FS Bancorp, Inc.: Form 10-Q for the period ended Mar 31, 2024

Forward–Looking Statements

This report contains forward-looking statements, which can be 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 subject to significant risks and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:

• potential adverse impacts to economic conditions in the Company’s local market areas, other markets where the Company has lending relationships, or other aspects of the Company’s business operations or financial markets, including, without limitation, as a result of employment levels, labor shortages, the effects of inflation, a potential recession or slowed economic growth;
• changes in the interest rate environment, including the recent past increases in the Board of Governors of the Federal Reserve System (“Federal Reserve”) benchmark rate and duration at which such increased interest rate levels are maintained, which could adversely affect our revenues and expenses, the values of our assets and obligations, and the availability and cost of capital and liquidity;
• the impact of continuing high inflation and the current and future monetary policies of the Federal Reserve in response thereto;
• the effects of any federal government shutdown;
• the credit risks of lending activities, including changes in the level and trend of loan delinquencies, write offs, changes in our allowance for credit losses (“ACL”) on loans, and provision for credit losses on loans that may be impacted by deterioration in the housing and commercial real estate markets;
• secondary market conditions and our ability to originate loans for sale and sell loans in the secondary market;
• fluctuations in the demand for loans, the number of unsold homes, land and other properties, and fluctuations in real estate values in our market area;
• staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges;
• 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 the interest rate environment that reduce our interest margins or reduce the fair value of financial instruments;
• increased competitive pressures among financial services companies;
• our ability to execute our plans to grow our residential construction lending, our home lending operations, our warehouse lending, and the geographic expansion of our indirect home improvement lending;
• our ability to attract and retain deposits;
• our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we may in the future acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames and any goodwill charges related thereto;
• our ability to control operating costs and expenses;
• our ability to retain key members of our senior management team;
• changes in consumer spending, borrowing, and savings habits;
• our ability to successfully manage our growth;
• the impact of bank failures or adverse developments at other banks and related negative press about the banking industry in general on investor and depositor sentiment;
• legislative or regulatory changes that adversely affect our business including changes in banking, securities and tax law, and in regulatory policies and principles, or the interpretation of regulatory capital or other rules;

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• our ability to pay dividends on our common stock;
• the quality and composition of our securities portfolio and the impact of any adverse changes in the securities markets;
• changes in accounting policies and practices, as may be adopted by the bank regulatory agencies, the Public Company Accounting Oversight Board or the Financial Accounting Standards Board (“FASB”);
• costs and effects of litigation, including settlements and judgments;
• 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;
• inability of key third-party vendors to perform their obligations to us;
• the economic impact of climate change, severe weather events, natural disasters, pandemics, epidemics and other public health crises, acts of war or terrorism, civil unrest, and other external events on our business;
• other economic, competitive, governmental, bank regulatory, consumer and technical factors affecting our operations, pricing, products and services, and
• other risks described elsewhere in this Form 10‑Q and our other reports filed with or furnished to SEC, including our Annual Report on Form 10-K for the year ended December 31, 2023 (the “2023 Form 10-K”).

Any of the forward-looking statements made in this Form 10‑Q and in other public statements 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 foresee. Forward-looking statements are based upon management’s beliefs and assumptions at the time they are made. The Company undertakes no obligation to update or revise any forward-looking statement included in this report 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. In light of 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.

Overview

FS Bancorp and its subsidiary bank, 1st Security Bank, have been serving the Puget Sound area since 1907, including its bank acquisitions, when the predecessor to Anchor Bank was formed. On July 9, 2012, the Bank converted from mutual to stock ownership and became the wholly owned subsidiary of FS Bancorp.

The Company is relationship-driven, delivering banking and financial services to local families, local and regional businesses and industry niches in suburban communities in the greater Puget Sound area, the Kennewick-Pasco-Richland metropolitan area of Washington, also known as the Tri-Cities, Goldendale, Vancouver, and White Salmon, Washington and Manzanita, Newport, Ontario, Tillamook and Waldport, Oregon.

On February 24, 2023, the Company completed its purchase of seven retail bank branches from Columbia State Bank (the “Branch Acquisition”) and acquired approximately $425.5 million in deposits and $66.1 million in loans. The seven acquired branches are in the communities of Goldendale, and White Salmon, Washington, and Manzanita, Newport, Ontario, Tillamook, and Waldport, Oregon. The Branch Acquisition expanded our Puget Sound-focused retail footprint into southeast Washington and the state of Oregon as well as providing an opportunity to extend our unique brand of community banking into those communities.

The Company also maintains its long-standing indirect consumer lending platform which operates primarily throughout the Western United States. The Company emphasizes long-term relationships with families and businesses within the communities served, working with them to meet their financial needs. The Company is also actively involved in community activities and events within these market areas, which further strengthens our relationships within those markets.

The Company's strategic focus involves diversifying revenues, expanding lending channels, and enhancing the banking franchise. Management is committed to establishing varied revenue streams considering credit, interest rate, and concentration risks. The business plan includes:

• Growing and diversifying our loan portfolio;
• Maintaining strong asset quality;
• Emphasizing lower cost core deposits to reduce the costs of funding our loan growth;
• Capturing customers’ complete relationships through a broad array of products and services, leveraging community involvement, and selectively emphasizing offerings aligned with customers’ banking needs; and
• Expanding into new markets.

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As a diversified lender, the Company specializes in originating one-to-four-family loans, commercial real estate (“CRE”) mortgages, second mortgages, consumer loans, marine lending, and commercial business loans.

