Eagle Financial Services Inc: Form 10-Q/A for the period ended Mar 31, 2024

The purpose of this discussion is to focus on the important factors affecting the Company’s financial condition, results of operations, liquidity and capital resources. This discussion should be read in conjunction with the Company’s Consolidated Financial Statements and the Notes to the Consolidated Financial Statements presented in Part I, Item 1, Financial Statements, of this Form 10-Q and Part II, Item 8, Financial Statements and Supplementary Data, of the 2023 Form 10-K.

GENERAL

Eagle Financial Services, Inc. is a bank holding company which owns 100% of the stock of Bank of Clarke (the “Bank” and, collectively with Eagle Financial Services, Inc., the “Company”, “we”, “us” or “our”). Accordingly, the results of operations for the Company are dependent upon the operations of the Bank. The Bank conducts a commercial banking business which consists of attracting deposits from the general public and investing those funds in commercial, consumer and real estate loans and municipal and U.S. government agency securities. The Bank’s deposits are insured by the Federal Deposit Insurance Corporation to the maximum extent permitted by law. At March 31, 2024, the Company had total assets of $1.78 billion, net loans of $1.42 billion, total deposits of $1.47 billion, and shareholders’ equity of $107.8 million. The Company’s net income was $2.5 million for the three months ended March 31, 2024.

MANAGEMENT’S STRATEGY

The Company strives to be an outstanding financial institution in its market by building solid sustainable relationships with: (1) its customers, by providing highly personalized customer service, a network of conveniently placed branches and ATMs, a competitive variety of products/services and courteous, professional employees, (2) its employees, by providing generous benefits, a positive work environment, advancement opportunities and incentives to exceed expectations, (3) its communities, by participating in local concerns, providing monetary support, supporting employee volunteerism and providing employment opportunities, and (4) its shareholders, by providing sound profits and returns, sustainable growth, regular dividends and committing to its local, independent status.

OPERATING STRATEGY

The Bank is a locally owned and managed financial institution. This allows the Bank to be flexible and responsive in the products and services it offers. The Bank grows primarily by lending funds to local residents and businesses at a competitive price that reflects the inherent risk of lending. The Bank attempts to fund these loans through deposits gathered from local residents and businesses. The Bank prices its deposits by comparing alternative sources of funds and selecting the lowest cost available. When deposits are not adequate to fund asset growth, the Bank relies on borrowings, both short and long term. The Bank’s primary source of borrowed funds is the Federal Home Loan Bank of Atlanta which offers numerous terms and rate structures to the Bank.

As interest rates change, the Bank attempts to maintain its net interest margin by changing the price, terms, and mix of its financial assets and liabilities. The Bank also earns fees on services provided through its trust department, sales of investments, secondary market mortgage activities, and deposit operations. The Bank also incurs noninterest expenses such as compensating employees, maintaining and acquiring fixed assets, and purchasing goods and services necessary to support its daily operations.

The Bank has a marketing department which seeks to develop new business. This is accomplished through an ongoing calling program whereby account officers visit with existing and potential customers to discuss the products and services offered. The Bank also utilizes traditional advertising such as television commercials, radio ads, newspaper ads, and billboards.

LENDING POLICIES

Administration and supervision over the lending process is provided by the Bank’s Credit Administration Department. The principal risk associated with the Bank’s loan portfolio is the creditworthiness of its borrowers. In an effort to manage this risk, the Bank’s policy gives loan amount approval limits to individual loan officers based on their position and level of experience. Credit risk is increased or decreased, depending on the type of loan and prevailing economic conditions. In consideration of the different types of loans in the portfolio, the risk associated with real estate mortgage loans, commercial loans and consumer loans varies based on employment levels, consumer confidence, fluctuations in the value of real estate and other conditions that affect the ability of borrowers to repay debt.

The Company has written policies and procedures to help manage credit risk. The Company utilizes a loan review process that includes formulation of portfolio management strategy, guidelines for underwriting standards and risk assessment, procedures for ongoing identification and management of credit deterioration, and regular portfolio reviews to establish loss exposure and to ascertain compliance with the Company’s policies.

The Bank uses a tiered approach to approve credit requests consisting of individual lending authorities, joint approval of Co-Approval officers (Executive, Regional Credit Officer, Small Business Credit Officer), and a director loan committee. Lending limits for individuals are set by the Board of Directors and are determined by loan purpose, collateral type, and internal risk rating of the borrower. The highest individual authority (Executive) is assigned to the Bank’s President/ Chief Executive Officer, Chief Banking Officer and Chief Credit Officer (approval authority only). Two Executive officers may combine their authority to approve loan requests to borrowers with credit exposure up to $10.0 million on a secured basis and $6.0 million unsecured. Three Executive officers may combine to approve loan requests to borrowers with credit exposure up to $15.0 million on a secured basis and $9.0 million unsecured. Consumer Central Lenders can co-approve consumer, home equity lines of credit and home equity loan requests up to their stated authorities. Officers in Categories A through F have lesser authorities and with approval of an Executive officer may extend loans to borrowers with exposure of $5.0 million on a secured basis and $3.0 million unsecured. Officers in Categories A through F can also utilize the co-approval of the Regional and Small Business Credit Officers to extend loans with exposures up to $2.5 million and $1.5 million respectively on a secured basis, and up to $1 million and $750 thousand respectively on an unsecured basis. Loans exceeding $15.0 million and up to the Bank’s legal lending limit can be approved by the Risk Committee consisting of four directors (three directors constituting a quorum). The Director’s Loan Committee also reviews and approves changes to the Bank’s Loan Policy as presented by management.

