First Western Financial Inc: Form 10-Q for the period ended Sep 30, 2024

The following discussion and analysis is intended to assist readers in understanding our financial condition and results of operations for the three and nine months ended September 30, 2024 and should be read in conjunction with our consolidated financial statements and the accompanying notes thereto included in this Quarterly Report on Form 10-Q (this "Form 10-Q") and in our Annual Report on Form 10-K filed with the Securities and Exchange Commission ("SEC") on March 15, 2024. Unless we state otherwise or the context otherwise requires, references in this Form 10-Q to "we," "our," "us," "the Company," and "First Western" refer to First Western Financial, Inc. and its consolidated subsidiaries, including First Western Trust Bank, which we sometimes refer to as "the Bank" or "our Bank."

The following discussion contains "forward-looking statements" that reflect our future plans, estimates, beliefs, and expected performance. We caution that assumptions, expectations, projections, intentions, or beliefs about future events may, and often do, vary from actual results and the differences can be material. See "Cautionary Note Regarding Forward-Looking Statements." Also, see the risk factors and other cautionary statements described under the heading "Item 1A - Risk Factors" included in our Annual Report Form 10-K filed with the SEC on March 15, 2024 and in Part II–Item 1A of this Form 10-Q. We do not undertake any obligation to publicly update any forward-looking statements except as otherwise required by applicable law.

Company Overview

We are a financial holding company founded in 2002 and headquartered in Denver, Colorado. We provide a fully integrated suite of wealth management services to our clients including banking, trust, and investment management products and services. Our mission is to be the best private bank for the Western wealth management client. We target entrepreneurs, professionals, and high-net worth individuals, typically with $1.0 million-plus in liquid net worth, and their related philanthropic and business organizations, which we refer to as the "Western wealth management client". We believe that the Western wealth management client shares our entrepreneurial spirit and values our sophisticated, high-touch wealth management services that are tailored to meet their specific needs. We partner with our clients to solve their unique financial needs through our expert integrated services provided in a team approach.

We offer our services through a branded network of boutique private trust bank offices, which we believe are strategically located in affluent and high-growth markets in locations across Colorado, Arizona, Wyoming, Montana, and California. Our profit centers, which are comprised of private bankers, lenders, wealth planners, and portfolio managers, under the leadership of a local chairman and/or president, are also supported centrally by teams providing management services such as operations, risk management, credit administration, marketing, technology support, human capital, and accounting/finance services, which we refer to as support centers.

From 2004, when we opened our first profit center, until September 30, 2024, we have expanded our footprint into fourteen full service profit centers, five loan production offices, and one trust office located across five states. As of and for the nine months ended September 30, 2024, we had $2.91 billion in total assets, $65.7 million in total revenues, and provided fiduciary and advisory services on $7.5 billion of assets under management ("AUM").

Recent Industry Developments

During 2023, the banking industry experienced significant disruption and volatility with the failure of multiple banks creating industry wide concerns related to liquidity, deposit outflows, unrealized securities losses, and eroding consumer confidence in the banking industry. Despite the market wide impact to bank stock prices, the Bank remains stable with strong fundamentals including uninsured deposits at $929.4 million, or 37.1% of total deposits as of September 30, 2024. The Company has a low amount of held-to-maturity securities, which represent 2.6% of total assets, and carries unrecognized losses amounting to 2.5% of Total shareholders’ equity as of September 30, 2024. We have a conservative credit appetite as evidenced by our limited exposure to non-owner occupied office space commercial real estate (“CRE”) which has been impacted by the shift to hybrid work environments. Our client base is well diversified with no single industry concentration.

Primary Factors Used to Evaluate the Results of Operations

As a financial institution, we manage and evaluate various aspects of both our results of operations and our financial condition. We evaluate the comparative levels and trends of the line items in our Condensed Consolidated Balance Sheets and Statements of Income as well as various financial ratios that are commonly used in our industry. The primary factors we use to evaluate our results of operations include net interest income, non-interest income, and non-interest expense.

Net Interest Income

Net interest income represents interest income less interest expense. We generate interest income on interest-earning assets, primarily loans and investment securities. We incur interest expense on interest-bearing liabilities, primarily interest-bearing deposits and borrowings. To evaluate Net interest income, we measure and monitor: (i) yields on loans, investment securities, and other interest-earning assets; (ii) the costs of deposits and other funding sources; (iii) the rates incurred on borrowings and other interest-bearing liabilities; and (iv) the regulatory risk weighting associated with the assets. Interest income is primarily impacted by loan growth and loan repayments, along with changes in interest rates on the loans. Interest expense is primarily impacted by changes in deposit balances, changes in interest rates on deposits, along with the volume and type of interest-bearing liabilities. Net interest income is primarily impacted by changes in market interest rates, the slope of the yield curve, and interest we earn on interest-earning assets or pay on interest-bearing liabilities.

Non-Interest Income

Non-interest income primarily consists of the following:

• *Trust and investment management fees—*fees and other sources of income charged to clients for managing their trust and investment assets, providing financial planning consulting services, 401(k) and retirement advisory consulting services, and other wealth management services. Trust and investment management fees are primarily impacted by rates charged and increases and decreases in AUM. AUM is primarily impacted by opening and closing of client advisory and trust accounts, contributions and withdrawals, and the fluctuation in market values.
• *Net gain on mortgage loans—*gain on originating and selling mortgages and origination fees, less commissions to loan originators, document review, and other costs specific to originating and selling the loan. The market adjustments for interest rate lock commitments ("IRLC"), mortgage derivatives, and gains and losses incurred on the mandatory trading of loans are also included in this line item. Net gain on mortgage loans is primarily impacted by the amount of loans sold, the type of loans sold, and market conditions.
• *Net gain on loans accounted for under the fair value option—*unrealized gains or losses on the fair value adjustments to held for investment loans on which the Bank has elected the fair value option of accounting. This also includes realized gains or losses on charge-offs and recoveries.
• *Bank fees—*income generated through bank-related service charges such as: electronic transfer fees, treasury management fees, bill pay fees, servicing fees for Main Street Lending Program (“MSLP”), loan prepayment penalty fees, loan interest rate swap fees, and other banking fees. Banking fees are primarily impacted by the level of business activities and cash movement activities of our clients.
• *Risk management and insurance fees—*commissions earned on insurance policies we have placed for clients through our client risk management team who incorporate insurance services, primarily life insurance, to support our clients’ wealth planning needs. Our insurance revenues are primarily impacted by the type and volume of policies placed for our clients.
• *Income on company-owned life insurance—*income earned on the growth of the cash surrender value of life insurance policies we hold on certain key associates. The income on the increase in the cash surrender value is non-taxable income.

Non-Interest Expense

Non-interest expense is comprised primarily of the following:

• *Salaries and employee benefits—*all forms of compensation-related expenses including salary, incentive compensation, payroll-related taxes, stock-based compensation, benefit plans, health insurance, 401(k) plan match costs, and other benefit-related expenses. Salaries and employee benefit costs are primarily impacted by changes in headcount and fluctuations in benefits costs.
• *Occupancy and equipment—*costs related to building and land maintenance, leasing our office space, depreciation charges for the buildings, building improvements, furniture, fixtures and equipment, amortization of leasehold improvements, utilities, and other occupancy-related expenses. Occupancy and equipment costs are primarily impacted by the number of locations we occupy.
• *Professional services—*costs related to legal, accounting, tax, consulting, personnel recruiting, insurance, and other outsourcing arrangements. Professional services costs are primarily impacted by corporate activities requiring specialized services. FDIC insurance expense is also included in this line and represents the assessments we pay to the FDIC for deposit insurance.
• *Technology and information systems—*costs related to software and information technology services to support office activities and internal networks. Technology and information system costs are primarily impacted by the number of locations we occupy, the number of associates we have, and the level of service we require from our third-party technology vendors.
• *Data processing—*costs related to processing fees paid to our third-party data processing system providers relating to our core private trust banking platform. Data processing costs are primarily impacted by the number of loan, deposit, and trust accounts we have and the level of transactions processed for our clients.
• *Marketing—*costs related to promoting our business through advertising, promotions, charitable events, sponsorships, donations, and other marketing-related expenses. Marketing costs are primarily impacted by the levels of advertising programs and other marketing activities and events held throughout the year.
• *Amortization of other intangible assets—*primarily represents the amortization of intangible assets including client lists, core deposit intangibles, and other similar items recognized in connection with acquisitions.
• *Other—*includes costs related to operational expenses associated with office supplies, postage, travel expenses, meals and entertainment, dues and memberships, costs to maintain or prepare other real estate owned (“OREO”) for sale, director compensation and travel, and other general corporate expenses that do not fit within one of the specific non-interest expense lines described above. Other operational expenses are generally impacted by our business activities and needs.

