First Northwest Bancorp: Form 10-Q for the period ended Sep 30, 2023

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

Certain matters discussed in this Quarterly Report on Form 10-Q constitute forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not statements of historical fact, are based on certain assumptions and are generally identified by the use of words such as "believes," "expects," "anticipates," "estimates" or similar expressions. Forward-looking statements include, but are not limited to:

• statements of our goals, intentions and expectations;
• statements regarding our business plans, prospects, growth and operating strategies;
• statements regarding the quality of our loan and investment portfolios; and
• estimates of our risks and future costs and benefits.

These forward-looking statements are based on current beliefs and expectations of management and are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond the Company’s control. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:

• the risks associated with lending and potential adverse changes in the credit quality of loans in our portfolio;
• legislative or regulatory changes, including expanded consumer protection regulation, responses to recent events in the banking industry, inflation and climate change issues, which could adversely affect the Company's business;
• continued depressed market demand for loans that we originate for sale;
• our ability to control operating costs and expenses;
• whether our management team can succeed in implementing our operational strategy, including but not limited to our efforts to achieve loan and revenue growth;
• our ability to successfully execute on merger and/or acquisition strategies, integrate any newly acquired assets, liabilities, customers, systems, and management personnel into our operations and realize related cost savings within expected time frames;
• our ability to successfully execute on growth strategies related to our entry into new markets and delivery channels, including banking as a service;
• our ability to develop user-friendly digital applications to serve existing customers and attract new customers;
• the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation;
• changes in monetary policy and fiscal policies, including interest rate policies of the Federal Reserve, and the relative differences between short and long-term interest rates, deposit interest rates, our net interest margin and funding sources;
• pressures on liquidity, including as a result of withdrawals of deposits or declines in the value of our investment portfolio;
• increased competitive pressures among financial services companies, particularly from non-traditional banking entities such as challenger banks, fintech, and mega technology companies;
• our ability to attract and retain deposits at a reasonable cost;
• changes in consumer spending, borrowing and savings habits, resulting in reduced demand for banking products and services, particularly in the event of a recession that affects our market areas;
• results of examinations by the Washington State Department of Financial Institutions, Department of Banks, the Federal Deposit Insurance Corporation, Federal Reserve Bank of San Francisco, or other regulatory authorities, which could result in restrictions that may adversely affect our liquidity and earnings;
• disruptions, security breaches, or other adverse events, failures or interruptions in, or attacks on, our information technology systems or on the third-party vendors who perform several of our critical processing functions;
• risks related to overall economic conditions, including the impact on the economy of a rising interest rate environment, inflationary pressures, and geopolitical instability, including the wars in Ukraine and the Middle East;
• any failure of key third-party vendors to perform their obligations to us;
• the effects of any reputational damage to the Company resulting from any of the foregoing; and
• other economic, competitive, governmental, regulatory and technical factors affecting our operations, pricing, products and services and other risks described elsewhere in our filings with the Securities and Exchange Commission, including this Form 10-Q and the Company's Annual Report on Form 10-K for the year ended December 31, 2022, ("2022 Form 10-K").

Any of the forward-looking statements that we make in this report and in other statements we make may turn out to be wrong because of inaccurate assumptions we might make, because of the factors illustrated above or because of other factors that we cannot anticipate or predict. Any forward-looking statements are based upon management’s beliefs and assumptions at the time they are made. We undertake no obligation to publicly update or revise any forward-looking statements included or incorporated by reference in this document or to update the reasons why actual results could differ from those contained in such statements, whether as a result of new information, future events or otherwise. Due to these risks, uncertainties and assumptions, the forward-looking statements discussed in this report might not occur, and you should not put undue reliance on any forward-looking statements.

General

First Northwest is a bank holding company and a financial holding company and is engaged in banking activities through its wholly owned subsidiary, First Fed Bank, as well as certain non-banking financial activities. Non-financial investments include several limited partnership investments, including a 33.3% interest in The Meriwether Group, LLC ("MWG"). The Company's business activities are generally focused on passive investment activities and oversight of the activities of First Fed. The Company also entered into partnerships to strategically invest in fintech-related businesses, which may result in additional investment opportunities.

First Fed Bank is a community-oriented financial institution founded in 1923 in Port Angeles, Washington. We have 16 locations including 12 full-service branches and four business centers in Clallam, Jefferson, King, Kitsap, and Whatcom counties. First Fed’s business and operating strategy is focused on building sustainable earnings by delivering a fully array of financial products and services for individuals, small business, and commercial customers. Lending activities include the origination of first lien one-to-four family mortgage loans, commercial and multi-family real estate loans, residential and commercial construction and land loans, commercial business loans, SBA loans, and consumer loans, consisting primarily of home equity loans and lines of credit. Over the last five years, we have significantly increased the origination of commercial real estate, multi-family real estate, construction, and commercial business loans, and have increased our consumer loan portfolio through our manufactured home and auto loan purchase programs. We offer traditional consumer and business deposit products, including transaction accounts, savings and money market accounts and certificates of deposit ("CDs") for individuals and businesses. Deposits are our primary source of funding for our lending and investing activities.

