

14,779

$

3,101

$

11,678

The accompanying notes to the Consolidated Financial Statements are an integral part of these statements.

6

Unity Bancorp, Inc.

Consolidated Statements of Changes in Shareholders’ Equity

For the three and six months ended June 30, 2020 and 2019

(Unaudited)

    

    

    

Accumulated

    

other

Total

Stock

Retained

comprehensive

Treasury

shareholders’

(In thousands)

    

Shares

    

Amount

    

earnings

    

income (loss)

    

stock

    

equity

Balance, December 31, 2019

 

10,881

$

90,113

$

70,442

$

154

$

$

160,709

Net income

 

 

 

5,368

 

 

5,368

Other comprehensive loss, net of tax

 

 

 

 

(986)

 

(986)

Dividends on common stock ($0.08 per share)

 

 

30

 

(871)

 

 

(841)

Common stock issued and related tax effects (1)

 

13

 

227

 

 

 

227

Acquisition of treasury stock, at cost

(11)

(172)

(172)

Balance, March 31, 2020

 

10,883

 

90,370

 

74,939

 

(832)

(172)

 

164,305

Net income

 

 

 

5,171

 

 

5,171

Other comprehensive income, net of tax

 

 

 

 

74

 

74

Dividends on common stock ($0.08 per share)

 

 

29

 

(857)

 

 

(828)

Common stock issued and related tax effects (1)

 

45

 

704

 

 

 

704

Acquisition of treasury stock, at cost

(200)

(2,819)

(2,819)

Balance, June 30, 2020

 

10,728

$

91,103

$

79,253

$

(758)

$

(2,991)

$

166,607

    

    

    

Accumulated

    

other

Total

Stock

Retained

comprehensive

shareholders’

(In thousands)

    

Shares

    

Amount

    

earnings

    

(loss) income

    

equity

Balance, December 31, 2018

 

10,780

$

88,484

$

50,161

$

(157)

$

138,488

Net income

 

 

 

5,740

 

 

5,740

Other comprehensive loss, net of tax

 

 

 

 

(50)

 

(50)

Dividends on common stock ($0.07 per share)

 

 

26

 

(756)

 

 

(730)

Common stock issued and related tax effects (1)

 

42

 

269

 

 

 

269

Balance, March 31, 2019

 

10,822

 

88,779

 

55,145

 

(207)

 

143,717

Net income

 

 

 

5,834

 

 

5,834

Other comprehensive income, net of tax

 

 

 

 

154

 

154

Dividends on common stock ($0.08 per share)

 

 

31

 

(870)

 

 

(839)

Common stock issued and related tax effects (1)

 

34

 

517

 

 

 

517

Balance, June 30, 2019

 

10,856

$

89,327

$

60,109

$

(53)

$

149,383

(1)Includes the issuance of common stock under employee benefit plans, which includes nonqualified stock options and restricted stock expense related entries, employee option exercises and the tax benefit of options exercised.

The accompanying notes to the Consolidated Financial Statements are an integral part of these statements.

7

Unity Bancorp, Inc.

Consolidated Statements of Cash Flows

(Unaudited)

For the six months ended June 30, 

(In thousands)

    

2020

    

2019

OPERATING ACTIVITIES:

 

  

 

  

Net income

$

10,539

$

11,574

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

 

  

 

  

Provision for loan losses

 

4,000

 

850

Net amortization of purchase premiums and discounts on securities

 

115

 

81

Depreciation and amortization

 

791

 

795

PPP deferred fees and costs

4,419

Deferred income tax (benefit)

 

(1,343)

 

(262)

Net security gains

 

(306)

 

Stock compensation expense

 

707

 

604

Valuation writedowns on OREO

 

200

 

Gain on sale of mortgage loans, net

 

(1,861)

 

(619)

Gain on sale of SBA loans held for sale, net

 

(565)

 

(554)

Origination of mortgage loans sold

 

(105,855)

 

(43,022)

Origination of SBA loans held for sale

 

(3,150)

 

(5,479)

Proceeds from sale of mortgage loans, net

 

107,716

 

43,641

Proceeds from sale of SBA loans held for sale, net

 

7,095

 

9,629

BOLI income

 

(327)

 

(297)

Net change in other assets and liabilities

 

(2,746)

 

(1,221)

Net cash provided by operating activities

 

19,429

 

15,720

INVESTING ACTIVITIES

 

  

 

  

Purchases of securities available for sale

 

(2,717)

 

Purchases of FHLB stock, at cost

 

(39,430)

 

(42,989)

Maturities and principal payments on securities held to maturity

 

 

413

Maturities and principal payments on debt securities available for sale

 

8,471

 

2,306

Proceeds from sales of securities available for sale

 

6,029

 

Proceeds from sales of equity securities

 

111

 

Proceeds from redemption of FHLB stock

 

41,985

 

43,785

Proceeds from sale of OREO

 

812

 

Originations of SBA PPP Loans

(140,516)

Net increase in loans

 

(34,351)

 

(45,083)

Proceeds from BOLI

 

215

 

Purchases of premises and equipment

 

(278)

 

(287)

Net cash used in investing activities

 

(159,669)

 

(41,855)

FINANCING ACTIVITIES

 

  

 

  

Net increase in deposits

 

233,343

 

56,666

Proceeds from new borrowings

 

183,000

 

190,000

Repayments of borrowings

 

(243,000)

 

(210,000)

Proceeds from exercise of stock options

 

396

 

363

Fair market value of shares withheld to cover employee tax liability

 

(172)

 

Dividends on common stock

 

(1,669)

 

(1,569)

Purchase of treasury stock

(2,991)

Net cash provided by financing activities

 

168,907

 

35,460

Increase in cash and cash equivalents

 

28,667

 

9,325

Cash and cash equivalents, beginning of period

 

158,016

 

145,515

Cash and cash equivalents, end of period

$

186,683

$

154,840

SUPPLEMENTAL DISCLOSURES

 

  

 

  

Cash:

 

  

 

  

Interest paid

$

8,321

$

8,847

Income taxes paid

3,632

4,132

Noncash investing activities:

  

  

Establishment of lease liability and right-of-use asset

3,191

Transfer of SBA loans held for sale to held to maturity

1,204

Capitalization of servicing rights

578

428

Transfer of loans to OREO

976

The accompanying notes to the Consolidated Financial Statements are an integral part of these statements.

8

Unity Bancorp, Inc.

Notes to the Consolidated Financial Statements (Unaudited)

June 30, 2020

NOTE 1. Significant Accounting Policies

The accompanying Consolidated Financial Statements include the accounts of Unity Bancorp, Inc. (the "Parent Company") and its wholly-owned subsidiary, Unity Bank (the "Bank" or when consolidated with the Parent Company, the "Company"), and reflect all adjustments and disclosures which are generally routine and recurring in nature, and in the opinion of management, necessary for a fair presentation of interim results. The Bank has multiple subsidiaries used to hold part of its investment and loan portfolios and OREO properties. All significant intercompany balances and transactions have been eliminated in consolidation. Certain reclassifications have been made to prior period amounts to conform to the current year presentation, with no impact on current earnings or shareholders’ equity. The financial information has been prepared in accordance with U.S. generally accepted accounting principles and has not been audited. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and revenues and expenses during the reporting periods. Actual results could differ from those estimates. Amounts requiring the use of significant estimates include the allowance for loan losses, valuation of deferred tax and servicing assets, the carrying value of loans held for sale and other real estate owned, the valuation of securities and the determination of other-than-temporary impairment for securities and fair value disclosures. Management believes that the allowance for loan losses is adequate. While management uses available information to recognize losses on loans, future additions to the allowance for loan losses may be necessary based on changes in economic conditions. The markets served by the Company have been significantly impacted by the COVID-19 pandemic, which started during the first quarter of 2020. The Company continues to assess the financial impact of the COVID-19 pandemic.

The interim unaudited Consolidated Financial Statements included herein have been prepared in accordance with instructions for Form 10-Q and the rules and regulations of the Securities and Exchange Commission (“SEC”) and consist of normal recurring adjustments necessary for the fair presentation of interim results. The results of operations for the six months ended June 30, 2020 are not necessarily indicative of the results which may be expected for the entire year. As used in this Form 10-Q, “we” and “us” and “our” refer to Unity Bancorp, Inc., and its consolidated subsidiary, Unity Bank, depending on the context. Certain information and financial disclosures required by U.S. generally accepted accounting principles have been condensed or omitted from interim reporting pursuant to SEC rules. Interim financial statements should be read in conjunction with the Company’s Consolidated Financial Statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019.

Other-Than-Temporary Impairment

The Company has a process in place to identify securities that could potentially incur credit impairment that is other-than-temporary. This process involves monitoring late payments, pricing levels, downgrades by rating agencies, key financial ratios, financial statements, revenue forecasts and cash flow projections as indicators of credit issues. Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concern warrants such evaluation. This evaluation considers relevant facts and circumstances in evaluating whether a credit or interest rate-related impairment of a security is other-than-temporary. Relevant facts and circumstances considered include: (1) the extent and length of time the fair value has been below cost; (2) the reasons for the decline in value; (3) the financial position and access to capital of the issuer, including the current and future impact of any specific events and (4) for fixed maturity securities, the intent to sell a security or whether it is more likely than not the Company will be required to sell the security before the recovery of its amortized cost which, in some cases, may extend to maturity and for equity securities, our ability and intent to hold the security for a forecasted period of time that allows for the recovery in value.

Management assesses its intent to sell or whether it is more likely than not that it will be required to sell a security before recovery of its amortized cost basis less any current-period credit losses. For debt securities that are considered other-than-temporarily impaired with no intent to sell and no requirement to sell prior to recovery of its amortized cost basis, the amount of the impairment is separated into the amount that is credit related (credit loss component) and the amount

9

due to all other factors. The credit loss component is recognized in earnings and is the difference between the security’s amortized cost basis and the present value of its expected future cash flows. The remaining difference between the security’s fair value and the present value of future expected cash flows is due to factors that are not credit related and is recognized in other comprehensive income. For debt securities where management has the intent to sell, the amount of the impairment is reflected in earnings as realized losses.