The following sections discuss the major loan categories within the total loan portfolio:

One-to-Four-Family Residential Real Estate Lending

Residential lending activity may be generated by the Bank’s loan officer solicitations, referrals by real estate professionals, and existing or new bank customers. Loan applications are taken by a Bank loan officer. As part of the application process, information is gathered concerning income, employment and credit history of the applicant. The valuation of residential collateral is provided by independent fee appraisers who have been approved by the Bank’s Directors Loan Committee. In connection with residential real estate loans, the Bank requires title insurance, hazard insurance and, if applicable, flood insurance. In addition to traditional residential mortgage loans secured by a first or junior lien on the property, the Bank offers home equity lines of credit.

Commercial Real Estate Lending

Commercial real estate loans are secured by various types of commercial real estate in the Bank’s market area, including multi-family residential buildings, commercial buildings and offices, small shopping centers and churches. Commercial real estate loan originations are obtained through broker referrals, direct solicitation of developers and continued business from customers. In its underwriting of commercial real estate, the Bank’s loan to original appraised value ratio is generally 80% or less. Commercial real estate lending entails significant additional risk as compared with residential mortgage lending. Commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the repayment of loans secured by income producing properties is typically dependent on the successful operation of a business or a real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or the economy, in general. The Bank’s commercial real estate loan underwriting criteria require an examination of debt service coverage ratios, the borrower’s creditworthiness, prior credit history and reputation, and the Bank typically requires personal guarantees or endorsements of the borrowers’ principal owners.

Construction and Land Development Lending

The Bank makes local construction loans, primarily residential, and land acquisition and development loans. The construction loans are secured by residential houses under construction and the underlying land for which the loan was obtained. The average life of most construction loans is less than one year and the Bank offers both fixed and variable rate interest structures. The interest rate structure offered to customers depends on the total amount of these loans outstanding and the impact of the interest rate structure on the Bank’s overall interest rate risk. There are two characteristics of construction lending which impact its overall risk as compared to residential mortgage lending. First, there is more concentration risk due to the extension of a large loan balance through several lines of credit to a single developer or contractor. Second, there is more collateral risk due to the fact that loan funds are provided to the borrower based upon the estimated value of the collateral after completion. This could cause an inaccurate estimate of the amount needed to complete construction or an excessive loan-to-value ratio. To mitigate the risks associated with construction lending, the Bank generally limits loan amounts to 80% of the estimated appraised value of the finished construction project. The Bank also obtains a first lien on the property as security for its construction loans and typically requires personal guarantees from the borrower’s principal owners. Finally, the Bank performs inspections of the construction projects to ensure that the percentage of construction completed correlates with the amount of draws on the construction line of credit.

Commercial and Industrial Lending

Commercial business loans generally have more risk than residential mortgage loans, but have higher yields. To manage these risks, the Bank generally obtains appropriate collateral and personal guarantees from the borrower’s principal owners and monitors the financial condition of its business borrowers. Residential mortgage loans generally are made on the basis of the borrower’s ability to make repayment from employment and other income and are secured by real estate whose value tends to be readily ascertainable. In contrast, commercial business loans typically are made on the basis of the borrower’s ability to make repayment from cash flow from its business and are secured by business assets, such as commercial real estate, accounts receivable, equipment and inventory. As a result, the availability of funds for the repayment of commercial business loans is substantially dependent on the success of the business itself. Furthermore, the collateral for commercial business loans may depreciate over time and generally cannot be appraised with as much precision as residential real estate.

Consumer Lending

The Bank offers various secured and unsecured consumer loans, which include personal installment loans, personal lines of credit, automobile loans, and credit card loans. The Bank originates its consumer loans within its geographic market area and these loans are generally made to customers with whom the Bank has an existing relationship. Consumer loans generally entail greater risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured or secured by rapidly depreciable assets such as automobiles. In such cases, any repossessed collateral on a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

The underwriting standards employed by the Bank for consumer loans include a determination of the applicant’s payment history on other debts and an assessment of ability to meet existing obligations and payments on the proposed loan. The stability of the applicant’s monthly income may be determined by verification of gross monthly income from primary employment, and from any verifiable secondary income. Although creditworthiness of the applicant is the primary consideration, the underwriting process also includes an analysis of the value of the security in relation to the proposed loan amount.

Marine Lending

The Bank’s marine loan portfolio is comprised of originated retail loans. In August 2023, the Company completed a sale of specific assets from its marine lending segment and reduced its workforce associated with the marine lending division, as it expects to cease accepting new marine lending business. As part of the sale, the Company sold its interest in marine vessel floor plan loans, its rights to service loans that had been sold to secondary market investors prior to the date of sale, and other assets that were not individually significant. Subsequent to the sale the Company retained ownership of its portfolio of marine vessel retail loans, which continue to constitute a significant portion of the Company's assets, revenues, and earnings. At present, the Company expects to hold the retained outstanding loans until they are ultimately repaid. Retail loans were generally limited to premium manufacturers with established relationships with the Company which have a vested interest in the secondary market pricing of their respective brand due to the limited inventory available for resale. Consequently, while not contractually committed, manufacturers will often support secondary resale values which can have the effect of reducing losses from non-performing retail marine loans. Retail borrowers generally have very high credit scores, substantial down payments, substantial net worth, personal liquidity, and excess cash flow.

