Hawthorn Bancshares, Inc.: Form 10-Q for the period ended Mar 31, 2024

Forward-Looking Statements

This report contains certain forward-looking statements with respect to the financial condition, results of operations, plans, objectives, strategy, future performance and business of Hawthorn Bancshares, Inc., and its subsidiaries (collectively, the "Company," "we," "our," or "us"), including, without limitation:

• statements that are not historical in nature, and
• statements preceded by, followed by or that include the words believes, expects, may, will, should, could, anticipates, estimates, intends, plans, hopes or similar expressions.

Forward-looking statements are not guarantees of future performance or results. They involve risks, uncertainties and assumptions. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:

• competitive pressures among financial services companies may increase significantly,
• changes in the interest rate environment may reduce interest margins,
• general economic conditions, either nationally or in Missouri, may be less favorable than expected and may adversely affect the quality of our loans and other assets,
• increases in non-performing assets in the Company’s loan portfolios and adverse economic conditions may necessitate increases to our provisions for credit losses,
• costs or difficulties related to any integration of any business of the Company and its acquisition targets may be greater than expected,
• legislative, regulatory or tax law changes may adversely affect the business in which the Company and its subsidiaries are engaged,
• credit and market risks relating to increasing inflation,
• economic or other disruptions caused by acts of terrorism, war or other conflicts, including the Russia-Ukraine conflict, and the Israel-Hamas conflict, natural disasters, such as hurricanes, freezes, flooding and other man-made disasters, such as oil spills or power outages, health emergencies, epidemics or pandemics, climate changes or other catastrophic events,
• changes may occur in the securities markets,
• changes in the level and direction of loan delinquencies and write-offs and changes in estimates of the adequacy of the allowance for credit losses, and
• technological changes, including potential cyber-security incidents and other disruptions, or innovations to the financial services industry, including as a result of the increased telework environment.

We have described additional factors that could cause actual results to be materially different from those described in the forward-looking statements under the caption Risk Factors in Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2023 (the "2023 Form 10-K"), and in other reports filed by us with the Securities and Exchange Commission ("SEC") from time to time. Other factors that have not been identified in this report could also have this effect. You are cautioned not to put undue reliance on any forward-looking statement, which speak only as of the date they were made. Except as required by law, the Company undertakes no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events, or changes in its business, results of operations or financial condition over time.

Overview

Crucial to the Company’s community banking strategy is growth in its commercial banking services, retail mortgage lending and retail banking services. Through the branch network of its subsidiary bank, Hawthorn Bank (the Bank), the Company, with $1.8 billion in assets at March 31, 2024, provides a broad range of commercial and personal banking services. The Bank’s specialties include commercial banking for small and mid-sized businesses, including equipment, operating, commercial real estate, Small Business Administration loans, and personal banking services including real estate mortgage lending, installment and consumer loans, certificates of deposit, individual retirement and other time deposit accounts, checking accounts, savings accounts, and money market accounts. Other financial services that the Company provides include trust services that include estate planning, investment and asset management services and a comprehensive suite of cash management services. The geographic areas in which the Company provides products and services include the Missouri communities in and surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, and the greater Kansas City metropolitan area.

The Company’s primary source of revenue is net interest income derived primarily from lending and deposit taking activities. Much of the Company’s business is commercial, commercial real estate development, and residential mortgage lending. The Company’s income from mortgage brokerage activities is directly dependent on mortgage rates and the level of home purchases and refinancing activity.

The success of the Company’s growth strategy depends primarily on the ability of the Bank to generate an increasing level of loans and deposits at acceptable risk levels and on acceptable terms without significant increases in non-interest expenses relative to revenues generated. The Company’s financial performance also depends, in part, on its ability to manage various portfolios and to successfully introduce additional financial products and services by expanding new and existing customer relationships, utilizing improved technology, and enhancing customer satisfaction. Furthermore, the success of the Company’s growth strategy depends on its ability to maintain sufficient regulatory capital levels during periods in which general economic conditions are unfavorable and despite economic conditions being beyond its control.

The Bank is a full-service bank that conducts a general banking business, offering its customers checking and savings accounts, debit cards, certificates of deposit, safety deposit boxes and a wide range of lending services, including commercial, financial and agricultural loans, residential real estate loans, single-payment personal loans, installment loans and credit card accounts. In addition, the Bank provides trust services.

The deposit accounts of the Bank are insured by the Federal Deposit Insurance Corporation ("FDIC") to the extent provided by law. The operations of the Bank are supervised and regulated by the FDIC and the Missouri Division of Finance. Periodic examinations of the Bank are conducted by representatives of the FDIC and the Missouri Division of Finance. Such regulations, supervision and examinations are principally for the benefit of depositors, rather than for the benefit of shareholders. The Company is subject to supervision and examination by the Board of Governors of the Federal Reserve System.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Certain accounting policies are considered most critical to the understanding of the Company’s financial condition and results of operations. These critical accounting policies and estimates require management’s most difficult, subjective and complex judgments about matters that are inherently uncertain. Because these estimates and judgments are based on current circumstances, they may change over time or prove to be inaccurate based on actual experiences. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of a materially different financial condition and/or results of operations could reasonably be expected. The Company has identified certain accounting policies as "critical accounting policies and estimates," consisting of those related to the allowance for credit losses, as described in the section captioned "Critical Accounting Policies and Estimates" incorporated by reference in Item 7, Management's Discussion and Analysis of Financial Condition and results of Operations included in the 2023 Form 10-K. There have been no changes in the Company's application of critical accounting policies and estimates since December 31, 2023.

