Bancorp 34, Inc.: Form 10-Q for the period ended Jun 30, 2018

Management’s discussion and analysis of financial condition at June 30, 2018 and December 31, 2017 and results of operations for the three and six months ended June 30, 2018 and 2017 is intended to assist in understanding the financial condition and results of operations of the Company. The information contained in this section should be read in conjunction with the Unaudited Consolidated Financial Statements and the notes thereto, appearing in Part 1, Item 1 of this report.

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

Certain statements contained in this document that are not historical facts may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (referred to as the Securities Act), and Section 21E of the Securities Exchange Act of 1934, as amended (referred to as the Securities Exchange Act), and are intended to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. You can identify these statements from the use of the words “may,” “will,” “should,” “could,” “would,” “plan,” “potential,” “estimate,” “project,” “tend,” “believe,” “intend,” “anticipate,” “expect,” “target” and similar expressions.

These forward-looking statements are subject to significant risks, assumptions and uncertainties, including among other things, changes in general economic and business conditions. Because of these and other uncertainties, Bancorp 34’s actual results, performance or achievements, or industry results, may be materially different from the results indicated by these forward-looking statements. You should not place undue reliance on any forward-looking statements, which speak only as of the dates on which they were made. Bancorp 34 is not undertaking an obligation to update these forward-looking statements, even though its situation may change in the future, except as required under federal securities law. Bancorp 34 qualifies all of its forward-looking statements by these cautionary statements.

Critical Accounting Policies

Critical accounting policies are those that involve significant judgments and assumptions by management and that have, or could have, a material impact on our income or the carrying value of our assets. Our critical accounting policies are those related to our allowance for loan losses, the evaluation of other-than-temporary impairment of investment securities, the valuation of and our ability to realize deferred tax assets and the measurement of fair values of financial instruments.

Allowance for Loan Losses. The allowance for loan losses is calculated with the objective of maintaining an allowance necessary to absorb credit losses inherent in the loan portfolio. Management’s determination of the adequacy of the allowance is based on periodic evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective, as it requires an estimate of the loss content for each risk rating and for each impaired loan, an estimate of the amounts and timing of expected future cash flows, and an estimate of the value of collateral.

We have established a systematic method of periodically reviewing the credit quality of the loan portfolio in order to establish an allowance for loan losses. The allowance for loan losses is based on our current judgments about the credit quality of individual loans and segments of the loan portfolio. The allowance for loan losses is established through a provision for loan losses based on our evaluation of the probable losses inherent in the loan portfolio, and considers all known internal and external factors that affect loan collectability as of the reporting date. Our evaluation, which includes a review of loans on which full collectability may not be reasonably assured, considers among other matters, the estimated net realizable value or the fair value of the underlying collateral, economic conditions, historical loan loss experience, our knowledge of inherent losses in the portfolio that are probable and reasonably estimable and other factors that warrant recognition in providing an appropriate loan loss allowance. Management believes this is a critical accounting policy because this evaluation involves a high degree of complexity and requires us to make subjective judgments that often require assumptions or estimates about various matters.

The allowance for loan losses consists primarily of specific allocations and general allocations. Specific allocations are made for loans that are determined to be impaired. Impairment is measured by determining the present value of expected future cash flows or, for collateral-dependent loans, the fair value of the collateral, including adjustments for market conditions and selling expenses. The general allocation is determined by segregating the remaining loans by type of loan, risk weighting and payment history. We also analyze delinquency trends, general economic conditions, trends in historical loss experience, and geographic and industry concentrations. This analysis establishes factors that are applied to the loan groups to determine the amount of the general allowance. The principal assumption used in calculating the allowance for loan losses is the estimate of loss for each risk rating. Actual loan losses may be significantly more than the allowance we have established, which could have a material negative effect on our financial results.