At March 31, 2024, the Company's loan portfolio included real estate loans, consumer loans, and commercial business loans representing 62.8%, 26.3%, and 10.9% of the portfolio, respectively.

Fixture secured loans to finance window, gutter, siding replacement, solar panels, spas, and other improvement renovations are a large segment of the consumer loan portfolio. These fixture-secured consumer loans are dependent on the Company’s contractor/dealer network of 77 active dealers located throughout Washington, Oregon, California, Idaho, Colorado, Nevada, Arizona, Minnesota, Texas, Utah, Massachusetts, Montana, and New Hampshire. Five of these contractor/dealers were responsible for 77.1% of the dollar volume of funded loans for the three months ended March 31, 2024. The Company funded $34.9 million or approximately 1,600 loans in the fixture-secured consumer loan category during the quarter ended March 31, 2024.

The following table details fixture secured loan originations by state for the periods indicated:

(Dollars in thousands)

The Company originates one-to-four-family residential mortgage loans through referrals from real estate agents, financial planners, builders, and from existing customers. Retail banking customers are also an important source of the Company’s loan originations. The Company originated $151.4 million of one-to-four-family loans (which included loans held for sale, loans held for investment and fixed seconds) in addition to $2.6 million of loans brokered to other institutions through the home lending segment during the three months ended March 31, 2024, of which $93.9 million were sold to investors. Of the loans sold to investors, $55.5 million were sold to the FNMA, FHLMC, FHLB, and/or GNMA with servicing rights retained for the purpose of further developing these customer relationships. At March 31, 2024, one-to-four-family residential mortgage loans held for investment totaled $580.1 million, or 23.7%, of the total gross loan portfolio, while loans held for sale totaled $50.0 million and home equity loans totaled $73.3 million at that date.

For the three months ended March 31, 2024, one-to-four-family loan originations and refinancing activity increased compared to the prior quarter as a result of slightly decreased market interest rates. Residential construction and development lending, while not as common as other loan origination options like one-to-four-family loans, continues to be an important element in our total loan portfolio, and we continue to take a disciplined approach by concentrating our efforts on loans to builders and developers in our market areas known to us. These short-term loans typically have a maturity period of six to 18 months, with disbursements not fully realized at origination, leading to a short-term reduction in net loans receivable.

The Company is significantly affected by prevailing economic conditions, as well as government policies and regulations concerning, among other things, monetary and fiscal affairs. Deposit flows are influenced by a number of factors, including interest rates paid on time deposits, other investments, account maturities, and the overall level of personal income and savings. Lending activities are influenced by the demand for funds, the number and quality of lenders, and regional economic cycles. Sources of funds for lending activities include primarily deposits, including brokered deposits, borrowings, payments on loans, and income provided from operations.

The Company’s earnings are primarily dependent upon net interest income, the difference between interest income and interest expense. Interest income is a function of the balances of loans and investments outstanding during a given period and the yield earned on these loans and investments. Interest expense is a function of the amount of deposits and borrowings outstanding during the same period and interest rates paid on these deposits and borrowings.

The Company’s earnings are also affected by fee income from mortgage banking activities, the provision for (recapture of) credit losses, service charges and fees, gains from sales of assets, operating expenses and income taxes. Most notable of these factors, the Company recorded a provision for credit losses of $1.4 million for the three months ended March 31, 2024, compared to $2.1 million for the same period one year ago. The decreased provision for credit losses in the current period was primarily due to a decrease in net loan growth, particularly in consumer loans, partially offset by an increase in provision for credit losses due to higher net charge-offs in commercial business, indirect home improvement, and marine loans.

Critical Accounting Estimates

We prepare our consolidated financial statements in accordance with GAAP. In doing so, we must make estimates and assumptions. Our critical accounting estimates are those estimates that involve a significant level of uncertainty at the time the estimate was made, and changes in the estimate that are reasonably likely to occur from period to period, or use of different estimates that we reasonably could have used in the current period, would have a material impact on our financial condition or results of operations. Accordingly, actual results could differ materially from our estimates. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. Management believes that its critical accounting policies include the following:

ACL on Held-to-Maturity Securities. Management measures expected credit losses on held-to-maturity securities by individual security. Accrued interest receivable on held-to-maturity debt securities is excluded from the estimate of credit losses. The estimate of expected credit losses considers credit ratings and historical credit loss information that is adjusted for current conditions and reasonable and supportable forecasts.

The held-to-maturity portfolio consists entirely of corporate securities. Securities are generally rated investment grade or higher. Securities are analyzed individually to establish a reserve.

ACL on Available-for-Sale Securities. For available-for-sale securities in an unrealized loss position, management first assesses whether it intends to sell, or is more likely than not to be required to sell, the security before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the security’s amortized cost basis is written down to fair value through income. For debt securities available-for-sale that do not meet the aforementioned criteria, the Company evaluates whether the decline in fair value has resulted from credit losses or other factors. In making this assessment, management considers the extent to which fair value is less than amortized cost, any changes to the rating of the security by a rating agency, and adverse conditions specifically related to the security, among other factors. If this assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security are compared to the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an ACL is recorded, limited by the amount that the fair value is less than the amortized cost basis.

Changes in the ACL are recorded as a provision for (recapture of) credit losses. Losses are charged against the ACL when management believes the uncollectibility of an available-for-sale security is confirmed or when either of the criteria regarding intent or requirement to sell is met. Accrued interest receivable on available-for-sale debt securities is not included in the estimate of credit losses.