CRITICAL ACCOUNTING POLICIES

The financial statements of the Company are prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The financial information contained within these statements is, to a significant extent, based on measurements of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained when earning income, recognizing an expense, recovering an asset or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of the transactions would be the same, the timing of events that would impact the transactions could change.

Allowance for Credit Losses on Loans

The Company establishes the allowance for credit losses through charges to earnings in the form of a provision for credit losses. Loan losses are charged against the allowance for credit losses for the difference between the carrying value of the loan and the estimated net realizable value or fair value of the collateral, if collateral dependent, when management believes that the collectability of the principal is unlikely. Subsequent recoveries, if any, are credited to the allowance. The allowance represents management’s current estimate of expected credit losses over the contractual term of loans held for investment, and is recorded at an amount that, in management’s judgment, reduces the recorded investment in loans to the net amount expected to be collected. Management’s judgment in determining the level of the allowance is based on evaluations of historical loan losses, current conditions and reasonable and supportable forecasts relevant to the collectability of loans. The measurement of the allowance for credit losses is based in part on forecasts of unemployment, inflation, as well as the consumer price index, and may also consider other factors, which we believe to be indicative of risk factors related to collectability. Management also assesses the risk of credit losses arising from changes in economic conditions; the nature and volume of the loan portfolio; the volume and severity of delinquencies and adversely classified loan balances; lending policy and procedures; credit administration and lending staff; loan review; concentrations of credit and the value of underlying collateral in determining the recorded balance of the allowance for credit losses. This evaluation is inherently subjective because it requires estimates that are susceptible to significant revision as more information becomes available. In evaluating the level of the allowance, we consider a range of possible assumptions and outcomes related to the various factors identified above. Refer to the 2023 Form 10-K for additional detail concerning the determination of the allowance for credit losses on loans.

FORWARD LOOKING STATEMENTS

The Company makes forward looking statements in this report that are subject to risks and uncertainties. These forward looking statements include statements regarding our expectations, intentions or objectives concerning our profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals. The words “believes,” “expects,” “may,” “will,” “should,” "could," “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or other similar words or terms are intended to identify forward looking statements. These forward looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:

• difficult market conditions in our industry;
• effects of soundness of other financial institutions;
• potential impact on us of existing and future legislation and regulations;
• the ability to successfully manage growth or implement growth strategies if the Bank is unable to identify attractive markets, locations or opportunities to expand in the future or if the Bank is unable to successfully integrate new branches, business lines or other growth opportunities into its existing operations;
• competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;
• the successful management of interest rate risk;
• risks inherent in making loans such as repayment risks and fluctuating collateral values;
• changes in general economic and business conditions in the Bank’s market area;
• reliance on the Bank’s management team, including the ability to attract and retain key personnel;
• changes in interest rates and interest rate policies;
• maintaining capital levels adequate to support growth;
• maintaining cost controls and asset qualities as new branches are opened or acquired;
• demand, development and acceptance of new products and services;
• deposit flows;
• the cost and availability of secondary funding sources;
• problems with technology utilized by the Bank;
• changing trends in customer profiles and behavior;
• geopolitical conditions, including acts or threats of terrorism, international hostilities, or actions taken by the U.S. or other governments in response to acts or threats of terrorism and/or military conflicts, which could impact business and economic conditions in the U.S. and abroad;
• the Company's potential exposure to fraud, negligence, computer theft, and cyber-crime;
• changes in accounting policies and banking and other law and regulations; and
• other factors described in Item 1A., "Risk Factors," in the Company's 2023 Form 10-K.

Because of these uncertainties, actual future results may be materially different from the results indicated by these forward looking statements. In addition, past results of operations do not necessarily indicate future results.

RESULTS OF OPERATIONS

Net Income

Net income for the three months ended March 31, 2024 was $2.5 million, a decrease of 1.43%, or $37 thousand, when compared to the same period in 2023. Earnings per share, basic and diluted were $0.72 and $0.73 for the three months ended March 31, 2024 and 2023, respectively.

Return on average assets ("ROA") measures how efficiently the Company uses its assets to produce net income. Some issues reflected within this efficiency include the Company’s asset mix, funding sources, pricing, fee generation, and cost control. The ROA of the Company, on an annualized basis, for the three months ended March 31, 2024 and 2023 was 0.57% and 0.63%, respectively.

Return on average equity ("ROE") measures the utilization of shareholders’ equity in generating net income. This measurement is affected by the same factors as ROA with consideration to how much of the Company’s assets are funded by shareholders. The ROE of the Company, on an annualized basis, for the three months ended March 31, 2024 and 2023 was 9.41% and 10.14%, respectively.

Net Interest Income

Net interest income is our primary source of revenue, representing the difference between interest and fees earned on interest-earning assets and the interest paid on deposits and other interest-bearing liabilities. The level of net interest income is impacted primarily by variations in the volume and mix of these assets and liabilities, as well as changes in interest rates. Net interest income was $12.4 million and $12.6 million for the three months ended March 31, 2024 and 2023, respectively, which represents a decrease of $220 thousand, or 1.74%. Net interest income decreased due to the impact of the rising interest rate environment throughout 2023 as the increase in average rates paid outpaced the increase in average rates earned. The Company's net interest spread and net interest margin decreased 38 basis points and 27 basis points, respectively, for the three months ended March 31, 2024 compared to three months ended March 31, 2023.