Other-Than-Temporary Impairment. Securities are evaluated on at least a quarterly basis, to determine whether a decline in their value is other-than-temporary. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) whether or not we intend to sell or expect that it is more likely than not that we will be required to sell the investment security prior to an anticipated recovery in fair value. Once a decline in value for a debt security is determined to be other than temporary, the other-than-temporary impairment is separated in (a) the amount of total other-than-temporary impairment related to a decrease in cash flows expected to be collected from the debt security (the credit loss) and (b) the amount of other-than-temporary impairment related to all other factors. The amount of the total other-than-temporary impairment related to credit loss is recognized in operations. The amount of other-than-temporary impairment related to other factors is recognized in other comprehensive income (loss).

Valuation of Deferred Tax Assets. As a result of the reduction in the Federal corporate tax rate effective in 2018 under the Tax Cuts and Jobs Act signed into law in December 2017, income tax expense for 2017 includes a $1.2 million deferred tax asset re-measurement adjustment. Effective December 31, 2016, we reversed 100% of our net deferred tax asset valuation allowances and recognized an income tax benefit based upon our assessment of net deferred tax assets that are more-likely-than-not to be realized. The net deferred tax asset had been offset by an equal valuation allowance from June 2012 through November 2016. In evaluating our ability to realize deferred tax assets, management considers all positive and negative information, including our past operating results and our forecast of future taxable income. In determining future taxable income, management utilizes a budget process that makes business assumptions and the implementation of feasible and prudent tax planning strategies, if any. These assumptions require us to make judgments about our future taxable income that are consistent with the plans and estimates we use to manage our business. Any change in estimated future taxable income or effective tax rates may result in changes to the carrying balance of our net deferred tax assets which would result in an income tax benefit or expense in the same period.

Fair Value Measurements. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. A three-level of fair value hierarchy prioritizes the inputs used to measure fair value:

• Level 1 – Quoted prices in active markets for identical assets or liabilities; includes certain U.S. Treasury and other U.S. Government agency debt that is highly liquid and actively traded in over-the-counter markets.
• Level 2 – Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
• Level 3 – Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

The asset or liability’s fair value measurement level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement.

Average Balance Sheets

The following tables set forth average balances, average yields and costs, and certain other information for the periods indicated. Tax-equivalent yield adjustments have not been made for tax-exempt securities, as the effect thereof was not material. All average balances are daily average balances. Non-accrual loans were included in the computation of average balances, but have been reflected in the table as loans carrying a zero yield. The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income.

(Dollars in thousands)

(1) Yield/Rate for the three-month periods have been annualized.

(2) Net interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average rate of interest-bearing liabilities.

(3) Net interest-earning assets represent total interest-earning assets less total interest-bearing liabilities.

(4) Net interest margin represents net interest income as a percentage of average total interest-earning assets.

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(Dollars in thousands)

(1) Yield/Rate for the six-month periods have been annualized.

(2) Net interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average rate of interest-bearing liabilities.

(3) Net interest-earning assets represent total interest-earning assets less total interest-bearing liabilities.

(4) Net interest margin represents net interest income as a percentage of average total interest-earning assets.

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Comparison of Financial Condition at June 30, 2018 and December 31, 2017

Cash and cash equivalents increased $11.4 million, or 114.9%, to $21.2 million at June 30, 2018 from $9.9 million at December 31, 2017. The company was holding excess liquid funds at June 30, 2018 due to anticipated near-term loan growth projections, funded by $10.0 million in brokered certificates of deposit on June 28, 2018.

Available-for-sale securities increased $4.8 million, or 19.8%, during the six months ended June 30, 2018 to $29.2 million as we took advantage of higher interest rates in June to replace some of our regular monthly mortgage-backed securities principal reductions.

Loans held for sale at June 30, 2018 totaled $21.3 million, consisting entirely of residential mortgage loans. We currently sell a significant majority of our residential mortgage loans in the secondary market. At December 31, 2017, loans held for sale totaled $15.4 million. The balances at any date vary based upon the timing and volume of current loan originations and sales.