Operating Segments

The Company’s reportable segments consist of Wealth Management and Mortgage. We measure the overall profitability of operating segments based on Income before income tax. We believe this is a more useful measurement as our wealth management products and services are fully integrated with our private trust bank. We allocate costs to our segments, which consist primarily of compensation and overhead expense directly attributable to the products and services within the Wealth Management and Mortgage segments. We measure the profitability of each segment based on a post-allocation basis, as we believe it better approximates the operating cash flows generated by our reportable operating segments. A description of each segment is provided in Note 14 – Segment Reporting of the accompanying Notes to the Condensed Consolidated Financial Statements.

Primary Factors Used to Evaluate our Balance Sheet

The primary factors we use to evaluate our balance sheet include asset and liability levels, asset quality, capital, liquidity, and potential profit production from assets.

We manage our asset levels to ensure our lending initiatives are efficiently and profitably supported and to ensure we have the necessary liquidity and capital to meet the required regulatory capital ratios. Funding needs are evaluated and forecasted by communicating with clients, reviewing loan maturity and draw expectations, and projecting new loan opportunities.

We manage the diversification and quality of our assets based upon factors that include the level, distribution, severity, and trend of problem assets such as those determined to be classified, delinquent, non-accrual, non-performing or restructured; the adequacy of our allowance for credit losses; the diversification and quality of loan and investment portfolios; the extent of counterparty risks, credit risk concentrations, and other factors.

We manage our liquidity based upon factors that include the level and quality of capital and our overall financial condition, the trend and volume of problem assets, our balance sheet risk exposure, the level of deposits as a percentage of total loans, the amount of non-deposit funding used to fund assets, the availability of unused funding sources and off-balance sheet obligations, the availability of assets to be readily converted into cash without undue loss, the amount of cash and liquid securities we hold, and other factors.

Financial institution regulators have established guidelines for minimum capital ratios for banks and bank holding companies. The Company has adopted the Basel III regulatory capital framework. As of September 30, 2024, the Bank’s capital ratios exceeded the current well capitalized regulatory requirements established under Basel III.

Results of Operations

Overview

The three months ended September 30, 2024 compared with the three months ended September 30, 2023. We reported Net income available to common shareholders of $2.1 million for the three months ended September 30, 2024, compared to $3.1 million of Net income available to common shareholders for the three months ended September 30, 2023, a $1.0 million, or 31.6% decrease. For the three months ended September 30, 2024, our Income before income tax was $2.7 million, a $1.6 million, or 36.7% decrease from the three months ended September 30, 2023. The decrease was primarily driven by an increase in Non-interest expense and decrease in Net interest income as a result of higher Interest expense due to higher deposit costs, offset partially by higher Non-interest income.

The nine months ended September 30, 2024 compared with the nine months ended September 30, 2023. We reported Net income available to common shareholders of $5.7 million for the nine months ended September 30, 2024, compared to $8.4 million of Net income available to common shareholders for the nine months ended September 30, 2023, a $2.7 million, or 32.2% decrease. For the nine months ended September 30, 2024, our Income before income tax was $7.7 million, a $3.8 million, or 32.9% decrease from the nine months ended September 30, 2023. The decrease was primarily driven by a $8.4 million decrease in Net interest income, after Provision for credit losses partially offset by a $5.4 million increase in Non-interest income. The decrease in Net interest income, after Provision for credit losses, was due to higher rates on deposits and borrowings resulting from increased market rates partially offset by higher interest income.

Net Interest Income

The three months ended September 30, 2024 compared with the three months ended September 30, 2023. For the three months ended September 30, 2024, Net interest income, before the Provision for credit losses, was $15.6 million, a decrease of $1.2 million, or 7.1%, compared to the three months ended September 30, 2023. The decrease in Net interest income was primarily driven by a $160.9 million increase in average Interest-bearing deposit balances and a 44 basis point increase in the average rates on interest-bearing deposits. Net interest margin decreased 14 basis points to 2.32% in the third quarter of 2024 from 2.46% reported in the third quarter of 2023 primarily due to pricing pressure on Interest-bearing deposits and an unfavorable mix shift in the deposit portfolio offset partially by an increase in average yield on interest earning assets.

The nine months ended September 30, 2024 compared with the nine months ended September 30, 2023. For the nine months ended September 30, 2024, Net interest income, before the Provision for credit losses, was $47.4 million, a decrease of $7.4 million, or 13.4%, compared to the nine months ended September 30, 2023. The decrease in Net interest income was driven by a $172.2 million increase in average Interest-bearing deposits with a 78 basis point increase in the average rates on Interest-bearing deposits. Net interest income was also negatively impacted by a $10.3 million decrease in average loans outstanding excluding loans held for sale and loans held at fair value offset by a 34 basis point increase in the average yield on loans. Net interest margin decreased 37 basis points to 2.34% for the nine months ended September 30, 2024 from 2.71% reported for the nine months ended September 30, 2023.

The decrease in average loans outstanding for the three months ended September 30, 2024 compared to the same period in 2023 was primarily due to a net decline in the Cash, Securities and Other, Construction and Development, and Commercial and Industrial portfolios offset by net growth in the Commercial Real Estate portfolio. Another contributing factor to the decline was the resolution of a problem credit relationship, which decreased non-performing loans by $30.0 million and increased Other real estate owned ("OREO") by $25.6 million. Average loan yields excluding Loans held for sale and Loans held at fair value were 5.74% and 5.72% for the three and nine months ended September 30, 2024, compared to 5.42% and 5.38% for the three and nine months ended September 30, 2023. The increase in loan yields during the three and nine month periods were primarily driven by an increase in yields on the variable rate portfolio and an increase in yields on new loan production due to the rising interest rate environment.

Interest income on our investment securities portfolio increased as a result of higher average yields, partially offset by lower average investment balances for the three and nine months ended September 30, 2024 compared to the same period in 2023. Our average investment yields during the three and nine months ended September 30, 2024 were 3.57% and 3.43%, an increase of 48 basis points and 32 basis points compared to the same periods in 2023. Our average investment securities balance during the three and nine months ended September 30, 2024 was $79.0 million and $76.4 million, a decrease of $1.0 million and $3.7 million compared to the same period in 2023.

Interest expense on deposits increased during the three and nine months ended September 30, 2024 compared to the same period in 2023. Average interest-bearing deposit rates were 4.19% and 4.17% for the three and nine months ended September 30, 2024, compared to 3.75% and 3.39% for the three and nine months ended September 30, 2023. The increase in Interest-bearing deposit rates was primarily attributable to the higher interest rate environment and highly competitive deposit market.

The following presents an analysis of Net interest income and Net interest margin during the periods presented, using daily average balances for each major category of interest-earning assets and interest-bearing liabilities, the interest earned or paid, and the average rate earned or paid on those assets or liabilities.

(dollars in thousands)

55

(dollars in thousands)

(1) Average balance represents daily averages, unless otherwise noted.

(2) Represents monthly averages.

(3) Non-performing loans are included in the respective average loan balances. Income, if any, on such loans is recognized on a cash basis.

(4) Mortgage loans held for sale are included in the interest-earning assets above, with interest income recognized in the Interest and dividend income on loans, including fees line in the Condensed Consolidated Statements of Income. These balances are included in the margin calculations in these tables.

(5) Tax-equivalent yield adjustments are immaterial.

(6) Net interest spread is the average yield on interest-earning assets minus the average rate on interest-bearing liabilities.