The present value of expected future cash flows is determined using the best estimate cash flows discounted at the effective interest rate implicit to the security at the date of purchase or the current yield to accrete an asset-backed or floating rate security. The methodology and assumptions for establishing the best estimate cash flows vary depending on the type of security. The asset-backed securities cash flow estimates are based on bond specific facts and circumstances that may include collateral characteristics, expectations of delinquency and default rates, loss severity and prepayment speeds and structural support, including subordination and guarantees. The corporate bond cash flow estimates are derived from scenario-based outcomes of expected corporate restructurings or the disposition of assets using bond specific facts and circumstances including timing, security interests and loss severity.

Transfers of Financial Assets

Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.

Loans

Loans Held for Sale

Loans held for sale represent the guaranteed portion of Small Business Administration (“SBA”) loans and are reflected at the lower of aggregate cost or market value. The Company originates loans to customers under an SBA program that historically has provided for SBA guarantees of up to 90 percent of each loan. The Company generally sells the guaranteed portion of its SBA loans to a third party and retains the servicing, holding the nonguaranteed portion in its portfolio. The net amount of loan origination fees on loans sold is included in the carrying value and in the gain or loss on the sale. When sales of SBA loans do occur, the premium received on the sale and the present value of future cash flows of the servicing assets are recognized in income. All criteria for sale accounting must be met in order for the loan sales to occur; see details under the “Transfers of Financial Assets” heading above.

Servicing assets represent the estimated fair value of retained servicing rights, net of servicing costs, at the time loans are sold. Servicing assets are amortized in proportion to, and over the period of, estimated net servicing revenues. Impairment is evaluated based on stratifying the underlying financial assets by date of origination and term. Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market-based assumptions. Any impairment, if temporary, would be reported as a valuation allowance.

Serviced loans sold to others are not included in the accompanying Consolidated Balance Sheets. Income and fees collected for loan servicing are credited to noninterest income when earned, net of amortization on the related servicing assets.

Loans Held to Maturity

Loans held to maturity are stated at the unpaid principal balance, net of unearned discounts and deferred loan origination fees and costs. In accordance with the level yield method, loan origination fees, net of direct loan origination costs, are deferred and recognized over the estimated life of the related loans as an adjustment to the loan yield. Interest is credited to operations primarily based upon the principal balance outstanding.

10

Loans are reported as past due when either interest or principal is unpaid in the following circumstances: fixed payment loans when the borrower is in arrears for two or more monthly payments; open end credit for two or more billing cycles; and single payment notes if interest or principal remains unpaid for 30 days or more.

Nonperforming loans consist of loans that are not accruing interest as a result of principal or interest being in default for a period of 90 days or more or when the ability to collect principal and interest according to the contractual terms is in doubt (nonaccrual loans). When a loan is classified as nonaccrual, interest accruals are discontinued and all past due interest previously recognized as income is reversed and charged against current period earnings. Generally, until the loan becomes current, any payments received from the borrower are applied to outstanding principal until such time as management determines that the financial condition of the borrower and other factors merit recognition of a portion of such payments as interest income. Loans may be returned to an accrual status when the ability to collect is reasonably assured and when the loan is brought current as to principal and interest.

Loans are charged off when collection is sufficiently questionable and when the Company can no longer justify maintaining the loan as an asset on the balance sheet. Loans qualify for charge-off when, after thorough analysis, all possible sources of repayment are insufficient. These include: 1) potential future cash flows, 2) value of collateral, and/or 3) strength of co-makers and guarantors. All unsecured loans are charged off upon the establishment of the loan’s nonaccrual status. Additionally, all loans classified as a loss or that portion of the loan classified as a loss is charged off. All loan charge-offs are approved by the Board of Directors.

Troubled debt restructurings ("TDRs") occur when a creditor, for economic or legal reasons related to a debtor’s financial condition, grants a concession to the debtor that it would not otherwise consider. These concessions typically include reductions in interest rate, extending the maturity of a loan, or a combination of both. Interest income on accruing TDRs is credited to operations primarily based upon the principal amount outstanding, as stated in the paragraphs above.

The Company evaluates its loans for impairment. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. The Company has defined impaired loans to be all TDRs and nonperforming loans individually evaluated for impairment. Impairment is evaluated in total for smaller-balance loans of a similar nature (consumer and residential mortgage loans), and on an individual basis for all other loans. Impairment of a loan is measured based on the present value of expected future cash flows, discounted at the loan’s effective interest rate, or as a practical expedient, based on a loan’s observable market price or the fair value of collateral, net of estimated costs to sell, if the loan is collateral-dependent. If the value of the impaired loan is less than the recorded investment in the loan, the Company establishes a valuation allowance, or adjusts existing valuation allowances, with a corresponding charge to the provision for loan losses.

For additional information on loans, see Note 8 to the Consolidated Financial Statements and the section titled "Loan Portfolio" under Item 2. Management’s Discussion and Analysis.

Allowance for Loan Losses and Reserve for Unfunded Loan Commitments

The allowance for loan losses is maintained at a level management considers adequate to provide for probable loan losses as of the balance sheet date. The allowance is increased by provisions charged to expense and is reduced by net charge-offs.

The level of the allowance is based on management’s evaluation of probable losses in the loan portfolio, after consideration of prevailing economic conditions in the Company’s market area, the volume and composition of the loan portfolio, and historical loan loss experience. The allowance for loan losses consists of specific reserves for individually impaired credits and TDRs, reserves for nonimpaired loans based on historical loss factors and reserves based on general economic factors and other qualitative risk factors such as changes in delinquency trends, industry concentrations or local/national economic trends. This risk assessment process is performed at least quarterly, and, as adjustments become necessary, they are realized in the periods in which they become known.

11

Although management attempts to maintain the allowance at a level deemed adequate to provide for probable losses, future additions to the allowance may be necessary based upon certain factors including changes in market conditions and underlying collateral values. In addition, various regulatory agencies periodically review the adequacy of the Company’s allowance for loan losses. These agencies may require the Company to make additional provisions based on their judgments about information available to them at the time of their examination.

The Company maintains an allowance for unfunded loan commitments that is maintained at a level that management believes is adequate to absorb estimated probable losses. Adjustments to the allowance are made through other expenses and applied to the allowance which is maintained in other liabilities.

For additional information on the allowance for loan losses and unfunded loan commitments, see Note 9 to the Consolidated Financial Statements and the sections titled "Asset Quality" and "Allowance for Loan Losses and Reserve for Unfunded Loan Commitments" under Item 2. Management’s Discussion and Analysis.

Income Taxes

The Company accounts for income taxes according to the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using the enacted tax rates applicable to taxable income for the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

Valuation reserves are established against certain deferred tax assets when it is more likely than not that the deferred tax assets will not be realized. Increases or decreases in the valuation reserve are charged or credited to the income tax provision. When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that ultimately would be sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. The evaluation of a tax position taken is considered by itself and not offset or aggregated with other positions. Tax positions that meet the more likely than not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination.

Interest and penalties associated with unrecognized tax benefits would be recognized in income tax expense on the income statement.

NOTE 2. Litigation

The Company may, in the ordinary course of business, become a party to litigation involving collection matters, contract claims and other legal proceedings relating to the conduct of its business. In the best judgment of management, based upon consultation with counsel, the consolidated financial position and results of operations of the Company will not be affected materially by the final outcome of any pending legal proceedings or other contingent liabilities and commitments.

NOTE 3. Net Income per Share

Basic net income per common share is calculated as net income divided by the weighted average common shares outstanding during the reporting period.

12

Diluted net income per common share is computed similarly to that of basic net income per common share, except that the denominator is increased to include the number of additional common shares that would have been outstanding if all potentially dilutive common shares, principally stock options, were issued during the reporting period utilizing the Treasury stock method.

The following is a reconciliation of the calculation of basic and diluted income per share:

For the three months ended June 30, 

For the six months ended June 30, 

(In thousands, except per share amounts)

    

2020

    

2019

    

2020

    

2019

Net income

$

5,171

$

5,834

$

10,539

$

11,574

Weighted average common shares outstanding - Basic

 

10,792

 

10,843

 

10,838

 

10,822

Plus: Potential dilutive common stock equivalents

 

96

 

183

 

124

 

189

Weighted average common shares outstanding - Diluted

 

10,888

 

11,026

 

10,962

 

11,011

Net income per common share - Basic

$

0.48

$

0.54

$

0.97

$

1.07

Net income per common share - Diluted

 

0.47

 

0.53

 

0.96

 

1.05

Stock options and common stock excluded from the income per share calculation as their effect would have been anti-dilutive

 

450

 

251

 

403

 

230

NOTE 4. Income Taxes

The Company follows FASB ASC Topic 740, “Income Taxes,” which prescribes a threshold for the financial statement recognition of income taxes and provides criteria for the measurement of tax positions taken or expected to be taken in a tax return. ASC 740 also includes guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition of income taxes.

On July 1, 2018, New Jersey’s Assembly Bill 4202 was signed into law. The bill, effective January 1, 2018, imposes a temporary surtax on corporations earning New Jersey allocated taxable income in excess of $1 million at a rate of 2.5 percent for tax years beginning on or after January 1, 2018, through December 31, 2019, and at 1.5 percent for tax years beginning on or after January 1, 2020, through December 31, 2021. In addition, New Jersey adopted mandatory unitary combined reporting for its Corporation Business Tax, which became effective for periods on or after January 1, 2019.