Executive Summary

The Company has prepared all of the consolidated financial information in this report in accordance with United States (U.S.) generally accepted accounting principles ("U.S. GAAP") and the rules of the SEC. In preparing the consolidated financial statements in accordance with U.S. GAAP, the Company makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurances that actual results will not differ from those estimates.

(In thousands, except per share data)

(1) Efficiency ratio is calculated as non-interest expense as a percentage of revenue. Total revenue is calculated as net interest income plus non-interest income.

(Dollars in thousands, except per share data)

(1) Tier 1 leverage ratio is calculated by dividing Tier 1 capital by average total consolidated assets

Results of Operations Highlights:

Consolidated net income of $4.5 million, or $0.63 per diluted share, for the three months ended March 31, 2024 increased $1.2 million, or 36.2%, compared to $3.3 million, or $0.47 per diluted share, for the three months ended March 31, 2023. The results reflect the Company's focus to improve profitability from core businesses while managing expenses. For the three months ended March 31, 2024, the return on average assets was 0.97%, the return on average stockholders’ equity was 13.12%, and the efficiency ratio was 70.8%.

Net interest income of $14.7 million for the three months ended March 31, 2024 increased $0.8 million compared to $13.9 million for the three months ended March 31, 2023. Net interest margin, on a fully taxable equivalent basis ("FTE"), was 3.39% for the three months ended March 31, 2024, an increase from 3.16% for the three months ended March 31, 2023. The change to net interest margin on a fully taxable equivalent basis is discussed in greater detail under the Average Balance Sheet Data and Rate and Volume Analysis sections below.

Non-interest income of $3.0 million for the three months ended March 31, 2024 decreased $0.2 million, or 5.1%, compared to $3.2 million for the three months ended March 31, 2023. The decrease is primarily due to the sale of the mortgage servicing portfolio resulting in a decrease in real estate servicing fees and the gains on sales of real estate mortgages. These changes are discussed in greater detail under the Non-interest Income and Expense section below.

Non-interest expense for the three months ended March 31, 2024 was $12.6 million, an increase of $0.1 million, or 0.8%, from the three months ended March 31, 2023. The Company continues to establish a unified company culture and improving operational efficiencies. The Company began investing in new technologies and utilizing consulting and professional services to accomplish these goals. These changes are discussed in greater detail under the Non-interest Income and Expense section below.

Balance Sheet Highlights:

Cash and cash equivalents – Cash and cash equivalents decreased $50.0 million, or 53.5%, to $43.5 million as of March 31, 2024 compared to December 31, 2023 and increased $9.7 million, or 28.8%, from March 31, 2023. The Company elected to reposition its balance sheet during the fourth quarter of 2023 by selling $83.7 million in book value of investment securities, with an average yield of 1.57%, for an after-tax realized loss of $9.1 million. Proceeds from the sale of investments were reinvested into the securities portfolio and bank-owned life insurance during the first quarter of 2024. See the Liquidity Management section for further discussion.

Loans – Loans held for investment decreased $20.3 million, or 1.3%, to $1.5 billion as of March 31, 2024 as compared to December 31, 2023 and decreased $23.2 million, or 1.5%, from March 31, 2023.

Asset quality – Non-performing loans totaled $8.5 million at March 31, 2024, an increase from $6.4 million at December 31, 2023, and a decrease of $11.1 million from $19.6 million at March 31, 2023. The decrease in non-performing loans in the current quarter compared to the prior year quarter is primarily due to three large non-accrual loan relationships returning to accruing status. The allowance for credit losses to total loans was 1.56% at March 31, 2024, compared to 1.54% at December 31, 2023 and 1.43% at March 31, 2023. These changes are discussed in greater detail under the Lending and Credit Management section below.

Deposits – Total deposits at March 31, 2024 were $1.5 billion, a decrease of $43.0 million, or 2.7%, from December 31, 2023, and a decrease of $80.1 million, or 5.0%, from March 31, 2023. The decrease in deposits at March 31, 2024 as compared to December 31, 2023 and March 31, 2023 was primarily a result of the Company's strategy to reduce exposure to public funds. Also, the Company elected to discontinue the repurchase agreement product during 2023 and began migrating accounts to reciprocal deposit products within the Company's deposit mix.

Federal Home Loan Bank ("FHLB") advances and other borrowings – Total FHLB advances and other borrowings increased $2.0 million, or 1.9%, to $109.0 million as of March 31, 2024 compared to $107.0 million as of December 31, 2023, and increased $16.0 million, or 17.2%, compared to $93.0 million as of March 31, 2023.

Capital – The Company maintains its “well capitalized” regulatory capital position. At March 31, 2024, capital ratios were as follows: total risk-based capital to risk-weighted assets 13.92%; tier 1 capital to risk-weighted assets 12.51%; tier 1 leverage 10.71%; and common equity to assets 7.45%.