Loans held for investment increased $18.7 million, or 7.2%, to $279.8 million at June 30, 2018 from $261.0 million at December 31, 2017, due to organic growth. In the six months ended June 30, 2018, commercial real estate loans increased to $17.1 million and represented 88.5% of the gross loan portfolio at June 30, 2018, up from 82.0% at June 30, 2017.

Total deposits increased $10.9 million, or 4.6%, to $246.5 million at June 30, 2018 from $235.6 million at December 31, 2017. The increase included a $7.7 million, or 20.5%, increase in non-interest bearing demand deposits and an $8.8 million, or 14.0% increase in time deposits, partially offset by a $5.6 million, or 4.1%, decrease in savings and NOW deposits. The increase in time deposits included $15.0 million in new brokered deposits, partially offset by decreases of $3.5 million in internet and $2.7 million in retail deposits, respectively.

Borrowings, consisting solely of Federal Home Loan Bank advances, increased $35.0 million, or 77.8%, to $80.0 million at June 30, 2018 from $45.0 million at December 31, 2017. We utilize short-term borrowings to fund loans held for sale and net growth in loans held for investment.

Total stockholders’ equity decreased $5.0 million, or 9.8%, to $46.0 million at June 30, 2018 from $51.0 million at December 31, 2017. The decrease was primarily due to a $4.2 million special dividend paid in the second quarter of 2018 and $1.6 million used to repurchase common stock in the first quarter of 2018, partially offset by $750,000 of net income during the six-month period.

Comparison of Operating Results for the Three Months Ended June 30, 2018 and 2017

General. We had net income of $380,000 for the three months ended June 30, 2018, compared to $338,000 for the three months ended June 30, 2017.

Interest Income. Interest income increased $215,000, or 5.4%, to $4.2 million for the three months ended June 30, 2018 from $4.0 million for the three months ended June 30, 2017. The increase was due to an $11.8 million, or 3.7%, increase in average interest-earning assets and an eight basis point increase in average yields, and by a change in asset mix as loans, our highest yielding assets, increased to 86.9% of average interest-earning assets from 86.0% of average interest-earning assets. Loan and securities interest rates increased in 2018 compared to 2017 due to the higher interest rate environment. The yield on average interest-earning assets increased eight basis points to 5.18% for the three months ended June 30, 2018, from 5.10% for the three months ended June 30, 2017, due primarily to a 24 basis point increase in securities yield from 1.97% for the three months ended June 30, 2017, to 2.21% for the three months ended June 30, 2018. Interest income on loans increased due primarily to a $12.9 million, or 4.8%, increase in average loan balances due to organic growth and a one basis point increase in yield. Interest on securities increased $2,000, or 1.4%, for the three months ended June 30, 2018 compared to the three months ended June 30, 2017. The average balance of securities decreased $2.8 million, or 9.4%, to $26.7 million for the three months ended June 30, 2018, compared to $29.5 million for the three months ended June 30, 2017.

Interest Expense. Interest expense increased $254,000, or 47.5%, to $787,000 for the three months ended June 30, 2018 from $533,000 for the three months ended June 30, 2017. The increase was the result of increases of $131,000, or 91.6%, in interest expense on borrowings and $123,000, or 31.5%, in interest expense on deposits. The average balance of borrowings increased $7.4 million, or 13.0%, from the quarter ended June 30, 2017 to the quarter ended June 30, 2018 and the average rate paid increased 72 basis points from 1.00% for the three months ended June 30, 2017 to 1.72% for the three months ended June 30, 2018.

Interest paid on checking, money market and savings accounts increased $45,000, or 18.0%, to $295,000 for the three months ended June 30, 2018 from $250,000 for the three months ended June 30, 2017. The average rate we paid on such deposit accounts increased 13 basis points to 0.92% for the three months ended June 30, 2018 from 0.79% for the three months ended June 30, 2017 and the average balance increased $2.6 million, or 2.1%, to $128.9 million for the three months ended June 30, 2018 from $126.3 million for the three months ended June 30, 2017. The average rates we pay on deposits is considerably higher in the Arizona market.