For the quarter ended June 30, 2020, the Company reported income tax expense of $1.5 million for an effective tax rate of 22.3 percent, compared to an income tax expense of $1.6 million and an effective tax rate of 22.0 percent for the prior year’s quarter. For the six months ended June 30, 2020, the Company reported income tax expense of $3.1 million for an effective tax rate of 22.6 percent, compared to an income tax expense of $3.2 million and an effective tax rate of 21.5 percent for the six months ended June 30, 2019. The Company did not recognize or accrue any interest or penalties related to income taxes during the three or six months ended June 30, 2020 or 2019. The Company did not have an accrual for uncertain tax positions as of June 30, 2020 or December 31, 2019, as deductions taken and benefits accrued are based on widely understood administrative practices and procedures and are based on clear and unambiguous tax law. Tax returns for all years 2015 and thereafter are subject to future examination by tax authorities.

13

NOTE 5. Other Comprehensive Income (Loss)

The following tables show the changes in other comprehensive income (loss) for the three and six months ended June 30, 2020 and 2019, net of tax:

For the three months ended June 30, 2020

 

 

Adjustments

 

Net unrealized

 

Accumulated

 

Net unrealized

 

related to

 

losses

 

other

 

gains on

 

defined benefit

 

from cash flow

 

comprehensive

(In thousands)

securities

 

plan

 

hedges

 

(loss) income

Balance, beginning of period (1)

    

$

319

    

$

(280)

    

$

(836)

    

$

(797)

Other comprehensive income (loss) before reclassifications

 

362

 

 

(241)

 

121

Less amounts reclassified from accumulated other comprehensive income (loss)

 

62

 

(15)

 

 

47

Period change

 

300

 

15

 

(241)

 

74

Balance, end of period (1)

$

619

$

(265)

$

(1,077)

$

(723)

For the three months ended June 30, 2019

 

 

Adjustments

 

Net unrealized

 

Accumulated

 

Net unrealized

 

related to

 

gains (losses)

 

other

 

(losses) gains on

 

defined benefit

 

from cash flow

 

comprehensive

(In thousands)

securities

 

plan

 

hedges

 

(loss) income

Balance, beginning of period (1)

    

$

(560)

    

$

(340)

    

$

728

    

$

(172)

Other comprehensive income (loss) before reclassifications

 

631

 

 

(415)

 

216

Less amounts reclassified from accumulated other comprehensive income (loss)

 

77

 

(15)

 

 

62

Period change

 

554

 

15

 

(415)

 

154

Balance, end of period (1)

$

(6)

$

(325)

$

313

$

(18)

For the six months ended June 30, 2020

 

 

Adjustments

 

Net unrealized

 

Accumulated

 

Net unrealized

 

related to

 

gains (losses)

 

other

 

gains (losses) on

 

defined benefit

 

from cash flow

 

comprehensive

(In thousands)

securities

 

plan

 

hedges

 

income (loss)

Balance, beginning of period (1)

    

$

316

    

$

(295)

    

$

168

    

$

189

Other comprehensive income (loss) before reclassifications

 

231

 

 

(1,245)

 

(1,014)

Less amounts reclassified from accumulated other comprehensive loss

 

(72)

 

(30)

 

 

(102)

Period change

 

303

 

30

 

(1,245)

 

(912)

Balance, end of period (1)

$

619

$

(265)

$

(1,077)

$

(723)

14

For the six months ended June 30, 2019

 

 

Adjustments

 

Net unrealized

 

Accumulated

 

Net unrealized

 

related to

 

gains (losses)

 

other

 

(losses) gains on

 

defined benefit

 

from cash flow

 

comprehensive

(In thousands)

securities

 

plan

 

hedges

 

(loss) income

Balance, beginning of period (1)

    

$

(721)

    

$

(431)

    

$

1,030

    

$

(122)

Other comprehensive income (loss) before reclassifications

 

871

 

 

(717)

 

154

Less amounts reclassified from accumulated other comprehensive income (loss)

 

156

 

(106)

 

 

50

Period change

 

715

 

106

 

(717)

 

104

Balance, end of period (1)

$

(6)

$

(325)

$

313

$

(18)

(1)AOCI does not reflect the net reclassification of $35 thousand to Retained Earnings as a result of ASU 2016-01, "Financial Instruments Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities" & ASU 2018-02, "Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income".

NOTE 6. Fair Value

Fair Value Measurement

The Company follows FASB ASC Topic 820, “Fair Value Measurement and Disclosures,” which requires additional disclosures about the Company’s assets and liabilities that are measured at fair value. Fair value is the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. In determining fair value, the Company uses various methods including market, income and cost approaches. Based on these approaches, the Company often utilizes certain assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and/or the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated, or generally unobservable inputs. The Company utilizes techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. The fair value hierarchy ranks the quality and reliability of the information used to determine fair values. Financial assets and liabilities carried at fair value will be classified and disclosed as follows:

Level 1 Inputs

Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.
Generally, this includes debt and equity securities and derivative contracts that are traded in an active exchange market (i.e. New York Stock Exchange), as well as certain U.S. Treasury, U.S. Government and sponsored entity agency mortgage-backed securities that are highly liquid and are actively traded in over-the-counter markets.

Level 2 Inputs

Quoted prices for similar assets or liabilities in active markets.
Quoted prices for identical or similar assets or liabilities in inactive markets.
Inputs other than quoted prices that are observable, either directly or indirectly, for the term of the asset or liability (i.e., interest rates, yield curves, credit risks, prepayment speeds or volatilities) or “market corroborated inputs.”
Generally, this includes U.S. Government and sponsored entity mortgage-backed securities, corporate debt securities and derivative contracts.

15

Level 3 Inputs

Prices or valuation techniques that require inputs that are both unobservable (i.e. supported by little or no market activity) and that are significant to the fair value of the assets or liabilities.
These assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

Fair Value on a Recurring Basis

The following is a description of the valuation methodologies used for instruments measured at fair value on a recurring basis:

Debt Securities Available for Sale

The fair value of available for sale ("AFS") debt securities is the market value based on quoted market prices, when available, or market prices provided by recognized broker dealers (Level 1). If listed prices or quotes are not available, fair value is based upon quoted market prices for similar or identical assets or other observable inputs (Level 2) or externally developed models that use unobservable inputs due to limited or no market activity of the instrument (Level 3).

As of June 30, 2020, the fair value of the Company’s AFS debt securities portfolio was $53.1 million. Approximately 42 percent of the portfolio was made up of residential mortgage-backed securities, which had a fair value of $22.4 million at June 30, 2020. Approximately $22.1 million of the residential mortgage-backed securities are guaranteed by the Government National Mortgage Association ("GNMA"), the Federal National Mortgage Association ("FNMA") or the Federal Home Loan Mortgage Corporation ("FHLMC"). The underlying loans for these securities are residential mortgages that are geographically dispersed throughout the United States.

Most of the Company’s AFS debt securities were classified as Level 2 assets at June 30, 2020. The valuation of AFS debt securities using Level 2 inputs was primarily determined using the market approach, which uses quoted prices for similar assets or liabilities in active markets and all other relevant information. It includes model pricing, defined as valuing securities based upon their relationship with other benchmark securities.

Included in the Company’s AFS debt securities are three corporate bonds which are classified as Level 3 assets at June 30, 2020, which were previously classified as Level 2 assets.  The valuation of these corporate bonds is determined using broker quotes, third-party vendor prices, or other valuation techniques, such as discounted cash flow techniques.  Market inputs used in the other valuation techniques or underlying third-party vendor prices or broker quotes include benchmark and government bond yield curves, credit spreads, and trade execution data. 

The following table presents a reconciliation of the Level 3 available for sale debt securities measured at fair value on a recurring basis for the three and six months ended June 30, 2020 and 2019:

(In thousands)

    

2020

    

2019

Balance at beginning of period (1)

 

$

6,238

 

$

Purchases/additions

Sales/reductions

 

 

Realized

 

 

Unrealized

 

5

 

Balance at end of period

$

6,243

$

(1) Includes AFS debt securities classified as Level 2 at December 31, 2019, which were transferred to Level 3 during the period ended June 30, 2020.

16

Equity Securities with Readily Determinable Fair Values

The fair value of equity securities is the market value based on quoted market prices, when available, or market prices provided by recognized broker dealers (Level 1). If listed prices or quotes are not available, fair value is based upon quoted market prices for similar or identical assets or other observable inputs (Level 2) or externally developed models that use unobservable inputs due to limited or no market activity of the instrument (Level 3).

As of June 30, 2020, the fair value of the Company’s equity securities portfolio was $1.8 million.

All of the Company’s equity securities were classified as Level 2 assets at June 30, 2020. The valuation of equity securities using Level 2 inputs was primarily determined using the market approach, which uses quoted prices for similar assets or liabilities in active markets and all other relevant information.

There were no changes in the inputs or methodologies used to determine fair value during the period ended June 30, 2020, as compared to the periods ended December 31, 2019 and June 30, 2019.

Loans Held for Sale

Fair Value for loans held for sale is derived from quoted market prices for similar loans, in which case they are characterized as Level 2 assets in the fair value hierarchy.

Interest Rate Swap Agreements

The fair value of interest rate swap agreements is the market value based on quoted market prices, when available, or market prices provided by recognized broker dealers (Level 1). If listed prices or quotes are not available, fair value is based upon quoted market prices for similar or identical assets or other observable inputs (Level 2) or externally developed models that use unobservable inputs due to limited or no market activity of the instrument (Level 3).

The Company’s derivative instruments are classified as Level 2 assets, as the readily observable market inputs to these models are validated to external sources, such as industry pricing services, or are corroborated through recent trades, dealer quotes, yield curves, implied volatility or other market-related data.