(7) Net interest income is the difference between income earned on interest-earning assets and expense paid on interest-bearing liabilities.

(8) Net interest margin is equal to annualized net interest income divided by average interest-earning assets.

The following table presents the dollar amount of changes in interest income and interest expense during the periods presented for each component of interest-earning assets and interest-bearing liabilities, and distinguishes between changes attributable to volume and interest rates. Changes attributable to both rate and volume that cannot be separated have been allocated to volume:

(dollars in thousands)

Provision for Credit Losses

We have a dedicated problem loan resolution team comprised of associates from our credit, senior leadership, risk, and accounting teams that meets frequently to ensure that watch list and problem credits are identified early and actively managed. We work to identify potential losses in a timely manner and proactively manage the problem credits to minimize losses. For the three and nine months ended September 30, 2024, we recorded a $0.5 million and $2.9 million Provision for credit losses, respectively. For the three and nine months ended September 30, 2023, we recorded a $0.3 million and $1.9 million Provision for credit losses, respectively. The $0.5 million provision recorded for the three months ended September 30, 2024 was primarily due to two non-performing loans written down to fair value through the provision and transfered to Loans held for sale offset by a recovery on one non-performing loan. The $2.9 million provision recorded for the nine months ended September 30, 2024 was primarily due to an increase in Provision for credit losses on individually analyzed loans due to the charge-off and resolution of one loan relationship partially offset by the release of Provision for credit losses on unfunded loan commitments.

The Company has increased loan level reviews and portfolio monitoring to address the changing environment. Management believes the financial strength of the Bank’s clientele and the diversity of the portfolio continues to mitigate the credit risk within the portfolio.

Non-Interest Income

The three months ended September 30, 2024 compared with the three months ended September 30, 2023. For the three months ended September 30, 2024 compared with the three months ended September 30, 2023, Non-interest income increased $0.9 million, or 14.3%, to $7.0 million. The increase in Non-interest income during the three months ended September 30, 2024 was driven primarily by an increases in Net gain on mortgage loans and Risk management and insurance fees.

The nine months ended September 30, 2024 compared with the nine months ended September 30, 2023. For the nine months ended September 30, 2024 compared with the nine months ended September 30, 2023, Non-interest income increased $5.4 million, or 33.7%, to $21.2 million. The increase in Non-interest income during the nine months ended September 30, 2024 was primarily driven by an increase in Net gain on mortgage loans and a decrease in net loss on loans accounted for under the fair value option.

The following presents the significant categories of our non-interest income during the periods presented:

(dollars in thousands)

(dollars in thousands)

* Represents percentages that are insignificant

*Trust and investment management fees—*Trust and investment management fees decreased $0.1 million, or 2.4% for the three months ended September 30, 2024. The increase in Trust and investment management fees of $0.5 million, or 3.2% for the nine months ended September 30, 2024 was primarily attributable to an increase in assets under management due to an increase in market values and an increase in our fee structure compared to the prior year.

*Net gain on mortgage loans—*The increase in Net gain on mortgage loans of $0.8 million, or 121.9% for the three months ended September 30, 2024 was driven by higher origination volumes. The increase in Net gain on mortgage loans of $2.1 million, or 85.3% for the nine months ended September 30, 2024 was driven by higher average gain on sale margins and origination volumes.

*Net gain (loss) on loans held for sale—*During the nine months ended September 30, 2024, the Company reclassified $3.7 million of loans held for investment to loans held for sale for three non-performing notes. The transfers occurred at the point in time the Company decided to sell the loans. During the nine months ended September 30, 2024, a total of $3.2 million reclassified loans held for investment were sold, resulting in a Net gain on loans held for sale of $0.1 million. During the nine months ended September 30, 2023, the Company transferred $39.2 million of non-relationship loans held for investment to Loans held for sale. Upon transfer of the loans, the Company recorded a net loss on Loans held for sale of $0.2 million, primarily attributable to the slight decline in fair value as a result of the rising interest rates on comparable loans in the market.

*Risk management and insurance fees—*The increase in Risk management and insurance fees of $0.2 million, or 153.1% and $0.2 million, or 40.0% for the three and nine months ended September 30, 2024 was primarily driven by an increase in insurance client agreements.

*Net loss on loans accounted for under the fair value option—*The Company elected the fair value option on certain loans purchased in 2022. The decrease in loss on loans accounted for under the fair value option of $1.1 million, or 55.7% for the nine months ended September 30, 2024 was primarily attributable to improvement in fair value due to an increase in interest rates and overall improved performance of the portfolio.

*Other—*The increase in other income of $1.2 million, or 151.5% for the nine months ended September 30, 2024 was attributable to a $1.2 million impairment taken in 2023 to the carrying value of a contingent consideration asset related to the sale of First Western Capital Management in 2020. The value was established using asset growth assumptions provided by the buyer, which had not materialized.

Non-Interest Expense

The three months ended September 30, 2024 compared with the three months ended September 30, 2023. The increase in Non-interest expense of 5.8% to $19.4 million for the three months ended September 30, 2024 was driven by Salaries and employee benefits due to increased front office headcount and higher insurance commissions, Technology and information system costs related to enhancements of our information technology infrastructure, and Occupancy and equipment costs related to additional rent expense on the extension of a lease in the first quarter of 2024.

The nine months ended September 30, 2024 compared with the nine months ended September 30, 2023. The increase in Non-interest expense of 1.2% to $58.1 million for the nine months ended September 30, 2024, was driven by Other operational costs attributed to higher costs on non-performing asset workouts and fraud losses, Technology and information system costs related to enhancements of our information technology infrastructure, and Occupancy and equipment costs related to additional rent expense on the extension of a lease in the first quarter of 2024, offset by lower Salaries and employee benefits as a result of staffing reductions in 2023 to better align expenses with lower revenue.

The following presents the significant categories of our Non-interest expense during the periods presented:

(dollars in thousands)

(dollars in thousands)

*Salaries and employee benefits—*The increase in Salaries and employee benefits of $0.5 million, or 4.3% for the three months ended September 30, 2024 was primarily due to increased front office headcount. The decrease in Salaries and employee benefits of $1.4 million, or 4.0% for the nine months ended September 30, 2024 was primarily related to staffing reductions in 2023 to better align expenses with lower revenue.

*Occupancy and equipment—*The increase in Occupancy and equipment of $0.3 million, or 17.7%, and $0.5 million, or 9.2% for the three and nine months ended September 30, 2024, was driven by additional rent expense relating to the extension of a lease in the first quarter of 2024.

*Professional services—*The increase in Professional services of $0.5 million, or 8.5% for the nine months ended September 30, 2024, was driven by increased legal fees, audit fees, and FDIC insurance costs due to an increase in our assessment rate.

*Technology and information systems—*The increase in Technology and information systems of $0.1 million, or 15.3%, and $0.5 million or 20.6% for the three and nine months ended September 30, 2024, was primarily driven by increased costs related to enhancements of our information technology infrastructure.

*Data processing—*The decrease in Data processing of $0.2 million, or 6.0% for the nine months ended September 30, 2024, was driven by lower system costs related to our trust and investment management system.

*Marketing—*The decrease in Marketing $0.3 million, or 27.9% for the nine months ended September 30, 2024, was driven by lower advertising costs and decreased events and sponsorships to better align expenses with lower revenue.

*Other—*The increase in Other of $0.1 million, or 12.0%, for the three months ended September 30, 2024, was primarily driven by costs related to non-performing asset workouts. The increase in Other of $1.1 million, or 30.9%, for the nine months ended September 30, 2024, was primarily driven by increased costs related to non-performing asset workouts and fraud losses.

Income Tax

The Company recorded an income tax provision of $0.5 million and $1.1 million for the three months ended September 30, 2024 and 2023, respectively, reflecting an effective tax rate of 20.1% and 26.1%, respectively. The Company recorded an income tax provision of $1.9 million and $3.0 million for the nine months ended September 30, 2024 and 2023, respectively, reflecting an effective tax rate of 25.3% and 26.0%, respectively.