Total interest and dividend income was $21.9 million and $18.6 million for the three months ended March 31, 2024 and 2023, respectively, which represents an increase of $3.3 million, or 18.07%. The increase in interest income was driven by an increase in the average balance of the loan portfolio along with the rise in interest rates over the past 15 months. Average interest-earning assets increased $97.5 million, or 6.20%, when comparing the three months ended March 31, 2023 to the three months ended March 31, 2024, while the average yield on earning-assets increased by 49 basis points over the same period.

Total interest expense was $9.5 million and $5.9 million for the three months ended March 31, 2024 and 2023, respectively, which represents an increase of $3.6 million, or 61.62%. The interest rate environment, coupled with the growth of higher-paying deposit accounts, have been the main drivers for the increase in interest expense. Interest expense on deposit accounts increased $4.0 million, or 114.63%, during the three months ended March 31, 2024, of which $3.0 million was attributable to time deposits. During the three months ended March 31, 2024 and 2023 the average balance of interest-bearing deposits was $1.05 billion and $867.0 million, respectively. The $4.0 million increase in deposit interest expense was slightly offset by a decrease in interest expense on Federal Home Loan Bank advances. The average balance of Federal Home Loan Bank advances was $145.9 million and $169.7 million with an average rate of 4.72% and 4.85% during the three months ended March 31, 2024 and 2023, respectively.

The net interest margin was 3.00% and 3.27% for the three months ended March 31, 2024 and 2023, respectively. Tax-equivalent net interest income is calculated by adding the tax benefit on certain securities and loans, whose interest is tax-exempt, to total interest income then subtracting total interest expense. The tax rate used to calculate the tax benefit was 21% for 2024 and 2023.

Net interest margin has primarily declined due to deposit pricing pressure as interest rates increased throughout 2023 and competition for new deposits was experienced. If these factors persist, net interest margin may experience further downward pressure and may also result in the Company having to borrow additional wholesale funding to fund asset growth, which is more expensive than deposits.

The following table shows interest income on earning assets and related average yields as well as interest expense on interest-bearing liabilities and related average rates paid for the three months ended March 31, 2024 and 2023 (dollars in thousands):

(1) Income and yields are reported on a tax-equivalent basis using a federal tax rate of 21%.

(2) Annualized.

The following table reconciles tax-equivalent net interest income, which is not a measurement under GAAP, to net interest income.

(in thousands)

(1) Tax benefit was calculated using the federal statutory tax rate of 21%.

The tax-equivalent yield on earning assets increased from 4.79% to 5.28% for the three months ended March 31, 2024 compared to the same three month period in 2023 . For those same time periods, the tax-equivalent yield on securities increased 29 basis points. The tax equivalent yield on loans increased 44 basis points from 5.10% for the three months ended March 31, 2023 to 5.54% for the same time period in 2024. The increase in the tax-equivalent yield on earning assets for the three months ended March 31, 2024 resulted mostly from the increase in the tax-equivalent yield on loans. The increase in the yield on loans as compared to the corresponding period in 2023 was primarily due to the rising interest rate environment over the past 15 months.

The average rate on interest-bearing liabilities increased from 2.23% to 3.10% for the three months ended March 31, 2024 compared to the same three month period in 2023. The average rate on interest-bearing deposits increased 121 basis points during the period, driven by the increase in time deposits. The interest rate environment, along with the growth of higher-cost deposit accounts, have been the main drivers for the increased in the average rate on interest bearing deposits.

Provision for Credit Losses

The provision for credit losses is based upon management’s estimate of the amount required to maintain an adequate allowance for credit losses as discussed within the Critical Accounting Policies section above and in Note 1 of our interim financial information. The Company's calculation of the provision for credit losses consists of changes in the allowance for credit losses on loans and the reserve for unfunded loan commitments. The allowance for credit losses on loans represents management’s current estimate of expected credit losses over the contractual term of loans held for investment, and is recorded at an amount that, in management’s judgment, reduces the recorded investment in loans to the net amount expected to be collected. Management’s judgment in determining the level of the allowance is based on evaluations of historical loan losses, current conditions and reasonable and supportable forecasts relevant to the collectability of loans. This evaluation is inherently subjective because it requires estimates that are susceptible to significant revision as more information becomes available. The amount of provision for credit losses on loans is affected by several factors including the growth rate of loans, net charge-offs (recoveries), and the estimated amount of expected losses within the loan portfolio. The provision for credit losses for the three months ended March 31, 2024 and 2023 was $475 thousand and $664 thousand, respectively. The provision for credit losses for the three months ended March 31, 2024 resulted mostly from net credit losses charged to the allowance as the composition of the portfolio was substantially the same as the prior measurement period.

Noninterest Income

Total noninterest income was $3.5 million for each of the three months ended March 31, 2024 and 2023. Management reviews the activities which generate noninterest income on an ongoing basis. The following table provides the components of noninterest income for the three months ended March 31, 2024 and 2023, which are included within the respective Consolidated Statements of Income headings. Variances that the Company believes require explanation are discussed below the table.