17

The tables below present the balances of assets and liabilities measured at fair value on a recurring basis as of June 30, 2020 and December 31, 2019:

Fair Value Measurements at June 30, 2020 Using

Quoted Prices in

Assets/Liabilities

Active Markets

Significant Other

Significant

Measured at Fair

for Identical

Observable

Unobservable

(In thousands)

    

Value

    

Assets (Level 1)

    

Inputs (Level 2)

    

Inputs (Level 3)

Measured on a recurring basis:

 

  

 

  

 

  

 

  

Assets:

 

  

 

  

 

  

 

  

Debt securities available for sale:

 

  

 

  

 

  

 

  

U.S. Government sponsored entities

$

2,772

$

$

2,772

$

State and political subdivisions

 

3,334

 

 

3,334

 

Residential mortgage-backed securities

 

22,373

 

 

22,373

 

Corporate and other securities

 

24,623

 

 

18,380

 

6,243

Total debt securities available for sale

$

53,102

$

$

46,859

$

6,243

Equity securities with readily determinable fair values

 

1,786

 

 

1,786

 

Total equity securities

$

1,786

$

$

1,786

$

Loans held for sale

 

11,707

 

 

11,707

 

Total loans held for sale

$

11,707

$

11,707

Interest rate swap agreements

 

(1,512)

 

 

(1,512)

 

Total swap agreements

$

(1,512)

$

$

(1,512)

$

Fair value Measurements at December 31, 2019 Using

Quoted Prices in

Assets/Liabilities

Active Markets

Significant Other

Significant

Measured at Fair

for Identical

Observable

Unobservable

(In thousands)

    

Value

    

Assets (Level 1)

    

Inputs (Level 2)

    

Inputs (Level 3)

Measured on a recurring basis:

 

  

 

  

 

  

 

  

Assets:

 

  

 

  

 

  

 

  

Debt securities available for sale:

 

  

 

  

 

  

 

  

U.S. Government sponsored entities

$

5,753

$

$

5,753

$

State and political subdivisions

 

5,154

 

 

5,154

 

Residential mortgage-backed securities

 

27,964

 

 

27,964

 

Corporate and other securities

 

25,404

 

 

25,404

 

Total debt securities available for sale

$

64,275

$

$

64,275

$

Equity securities with readily determinable fair values

 

2,289

 

 

2,289

 

Total equity securities

$

2,289

$

$

2,289

$

Loans held for sale

 

14,862

 

 

14,862

 

Total loans held for sale

$

14,862

$

14,862

Interest rate swap agreements

 

238

 

 

238

 

Total swap agreements

$

238

$

$

238

$

18

Fair Value on a Nonrecurring Basis

The following tables present the assets and liabilities subject to fair value adjustments (impairment) on a non-recurring basis carried on the balance sheet by caption and by level within the hierarchy (as described above):

Fair Value Measurements at June 30, 2020 Using

Quoted Prices

Significant

in Active

Other

Significant

Assets/Liabilities

Markets for

Observable

Unobservable

Net Provision

Measured at Fair

Identical Assets

Inputs

Inputs

During

(In thousands)

    

Value

    

(Level 1)

    

(Level 2)

    

(Level 3)

    

Period

Measured on a non-recurring basis:

 

  

 

  

 

  

 

  

 

  

Financial assets:

 

  

 

  

 

  

 

  

 

  

OREO

$

711

$

$

$

711

$

(200)

Impaired collateral-dependent loans

 

9,004

 

 

 

9,004

432

Fair Value Measurements at December 31, 2019 Using

Quoted Prices

Significant

in Active

Other

Significant

Assets/Liabilities

Markets for

Observable

Unobservable

Net Credit

Measured at Fair

Identical Assets

Inputs

Inputs

During

(In thousands)

    

Value

    

(Level 1)

    

(Level 2)

    

(Level 3)

    

Period

Financial assets:

 

  

 

  

 

  

 

  

 

  

OREO

$

1,723

$

$

$

1,723

$

(231)

Impaired collateral-dependent loans

 

1,925

 

 

 

1,925

 

(253)

Certain assets and liabilities are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The following is a description of the valuation methodologies used for instruments measured at fair value on a nonrecurring basis:

Appraisal Policy

All appraisals must be performed in accordance with the Uniform Standards of Professional Appraisal Practice ("USPAP"). Appraisals are certified to the Company and performed by appraisers on the Company’s approved list of appraisers. Evaluations are completed by a person independent of Company management. The content of the appraisal depends on the complexity of the property. Appraisals are completed on a “retail value” and an “as is value.”

OREO

The fair value of OREO is determined using third party appraisals, which may be discounted based on management’s review and changes in market conditions (Level 3 Inputs).

Impaired Collateral-Dependent Loans

The fair value of impaired collateral-dependent loans is derived in accordance with FASB ASC Topic 310, “Receivables.” Fair value is determined based on the loan’s observable market price or the fair value of the collateral. Partially charged-off loans are measured for impairment based upon a third party appraisal for collateral-dependent loans. When an updated appraisal is received for a nonperforming loan, the value on the appraisal may be discounted in the manner discussed above. If there is a deficiency in the value after the Company applies these discounts, management applies a specific reserve and the loan remains in nonaccrual status. The receipt of an updated appraisal would not qualify as a reason to put a loan back into accruing status. The Company removes loans from nonaccrual status generally when the borrower makes three months of contractual payments and demonstrates the ability to service the debt going forward. Charge-offs are determined based upon the loss that management believes the Company will incur after evaluating collateral for impairment based upon the valuation methods described above and the ability of the borrower to pay any deficiency.

19

The valuation allowance for impaired loans is included in the allowance for loan losses in the consolidated balance sheets. At June 30, 2020, the valuation allowance for impaired loans was $846 thousand, an increase of $432 thousand from $414 thousand at December 31, 2019.

Fair Value of Financial Instruments

FASB ASC Topic 825, “Financial Instruments,” requires the disclosure of the estimated fair value of certain financial instruments, including those financial instruments for which the Company did not elect the fair value option. These estimated fair values as of June 30, 2020 and December 31, 2019 have been determined using available market information and appropriate valuation methodologies. Considerable judgment is required to interpret market data to develop estimates of fair value. The estimates presented are not necessarily indicative of amounts the Company could realize in a current market exchange. The use of alternative market assumptions and estimation methodologies could have had a material effect on these estimates of fair value. The methodology for estimating the fair value of financial assets and liabilities that are measured on a recurring or nonrecurring basis are discussed above. The following methods and assumptions were used to estimate the fair value of other financial instruments for which it is practicable to estimate that value:

Cash and Cash Equivalents

For these short-term instruments, the carrying value is a reasonable estimate of fair value.

Securities

The fair value of securities is based upon quoted market prices for similar or identical assets or other observable inputs (Level 2) or externally developed models that use unobservable inputs due to limited or no market activity of the instrument (Level 3).

SBA Loans Held for Sale

The fair value of SBA loans held for sale is estimated by using a market approach that includes significant other observable inputs.

Loans

The fair value of loans is estimated by discounting the future cash flows using current market rates that reflect the interest rate risk inherent in the loan, except for previously discussed impaired loans.

FHLB Stock

Federal Home Loan Bank stock is carried at cost. Carrying value approximates fair value based on the redemption provisions of the issues.

Servicing Assets

Servicing assets do not trade in an active, open market with readily observable prices. The Company estimates the fair value of servicing assets using discounted cash flow models incorporating numerous assumptions from the perspective of a market participant including market discount rates and prepayment speeds.

Accrued Interest

The carrying amounts of accrued interest approximate fair value.

20

Deposit Liabilities

The fair value of demand deposits and savings accounts is the amount payable on demand at the reporting date (i.e. carrying value). The fair value of fixed-maturity certificates of deposit is estimated by discounting the future cash flows using current market rates.

Borrowed Funds and Subordinated Debentures

The fair value of borrowings is estimated by discounting the projected future cash flows using current market rates.

Standby Letters of Credit

At June 30, 2020, the Bank had standby letters of credit outstanding of $4.5 million, compared to $4.8 million at December 31, 2019. The fair value of these commitments is nominal.

The table below presents the carrying amount and estimated fair values of the Company’s financial instruments presented as of June 30, 2020 and December 31, 2019:

June 30, 2020

December 31, 2019

Fair value

Carrying

Estimated

Carrying

Estimated

(In thousands)

    

level

    

amount

    

fair value

    

amount

    

fair value

Financial assets:

 

  

 

  

 

  

 

  

 

  

Cash and cash equivalents

 

Level 1

$

186,683

$

186,683

$

158,016

$

158,016

Securities (1)

 

Level 2

 

54,888

 

54,888

 

66,564

 

66,564

SBA loans held for sale

 

Level 2

 

10,602

 

11,707

 

13,529

 

14,862

Loans, net of allowance for loan losses (2)

 

Level 2

 

1,561,671

 

1,581,341

 

1,395,634

 

1,398,997

FHLB stock

 

Level 2

 

11,629

 

11,629

 

14,184

 

14,184

Servicing assets

 

Level 3

 

2,138

 

2,138

 

2,026

 

2,026

Accrued interest receivable

 

Level 2

 

11,039

 

11,039

 

6,984

 

6,984

OREO

 

Level 3

 

711

711

1,723

 

1,723

Financial liabilities:

 

 

 

 

 

Deposits

 

Level 2

 

1,483,457

 

1,489,973

 

1,250,114

 

1,252,082

Borrowed funds and subordinated debentures

 

Level 2

 

233,310

 

235,645

 

293,310

 

292,766

Accrued interest payable

 

Level 2

 

228

 

228

 

455

 

455

(1)Includes corporate securities that are considered Level 3 and reported separately in the table under the “Fair Value on a Recurring Basis” heading. These securities had book values of $6.2 million and market values of $6.2 million.
(2)Includes collateral-dependent impaired loans that are considered Level 3 and reported separately in the tables under the “Fair Value on a Nonrecurring Basis” heading. Collateral-dependent impaired loans, net of specific reserves totaled $9.0 million and $1.9 million at June 30, 2020 and December 31, 2019, respectively.

Limitations

Fair value estimates are made at a point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

21

Fair value estimates are based on existing on- and off-statement of condition financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. In addition, the tax ramifications related to the effect of fair value estimates have not been considered in the above estimates.

