The Company has continued its tremendous start to 2022 by carrying forward the momentum from 2021. The first six months have been the first post-acquisitions months since the acquisitions of Ossian and Perpetual which gives us a picture of our core business going forward. Organic loan growth increased 19.9%, which excludes acquisition and PPP balances, on a year-over-year basis with second quarter being the fourth consecutive quarter with organic loan growth greater than 10%. On
April 1st, the Bank officially celebrated its 125th birthday in each of the locations with management delivering treats for employees and customers. A committee has been formed within the Bank to promote the Bank's birthday and continue the celebration with special events throughout the year. In July, in conjunction with the five year anniversary of being traded on NASDAQ, the Company will ring the closing bell in New York. On June 14th, Farmers & Merchants Bancorp, Inc., entered into an Agreement and Plan of Merger with Peoples-Sidney Financial Corporation, a Delawarecorporation ("PPSF"), which provides for the merger of PPSF with and into F&M and the merger of PPSF's wholly-owned banking subsidiary, Peoples Federal Savings and Loan Association(" Peoples Bank"), with and into F&M's wholly-owned banking subsidiary, The Farmers & Merchants State Bank(" F&M Bank"). All of the outstanding shares of PPSF's common stock will be converted into the right to receive the cash or stock consideration as described in, and subject to, the terms and conditions of the Merger Agreement. Refer to Note 9 Proposed Business Combination for additional detail on the merger. F&M Commercial Banking Division entered the second quarter 2022 with a strong loan pipeline and demand throughout F&M's footprint. Client performance results from 2021 and year to date 2022 remain good. As second quarter 2022 came to an end, client concerns about availability of workforce, interruptions and delays in the supply chain and concerns over energy prices remained. Rising interest rates were also a concern for clients, but to date have not dramatically slowed commercial activity. Credit quality of the portfolio remains good, past dues and delinquencies remained low at the end of the quarter. Second quarter fee income remained solid and kept pace with first quarter. The agriculture sector saw favorable planting conditions for 2022, and growing conditions have been acceptable to date. Commodity prices remain high and at levels that remain profitable for our farm customers. Our ag clients are closely watching higher input costs and potential supply issues. Agri-business continues to remain stable. With rising interest rates, it is anticipated that our clients will carefully evaluate borrowing decisions. The agriculture portfolio remains sound. Home loan rates have continued to increase and the volume of refinancing loans has slowed as compared to the same time in 2021. Turn times have become more manageable and the Bank is focusing on home equity lines as an opportunity for growth. Limited inventory and the demand for homes remain strong. During the quarter, 266 loans, including home equity and lines of credit, were closed totaling $32.1 millionwhich compares to 297 loans and $33.0 millionduring the second quarter in 2021. The second quarter gain on 1-4 family mortgage sales was down by approximately 64.3% compared to second quarter 2021. According to ATTOM's latest home affordability analysis, the portion of average wages required for major home-ownership expenses nationwide rose in Q2 2022 to 31.5 percent, as the median price of a single-family home hit a new high of $349,000and 30-year mortgage rates shot up above 5 percent. Increased lumber prices have impacted remodeling costs and new construction; however, we have seen input prices begin to decrease. Net interest earnings increased by $10.6 millionas compared to first six months of 2021. The improvement was primarily due to growth in the balance sheet as the Company continues to operate in the low rate environment following the national prime rate drop of 150 basis points in the first quarter of 2020. Interest rates have increased as the national prime rate increased 25 basis points this March, 50 basis points in May and 75 basis points in June. Year to date net interest margin increased 3 basis points compared to year to date 2021. For second quarter, net interest margin increased 26 basis points compared to same quarter prior year and 33 basis points compared to first quarter 2022. The asset yield increased by 2 basis points compared to prior year to date, 26 basis points for second quarter compared to prior year second quarter and 32 basis points compared to first quarter 2022. Loan interest for 2021 included the impact of the PPP origination fees. Cost of funds decreased 4 basis points on a year to date basis, remained constant when comparing second quarter 2022 to prior year second quarter and decreased 1 basis point when comparing second quarter to first quarter 2022. Interest expense has been positively impacted with the time deposit and FHLB borrowing accretions resulting from the acquisitions as a reduction to interest expense. Further discussion of the balance sheet composition movements and the impact on the earnings can be viewed in the Material Results of Operations section that follows. Net income improved 65.5% in comparing the first half of 2022 to the first half of 2021 and earnings per share increased 42.0% in the same comparison. The higher net income was mainly driven by higher interest income. Interest income on a 51 -------------------------------------------------------------------------------- year to date basis increased 33.6% or $11.5 millioncompared to 2021. Interest income included $776 thousandof net loan accretion income resulting from the acquisitions year to date and $403 thousandfor second quarter. As mentioned previously, interest expense was offset by acquisition accretions for time deposits and FHLB borrowings which equaled $1.3 millionyear to date and $640 thousandfor the quarter. Interest expense increased by 26.8% and $881 thousandon a year to date basis compared to first six months 2021 on 33.0% higher average balances in 2022. Provision expense decreased $133 thousand. Noninterest income decreased 15.0% or $1.4 millionover the same period 2021. Decreased gain on sales of both 1-4 family mortgage loans and fixed rate agricultural loans along with gain on sale of available-for-sale securities were the biggest contributors. 1-4 family mortgage activity remains strong though has slowed compared to 2021 activity. We expect additional slowing in 2022 as refinancing has slowed, housing prices had increased, inventory of available homes is low due to quick turnover throughout most of the Bank's market area due to the increase in interest rates. The Bank has increased the number of Home Loan Originators (HLOs) due to a larger footprint which we hope stabilizes the activity. Noninterest expenses increased $1.3 millionor 5.1% with salaries and wages increasing $1.9 million. The Company has worked diligently to manage during volatile times and the increase in our size and footprint has helped establish diversity of revenue streams and insulate our earnings. While we report and recognize the many one-time costs incurred by our strategic focus, we continue to realize the long-term benefits of our strategies. Our historical prudent approach to lending has continued to demonstrate its benefits in our credit quality. Past dues over 30 days as of June 30, 2022were 0.20% of total loans outstanding. We continue to strengthen relationships with our customers, employees, shareholders and communities in support of our mission to "help people live their best lives." The Company remains well capitalized and plans to continue in our strategic vision of expansion to be a $3 billionbank by the end of 2022.