(dollars in thousands)

Wealth management fee income increased from 2023 to 2024. Wealth management fee income is comprised of income from fiduciary activities as well as commissions from the sale of non-deposit investment products. The amount of income from fiduciary activities is determined by the number of active accounts and total assets under management. Total assets under management have seen an increase during the three months ended March 31, 2024 when compared to the three months ended March 31, 2023 as a result of new business efforts. Fee increases and one-time fees for estates and other services have also contributed to the year over year increases in revenue.

Other service charges and fees decreased during the three months ended March 31, 2024 when compared to the same period in 2023. This decrease can be attributed to lower loan servicing income as a result of the Company's August 2023 sale of certain marine finance division assets, including rights to service loans that had been sold to secondary market investors prior to the date of sale. The Company's portfolio of loans serviced for others was $7.6 million and $252.5 million at March 31, 2024 and 2023, respectively.

Gain on sale of loans decreased during the three months ended March 31, 2024 when compared to the same period in 2023. During the first quarter of 2024, the Company sold $10.9 million in mortgage loans on the secondary market. There were no sales of SBA commercial loans or marine loans during the first quarter of 2024. During the first quarter of 202,3 the Company sold $2.1 million in mortgage loans on the secondary market, $2.1 million in SBA commercial loans and $23.6 million of marine loans. These loan sales resulted in gains of $161 thousand and $456 thousand during the three months ended March 31, 2024 and 2023, respectively.

Bank owned life insurance ("BOLI") fee income increased during the three months ended March 31, 2024 when compared to the same period in 2023 as a result of an investment of $5 million into BOLI by the Company during the fourth quarter of 2023.

Other operating income decreased for the three months ended March 31, 2024 when compared to the same periods in 2023. This decrease can be mainly attributed to cash distributions received during the three months of 2023 from our investment in Bankers Insurance, that were not received during the three months of 2024.

Noninterest Expenses

Total noninterest expenses decreased $9 thousand, or 0.1% for the three months ended March 31, 2024 compared to the same period in 2023. The following table presents the components of noninterest expense for the three months ended March 31, 2024 and 2023, which are included within the respective Consolidated Statements of Income headings. Variances that the Company believes require explanation are discussed below the table.

(dollars in thousands)

NM - Not Meaningful

On August 23, 2023, the Company completed a sale of specific assets from its marine lending segment. As part of the sale, the Company sold its interest in marine vessel floor plan loans totaling $52.8 million, its rights to service loans that had been sold to secondary market investors prior to the date of sale (valued at $595 thousand on balance sheet prior to sale), and other assets that were not individually significant. The Company received total consideration, net of selling expenses, of $53.5 million and recognized a gain of $435 thousand. The assets sold as well as their related revenues and contribution to earnings did not constitute a significant portion of the Company's assets or operating results for the year ended December 31, 2023. As part of the sale, the Company reduced its workforce associated with the marine lending division, as it expects to cease accepting new marine lending business. Subsequent to the sale of these assets, the Company retained ownership of approximately $260.5 million of marine vessel retail loans which continue to constitute a significant portion of the Company's assets, revenues, and earnings. At present, the Company expects to hold the retained outstanding loans until they are ultimately repaid. Subsequent to the sale, non-interest expenses related to marine lending have been significantly reduced or eliminated as discussed in variance explanation paragraphs below.

Salaries and employee benefits decreased during the three months ended March 31, 2024 over 2023, largely reflecting decreases in salaries and incentive expenses while experiencing increases in employee benefits and commission expenses. The Company's number of full-time equivalent employees ("FTE's") has decreased from 253 at March 31, 2023 to 238 at March 31, 2024. In addition to normal staffing fluctuation, the decrease in the number of FTE's was due to the sale of the marine finance assets during the third quarter of 2023. The Company reduced its workforce associated with the marine lending division as it expects to cease accepting new marine lending business. Partially offsetting the expense decreases due to the lower number of FTE's, were annual pay increases, commissions paid on new business efforts, increasing insurance costs and enhanced employee benefit plans.

Advertising and marketing expenses and computer software expenses decreased during the three months ended March 31, 2024 compared to the same period in 2023. This was primarily due to the discontinuation of new marine lending business, including the cost of business development and computer systems, as well as corporate rebranding expenses incurred during the 2023 period.

FDIC assessment and bank franchise tax expenses, which are based in part on asset size and capital levels, have increased during the three months ended March 31, 2024 over 2023. The increase in FDIC assessment was also due to a two basis point increase in the assessment rate charged by the FDIC, which was applied to all financial institutions.

Professional fees decreased between the three months ended March 31, 2024 and the same period in 2023. During the 2023 period there were legal expenses for the marine lending business, legal costs related to the ESOP termination, and strategic planning expenses that were not incurred during the 2024 period.

Data processing fee expenses increased during three months ended March 31, 2024 over the same period in 2023, reflecting increased costs for core systems, including fees that are volume based,

The efficiency ratio of the Company was 77.73% and 76.52% for the three months ended March 31, 2024 and 2023, respectively. The efficiency ratio is not a measurement under accounting principles generally accepted in the United States. It is calculated by dividing noninterest expense by the sum of tax equivalent net interest income and noninterest income excluding gains and losses on the investment portfolio and other gains/losses from OREO, repossessed vehicles, disposals of bank premises and equipment, etc. The tax rate utilized is 21%. The Company calculates and reviews this ratio as a means of evaluating operational efficiency.

The calculation of the efficiency ratio for the three months ended March 31, 2024 and 2023 was as follows:

(in thousands)

(1) Includes tax-equivalent adjustments on loans and securities using the federal statutory tax rate of 21%.