Average Balance Sheet Data

Net interest income is the largest source of revenue resulting from the Company’s lending, investing, borrowing, and deposit gathering activities. It is affected both by changes in the level of interest rates and changes in the amounts and mix of interest-earning assets and interest-bearing liabilities. The following table presents average balance sheet data, net interest income, average yields of earning assets, average costs of interest-bearing liabilities, net interest spread and net interest margin on a fully taxable equivalent basis for each of the three month periods ended March 31, 2024 and 2023, respectively. The average balances used in this table and other statistical data were calculated using average daily balances.

(Dollars in thousands)

(1) Interest income and yields are presented on a FTE basis using the federal statutory income tax rate of 21%, net of nondeductible interest expense, for the three months ended March 31, 2024 and 2023. Such adjustments totaled $0.2 million and $0.3 million for the three months ended March 31, 2024 and 2023, respectively.

(2) Non-accruing loans are included in the average amounts outstanding.

Rate and Volume Analysis

The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category of interest earning assets and interest-bearing liabilities, identifying changes related to volumes and rates for the three months ended March 31, 2024 compared to the three months ended March 31, 2023, respectively. The change in interest due to the combined rate/volume variance has been allocated to rate and volume changes in proportion to the absolute dollar amounts of change in each.

(in thousands)

(1) Interest income and yields are presented on a FTE basis using the federal statutory income tax rate of 21%, net of nondeductible interest expense, for the three months ended March 31, 2024 and 2023, respectively. Such adjustments totaled $0.2 million for the three months ended March 31, 2024 compared to $0.3 million for the three months ended March 31, 2023.

(2) Non-accruing loans are included in the average amounts outstanding.

Financial results for the three months ended March 31, 2024 compared to the three months ended March 31, 2023 reflected an increase in net interest income, on a fully taxable equivalent basis, of $0.7 million, or 4.7%. Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) increased to 3.39% for the three months ended March 31, 2024 compared to 3.16% for the three months ended March 31, 2023.

Interest income on a fully taxable equivalent basis increased $3.0 million for the three months ended March 31, 2024 compared to the three months ended March 31, 2023, while interest expense increased $2.3 million for the three months ended March 31, 2024, resulting in an increase in net interest income on a fully taxable equivalent basis.

Average interest-earning assets decreased $60.3 million, or 3.3%, to $1.77 billion for the three months ended March 31, 2024 compared to $1.83 billion for the three months ended March 31, 2023, and average interest-bearing liabilities decreased $20.5 million, or 1.5%, to $1.31 billion for the three months ended March 31, 2024 compared to $1.33 billion for the three months ended March 31, 2023.

Total interest income (expressed on a fully taxable equivalent basis) was $24.3 million for the three months ended March 31, 2024 compared to $21.3 million for the three months ended March 31, 2023. The Company’s rates earned on interest earning assets were 5.50% for the three months ended March 31, 2024 compared to 4.70% for the three months ended March 31, 2023.

Interest income on loans held for investment was $21.8 million for the three months ended March 31, 2024 compared to $18.9 million for the three months ended March 31, 2023.

Average loans outstanding remained consistent at $1.52 billion for both the three months ended March 31, 2024 and 2023. The average yield on loans increased to 5.75% for the three months ended March 31, 2024 compared to 5.03% for the three months ended March 31, 2023. See the Lending and Credit Management section for further discussion of changes in the composition of the lending portfolio.

Interest income on available-for-sale securities was $1.5 million for the three months ended March 31, 2024 compared to $1.7 million for the three months ended March 31, 2023.

Average securities decreased $70.5 million, or 27.6%, to $184.5 million for the three months ended March 31, 2024 compared to $255.0 million for the three months ended March 31, 2023. The average yield on securities increased to 3.22% for the three months ended March 31, 2024 compared to 2.73% for the three months ended March 31, 2023. The Company elected to reposition its balance sheet during the fourth quarter of 2023 by selling $83.7 million in book value of investment securities, with an average yield of 1.57%. See the Liquidity Management section for further discussion.

Total interest expense increased to $9.3 million for the three months ended March 31, 2024 compared to $7.0 million for the three months ended March 31, 2023. The Company’s rates paid on interest bearing liabilities were 2.85% for the three months ended March 31, 2024 compared to 2.13% for the three months ended March 31, 2023. See the Liquidity Management section for further discussion.

Interest expense on deposits increased to $7.5 million for the three months ended March 31, 2024 compared to $5.6 million for the three months ended March 31, 2023.

Average interest-bearing deposits decreased $29.6 million, or 2.5%, to $1.15 billion for the three months ended March 31, 2024 compared to $1.18 billion for the three months ended March 31, 2023. The average cost of deposits increased to 2.61% for the three months ended March 31, 2024 compared to 1.91% for the three months ended March 31, 2023.

Interest expense on borrowings increased to $1.8 million for the three months ended March 31, 2024 compared to $1.4 million for the three months ended March 31, 2023.

Average borrowings increased $9.1 million, or 6.0%, to $160.6 million for the three months ended March 31, 2024 compared to $151.5 million for the three months ended March 31, 2023. The average cost of borrowings increased to 4.61% for the three months ended March 31, 2024 compared to 3.84% for the three months ended March 31, 2023. The increase in cost of funds primarily resulted from higher market interest rates.