TYPE OF ACTIVITIES
Farmers & Merchants Bancorp, Inc.(the "Company") is a financial holding company incorporated under the laws of Ohioin 1985. Our subsidiaries are The Farmers & Merchants State Bank(the "Bank"), a local independent community bank that has been primarily serving Northwest Ohioand Northeast Indianasince 1897, and Farmers & Merchants Risk Management, Inc., a captive insurance company formed in December 2014and located in Nevada. We report our financial condition and net income on a consolidated basis and we have only one segment. Our executive offices are located at 307 North Defiance Street, Archbold, Ohio43502, and our telephone number is (419) 446-2501. The Bank operates thirty full-service banking offices throughout Northwest Ohioand Northeast Indianaand a drive-up facility in Archbold. The Bank also operates four Loan Production Offices (LPOs), two in Ohioand one in Indianaand Michigan. The Farmers & Merchants State Bankengages in general commercial banking and savings business including commercial, agricultural and residential mortgage, consumer and credit card lending activities. The largest segment of the lending business relates to commercial, both real estate and non-real estate. The type of commercial business ranges from small business to multi-million dollar companies. The loans are a reflection of business located within the Banks' market area. Because the Bank's offices are primarily located in Northwest Ohioand Northeast Indiana, a substantial amount of the loan portfolio is comprised of loans made to customers in the farming industry for such items as farm land, farm equipment and operating loans for seed, fertilizer, and feed. Other types of lending activities include loans for home improvements, and loans for the purchase of autos, trucks, recreational vehicles, motorcycles, and other consumer goods. The Bank also provides checking account services, as well as savings and time deposit services such as certificates of deposits. In addition, Automated Teller Machines (ATMs) or Interactive Teller Machines (ITMs) are provided at most branch locations along with other independent locations in the market area. ITMs operate as an ATM with the addition of remote teller access to assist the user. The Bank has custodial services for Individual Retirement Accounts (IRAs) and Health Savings Accounts (HSAs). The Bank provides on-line banking access for consumer and business customers. For consumers, this includes bill-pay, on-line statement opportunities and mobile banking. For business customers, it provides the option of electronic transaction origination such as wire and Automated Clearing House (ACH) file transmittal. In addition, the Bank offers remote deposit capture or electronic deposit processing and merchant credit card services. Mobile banking was added in 2012 and has been widely accepted and used by consumers. Upgrades to our digital products and services continue to occur in both retail and business lines. The Bank continues to offer new suites of products as customer preferences change and the Bank adapts and adopts new technologies. The Bank continues to offer products that also meet the needs of our more traditional customers. The Bank has established underwriting policies and procedures which facilitate operating in a safe and sound manner in accordance with supervisory and regulatory guidance. Within this sphere of safety and soundness, the Bank's practice has been to not promote innovative, unproven credit products which may not be in the best interest of the Bank or its customers. The Bank does offer a hybrid mortgage loan. Hybrid loans are loans that start out as a fixed rate mortgage but after a set 52 -------------------------------------------------------------------------------- number of years automatically adjust to an adjustable rate mortgage. The Bank offers a three year, a five year and a seven year fixed rate mortgage after which the interest rate will adjust annually. In order to offer longer term fixed rate mortgages, the Bank does participate in the Freddie Mac, Farmer Mac and Small Business Lending programs. The Bank also normally retains the servicing rights on these partially or 100% sold loans. In order for the customer to participate in these programs they must meet the requirements established by those agencies. In addition, the Bank does sell some of its longer term fixed rate agricultural mortgages into the secondary market with the aid of brokers. With the acquisition in the 4th quarter of 2021, the Bank saw an increase in fixed rate, long-term mortgage loans to our portfolio from that banking service area. The Bank does not have a program to fund sub-prime loans. Sub-prime loans are characterized as a lending program or strategy that targets borrowers who pose a significantly higher risk of default than traditional retail banking customers. All loan requests are reviewed as to credit worthiness and are subject to the Bank's underwriting guidelines as to secured versus unsecured credit. Secured loans are in turn subject to loan to value (LTV) requirements based on collateral types as set forth in the Bank's Loan Policy. In addition, credit scores of those seeking consumer credit are reviewed and if they do not meet the Bank's Loan Policy guidelines an additional officer approval is required.
• Maximum loan to value (LTV) for cars, SUVs, and trucks is 110% depending on whether direct or indirect. • Loans above 100% are generally the result of sales tax.
• Boats, motorhomes, motorcycles, motorhomes and coaches vary from 80% to 90%
based on age of vehicle. • 1st or 2nd mortgages on 1-4 family homes maximum range from 80-85%. • Raw land LTV maximum ranges from 65%-75% depending on whether or not the property has been improved.
• Up to 80% LTV less holdbacks and over 90 days.
Inventory: • Agriculture: o Livestock and grain up to 80% LTV, crops (insured) up to 75% and Warehouse Receipts up to 87%. • Commercial: o Maximum LTV of 50% on raw and finished goods. • Floor plan: o New/used vehicles to 100% of wholesale. o New/Used recreational vehicles and manufactured homes to 80% of wholesale. Equipment: • New NTE 80% of invoice, used NTE 50% of listed book or 75% of appraised value. • Restaurant equipment up to 35% of market value. • Heavy trucks, titled trailers NTE 75% LTV and aircraft up to 75% of appraised value.
• Maximum LTVs range from 70%-80% depending on type. • Maximum LTV on non-traditional loan up to 85%. FM Investment Services, the brokerage department of the Bank, opened for business in
April 1999. Securities are offered through Raymond James Financial Services, Inc.In November of 2020, FM Investment Services purchased the assets and clients of Adams County Financial Resources (ACFR) which is discussed in further detail in Note 2 to the Company's financial statements. Securities are offered through Raymond James Financial Services, Inc.In December of 2014, the Company became a financial holding company within the meaning of the Bank Holding Company Act of 1956 as amended (the "Act"), in order to provide the flexibility to take advantage of the expanded powers available to a financial holding company under the Act. Our subsidiary bank is in turn regulated and examined by the Ohio Division of Financial Institutionsand the Federal Deposit Insurance Corporation. The activities of our bank subsidiary are also subject to other federal and state laws and regulations. The Company also formed a captive insurance company (the "captive") in December 2014which is located in Nevadaand regulated by the State of Nevada Division of Insurance. The Bank's primary market includes communities located in the Ohiocounties of Champaign, Defiance, Fulton, Hancock, Henry, Lucas, Williams, Woodand in the Indianacounties of Adams, Allen, DeKalb, Jay, Steubenand Wells. In our banking activities, we compete directly with other commercial banks, credit unions, farm credit services, and savings and loan institutions in each of our operating localities. In a number of our locations, we compete against entities which are much larger 53 --------------------------------------------------------------------------------
that we. The main competitive factors for loans and deposits are the rates charged as well as the location and quality of services provided.
June 30, 2022, we had 390 full time equivalent employees. The employees are not represented by a collective bargaining unit. We provide our employees with a comprehensive benefit program, some of which is contributory. We consider our employee relations to be good.
RECENT REGULATORY DEVELOPMENTS
The Bank remains attentive to the current regulatory environment in light of the regulatory agencies' risk-based approach to examinations. Regulatory changes and the complexity of new and amended rules have resulted in challenges and uncertainties which could pose an increased risk of noncompliance. Various significant mortgage rules require monitoring by means of testing, validation of results, additional training, and further research or consultation to assist with ongoing compliance. The global spread of the Coronavirus (COVID-19) and resulting declaration of a world-wide pandemic have impacted the financial services industry and banking operations in