Net Interest Income. Net interest income decreased $39,000, or 1.2%, to $3.4 million for the three months ended June 30, 2018 from $3.5 million for the three months ended June 30, 2017, primarily due to a 27 basis point decrease in net interest rate spread from 4.22% for the three months ended June 30, 2017 to 3.95% for the three months ended June 30, 2018. Average interest bearing liability rates increased 36 basis points compared to an eight basis point increase in the average interest earning assets yield. Our average net interest-earning assets decreased by $1.2 million, or 1.7%, to $69.5 million for the three months ended June 30, 2018 from $70.7 million for the three months ended June 30, 2017 due primarily to higher growth in interest-bearing liabilities than interest-earning assets. Loan yield was 5.65% of average loans for the three months ended June 30, 2018, compared to 5.64% in the comparable quarter in 2017. Our cost of borrowings increased 72 basis points to 1.72% for the quarter ended June 30, 2018 from 1.00% for the quarter ended June 30, 2017 due to the increase in short-term market interest rates. The target Federal Funds rate has increased 125 basis points from 0.75% at December 31, 2016 to 2.0% at June 30, 2018 with three 25 basis point increases in 2017 and two in 2018.

Provision for Loan Losses. Provisions for loan losses are charged to operations to establish an allowance for loan losses at a level necessary to absorb known and inherent losses that are both probable and reasonably estimable at the date of the financial statements. If allowance for loan losses is larger than necessary, we post a negative provision as a benefit to earnings. In evaluating the level of the allowance for loan losses, management analyzes several qualitative loan portfolio risk factors including but not limited to, charge-off history over a relevant period, changes in management or underwriting policies, current economic conditions, delinquency statistics, geographic and industry concentrations, the adequacy of the underlying collateral, the financial strength of the borrower and results of internal and external loan reviews.

See “Asset Quality - Allowance for Loan Losses” for additional information.

After an evaluation of these factors, we recorded a provision for loan losses of $71,000 for the three months ended June 30, 2018, compared to $150,000 for the three months ended June 30, 2017. In the quarter ended June 30, 2018, gross loans held for investment grew $18.7 million, or 7.2%. Net recoveries were $6,000 in the three months ended June 30, 2018 and $7,000 for the comparable 2017 quarter.

To the best of our knowledge, we have recorded all loan losses that are both probable and reasonable to estimate at June 30, 2018. However, future changes in the factors described above, including, but not limited to, actual loss experience with respect to our loan portfolio, could result in material increases in our provision for loan losses. In addition, the Office of the Comptroller of the Currency, as an integral part of its examination process, will periodically review our allowance for loan losses and may require us to recognize adjustments to the allowance based on its judgments about the recoverability of our loan balances based upon information available to it at the time of its examination.

Noninterest Income. Noninterest income increased $1.6 million, or 57.7%, to $4.2 million for the three months ended June 30, 2018 from $2.7 million for the three months ended June 30, 2017 due to a higher volume of loan sales and related gains.

The gain on sale of loans increased $1.5 million, or 59.5%, to $4.1 million for the three months ended June 30, 2018 from $2.5 million for the three months ended June 30, 2017 due to expansion of our secondary mortgage loan operation. During the three months ended June 30, 2018, we sold $86.6 million of mortgage loans for a gain of $4.0 million, compared to $63.2 million of mortgage loan sales during the three months ended June 30, 2017 for a gain of $2.3 million. There were $171,000 of SBA loans sold during the three months ended June 30, 2018 with gains of $15,000 recognized directly into income compared to $2.3 million sold in the quarter ended June 30, 2017 with gains of $226,000. We realized a 3.9% average premium (gain on sale/sold loans) on the sales of mortgage loans for the three months ended June 30, 2018 and 3.7% for the three months ended June 30, 2017. We began selling mortgage loans under mandatory delivery contracts as opposed to on a best efforts basis in September 2017, and sales gain percentages tend to be larger under mandatory delivery contracts. Premiums also vary from period to period based upon the mix of government Federal Housing Administration (FHA) and VA loans to conventional loans, geographic markets and market interest rates, specifically 10-year Treasury rates.