ACL on Loans. The ACL on loans is a valuation account that is deducted from the loans’ amortized cost basis to present the net amount expected to be collected on the loans. Loans are charged off against the ACL when management believes the uncollectibility of a loan balance is confirmed and recaptures are credited to the ACL when received. In the case of recaptures, amounts may not exceed the aggregate of amounts previously charged off.

Management utilizes relevant available information, from internal and external sources, relating to past events, current conditions, historical loss experience, and reasonable and supportable forecasts. The lookback period in the analysis includes historical data from 2009 to present. Adjustments to historical loss information are made when management determines historical data is not likely reflective of the current portfolio such as limited data sets or lack of default or loss history. Management may selectively apply external market data to subjectively adjust the Company’s own loss history including index or peer data. Accrued interest receivable is excluded from the estimate of credit losses on loans.

The ACL on loans is measured on a collective cohort basis when similar risk characteristics exist. Generally, collectively assessed loans are grouped by call report code and then risk-grade grouping. Risk grade is grouped within each call report code by pass, watch, special mention, substandard, and doubtful. Other loan types are separated into their own cohorts due to specific risk characteristics for that pool of loans.

The Company has elected a non-discounted cash flow methodology with probability of default (“PD”) and loss given default (“LGD”) for all call report code cohorts (“cohorts”), except for the indirect and marine portfolios which are evaluated under a vintage methodology. The vintage methodology measures the expected loss calculation for future periods based on historical performance by the origination period of loans with similar life cycles and risk characteristics. Guaranteed portions of loans are measured with zero risk due to cash collateral and full guaranty.

The PD calculation looks at the historical loan portfolio at points in time (each month during the lookback period) to determine the probability that loans in a certain cohort will default over the next 12-month period. A default is defined as a loan that has moved to past due 90 days and greater, nonaccrual status, or experienced a charge-off during the period. In cohorts where the Company’s historical data is insufficient due to a minimal amount of default activity or zero defaults, management uses index PDs comprised of rates derived from the PD experience of other community banks in place of the Company’s historical PDs. Additionally, management reviews all other cohorts to determine if index PDs should be used outside of these criteria.

The LGD calculation looks at actual losses (net charge-offs) experienced over the entire lookback period for each cohort of loans. The aggregate loss amount is divided by the exposure at default to determine an LGD rate. All defaults (non-accrual, charge-off, or greater than 90 days past due) occurring during the lookback period are included in the denominator, whether a loss occurred or not and exposure at default is determined by the loan balance immediately preceding the default event (i.e., nonaccrual or charge-off). Due to limited charge-off history, management uses index LGDs comprised of rates derived from the LGD experience of other community banks in place of the Company’s historical LGDs.

The Company utilizes reasonable and supportable forecasts of future economic conditions when estimating the ACL on loans. The calculation includes a 12-month PD forecast based on the Company’s regression model comparing peer nonperforming loan ratios to the national unemployment rate. After the forecast period, PD rates revert on a straight-line basis back to long-term historical average rates over a 12-month period. Due to limited default history, management uses index PDs comprised of rates derived from the PD experience of other community banks in place of the Company’s historical PDs.

The Company recognizes that all significant factors that affect the collectability of the loan portfolio must be considered to determine the estimated credit losses as of the evaluation date. Furthermore, the methodology, in and of itself and even when selectively adjusted by comparison to market and peer data, does not provide a sufficient basis to determine the estimated credit losses. The Company adjusts the modeled historical losses by qualitative and environmental adjustments to incorporate all significant risks to form a sufficient basis to estimate the credit losses.

Loans classified as nonaccrual, are reviewed quarterly for potential individual assessment. Any loan classified as a nonaccrual that is not determined to need individual assessment is evaluated collectively within its respective cohort.

Where the primary and/or expected source of repayment of a specific loan is believed to be the future liquidation of available collateral, impairment will generally be measured based upon expected future collateral proceeds, net of disposition expenses including sales commissions as well as other costs potentially necessary to sell the asset(s) (i.e., past due taxes, liens, etc.). Estimates of future collateral proceeds will be based upon available appraisals, reference to recent valuations of comparable properties, use of consultants or other professionals with relevant market and/or property-specific knowledge, and any other sources of information believed appropriate by management under the specific circumstances. When appraisals are ordered to support the impairment analysis of an impaired loan, the appraisal is reviewed by the Company’s internal appraisal reviewer.

Where the primary and/or expected source of repayment of a specific loan is believed to be the receipt of principal and interest payments from the borrower and/or the refinancing of the loan by another creditor, impairment will generally be measured based upon the present value of expected proceeds discounted at the contractual interest rate. Expected refinancing proceeds may be estimated from review of term sheets received by the borrower from other creditors and/or from the Company’s knowledge of terms generally available from other banks.

Expected credit losses are estimated over the contractual term of the loans, adjusted for expected prepayments when appropriate. The contractual term excludes expected extensions, renewals and modifications. Prepayment assumptions will be determined by analysis of historical behavior by loan cohort.

ACL on Unfunded Commitments. The Company estimates expected credit losses over the contractual period in which the Company is exposed to credit risk via a contractual obligation to extend credit unless that obligation is unconditionally cancellable by the Company. The ACL for unfunded commitments is adjusted through a provision for (recapture of) credit losses. The estimate includes consideration of the likelihood that funding will occur and an estimate of expected credit losses on commitments expected to be funded over its estimated life. The estimate utilizes the same factors and assumptions as the ACL on loans and is applied at the same collective cohort level.