the United States(US) and world-wide. The financial services sector is identified as a Critical Infrastructure Sector by the Department of Homeland Securityduring the COVID-19 response efforts. How basic business operations can be conducted has undergone a rapid and dramatic change. At the same time continuity of business operations involves promoting safety and security of customers and employees, providing a quality customer experience, and maintaining effective delivery systems and channels of communication. Regulatory guidance has been issued to manage and mitigate the unprecedented impact of the COVID-19 pandemic on business operations. Regulatory agencies promote prudent and practical efforts to assist customers and communities during this national emergency. Such assistance to alleviate the financial impact on affected customers involved modification of loan terms for existing borrowers, waiver of certain fees and charges, providing small dollar loans, and offering forbearance and payment deferrals on mortgage loan obligations due to financial hardship. Legislation enacted in March 2020has provided the CARES Act. The CARES Act, among other matters, resulted in expansion of SBA Lending Programs; provided for a financial election to suspend GAAP principles and regulatory determinations for COVID-19 related loan modifications that would otherwise be deemed Troubled Debt Restructuring; gave the FDICauthority to establish a temporary Debt Guarantee Program for bank liabilities; delayed Current Expected Credit Losses (CECL) compliance; reduced the Community Bank Leverage Ratio to 8% to eliminate risk-based capital compliance for banks under $10 billion; required credit furnishers that agree to deferred loan payments, forbearance on a delinquent account, or any other relief during the national emergency to report accounts as current to Credit Reporting Agencies; and defined forbearance requirements and terms for single family and multi-family loans backed by federal government agencies or government sponsored entities due to COVID-19 financial hardship. Of immediate and significant importance was the rollout of the SBA Paycheck Protection Program (PPP). The PPP authorized lending of up to $350 billionin 100% guaranteed 7(a) loans to cover payroll costs, interest on mortgage payments, rent obligations, and utilities. The PPP provided a guaranteed loan for which a portion of the loan up to or equal to 8 weeks of covered payroll and specific operating expenses can be forgiven. The maximum loan size was capped at the lessor of 250% of the average monthly payroll costs or $10 million. In April 2020, legislation known as the Paycheck Protection Program and Health Care Enhancement Act provided additional funding to replenish and supplement key programs under the CARES Act. Included in this legislation was the extension of the PPP with an additional $320 billionin funding. At least $60 billionof this funding was to be set aside for small and midsize banks and community lenders. Since April, the SBA has issued various Interim Final Rules to supplement and clarify matters involving the PPP. The Paycheck Protection Program Flexibility Act of 2020 (PPPFA) was enacted in early June 2020. This provided more flexibility to Borrowers regarding use of PPP loan funds. Certain provisions were retroactive to the date of the CARES Act and all PPP loans. Among these provisions were the extension of the covered period of the loan, extension of the forgiveness period, deferral of payments based on the loan forgiveness period, reduction in the minimum that must be spent for payroll costs, extended date by which employees must be rehired, and removal of restrictions on payroll tax deferral. The term for subsequent PPO loans made after enactment of the PPPFA was extended to five years from two. A primary focus is now directed to aiding PPP borrowers in navigating the loan forgiveness process. FFCRA requirements to provide paid leave to employees ended on December 31, 2020. Due to the extended duration of the COVID-19 pandemic, employers subject to FFCRA could voluntarily extend the paid leave option until March 31, 2021. If the employer has elected to voluntarily apply the FFCRA extension, employees eligible for leave in 2020 and did not use the leave may take the leave in 2021. Under the American Rescue Plan of 2021 enacted in March 2021, for those employers who voluntarily extend the paid leave option, paid leave was reset starting April 1, 2021. If employees previously exhausted their paid leave under FFCRA, they may be entitled to an additional 10 days/80 hours for use. Additionally, the PPP was reauthorized with passage of the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act. It was originally 54 -------------------------------------------------------------------------------- intended to run through March 31, 2021and was subsequently extended to May 31, 2021. Under the new legislation, $284 billionin funding for first and second-time PPP loan borrowers was provided to the SBA. Three categories of businesses are eligible to apply for PPP: 1) qualified business that did not receive a PPP loan during the first funding round; 2) previous PPP loan recipients who need a second loan and meet certain criteria; previous PPP loan recipients who returned all or a portion of their original loans and want to apply to additional funding. To be eligible, any business applying for PPP must have been in operation since at least February 15, 2020. Specific eligibility criteria apply to first-time PPP borrowers and previous PPP loan recipients. For 2021, PPP provides expanded coverage for expenditures in addition to covered payroll and specific operating expenses. For second-time loan recipients, the maximum loan amount was reduced from $10 millionto $2 million. A loan recipient is eligible for full loan forgiveness if at least 60% of the loan amount is spent on payroll costs. Funds must be spent over a covered period of the loan recipients' choosing between eight and 24 weeks after loan origination to be eligible for forgiveness. Depending on the continued duration of COVID-19 spread, further legislation and regulatory guidance may continue due to the economic impact on customers, businesses, communities, and industry sectors. The Coronavirus Response and Relief Supplemental Appropriations Act, passed by Congressin December 2020, extended certain provisions of the CARES Act affecting the Company into 2021. Key banking provisions under this legislation include the following: • Provided an additional $284.6 billionin Paycheck Protection Program (PPP) funding for loans to small businesses, including for borrowers who have previously received a PPP loan. • A one-page simplified forgiveness process for PPP loans under $150,000. • Clarification to various CARES Act provisions, the tax treatment of
PPP expenses, lender responsibilities for agent fees, and
harmless" protections under the PPP and other laws.
• A further deferral of the recognition of the Troubled Debt Restructuring (TDR) until
60 days after the termination of the national emergency, or
2022. During third quarter 2021, there was one loan
$3.1 millionthat would have been previously treated as TDR under the guidance in ASC 310-40. • A further optional delay in Current Expected Credit Loss (CECL) accounting until January 1, 2022. • A new round of Economic Impact Payments (EIPs) for consumers, with aggressive distribution timelines and new exemptions from garnishments. • Significant added support for Community Development Financial Institutions (CDFIs) and Minority Depository Institutions (MDIs).
• Funding for farm support programs and tenant assistance programs.
• Termination of existing
Federal Reserveemergency lending authority under the CARES Act, while preserving the Fed's general 13(3) emergency authority existing prior to that Act. In December 2020, new Qualified Mortgage (QM) Definition rules were issued by the Consumer Financial Protection Bureau. One set of rules revised the General QM definition and another set added the definition of a Seasoned QM Loan. Both QM Loan rules had an effective date of March 1, 2021. The revised General QM rule replaced the General QM loans definition of a 43% debt-to-income (DTI) limit with a focus on the loan pricing and whether the Annual Percentage Rate exceeds the average prime offer rate by less than 2.25 percentage points. Compliance with the revised General QM Loan rule had a mandatory compliance date of July 1, 2021. The existing Temporary Government Sponsored Entity (GSE) QM option was set to expire as of the mandatory compliance date for the revised General QM Rule. Subsequently, the CFPBissued a final rule published in the Federal Registeron April 30, 2021which delayed and extended the mandatory compliance date for the revised General QM rule to October 1, 2022. At the present time, the Company has the option to comply with either the original DTI-based General QM Loan definition or the revised price-based new General QM Loan definition. Since the Company sells fixed rate consumer mortgage loans to the Federal Home Loan Mortgage Corporation, it must remain attentive to their current loan underwriting requirements and how they evolve in the extended interim period. With regard to all regulatory matters, the Bank remains committed in making good faith efforts to comply with technical requirements of the laws, rules, regulations, and guidance from both federal and state agencies which govern its activities.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in
the United States of America, and the Company follows general practices within the financial services industry in which it operates. At times the application of these principles requires management to make assumptions, estimates and judgments that affect the amounts reported in the financial statements and accompanying notes.
These assumptions, estimates and judgments are based on the information available at the date of the financial statements. As this information changes, the financial statements may reflect different assumptions, estimates and judgments. Certain
55 -------------------------------------------------------------------------------- policies inherently have a greater reliance on assumptions, estimates and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Examples of critical assumptions, estimates and judgments are when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not required to be recorded at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability must be recorded contingent upon a future event. These policies, along with the disclosures presented in the notes to the condensed consolidated financial statements and in the management discussion and analysis of the financial condition and results of operations, provide information on how significant assets and liabilities are valued and how those values are determined for the financial statements. Based on the valuation techniques used and the sensitivity of financial statement amounts to assumptions, estimates, and judgments underlying those amounts, management has identified the determination of the ALLL, the valuation of its Mortgage Servicing Rights and the valuation of real estate acquired through or in lieu of loan foreclosures ("OREO Property") as the accounting areas that require the most subjective or complex judgments, and as such could be the most subject to revision as new information becomes available. OREO Property held for sale is initially recorded at fair value at the date of foreclosure. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of cost or fair value minus estimated costs to sell. Costs of holding foreclosed real estate are charged to expense in the current period, except for significant property improvements, which are capitalized. Valuations are periodically performed by management and a write-down is recorded by a charge to non-interest expense if the carrying value exceeds the fair value minus estimated costs to sell.