Income Taxes

Income tax expense was $495 thousand and $535 thousand during the three months ended March 31, 2024 and 2023, respectively. The effective tax rate was 16.27% and 17.15% for the three months ended March 31, 2024 and 2023, respectively. The effective tax rate is below the statutory rate of 21% due to tax-exempt income on investment securities and loans. The effective tax rate is also impacted by BOLI as well as income tax credits on qualified affordable housing project investments as discussed in Note 12 to the Consolidated Financial Statements as well as qualified rehabilitation credits.

Business Segments

The Company has three reportable operating segments: community banking, marine lending and wealth management. Revenue from community banking operations consist primarily of net interest income related to investments in loans and securities and outstanding deposits and borrowings, fees earned on deposit accounts and debit card interchange activity. Revenue from marine lending operations consist primarily of net interest income related to commercial and consumer marine loans and gains on sales of loans. The wealth management division's net revenues are comprised primarily of income from offering wealth management services and insurance products through third-party service providers.

On August 23, 2023, the Company completed a sale of specific assets from its marine lending segment. As part of the sale, the Company sold its interest in marine vessel floor plan loans totaling $52.8 million, its rights to service loans that had been sold to secondary market investors prior to the date of sale (valued at $595.4 thousand on balance sheet prior to sale), and other assets that were not individually significant. The Company received total consideration, net of selling expenses, of $53.5 million and recognized a gain of $435 thousand. The assets sold as well as their related revenues and contribution to earnings did not constitute a significant portion of the Company's assets or operating results for the year-to-date period ending September 30, 2023. As part of the sale, the Company reduced its workforce associated with the marine lending division, as it expects to cease accepting new marine lending business. Subsequent to the sale of these assets, the Company retained ownership of approximately $260.5 million of marine vessel retail loans which continue to constitute a significant portion of the Company's assets, revenues, and earnings. At present, the Company expects to hold the retained outstanding loans until they are ultimately repaid.

Financial information for the parent company is included in the "All Other" category. The parent company's operating results are comprised primarily of interest expense associated with subordinated debt. Refer to Note 16 for additional information.

The following tables provide income and asset information for the three months ended March 31, 2024 and 2023 and as of March 31, 2024 and December 31, 2023, which are included within the Consolidated Balance Sheets and Consolidated Statements of Income.

(in thousands)

49

FINANCIAL CONDITION

Securities

Total securities available for sale were $131.9 million at March 31, 2024, compared to $137.4 million at December 31, 2023. This represents a decrease of $5.5 million, or 4.06%. The Company purchased no securities during the three months ended March 31, 2024. The Company had total maturities, calls, and principal repayments of $3.2 million during the three months ended March 31, 2024. Note 4 to the Consolidated Financial Statements provides additional details about the Company’s securities portfolio at March 31, 2024 and December 31, 2023. The Company had a net unrealized loss on available for sale securities of $25.1 million at March 31, 2024 as compared to a net unrealized loss of $22.8 million at December 31, 2023. Unrealized gains or losses on available for sale securities are reported within shareholders’ equity, net of the related deferred tax effect, as accumulated other comprehensive income (loss). The primary cause of the unrealized losses at March 31, 2024 and December 31, 2023 was changes in market interest rates and other market conditions and not credit concerns of the issuers. Since the losses can be primarily attributed to changes in market interest rates and conditions and not expected cash flows or an issuer’s financial condition and management does not intend to sell and it is likely that management will not be required to sell the securities prior to their anticipated recovery, the Company concluded a credit loss did not exist.

Loan Portfolio

The Company’s primary use of funds is supporting lending activities from which it derives the greatest amount of interest income. Gross loans were $1.44 billion and $1.46 billion at March 31, 2024 and December 31, 2023, respectively. This represents a decrease of $23.6 million, or 1.62%, during the three months ended March 31, 2024. The ratio of gross loans to deposits increased during the three months ended March 31, 2024 from 97.10% at December 31, 2023 to 97.63% at March 31, 2024.

The loan portfolio consists primarily of loans for owner-occupied single-family dwellings and loans secured by commercial real estate. Note 5 to the Consolidated Financial Statements provides the composition of the loan portfolio at March 31, 2024 and December 31, 2023. During the three months ended March 31, 2024, through the normal course of business, $10.8 million in loans were sold, consisting of mortgage loans. These loan sales resulted in net gains of $161 thousand. The decline in loans was largely due to paydowns and a large consumer loan payoff, while experiencing modest growth in other areas during the quarter.

Residential real estate loans, consisting of first liens, junior liens and home equity loans, were $354.2 million, or 24.61%, and $356.1 million, or 24.35%, of total loans at March 31, 2024 and December 31, 2023, respectively. The decline of $2.0 million, or 0.55%, reflects the Company's efforts to originate more salable loans than portfolio loans.

Commercial real estate loans (including multifamily loans) were $598.9 million, or 41.62%, and $600.3 million, or 41.04%, of total loans at March 31, 2024 and December 31, 2023, respectively, representing a decrease of $1.4 million, or 0.23%, during the three months ended March 31, 2024. Owner occupied commercial real estate loans experienced a slight increase during the three months ended March 31, 2024, while non-owner occupied and multifamily commercial real estate loans declined during the same period.