Business Combinations and Goodwill. Pursuant to applicable accounting guidance, the Company recognizes assets acquired, including identified intangible assets, and the liabilities assumed in acquisitions at their fair values as of the acquisition date. Transaction costs related to the acquisition are expensed in the period incurred. The determination of fair values involves estimates based on internal or third-party valuations, including appraisals, discounted cash flow analysis, and other techniques incorporating factors such as attrition, inflation, asset growth rates, discount rates, credit risk, and multiples of earnings. The determination of fair value may require us to make point-in-time estimates about discount rates, future expected cash flows, market conditions, and other future events that can be volatile in nature and challenging to assess. While we use the best estimates and assumptions to accurately value assets acquired and liabilities assumed at the acquisition date, the estimates are inherently uncertain and subject to refinement.

In whole bank or bank branch acquisitions, the primary identifiable intangible asset recorded is the value of the core deposit intangibles, representing the estimated value of the long-term deposit relationships acquired. The determination involves assumptions and estimates, typically determined through discounted cash flow analysis, considering customer attrition/runoff, alternative funding costs, deposit servicing costs, and discount rates. Amortization of core deposit intangibles occurs over estimated useful lives reviewed periodically for reasonableness. These estimated useful lives, typically ranging from seven to 10 years with an accelerated rate of amortization are periodically reviewed for reasonableness. Identifiable intangible assets, including core deposit intangibles, are assessed for impairment when events or changes suggest the carrying value may not be recoverable. The Company's policy dictates recognition of an impairment loss equal to the difference between the asset’s carrying amount and its fair value if the expected undiscounted future cash flows are less than the carrying amount. Estimating future cash flows involves the use of multiple estimates and assumptions, as previously mentioned.

The ACL on purchase credit deteriorated (“PCD”) assets is recognized within business combination accounting with no initial impact to net income. Subsequent changes in estimates of expected credit losses on PCD loans are recognized through a provision for (recapture of) credit losses in subsequent periods as they arise. The ACL on non-PCD assets is recognized as provision expense in the same reporting period as the business combination. Estimated loan losses for acquired loans are determined using methodologies and applying estimates and assumptions that were described previously in the section above entitled, “Allowance for Credit Losses on Loans.”

Non-PCD loans acquired are generally estimated at fair value using a discounted cash flow approach with differences from contractual unpaid principal balances referred to as “discounts.” These discounts are accreted to interest income over the loans' estimated remaining lives.

Similar adjustments are made for premiums or discounts on acquired debt impacting interest expense over their remaining lives. Actual accretion or amortization may differ materially from our estimates impacting our operating results.

Goodwill arising from business combinations represents the excess of the purchase price over the sum of the estimated fair values of the tangible and identifiable intangible assets acquired less the estimated fair value of the liabilities assumed. Goodwill has an indefinite useful life and is evaluated for impairment annually or more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. Accounting for goodwill also involves a higher degree of judgment than most other significant accounting policies. ASC 350–10 establishes standards for an impairment assessment of goodwill.

The initial recognition of goodwill and other intangible assets, along with subsequent analyses, necessitates subjective judgments from management. These judgements involve estimating how acquired assets will perform in the future using valuation methods including discounted cash flow analysis. Additionally, the challenge arises as estimated cash flows may extend beyond 10 years, making them difficult to determine over an extended timeframe. Significant events and factors influencing these estimates include competitive forces, customer behaviors, attrition, changes in revenue growth trends, cost structures, technology, alterations in discount rates, and specific industry and market conditions. To validate assumptions in its estimates, the Company reviews the historical performance of underlying or similar assets, ensuring the reasonableness of cash flow estimates.

The Company’s annual assessment of potential goodwill impairment was completed during the fourth quarter of 2023. Based on the results of this assessment, no goodwill impairment was recognized. Because of current economic conditions the Company continues to monitor goodwill and other intangible assets for impairment indicators throughout the year.

On an on-going basis, the Company evaluates its estimates. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The Company’s accounting policies are discussed in detail in “Note 1 – Basis of Presentation and Summary” of the Notes to Consolidated Financial Statements included in Item 8. “Financial Statement and Supplementary Data” of Form 10–K.

Comparison of Financial Condition at March 31, 2024 and December 31, 2023

Assets. Total assets were $2.97 billion at both March 31, 2024 and December 31, 2023. The changes in total assets at March 31, 2024, compared to December 31, 2023, included increases of $24.3 million in loans held for sale, $13.9 million in loans receivable, net, and $3.6 million in other assets, partially offset by decreases of $20.3 million in total cash and cash equivalents, $13.3 million in securities available-for-sale, $8.1 million in MSRs held for sale, and $1.9 million in deferred tax asset, net.

Loans receivable, net increased $13.9 million to $2.42 billion at March 31, 2024, from $2.40 billion at December 31, 2023, Total real estate loans increased $5.8 million to $1.54 billion at March 31, 2024, compared to December 31, 2023, reflecting increases in one-to-four-family loans (excluding loans held for sale) of $12.3 million and home equity loans of $3.8 million, partially offset by decreases in CRE loans of $7.3 million, construction and development loans of $1.7 million, and multi-family loans of $1.4 million. Undisbursed construction and development loan commitments increased $13.6 million, to $168.2 million at March 31, 2024, as compared to $154.6 million at December 31, 2023. Similarly, commercial business loans increased $8.7 million to $264.5 million at March 31, 2024, compared to December 31, 2023, as a result of an increase in commercial and industrial lending of $18.1 million, partially offset by a decrease in warehouse lending of $9.5 million. Consumer loans decreased $621,000 to $646.1 million at March 31, 2024, compared to December 31, 2023, primarily due to a decrease of $1.1 million in indirect home improvement loans and $131,000 in other consumer loans, partially offset by an increase of $611,000 in marine loans.