Segment Reporting

We have two reportable operating segments: Wealth Management and Mortgage. Our Wealth Management segment consists of operations relating to the Company’s fully integrated wealth management products and services. Services provided include deposit, loan, insurance, and trust and investment management advisory products and services for which fee revenue is recognized. Our Mortgage segment consists of operations relating to the Company’s residential mortgage service offerings. Services provided by our Mortgage segment include soliciting, originating, and selling mortgage loans into the secondary market. Mortgage products are financial in nature, for which origination fees are recognized net of origination expenses, upon the funding of the mortgage loans. Mortgage loans held for sale are accounted for under the fair value option with changes in fair value reported through earnings at inception when loans are locked to the borrower and until the loan is sold to third parties, at which time additional gains or losses on the sale are recorded. Mortgage loans originated and held for investment purposes are recorded in the Wealth Management segment, as this segment provides ongoing services to our clients.

The following table presents key metrics related to our segments during the periods presented:

(dollars in thousands)

(dollars in thousands)

(1) Net interest income after provision plus non-interest income.

The following presents selected financial metrics of each segment as of and during the periods presented:

Wealth Management

(dollars in thousands)

(dollars in thousands)

The Wealth Management segment reported Income before income tax of $2.2 million for the three months ended September 30, 2024, compared to $5.1 million for the same period in 2023. The Wealth Management segment reported Income before income tax of $6.3 million for the nine months ended September 30, 2024, compared to $13.3 million for the same period in 2023. The majority of our assets and liabilities are on the Wealth Management segment balance sheet and the decrease in Income before taxes is primarily driven by a decrease in Net interest income and increase in Non-interest expense partially offset by an increase in Non-interest income. The decrease in Net interest income is primarily due to pricing pressure on interest-bearing deposits and an unfavorable mix shift in the deposit portfolio, offset partially by an increase in Interest income.

Mortgage

(dollars in thousands)

(dollars in thousands)

The Mortgage segment reported Income before income tax of $0.5 million for the three months ended September 30, 2024, compared to a loss before income tax of $0.9 million for the same period in 2023. The Mortgage segment reported Income before income tax of $1.4 million for the nine months ended September 30, 2024, compared to a loss before income tax of $1.9 million for the same period in 2023. The overall increase in Income before taxes was primarily driven by an increase in Non-interest income and a decrease in Non-interest expense. The increase in Non-interest income was primarily driven by higher average gain on sale margins and origination volume. The decrease in Non-interest expense was due to lower Salaries and employee benefits as a result of staffing reductions in 2023 to better align expenses with lower levels of origination activity.

Financial Condition

The following presents our Condensed Consolidated Balance Sheets as of the dates noted:

(dollars in thousands)

Cash and cash equivalents increased by $21.8 million, or 8.6%, to $276.2 million as of September 30, 2024 compared to December 31, 2023. The increase was a result of the decrease in loans, offset partially by a decrease in borrowings and deposits.

Held-to-maturity debt securities increased by $2.6 million, or 3.6%, to $76.7 million as of September 30, 2024 compared to December 31, 2023. The increase is primarily due to Held-to-maturity debt security purchases executed during the second quarter of 2024.

Loans, net of allowance decreased by $142.6 million, or 5.7%, to $2.4 billion as of September 30, 2024 compared to December 31, 2023. The decrease is due to limited new production that was more than offset by payoffs and a lower level of draws on existing credit lines than previous quarters.

Mortgage loans held for sale increased $5.1 million, or 69.9%, to $12.3 million as of September 30, 2024 compared to December 31, 2023. The increase was driven by higher funded loan volume and the timing of loan sale settlements.

Other assets increased by $49.0 million, or 58.1%, to $133.2 million as of September 30, 2024 compared to December 31, 2023. The increase was primarily driven by an increase in our lease assets due to an extension of a lease recorded during the first quarter and an increase of $37.0 million in other real estate owned due to taking physical possession of three foreclosed properties during the second and third quarters.

Deposits decreased $26.0 million, or 1.0%, to $2.50 billion as of September 30, 2024 compared to December 31, 2023. The decrease was driven primarily by seasonal tax payments, operating account fluctuations and clients using liquidity for strategic investments. Money market deposit accounts decreased $35.5 million, or 2.6%, to $1.35 billion as of September 30, 2024 compared to December 31, 2023. Time deposit accounts increased $37.0 million, or 7.5%, from December 31, 2023 to $533.5 million as of September 30, 2024. Interest checking accounts decreased $17.2 million, or 11.7%, to $130.3 million from December 31, 2023 to September 30, 2024.

Borrowings decreased $63.2 million, or 35.5%, to $114.9 million as of September 30, 2024 compared to December 31, 2023. The decrease was primarily driven by a lower reliance on FHLB and FRB borrowings due to the decrease in loans.

Other liabilities increased $19.5 million, or 76.3%, to $45.2 million as of September 30, 2024 compared to December 31, 2023. The increase is primarily due to an increase in payables related to participated problem credits and an increase in our lease liability due to an extension of a lease recorded in the first quarter, offset by lower salaries payable due to timing of 401K match payouts and incentive compensation payments and a decrease in accrued interest payable on borrowings related to the interest on the $31.0 million repayment of a Bank Term Funding Program loan that matured in March 2024.

Total shareholders’ equity increased $6.1 million, or 2.5%, from December 31, 2023 to $248.8 million as of September 30, 2024. The increase is primarily due to Net income for the year.

Assets Under Management

(dollars in millions)

* Trust & investment management fees divided by period end balance.

(1) AUM reported for the current period is one quarter in arrears.

AUM increased $454.0 million, or 6.5%, during the three months ended September 30, 2024 driven primarily by a net increase in market values, offset slightly by asset withdrawals. For the nine months ended September 30, 2024, AUM increased $713.0 million, or 10.6%. The increase was attributable to contributions and improving market conditions year-over-year resulting in an increase in the value of assets under management balances offset partially by withdrawals.

Debt Securities

Debt securities we intend to hold for an indefinite period of time, but not necessarily to maturity, are classified as available-for-sale and are recorded at fair value using current market information from a pricing service, with unrealized gains and losses excluded from earnings and reported in other comprehensive income, net of tax. The carrying values of our debt securities classified as available-for-sale are adjusted for unrealized gain or loss, and any gain or loss is reported on an after-tax basis as a component of other comprehensive income in shareholders’ equity.

Debt securities for which we have the intent and ability to hold to their maturity are classified as Held-to-maturity debt securities and are recorded at amortized cost. Debt securities held-to-maturity are carried at cost, adjusted for the amortization of premiums and the accretion of discounts using the level-yield method over the remaining period until maturity. As of September 30, 2024 and December 31, 2023, all our investments in debt securities were classified as held-to-maturity.

The following presents the amortized cost and estimated fair value of our debt securities as of the dates noted:

(dollars in thousands)

(dollars in thousands)

67

The following presents the book value of our contractual maturities and weighted average yield for our investment securities as of the dates presented. Contractual maturities may differ from expected maturities because issuers can have the right to call or prepay obligations without penalties. Our investments are taxable securities. The weighted average yield for each range of maturities was calculated using the yield on each security within that range weighted by the amortized cost of each security as of September 30, 2024. Weighted average yields are not presented on a taxable equivalent basis.

(dollars in thousands)

(dollars in thousands)

* Represents percentages that are not meaningful due to being insignificant or exceeding 100%

As of September 30, 2024 and December 31, 2023, there were no holdings of securities of any one issuer, other than the U.S. Government sponsored entities and agencies, in an amount greater than 10% of shareholders’ equity.