Net income from transactions of foreclosed real estate held for sale is reported as either non-interest income or non-interest expense, depending on whether the property is overall in a gain or loss position. To
there was no Heritage OREO. OREO totaled
The ALLL and ACL represents management's estimate of probable credit losses inherent in the Bank's loan portfolio, unfunded loan commitments, and letters of credit at the report date. The ALLL methodology is regularly reviewed for its appropriateness and is approved annually by the Board of Directors. This written methodology is consistent with Generally Accepted Accounting Principles which provides for a consistently applied analysis. The Bank's methodology provides an estimate of the probable credit losses either by calculating a specific loss per credit or by applying a composite of historical factors over a relevant period of time with current internal and external factors which may affect credit collectability. Such factors which may influence estimated losses are the conditions of the local and national economy, local unemployment trends, and abilities of lending staff, valuation trends of fixed assets, and trends in credit delinquency, classified credits, and credit losses. Inherent in most estimates is imprecision. The Bank's ALLL may include a margin for imprecision with an unallocated portion. Bank regulatory agencies and external auditors periodically review the Bank's methodology and adequacy of the ALLL. Any required changes in the ALLL or loan charge-offs by these agencies or auditors may have a material effect on the ALLL. For more information regarding the estimates and calculations used to establish the ALLL please see Note 4 to the consolidated financial statements provided herewith. The Bank is also required to estimate the value of its mortgage servicing rights. The Bank's mortgage servicing rights relating to fixed rate single-family mortgage loans that it has sold without recourse but services for others for a fee represent an asset on the Bank's balance sheet. The valuation is completed by an independent third party. The expected and actual rates of mortgage loan prepayments are the most significant factors driving the potential for the impairment of the value of mortgage servicing assets. Increases in mortgage loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced. The Bank's mortgage servicing rights relating to loans serviced for others represent an asset. This asset is initially capitalized and included on the Company's consolidated balance sheet. The mortgage servicing rights are then amortized as noninterest expense in proportion to, and over the period of the estimated future net servicing income of the underlying mortgage servicing rights. There are a number of factors, however, that can affect the ultimate value of the mortgage servicing rights to the Bank. The expected and actual rates of mortgage loan prepayments are the most significant factors driving the potential for the impairment of the value of mortgage servicing assets. Increases in mortgage loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced, meaning that the present value of the mortgage servicing rights is less than the carrying value of those rights on the Bank's balance sheet. Therefore, in an attempt to reflect an accurate expected value to the Bank of the mortgage servicing rights, the Bank receives a valuation of its mortgage servicing rights from an independent third party. The independent third party's valuation of the mortgage servicing rights is 56 -------------------------------------------------------------------------------- based on relevant characteristics of the Bank's loan servicing portfolio, such as loan terms, interest rates and recent national prepayment experience, as well as current national market interest rate levels, market forecasts and other economic conditions. For purposes of determining impairment, the mortgage servicing assets are stratified into like groups based on loan type, term, new versus seasoned and interest rate. Management, with the advice from its third-party valuation firm, reviewed the assumptions related to prepayment speeds, discount rates, and capitalized mortgage servicing income on a quarterly basis. Changes are reflected in the following quarter's analysis related to the mortgage servicing asset. In addition, based upon the independent third party's valuation of the Bank's mortgage servicing rights, management then establishes a valuation allowance by each stratum, if necessary, to quantify the likely impairment of the value of the mortgage servicing rights to the Bank. The estimates of prepayment speeds and discount rates are inherently uncertain, and different estimates could have a material impact on the Bank's net income and results of operations. The valuation allowance is evaluated and adjusted quarterly by management to reflect changes in the fair value of the underlying mortgage servicing rights based on market conditions. The accuracy of these estimates and assumptions by management and its third party valuation specialist can be directly tied back to the fact that management has only been required to record minor valuation allowances through its income statement over time based upon the valuation of each stratum of servicing rights.
MATERIAL CHANGES IN FINANCIAL POSITION, LIQUIDITY AND CAPITAL RESOURCES
The Company plans to continue in its growth mode in 2022 led by loan growth from within our newer markets. The Bank is focused on funding the loan growth with the least expensive source of deposits, sale of securities or borrowings. Growing deposits will also be a focus especially in our newer markets. The Bank offers the Insured Cash Sweep ("ICS") product accessed through the Promontory network of financial institutions which helps to reduce the amount of pledged securities. This has provided more availability for runoff of securities by the Bank if warranted to fund loan growth. Liquidity in terms of cash and cash equivalents ended
$109.4 millionlower as of June 30, 2022than it was at yearend December 31, 2021. Prior year's excess liquidity along with an increase in deposits of $30.6 millionhelped to fund the $175.2 millionincrease in net loans since year end 2021. All loan portfolios with the exception of the consumer and other portfolios increased compared to December 31, 2021with the largest increase in the commercial real estate portfolio. In comparing to the same prior year period, the June 30, 2022(net of deferred fees and cost) loan balances of approximately $2.0 billionaccounted for $576.4 millionor 39.5% increase when compared to 2021's $1.5 billion. The year over year improvement was made up of a combined increase of 50.7% in commercial and industrial related loans (comprised of 41.7% in commercial real estate loans and 9.0% in non-real estate commercial loans). PPP loans of approximately $8 thousandand $47.1 millionare included in the non-real estate commercial portfolio as of June 30, 2022and June 30, 2021, respectively. Consumer real estate loans increased by 111.0% and other loans by 130.6%. Consumer loans decreased by 1.6%. Agricultural related loans increased 31.6% year over year (comprised of 5.4% in agricultural real estate and 26.2% in non-real estate agricultural loans). The Company credits the growth not only to the OFSI and PFSB acquisitions but also to the strong team of lenders focused on providing customers valuable localized services and thereby increasing our market share.
The graph below presents the breakdown of the category of the loan portfolio in
(In Thousands) June 30, 2022 June 30, 2021 June 30, 2020 Amount Amount Amount Consumer Real Estate
$ 410,468 $ 194,574 $ 173,615Agricultural Real Estate 199,650 189,426 194,310 Agricultural 127,340 100,905 107,615 Commercial Real Estate 977,588 689,728 588,176 Commercial and Industrial 232,881 213,707 221,034 Consumer 55,648 56,534 50,259 Other 31,243 13,549 9,714
Total loans, net of fees and deferred costs
Here is a contractual schedule by major category of loans excluding fair value adjustments at
(In Thousands) After One Within Year Within After One Year Five Years Five Years Consumer Real Estate
$ 6,903 $ 32,255 $ 375,256Agricultural Real Estate 1,581 6,838 191,897 Agricultural 66,263 37,602 23,305 Commercial Real Estate 37,643 298,161 643,569 Commercial and Industrial 92,114 84,318 57,302 Consumer 2,163 37,422 15,921 Other 247 1,451 29,553 While the security portfolio has been utilized to fund loan growth for the last three years, additional sources have been cultivated during 2020, 2021, and 2022. The security portfolio decreased $30.2 millionin the first six months of 2022 from year end 2021 due to an increase of gross unrealized losses of $35.5 million. The security portfolio decreased $7.8 millionfrom June 2021due to an increase of gross unrealized losses of $40.5 million. The amount of pledged investment securities increased by $15.0 millionas compared to year end and $51.6 millionas compared to June 30, 2021. Liquidity is improved with the additional option of selling unpledged investment securities if needed to fund loan growth or other initiatives. As of June 30, 2022, pledged investment securities totaled $130.0 million. The current portfolio is in a net unrealized loss position of $39.6 million. For the Bank, an additional $68.3 millionis also available from the Federal Home Loan Bankbased on current amounts of pledged collateral. At the present time, only 1-4 family and home equity portfolios are pledged. Additional borrowings would be available if additional portfolios (i.e. commercial real estate) were pledged. On July 30, 2021, the Company announced the completion of a private placement of $35 millionaggregate principal amount of its 3.25% fixed-to-floating rate subordinated notes due July 30, 2031(the "Notes") to various accredited investors (the "Offering"). The price for the Notes was 100% of the principal amount of the Notes. The Notes qualify as Tier 2 capital for regulatory purposes in proportionate amounts until July 30, 2026. The Company used the net proceeds from the Offering for general corporate purposes, including financing acquisitions and organic growth. Due to the funding requirement for the acquisition of PFSB to be provided from the holding company, the Company secured borrowings from a correspondent bank. Two loans were secured, the first a $30 million12-month term note and the second a 12-month line of credit for $10 million. Both loans were advanced on October 1, 2021. Interest on both loans is due quarterly and accrues at a rate 2.50% per annum with reporting and capital covenants included. The structure of the acquisition required all accounting of the transaction to be recorded at the Bank level as Perpetual did not have a holding company. Therefore, the Company advanced funds from the Bank to the Company to facilitate payoff of the term note. The term note and the line of credit balance were paid off in the second quarter of 2022. The line of credit remains open for future liquidity needs.
With the exception of FHLB shares, recorded at cost, which are presented as other securities, the Company’s entire securities portfolio is classified as “available for sale” and, as such, is recorded at fair value. .