Loans held for sale, consisting of one-to-four-family loans, increased by $24.3 million to $50.0 million at March 31, 2024, from $25.7 million at December 31, 2023. The Company continues to invest in its home lending operations and strategically manage production capacity in the markets we serve.

One-to-four-family loan originations for the three months ended March 31, 2024, included $110.5 million of loans originated for sale, $40.9 million of portfolio loans including first and second liens, and $2.6 million of loans brokered to other institutions.

Originations of one-to-four-family loans for the periods indicated were as follows:

(Dollars in thousands)

During the three months ended March 31, 2024, the Company sold $93.9 million of one-to-four-family loans compared to $77.3 million for the same period one year ago. Gross margin on home loan sales increased to 3.43% for the three months ended March 31, 2024, compared to 3.05% for the three months ended March 31, 2023. Gross margin is defined as the margin on loans sold (cash sales) without the impact of deferred costs.

The ACL on loans totaled $31.5 million or 1.29% of gross loans receivable (excluding loans held for sale), at March 31, 2024, compared to $31.5 million or 1.30% of gross loans receivable (excluding loans held for sale, at December 31, 2023. The ACL on unfunded loan commitments was $1.5 million at both March 31, 2024 and December 31, 2023.

Classified loans totaled $24.9 million at March 31, 2024, all of which were classified as substandard, compared to classified loans of $24.9 million at December 31, 2023, of which $24.5 million were classified as substandard and $399,000 were classified as doubtful. Nonperforming loans, consisting solely of nonaccrual loans, increased $1.2 million to $12.1 million at March 31, 2024, from $11.0 million at December 31, 2023, primarily due to increases in commercial business loans of $659,000 and indirect home improvement loans of $332,000. The ratio of nonperforming loans to total gross loans was 0.49% at March 31, 2024, compared to 0.45% at December 31, 2023. There were no OREO properties at both March 31, 2024 and December 31, 2023.

Liabilities. Total liabilities decreased $16.4 million to $2.69 billion at March 31, 2024, from $2.71 billion at December 31, 2023, primarily due to a decrease of $57.0 million in deposits, offset by increases of $36.2 million in borrowings and $4.8 million in other liabilities.

Total deposits decreased $57.0 million to $2.47 billion at March 31, 2024, from $2.52 billion at December 31, 2023. CDs, which include retail and non-retail CDs, increased $15.6 million to $1.11 billion at March 31, 2024, from $1.10 billion at December 31, 2023, with non-retail CDs representing 31.0% and 34.2% of total CDs at such dates, respectively. At March 31, 2024, non-retail CDs, which include brokered CDs, online CDs and public funds CDs decreased $30.0 million to $344.5 million, compared to $374.5 million at December 31, 2023, primarily due to a decrease of $30.0 million in brokered CDs.

Transactional accounts (noninterest-bearing checking, interest-bearing checking and escrow accounts) decreased $79.9 million to $834.9 million at March 31, 2024, from $914.9 million at December 31, 2023, due to decreases of $56.0 million in interest-bearing checking and $35.5 million in noninterest-bearing checking, partially offset by an increase of $11.6 million in escrow accounts related to mortgages serviced. Money market and savings accounts increased $7.3 million to $518.0 million at March 31, 2024, from $510.7 million at December 31, 2023.

Deposits are summarized as follows at the dates indicated:

(Dollars in thousands)

(1) Includes $0.0 and $70.2 million of brokered deposits at March 31, 2024 and December 31, 2023, respectively.

(2) Includes $8.0 million and $1,000 of brokered deposits at March 31, 2024 and December 31, 2023, respectively.

(3) Includes $331.3 million and $361.3 million of brokered CDs at March 31, 2024 and December 31, 2023, respectively.

(4) CDs that meet or exceed the FDIC insurance limit.

(5) Noninterest-bearing checking.

The Bank had uninsured deposits of approximately $614.1 million or 24.9% of total deposits, at March 31, 2024, compared to approximately $606.5 million or 24.0% of total deposits at December 31, 2023. The uninsured amounts are estimates based on the methodologies and assumptions used for the Bank’s regulatory reporting requirements.

At March 31, 2024, borrowings totaled $129.9 million and were comprised of advances from the Federal Reserve Bank’s Bank Term Funding Program (“BTFP”) of $89.9 million, FRB overnight borrowings of $23.0 million, and FHLB fixed-rate advances of $17.1 million. Borrowings increased $36.2 million to $129.9 million at March 31, 2024, from $93.7 million at December 31, 2023. The increased borrowings were partially attributable to a decrease in total deposits.

Stockholders’ Equity. Total stockholders’ equity increased $13.4 million to $277.9 million at March 31, 2024, from $264.5 million at December 31, 2023. The increase in stockholders’ equity was primarily due to net income of $8.4 million, partially offset by dividends paid of $2.0 million. In addition, stockholders’ equity was positively impacted by decreases in unrealized net losses in securities available-for-sale of $4.3 million, net of tax, and unrealized net gains on fair value and cash flow hedges of $2.6 million, net of tax, reflecting sales of investment securities in unrealized loss positions and changes in market interest rates benefiting hedges during the quarter, resulting in a $6.9 million improvement in accumulated other comprehensive loss.