First Northwest's limited partnership investments include Canapi Ventures Fund, LP; BankTech Ventures, LP; and JAM FINTOP Blockchain, LP. These limited partnerships invest in fintech-related businesses with a focus on developing digital solutions applicable to the banking industry. In 2022, First Northwest acquired a 33% interest in MWG, a boutique investment bank and consulting firm focused on providing entrepreneurs with resources to help them succeed. Also in 2022, the Company acquired a 25% equity interest as a general partner in Meriwether Group Capital, LLC ("MWGC"), which provides financial advice for borrowers and capital for the Meriwether Group Capital Hero Fund LP ("Hero Fund"). The Hero Fund is a private commercial lender focused on lower-middle market businesses, primarily in the Pacific Northwest. First Northwest also has a limited partnership investment in the Hero Fund. MWG also holds a 20% general partner interest in MWGC.

First Northwest is impacted by prevailing economic conditions as well as government policies and regulations concerning, among other things, monetary and fiscal affairs, housing and financial institutions. Deposit flows are influenced by several factors, including interest rates paid on competing deposits, alternative investment options available to our customers, account maturities, the number and quality of our deposit originators, digital delivery systems, branding and customer acquisition, and the overall level of personal income and savings in the markets where we do business. Lending activities are influenced by the demand and pricing for loan funds, our credit policies, the number and quality of our lenders and credit underwriters, digital delivery systems, branding and customer acquisition, and regional economic cycles.

Our primary source of pre-tax income is net interest income. Net interest income is the difference between interest income earned on our loans and investments and interest expense paid on our deposits and borrowings. Changes in our asset and liability mix, market and portfolio interest rates and cash flows from existing assets and liabilities affect our net interest income. A secondary source of income for the Company is noninterest income, which includes revenue earned from providing products and services, including service charges on deposit accounts, late and other charges on loans, mortgage banking income, loan sales and servicing income, interest rate swap fee income, earnings from bank-owned life insurance, investment services income, gains and losses from sales of securities, and changes in the market value of our equity and partnership investments.

An offset to net interest income is the provision for credit losses, which represents the periodic charge to operations that is required to adequately provide for losses inherent in our investment, loan and unfunded commitment portfolios through the ACL. A recapture of previously recognized provision for credit losses may be added to net income as the underlying assumptions driving anticipated loss rates within the CECL model improve, such as the United States unemployment and gross domestic product metrics, lower loan or unfunded commitment balances, or receipt of recoveries for amounts previously charged off.

Noninterest expenses we incur in operating our business consist of salaries and employee benefit costs, occupancy and equipment expenses, federal deposit insurance premiums and regulatory assessments, data processing expenses, marketing and other customer acquisition expenses, legal and other professional fees, expenses related to real estate and personal property owned, and other expenses.

Critical Accounting Policies

On January 1, 2023, the Company adopted ASU 2016-13, Measurement of Credit Losses on Financial Instruments, referred to as the Current Expected Credit Loss or CECL model. In conjunction with the adoption of CECL, the Company also adopted ASU 2022-02, Financial Instruments - Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures. For additional information on these ASUs, see "Note 1 - Basis of Presentation and Critical Accounting Policies - Recently adopted accounting pronouncements" of the Notes to the Consolidated Financial Statements included in Part I. Item 1 of this report.

Effective with the execution of a hedging agreement in the first quarter of 2023, the Company implemented an accounting policy on derivatives and hedging. For additional information on the hedging policy, see "Note 1 - Basis of Presentation and Critical Accounting Policies - Recently adopted accounting pronouncements" of the Notes to the Consolidated Financial Statements included in Part I. Item 1 of this report.

There were no other material changes to the critical accounting policies from those disclosed in the Company's 2022 Form 10-K.

Comparison of Financial Condition at September 30, 2023 and December 31, 2022

Assets. Total assets increased to $2.15 billion, or 5.5%, at September 30, 2023, from $2.04 billion at December 31, 2022.

Cash and cash equivalents increased by $38.3 million, or 84.0%, to $83.9 million as of September 30, 2023, compared to $45.6 million as of December 31, 2022. Cash increased during the current year as the Bank increased balance sheet liquidity in response to stresses within the banking industry and related concerns with respect to uncertainty pertaining to deposit costs and retention.

Investment securities decreased $17.3 million, or 5.3%, to $309.3 million at September 30, 2023, from $326.6 million at December 31, 2022. The decrease was due to normal payments and prepayment activity as well as a mark-to-market valuation decrease of $7.7 million, primarily related to a declining market outlook on the municipal bond portfolio due to the current rate environment. The investment portfolio, including mortgage-backed securities, had an estimated projected average life of 7.7 years as of September 30, 2023, compared to 8.2 years as of December 31, 2022, and had an estimated average repricing term of 7.3 years as of September 30, 2023, compared to 7.1 years as of December 31, 2022, based on the interest rate environment at those times. The effective duration of the investment portfolio was 4.9 years at September 30, 2023, compared to 5.1 years at December 31, 2022. We believe prepayment activity may continue to slow if interest rates continue to rise, extending the projected duration and causing additional deterioration to the market value of our securities portfolio.

Included in MBS non-agency are $58.7 million of commercial mortgage-backed securities ("CMBS"), of which 85.6%, or $50.2 million, are in "A" tranches. The majority of the remaining 14.4%, or $8.5 million, are in "B" tranches, with one investment in a "C" tranche. Our largest exposure is to long-term care facilities, which makes up 53.9%, or $31.7 million, of our private label CMBS securities. All of the CMBS bonds have credit enhancements that further reduce risk of loss on these investments.