Management feels confident that liquidity needs for future growth can be met through additional maturities and/or sales from the security portfolio, increased deposits and additional borrowings. For short term needs, the Bank has
$69 millionof unsecured borrowing capacity through its correspondent banks as of June 30, 2022and June 30, 2021. The Bank also had access to $130.4 millionand $94.2 millionthrough a Cash Management Advance with the Federal Home Loan Bankas of June 30, 2022and June 30, 2021, respectively. Overall total assets increased 1.4% since year end 2021 and grew 23.4% since June 30, 2021. The largest growth in both periods was in the loan portfolios. Securities and goodwill also increased significantly compared to June 30, 2021. Refer to Note 2 for information on assets acquired from OFSI and PFSB. Federal Home Loan Bankadvances accounted for the largest growth within liabilities, up 77.2% or $18.6 millionsince year end and 138.6% or $24.8 millionover June 30, 2021balances. Deposits also experienced growth, up 1.4% or $30.6 millionsince year end 2021 and 20.0% or $370 millionover June 30, 2021. Refer to Note 2 for information on liabilities acquired 58 -------------------------------------------------------------------------------- from OFSI and PFSB. The growth of deposits correlated to a flight to safety as the stock market continues to experience some volatility. Core deposits continue to drive the increase which provide the opportunity to generate additional noninterest income. This growth aided the Company's liquidity position and helped to fund the loan growth for the periods along with usage of Federal Home Loan Bankadvances and federal funds purchased. Shareholders' equity decreased by $16.3 millionas of the second quarter of 2022 compared to year end 2021. Earnings exceeded dividend declarations during the six months ended June 30, 2022. Accumulated other comprehensive loss increased in unrealized loss position by $28.1 millionfrom December 2021to an unrealized loss of $31.3 millionon June 30, 2022. The increase in unrealized loss position has no impact on regulatory tangible book price. The available-for-sale security portfolio is used as a protection to falling rates. If there is an unrealized loss in our security portfolio due to rising interest rates, it bodes well for our adjustable rate loan portfolio and new loan production to price up. Dividends declared increased over the previous quarter by $0.0125per share to $0.2025 per share from $0.19per share. Compared to June 30, 2021, shareholders' equity increased 12.1% or $30.3 millionmostly attributable to the issuance of stock in the Perpetual acquisition as discussed in Note 2. Profits were higher year to date June 2022than year to date June 2021by $6.5 million. Basel III regulatory capital requirements became effective in 2016. The Bank and Companyinclude a capital conservation buffer as a part of the transition provision. For calendar year 2016, the applicable required capital conservation buffer percentage of 0.625% was the base above which institutions avoid limitations on distributions and certain discretionary bonus payments. The total buffer requirement increased to 2.5% for calendar year 2019. As of June 30, 2022, the Company and the Bank are both positioned well above the 2019 requirement.
The Bank continues to be well capitalized at
Tier I Leverage Ratio 9.16 % Risk Based Capital Tier I 11.58 %
Total Risk Based Capital12.54 % Stockholders' Equity/Total Assets 10.87 % Capital Conservation Buffer 4.54 %
MATERIAL CHANGES IN OPERATING RESULTS
Comparison of interest income and expense results for the three-month periods ended
When comparing second quarter 2022 to second quarter 2021, average loan balances with the acquisitions of OFSI and PFSB grew
$579.8 millionwith average quarterly PPP loans decreasing $52.8 million. This represented a 40.8% increase in a one-year time period. Interest income on loan balances experienced an increase of $6.1 millionas compared to the quarter ended June 30, 2021. This increase was primarily the result of the significant growth in the end of period loan balances between periods, 19.7% of which was directly attributable to the Company's recent acquisitions and 19.9% of which was due to organic loan growth within the Bank's broader markets. Net fee income for the PPP loans was recognized on a straight line basis over 24 months for the first draw and 60 months for the second draw and was accelerated upon payoff. PPP loan balances at the end of June 2022were $8 thousandcompared to $47.1 millionat the end of June 2021. PPP loan income for the quarter included interest income of $0.3 thousandand net fee income of $9.8 thousandcompared to $134.7 thousandof loan interest income and $615.4 thousandof net fee income for 2021. The available-for-sale securities portfolio increased in average balances by $59.4 millionwhen comparing to the previous year while the income increased $237 thousandover second quarter. Federal funds sold and interest-bearing deposits decreased in average balances by $106.5 millionas compared to the same quarter in 2021 with increased income of $15 thousandfor the current quarter. Refer to Note 2 Business Combination and Asset Purchase for information on assets acquired from OFSI and PFSB. The overall total average balance of the Bank's earning assets increased by $532.7 millionand interest income for the quarter comparisons was higher for second quarter 2022 by 36.4% or $6.4 millionas compared to second quarter 2021. Increases in the prime lending rate between periods has contributed to an increase in rate yield. 59 -------------------------------------------------------------------------------- Annualized yield, for the quarter ended June 30, 2022, was 3.79% as compared to 3.53% for the quarter ended June 30, 2021. The following charts demonstrate the value of increased loan balances in the balance sheet mix, as well as the impact on the changes in interest rates. The yields on tax-exempt securities and the portion of the tax-exempt IDB loans included in loans have been tax adjusted based on a 21% tax rate in the charts to follow. (In Thousands) Quarter to Date Ended June 30, 2022 Annualized Yield/Rate Interest Earning Assets: Average Balance Interest/Dividends June 30, 2022 June 30, 2021 Loans $ 1,999,357 $ 22,388 4.48 % 4.58 % Taxable investment securities 422,482 1,344 1.27 % 1.20 % Tax-exempt investment securities 21,649 70 1.64 % 2.23 % Fed funds sold & other 81,091 109 0.54 % 0.20 % Total Interest Earning Assets $ 2,524,579 $ 23,911 3.79 % 3.53 % Change in Interest Income Quarterto Date June 30, 2022Compared to June 30, 2021 (In Thousands) Change Due Change Due Interest Earning Assets: Total Change to Volume to Rate Loans $ 6,129 $ 6,643 $ (514 )Taxable investment securities 244 165 79 Tax-exempt investment securities (7 ) 23 (30 ) Fed funds sold & other 15 (53 )
Total interest-earning assets
(397 ) Interest Expense Offsetting the higher interest income for the quarter was an increase in interest expense in 2022 of
$493 thousandor 31.7% compared to second quarter 2021. Since 2021, average interest-bearing deposit balances have increased $374.1 millionor 27.2% and the Company recognized $103 thousandmore in interest expense for the most recent quarter. The prime rate dropped 150 basis points in March of 2020 and management adjusted deposit rates accordingly. March 2022saw the first rate change since 2020 with an increase of 25 basis points which was followed by increases of 50 and 75 basis points in May and June respectively. Interest expense on FHLB borrowings and other borrowings increased $103 thousandin the second quarter 2022 over the same time frame in 2021 due to borrowings taken on from the Perpetual acquisition and new FHLB borrowings of $20 millionin May 2022used to fund loan growth. Interest expense on fed funds purchased and securities sold under agreement to repurchase increased $3 thousandcompared to second quarter 2021. Interest expense on subordinated notes was $284 thousandfor the most recent quarter. Refer to Note 8 for additional information on subordinated notes. Liabilities assumed from OFSI and PFSB can be seen in Note 2. (In Thousands) Quarter to Date Ended June 30, 2022 Annualized Yield/Rate Interest Bearing Liabilities: Average Balance Interest June 30, 2022 June 30, 2021 Savings deposits $ 1,312,444 $ 777 0.24 % 0.20 % Other time deposits 435,091 602 0.55 % 1.13 % Other borrowed money 39,172 218 2.23 % 2.58 % Fed funds purchased & securities sold under agreement to repurchase 35,260 166 1.88 % 2.17 % Subordinated notes 34,509 284 3.29 % 0.00 % Total Interest Bearing Liabilities $ 1,856,476 $ 2,047 0.44 % 0.44 % 60
-------------------------------------------------------------------------------- Change in
Interest Expense Quarterto Date June 30, 2022Compared to June 30, 2021 (In Thousands) Change Due Change Due Interest Bearing Liabilities: Total Change to Volume to Rate Savings deposits $ 211 $ 95 $ 116Other time deposits (108 ) 524 (632 ) Other borrowed money 103 137 (34 ) Fed funds purchased & securities sold under agreement to repurchase 3 29 (26 ) Subordinated notes 284 284
Total interest-bearing liabilities $493
Overall, net interest spread for the second quarter 2022 was 26 basis points higher than last year. As the following chart indicates, the improvement in yields on interest earning assets was solely responsible for the increase in net interest spread as cost of funds remained constant when comparing to the same period a year ago. June 30, 2022 June 30, 2021 June 30, 2020 Interest/Dividend income/yield 3.79 % 3.53 % 4.25 % Interest Expense/cost 0.44 % 0.44 % 0.91 % Net Interest Spread 3.35 % 3.09 % 3.34 % Net Interest Margin 3.47 % 3.21 % 3.59 % Net Interest Income Net interest income increased
$5.9 millionfor the second quarter 2022 over the same time frame in 2021 with the increase in interest income of $6.4 millionoffset by the higher interest expense of $493 thousand, as previously mentioned. As the new loans added in 2021 and 2022 generate more income, management expects the benefits of the Company's strategy of repositioning the balance sheet to continue to increase net interest income. In terms of net interest margin rate, the Bank recognizes competition for deposits may again increase and put pressure on the margin which may lead to a tightening.