Book value per common share was $36.06 at March 31, 2024, compared to $34.36 at December 31, 2023. The calculation of book value per share at March 31, 2024, was based on 7,707,651 common shares, after deducting the 98,144 unvested restricted stock shares from the 7,805,795 reported common shares outstanding as of that date. Similarly, the book value per share at December 31, 2023, was calculated based on 7,698,401 common shares, after deducting the 102,144 unvested restricted stock shares from the 7,800,545 reported common shares outstanding as of that date.

Comparison of Results of Operations for the Three Months Ended March 31, 2024 and 2023

General. Net income was $8.4 million for the three months ended March 31, 2024, compared to $8.2 million for the three months ended March 31, 2023. The increase in net income was primarily due to a $709,000 or 33.6% decrease in the provision for credit losses, partially offset by a $316,000 or $1.0% decrease in net interest income, a $108,000 or 2.1% decrease in noninterest income and a $95,000 or 4.7% increase in provision for income taxes. Total noninterest expense remained relatively unchanged at $23.5 million for the three months ended March 31, 2024, compared to the same period in 2023.

Average Balances, Interest and Average Yields/Cost

The following table sets 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 resultant spread at for the periods presented. Average balances are daily average balances. Nonaccrual loans have been included in the table as loans carrying a zero yield. The yields on tax-exempt municipal bonds have not been computed on a tax equivalent basis.

(Dollars in thousands)

(1) Includes net deferred fee recognition of $1.3 million and $1.8 million for the three months ended March 31, 2024 and 2023, respectively.

(2) Available for sale (“AFS”) and held to maturity (“HTM”) securities are shown at amortized cost.

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Net Interest Income. Net interest income decreased $316,000 to $30.3 million for the three months ended March 31, 2024, from $30.7 million for the three months ended March 31, 2023, due to an increase in interest expense on deposits and, to a lesser extent, borrowings, partially offset by an increase in interest and dividend income. Total interest income increased $6.3 million for the three months ended March 31, 2024, compared to the same period in 2023, primarily due to an increase of $5.0 million in interest income on loans receivable, including fees, impacted primarily as a result of new loans being originated at higher rates and variable-rate loans repricing higher following increased market interest rates during the first six months of 2023. In addition, interest income on investment securities, excluding FHLB stock, increased $1.3 million, and interest-bearing deposits at other financial institutions increased $15,000, during the three months ended March 31, 2024, compared to the same period in 2023, primarily due to recent increases in market interest rates. Total interest expense increased $6.6 million for the three months ended March 31, 2024, compared to the same period in 2023, primarily as a result of higher market interest rates, higher utilization of borrowings and a shift in deposit mix from transactional accounts to higher cost CDs.

Net interest margin (“NIM”) decreased 44 basis points to 4.26% for the three months ended March 31, 2024, from 4.70% for the same quarter the prior year. The change in NIM reflects the increased costs of deposits and borrowings which outpaced the increased yields earned on interest-earning assets.

Interest Income. Interest income for the three months ended March 31, 2024, increased $6.3 million to $44.9 million, from $38.6 million for the three months ended March 31, 2023. The increase was primarily attributable to a $218.7 million increase in the average balance of total interest-earning assets and a 39-basis point increase in the average yield on total interest-earning assets.

The following table compares average interest-earning asset balances, associated yields, and resulting changes in interest income for the three months ended March 31, 2024 and 2023:

(Dollars in thousands)

(1) The average loans receivable, net balances include nonaccrual loans.

(2) Includes net deferred fee recognition of $1.3 million and $1.8 million for the three months ended March 31, 2024 and 2023, respectively.

(3) Shown at amortized cost.

Interest Expense. Interest expense increased $6.6 million to $14.5 million for the three months ended March 31, 2024, from $8.0 million for the comparable quarter in 2023, primarily due to an increase of interest expense on deposits of $6.3 million and on borrowings of $326,000. The average cost of funds for total interest-bearing liabilities increased 118 basis points to 2.95% for the three months ended March 31, 2024, from 1.77% for the three months ended March 31, 2023. The increase in interest expense was predominantly due to an increase in cost for deposits and borrowings as well as an increase in the average balances of CDs and borrowings. The average cost of total interest-bearing deposits increased 124 basis points to 2.83%, for the three months ended March 31, 2024, compared to 1.59%, for the three months ended March 31, 2023. The average balance of total interest-bearing deposits increased $144.7 million to $1.83 billion for the three months ended March 31, 2024, compared to $1.69 billion for the three months ended March 31, 2023. The average cost of funds, including noninterest-bearing checking, increased 89 basis points to 2.21% for the three months ended March 31, 2024, from 1.32% for the three months ended March 31, 2023.

The following table details average balances of interest-bearing liabilities, associated rates, and resulting change in interest expense for the three months ended March 31, 2024 and 2023:

(Dollars in thousands)

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Provision for Credit Losses. For the three months ended March 31, 2024, the provision for credit losses was $1.4 million, consisting of a $1.4 million provision for credit losses on loans, partially offset by a $22,000 recapture of the ACL on unfunded loan commitments, compared to $2.1 million provision for credit losses for the three months ended March 31, 2023, consisting of a $2.4 million provision for credit losses on loans, offset by a $249,000 recapture of the ACL on unfunded loan commitments. The provision for credit losses on loans reflects the increase in the loan portfolio, as well as an increase in nonperforming loans and higher net charge-offs.