Allowance for Credit Losses for HTM Debt Securities

Management measures expected credit losses on Held-to-maturity debt securities on a collective basis by major security type. The majority of our held-to-maturity investment portfolio consists of debt securities issued by U.S. government entities and agencies and we consider the risk of credit loss to be zero and, therefore, we do not record an ACL. The Company's non-government backed debt securities include private label CMO and MBS as well as corporate bonds. Accrued interest receivable on Held-to-maturity debt securities totaled $0.5 million and $0.4 million as of September 30, 2024 and December 31, 2023, respectively, and is excluded from the estimate of credit losses. The following table presents the activity in the Allowance for credit losses for debt securities held-to-maturity by major security type for the periods noted:

(dollars in thousands)

(dollars in thousands)

Loan Portfolio

Our primary source of interest income is derived through interest earned on loans to high net worth individuals and their related commercial interests. Our senior lending and credit team consists of seasoned, experienced personnel and we believe that our officers are well versed in the types of lending in which we are engaged. Underwriting policies and decisions are managed centrally and the approval process is tiered based on loan size, making the process consistent, efficient, and effective. The management team and credit culture demands prudent, practical, and conservative approaches to all credit requests in compliance with the loan policy guidelines to ensure strong credit underwriting practices.

In addition to originating loans for our own portfolio, we conduct mortgage banking activities in which we originate and sell servicing-released, whole loans in the secondary market. Our mortgage banking loan sale activities are primarily directed at originating single family mortgages that are priced and underwritten to conform to previously agreed-upon criteria before loan funding and are delivered to the investor shortly after funding. The level of future loan originations, loan sales, and loan repayments depends on overall credit availability, the interest rate environment, the strength of the general economy, local real estate markets and the housing industry, and conditions in the secondary loan sale market. The amount of gain or loss on the sale of loans is primarily driven by market conditions and changes in interest rates, as well as our pricing and asset liability management strategies. As of September 30, 2024 and December 31, 2023, we had Mortgage loans held for sale of $12.3 million and $7.3 million, respectively, of residential mortgage loans we originated. As of September 30, 2024 and December 31, 2023, we had loans held for sale of $0.5 million and $0.0 million, respectively, consisting of one non-performing loan.

Beginning in the first quarter of 2022, the Company entered into whole loan purchase agreements to acquire third party originated and serviced unsecured consumer loans to hold for investment. As of September 30, 2024, the Company has $8.6 million in loans accounted for under the fair value option with an unpaid principal balance amount of $8.9 million. As of December 31, 2023, the Company had $13.7 million in loans accounted for under the fair value option with an unpaid principal balance amount of $14.1 million. See Note 12 – Fair Value in the Notes to Condensed Consolidated Financial Statements.

As of September 30, 2024, the Company has $2.6 million in PPP loans outstanding with $50 thousand in remaining fees to be recognized. As of December 31, 2023, the Company had $4.2 million in PPP loans outstanding with $0.1 million in remaining fees to be recognized. The remaining fees represent the net amount of the fees from the SBA for participation in the PPP less the loan origination costs on these loans. The current amortization of this income is being recognized over a five-year period from the time of origination, however, if a loan receives full forgiveness from the SBA or if the borrower repays the loan, the remaining income will be recognized upon payoff.

The following presents the amortized cost of our loan portfolio by type of loan as of the dates noted (dollars in thousands):

(1) Includes PPP loans of $2.6 million and $4.2 million as of September 30, 2024 and December 31, 2023, respectively.

(2) Includes $8.9 million and $14.1 million of unpaid principal balance of Loans held for investment accounted for under fair value option as of September 30, 2024 and December 31, 2023, respectively.

(3) Includes $12.1 million and $7.1 million of unpaid principal balance of Mortgage loans held for sale as of September 30, 2024 and December 31, 2023, respectively.

• *Cash, Securities, and Other—*consists of consumer and commercial purpose loans, which are primarily secured by securities managed and under custody with us, cash on deposit with us, or life insurance policies. In addition, loans in this portfolio are collateralized with other sources of collateral. This segment of our portfolio is affected by a variety of local and national economic factors affecting borrowers’ employment prospects, income levels, and overall economic sentiment. PPP loans that are fully guaranteed by the SBA are classified within this line item and had balances of $2.6 million and $4.2 million as of September 30, 2024 and December 31, 2023, respectively.
• *Consumer and Other—*consists of unsecured consumer loans. This segment of our portfolio is affected by a variety of local and national economic factors affecting borrowers’ employment prospects, income levels, and overall economic sentiment. Loans held for investment accounted for under the fair value option are primarily consumer and other loans and are presented separately within the above table. They had an unpaid principal balance of $8.9 million and $14.1 million as of September 30, 2024 and December 31, 2023, respectively.
• *Construction and Development—*consists of loans to finance the construction of residential and non-residential properties. These loans are dependent on the strength of the industries of the related borrowers and the risks consistent with construction projects.
• *1-4 Family Residential—*consists of loans and home equity lines of credit secured by 1-4 family residential properties. These loans typically enable borrowers to purchase or refinance existing homes, most of which serve as the primary residence of the owner. In addition, some borrowers secure a commercial purpose loan with owner occupied or non-owner occupied 1-4 family residential properties. Loans in this segment are dependent on the industries tied to these loans as well as the national and local economies, and local residential and commercial real estate markets.
• *Commercial Real Estate, Owner Occupied, and Non-Owner Occupied—*consists of commercial loans collateralized by real estate. These loans may be collateralized by owner occupied or non-owner occupied real estate, as well as multi-family residential real estate. These loans are dependent on the strength of the industries of the related borrowers and the success of their businesses.
• *Commercial and Industrial—*consists of commercial and industrial loans, including working capital lines of credit, permanent working capital term loans, business asset loans, acquisition, expansion and development loans, and other loan products, primarily in our target markets. This portfolio primarily consists of term loans and lines of credit which are dependent on the strength of the industries of the related borrowers and the success of their businesses. MSLP loans of $2.0 million and $5.1 million as of September 30, 2024 and December 31, 2023, respectively, are included in this category.

The contractual maturity ranges of loans in our loan portfolio and the amount of such loans with fixed and floating interest rates in each maturity range, at amortized cost as of the dates noted, are summarized in the following tables:

(dollars in thousands)

(dollars in thousands)

(1) Includes PPP loans.

Loan Modifications

The following table presents the amortized cost basis as of September 30, 2024 of the loans modified to borrowers experiencing financial difficulty disaggregated by class of financing receivable and type of concession granted during the nine months ended September 30, 2024. For the three months ended September 30, 2024, there were no loan modifications made to borrowers experiencing financial difficulty. For the three and nine months ended September 30, 2023, the Company made protective advances of $0.0 million and $0.5 million to borrowers experiencing financial difficulty. The percentage of the amortized cost basis of loans that were modified to borrowers in financial distress as compared to the amortized cost basis of each class of financing receivable is also presented below.

(dollars in thousands)

The following table presents the amortized cost basis as of September 30, 2023 of the loans modified to borrowers experiencing financial difficulty disaggregated by class of financing receivable and type of concession granted during the three and nine months ended September 30, 2023.

(dollars in thousands)

The following tables present the financial effect by type of modification made to borrowers experiencing financial difficulty during the periods noted:

(dollars in thousands)

(dollars in thousands)

There were no loans that experienced a default during the three and nine months ended September 30, 2024, subsequent to being granted a modification in the preceding twelve months. There were no loans that experienced a default during the three and nine months ended September 30, 2023, subsequent to being granted a modification in the preceding twelve months.

Non-Performing Assets

Non-performing assets include non-accrual loans and OREO. The accrual of interest on loans is discontinued at the time the loan becomes 90 or more days delinquent unless the loan is well secured and in the process of collection or renewal due to maturity. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on non-accrual status or charged off if collection of interest or principal is considered doubtful.

OREO represents assets acquired through, or in lieu of, foreclosure. The amounts reported as OREO are supported by recent appraisals, with the appraised values adjusted, where applicable, for expected transaction fees likely to be incurred upon sale of the property. We incur recurring expenses relating to OREO in the form of maintenance, taxes, insurance, and legal fees, among others, until the OREO parcel is disposed. While disposition efforts with respect to our OREO are generally ongoing, if these properties are appraised at lower-than-expected values or if we are unable to sell the properties at the prices for which we expect to be able to sell them, we may incur additional losses. In the second quarter of 2024, the Company recorded $11.4 million of OREO as a result of obtaining physical possession of two foreclosed properties as partial consideration for amounts owed on non-performing loans related to an isolated loan relationship. During the third quarter of 2024, the Company recorded an additional $25.6 million of OREO related to a third foreclosed property within the same loan relationship. As of September 30, 2024, these OREO properties had a carrying amount of $37.0 million. As of December 31, 2023, we did not own any OREO properties.