Comparison of non-interest operating results for the three-month periods ended
Provision Expense The Allowance for Loan and Lease Losses (ALLL) has a direct impact on the provision expense. The increase in the ALLL is funded through recoveries and provision expense. The following tables both deal with the allowance for credit losses. The first table breaks down the activity within ALLL for each loan portfolio class and shows the contribution provided by both the recoveries and the provision along with the reduction of the allowance caused by charge-offs. The second table discloses how much of the ALLL is attributed to each class of the loan portfolio, as well as the percent that each particular class of the loan portfolio represents to the entire loan portfolio in the aggregate. The consumer loan portfolio accounted for the largest component of charge-offs and recoveries for second quarter of 2022 and 2021. The commercial real estate portfolio is currently creating a large impact on the ALLL due to the loan growth. Total provision for loan losses was
$987 thousandhigher for the second quarter 2022 as compared to the same quarter 2021. Provision for loan loss has stabilized beginning in third quarter of 2021 and the provision expense for the second quarter of 2022 was adequate. There is still some lingering uncertainty regarding COVID-19; therefore, it is prudent to incorporate the impact of COVID-19 in the evaluation of the adequacy of ALLL. The restaurant and hospitality sectors have been hit especially hard. Risk in the Consumer and 1-4 Family Portfolio has also increased. Management continues to monitor asset quality, making adjustments to the provision as necessary. The impact of higher interest rates and inflation will be taken into consideration when reviewing qualitative factors. Loan charge-offs were $79 thousandhigher in second quarter 2022 than the same quarter 2021. Recoveries were $83 thousandhigher in second quarter 2022 as compared to second quarter 2021. Combined net charge-offs were $4 thousandlower in second quarter 2022 than the same time period 2021. Past due loans, which include no deferrals related to COVID-19, increased $2.4 millionat June 30, 2022as compared to June 30, 2021. The largest changes were attributed to the increase of past due balances in the agricultural real estate portfolio and consumer real estate portfolio. 61 -------------------------------------------------------------------------------- The following table breaks down the activity within the ALLL for each loan portfolio class and shows the contribution provided by both recoveries and the provision, along with the reduction of the allowance caused by charge-offs. The time period covered is for three months ended June 30, 2022, 2021, and 2020. (In Thousands) Three Months Ended Three Months Ended Three Months Ended June 30, 2022 June 30, 2021 June 30, 2020 Loans, net of deferred fees and costs $ 2,034,818 $ 1,458,423 $ 1,344,723 Daily average of outstanding loans $ 1,999,357 $ 1,419,531 $ 1,321,405 Nonaccrual loans $ 5,247 $ 7,031 $ 8,473 Nonperforming loans* $ 5,247 $ 7,031 $ 8,473 Allowance for Loan Losses - January 1, $ 16,771 $ 14,425 $ 8,533 Loans Charged off: Consumer Real Estate - - - Agriculture Real Estate - - - Agricultural - - - Commercial Real Estate - - 8 Commercial and Industrial - - 165 Consumer 117 38 64 117 38 237 Loan Recoveries: Consumer Real Estate 4 3 2 Agriculture Real Estate - - - Agricultural - 6 - Commercial Real Estate 3 3 2 Commercial and Industrial 65 5 6 Consumer 70 42 58 142 59 68 Net Charge Offs: Consumer Real Estate (4 ) (3 ) (2 ) Agriculture Real Estate - - - Agricultural - (6 ) - Commercial Real Estate (3 ) (3 ) 6 Commercial and Industrial (65 ) (5 ) 159 Consumer 47 (4 ) 6 (25 ) (21 ) 169 Provision for loan loss 1,628 641 1,569 Acquisition provision for loan loss - - - Allowance for Loan & Lease Losses - June 30, 18,424 15,087 9,933 Allowance for Unfunded Loan Commitments & Letters of Credit - June 30, 1,167 1,145 605 Total Allowance for Credit Losses - June 30, $ 19,591 $ 16,232 $ 10,538 Ratio of Net Charge-offs to Average Outstanding Loans 0.00 % 0.00 % 0.01 % Ratio of Nonaccrual Loans to Loans 0.26 % 0.48 % 0.63 % Ratio of the Allowance for Loan & Lease Losses to Loans 0.91 % 1.03 % 0.74 % Ratio of the Allowance for Loan & Lease Losses to Nonaccrual Loans 351.44 % 214.58 % 117.24 % Ratio of the Allowance for Loan & Lease Losses to Nonperforming Loans* 351.44 % 214.58 % 117.24 % * Nonperforming loans are defined as all loans on nonaccrual, plus any loans 90 days past due not on nonaccrual. 62
-------------------------------------------------------------------------------- The Bank uses the following guidelines as stated in policy to determine when to realize a charge-off of a loan, whether partial loan balance or full loan balance. The Bank is also following the guidelines established under the CARES Act. A charge down in whole or in part is realized when unsecured consumer loans, credit card credits and overdraft lines of credit reach 90 days delinquency. At 120 days delinquent, secured consumer loans are charged down to the value of the collateral, if repossession of the collateral is assured and/or in the process of repossession. Consumer mortgage loan deficiencies are charged down upon the sale of the collateral or sooner upon the recognition of collateral deficiency. A broker's price opinion or appraisal will be completed on all home loans in litigation and any deficiency will be charged off before reaching 150 days delinquent. Commercial and agricultural credits are charged down/allocated at 120 days delinquency, unless an established and approved work-out plan is in place or litigation of the credit will likely result in recovery of the loan balance. Upon notification of bankruptcy, unsecured debt is charged off. Additional charge-offs may be realized as further unsecured positions are recognized. Loans classified as nonaccrual were lower as of
June 30, 2022at $5.2 millionas compared to $7.0 millionas of June 30, 2021. The consumer real estate portfolio decreased $68 thousandwhile the commercial real estate portfolio decreased $504 thousand. The agricultural real estate decreased $3.0 millionas compared to June 30, 2021while the agricultural portfolio increased $1.2 millionfor the same period of comparison. In determining the allocation for impaired loans, the Bank applies the appraised market value of the collateral securing the asset, reduced by applying a discount for estimated costs of collateral liquidation. In some instances where the discounted market value is less than the loan amount, a specific impairment allocation is assigned, which may be reduced or eliminated by the write down of the credit's active principal outstanding balance. For the majority of the Bank's impaired loans, including all collateral dependent loans, the Bank will apply the appraised market value methodology. However, the Bank may also utilize a measurement incorporating the present value of expected future cash flows discounted at the loan's effective rate of interest. To determine appraised market value, collateral asset values securing an impaired loan are periodically evaluated. Maximum time of re-evaluation is every 12 months for chattels and titled vehicles and every two years for real estate. In this process, third party evaluations are obtained and heavily relied upon. Until such time that updated appraisals are received, the Bank may discount the collateral value used.