During the three months ended March 31, 2024, net loan charge-offs totaled $1.5 million, compared to $410,000 during the three months ended March 31, 2023. The increase was primarily due to increases in net charge-offs of $441,000 in indirect home improvement loans, $408,000 in commercial business loans, and $169,000 in marine loans. A further decline in national and local economic conditions, as a result the effects of inflation, a potential recession or slowed economic growth, among other economic factors, could result in a material increase in the ACL on loans and may adversely affect the Company’s financial condition and result of operations.

Noninterest Income. Noninterest income decreased $108,000 to $5.1 million for the three months ended March 31, 2024, from $5.2 million for the three months ended March 31, 2023. The decrease reflects an $8.0 million loss on sale of investment securities resulting from management's strategic decision to increase the yields earned on and reduce the duration of the securities portfolio, and a $650,000 decrease in other noninterest income, primarily due to fair value adjustments to loans in the loan portfolio, partially offset by an $8.2 million increase in gain on sale of MSRs and a $362,000 gain on sale of loans. Gross margin on home loan sales increased to 3.43% for the three months ended March 31, 2024, from 3.05% for the three months ended March 31, 2023.

Noninterest Expense. Noninterest expense was $23.5 million for both the three months ended March 31, 2024 and 2023. The variations in noninterest expense were primarily due to the absence of acquisition costs in the current period, in contrast to $1.5 million incurred in the prior year. Additionally, there was a decrease of $307,000 in salaries and benefits, partially offset by increases of $482,000 in amortization of core deposit intangible, $390,000 in data processing, $316,000 in operations, $245,000 in professional and board fees, $185,000 in occupancy expense, and $115,000 in loan costs.

The efficiency ratio, which is calculated by dividing noninterest expense by total net interest income and noninterest income, worsened to 66.36% for the three months ended March 31, 2024, compared to 65.56% for the three months ended March 31, 2023, primarily due to decreases in net interest income and noninterest income.

Provision for Income Taxes. For the three months ended March 31, 2024, the Company recorded a provision for income taxes of $2.1 million as compared to $2.0 million for the three months ended March 31, 2023. The increase in the income taxes provision was primarily due to a $280,000 increase in pre-tax income during the three months ended March 31, 2024, as compared to the same quarter last year. The effective corporate income tax rates for the three months ended March 31, 2024 and 2023 were 20.2% and 19.9%, respectively. The increase in the effective corporate income tax rate was attributable to a decrease in nontaxable income between periods, to include an increase in non-deductible interest expense attributable to the related assets.

Liquidity

Management maintains a liquidity position that it believes will adequately provide funding for loan demand and deposit runoff that may occur in the normal course of business. The Company relies on several different sources to meet potential liquidity demands. The primary sources are increases in deposit accounts, FHLB advances, purchases of federal funds, sale of securities available-for-sale, cash flows from loan payments, sales of one-to-four-family loans held for sale, and maturing securities. While the maturities and the scheduled amortization of loans are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition.

The Bank must maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund its operations. The Bank generally maintains sufficient cash and short-term investments to meet short-term liquidity needs. At March 31, 2024, the Bank’s total borrowing capacity was $698.7 million with the FHLB of Des Moines, with unused borrowing capacity of $681.2 million. The FHLB borrowing limit is based on certain categories of loans, primarily real estate loans that qualify as collateral for FHLB advances. At March 31, 2024, the Bank held approximately $1.09 billion in loans that qualify as collateral for FHLB advances.

In addition to the availability of liquidity from the FHLB of Des Moines, the Bank maintains a short-term borrowing line with the FRB with a limit of $269.3 million and a combined credit limit of $101.0 million in written federal funds lines of credit through correspondent banking relationships at March 31, 2024. The FRB borrowing limit is based on certain categories of loans, primarily consumer loans that qualify as collateral for FRB line of credit. At March 31, 2024, the Bank held approximately $632.8 million in loans that qualify as collateral for the FRB line of credit. Additionally, securities with a carrying value of $76.2 million were pledged primarily to provide contingent liquidity through the BTFP at the Federal Reserve Bank at March 31, 2024, with a current limit of $90.1 million and no unused borrowing capacity. Subject to market conditions, we expect to utilize these borrowing facilities from time to time in the future to fund loan originations and deposit withdrawals, to satisfy other financial commitments, repay maturing debt and to take advantage of investment opportunities to the extent feasible.

The Bank’s Asset and Liability Management Policy permits management to utilize brokered deposits up to 20% of deposits or $494.9 million at March 31, 2024. Total brokered deposits at March 31, 2024 were $339.3 million. Management utilizes brokered deposits to mitigate interest rate risk and to enhance liquidity when appropriate.

Liquidity management is both a daily and long-term function of the Company’s management. Excess liquidity is generally invested in short-term investments, such as overnight deposits and federal funds. On a longer-term basis, a strategy is maintained of investing in various lending products and investment securities, including U.S. Government obligations and U.S. agency securities. The Company uses sources of funds primarily to meet ongoing commitments, pay maturing deposits, fund withdrawals, and to fund loan commitments. At March 31, 2024, outstanding loan commitments, including unused lines of credit totaled $566.6 million. The Company purchased $38.0 million in securities during the three months ended March 31, 2024. The Company purchased no securities during the three months ended March 31, 2023. Proceeds from securities repayments, maturities and sales were $48.3 million and $2.5 million during the three months ended March 31, 2024 and 2023, respectively.