Non-interest Income and Expense

Non-interest income for the periods indicated was as follows:

(Dollars in thousands)

* Total revenue is calculated as net interest income plus non-interest income.

Total non-interest income decreased $0.2 million, or 5.1%, to $3.0 million for the three months ended March 31, 2024 compared to $3.2 million for the three months ended March 31, 2023.

Real estate servicing fees, net of the change in valuation of mortgage servicing rights (MSRs) decreased $0.2 million, or 98.4%, from the three months ended March 31, 2023. On January 31, 2024 the Company sold its servicing portfolio and the balance of the serviced loans transferred on April 30, 2024. At March 31, 2024, the balance of the servicing portfolio for loans sold to the secondary market was $215.2 million of mortgage loans at March 31, 2024 compared to $220.7 million and $235.2 million at December 31, 2023 and March 31, 2023, respectively.

Gain on sales of mortgage loans decreased to $0.3 million for the three months ended March 31, 2024 compared to $0.5 million for the three months ended March 31, 2023. The Company sold $15.1 million of loans for the three months ended March 31, 2024 compared to $20.2 million for the three months ended March 31, 2023.

Non-interest expense for the periods indicated was as follows:

(Dollars in thousands)

* Efficiency ratio is calculated as non-interest expense as a percent of revenue. Total revenue is calculated as net interest income plus non-interest income.

Total non-interest expense increased $0.1 million, or 0.8%, to $12.6 million for the three months ended March 31, 2024 compared to $12.5 million for the three months ended March 31, 2023.

Salaries decreased $0.2 million, or 4.3%, to $5.2 million for the three months ended March 31, 2024 compared to $5.5 million for the three months ended March 31, 2023. The decrease was primarily due to a planned reduction of full-time employees during the fourth quarter of 2023.

Processing, network, and bank card expense increased $0.2 million, or 18.4%, to $1.4 million for the three months ended March 31, 2024 compared to $1.2 million for the three months ended March 31, 2023. The increase was primarily a result of ATM and debit card interchange fees as well as increases in processing expense.

Legal, examination and professional fees increased $0.3 million, or 63.0%, to $0.8 million for the three months ended March 31, 2024 compared to $0.5 million for the three months ended March 31, 2023. The increase was primarily due to consulting, audit, and legal fees related to strategic planning initiatives. Included in this increase was a settlement agreement resulting from terminating a contract related to a digital account opening project canceled in the fourth quarter of 2023.

Loan expense decreased $0.2 million, or 54.8%, to $0.2 million for the three months ended March 31, 2024 compared to $0.4 million for the three months ended March 31, 2023. The decrease was primarily due to recognition of an adjustment to an unearned dealers reserve related to prior years' activity in the first quarter of 2023.

Income Taxes

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements was 17.8% for both the three months ended March 31, 2024 and 2023. The effective tax rate for each of the three months ended March 31, 2024 and 2023, is lower than the U.S. federal statutory rate of 21% primarily due to tax-free revenues.

Included in the effective tax rate is a $0.01 million benefit associated with a historic tax credit investment for each of the three months ended March 31, 2024 and 2023. The investment is expected to generate a $0.3 million tax benefit over the life of the project and is being recognized under the deferral method of accounting.

Lending and Credit Management

Interest earned on the loan portfolio is a primary source of interest income for the Company. Net loans represented 81.5% of total assets as of March 31, 2024 compared to 80.8% as of December 31, 2023.

Lending activities are conducted pursuant to an established loan policy approved by the Bank’s Board of Directors. The Bank’s credit review process is overseen by market loan committees with established loan approval limits. In addition, a senior loan committee reviews all credit relationships in aggregate over an established dollar amount. The senior loan committee meets weekly and is comprised of senior managers of the Bank.

Major classifications within the Company’s held-for-investment loan portfolio as of the dates indicated is as follows:

(Dollars in thousands)

The Company extends credit to its local community markets through traditional real estate mortgage products. The Company does not participate in credit extension to sub-prime residential real estate markets. The Company does not lend funds for transactions defined as “highly leveraged” by bank regulatory authorities or for foreign loans. Additionally, the Company does not have any concentrations of loans exceeding 10% of total loans that are not otherwise disclosed in the loan portfolio composition table. The Company does not have any interest-earning assets that would have been included in non-accrual, past due, or restructured loans if such assets were loans.

The Company generally does not retain long-term fixed rate residential mortgage loans in its portfolio. Fixed rate loans conforming to standards required by the secondary market are offered to qualified borrowers but are not funded until the Company has a non-recourse purchase commitment from the secondary market at a predetermined price. During the three months ended March 31, 2024, the Company sold approximately $15.1 million of loans to investors compared to $20.2 million for the three months ended March 31, 2023. On January 31, 2024 the Company sold its servicing portfolio and the balance of the serviced loans transferred on April 30, 2024. At March 31, 2024, the Company was servicing approximately $215.2 million of loans sold to the secondary market compared to $220.7 million at December 31, 2023, and $235.2 million at March 31, 2023.