The investment portfolio was composed of 49.0% in amortizing securities at September 30, 2023, compared to 50.8% at December 31, 2022. The projected average life of our securities may vary due to prepayment activity, particularly in the mortgage-backed securities portfolio, which is impacted by prevailing market interest rates. Securities are bought and sold to manage liquidity, improve long-term portfolio yields and manage interest rate risk in the portfolio. For additional information, see Note 2 of the Notes to Consolidated Financial Statements contained in Item 1 of this Form 10-Q.

Net loans, excluding loans held for sale, increased $86.6 million to $1.62 billion at September 30, 2023, from $1.53 billion at December 31, 2022. During the nine months ended September 30, 2023, multi-family loans increased $72.8 million through new originations totaling $40.1 million, and $27.8 million of construction loans converting into permanent amortizing loans, including $17.8 million of acquisition-renovation loans. One-to-four family residential loans increased $26.4 million as a result of $3.3 million in new amortizing loan originations and $48.0 million of residential construction loans that converted to permanent amortizing loans, partially offset by loan prepayments totaling $17.5 million and $7.4 million of scheduled payments received. Commercial business loans increased $24.5 million as a result of $15.2 million of Bankers Healthcare Group loan purchases and $9.2 million of organic originations and draws on existing commitments in excess of payoffs and scheduled payments. Home equity loans increased $11.6 million primarily as a result of $5.7 million in new fixed-rate originations and $7.7 million in new home equity lines of credit, offset by payment activity. Auto and other consumer loans increased $9.9 million, due to a $14.3 million purchase of a pool of manufactured home loans and $2.8 million in individual manufactured home loan purchases, offset by a net decrease in auto loans of $1.3 million and payment activity. Commercial real estate loans decreased $7.3 million, with early payoffs and scheduled payments in excess of the $4.3 million from construction loans that converted into permanent amortizing loans.

Construction and land loans decreased $50.2 million, or 25.9%, to $143.4 million at September 30, 2023, from $193.7 million at December 31, 2022, with $77.6 million converting into fully amortizing loans and additional decreases from loans being paid in full, partially offset by draws on new and existing loans. Construction loans in the portfolio are geographically dispersed throughout western Washington with two loans in Oregon and two loans in Idaho. We manage construction lending by utilizing a licensed third-party vendor to assist us in monitoring the progress toward completion of our construction projects. We continue to monitor the impact of supply chain challenges, inflation and consumer demand in a rising interest rate environment on completion of the projects currently in the portfolio. As of the date of this report, we have no reason to believe that any of the projects in process will not be completed. At September 30, 2023, no acquisition-renovation loans were included in the construction loan total compared to $19.3 million at December 31, 2022. These commercial acquisition-renovation loans represent financing primarily for the acquisition of multi-family properties with a construction component used for the renovation of common areas and specific units of the building. Given the construction component of these loans, we are required to report them as construction under regulatory guidelines; however, we consider these loans to be lower risk than typical ground-up construction projects. At September 30, 2023, 42% of construction commitments were for one-to-four family residential properties, which are anticipated to convert into amortizing loans upon completion.

We monitor real estate values and general economic conditions in our market areas, in addition to assessing the strength of our borrowers, including their equity contributions to a project, to prudently underwrite construction loans. We continually assess our lending strategies across all product lines and markets where we do business to improve earnings while also prudently managing credit risk.

The following tables show our construction commitments by type and geographic concentrations at the dates indicated:

(In thousands)

(1) Includes Clallam and Jefferson counties.

(2) Includes Kitsap, Mason, Thurston, Pierce, King, Snohomish, Skagit, Whatcom, and Island counties.

(In thousands)

(1) Includes Clallam and Jefferson counties.

(2) Includes Kitsap, Mason, Thurston, Pierce, King, Snohomish, Skagit, Whatcom, and Island counties.

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During the nine months ended September 30, 2023, the Company originated $171.5 million of organic loans, of which $122.8 million, or 71.6%, were originated in the Puget Sound region, $42.2 million, or 24.5%, in the North Olympic Peninsula, $3.0 million, or 1.8%, in other areas throughout Washington State, and $3.5 million, or 2.1%, in other states. The Company purchased an additional $33.2 million in auto loans, $17.1 million in manufactured home loans, and $15.2 million in commercial business loans with collateral located throughout the United States during the nine months ended September 30, 2023. We will continue to strategically evaluate opportunities to acquire assets through wholesale channels in order to supplement organic originations and increase net interest income. The Northpointe Mortgage Purchase Program ("Northpointe MPP") also provides a temporary source of additional interest income but is dependent on demand for funding, with repayment of advances to this program typically occurring within 30 days or less. The total loan portfolio was composed of 79.1% organic originations and 20.9% purchased loans at September 30, 2023.

The ACLL increased to $17.0 million at September 30, 2023, as the Company adopted CECL on January 1, 2023, recording a day-one adjusting entry of $2.2 million. The Company made a $315,000 provision for credit loss on loans for the nine-month period. Net charge-offs were $2.5 million for the nine-month period. The ACLL as a percentage of total loans was 1.0% and 1.1% at September 30, 2023 and December 31, 2022, respectively.

Nonperforming loans increased $581,000, or 32.4%, to $2.4 million at September 30, 2023, from $1.8 million at December 31, 2022, reflecting the deterioration of three mortgage loans totaling $836,000, partially offset by payments received on other nonperforming loans. Nonperforming loans to total loans was 0.1% at both September 30, 2023 and December 31, 2022. The ACLL as a percentage of nonperforming loans decreased to 714% at September 30, 2023, down from 900% at December 31, 2022.