The Bank’s liquidity is also affected by the volume of loans sold and loan principal payments. During the three months ended March 31, 2024 and 2023, the Bank sold $93.9 million and $77.3 million in loans, respectively.

Total deposits decreased $57.0 million during the three months ended March 31, 2024 primarily driven by a net decrease in brokered deposits of $92.2 million. CDs scheduled to mature in three months or less at March 31, 2024, totaled $336.0 million. It is management’s policy to offer deposit rates that are competitive with other local financial institutions. Based on this strategy, management believes that a majority of maturing relationship deposits will remain with the Bank.

For the remainder of 2024, we project that fixed commitments will include $1.4 million of operating lease payments. For information regarding our operating leases, see “Note 7 – Leases” of the Notes to Consolidated Financial Statements included in this report. FHLB advances of $1.1 million are scheduled to mature within the next twelve months.

As a separate legal entity from the Bank, FS Bancorp, Inc. must provide for its own liquidity. In addition to its own operating expenses (many of which are paid to the Bank), FS Bancorp is responsible for paying for any stock repurchases, dividends declared to its stockholders, interest and principal on outstanding debt, and other general corporate expenses. Sources of capital and liquidity for FS Bancorp include distributions from the Bank and the issuance of debt or equity securities, although there are regulatory restrictions on the ability of the Bank to make distributions.

Dividends and other capital distributions from the Bank are subject to regulatory notice and certain restrictions. The unrestricted cash of FS Bancorp held at the Bank on an unconsolidated basis totaled $9.3 million at March 31, 2024. The Company currently expects to continue the current practice of paying quarterly cash dividends on common stock subject to the Board of Directors' discretion to modify or terminate this practice at any time and for any reason without prior notice. Our current quarterly common stock dividend rate is $0.26 per share, which we believe is a dividend rate per share which enables us to balance our multiple objectives of managing and investing in the Bank, and returning a substantial portion of our cash to our shareholders. Assuming continued payment during 2024 at this rate of $0.26 per share, our total dividends paid each quarter would be approximately $2.0 million based on the number of the current outstanding shares as of March 31, 2024.

Under FS Bancorp’s existing stock repurchase program, approximately $3.0 million remained available for future repurchases as of March 31, 2024. See “Unregistered Sales of Equity Securities and Use of Proceeds” in Item 2, Part II of this Form 10-Q for additional information relating to stock repurchases.

Capital Resources

The Bank is subject to minimum capital requirements imposed by the FDIC. Based on its capital levels at March 31, 2024, the Bank exceeded these requirements as of that date. Consistent with our goals to operate a sound and profitable organization, our policy is for the Bank to maintain a well-capitalized status under the capital categories of the FDIC. Based on capital levels at March 31, 2024, the Bank was considered to be well capitalized. At March 31, 2024, the Bank exceeded all regulatory capital requirements with Tier 1 leverage-based capital, Tier 1 risk-based capital, total risk-based capital, and common equity Tier 1 capital ratios of 10.6%, 12.5%, 13.7%, and 12.5%, respectively.

As a bank holding company registered with the Federal Reserve, the Company is subject to the capital adequacy requirements of the Federal Reserve. Bank holding companies with less than $3.0 billion in assets are generally not subject to compliance with the Federal Reserve’s capital regulations, which are generally the same as the capital regulations applicable to the Bank. The Federal Reserve has a policy that a bank holding company is required to serve as a source of financial and managerial strength to the holding company’s subsidiary bank and the Federal Reserve expects the holding company’s subsidiary bank to be well capitalized under the prompt corrective action regulations. If FS Bancorp were subject to regulatory capital guidelines for bank holding companies with $3.0 billion or more in assets at March 31, 2024, FS Bancorp would have exceeded all regulatory capital requirements. For informational purposes, the regulatory capital ratios calculated for FS Bancorp at March 31, 2024 were 9.2% for Tier 1 leverage-based capital, 10.9% for Tier 1 risk-based capital, 14.1% for total risk-based capital, and 10.9% for CET 1 capital ratio. For additional information regarding regulatory capital compliance, see the discussion included in “Note 14 – Regulatory Capital” to the Notes to Consolidated Financial Statements included in Part I. Item 1 of this report.

(a) Evaluation of Disclosure Controls and Procedures

An evaluation of the disclosure controls and procedures as defined in Rule 13a‑15(e) of the Exchange Act was carried out as of March 31, 2024, under the supervision and with the participation of the Company’s Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”) and several other members of the Company’s senior management. In designing and evaluating the Company’s disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also 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.

Based upon the foregoing evaluation, the Company’s CEO and CFO concluded that as of March 31, 2024, the Company’s disclosure controls and procedures were effective in ensuring that information we are required to disclose in the reports we file or submit under the Exchange Act is (1) recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and (2) accumulated and communicated to FS Bancorp management, including its CEO and CFO, as appropriate to allow timely decisions regarding required disclosure, specified in the SEC’s rules and forms.

(b) Changes in Internal Controls

There were no changes in the Company’s internal control over financial reporting that occurred during the three months ended March 31, 2024, that have materially affected or are reasonably likely to materially affect our internal control over financial reporting. The Company does not expect that its disclosure controls and procedures and internal control over financial reporting will prevent all error and all 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 can occur because of simple error or mistake. Additionally, controls may be circumvented by the individual acts of some persons, by collusion of two or more people, or by override of the control. The design of any control procedure is also 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 may 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.