Risk Elements of the Loan Portfolio

Management, internal loan review and the senior loan committee formally review all loans in excess of certain dollar amounts (periodically established) at least annually. Loans in excess of $2.0 million in the aggregate and all adversely classified credits identified by management are reviewed by the senior loan committee. In addition, all other loans are reviewed on a risk weighted selection process. The senior loan committee reviews and reports to the Board of Directors, at scheduled meetings: past due, classified, and watch list loans in order to classify or reclassify loans as loans requiring attention, special mention, substandard, doubtful, or loss. During this review, management will evaluate individual loans for expected credit losses when those loans do not share similar risk characteristics with loans evaluated using a collective (pooled) basis. If management determines that it is probable that all amounts due on a loan will not be collected under the original terms of the loan agreement, the loan is individually analyzed and in conjunction with current economic conditions and loss experience, reserves are estimated as further discussed below.

Loans not individually evaluated are aggregated and collectively analyzed. Management determined that segmenting loans not individually analyzed by the federal call report codes represents the most prudent way to consolidate loans by their associated risk qualities.

General reserves are recorded for collectively analyzed loans using a consistent methodology. Two different models are used for calculating the general reserve. The Discounted Cash Flow model considers quantitative peer group historic loss experience, forecasts over the estimated life of the loan pools, industry data, and qualitative or environmental factors, such as: lending policies and procedures; economic conditions; the nature, volume and terms of the portfolio; lending staff and management; past due loans; the loan review system; collateral values; concentrations of credit; and external factors. The Remaining Life model applies a long-term average loss rate calculated using peer data that is adjusted for qualitative or environmental factors such as those previously noted. The model used depends on the loan portfolio segment. Management believes, but there can be no assurance, that these procedures keep management informed of potential problem loans.

Non-Performing Assets

The following table summarizes non-performing assets at the dates indicated:

(Dollars in thousands)

(a) Non-performing loans include loans 90 days past due and accruing, non-accrual loans, and non-performing TDRs included in non-accrual loans and 90 days past due.

(b) Non-performing assets include non-performing loans and other real estate owned and repossessed assets.

Total non-performing assets were $10.5 million, or 0.69% of total loans, at March 31, 2024 compared to $8.2 million, or 0.53% of total loans, at December 31, 2023.

Total non-accrual loans at March 31, 2024 increased $1.7 million, or 26.5%, to $8.0 million compared to $6.3 million at December 31, 2023.

There were $0.6 million in loans past due 90 days and still accruing interest at March 31, 2024 compared to $0.1 million at December 31, 2023. Other real estate and repossessed assets were $1.9 million and $1.7 million at March 31, 2024 and December 31, 2023, respectively. There were no non-accrual loans added to other real estate owned and repossessed assets during either of the three months ended March 31, 2024 and 2023.

Provision and Allowance for Credit Losses on Loans and Liability for Unfunded Commitments

Allowance for Credit Losses

The following table is a summary of the allocation of the allowance for credit losses:

(Dollars in thousands)

The allowance for credit losses was $23.7 million, or 1.56%, of loans outstanding at March 31, 2024 compared to $23.7 million, or 1.54%, of loans outstanding at December 31, 2023. The ratio of the allowance for credit losses to non-performing loans was 276.93% at March 31, 2024, compared to 370.25% at December 31, 2023.

(Release of) Provision for Credit Losses

(In thousands)

The Company recognized a release of provision for credit losses of $0.2 million for the three months ended March 31, 2024, compared to a $0.7 million provision for credit losses for the three months ended March 31, 2023. The release of the provision expense was a result of a decrease in overall unfunded commitments and a reduction in pooled reserves on primarily commercial, residential construction and multifamily commitments.

The following table summarizes credit loss experience for the periods indicated:

(Dollars in thousands)

Net Loan (Charge-Offs) Recoveries

The Company’s net charge-offs were comparable at $0.1 million for both the three months ended March 31, 2024 and 2023.

Loans Held for Sale

The Company designates certain long-term fixed rate personal real estate loans as held for sale. These loans are initially measured at fair value under the fair value option election with subsequent changes in fair value recognized in mortgage banking income. The loans are primarily sold to Freddie Mac, Fannie Mae, and PennyMac and other various secondary market investors. At March 31, 2024, the carrying amount of these loans was $2.9 million compared to $3.9 million at December 31, 2023.

Liquidity and Capital Resources

Liquidity Management

The role of liquidity management is to ensure that funds are available to meet depositors’ withdrawal and borrowers’ credit demands while at the same time maximizing profitability. This is accomplished by balancing changes in demand for funds with changes in the supply of those funds. Liquidity to meet these demands is provided by maturing assets, short-term liquid assets that can be converted to cash and the ability to attract funds from external sources, principally depositors. Due to the nature of services offered by the Company, management prefers to focus on transaction accounts and full-service relationships with customers as the primary sources of funding.

The Company’s Asset/Liability Committee (ALCO), primarily made up of senior management, has direct oversight responsibility for the Company’s liquidity position and profile. A combination of daily, weekly, and monthly reports provided to management detail the following: internal liquidity metrics, composition and level of the liquid asset portfolio, timing differences in short-term cash flow obligations, available pricing and market access to the financial markets for capital, and exposure to contingent draws on the Company’s liquidity.

The Company has a number of sources of funds to meet liquidity needs on a daily basis. The Company’s most liquid assets are comprised of available-for-sale investment securities, not including other debt securities, federal funds sold, and excess reserves held at the Federal Reserve.