NOTE 7. Securities

This table provides the major components of debt securities available for sale ("AFS") and equity securities with readily determinable fair values ("equity securities") at amortized cost and estimated fair value at June 30, 2020 and December 31, 2019:

June 30, 2020

December 31, 2019

    

    

Gross

    

Gross

    

    

    

Gross

    

Gross

    

Amortized

unrealized

unrealized

Estimated

Amortized

unrealized

unrealized

Estimated

(In thousands)

cost

gains

losses

fair value

cost

gains

losses

fair value

Available for sale:

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

U.S. Government sponsored entities

$

2,749

$

23

$

$

2,772

$

5,751

$

4

$

(2)

$

5,753

State and political subdivisions

 

3,320

 

24

 

(10)

 

3,334

 

4,992

 

174

 

(12)

 

5,154

Residential mortgage-backed securities

 

21,463

 

916

 

(6)

 

22,373

 

27,698

 

372

 

(106)

 

27,964

Corporate and other securities

 

24,756

 

174

 

(307)

 

24,623

 

25,442

 

230

 

(268)

 

25,404

Total debt securities available for sale

$

52,288

$

1,137

$

(323)

$

53,102

$

63,883

$

780

$

(388)

$

64,275

Equity securities:

 

 

 

 

 

 

 

 

Total equity securities

$

2,112

$

$

(326)

$

1,786

$

2,218

$

142

$

(71)

$

2,289

This table provides the remaining contractual maturities and yields of securities within the investment portfolios. The carrying value of securities at June 30, 2020 is distributed by contractual maturity. Mortgage-backed securities and other securities, which may have principal prepayment provisions, are distributed based on contractual maturity. Expected maturities will differ materially from contractual maturities as a result of early prepayments and calls.

After one through

After five through

Total carrying

 

Within one year

five years

ten years

After ten years

value

 

(In thousands, except percentages)

    

Amount

    

Yield

    

Amount

    

Yield

    

Amount

    

Yield

    

Amount

    

Yield

    

Amount

    

Yield

 

Available for sale at fair value:

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

  

U.S. Government sponsored entities

$

2,772

 

1.57

%  

$

 

%  

$

 

%  

$

 

%  

$

2,772

 

1.57

%

State and political subdivisions

 

1,146

 

1.48

 

884

 

3.29

 

502

 

5.06

 

802

 

2.74

 

3,334

 

2.80

Residential mortgage-backed securities

 

1

 

4.48

 

278

 

2.37

 

2,202

 

2.48

 

19,892

 

2.63

 

22,373

 

2.61

Corporate and other securities

 

 

 

1,611

 

3.00

 

17,769

 

4.48

 

5,243

 

4.38

 

24,623

 

4.36

Total debt securities available for sale

$

3,919

 

1.54

%  

$

2,773

 

3.03

%  

$

20,473

 

4.28

%  

$

25,937

 

2.99

%  

$

53,102

 

3.38

%

Equity Securities at fair value:

 

  

 

  

 

  

 

  

 

  

 

  

 

  

 

 

 

Total equity securities

$

 

%  

$

 

%  

$

 

%  

$

1,786

 

2.58

%  

$

1,786

 

2.58

%

22

The fair value of securities with unrealized losses by length of time that the individual securities have been in a continuous unrealized loss position at June 30, 2020 and December 31, 2019 are as follows:

June 30, 2020

Less than 12 months

12 months and greater

Total

    

Total

    

    

    

    

    

    

number in a

Estimated

Unrealized

Estimated

Unrealized

Estimated

Unrealized

(In thousands, except number in a loss position)

loss position

fair value

loss

fair value

loss

fair value

loss

Available for sale:

 

  

 

  

 

  

 

  

 

  

 

  

 

  

State and political subdivisions

 

1

$

$

$

802

$

(10)

$

802

$

(10)

Residential mortgage-backed securities

 

3

 

996

 

(6)

 

402

 

 

1,398

 

(6)

Corporate and other securities

 

8

 

6,277

 

(76)

 

3,759

 

(231)

 

10,036

 

(307)

Total temporarily impaired securities

 

12

$

7,273

$

(82)

$

4,963

$

(241)

$

12,236

$

(323)

December 31, 2019

Less than 12 months

12 months and greater

Total

    

Total

    

    

    

    

    

    

number in a

Estimated

Unrealized

Estimated

Unrealized

Estimated

Unrealized

(In thousands, except number in a loss position)

loss position

fair value

loss

fair value

loss

fair value

loss

Available for sale:

 

  

 

  

 

  

 

  

 

  

 

  

 

  

U.S. Government sponsored entities

 

1

$

$

$

1,995

$

(2)

$

1,995

$

(2)

State and political subdivisions

 

1

 

 

 

1,013

 

(12)

 

1,013

 

(12)

Residential mortgage-backed securities

 

10

 

3,707

 

(27)

 

4,996

 

(79)

 

8,703

 

(106)

Corporate and other securities

 

6

 

3,366

 

(13)

 

3,735

 

(255)

 

7,101

 

(268)

Total temporarily impaired securities

 

18

$

7,073

$

(40)

$

11,739

$

(348)

$

18,812

$

(388)

Unrealized Losses

The unrealized losses in each of the categories presented in the tables above are discussed in the paragraphs that follow:

U.S. government sponsored entities and state and political subdivision securities: The unrealized losses on investments in these types of securities were caused by the increase in interest rate spreads or the increase in interest rates at the long end of the Treasury curve. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the par value of the investments. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be at maturity, the Company did not consider these investments to be other-than temporarily impaired as of June 30, 2020 or December 31, 2019.

Residential and commercial mortgage-backed securities:  The unrealized losses on investments in mortgage-backed securities were caused by increases in interest rate spreads or the increase in interest rates at the long end of the Treasury curve. The majority of contractual cash flows of these securities are guaranteed by the Federal National Mortgage Association (FNMA), the Government National Mortgage Association (GNMA) or the Federal Home Loan Mortgage Corporation (FHLMC). It is expected that the securities would not be settled at a price significantly less than the par value of the investment. Because the decline in fair value is attributable to changes in interest rates and not credit quality, and because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be at maturity, the Company did not consider these investments to be other-than-temporarily impaired as of June 30, 2020 or December 31, 2019.

Corporate and other securities: Included in this category are corporate and other debt securities. The unrealized losses on corporate and other debt securities were due to widening credit spreads. The Company evaluated the prospects of the issuers and forecasted a recovery period; and as a result determined it did not consider these investments to be other-than-temporarily impaired as of June 30, 2020 or December 31, 2019. Because the Company does not intend to sell the securities and it is not more likely than not that the Company will be required to sell the securities before recovery of its amortized cost basis, which may be at maturity, the Company did not consider these securities to be other-than-temporarily impaired as of June 30, 2020 or December 31, 2019.

23

Realized Gains and Losses

Gross realized gains and losses on securities for the three and six months ended June 30, 2020 and 2019 are detailed in the table below:

For the three months ended June 30, 

For the six months ended June 30, 

(In thousands)

    

2020

    

2019

2020

    

2019

Available for sale:

 

  

 

  

  

 

  

Realized gains

$

5

$

$

301

$

Realized losses

 

 

 

 

Total debt securities available for sale

 

5

 

 

301

 

Net gains on sales of securities

$

5

$

$

301

$

The net realized gains are included in noninterest income in the Consolidated Statements of Income as net security gains. There were $5 thousand and $301 thousand of gross realized gains during the three and six months ended June 30, 2020, compared to 0 gross realized gains during the same period a year ago. There were 0 gross realized losses for the three and six months ended June 30, 2020, or 2019.

For the six months ended June 30, 2020, the net gain is attributed to the sale of 1 corporate bond with a book value of $2.2 million and resulting gains of $61 thousand, 3 mortgage-backed securities with a total book value of $2.8 million and resulting gains of $57 thousand, 1 tax-exempt municipal security with a book value of $381 thousand and resulting gains of $27 thousand, 1 taxable municipal security with a book value of $456 thousand and resulting gains of $140 thousand, and the call of 3 tax-exempt municipal securities with a total book value of $3.8 million and resulting gains of $16 thousand.

Equity Securities

Included in this category are Community Reinvestment Act ("CRA") investments and the Company’s current other equity holdings of financial institutions. Equity securities are defined to include (a) preferred, common and other ownership interests in entities including partnerships, joint ventures and limited liability companies and (b) rights to acquire or dispose of ownership interest in entities at fixed or determinable prices.

The Company follows ASU 2016-01, "Financial Instruments - Overall (Subtopic 825-10) - Recognition and Measurement of Financial Assets and Financial Liabilities," which aims to simplify accounting for financial instruments and to converge the guidance between U.S. GAAP and IFRS. ASU 2016-01 also includes guidance on how entities account for equity investments, present and disclose financial instruments, and measure the valuation allowance on deferred tax assets related to available-for-sale debt securities. The guidance in ASU 2016-01 requires an entity to disaggregate the net gains and losses on the equity investments recognized in the income statement during a reporting period into realized and unrealized gains and losses. As a result, equity securities are no longer carried at fair value through other comprehensive income ("OCI") or by applying the cost method to those equity securities that do not have readily determinable values. Equity securities are generally required to be measured at fair value with market value adjustments being reflected in net income. The Company adopted this standard as of January 1, 2018.

24

The following is a summary of unrealized and realized gains and losses recognized in net income on equity securities during the three and six months ended June 30, 2020 and 2019:

For the three months ended June 30, 

For the six months ended June 30, 

(In thousands)

    

2020

    

2019

    

2020

    

2019

Net gains (losses) recognized during the period on equity securities

$

74

$

98

$

(397)

$

198

Net gains recognized during the period on equity securities sold during the period

 

 

 

5

 

Unrealized gains (losses) recognized during the reporting period on equity securities still held at the reporting date

$

74

$

98

$

(392)

$

198

Pledged Securities

Securities with a carrying value of $3.1 million and $4.0 million at June 30, 2020 and December 31, 2019, respectively, were pledged to secure deposits, secure other borrowings and for other purposes required or permitted by law.