Classified loans increased $6.1 million to $23.0 million at September 30, 2023, from $16.9 million at December 31, 2022, due to downgrades of $2.9 million in commercial business loans, $1.3 million in commercial real estate loans, $1.1 million of additional funds disbursed on a substandard commercial construction loan, $862,000 for three single-family residential loans, along with delinquent unsecured consumer loans totaling $323,000 and home equity loans totaling $141,000.

Loan charge-offs are concentrated mainly in purchased unsecured consumer and indirect auto loans. The underwriting criteria for future loans purchased from the Splash unsecured consumer loan program were adjusted in an effort to minimize future losses. The Splash portfolio had loan balances of $8.7 million and $9.2 million at September 30, 2023 and December 31, 2022, respectively. The indirect auto loan program was discontinued in 2020, and the remaining loan balances under that program decreased to $2.6 million at September 30, 2023 from $4.8 million at December 31, 2022. We believe the ACLL is adequate to absorb the known and inherent risks of loss in the overall loan portfolio as of September 30, 2023.

Loans receivable, excluding loans held for sale, consisted of the following at the dates indicated:

(In thousands)

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The following table represents nonperforming assets at the dates indicated.

(In thousands)

Liabilities. Total liabilities increased to $2.0 billion at September 30, 2023, from $1.88 billion at December 31, 2022, due to an increase in deposits of $93.5 million and borrowings of $15.0 million.

Deposit balances increased $93.5 million to $1.66 billion at September 30, 2023 from $1.56 billion at December 31, 2022. During the nine-month period ended September 30, 2023, CDs increased $198.0 million and savings accounts increased $52.3 million, offset by money market account decreases of $100.3 million and demand deposit account decreases of $56.5 million. We believe the shift between categories was driven by customers seeking higher rates and spending excess savings accumulated in 2020 and 2021. We utilize brokered CDs as an additional funding source to provide liquidity, manage cost of funds, reduce reliance on FHLB advances, and manage interest rate risk. Brokered CDs totaling $169.6 million were included in the $579.7 million balance of CDs at September 30, 2023. Brokered CD balances increased $35.7 million, business and public fund account balances increased $33.7 million, and consumer account balances increased $23.4 million during the nine-month period ended September 30, 2023.

FHLB advances increased $29.0 million, or 12.9% to $253.0 million at September 30, 2023, from $224.0 million at December 31, 2022. We increased short-term advances to provide additional balance sheet liquidity, fund loan growth and keep the duration of liabilities shorter relative to taking on longer term advances.

Equity. Total shareholders' equity decreased $2.2 million to $156.1 million for the nine months ended September 30, 2023. The Company recorded year-to-date net income of $7.8 million and a $419,000 increase in the fair market value of derivatives, net of taxes. Increases were offset by an increase in the after-tax unrealized loss on available-for-sale investments of $5.8 million, a $3.0 million decrease for the cumulative CECL adjustment, $2.0 million of dividends declared and the cost of repurchased shares. Year-to-date, we repurchased 75,690 shares of common stock under the October 2020 stock repurchase plan at an average price of $12.91 per share for a total of $980,000, leaving 226,337 shares remaining in the current share repurchase program.

Comparison of Results of Operations for the Three Months Ended September 30, 2023 and 2022

General. Net income attributable to the Company was $2.5 million for the three months ended September 30, 2023, compared to $4.3 million for the three months ended September 30, 2022. A $2.9 million decrease in net interest income after provision for credit losses was offset by a $570,000 increase in noninterest income and a $1.0 million decrease in noninterest expense.

Net Interest Income. Net interest income decreased $3.3 million to $15.0 million for the three months ended September 30, 2023, from $18.2 million for the three months ended September 30, 2022. This decrease was mainly the result of higher rates paid on interest-bearing liabilities, which increased 187 basis points to 2.60% for the three months ended September 30, 2023, compared to 0.73% for the same period in the prior year. This was due to an increase in the average balances of CDs and advances and higher rates paid on all deposits and advances. The average yield on interest-earning assets increased 69 basis points to 5.14% for the three months ended September 30, 2023, compared to 4.45% for the same period last year, due primarily to higher yields on variable-rate assets and new loan originations.

Total cost of funds increased 164 basis points to 2.23% for the three months ended September 30, 2023, from 0.59% for the same period in 2022. The net interest margin decreased 91 basis points to 2.97% for the three months ended September 30, 2023, from 3.88% for the same period in 2022. While increases in the cost of funding are currently outpacing the growth of the yield on interest-earning assets, the Company has taken measures to reverse interest rate margin compression. The Bank augments organic loan production with higher yielding purchased loans through relationships with loan originators. A fair value hedging agreement provides additional interest income and new loan originations are priced to current market rates.

Interest Income. Total interest income increased $5.0 million, or 23.9%, to $25.8 million for the three months ended September 30, 2023, from $20.9 million for the comparable period in 2022, primarily due to higher yields on interest-earning assets. Interest and fees on loans receivable increased $4.0 million, to $21.7 million for the three months ended September 30, 2023, from $17.8 million for the three months ended September 30, 2022, primarily due to an increase in average loan yields to 5.31% for the three months ended September 30, 2023, from 4.75% for the same period in 2022, coupled with an increase in the average balance of net loans receivable of $140.1 million compared to the third quarter of 2022. The loan portfolio has grown through our renewed short-term participation in the Northpointe MPP, draws on new and existing business lines of credit, originations of multi-family real estate loans, and purchases of auto, manufactured home, and purchased Bankers Healthcare Group commercial loans. Loan yields increased over the prior year due to higher rates on new originations as well as the repricing of variable rate loans tied to the Prime Rate or other indices. The yield earned on investment securities also increased 116 basis points to 4.18% compared to the same period in 2022, as increases in floating bond rates and a slowdown in prepayment speeds, which reduces amortization of premium costs, have positively impacted investment securities income. The yield on interest-earning deposits in banks also increased to 5.46% from 2.72% for the comparable period in 2022, benefitting from increases in rates paid on excess balances held at the FRB.