(in thousands)

The fair value of the available-for-sale investment portfolio was $183.5 million at March 31, 2024 and included an unrealized net loss of $30.0 million. The portfolio includes projected maturities and mortgage-backed securities pay-downs of approximately $3.1 million over the next twelve months, which offer resources to meet either new loan demand or reductions in the Company’s borrowings.

The Company pledges portions of its investment securities portfolio to secure public fund deposits, federal funds purchase lines, securities sold under agreements to repurchase, borrowing capacity at the Federal Reserve Bank, and for other purposes as required or permitted by law. At March 31, 2024 and December 31, 2023, the Company’s unpledged securities in the available-for-sale portfolio totaled approximately $92.0 million and $99.5 million, respectively.

Total investment securities pledged for these purposes were as follows:

(in thousands)

Liquidity is available from the Company’s base of core customer deposits, defined as demand, interest checking, savings, money market deposit accounts, and time deposits less than $250,000, less all brokered deposits under $250,000. At March 31, 2024, such deposits totaled $1.4 billion and represented 91.5% of the Company’s total deposits. These core deposits are normally less volatile and are often tied to other products of the Company through long lasting relationships.

Core deposits at March 31, 2024 and December 31, 2023 were as follows:

(in thousands)

Estimated uninsured deposits totaled $345.3 million, including $100.3 million of certificates of deposit, at March 31, 2024, compared to $387.1 million, including $108.1 million of certificates of deposit, at December 31, 2023. The Company had brokered deposits totaling $30.3 million and $0.2 million at March 31, 2024 and December 31, 2023, respectively.

Included in the uninsured deposits at March 31, 2024 and December 31, 2023 are public fund deposits greater than $250,000 which are collateralized by the Company totaling $96.1 million and $137.7 million, respectively.

Other components of liquidity are the level of borrowings from third-party sources and the availability of future credit. The Company’s outside borrowings are comprised of securities sold under agreements to repurchase, advances from the Federal Home Loan Bank (FHLB), and subordinated notes. Federal funds purchased are overnight borrowings obtained mainly from upstream correspondent banks with which the Company maintains approved credit lines. As of March 31, 2024, under agreements with these unaffiliated banks, the Bank may borrow up to $35.0 million in federal funds on an unsecured basis and $8.3 million on a secured basis. There were no federal funds purchased outstanding at March 31, 2024. The Company may periodically borrow additional short-term funds from the Federal Reserve Bank through the discount window, although no such borrowings were outstanding at March 31, 2024.

The Bank is a member of the FHLB and has access to credit products of the FHLB. As of March 31, 2024, the Bank had $109.0 million in outstanding borrowings with the FHLB. In addition, the Company has $49.5 million in outstanding subordinated notes issued to wholly-owned grantor trusts, funded by preferred securities issued by the trusts.

Borrowings outstanding at March 31, 2024 and December 31, 2023 were as follows:

(in thousands)

The Company pledges certain assets, including loans and investment securities to the Federal Reserve Bank, FHLB, and other correspondent banks as security to establish lines of credit and to borrow from these entities. Based on the type and value of collateral pledged, the FHLB establishes a collateral value from which the Company may draw advances against this collateral. This collateral is also used to enable the FHLB to issue letters of credit in favor of public fund depositors of the Company. The Federal Reserve Bank also establishes a collateral value of assets pledged to support borrowings from the discount window.

The following table reflects collateral value of assets pledged, borrowings, and letters of credit outstanding, in addition to the estimated future funding capacity available to the Company as follows:

(in thousands)

At March 31, 2024, loans of $696.8 million were pledged to the FHLB as collateral for borrowings and letters of credit. At March 31, 2024, investments with a market value of $8.9 million were pledged to secure federal funds purchase lines and borrowing capacity at the Federal Reserve Bank.

Based upon the above, management believes the Company has more than adequate liquidity, both on balance sheet and through the additional funding capacity with the FHLB, the Federal Reserve Bank and Federal funds purchased lines to meet future anticipated liquidity needs in both the short and long-term.

Sources and Uses of Funds

Cash and cash equivalents were $43.5 million at March 31, 2024 compared to $93.5 million at December 31, 2023. The $50.0 million decrease resulted from changes in the various cash flows produced by operating, investing, and financing activities of the Company, as shown in the accompanying consolidated statement of cash flows for the three months ended March 31, 2024. Cash flow provided by operating activities consists mainly of net income adjusted for certain non-cash items. Operating activities provided total cash of $5.6 million for the three months ended March 31, 2024.

Investing activities, consisting mainly of purchases, sales and maturities of available-for-sale securities, and changes in the level of the loan portfolio, used total cash of $13.0 million during the three months ended March 31, 2024. The cash flow primarily consisted of a $20.2 million net decrease in loans held for investment.

Financing activities used total cash of $42.6 million during the three months ended March 31, 2024, resulting primarily from a $66.3 million decrease in demand deposits and interest-bearing transaction accounts. These decreases were partially offset by a $23.4 million increase in time deposits.