The amount of lost interest for non-accrual loans was $1.6 million and $0.5 million for the three months ended September 30, 2024 and 2023, respectively. The amount of lost interest for non-accrual loans was $6.2 million and $1.4 million for the nine months ended September 30, 2024 and 2023, respectively.

We had amortized cost of $51.5 million and $50.8 million in non-performing assets as of September 30, 2024 and December 31, 2023, respectively. Although consistent balances of non-performing assets when comparing September 30, 2024 and December 31, 2023, there was significant activity within the three months ended September 30, 2024. Non-performing assets increased $2.7 million during the three months ended September 30, 2024, which was the combination of an increase in OREO of $25.6 million, offset by a decrease in non-performing loans of $22.9 million. The decrease in non-performing loans was driven by the migration of one loan relationship out of non-performing loans and into OREO, pay downs, charge-offs, and the sale of a non-performing loan, offset by additions to non-performing loans.

The following table presents the amortized cost basis of non-performing assets as of the dates noted:

(dollars in thousands)

(1) Excludes Mortgage loans held for sale of $12.3 million and $7.3 million as of September 30, 2024 and December 31, 2023, respectively. Excludes loans held for sale of $0.5 million and $0.0 million as of September 30, 2024 and December 31, 2023, respectively. Excludes $8.9 million and $14.1 million of unpaid principal balance of loans held for investment accounted for under the fair value option as of September 30, 2024 and December 31, 2023, respectively.

(2) Held at the lower of cost or market as noted per Note 12.

Credit Quality Indicators

We categorize loans into risk categories based on relevant information about the ability of the borrowers to service their debt, such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. We analyze loans individually by classifying the loans by credit risk on a quarterly basis, which are segregated into the following definitions for risk ratings:

*Special Mention—*Loans categorized as special mention have a potential weakness or borrowing relationships that require more than the usual amount of management attention. Adverse industry conditions, deteriorating financial conditions, declining trends, management problems, documentation deficiencies, or other similar weaknesses may be evident. Ability to meet current payment schedules may be questionable, even though interest and principal are still being paid as agreed. The asset has potential weaknesses that may result in deteriorating repayment prospects if left uncorrected. Loans in this risk grade are not considered adversely classified.

*Substandard—*Substandard loans are considered "classified" and are inadequately protected by the current net worth and paying capacity of the obligor or by the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardizes the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loans in this category may be placed on non-accrual status and may individually be evaluated.

*Doubtful—*Loans graded doubtful are considered "classified" and have all the weaknesses inherent in those classified as Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions, and values, highly questionable and improbable. However, the amount or certainty of eventual loss is not known because of specific pending factors.

Loans accounted for under the fair value option are not rated.

Loans not meeting any of the three criteria above are considered to be pass-rated loans.

As of September 30, 2024 and December 31, 2023, non-performing loans of $14.4 million and $50.8 million, respectively, were included in the substandard category in the table below. The following presents the amortized cost basis of loans by credit quality indicator, by class of financing receivable, as of the dates noted:

(dollars in thousands)

(dollars in thousands)

(1) Includes PPP loans of $2.6 million and $4.2 million as of September 30, 2024 and December 31, 2023, respectively.

(2) Includes $8.6 million and $13.7 million of loans held for investment accounted for under fair value option as of September 30, 2024 and December 31, 2023, respectively.

Allowance for Credit Losses on Loans

The Allowance for credit losses (“ACL”) is a valuation account that is deducted from the loans’ amortized cost basis to present the net amount expected to be collected on the loans. The ACL excludes loans held for sale and loans accounted for under the fair value option. The Company elected to not measure an ACL for accrued interest receivables, as we write off applicable accrued interest receivable balances in a timely manner when a loan is placed on non-accrual status, in which any accrued but uncollected interest is reversed from current income. Loans are charged off against the allowance when management believes the uncollectability of a loan balance is confirmed. Expected recoveries do not exceed the aggregate of amounts previously charged-off and expected to be charged-off. Management estimates the allowance balance using relevant available information, from internal and external sources, related to past events, current conditions, and reasonable and supportable forecasts. Actual Company and regional peer historical credit loss experience provides the basis for the estimation of expected credit losses. The Company identified and grouped portfolio segments based on risk characteristics and underlying collateral. The call code for each financial asset type was assessed and, where appropriate, expanded for certain call codes into separate segments based on risk characteristics.

ASU 2016-13 for Current Expected Credit Losses (“CECL”) requires an allowance for credit losses on all portfolio loans including purchased loans without credit deterioration. As of September 30, 2024, the Company held $172.6 million in acquired loans with $1.4 million in Allowance for credit losses as well as $3.9 million in unamortized discounts. As of December 31, 2023, the Company held $208.2 million in acquired loans with $2.0 million in Allowance for credit losses as well as $3.9 million in unamortized discounts.

ACL for pooled loans are estimated using a discounted cash flow (“DCF”) methodology using the amortized cost basis (excluding interest) for all loans modeled within a performing pool of loans. The DCF analysis pairs loan-level term information, for example, maturity date, payment amount, interest rate, with top-down pool assumptions such as default rates, prepayment speeds, to produce individual expected cash flows for every instrument in the segment. The results are then aggregated to produce segment level results and reserve requirements for each segment.

The quantitative DCF model also incorporates forward-looking macroeconomic information over a reasonable and supportable period of four quarters. Subsequent to the four quarter period, the Company reverts to its historical loss rate and historical prepayment and curtailment speeds on a straight-line basis over a four quarter reversion period.

The Company applies qualitative factors to capture losses that are expected but may not be adequately reflected in the quantitative model described above. Qualitative adjustments are made based on management’s assessment of the risks that may lead to a future loan loss or differences in current loan-specific risk characteristics such as differences in underwriting standards, portfolio mix, changes in environmental and economic conditions, or other relevant factors.

Loans that do not share risk characteristics are evaluated on an individual basis. Loans evaluated individually are not included in the pooled loan evaluation. When management determines that foreclosure is probable, expected credit losses are based on the fair value of the collateral at the reporting date, adjusted for selling costs as appropriate.

ACL – held-to-maturity securities: Held-to maturity securities are carried at amortized cost when management has the positive intent and ability to hold them to maturity. The majority of our held-to-maturity investment portfolio consists of securities issued by U.S. government entities and agencies. These securities are either explicitly or implicitly guaranteed by the U.S. government, are highly rated by major rating agencies, and have a long history of no credit losses. With respect to these securities, we consider the risk of credit loss to be zero and, therefore, we do not record an ACL for these securities. The Company's non-government backed securities include private label CMO and MBS debt securities and corporate bonds. Private label refers to private institutions such as brokerage firms, banks, and home builders, that also securitize mortgages.

Management measures expected credit losses on held-to-maturity debt securities on a collective basis by major security type. Accrued interest receivable on held-to-maturity debt securities is excluded from the estimate of credit losses. The estimate of expected credit losses considers historical credit loss information that is adjusted for current conditions and reasonable and supportable forecasts. Management reviewed the collectability of CMO and MBS debt securities and corporate bonds taking into consideration factors such as the asset quality and delinquencies of the issuers.

ACL – off-balance sheet credit exposures: The Company estimates expected credit losses over the contractual period in which the Company is exposed to credit risk via a contractual obligation to extend credit, unless that obligation is unconditionally cancellable by the Company. The allowance for credit losses on off-balance sheet credit exposures is adjusted through the Provision for credit losses and is recorded in Other liabilities. The estimate includes consideration of the likelihood that funding will occur and an estimate of expected credit losses on commitments expected to be funded over its estimated life. The probability of funding is based on historical utilization statistics for unfunded loan commitments. The loss rates used are calculated using the same assumptions as the associated funded balance.