The following table compares average earning asset balances, associated yields, and resulting changes in interest income for the periods shown:

(Dollars in thousands)

Interest Expense. Total interest expense increased $8.2 million, or 310.6%, to $10.9 million for the three months ended September 30, 2023, compared to $2.7 million for the three months ended September 30, 2022. The increase over the third quarter of 2022 was the result of an increase in the cost of deposits to 1.85% from 0.32% in same period one year ago along with higher volumes of CDs. A shift in the deposit mix from no or low-cost transaction and money market accounts to a higher volume of CDs and promotional savings accounts resulted in higher costs of deposits. Borrowing expense increased due to an average balance increase of $62.3 million and an increase in the cost of advances, primarily FHLB advances, compared to the same period in 2022.

Average deposit account balances were composed of 83% in interest-bearing deposits and 17% in noninterest-bearing deposits at September 30, 2023, compared to 78% and 22%, respectively, at September 30, 2022. During the three months ended September 30, 2023, interest expense increased on CDs due to an increase in the average balances of $292.7 million, along with an increase in the average rates paid of 89 basis points, compared to the three months ended September 30, 2022. During the same period, the average balances of money market accounts decreased $183.0 million, offset by a 72 basis point average rate increase, resulting in an increase to interest expense. The average cost of interest-bearing deposit accounts increased to 2.22% for the three months ended September 30, 2023, from 0.41% for the three months ended September 30, 2022, due to changes to the deposit mix, driven by customer preferences and the use of higher rate promotional products designed to retain existing deposits and generate new deposits. The mix of customer deposit balances shifted from non-maturity accounts towards higher cost term certificate and savings products. Customer CDs represented 27.6% and 15.2% of customer deposits at September 30, 2023 and 2022, respectively.

The following table details average balances, cost of funds and the change in interest expense for the periods shown:

(Dollars in thousands)

Provision for Credit Losses. The Company recorded a $371,000 provision for credit losses in the three months ended September 30, 2023, reflecting growth in the loan portfolio and additional charge-offs from the Splash unsecured consumer loan program, partially offset by a recapture due to a lower unfunded commitment balance. This compares to a $750,000 loan loss provision for the three months ended September 30, 2022, which was estimated using the incurred loss method based on historical loss trends combined with qualitative adjustments.

The following table details activity and information related to the ACLL for the periods shown:

(Dollars in thousands)

Noninterest Income. Noninterest income increased $570,000, or 24.4%, to $2.9 million for the three months ended September 30, 2023, from $2.3 million for the three months ended September 30, 2022. The increase was primarily due to a $750,000 reclassification from interest income to noninterest income recouped on Splash loan charge-offs, referral fee income of $219,000 and a quarter-over-quarter increase of $108,00 in swap fee income. Saleable mortgage loan production continues to be hindered by the increase in market rates on mortgage loans and a lack of single-family home inventory compared to the same period in the prior year. In addition, during the current quarter, commercial loan late charge fee income declined $159,000, the valuation of servicing rights on sold loans decreased $129,000 and no loans were sold to the SBA, resulting in a combined quarter-over-quarter decrease in the net gain on sale of loans of $114,000.

The following table provides a detailed analysis of the changes in the components of noninterest income for the periods shown:

(Dollars in thousands)

Noninterest Expense. Noninterest expense decreased $1.0 million, or 6.5%, to $14.4 million for the three months ended September 30, 2023, compared to $15.4 million for the three months ended September 30, 2022. The decrease in expenses compared to the third quarter of 2022 reflects a $1.1 million decrease related to Quin Ventures compensation, advertising and customer acquisition costs, and occupancy expenses. Additional decreases in Bank incentive compensation paid and other non-recurring compensation expenses were partially offset by higher Bank professional fees and FDIC insurance premiums. The Company continues to manage expenses, with a focus on controlling compensation expenses and reducing advertising and other discretionary spending.

The following table provides an analysis of the changes in the components of noninterest expense for the periods shown:

(Dollars in thousands)

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Provision for Income Tax. An income tax expense of $603,000 was recorded for the three months ended September 30, 2023, compared to $818,000 for the three months ended September 30, 2022, due to a year-over-year decrease in income before taxes of $1.3 million. The provision includes accruals for both federal and state income taxes. The provision for state income tax began in the second quarter of 2022 with respect to certain states in which we have employees and collateral for loans, thereby creating nexus in those states for income tax purposes. For additional information, see Note 7 of the Notes to Consolidated Financial Statements contained in Item 1 of this Form 10-Q.

Comparison of Results of Operations for the Nine Months Ended September 30, 2023 and 2022

General. Net income attributable to the Company was $7.81 million for the nine months ended September 30, 2023, compared to $9.59 million for the nine months ended September 30, 2022. A $2.6 million decrease in net interest income after provision for credit losses and a $1.8 million decrease in the net loss attributable to the noncontrolling interest in Quin Ventures were offset by a $2.7 million decrease in noninterest expense. Noninterest income was flat period over period.