NOTE 8. Loans

The following table sets forth the classification of loans by class, including unearned fees, deferred costs and excluding the allowance for loan losses as of June 30, 2020 and December 31, 2019:

(In thousands)

    

June 30, 2020

    

December 31, 2019

SBA loans held for investment

$

36,966

$

35,767

SBA PPP loans

136,039

Commercial loans

 

  

 

  

SBA 504 loans

 

23,299

 

26,726

Commercial other

 

121,961

 

112,014

Commercial real estate

 

586,332

 

578,643

Commercial real estate construction

 

61,160

 

47,649

Residential mortgage loans

 

469,987

 

467,706

Consumer loans

 

 

Home equity

 

67,592

 

69,589

Consumer other

 

78,569

 

73,935

Total loans held for investment

$

1,581,905

$

1,412,029

SBA loans held for sale

 

10,602

 

13,529

Total loans

$

1,592,507

$

1,425,558

Loans are made to individuals as well as commercial entities. Specific loan terms vary as to interest rate, repayment, and collateral requirements based on the type of loan requested and the credit worthiness of the prospective borrower. Credit risk tends to be geographically concentrated in that a majority of the loan customers are located in the markets serviced by the Bank. Loan performance may be adversely affected by factors impacting the general economy or conditions specific to the real estate market such as geographic location and/or property type. A description of the Company’s different loan segments follows:

SBA Loans: SBA 7(a) loans, on which the SBA has historically provided guarantees of up to 90 percent of the principal balance, are considered a higher risk loan product for the Company than its other loan products. The guaranteed portion of the Company’s SBA loans is generally sold in the secondary market with the nonguaranteed portion held in the portfolio as a loan held for investment. SBA loans are for the purpose of providing working capital, financing the purchase of equipment, inventory or commercial real estate and for other business purposes. Loans are guaranteed by the businesses’ major owners. SBA loans are made based primarily on the historical and projected cash flow of the business and secondarily on the underlying collateral provided.

25

On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act was signed into law. It contains substantial tax and spending provisions intended to address the impact of the COVID-19 pandemic. The CARES Act includes a range of other provisions designed to support the U.S. economy and mitigate the impact of COVID-19 on financial institutions and their customers, including through the authorization of various relief programs and measures that the U.S. Department of the Treasury, the Small Business Administration, the Federal Reserve Board (“FRB”) and other federal banking agencies have implemented or may implement.

The CARES Act provides assistance to small businesses through the establishment of the SBA Paycheck Protection Program ("PPP"). The PPP generally provides small businesses with funds to pay up to 24 weeks of payroll costs, including certain benefits. The funds are provided in the form of loans that may be fully or partially forgiven when used for payroll costs, interest on mortgages, rent, and utilities. The payments on these loans will be deferred for up to six months. Loans made after June 5, 2020, mature in five years, and loans made prior to June 5, 2020, mature in two years but can be extended to five years if the lender agrees. Forgiveness of the PPP loans is based on the borrower maintaining or quickly rehiring employees and maintaining salary levels. Most small businesses with 500 or fewer employees are eligible. Applications for the PPP loans started on April 3, 2020 and was extended through August 8, 2020. As an existing SBA 7(a) lender, the Company opted to participate in the program.

Commercial Loans: Commercial credit is extended primarily to middle market and small business customers. Commercial loans are generally made in the Company’s market place for the purpose of providing working capital, financing the purchase of equipment, inventory or commercial real estate and for other business purposes. The SBA 504 program consists of real estate backed commercial mortgages where the Company has the first mortgage and the SBA has the second mortgage on the property. Loans will generally be guaranteed in full or for a meaningful amount by the businesses’ major owners. Commercial loans are made based primarily on the historical and projected cash flow of the business and secondarily on the underlying collateral provided. Generally, the Company has a 50 percent loan to value ratio on SBA 504 program loans at origination.

Residential Mortgage and Consumer Loans: The Company originates mortgage and consumer loans including principally residential real estate and home equity lines and loans and consumer construction lines. The Company originates qualified mortgages which are generally sold in the secondary market and nonqualified mortgages which are generally held for investment. Each loan type is evaluated on debt to income, type of collateral and loan to collateral value, credit history and Company’s relationship with the borrower.

Inherent in the lending function is credit risk, which is the possibility a borrower may not perform in accordance with the contractual terms of their loan. A borrower’s inability to pay their obligations according to the contractual terms can create the risk of past due loans and, ultimately, credit losses, especially on collateral deficient loans. The Company minimizes its credit risk by loan diversification and adhering to credit administration policies and procedures. Due diligence on loans begins when we initiate contact regarding a loan with a borrower. Documentation, including a borrower’s credit history, materials establishing the value and liquidity of potential collateral, the purpose of the loan, the source of funds for repayment of the loan, and other factors, are analyzed before a loan is submitted for approval. The loan portfolio is then subject to on-going internal reviews for credit quality which in part is derived from ongoing collection and review of borrowers’ financial information, as well as independent credit reviews by an outside firm.

The Company’s extension of credit is governed by the Credit Risk Policy which was established to control the quality of the Company’s loans. This policy and the underlying procedures are reviewed and approved by the Board of Directors on a regular basis.

Credit Ratings

For SBA 7(a), SBA 504 and commercial loans, management uses internally assigned risk ratings as the best indicator of credit quality. A loan’s internal risk rating is updated at least annually and more frequently if circumstances warrant a change in risk rating. The Company uses a 1 through 10 loan grading system that follows regulatory accepted definitions.

26

Pass: Risk ratings of 1 through 6 are used for loans that are performing, as they meet, and are expected to continue to meet, all of the terms and conditions set forth in the original loan documentation, and are generally current on principal and interest payments. These performing loans are termed “Pass”.

Special Mention: Criticized loans are assigned a risk rating of 7 and termed “Special Mention”, as the borrowers exhibit potential credit weaknesses or downward trends deserving management’s close attention. If not checked or corrected, these trends will weaken the Bank’s collateral and position. While potentially weak, these borrowers are currently marginally acceptable and no loss of interest or principal is anticipated. As a result, special mention assets do not expose an institution to sufficient risk to warrant adverse classification. Included in “Special Mention” could be turnaround situations, such as borrowers with deteriorating trends beyond one year, borrowers in startup or deteriorating industries, or borrowers with a poor market share in an average industry. "Special Mention" loans may include an element of asset quality, financial flexibility, or below average management. Management and ownership may have limited depth or experience. Regulatory agencies have agreed on a consistent definition of “Special Mention” as an asset with potential weaknesses which, if left uncorrected, may result in deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future date. This definition is intended to ensure that the “Special Mention” category is not used to identify assets that have as their sole weakness credit data exceptions or collateral documentation exceptions that are not material to the repayment of the asset.

Substandard: Classified loans are assigned a risk rating of an 8 or 9, depending upon the prospect for collection, and deemed “Substandard”. A risk rating of 8 is used for borrowers with well-defined weaknesses that jeopardize the orderly liquidation of debt. The loan is inadequately protected by the current paying capacity of the obligor or by the collateral pledged, if any. Normal repayment from the borrower is in jeopardy, although no loss of principal is envisioned. There is a distinct possibility that a partial loss of interest and/or principal will occur if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets classified “Substandard”.

A risk rating of 9 is used for borrowers that have all the weaknesses inherent in a loan with a risk rating of 8, with the added characteristic that the weaknesses make collection of debt in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Serious problems exist to the point where partial loss of principal is likely. The possibility of loss is extremely high, but because of certain important, reasonably specific pending factors that may work to strengthen the assets, the loans’ classification as estimated losses is deferred until a more exact status may be determined. Pending factors include proposed merger, acquisition, or liquidation procedures; capital injection; perfecting liens on additional collateral; and refinancing plans. Partial charge-offs are likely.

Loss: Once a borrower is deemed incapable of repayment of unsecured debt, the risk rating becomes a 10, the loan is termed a “Loss”, and charged-off immediately. Loans to such borrowers are considered uncollectible and of such little value that continuance as active assets of the Bank is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off these basically worthless assets even though partial recovery may be affected in the future.

For residential mortgage and consumer loans, management uses performing versus nonperforming as the best indicator of credit quality. Nonperforming loans consist of loans that are not accruing interest (nonaccrual loans) as a result of principal or interest being in default for a period of 90 days or more or when the ability to collect principal and interest according to the contractual terms is in doubt. These credit quality indicators are updated on an ongoing basis, as a loan is placed on nonaccrual status as soon as management believes there is sufficient doubt as to the ultimate ability to collect interest on a loan.

At June 30, 2020, the Company owned $648 thousand in residential consumer properties that were included in OREO in the Consolidated Balance Sheets, compared to $1.7 million at December 31, 2019. Additionally, there were $6.4 million of residential consumer loans in the process of foreclosure at June 30, 2020, compared to $3.6 million at December 31, 2019.