The following table shows the allowance for loan loss balances by type of loan for the six months ended
(In Thousands) (In Thousands) June 30, 2022 June 30, 2021 % of Loan % of Loan Balance at End of Period Applicable To: Amount Category Amount Category Consumer Real Estate $ 939 20.17 % $ 649 13.34 % Agricultural Real Estate 346 9.81 % 1,217 12.99 % Agricultural 754 6.26 % 720 6.92 % Commercial Real Estate 10,427 48.04 % 8,831 47.29 % Commercial and Industrial 5,365 12.99 % 2,837 15.58 % Consumer 567 2.73 % 613 3.88 % Unallocated 26 0.00 % 220 0.00 % Allowance for Loan & Lease Losses 18,424 15,087 Off Balance Sheet Commitments 1,167 1,145 Total Allowance for Credit Losses
$ 19,591 $ 16,232Noninterest Income Noninterest income was down $707 thousandfor the second quarter 2022 over the same time frame in 2021. The Company has seen a decrease in its mortgage production volume and the gain on the sale of these loans was $791 thousandlower for the second quarter 2022 over the same period in 2021. Loan originations on loans held for sale for the second quarter 2022 were $20.9 millionwith proceeds from sale at $22.9 millionfor 2022 compared to 2021's second quarter activity of $29.5 millionin originations and $29.9 millionin sales. Loan originations driven by the refinance activity associated with the reduction in interest rates has slowed. The mortgages sold were both 1-4 family and agricultural real estate loans originated for sale. 63 -------------------------------------------------------------------------------- Combined service fees decreased by $84 thousandas compared to second quarter 2021. Debit card income increased by $95 thousandand bank owned life insurance cash surrender value increased $19 thousand. Also contributing to the increase was overdraft and returned check charges which increased $291 thousandcompared to first quarter 2021. Service fee income for 1-4 family and agricultural real estate loans increased by $30 thousandwhile servicing rights income decreased $501 thousand. The impact of mortgage servicing rights, both to income and expense, is shown in the following table which reconciles the value of mortgage servicing rights. The capitalization runs through noninterest income while the amortization thereof is included in non-interest expense. For the second quarter of 2022 and 2021, mortgage servicing rights caused a net $1 thousandin expense and $19 thousandin income, respectively. The lower capitalized additions for 2022 are attributed to a lower loan origination level of 1-4 families. A low interest rate environment has helped to generate the mortgage refinance activity. For loans of 15 years and less, the market value of the mortgage servicing rights was 0.970% in the second quarter 2022 versus 1.131% in second quarter 2021. For loans over 15 years, the value was 1.099% versus a higher 1.191% for the same periods respectively. The carrying value is greater than the market value of $3.4 million. A valuation allowance of $414 thousandwas established during 2021. During first quarter 2022, $134 thousandof the valuation allowance was reversed. An additional $91 thousandof the valuation allowance was reversed during the second quarter of 2022. Three Months Six Months (In Thousands) (In Thousands) 2022 2021 2022 2021 Beginning Balance $ 3,336 $ 3,444 $ 3,571 $ 3,320Capitalized Additions 149 226 354 855 Amortization (150 ) (207 ) (310 ) (712 ) Ending Balance, June 30, 3,335 3,463 3,615 3,463 Valuation Allowance 91 (317 ) (189 )
(317) Net mortgage service fees,
Noninterest Expense For the second quarter 2022, noninterest expenses were
$175 thousandhigher than for the same quarter in 2021. Salaries, wages, and employee benefits (includes normal merit increases, restricted stock expense, incentive payout and all employee benefits) increased $406 thousandin total. This was comprised of increased salaries of $775 thousandpartially offset by decreased benefits of $369 thousand. The second quarter of 2022 also saw the effects of the minimum living wage at $13.50per hour as compared to $12.50per hour for the second quarter in 2021. Consulting fees decreased $161 thousandduring the second quarter 2022 due to acquisition activity in 2021 of $292 thousandthat was not repeated in 2022. Legal fees decreased $183 thousand. Ohio Financial InstitutionTax increased $463 thousandover second quarter 2021 due to overall growth.. Data processing expenses also increased $226 thousand. Other general and administrative expenses increased $15 thousandas compared to second quarter 2021 primarily attributable to the Company's overall growth for the year.
The income tax expense was
Results overall, net income in the second quarter of 2022 was up
$3.3 millionas compared to the same quarter last year. Although second quarter 2022 included an increase of $987 thousandof loan loss provision as compared to second quarter 2021, net interest income after provision for loan losses increased $4.9 millionduring the same period of comparison. The Company has done an exceptional job of growing loans while keeping past dues low. The Company remains strong, stable, and well capitalized and has the capacity to continue to cover the increased costs of expansion. 64
Comparison of interest income and interest expense results for the six-month periods ended
Interest Income Higher loan balances of
$579.4 millioncreated an improvement in the interest income for the first six months of 2022 as compared to the first six months of 2021. PPP average loan balances decreased $46.9 millionyear over year. Interest income in total rose 33.6% or $11.5 millionwith interest income from loans accounting for $11.0 millionof the increase. Contributing to the overall improvement was also an increase in securities income of $493 thousandand an increase from fed funds sold and interest-bearing deposits of $50 thousandover 2021. The asset yield increased by 2 basis points to 3.63% for the first six months of 2022 compared to the first six months of 2021's 3.61%. PPP loan interest income recognized was $2.2 thousandfor the first six months of 2022 with net fee income of $77.2 thousandcompared to $234.7 thousandof loan interest income and $1.5 millionof net fee income for 2021. The growth factor contribution is shown in the charts which follow. The average interest earning asset base was $622.3 millionhigher in the first six months 2022 than the first six months of 2021, an increase of approximately 32.7%. Refer to Note 2 Business Combination and Asset Purchase for information on assets acquired from OFSI and PFSB. The yields on tax-exempt securities and the portion of the tax-exempt IDB loans included in loans have been tax adjusted based on a 21% tax rate in the charts to follow. (In Thousands) Year to Date Ended June 30, 2022 Annualized Yield/Rate Interest Earning Assets: Average Balance Interest/Dividends June 30, 2022 June 30, 2021 Loans $ 1,953,671 $ 42,843 4.39 % 4.64 % Taxable investment securities 426,189 2,639 1.24 % 1.22 % Tax-exempt investment securities 20,119 140 1.76 % 2.37 % Fed funds sold & other 124,050 188 0.30 % 0.17 % Total Interest Earning Assets $ 2,524,029 $ 45,810 3.63 % 3.61 % Change in Interest Income Year to Date June 30, 2022Compared to June 30, 2021(In Thousands) Change Due Change Due Interest Earning Assets: Total Change to Volume to Rate Loans $ 10,972 $ 13,442 $ (2,470 )Taxable investment securities 530 490 40 Tax-exempt investment securities (37 ) 14 (51 ) Fed funds sold & other 50 (33 ) 83 Total Interest Earning Assets $ 11,515 $ 13,913 $ (2,398 )Interest Expense Interest expense was higher for the first six months of 2022 compared to the first six months of 2021. At $4.2 million, the first six months of 2022 was up $881 thousandas compared to the same time period 2021 or 26.8%. The average balance of interest-bearing liabilities was higher by $504.1 millionin 2022 than the first six months of 2021. Interest bearing deposits increased $434.1 millionwhile Fed Funds purchased and securities sold under agreement to repurchase increased by a combined $2.1 million. Other borrowed money and subordinated notes increased $33.3 millionand $34.5 million, respectively as compared to a year ago. The higher balance coupled with the slight variation of the balance sheet mix, resulted in a 4 basis point decrease in the cost of funds at 0.44% for the first six months of 2022 as compared to 2021's 0.48%. Liabilities assumed from OFSI and PFSB can be seen in Note 2. 65
-------------------------------------------------------------------------------- The change chart below shows the increased cost was driven more by volume than rate. (In Thousands) Year to Date Ended June 30, 2022 Annualized Yield/Rate Interest Bearing Liabilities: Average Balance Interest June 30, 2022 June 30, 2021 Savings deposits $ 1,302,005 $ 1,365 0.21 % 0.21 % Other time deposits 447,471 1,374 0.61 % 1.20 % Other borrowed money 51,180 553 2.16 % 3.78 % Fed funds purchased & securities sold under agreement to repurchase 32,182 318 1.98 % 2.19 % Subordinated notes 34,495 553 3.12 % 0.00 % Total Interest Bearing Liabilities $ 1,867,333 $ 4,163 0.44 % 0.48 % Change in Interest Expense Year to Date
June 30, 2022Compared to June 30, 2021(In Thousands) Change Due Change Due Interest Bearing Liabilities: Total Change to Volume to Rate Savings deposits $ 225 $ 248 $ (23 )Other time deposits (102 ) 1,207 (1,309 ) Other borrowed money 216 629 (413 ) Fed funds purchased & securities sold under agreement to repurchase (11 ) 23 (34 ) Subordinated notes 553 553
Total interest-bearing liabilities $881
Overall, net interest spread figures for the first six months of 2022 were up from 2021 by 6 basis points and down 19 basis points from 2020. Net interest margin for the first six months of 2022 was higher than the same period of 2021 but lower than 2020. As the chart below illustrates, a slightly higher overall yield on interest earning assets aided by a lower overall cost of funds resulted in total net interest margin up 3 basis points since the first six months of 2021 and under the first six months of 2020 by 37 basis points. June 30, 2022 June 30, 2021 June 30, 2020 Interest/Dividend income/yield 3.63 % 3.61 % 4.44 % Interest Expense/cost 0.44 % 0.48 % 1.06 % Net Interest Spread 3.19 % 3.13 % 3.38 % Net Interest Margin 3.30 % 3.27 % 3.67 % Net Interest Income Net interest income was up
$10.6 millionin the first six months of 2022 over the same time frame in 2021 due to the higher interest income offset by the increase in interest expense as previously mentioned. As the new loans added in 2021 and 2022 generate more income, management expects the benefits of the Company's strategy of repositioning the balance sheet to continue to widen this margin as measured in dollars. In terms of net interest margin rate, the Bank recognizes competition for deposits may again increase and put pressure on the margin which may lead to a tightening.