Net Interest Income. Net interest income decreased $3.7 million to $47.2 million for the nine months ended September 30, 2023, from $50.9 million for the nine months ended September 30, 2022, as higher funding costs outpaced increased loan, investment and interest-earning deposit income.

Average earning assets increased $135.2 million year-over-year. The yield on average interest-earning assets increased 93 basis points to 5.09% for the nine months ended September 30, 2023, compared to 4.16% for the same period in the prior year, due to an increase in the average net loans receivable balance, higher loan yields, and an increase in yields earned on investment securities and interest-earning deposit accounts.

The average cost of interest-bearing liabilities increased to 2.26% for the nine months ended September 30, 2023, compared to 0.55% for the same period last year, due primarily to higher rates paid on all interest-bearing deposits and advances along with increases in the average balances of CDs and FHLB advances. Total cost of funds increased 148 basis points to 1.92% for the nine months ended September 30, 2023, from 0.44% for the same period in 2022. The net interest margin decreased 51 basis points to 3.22% for the nine months ended September 30, 2023, from 3.73% for the same period in 2022.

Interest Income. Total interest income increased $17.9 million, or 31.5%, to $74.6 million for the nine months ended September 30, 2023, from $56.7 million for the comparable period in 2022, primarily due to an increase in yields on interest-earning assets and an increase in average net loans receivable balances. Interest and fees on loans receivable increased $14.1 million, to $62.5 million for the nine months ended September 30, 2023, from $48.4 million for the nine months ended September 30, 2022, primarily due to an increase in the average balance of net loans receivable of $163.9 million compared to the prior year, coupled with an increase in average loan yields to 5.28% for the nine months ended September 30, 2023, from 4.56% for the same period in 2022. The loan portfolio saw increases in multi-family and commercial real estate balances, renewed short-term participation in Northpointe MPP, as well as additional purchased auto, manufactured home, and Bankers Healthcare Group commercial loans. Loan yields increased over the prior year due to higher rates on new originations as well as the repricing of variable rate loans tied to the Prime Rate or other variable-rate indices. The yield earned on investment securities also increased 116 basis points to 4.07% compared to the same period in 2022, as the purchase of higher-yielding investments occurred late in the first quarter of 2022 with the related increase only impacting income for the second and third quarters of 2022. An increase in rates on floating bonds and a slowdown in prepayment speeds, which reduces amortization of premium costs, also positively impacted investment securities income.

The following table compares average earning asset balances, associated yields, and resulting changes in interest income for the periods shown:

(Dollars in thousands)

Interest Expense. Total interest expense increased $21.6 million, or 372.9%, to $27.4 million for the nine months ended September 30, 2023, compared to $5.8 million for the nine months ended September 30, 2022. The increase over the first nine months of 2022 was the result of a 127 basis point increase in the cost of deposits from 0.24% one year prior along with a higher volume of CD balances. A shift in the deposit mix from no or low-cost transaction and money market accounts to a higher volume of CDs and savings accounts resulted in higher costs of funds on deposits. Interest expense on borrowings increased due to a $62.3 million increase in the average balance and a 234 basis point increase in the cost of advances, primarily FHLB advances, compared to the same period in 2022.

During the nine months ended September 30, 2023, interest expense on CDs increased due to higher average balances of $257.5 million, along with a 251 basis point increase in the average rates paid, compared to the nine months ended September 30, 2022. During the same period, the average balances of money market accounts decreased $179.0 million, with a 72 basis point average rate increase, resulting in an overall increase to interest expense. The average cost of interest-bearing deposit accounts increased to 1.83% for the nine months ended September 30, 2023, from 0.30% for the nine months ended September 30, 2022, due to the use of promotional products designed to retain existing deposits and generate new deposits. The mix of customer deposit balances shifted from non-maturity accounts towards higher cost CD and savings products. Customer CDs represented 27.7% and 14.0% of total deposits at September 30, 2023 and 2022, respectively. Brokered CDs represented 10.2% and 8.1% of total deposits at September 30, 2023 and 2022, respectively.

The following table details average balances, cost of funds and the change in interest expense for the periods shown:

(Dollars in thousands)

Provision for Credit Losses. The Company recorded a $171,000 provision for credit losses for the nine months ended September 30, 2023, reflecting year-to-date increases in loan balances offset by a decrease in unfunded commitments primarily due to construction loan disbursements. The provision expense related to higher outstanding loan balances from new funding and disbursements on prior commitments was partially offset by a recapture attributable to the decrease in unfunded commitments. Charged-off loan balances also contributed to the loan-related provision. This compares to a $1.3 million loan loss provision for the nine months ended September 30, 2022, which was estimated using the incurred loss method based on historical loss trends combined with qualitative adjustments.

The following table details activity and information related to the ACLL for the periods shown:

(Dollars in thousands)

Noninterest Income. Noninterest income decreased $10,000, or 0.1%, to $6.95 million for the nine months ended September 30, 2023, from $6.96 million for the nine months ended September 30, 2022. Other income increased due to the $750,000 Splash payment reclassification and a year-over-year increase of $271,000 in the recorded value of our equity and partnership fintech investments. Saleable mortgage loan production continues to be hindered by the rise in market rates on mortgage loans and a lack of single-family home inventory compared to the prior year which, when combined with a significant decrease in SBA loan sale activity, resulted in a $364,000 year-over-year decrease in net gain on sale of loans. A decline in the fair value of servicing rights compared to the same period in the prior year decreased that category by $212,000. No investment securities sales were recorded during the current year compared to sales in the same period of 2022 which generated $118,000 in gains.