In the normal course of business, the Company enters into certain forms of off-balance sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through the Company’s various risk management processes. Management considers both on-balance sheet and off-balance sheet transactions in its evaluation of the Company’s liquidity. The Company had $335.7 million in unused loan commitments and standby letters of credit as of March 31, 2024. Although the Company’s current liquidity resources are adequate to fund this commitment level, the nature of these commitments is such that the likelihood of such a funding demand is very low.

The Company is a legal entity, separate and distinct from the Bank, which must provide its own liquidity to meet its operating needs. The Company’s ongoing liquidity needs primarily include funding its operating expenses, paying cash dividends to its shareholders and, to a lesser extent, repurchasing its shares of common stock. The Company paid cash dividends to its shareholders totaling approximately $1.2 million during each of the three months ended March 31, 2024 and 2023. A large portion of the Company’s liquidity is obtained from the Bank in the form of dividends. The Bank declared and paid $5.0 million and $1.5 million in dividends to the Company during the three months ended March 31, 2024 and 2023, respectively. At March 31, 2024 and December 31, 2023, the Company had cash and cash equivalents totaling $8.9 million and $6.8 million, respectively. Subject to declaration by the Company's Board of Directors, the Company expects to continue paying quarterly cash dividends as a part of its current capital allocation strategy. Future dividends will be subject to the determination, declaration and discretion of the Company's Board of Directors and compliance with applicable regulatory capital requirements.

Pursuant to the Company's 2019 Repurchase Plan, management is given discretion to determine the number and pricing of the shares to be purchased under the plan by the Company from time to time, as well as the timing of any such purchases. The Company repurchased 20,995 common shares under the repurchase plan during the first quarter of 2024 at an average cost of $19.73 per share totaling $0.4 million. As of March 31, 2024, $4.6 million remains available for share repurchases pursuant to the plan. Repurchases under the plan may be effectuated in the open market, by block purchase, in privately negotiated transactions, or through other transactions managed by broker-dealers, or any combination thereof. No time limit was set for completion of share repurchases under the plan.

Capital Management

The Company and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification of the Company and the Bank are subject to qualitative judgments by the regulators about components, risk-weightings, and other factors.

The Basel III regulatory capital reforms adopted by U.S. federal regulatory authorities (the "Basel III Capital Rules"), among other things, (i) establish the capital measure called "Common Equity Tier 1" ("CET1"), (ii) specify that Tier 1 capital consists of CET1 and "Additional Tier 1 Capital" instruments meeting stated requirements, (iii) require that most deductions/adjustments to regulatory capital measures be made to CET1 and not to other components of capital and (iv) define the scope of the deductions/adjustments to the capital measures.

Additionally, the Basel III Capital Rules require that the Company maintain a 2.50% capital conservation buffer with respect to each of CET1, Tier 1 and total capital to risk-weighted assets, which provides for capital levels that exceed the minimum risk-based capital adequacy requirements. A financial institution with a conservation buffer of less than the required amount is subject to limitations on capital distributions, including dividend payments and stock repurchases, and certain discretionary bonus payments to executive officers.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of CET1, Tier 1 and total capital to risk-weighted assets, and of Tier 1 capital to average assets, each as defined in the regulations. Management believes, as of March 31, 2024, that the Company and the Bank meet all capital adequacy requirements to which they are subject.

Financial institutions are categorized as well capitalized or adequately capitalized, based on minimum total risk-based, Tier 1 risk-based, CET1 and Tier 1 leverage ratios. As shown in the table below, the Company’s capital ratios exceeded the regulatory definition of adequately capitalized as of March 31, 2024 and December 31, 2023. Based upon the information in its most recently filed call report, the Bank met the capital ratios necessary to be well-capitalized. The regulatory authorities can apply changes in classification of assets and such changes may retroactively subject the Company to changes in capital ratios. Any such change could reduce one or more capital ratios below well-capitalized status. In addition, a change may result in imposition of additional assessments by the FDIC or could result in regulatory actions that could have a material effect on our condition and results of operations. In addition, bank holding companies generally are required to maintain a Tier 1 leverage ratio of at least 4%.

Because the Bank had less than $15.0 billion in total consolidated assets as of December 31, 2009, the Company is allowed to continue its trust preferred securities, all of which were issued prior to May 19, 2010, as Tier 1 capital.

Under the Basel III Capital Rules, at March 31, 2024 and December 31, 2023, the Company met all capital adequacy requirements and had regulatory capital ratios in excess of the levels established for well-capitalized institutions, as shown in the following table as of the dates indicated:

(Dollars in thousands)

52

Asset/Liability and Interest Rate Risk

Management and the Board of Directors are responsible for managing interest rate risk and employing risk management policies that monitor and limit this exposure. Interest rate risk is measured using net interest income simulations and market value of portfolio equity analyses. These analyses use various assumptions, including the nature and timing of interest rate changes, yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, and reinvestment/replacement of asset and liability cash flows.

The principal objective of the Company’s asset and liability management function is to evaluate the interest rate risk within the balance sheet and pursue a controlled assumption of interest rate risk while maximizing earnings and preserving adequate levels of liquidity and capital. The asset and liability management function is under the guidance of the ALCO with direction from the Board of Directors. The ALCO meets quarterly to review the sensitivity of the Company’s assets and liabilities to interest rate changes and to discuss local and national market conditions. The ALCO also reviews the liquidity, capital, deposit mix, loan mix and investment positions of the Company.