27

The tables below detail the Company’s loan portfolio by class according to their credit quality indicators discussed in the paragraphs above as of June 30, 2020:

June 30, 2020

SBA & Commercial loans - Internal risk ratings

(In thousands)

    

Pass

    

Special mention

    

Substandard

    

Total

SBA loans held for investment

$

35,691

$

$

1,275

$

36,966

SBA PPP loans

136,007

32

136,039

Commercial loans

 

  

 

  

 

  

 

  

SBA 504 loans

 

23,275

 

 

24

 

23,299

Commercial other

 

117,793

 

2,500

 

1,668

 

121,961

Commercial real estate

 

568,819

 

46

 

17,467

 

586,332

Commercial real estate construction

 

61,160

 

 

 

61,160

Total commercial loans

 

771,047

 

2,546

 

19,159

 

792,752

Total SBA and commercial loans

$

942,745

$

2,546

$

20,466

$

965,757

    

    

Residential mortgage & Consumer loans - Performing/Nonperforming

(In thousands)

    

    

Performing

    

Nonperforming

    

Total

Residential mortgage loans

$

463,795

$

6,192

$

469,987

Consumer loans

 

  

 

 

  

Home equity

 

67,087

 

505

 

67,592

Consumer other

 

78,569

 

 

78,569

Total consumer loans

 

145,656

 

505

 

146,161

Total residential mortgage and consumer loans

$

609,451

$

6,697

$

616,148

The tables below detail the Company’s loan portfolio by class according to their credit quality indicators discussed in the paragraphs above as of December 31, 2019:

    

December 31, 2019

SBA & Commercial loans - Internal risk ratings

(In thousands)

    

Pass

    

Special mention

    

Substandard

    

Total

SBA loans held for investment

$

34,202

$

1,115

$

450

$

35,767

Commercial loans

 

  

 

  

 

  

 

  

SBA 504 loans

 

24,878

 

1,808

 

40

 

26,726

Commercial other

 

107,220

 

3,361

 

1,433

 

112,014

Commercial real estate

 

576,326

 

758

 

1,559

 

578,643

Commercial real estate construction

 

47,649

 

 

 

47,649

Total commercial loans

 

756,073

 

5,927

 

3,032

 

765,032

Total SBA and commercial loans

$

790,275

$

7,042

$

3,482

$

800,799

Residential mortgage & Consumer loans - Performing/Nonperforming

(In thousands)

 

  

Performing

Nonperforming

Total

Residential mortgage loans

 

  

$

463,770

$

3,936

$

467,706

Consumer loans

 

  

 

  

 

  

 

  

Home equity

 

  

 

69,589

 

 

69,589

Consumer other

 

  

 

73,915

 

20

 

73,935

Total consumer loans

 

  

 

143,504

 

20

 

143,524

Total residential mortgage and consumer loans

 

  

$

607,274

$

3,956

$

611,230

Nonperforming and Past Due Loans

Nonperforming loans consist of loans that are not accruing interest (nonaccrual loans) as a result of principal or interest being in default for a period of 90 days or more or when the ability to collect principal and interest according to the

28

contractual terms is in doubt. Loans past due 90 days or more and still accruing interest are not included in nonperforming loans and generally represent loans that are well collateralized and in the process of collection. The risk of loss is difficult to quantify and is subject to fluctuations in collateral values, general economic conditions and other factors. The Company values its collateral through the use of appraisals, broker price opinions, and knowledge of its local market.

The following tables set forth an aging analysis of past due and nonaccrual loans as of June 30, 2020 and December 31, 2019:

June 30, 2020

    

    

    

90+ days

    

    

    

    

3059 days

6089 days

and still

Nonaccrual

Total past

(In thousands)

past due

past due

accruing

(1)

due

Current

Total loans

SBA loans held for investment

$

828

$

606

$

$

2,331

$

3,765

$

33,201

$

36,966

SBA PPP loans

32

32

136,007

136,039

Commercial loans

 

  

 

  

 

  

 

  

 

  

 

 

  

SBA 504 loans

 

 

 

 

 

 

23,299

 

23,299

Commercial other

 

 

71

 

 

10

 

81

 

121,880

 

121,961

Commercial real estate

 

 

 

 

403

 

403

 

585,929

 

586,332

Commercial real estate construction

 

 

 

 

 

 

61,160

 

61,160

Residential mortgage loans

 

2,958

 

 

 

6,192

 

9,150

 

460,837

 

469,987

Consumer loans

 

 

 

 

 

  

 

 

Home equity

 

170

 

 

 

505

 

675

 

66,917

 

67,592

Consumer other

 

 

 

 

 

 

78,569

 

78,569

Total loans held for investment

3,956

677

9,473

14,106

1,567,799

1,581,905

SBA loans held for sale

 

 

 

 

 

 

10,602

 

10,602

Total loans

$

3,956

$

677

$

$

9,473

$

14,106

$

1,578,401

$

1,592,507

(1)At June 30, 2020, nonaccrual loans included $307 thousand of loans guaranteed by the SBA.

December 31, 2019

    

    

    

90+ days

    

    

    

    

3059 days

6089 days

and still

Nonaccrual

Total past

(In thousands)

past due

past due

accruing

(1)

due

Current

Total loans

SBA loans held for investment

$

1,048

$

$

$

1,164

$

2,212

$

33,555

$

35,767

Commercial loans

 

  

 

  

 

  

 

  

 

  

 

  

 

  

SBA 504 loans

 

 

1,808

 

 

 

1,808

 

24,918

 

26,726

Commercial other

 

71

 

 

 

316

 

387

 

111,627

 

112,014

Commercial real estate

 

215

 

 

 

213

 

428

 

578,215

 

578,643

Commercial real estate construction

 

 

 

 

 

 

47,649

 

47,649

Residential mortgage loans

 

4,383

 

1,676

 

930

 

3,936

 

10,925

 

456,781

 

467,706

Consumer loans

 

 

 

 

 

 

 

  

Home equity

 

1,446

 

178

 

 

 

1,624

 

67,965

 

69,589

Consumer other

 

 

113

 

 

20

 

133

 

73,802

 

73,935

Total loans held for investment

7,163

3,775

930

5,649

17,517

1,394,512

1,412,029

SBA loans held for sale

 

 

 

 

 

 

13,529

 

13,529

Total loans

$

7,163

$

3,775

$

930

$

5,649

$

17,517

$

1,408,041

$

1,425,558

(1)At December 31, 2019, nonaccrual loans included $59 thousand of loans guaranteed by the SBA.

29

Impaired Loans

The Company has defined impaired loans to be all nonperforming loans individually evaluated for impairment and TDRs. Management considers a loan impaired when, based on current information and events, it is determined that the Company will not be able to collect all amounts due according to the loan contract. Impairment is evaluated on an individual basis for SBA and commercial loans.

The following table provides detail on the Company’s impaired loans that are individually evaluated for impairment with the associated allowance amount, if applicable, as of June 30, 2020:

    

June 30, 2020

    

Unpaid

    

    

principal

Recorded

Specific

(In thousands)

balance

investment

reserves

With no related allowance:

  

 

  

 

  

SBA loans held for investment (1)

$

1,884

$

1,784

$

Commercial loans

 

  

 

  

 

  

Commercial other

684

684

Total commercial loans

 

684

 

684

 

Residential mortgage loans

4,871

4,766

Consumer loans:

Home equity

505

505

Total impaired loans with no related allowance

 

7,944

 

7,739

 

With an allowance:

 

  

 

  

 

  

SBA loans held for investment (1)

 

356

 

272

 

177

Commercial loans

 

  

 

  

 

  

Commercial other

 

28

 

10

 

10

Commercial real estate

 

903

 

403

 

403

Total commercial loans

 

931

 

413

 

413

Residential mortgage loans

1,426

1,426

256

Total impaired loans with a related allowance

 

2,713

 

2,111

 

846

Total individually evaluated impaired loans:

 

  

 

  

 

  

SBA loans held for investment (1)

 

2,240

 

2,056

 

177

Commercial loans

 

  

 

  

 

  

Commercial other

 

28

 

10

 

10

Commercial real estate

 

1,587

 

1,087

 

403

Total commercial loans

 

1,615

 

1,097

 

413

Residential mortgage loans

6,297

6,192

256

Consumer loans:

Home equity

505

505

Total individually evaluated impaired loans

$

10,657

$

9,850

$

846

(1)Balances are reduced by amount guaranteed by the SBA of $307 thousand at June 30, 2020.

30

The following table provides detail on the Company’s impaired loans that are individually evaluated for impairment with the associated allowance amount, if applicable, as of December 31, 2019:

    

December 31, 2019

    

Unpaid

    

    

principal

Recorded

Specific

(In thousands)

balance

investment

reserves

With no related allowance:

  

 

  

 

  

SBA loans held for investment (1)

$

1,224

$

1,064

$

Commercial loans

 

  

 

  

 

  

Commercial real estate

 

213

 

213

 

Total commercial loans

 

213

 

213

 

Total impaired loans with no related allowance

 

1,437

 

1,277

 

With an allowance:

 

  

 

  

 

  

SBA loans held for investment (1)

 

157

 

41

 

41

Commercial loans

 

  

 

  

 

  

Commercial other

 

816

 

316

 

316

Commercial real estate

 

705

 

705

 

57

Total commercial loans

 

1,521

 

1,021

 

373

Total impaired loans with a related allowance

 

1,678

 

1,062

 

414

Total individually evaluated impaired loans:

 

  

 

  

 

  

SBA loans held for investment (1)

 

1,381

 

1,105

 

41

Commercial loans

 

 

 

Commercial other

 

816

 

316

 

316

Commercial real estate

 

918

 

918

 

57

Total commercial loans

 

1,734

 

1,234

 

373

Total individually evaluated impaired loans

$

3,115

$

2,339

$

414

(1)Balances are reduced by amount guaranteed by the SBA of $59 thousand at December 31, 2019.

Impaired loans increased $7.5 million at June 30, 2020 compared to December 31, 2019. The increase in impaired loans was primarily due to the inclusion of residential and consumer loan evaluations, and the addition of 7 commercial loans totaling $987 thousand.

31

The following table presents the average recorded investments in impaired loans and the related amount of interest recognized during the time period in which the loans were impaired for the three and six months ended June 30, 2020 and 2019. The average balances are calculated based on the month-end balances of impaired loans. When the ultimate collectability of the total principal of an impaired loan is in doubt and the loan is on nonaccrual status, all payments are applied to principal under the cost recovery method, and therefore no interest income is recognized. The interest income recognized on impaired loans noted below represents primarily accruing TDRs and nominal amounts of income recognized on a cash basis for well-collateralized impaired loans.