Noninterest Expense. Noninterest expense increased $1.6 million, or 28.6%, to $7.1 million for the three months ended June 30, 2018 from $5.5 million for the three months ended June 30, 2017 due primarily to higher salaries and benefits, data processing fees and occupancy expense. The increases were primarily related to growth in our mortgage banking area, which sold 36.7% more loans and had 78.3% more sales gains in the three months ended June 30, 2018 compared to the three months ended June 30, 2017. The increase in salaries and benefits also included $181,000 of equity-based expense in 2018 from December 2017 grants, compared to $0 in the three months ended June 30, 2017. Average assets for the quarter ended June 30, 2018 were 4.1% larger than for the quarter ended June 30, 2017.

Provision for Income Tax. Provision for income tax expense was $119,000 for the three months ended June 30, 2018, representing an effective tax rate of 23.9% on pre-tax income. Although there are numerous differences between pre-tax income and actual taxable income that have an effect on the effective income tax rate for any given period, it is notable that the tax rate assumption used to compute income tax expense in 2018 is lower than previous years due to the permanent reduction in the Federal corporate income tax rate to 21% from the Tax Cuts and Jobs Act enacted in December 2017. A 34% Federal tax rate was applied to earnings in 2017 and previous years. We recognized an income tax expense of $150,000 for the three months ended June 30, 2017 representing 30.7% of the $488,000 income before income taxes.

Comparison of Operating Results for the Six Months Ended June 30, 2018 and 2017

General. We had net income of $750,000 for the six months ended June 30, 2018, compared to net income of $140,000 for the six months ended June 30, 2017. Results in the first six months of 2018 reflected a $307,000 lower provision for loan losses due to improving credit quality and more rapid loan growth in 2017 and a $267,000, or 4.0%, increase in net interest income, mostly due to a 3.5% increase in average interest-earning assets.

Interest Income. Interest income increased $684,000, or 9.0%, to $8.3 million for the six months ended June 30, 2018 from $7.6 million for the six months ended June 30, 2017. The increase was due to a 3.5% increase in average interest-earning assets and a 29 basis point increase in yield. Loans, our highest yielding asset, increased from 84.7% to 86.8% of average interest-earning assets. Interest and fees on loans increased $623,000, or 8.6%, to $7.9 million for the six months ended June 30, 2018, from $7.3 million for the six months ended June 30, 2017. Interest income on loans increased due to a $15.8 million, or 6.0%, increase in average loan balances due to organic growth and a 17 basis point increase in average yields. The average balance of securities decreased $3.5 million, or 9.4%, to $26.7 million for the six months ended June 30, 2018, compared to $30.3 million for the six months ended June 30, 2017 and the average yield increased 41 basis points.

The 29 basis point increase in yield on interest-earning assets from the six months ended June 30, 2017 to the six months ended June 30, 2018 was primarily due to a 17 basis point increase in loan yields and a 41 basis point increase in securities yields due to market interest rate increases.

Interest Expense. Interest expense increased $417,000, or 41.2%, to $1.4 million for the six months ended June 30, 2018 from $1.0 million for the six months ended June 30, 2017. The increase included a $240,000, or 31.3%, increase in interest expense on deposits and a $176,000, or 72.2%, increase in interest expense on borrowings. Our funding cost increases were facilitated by increases in market interest rates as the target Federal Funds rate increased 125 basis points from 0.75% at December 31, 2016 to 2.0% at June 30, 2018 with three 25 basis point increases in 2017 and two in 2018.

Average interest-bearing deposits for the six months ended June 30, 2018 were $195.4 million, representing a $7.7 million, or 4.1%, increase compared to average interest-bearing deposits of $187.7 million for the six months ended June 30, 2017. The average rate paid on interest-bearing deposits was 22 basis points higher at 1.04% for the six months ended June 30, 2018 compared to 0.82% for the 2017 period.