The following table provides a detailed analysis of the changes in the components of noninterest income for the periods shown:

(Dollars in thousands)

Noninterest Expense. Noninterest expense decreased $2.7 million, or 5.7%, to $44.5 million for the nine months ended September 30, 2023, compared to $47.2 million for the nine months ended September 30, 2022. Quin Ventures expenses decreased $3.6 million compared to the first nine months of 2022, mainly due to no Quin Ventures expense recorded for compensation, marketing and occupancy during the first nine months of 2023. Bank compensation and benefits decreased due to lower commissions and incentives paid as well as a decrease in medical insurance and payroll tax expense. The Bank received a medical insurance premium refund of $436,000 in the first quarter of 2023 and transitioned to a self-insured medical plan in 2023. Payroll tax expense was reduced in 2023 by the recognition of a portion of the Employee Retention Credit received in March 2023. These decreases were partially offset by increases in legal fees, consulting fees, data processing expenses associated with building enhanced technological infrastructure and FDIC insurance premiums.

The following table provides an analysis of the changes in the components of noninterest expense for the periods shown:

(Dollars in thousands)

54

Provision for Income Tax. An income tax expense of $1.9 million was recorded for the nine months ended September 30, 2023, compared to $1.8 million for the nine months ended September 30, 2022, due to a year-over-year increase in income before taxes of $78,000. The year-over-year provision was also impacted by a higher tax-exempt interest exclusion in 2023 due to a larger interest expense disallowance that impacted the effective tax rate. The provision includes accruals for both federal and state income taxes. The provision for state income tax began in the second quarter of 2022 with respect to certain states in which we have employees and collateral for loans, thereby creating nexus in those states for income tax purposes. For additional information, see Note 7 of the Notes to Consolidated Financial Statements contained in Item 1 of this Form 10-Q.

Average Balances, Interest and Average Yields/Cost

The following tables set forth, for the periods indicated, information regarding average balances of assets and liabilities as well as the total dollar amounts of interest income from average interest-earning assets and interest expense on average interest-bearing liabilities, resultant yields, interest rate spread, net interest margin (otherwise known as net yield on interest-earning assets), and the ratio of average interest-earning assets to average interest-bearing liabilities. Also presented is the weighted average yield on interest-earning assets, rates paid on interest-bearing liabilities and the net spread as of September 30, 2023 and 2022. Income and all average balances are monthly average balances, which management deems to be not materially different than daily averages. Nonaccrual loans have been included in the table as loans carrying a zero yield.

(Dollars in thousands)

(1) The average loans receivable, net balances include nonaccrual loans. (2) Includes interest-earning deposits (cash) at other financial institutions. (3) Cost of all deposits, including noninterest-bearing demand deposits, was 1.85% and 0.32% for the three months ended September 30, 2023 and 2022, respectively. (4) Net interest income divided by average interest-earning assets.

(Dollars in thousands)

(1) The average loans receivable, net balances include nonaccrual loans. (2) Includes interest-earning deposits (cash) at other financial institutions. (3) Cost of all deposits, including noninterest-bearing demand deposits, was 1.51% and 0.24% for the nine months ended September 30, 2023 and 2022, respectively. (4) Net interest income divided by average interest-earning assets.

Rate/Volume Analysis

The following table presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It distinguishes between the changes related to outstanding balances and changes in interest rates. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (i.e., changes in volume multiplied by old rate) and (ii) changes in rate (i.e., changes in rate multiplied by old volume). For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the change due to volume and the change due to rate.

(In thousands)

(In thousands)

(1) Includes interest-earning deposits (cash) at other financial institutions.

Off-Balance Sheet Activities

In the normal course of operations, First Fed engages in a variety of financial transactions that are not recorded in the financial statements. These transactions involve varying degrees of off-balance sheet credit, interest rate and liquidity risks. These transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments and lines of credit. For the nine months ended September 30, 2023 and the year ended December 31, 2022, we engaged in no off-balance sheet transactions likely to have a material effect on our financial condition, results of operations or cash flows.

Contractual Obligations

At September 30, 2023, our scheduled maturities of contractual obligations were as follows:

(In thousands)

Commitments and Off-Balance Sheet Arrangements

The following table summarizes our commitments and contingent liabilities with off-balance sheet risks as of September 30, 2023:

(In thousands)

Liquidity Management

Liquidity is the ability to meet current and future financial obligations of a short-term and long-term nature. Our primary sources of funds consist of deposit inflows, loan repayments, maturities and sales of securities, and borrowings from the FHLB. While maturities and scheduled amortization of loans and securities are usually predictable sources of funds, deposit flows, calls of investment securities and borrowed funds, and prepayments on loans and investment securities are greatly influenced by general interest rates, economic conditions and competition, which can cause those sources of funds to fluctuate.

Management regularly adjusts our investments in liquid assets based upon an assessment of expected loan demand, expected deposit flows, yields available on interest-earning deposits and securities, and the objectives of our liquidity management, interest-rate risk and investment policies. We increased available liquidity during 2023 in response to stresses within the banking industry and related concerns regarding liquidity.