    

For the three months ended June 30, 

2020

2019

    

    

Interest

    

    

Interest

income

income

Average

recognized

Average

recognized

recorded

on impaired

recorded

on impaired

(In thousands)

investment

loans

investment

loans

SBA loans held for investment (1)

$

1,265

$

3

$

618

$

4

Commercial loans

 

  

 

 

  

 

  

Commercial other

 

99

 

12

 

 

Commercial real estate

 

1,282

 

33

 

1,486

 

9

Residential mortgage loans

6,054

52

Consumer loans

Home equity

505

4

Total

$

9,205

$

104

$

2,104

$

13

    

For the six months ended June 30, 

2020

2019

    

    

Interest

    

    

Interest

income

income

Average

recognized

Average

recognized

recorded

on impaired

recorded

on impaired

(In thousands)

investment

loans

investment

loans

SBA loans held for investment (1)

$

1,197

$

6

$

901

$

8

Commercial loans

 

  

 

  

 

  

 

  

SBA 504 loans

 

300

 

32

 

 

Commercial other

 

52

 

21

 

4

 

Commercial real estate

 

1,165

 

45

 

1,637

 

17

Residential mortgage loans

5,875

81

Consumer loans

Home equity

424

9

Consumer other

38

Total

$

9,051

$

194

$

2,542

$

25

(1)Balances are reduced by the average amount guaranteed by the SBA of $418 thousand and $84 thousand for the six months ended June 30, 2020 and 2019, respectively.

TDRs

The Company’s loan portfolio also includes certain loans that have been modified as TDRs. TDRs occur when a creditor, for economic or legal reasons related to a debtor’s financial condition, grants a concession to the debtor that it would not otherwise consider, unless it results in a delay in payment that is insignificant. These concessions typically include reductions in interest rate, extending the maturity of a loan, or a combination of both. Under the CARES Act and regulatory guidance issued in regards to the COVID-19 pandemic, loan payment deferrals for periods of up to 180 days granted to borrowers adversely effected by the pandemic are not considered TDR’s if the borrower was current on its loan payments at year end 2019 or until the deferral was granted. When the Company modifies a loan, management evaluates for any possible impairment using either the discounted cash flows method, where the value of the modified loan is based on the present value of expected cash flows, discounted at the contractual interest rate of the original loan

32

agreement, or by using the fair value of the collateral less selling costs if the loan is collateral-dependent. If management determines that the value of the modified loan is less than the recorded investment in the loan, impairment is recognized by segment or class of loan, as applicable, through an allowance estimate or charge-off to the allowance. This process is used, regardless of loan type, and for loans modified as TDRs that subsequently default on their modified terms.

The Company had 1 performing TDR with a balance of $684 thousand and $705 thousand as of June 30, 2020 and December 31, 2019, respectively, which was included in the impaired loan numbers as of such dates. There were 0 specific reserves on the performing TDR as of June 30, 2020 compared to $57 thousand at December 31, 2019. The loan remains in accrual status since it continues to perform in accordance with the restructured terms.

To date, the Company’s TDRs consisted of interest rate reductions, interest only periods, principal balance reductions, and maturity extensions. There were 0 loans modified during the three and six months ended June 30, 2020 and 2019 that were deemed to be TDRs. There were 0 loans modified as a TDR within the previous 12 months that subsequently defaulted at some point during the three and six months ended June 30, 2020. In this case, the subsequent default is defined as 90 days past due or transferred to nonaccrual status.

NOTE 9. Allowance for Loan Losses and Reserve for Unfunded Loan Commitments

Allowance for Loan Losses

The Company has an established methodology to determine the adequacy of the allowance for loan losses that assesses the risks and losses inherent in the loan portfolio. At a minimum, the adequacy of the allowance for loan losses is reviewed by management on a quarterly basis. For purposes of determining the allowance for loan losses, the Company has segmented the loans in its portfolio by loan type. Loans are segmented into the following pools: SBA 7(a), commercial, residential mortgages, and consumer loans. Certain portfolio segments are further broken down into classes based on the associated risks within those segments and the type of collateral underlying each loan. Commercial loans are divided into the following five classes: commercial real estate, commercial real estate construction, unsecured business line of credit, commercial other, and SBA 504. Consumer loans are divided into two classes as follows:  home equity and other.

The standardized methodology used to assess the adequacy of the allowance includes the allocation of specific and general reserves. The same standard methodology is used, regardless of loan type. Specific reserves are made to individual impaired loans and TDRs (see Note 1 for additional information on this term). The general reserve is set based upon a representative average historical net charge-off rate adjusted for the following environmental factors: delinquency and impairment trends, charge-off and recovery trends, volume and loan term trends, changes in risk and underwriting policy trends, staffing and experience changes, national and local economic trends, industry conditions and credit concentration changes. Within the five-year historical net charge-off rate, the Company weights the past three years more heavily as it believes it is more indicative of future charge-offs. All of the environmental factors are ranked and assigned a basis points value based on the following scale: low, low moderate, moderate, high moderate and high risk. Each environmental factor is evaluated separately for each class of loans and risk weighted based on its individual characteristics.

For SBA 7(a) and commercial loans, the estimate of loss based on pools of loans with similar characteristics is made through the use of a standardized loan grading system that is applied on an individual loan level and updated on a continuous basis. The loan grading system incorporates reviews of the financial performance of the borrower, including cash flow, debt-service coverage ratio, earnings power, debt level and equity position, in conjunction with an assessment of the borrower’s industry and future prospects. It also incorporates analysis of the type of collateral and the relative loan to value ratio.
For residential mortgage and consumer loans, the estimate of loss is based on pools of loans with similar characteristics. Factors such as credit score, delinquency status and type of collateral are evaluated. Factors are updated frequently to capture the recent behavioral characteristics of the subject portfolios, as well as any changes in loss mitigation or credit origination strategies, and adjustments to the reserve factors are made as needed.

33

According to the Company’s policy, a loss (“charge-off”) is to be recognized and charged to the allowance for loan losses as soon as a loan is recognized as uncollectable. All credits which are 90 days past due must be analyzed for the Company’s ability to collect on the credit. Once a loss is known to exist, the charge-off approval process is immediately expedited. This charge-off policy is followed for all loan types.

The allocated allowance is the total of identified specific and general reserves by loan category. The allocation is not necessarily indicative of the categories in which future losses may occur. The total allowance is available to absorb losses from any segment of the portfolio.

The following tables detail the activity in the allowance for loan losses by portfolio segment for the three and six months ended June 30, 2020 and 2019:

For the three months ended June 30, 2020

    

SBA held

    

    

    

    

for

(In thousands)

investment

Commercial

Residential

Consumer

Total

Balance, beginning of period

$

1,005

$

10,129

$

4,763

$

1,479

$

17,376

Charge-offs

 

 

(219)

 

 

 

(219)

Recoveries

 

75

 

502

 

 

 

577

Net recoveries

 

75

 

283

 

 

 

358

Provision for (credit to) loan losses charged to expense

 

(76)

 

1,924

 

676

 

(24)

 

2,500

Balance, end of period

$

1,004

$

12,336

$

5,439

$

1,455

$

20,234

For the three months ended June 30, 2019

    

SBA held

    

    

    

    

for

(In thousands)

investment

Commercial

Residential

Consumer

Total

Balance, beginning of period

$

1,678

$

8,793

$

4,016

$

1,197

$

15,684

Charge-offs

 

(84)

 

 

 

 

(84)

Recoveries

 

1

 

4

 

 

10

 

15

Net (charge-offs) recoveries

 

(83)

 

4

 

 

10

 

(69)

Provision for (credit to) loan losses charged to expense

 

(274)

 

347

 

182

 

95

 

350

Balance, end of period

$

1,321

$

9,144

$

4,198

$

1,302

$

15,965

For the six months ended June 30, 2020

    

SBA held

    

    

    

    

for

(In thousands)

investment

Commercial

Residential

Consumer

Total

Balance, beginning of period

$

1,079

$

9,722

$

4,254

$

1,340

$

16,395

Charge-offs

 

(25)

 

(519)

 

(200)

 

 

(744)

Recoveries

 

80

 

503

 

 

 

583

Net recoveries (charge-offs)

 

55

 

(16)

 

(200)

 

 

(161)

Provision (credit) for loan losses charged to expense

 

(130)

 

2,630

 

1,385

 

115

 

4,000

Balance, end of period

$

1,004

$

12,336

$

5,439

$

1,455

$

20,234

For the six months ended June 30, 2019

    

SBA held

    

    

    

    

for

(In thousands)

investment

Commercial

Residential

Consumer

Total

Balance, beginning of period

$

1,655

$

8,705

$

3,900

$

1,228

$

15,488

Charge-offs

 

(393)

 

(1)

 

 

(1)

 

(395)

Recoveries

 

3

 

9

 

 

10

 

22

Net (charge-offs) recoveries

 

(390)

 

8

 

 

9

 

(373)

Provision for loan losses charged to expense

 

56

 

431

 

298

 

65

 

850

Balance, end of period

$

1,321

$

9,144

$

4,198

$

1,302

$

15,965

34

The following tables present loans and their related allowance for loan losses, by portfolio segment, as of June 30, 2020 and December 31, 2019:

June 30, 2020

    

SBA held

    

    

    

    

for

(In thousands)

investment

Commercial

Residential

Consumer

Total

Allowance for loan losses ending balance:

 

  

 

  

 

  

 

  

 

  

Individually evaluated for impairment

$

177

$

413

$

256

$

$

846

Collectively evaluated for impairment

 

827

 

11,923

 

5,183

 

1,455

 

19,388

Total

$

1,004

$

12,336

$

5,439

$

1,455

$

20,234

Loan ending balances:

 

  

 

  

 

  

 

  

 

  

Individually evaluated for impairment

$

2,056

$

1,097

$

6,192

$

505

$

9,850

Collectively evaluated for impairment

 

170,949

 

791,655

 

463,795

 

145,656

 

1,572,055

Total

$

173,005

$

792,752

$

469,987

$

146,161

$

1,581,905

December 31, 2019

    

SBA held