The ACL represents Management’s best estimate of current expected credit losses on loans considering available information, from internal and external sources, relevant to assessing collectability over the loans’ contractual terms, adjusted for expected prepayments when appropriate. Our quantitative discounted cash flow models use economic forecasts including; housing price index (“HPI”), gross domestic product (“GDP”), and national unemployment. The HPI, GDP, and unemployment twelve-month forecasts used in our model remained consistent during the nine months ended September 30, 2024. As such, the $1.6 million release of provision on pooled loans for the nine months ended September 30, 2024 was predominately due to net pay downs in the loan portfolio. The Allowance for credit losses on individually analyzed loans was $0.3 million and $3.8 million as of September 30, 2024 and December 31, 2023, respectively. This $3.5 million release of provision on individually analyzed loans for the nine months ended September 30, 2024 was due to the migration of one loan relationship out of non-performing loans and into OREO, pay downs, charge-offs, and the sale of a non-performing loan.

The following presents summary information regarding our allowance for credit losses during the periods presented:

(dollars in thousands)

(1) Average balances are average daily balances.

(2) Excludes average outstanding balances of Mortgage loans held for sale of $18.4 million and $12.7 million for the three months ended September 30, 2024 and 2023, respectively, and $15.2 million and $12.0 million for the nine months ended September 30, 2024 and 2023, respectively. Excludes average outstanding balances of loans held for investment under the fair value option of $9.7 million and $16.7 million for the three months ended September 30, 2024 and 2023, respectively, and $11.4 million and $19.7 million for the nine months ended September 30, 2024 and 2023, respectively.

(3) Excludes Mortgage loans held for sale of $12.3 million and $12.1 million as of September 30, 2024 and 2023, respectively. Excludes Loans held for sale of $0.5 million and $0.0 million as of September 30, 2024 and December 31, 2023, respectively. Excludes $8.9 million and $16.1 million of unpaid principal balance of loans held for investment accounted for under the fair value option as of September 30, 2024 and 2023, respectively.

The following presents the allocation of the allowance for credit losses among loan categories and other summary information. The allocation for credit losses by category should neither be interpreted as an indication of future charge-offs, nor as an indication that charge-offs in future periods will necessarily occur in these amounts or in the indicated proportions. The allocation of a portion of the allowance for credit losses to one category of loans does not preclude its availability to absorb losses in other categories.

(dollars in thousands)

(1) Represents the percentage of loans to total loans in the respective category.

Allowance for credit losses - off-balance sheet credit exposures

The Company estimates expected credit losses over the contractual period in which the Company is exposed to credit risk via a contractual obligation to extend credit, unless that obligation is unconditionally cancellable by the Company. The allowance for credit losses on off-balance sheet credit exposures is adjusted through Provision for credit losses and is recorded in Other liabilities. The estimate includes consideration of the likelihood that funding will occur and an estimate of expected credit losses on commitments expected to be funded over its estimated life. The probability of funding is based on historical utilization statistics for unfunded loan commitments. The loss rates used are calculated using the same assumptions as the associated funded balance. Refer above for changes in the factors that influenced the current estimate of ACL and reasons for the changes. The following table presents the changes in the ACL on unfunded loan commitments:

(dollars in thousands)

Deferred Tax Assets, Net

Deferred tax assets, net of our valuation allowance, represent the differences in timing of when items are recognized for GAAP purposes and when they are recognized for tax purposes, as well as our net operating losses. Our deferred tax assets, net, are valued based on the amounts that are expected to be recovered in the future utilizing the tax rates in effect at the time recognized. Deferred tax assets, net as of September 30, 2024 were $4.1 million, a decrease of $2.3 million, or 36.4%, from December 31, 2023.

Deposits

Our deposit products include money market accounts, demand deposit accounts, time-deposit accounts (typically certificates of deposit), interest checking accounts, and savings accounts. Our accounts are federally insured by the FDIC up to the legal maximum amount.

Total deposits decreased by $26.0 million, or 1.0%, to $2.50 billion as of September 30, 2024, from December 31, 2023. Total average deposits for the three months ended September 30, 2024 were $2.40 billion, an increase of $43.7 million, or 1.9%, compared to $2.36 billion as of September 30, 2023. Total average deposits for the nine months ended September 30, 2024 were $2.42 billion, an increase of $61.9 million, or 2.6%, compared to $2.36 billion as of September 30, 2023. The increase in average deposits for the three and nine months ended September 30, 2024 compared to the same periods in 2023 were driven primarily by Interest-bearing deposits due to new and expanded deposit relationships offset partially by a decline in Noninterest-bearing deposits.

The following presents the average balances and average rates paid on deposits during the periods presented:

(dollars in thousands)

(dollars in thousands)

Average noninterest-bearing deposits to average total deposits was 16.5% and 21.7% for the three months ended September 30, 2024 and 2023, respectively, and 17.3% and 22.4% for the nine months ended September 30, 2024 and 2023, respectively.

Our average cost of funds was 3.56% and 3.08% for the three months ended September 30, 2024 and 2023, respectively, and 3.52% and 2.77% for the nine months ended September 30, 2024 and 2023, respectively. The increase in cost of funds was primarily driven by increased rates on Interest-bearing deposit accounts and borrowings due to the current rate environment and an unfavorable mix shift in deposit balances.

Total money market accounts as of September 30, 2024 were $1.4 billion, a decrease of $35.5 million, or 2.6%, compared to December 31, 2023. Interest checking accounts decreased $17.2 million, or 11.7%, to $130.3 million compared to December 31, 2023.

Total time deposits as of September 30, 2024 were $533.5 million, an increase of $37.0 million, or 7.5%, from December 31, 2023.

The following presents the amount of certificates of deposit by time remaining until maturity as of September 30, 2024:

(dollars in thousands)

Borrowings

We have short-term and long-term borrowing sources available to supplement deposits and meet our liquidity needs. As of September 30, 2024 and December 31, 2023, borrowings totaled $114.9 million and $178.1 million, respectively.

On March 12, 2023 the Federal Reserve Board announced it would make additional funding available to eligible depository institutions to help assure banks have the ability to meet the needs of depositors made available through the creation of a new Bank Term Funding Program (“BTFP”). The BTFP is meant to be an additional resource of liquidity against high-quality securities, eliminating an institution’s need to quickly sell those securities in times of stress. On March 27, 2024, the Company repaid $31.0 million of BTFP borrowings. As of September 30, 2024, the Company has pledged a par value of $10.3 million in securities under the BTFP and borrowed $10.0 million with a maturity date of January 10, 2025. The rate for the borrowing is based on the one year overnight swap rate plus 10 basis points and is fixed over the term of the advance based on the date of the advance.

The decrease in borrowings as of September 30, 2024 compared to December 31, 2023 was driven by a lower reliance on FHLB and FRB borrowings due to the decrease in loans.

The following presents balances of each of the borrowing facilities as of the dates noted:

(dollars in thousands)

80

FHLB

We have a blanket pledge and security agreement with FHLB that requires certain loans and securities to be pledged as collateral for any outstanding borrowings under the agreement. The collateral pledged as of September 30, 2024 and December 31, 2023 amounted to $1.30 billion and $1.31 billion, respectively. Based on this collateral and the Company’s holdings of FHLB stock, the Company was eligible to borrow an additional $612.1 million as of September 30, 2024.

(dollars in thousands)

The Bank has borrowing capacity associated with two unsecured federal funds lines of credit up to $10.0 million and $19.0 million. As of September 30, 2024 and December 31, 2023, there were no amounts outstanding on any of the federal funds lines.

Our borrowing facilities include various financial and other covenants, including, but not limited to, a requirement that the Bank maintains regulatory capital that is deemed "well capitalized" by federal banking agencies. As of September 30, 2024 and December 31, 2023, the Company was in compliance with the covenant requirements.

Derivatives

Cash Flow Hedges: On March 21, 2023, the Company executed an interest rate swap with a notional amount that was designated as a cash flow hedge of certain Federal Home Loan Bank borrowings. The notional amount of the interest rate swaps does not represent amounts exchanged by the parties. The amount exchanged is determined by reference to the notional amount and the other terms of the individual interest rate swap agreements. The swap hedges the benchmark index (SOFR) with a receive float/pay fixed swap for the period March 21, 2023 through April 1, 2026. The notional amount of the interest rate swap as of September 30, 2024 and December 31, 2023 was $50.0 million. As of September 30, 2024 and December 31, 2023, this hedge was determined to be effective, and the Company expects the hedge to remain effective during the remaining terms of the swap.