The $176,000 increase in interest expense on borrowings was due to a 69 basis point increase in average rates paid. We primarily utilize short term FHLB advances, but added $10.0 million in two-year and $10.0 million in four-year fixed rate advances with an average rate of 1.11% in the second half of 2017 to lock in rates in anticipation of future market rate increases.

Interest paid on interest bearing checking, money market and savings accounts increased $87,000, or 17.8%, to $577,000 for the six months ended June 30, 2018 from $490,000 for the six months ended June 30, 2017. The average rate we paid on such deposit accounts increased 12 basis points to 0.90% for the six months ended June 30, 2018 from 0.78% for the six months ended June 30, 2017 and the average balance increased $3.8 million, or 3.0%, to $129.7 million for the six months ended June 30, 2018 from $125.9 million for the six months ended June 30, 2017. The increase in checking, savings and money market deposit rates is primarily due to increases in market interest rates. The average rates we pay on these accounts is considerably higher in the Arizona market.

Net Interest Income. Net interest income increased $267,000, or 4.0%, to 6.9 million for the six months ended June 30, 2018 from $6.6 million for the six months ended June 30, 2017, as a result of a higher balance of net interest-earning assets and a higher net interest rate spread. Our average net interest-earning assets increased by $3.5 million, or 5.0%, to 73.2 million for the six months ended June 30, 2018 from $69.7 million for the six months ended June 30, 2017 due primarily to organic growth. Our net interest rate spread declined by two basis points to 4.06% for the six months ended June 30, 2018 from 4.08% for the six months ended June 30, 2017. We carried 86.8% of our average interest-earning assets in loans, our highest yielding asset, for the six months ended June 30, 2018 compared to 84.7% in loans for the comparable period in 2017.

Provision for Loan Losses. We recorded a provision for loan losses of $93,000 for the six months ended June 30, 2018, compared to $400,000 for the six months ended June 30, 2017. Due to improving credit quality, in the six months ended June 30, 2018, the allowance for loan losses increased $82,000, or 2.6%, compared to an $18.8 million or 7.2% increase in gross loans held for investment. Net charge-offs were $11,000 in the six months ended June 30, 2018 and net recoveries were $14,000 for the comparable 2017 period.

Noninterest Income. Noninterest income increased $3.0 million, or 62.7%, to $7.8 million for the six months ended June 30, 2018 from $4.8 million for the six months ended June 30, 2017 primarily due to a higher volume of loan sales and larger average mortgage loan sales premiums.

Gain on sale of loans increased $2.9 million, or 64.4%, to $7.4 million for the six months ended June 30, 2018 from $4.5 million for the six months ended June 30, 2017 due to expansion in our secondary mortgage loan operation in 2017 and early 2018. During the six months ended June 30, 2018, we sold $159.4 million of mortgage loans for a gain of $7.3 million and $1.4 million of SBA loans for a gain of $123,000, compared to $115.5 million of mortgage loan sales and $2.4 million of SBA loan sales during the six months ended June 30, 2017 for gains of $4.3 million and $242,000, respectively. The average premium (gain on sale/sold loans) for the 2018 period was 4.2% compared to 3.7% for the 2017 period. Sales premiums have improved since we began using mandatory delivery and hedging in September 2017, and also vary from period to period based upon the mix of government FHA, VA and jumbo loans to conventional loans, geographic markets and market interest rates, specifically 10-year Treasury rates.

Noninterest Expense. Noninterest expense increased $2.8 million, or 25.4%, to $13.6 million for the six months ended June 30, 2018 from $10.9 million for the six months ended June 30, 2017 due primarily to higher salaries and benefits and data processing fees, partially offset by lower professional fees. The increase in salaries and benefits expense resulted primarily from the expansion of our mortgage banking program and $267,000 from equity-based expense in the first six months of 2018 from December 2017 grants. Average assets for the six months ended June 30, 2018 were 3.8% larger than the six months ended June 30, 2017.