Instantaneous parallel rate shift scenarios are modeled and utilized to evaluate risk and establish exposure limits for acceptable changes in net interest margin. These scenarios, known as rate shocks, simulate an instantaneous change in interest rates and use various assumptions, including, but not limited to, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment and replacement of asset and liability cash flows.

Management analyzes the economic value of equity as a secondary measure of interest rate risk. This is a complementary measure to net interest income where the calculated value is the result of the market value of assets less the market value of liabilities. The economic value of equity is a longer term view of interest rate risk because it measures the present value of the future cash flows. The impact of changes in interest rates on this calculation is analyzed for the risk to our future earnings and is used in conjunction with the analyses on net interest income.

The table below illustrates the impact of an immediate and sustained 200 and 100 basis point increase and a 200 and 100 basis point decrease in interest rates on net interest income based on the interest rate risk model at March 31, 2024 and December 31, 2023.

The change in the Company’s interest rate risk exposure from December 31, 2023 to March 31, 2024 was due to moderately higher rates on interest bearing assets projected to reprice in the next 12 months and projected repricing speeds on interest bearing assets and liabilities. In an immediate and sustained shock, interest bearing assets and liabilities are projected to reprice at relatively the same pace. In down rate scenarios, interest bearing assets are projected to reprice moderately faster than interest bearing liabilities providing slightly more net interest income in a falling rate market. Management believes the change in projected net interest income from interest rate shifts of up 200 bps and down 200 bps is an acceptable level of interest rate risk.

Many assumptions are used to calculate the impact of interest rate fluctuations. Actual results may be significantly different than our projections due to several factors, including the timing and frequency of rate changes, market conditions and the shape of the yield curve. The computations of interest rate risk shown above do not include actions that management may undertake to manage the risks in response to anticipated changes in interest rates and actual results may also differ due to any actions taken in response to the changing rates.

Effects of Inflation

The effects of inflation on financial institutions are different from the effects on other commercial enterprises since financial institutions make few significant capital or inventory expenditures, which are directly affected by changing prices. Because bank assets and liabilities are virtually all monetary in nature, inflation does not affect a financial institution as much as do changes in interest rates. The general level of inflation does underlie the general level of most interest rates, but interest rates do not increase at the rate of inflation as do prices of goods and services. Rather, interest rates react more to changes in the expected rate of inflation and to changes in monetary and fiscal policy.

Inflation does have an impact on the growth of total assets in the banking industry, often resulting in a need to increase capital at higher than normal rates to maintain an appropriate capital to asset ratio. In the opinion of management, inflation did not have a significant effect on the Company’s operations for the three months ended March 31, 2024.

Evaluation of Disclosure Controls and Procedures

Our Company’s management has evaluated, with the participation of our principal executive officer and principal financial officer, the effectiveness of our disclosure controls and procedures as defined in Rules 13a – 15(e) or 15d – 15(e) of the Securities Exchange Act of 1934 as of March 31, 2024. Based upon and as of the date of that evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were designed, and were effective, to provide reasonable assurance that information required to be disclosed in the reports we file and submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported as and when required. It should be noted that any system of disclosure controls and procedures, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met. In addition, the design of any system of disclosure controls and procedures is based in part upon assumptions about the likelihood of future events. Because of these and other inherent limitations of any such system, there can be no assurance that any design will always succeed in achieving its stated goals under all circumstances.

Changes in Internal Control Over Financial Reporting

There have been no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) or 15d-15(f) of the Securities Exchange Act of 1934) that occurred during the three months ended March 31, 2024 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

Impact of New Accounting Standards

Income Taxes. In December 2023, the FASB issued ASU No. 2023-09, Income Taxes (Topic 740): Improvements to Income Tax Disclosures. This ASU requires that public business entities on an annual basis (1) disclose specific categories in the rate reconciliation and (2) provide additional information for reconciling items that meet a quantitative threshold. The ASU requires that all entities disclose on an annual basis (1) the amount of income taxes paid, disaggregated by federal, state and foreign taxes and (2) the amount of income taxes paid disaggregated by individual jurisdictions in which income taxes paid is equal or greater than 5 percent of total income taxes paid. The ASU also requires that all entities disclose (1) income (loss) from continuing operations before income tax expense (or benefit) disaggregated between domestic or foreign and (2) income tax expense (or benefit) from continuing operations disaggregated by federal (national), state and foreign. This ASU is effective for public business entities for annual periods beginning after December 15, 2024. The Company does not expect adoption of the ASU to have a material effect on the Company's consolidated financial statements.

Segment disclosures. In November 2023, the FASB issued ASU 2023-07, Segment Reporting (Topic 280): Improvements to Reportable Segment Disclosures which requires enhanced disclosures on both an annual and interim basis about significant segment expenses, including for companies with only one reportable segment. This ASU is effective on a retrospective basis for fiscal years beginning after December 15, 2023, and interim periods within fiscal years beginning after December 15, 2024. The Company is evaluating the impact the adoption of this ASU will have on its consolidated financial statements and related disclosures.

There have been no material changes in the risk factors previously disclosed under Part I, Item 1A of the Company's Annual Report on Form 10-K for the year ended December 31, 2023.