Comparison of results of non-interest operating results for the six-month periods ended
Provision Expense Total provision for loan losses was
$133 thousandlower for the first six months 2022 than for the first six months 2021 attributable primarily to the lessened uncertainties associated with COVID-19 and its effects on the ability of individuals, businesses and other entities to meet their financial obligations. Therefore, it is prudent to incorporate the impact of COVID-19 in the evaluation of the adequacy of Allowance for Loan and Lease Losses (ALLL). The restaurant and hospitality sectors have been hit especially hard. Risk in the Consumer and 1-4 Family Portfolio has increased but the full impact remains unknown. Increases to the Bank's ALLL for the first six months of 2022, centered around current customers and businesses 66 -------------------------------------------------------------------------------- that are particularly vulnerable and qualitative factors were adjusted accordingly. Management continues to monitor asset quality, making adjustments to the provision as necessary. Loan charge-offs were $840 thousandlower in the first six months of 2022 compared to the same period 2021. Recoveries were $60 thousandhigher in the first six months of 2022 as compared to first six months of 2021. Combined net charge-offs were $900 thousandlower in the six months ended June 2022as compared to the same time period 2021. Management continues to evaluate the potential financial implications resulting from COVID-19 and adjusts ALLL qualitative factors as necessary. [ Remainder of this page intentionally left blank ] 67
-------------------------------------------------------------------------------- The following table breaks down the activity within the ALLL for each loan portfolio class and shows the contribution provided by both recoveries and the provision, along with the reduction of the allowance caused by charge-offs. The time period covered is for six months ended
June 30, 2021, 2020, and 2019. (In Thousands) Six Months Ended Six Months Ended Six Months Ended June 30, 2022 June 30, 2021 June 30, 2020 Loans, net of deferred fees and costs $ 2,034,818 $ 1,458,423 $ 1,344,723Daily average of outstanding loans $ 1,953,671 $ 1,374,302 $ 1,279,127Nonaccrual loans $ 5,247 $ 7,031 $ 8,473 Nonperforming loans* $ 5,247 $ 7,031 $ 8,473 Allowance for Loan Losses - January 1, $ 16,242 $ 13,672 $ 7,228 Loans Charged off: Consumer Real Estate - - 35 Agriculture Real Estate - - - Agricultural - 142 - Commercial Real Estate - - 8 Commercial and Industrial 6 809 165 Consumer 205 100 193 211 1,051 401 Loan Recoveries: Consumer Real Estate 9 6 5 Agriculture Real Estate - - - Agricultural - 6 - Commercial Real Estate 5 5 5 Commercial and Industrial 74 10 9 Consumer 97 98 88 185 125 107 Net Charge Offs: Consumer Real Estate (9 ) (6 ) 30 Agriculture Real Estate - - - Agricultural - 136 - Commercial Real Estate (5 ) (5 ) 3 Commercial and Industrial (68 ) 799 156 Consumer 108 2 105 26 926 294 Provision for loan loss 2,208 2,341 2,999 Acquisition provision for loan loss - - - Allowance for Loan & Lease Losses - June 30, 18,424 15,087 9,933 Allowance for Unfunded Loan Commitments & Letters of Credit - June 30, 1,167 1,145 605 Total Allowance for Credit Losses - June 30, $ 19,591 $ 16,232 $ 10,538 Ratio of Net Charge-offs to Average Outstanding Loans 0.00 % 0.07 % 0.02 % Ratio of Nonaccrual Loans to Loans 0.26 % 0.48 % 0.63 % Ratio of the Allowance for Loan & Lease Losses to Loans 0.91 % 1.03 % 0.74 % Ratio of the Allowance for Loan & Lease Losses to Nonaccrual Loans 351.44 % 214.58 % 117.24 % Ratio of the Allowance for Loan & Lease Losses to Nonperforming Loans* 351.44 % 214.58 % 117.24 % * Nonperforming loans are defined as all loans on nonaccrual, plus any loans 90 days past due not on nonaccrual. 68
Noninterest income for the first six months of 2022 decreased over the first six months of 2021 by
$1.4 million. Gain on sale of loans showed a $1.1 milliondecrease over the first six months of 2021. Combined service fees increased by $78 thousandwith increased debit card income of $95 thousandand bank owned life insurance cash surrender value increases of $19 thousand. Servicing rights income decreased by $501 thousand. Service charge income increased by $1 thousandwhile overdraft and returned check income increased by $291 thousand. The Company did sell some of its available-for-sale securities in the first six months of 2021 and recognized a gain of $293 thousandthat was not repeated in 2022. Noninterest Expense Through the first six months of 2022, noninterest expenses were $1.3 millionhigher than in the first six months of 2021. 2021 included $1.2 millionof third party acquisition related costs incurred with the Ossian and Perpetual transactions that were not repeated in 2022. The six months of 2022 included an increase of $1.9 millionin salaries and wages partially offset by a decrease of $309 thousandin employee benefits. Data processing fees were $325 thousandhigher than last year. Part of that increase was due to a credit for product upgrades in the amount of $100 thousandthat was received during the first six months of 2021 that was not repeated in 2022. Consulting fees decreased $206 thousanddue to acquisition activity in 2021 of $337 thousandthat was not repeated in 2022. FDICassessment expense decreased by $128 thousanddue to a decreased assessment rate that has offset an increased assessment base. Ohio Financial Institution Tax increased $435 thousandin the first six months of 2022 due to overall growth. General and administrative expenses increased $161 thousandover the first six months of 2021. Legal fees decreased $293 thousandover 2021 while loan and collection expense increased $114 thousand.
Income tax expense was
$1.6 millionhigher for the first six months of 2022 compared to the first six months of 2021. Effective tax rates were 19.64% and 19.39% for the first six months of 2022 and 2021 respectively. The slightly higher effective tax rate for the first six months of 2022 equaled an increase in income tax expense of $51 thousandwith the remainder driven from increased earnings. Net Income Overall, net income through the first six months of 2022 was up $6.5 millionas compared to the first six months of 2021. Increased interest income of $11.5 millionpartially offset by increased interest expense was the largest contributor to the increased net income for 2022. 69
Statements contained in this portion of the Company's report may be forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements may be identified by the use of words such as "intend," "believe," "expect," "anticipate," "should," "planned," "estimated," and "potential." Such forward-looking statements are based on current expectations, but actual results may differ materially from those currently anticipated due to a number of factors, which include, but are not limited to, factors discussed in documents filed by the Company with the
Securities and Exchange Commissionfrom time to time. Other factors which could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to, changes in interest rates, general economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasuryand the Federal Reserve Board, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Bank's market area, changes in relevant accounting principles and guidelines and other factors over which management has no control, including, but not limited to, the ongoing impact of the COVID-19 pandemic. The forward-looking statements are made as of the date of this report, and the Company assumes no obligation to update the forward-looking statements or to update the reasons why actual results differ from those projected in the forward-looking statements. 70
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