Our most liquid assets are cash and cash equivalents followed by available-for-sale securities. The levels of these assets depend on our operating, financing, lending and investing activities during any given period. At September 30, 2023, cash and cash equivalents totaled $83.9 million and unpledged securities classified as available-for-sale had a market value of $279.1 million. The Bank pledged collateral of $582.8 million to support borrowings from the FHLB, with a remaining borrowing capacity of $269.0 million at September 30, 2023. The Bank also has an established discount window borrowing arrangement with the FRB, for which available-for-sale securities with a market value of $9.0 million were pledged as of September 30, 2023, with a remaining borrowing capacity of $8.5 million. The Bank has established an additional arrangement with the FRB through the BTFP, for which available-for-sale securities with a market value of $15.1 million were pledged as of September 30, 2023, with a remaining borrowing capacity of $18.3 million. First Northwest has a $20.0 million borrowing arrangement with NexBank which is secured by First Northwest's personal property assets (with certain exclusions), including all the outstanding shares of First Fed, cash, loans receivable, and limited partnership investments. The remaining borrowing capacity of the NexBank line of credit was $12.0 million at September 30, 2023.

At September 30, 2023, we had $680,000 in loan commitments outstanding and $155.0 million in undisbursed loans and standby letters of credit, including $60.6 million in undisbursed construction loan commitments.

CDs due within one year as of September 30, 2023, totaled $449.2 million, or 77.5% of CDs with a weighted-average rate of 4.21%. If these maturing deposits are not renewed, we will seek other sources of funds, including other CDs, non-maturity deposits, and borrowings. We have the ability to attract and retain deposits by adjusting the interest rates offered as well as through sales and marketing efforts in the markets we serve. Depending on market conditions, we may be required to pay higher rates on such deposits or other borrowings than we currently pay on CDs. In addition, we believe that our branch network, and the general cash flows from our existing lending and investment activities, will provide adequate long-term liquidity. For additional information, see the Consolidated Statements of Cash Flows in Item 1 of this Form 10-Q.

First Fed has a diversified deposit base with approximately 61% of deposit account balances held by consumers, 29% held by business and public fund depositors, and 10% in brokered deposits. The average deposit account balance, excluding brokered and public fund accounts, was $28,000 at September 30, 2023. We estimate that 80-85% of our customer deposit balances are below the $250,000 FDIC insurance limit or fully collateralized. The remaining uninsured deposits represent less than 5% of depositors. Management believes that maintaining a diversified deposit base is an important factor in managing and maintaining adequate levels of liquidity.

The Company is a separate legal entity from the Bank and provides for its own liquidity. At September 30, 2023, the Company, on an unconsolidated basis, had liquid assets of $507,000. In addition to its operating expenses, the Company is responsible for paying dividends declared, if any, to its shareholders, funds paid for Company stock repurchases, interest payments on subordinated notes held at the Company level, payments on the NexBank revolving credit facility, and commitments to limited partnership investments. The Company may receive dividends or capital distributions from the Bank, although there may be regulatory limitations on the ability of the Bank to pay dividends. First Northwest previously contributed $8.0 million to Quin Ventures pursuant to the terms of a capital financing agreement and related promissory note. Quil Ventures Inc. agreed to repay the amount owed by Quin Ventures under the terms and conditions specified in a repayment and security agreement with First Northwest dated December 20, 2022.

Capital Resources

At September 30, 2023, shareholders' equity totaled $156.1 million, or 7.2% of total assets. Our book value per share of common stock was $16.20 at September 30, 2023, compared to $16.31 at December 31, 2022.

At September 30, 2023, the Bank exceeded all regulatory capital requirements and was considered "well capitalized" under FDIC regulatory capital guidelines.

The following table provides the capital requirements and actual results for First Fed at September 30, 2023.

(Dollars in thousands)

In order to avoid limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses, the Bank must maintain common equity tier 1 capital ("CET1") at an amount greater than the required minimum levels plus a capital conservation buffer of 2.5%.

Effect of Inflation and Changing Prices

The consolidated financial statements and related financial data presented in this report have been prepared according to GAAP, which require the measurement of financial and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time due to inflation. The primary impact of inflation on our operations is reflected in increased operating costs and the effect that general inflation may have on both short-term and long-term interest rates. Unlike companies in many other industries, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant impact on a financial institution's performance than do general levels of inflation. Although inflation expectations do affect interest rates, interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.

(a) Evaluation of Disclosure Controls and Procedures.

An evaluation of the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934 (the "Exchange Act")) was carried out under the supervision and with the participation of the Company's Chief Executive Officer (Principal Executive Officer), Chief Financial Officer (Principal Financial and Accounting Officer), and other members of the Company's management team as of the end of the period covered by this quarterly report. The Company's Chief Executive Officer and Chief Financial Officer concluded that as of September 30, 2023, the Company's disclosure controls and procedures were effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is (i) accumulated and communicated to the Company's management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission's rules and forms.

(b) Changes in Internal Controls.

There have been no changes in the Company's internal control over financial reporting (as defined in 13a-15(f) of the Exchange Act) that occurred during the quarter ended September 30, 2023, that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.

The Company intends to continually review and evaluate the design and effectiveness of its disclosure controls and procedures and to improve its controls and procedures over time and to correct any deficiencies that it may discover in the future. The goal is to ensure that senior management has timely access to all material financial and non-financial information concerning the Company's business. While the Company believes the present design of its disclosure controls and procedures is effective to achieve its goal, future events affecting its business may cause the Company to modify its disclosure controls and procedures. The Company does not expect that its disclosure controls and procedures and internal control over financial reporting will prevent every error or instance of fraud. A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met. Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns in controls or procedures can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any control procedure is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.