Marine loans were $247.0 million, or 17.17%, and $251.2 million, or 17.17%, of total loans at March 31, 2024 and December 31, 2023, respectively, representing a decrease of $4.1 million or 1.64%. The decline in marine loans reflects paydowns only and no new originations. On August 23, 2023, the Company completed a sale of specific assets from its marine lending segment. As part of the sale, the Company sold its interest in marine vessel floor plan loans totaling $52.8 million and reduced its workforce associated with the marine lending division as it expects to cease accepting new marine lending business. At present, the Company expects to hold the retained outstanding loans until they are ultimately repaid.

Allowance for Credit Losses on Loans

The purpose of, and the methods for, measuring the allowance for credit losses on loans are discussed in the Critical Accounting Policies section above. Note 5 to the Consolidated Financial Statements shows the activity within the allowance for credit losses on loans during the three months ended March 31, 2024 and 2023 and the year ended December 31, 2023. Charged-off loans were $705 thousand and $75 thousand for the three months ended March 31, 2024 and 2023, respectively. Recoveries were $185 thousand and $21 thousand for the three months ended March 31, 2024 and 2023, respectively. This resulted in net charge-offs of $520 thousand and $54 for the three months ended March 31, 2024 and 2023, respectively. The annualized ratio of net charge-offs to average loans was 0.04% and 0.00% for the three months ended March 31, 2024 and 2023, respectively. The allowance for credit losses on loans as a percentage of loans was 1.00% at March 31, 2024 and 0.99% at December 31, 2023. The increase as compared to December 31, 2023 was mainly attributable to net loan charge-offs coupled with a slight decline in gross loan balances.

Management believes that the allowance for credit losses on loans is currently adequate to absorb the current expected losses in the loan portfolio.

Nonperforming Assets and Other Assets

Nonperforming assets consist of nonaccrual loans, repossessed assets, OREO (foreclosed properties), and loans past due 90 days or more and still accruing as detailed in the table below.

Nonperforming assets decreased by $1.1 million during the three months ended March 31, 2024. Nonaccrual loans were $4.2 million and $5.6 million at March 31, 2024 and December 31, 2023. There was $415 thousand in OREO and repossessed at March 31, 2024 and $304 thousand at December 31, 2023. There were $411 thousand in loans past due 90 days or more and still accruing at March 31, 2024 and $181 thousand in loans past due 90 days or more and still accruing at December 31, 2023. The percentage of nonperforming assets to loans, OREO and repossessed assets was 0.35% at March 31, 2024 and 0.42% at December 31, 2023, respectively.

Total past due loans, as disclosed in Note 5 to the Consolidated Financial Statements, increased to $3.3 million at March 31, 2024 compared to $2.3 at December 31, 2023. The increase in past due loans was primarily due to three loans totaling $1.0 million, consisting of $605 thousand for a marine vessel, $295 thousand non-owner occupied commercial real estate property, and $185 thousand commercial business loan.

During the three months ended March 31, 2024, nonaccrual loans decreased by $1.5 million and totaled $4.2 million at March 31, 2024 compared to $5.6 million at December 31, 2023. The decrease reflects a $1.3 million payoff of a commercial real estate loan and loan charge-offs totaling $118 thousand. There were no new nonaccrual loans during the three months ended March 31, 2024. Management evaluates the financial condition of borrowers and the value of any collateral on nonaccrual loans. The results of these evaluations are used to estimate the amount of losses which may be realized on the disposition of these nonaccrual loans and are reflected in the allowance for credit losses on loans. At March 31, 2024 and December 31, 2023, there was no allowance for credit losses required on nonaccrual loans due to sufficient collateral values.

Loans are placed on nonaccrual status when collection of principal and interest is doubtful, generally when a loan becomes 90 days past due. There are three negative implications for earnings when a loan is placed on non-accrual status. First, all interest accrued but unpaid at the date that the loan is placed on non-accrual status is either deducted from interest income or written off as a loss. Second, accruals of interest are discontinued until it becomes certain that both principal and interest can be repaid. Finally, there may be actual losses to principal that require additional provisions for credit losses to be charged against earnings.

For real estate loans, upon foreclosure, the balance of the loan is transferred to OREO and carried at the fair value of the property based on current appraisals and other current market trends, less estimated selling costs. If a write down of the OREO property is necessary at the time of foreclosure, the amount is charged-off to the allowance for credit losses. A review of the recorded property value is performed in conjunction with normal quarterly reviews, and if market conditions indicate that the recorded value exceeds the fair value, additional write downs of the property value are charged directly to operations.

Deposits

Total deposits were $1.47 billion and $1.51 billion at March 31, 2024 and December 31, 2023, respectively. This represents a decrease of $32.4 million or 2.15% during the three months ended March 31, 2024. Note 7 to the Consolidated Financial Statements provides the composition of total deposits at March 31, 2024 and December 31, 2023. The decline in deposits was divided between core and non-core accounts, with decreases of $16.0 million and $16.4 million, respectively. During the first quarter of 2024, time deposits and noninterest demand deposits experienced the greatest declines. Time deposits with balances $250,000 and more decreased $16.7 million, time deposits with balances less than $250,000 decreased $14.2 million, reflecting maturities that are not being replaced. Noninterest bearing demand deposits decreased $11.8 million, while interest-bearing NOW accounts increased $10.2 million. Core deposits, consisting of checking accounts, NOW accounts, money market accounts, regular savings accounts and time deposits less than $250,000, totaled $1.27 billion, or 86.00% of total deposits at March 31, 2024 compared to $1.28 billion, or 85.22%, of total deposits at December 31, 2023. At March 31, 2024, over 75% of deposits were fully FDIC insured.