Provision for Income Tax. Provision for income tax expense was $214,000 for the six months ended June 30, 2018, representing an effective tax rate of 22.2% on pre-tax income. Although there are numerous differences between pre-tax income and actual taxable income that have an effect on the effective income tax rate for any given period, it is notable that the tax rate assumption used to compute income tax expense in 2018 is 13% lower than 2017 due to the permanent reduction in the Federal corporate income tax rate to 21% from the Tax Cuts and Jobs Act enacted in December 2017. We recognized income tax expense of $4,000 for the six months ended June 30, 2017, representing 2.8% of the $144,000 income before income taxes.

Asset Quality

We review loans on a regular basis, and place loans on nonaccrual status when either principal or interest is 90 days or more past due or earlier if we do not expect to receive full payment of interest or principal. Interest accrued and unpaid at the time a loan is placed on nonaccrual status is reversed from interest income. Once a loan is placed on nonaccrual status, the borrower must generally demonstrate at least six consecutive months of payment performance before the loan is eligible to return to accrual status.

Non-Performing Loans and Non-Performing Assets. The following table sets forth information regarding our non-performing assets. As of June 30, 2018 and December 31, 2017, we had no accruing troubled debt restructurings. Troubled debt restructurings include loans for which either a portion of interest or principal has been forgiven, or for loans modified at interest rates materially less than current market rates.

(Dollars in thousands)

Two large loan relationships partially secured by real estate comprise $4.5 million, or 80.0%, of the $5.7 million in nonaccrual loans at June 30, 2018. $3.6 million, or 64.2% of the total June 30, 2018 nonaccrual loan balance, is guaranteed by the SBA.

The nonperforming asset ratios decreased due to larger increases in loans held for investment and assets than the increase in nonaccrual loans.

Interest income that would have been recorded for the six months ended June 30, 2018, had nonaccruing loans been current according to their original terms amounted to $177,000. We recognized $4,000 of interest income on nonaccrual loans for the six months ended June 30, 2018.

At June 30, 2018, we had no loans that were not currently classified as nonaccrual, 90 days past due or troubled debt restructurings where known information about possible credit problems of borrowers caused management to have serious concerns as to the ability of the borrowers to comply with existing loan repayment terms and that could result in disclosure as non-accrual, 90 days past due or troubled debt restructurings.

Allowance for Loan Losses. The allowance for loan losses is maintained at a level which, in management’s judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management’s evaluation of the collectability of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, and economic conditions. Allowances for impaired loans are generally determined based on collateral values or the present value of estimated cash flows. Because of uncertainties associated with regional economic conditions, collateral values, and future cash flows on impaired loans, it is reasonably possible that management’s estimate of credit losses inherent in the loan portfolio and the related allowance may change materially in the near-term. The allowance is increased by a provision for loan losses, which is charged to expense and reduced by full and partial charge-offs, net of recoveries. Changes in the allowance relating to impaired loans are charged or credited to the provision for loan losses. Management’s periodic evaluation of the adequacy of the allowance is based on the current level of net loan losses, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, and current economic conditions.

The following table sets forth activity in our allowance for loan losses for the periods indicated.

(Dollars in thousands)

The ratio of our allowance for loan losses to nonperforming loans increased due primarily to a 13.0% increase in allowance for loan losses. The allowance for loan losses to total loans ratios increased because the 13.0% increase in allowance for loan losses was larger than the 0.4% increase in total gross loans.

Liquidity and Capital Resources

Liquidity is the ability to meet current and future financial obligations of a short-term nature. Our primary sources of funds consist of deposit inflows, FHLB borrowings, loan repayments and maturities and sales of securities. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition.

We regularly adjust our investments in liquid assets based upon our assessment of expected loan demand, expected deposit flows, yields available on interest-earning deposits and securities, and the objectives of our asset/liability management program. Excess liquid assets are invested generally in interest-earning deposits with other banks and short- and intermediate-term securities.