Derivatives Not Designated as Hedges: The Company periodically enters into interest rate swaps to offset interest rate exposure with its commercial and residential variable rate loan clients. Clients with variable rate loans may choose to enter into an interest rate swap to hedge the interest rate risk on the loan and effectively pay a fixed rate payment. The Company will simultaneously enter into an interest rate swap on the same underlying loan and notional amount to hedge risk on the fixed rate loan. The notional amount of interest rate swaps with its loan customers as of September 30, 2024 and December 31, 2023 was $50.6 million and $30.3 million, respectively. While these derivatives represent economic hedges, they do not qualify as hedges for accounting purposes.

Liquidity and Capital Resources

Liquidity resources primarily include Interest-bearing and Noninterest-bearing deposits which contribute to our ability to raise funds to support asset growth, acquisitions, and meet deposit withdrawals and other payment obligations. Access to purchased funds include the ability to borrow from FHLB, other correspondent banks, and the use of brokered deposits.

The following table presents the composition of our funding sources and the average assets in which those funds are invested as a percentage of average total assets during the periods presented:

Our primary source of funds is Interest-bearing and Noninterest-bearing deposits, and our primary use of funds is loans. We do not expect a change in the primary source or use of our funds in the foreseeable future.

Capital Resources

Total shareholders’ equity increased $6.1 million, or 2.5%, from December 31, 2023 to $248.8 million as of September 30, 2024. The increase was primarily due to Net income year to date.

On January 6, 2022, the Company filed a Form S-3 Registration Statement with the SEC providing that the Company may offer and sell from time to time, separately or together, in multiple series or in one or more offerings, any combination of common stock, preferred stock, debt securities, warrants, depository shares and units, up to a maximum aggregate offer price of $100 million.

On June 13, 2024, the Company announced that its board of directors authorized the repurchase of up to 200,000 shares of the Company’s common stock, no par value, from time to time, within one year (the “2024 Repurchase Plan”) and that the Board of Governors of the Federal Reserve System advised the Company that it has no objection to the Company’s 2024 Repurchase Plan. The Company may repurchase shares in privately negotiated transactions, in the open market, including pursuant to any trading plan that may be adopted in accordance with Rule 10b5-1 promulgated by the Securities and Exchange Commission, or otherwise in a manner that complies with applicable federal securities laws. The 2024 Repurchase Plan does not obligate the Company to acquire a specific dollar amount or number of shares and it may be extended, modified or discontinued at any time without notice. During the three months ended September 30, 2024, the Company repurchased 5,501 shares under the authorization of the 2024 Repurchase Plan. As of September 30, 2024, there were 194,499 shares available for repurchase under the plan.

We are subject to various regulatory capital adequacy requirements at a consolidated level and the Bank level. These requirements are administered by federal 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 our condensed consolidated financial statements. Under capital adequacy guidelines and, additionally for banks, the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices.

Capital levels are viewed as important indicators of an institution’s financial soundness by banking regulators. Generally, FDIC-insured depository institutions and their holding companies are required to maintain minimum capital relative to the amount and types of assets they hold. As of September 30, 2024 and December 31, 2023, our holding company and Bank were in compliance with all applicable regulatory capital requirements, and the Bank was classified as "well capitalized," for purposes of the prompt corrective action regulations. As we continue to grow our operations and maintain capital requirements, our regulatory capital levels may decrease depending on our level of earnings. We continue to monitor growth and control our capital activities in order to remain in compliance with all applicable regulatory capital standards.

The following table presents our regulatory capital ratios for the dates noted:

(dollars in thousands)

Contractual Obligations and Off-Balance Sheet Arrangements

We enter into credit-related financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our clients. These financial instruments include commitments to extend credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Condensed Consolidated Balance Sheets. Commitments may expire without being utilized. Our exposure to credit loss is represented by the contractual amount of these commitments, although material losses are not anticipated. We follow the same credit policies in making commitments as we do for on-balance sheet instruments.

The following presents future contractual obligations to make future payments during the periods presented:

(dollars in thousands)

(1) Reflects contractual maturity dates of March 31, 2030, December 1, 2030, September 1, 2031, and December 15, 2032.

The following presents financial instruments whose contract amounts represent credit risk, as of the periods presented:

(dollars in thousands)

We may enter into contracts for services in the conduct of ordinary business operations, which may require payment for services to be provided in the future and may contain penalty clauses for early termination of the contracts. We do not believe these off-balance sheet arrangements have or are reasonably likely to have a material effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources. However, there can be no assurance that such arrangements will not have an effect on future operations.

Critical Accounting Policies

Our accounting policies and procedures are described in Note 1 – Organization and Summary of Significant Accounting Policies in the accompanying Notes to the Condensed Consolidated Financial Statements as well as the Company’s Annual Report on Form 10-K for the year ended December 31, 2023 as filed with the SEC.

Interest Rate Sensitivity and Market Risk

Market risk is the risk of loss in a financial instrument arising from adverse changes in market prices and rates, foreign currency exchange rates, commodity prices, and equity prices. Our market risk arises primarily from interest rate risk inherent in lending, investing, and deposit taking activities. To that end, management actively monitors and manages interest rate risk exposure. We do not have any market risk sensitive instruments entered into for trading purposes.

Management uses various asset/liability strategies to manage the re-pricing characteristics of our assets and liabilities designed to ensure that exposure to interest rate fluctuations is limited within established guidelines of acceptable levels of risk-taking.

The board of directors monitors interest rate risk by analyzing the potential impact on the net economic value of equity and net interest income from potential changes in interest rates and considers the impact of alternative strategies or changes in balance sheet structure. We manage our balance sheet, in part, to maintain the potential impact on economic value of equity and net interest income within acceptable ranges despite changes in interest rates.

Our exposure to interest rate risk is reviewed at least quarterly by the board of directors. Interest rate risk exposure is measured using interest rate sensitivity analysis to determine the change in net interest income and economic value of equity in the event of hypothetical changes in interest rates. If potential changes to net economic value of equity and net interest income resulting from hypothetical interest rate changes are not within the limits established by our board of directors, the board of directors may direct management to adjust the asset and liability mix to bring interest rate risk within board-approved limits.

The following presents the sensitivity in net interest income and fair value of equity during the periods presented, using a parallel ramp scenario.

84

The model simulations as of September 30, 2024 imply that our balance sheet maintains a relatively consistent interest rate risk profile compared to our balance sheet as of December 31, 2023.

Although the simulation model is useful in identifying potential exposure to interest rate changes, actual results for net interest income and economic value of equity may differ. There are a variety of factors that can impact the outcomes such as timing and magnitude of interest rate changes, asset and liability mix, pre-payment speeds, deposit beta assumptions, and decay rates that differ from our projections. Additionally, the results do not account for actions implemented to manage our interest rate risk exposure.

Impact of Inflation

Our Condensed Consolidated Financial Statements and related notes included within this Form 10-Q have been prepared in accordance with GAAP, which requires the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative value of money over time due to inflation or recession.

Our assets and liabilities are substantially monetary in nature. Therefore, changes in interest rates can significantly impact our performance beyond the general effects of inflation. Interest rates do not necessarily move in the same direction or magnitude as prices of general goods and services, while other operating expenses can be correlated with the impact of general levels of inflation.

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this Form 10-Q, the Company carried out an evaluation, under the supervision and with the participation of its management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management was required to apply judgment in evaluating its controls and procedures. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or the “Exchange Act”) were effective as of the end of the period covered by this report.

Changes in Internal Control over Financial Reporting

There were no changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the three and nine months ended September 30, 2024 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

There has been no material change in the risk factors previously disclosed under “Item 1A. Risk Factors” of the Company’s 2023 Annual Report on Form 10-K filed with the SEC on March 15, 2024.