CAPITAL RESOURCES

The Bank continues to be a well capitalized financial institution. Total shareholders’ equity at March 31, 2024 was $107.7 million, reflecting a percentage of total assets of 6.04%, as compared to $108.4 million and 5.94% at December 31, 2023. The slight decrease in shareholders’ equity was primarily due to an increase in unrealized losses on the securities available for sale portfolio of $2.3 million or $1.8 million, net of tax and dividends declared of $1.1 million, offsetting net income of $2.5 million earned during the three months ended March 31, 2024. During each of the three months ended March 31, 2024 and 2023, the Company declared dividends of $0.30. The Company has a Dividend Investment Plan that allows shareholders to reinvest dividends in Company stock.

At March 31, 2024, the Bank met all capital adequacy requirements and had regulatory capital ratios in excess of the levels established for well-capitalized institutions. The Bank monitors these ratios on a quarterly basis and has several strategies, including without limitation the issuance of common stock, to ensure that these ratios remain above regulatory minimums. The Bank's capital amounts and ratios are presented using the Federal Reserve's risk-based capital framework.

Effective January 1, 2015, the Federal Reserve issued final risk-based capital rules to align with the Basel III regulatory capital framework and meet certain requirements of the Dodd-Frank Act. The final rules require the Bank to comply with the following minimum capital ratios: (i) a common equity Tier 1 capital ratio of 4.5% of risk-weighted assets; (ii) a Tier 1 capital ratio of 6.0% of risk-weighted assets; (iii) a total capital ratio of 8.0% of risk-weighted assets; and (iv) a leverage ratio of 4.0% of total assets. In addition, a capital conservation buffer requirement of 2.5% was effective January 1, 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with any ratio (excluding the leverage ratio) above the minimum but below the conservation buffer will face constraints on dividends, equity repurchases, and compensation based on the amount of the shortfall. The capital conservation buffer rule requires the Bank to maintain (i) a minimum ratio of common equity Tier 1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% common equity Tier 1 ratio, effectively resulting in a minimum ratio of common equity Tier 1 to risk-weighted assets of at least 7.0%), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio, effectively resulting in a minimum Tier 1 capital ratio of 8.5%), (iii) a minimum ratio of total capital to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (which is added to the 8.0% total capital ratio, effectively resulting in a minimum total capital ratio of 10.5%), and (iv) a minimum leverage ratio of 4.0%, calculated as the ratio of Tier 1 capital to average assets.

At March 31, 2024 and December 31, 2023, the Bank's capital ratios were as follows: Common equity Tier 1 capital was 10.40% and 10.27%, respectively, Tier 1 risk-based capital was 10.40% and 10.27%, respectively, Total risk-based capital was 11.32% and 11.16%, respectively, and Tier 1 leverage was 8.76% and 8.48%, respectively.

Pursuant to the Federal Reserve’s Small Bank Holding Company and Savings and Loan Holding Company Policy Statement, qualifying bank holding companies with total consolidated assets of less than $3 billion, such as the Company, are not subject to consolidated regulatory capital requirements.

On March 31, 2022, the Company entered into Subordinated Note Purchase Agreements with certain purchasers pursuant to which the Company issued and sold $30.0 million in aggregate principal amount of its 4.50% Fixed-to-Floating Rate Subordinated Notes due April 1, 2032. See Note 14 to the Consolidated Financial Statements included in this Form 10-Q, for discussion of subordinated debt.

LIQUIDITY

Liquidity management involves meeting the present and future financial obligations of the Company with the sale or maturity of assets or with the occurrence of additional liabilities. Liquidity needs are met with cash on hand, deposits in banks, federal funds sold, unpledged securities classified as available for sale and loans maturing within one year. At March 31, 2024, liquid assets totaled $351.8 million as compared to $367.7 million at December 31, 2023. These amounts represented 21.00% and 21.41% of total liabilities at March 31, 2024 and December 31, 2023, respectively. The Company generally attempts to minimize liquidity demand by primarily utilizing core deposits to fund asset growth. Securities provide a constant source of liquidity through paydowns and maturities. Also, the Company maintains short-term borrowing arrangements, namely federal funds lines of credit, with larger financial institutions as an additional source of liquidity. The Bank’s membership with the Federal Home Loan Bank of Atlanta provides a source of borrowings with numerous rate and term structures. The Company’s senior management monitors the liquidity position regularly and attempts to maintain a position which utilizes available funds most efficiently.

OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS

There have been no material changes in off-balance sheet arrangements and contractual obligations as reported in the 2023 Form 10-K.

There have been no material changes in Quantitative and Qualitative Disclosures about Market Risk as reported in the 2023 Form 10-K.

Disclosure Controls and Procedures

The Company, under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of its disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were effective as of March 31, 2024 to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms and that such information is accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Internal Control over Financial Reporting

Management is also responsible for establishing and maintaining adequate internal control over the Company’s financial reporting (as defined in Rule 13a-15(f) promulgated under the Securities Exchange Act of 1934, as amended). The Company is currently using the 2013 COSO Framework.

There were no changes in the Company’s internal control over financial reporting during the Company’s 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.

There were no material changes to the Company’s risk factors as disclosed in its Annual Report on Form 10-K for the year ended December 31, 2023.