We believe that we have enough sources of liquidity to satisfy our short-term liquidity needs as of June 30, 2018.

Our most liquid assets are cash and cash equivalents. The levels of these assets are dependent on our operating, financing, lending and investing activities during any given period. At June 30, 2018, cash and cash equivalents totaled $21.2 million. Available-for-sale securities, which provide additional sources of liquidity, totaled $29.2 million at June 30, 2018. In addition, at June 30, 2018, we had $80.0 million of advances outstanding from the Federal Home Loan Bank of Dallas and the ability to borrow an additional $56.1 million from the FHLB, $9.8 million from the Independent Bankers Bank (TIB), and $6.0 million from the Pacific Coast Bankers Bank (PCBB).

At June 30, 2018, we had $25.7 million in loan commitments outstanding, and $29.8 million in commitments to originate and sell mortgage loans. In addition, we had $17.7 million in unused lines of credit and $125,000 in commitments issued under standby letters of credit. Time deposits due within one year as of June 30, 2018 totaled $30.3 million, or 12.3% of total deposits. If these deposits do not remain with us, we will be required to seek other sources of funds, including other time deposits and Federal Home Loan Bank advances. Depending on market conditions, we may be required to pay higher rates on such deposits or other borrowings than we currently pay on the certificates of deposit due on or before June 30, 2019. We believe, however, based on past experience that a significant portion of our time deposits will remain with us, either as time deposits or as other deposit products. We have the ability to attract and retain deposits by adjusting the interest rates offered.

We have no material commitments or demands that are likely to affect our liquidity other than set forth above. In the event loan demand were to increase at a pace greater than expected, or any unforeseen demand or commitment were to occur, we would access our borrowing capacity with the Federal Home Loan Bank of Dallas or the other financial institutions, or increase our deposits by offering higher interest rates.

Our primary investing activities are the origination of loans and the purchase of securities. During the six months ended June 30, 2018, we originated $70.8 million of loans held for investment and $165.0 million of mortgage loans held for sale, compared to $51.1 million of loans held for investment and $112.7 million of mortgage loans held for sale during the six months ended June 30, 2017. In the six months ended June 30, 2018 and 2017 we purchased $8.0 million and $0 in securities, respectively. We have not purchased any whole loans in recent periods.

Financing activities consist primarily of activity in deposit accounts and Federal Home Loan Bank advances. We experienced net increases of $10.9 million and $4.6 million in total deposits for the six months ended June 30, 2018 and 2017, respectively. Deposit flows are affected by the overall level of interest rates, the interest rates and products offered by us and our local competitors and other factors. We generally manage the pricing of our deposits so that we are competitive in our market area.

We had $80.0 million in Federal Home Loan Bank advances at June 30, 2018 and $45.0 million at December 31, 2017. The increase was primarily due to increases of $18.8 million in loans, net, $5.9 million in loans held for sale and $4.8 million in securities.

Bancorp 34, Inc. is a separate legal entity from the Bank and must provide for its own liquidity to pay any dividends to stockholders, to repurchase its common stock, and for other corporate purposes. Bancorp 34, Inc.’s primary source of liquidity is dividend payments it may receive from the Bank. At June 30, 2018, Bancorp 34, Inc. (on an unconsolidated basis) had liquid assets of $708,000.

The Bank is subject to various regulatory capital requirements, including a risk-based capital measure. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk-weighted assets by assigning balance sheet assets and off-balance sheet items to broad risk categories. At June 30, 2018 and December 31, 2017, Bank 34 exceeded all regulatory capital requirements. Bank 34 is considered “well-capitalized” under regulatory guidelines.

An evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and the Executive Vice President and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended) as of June 30, 2018. Based on that evaluation, the Company’s management, including the Chief Executive Officer and the Executive Vice President and Chief Financial Officer, concluded that the Company’s disclosure controls and procedures were effective.

During the quarter ended June 30, 2018, there have been no changes in the Company’s internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.