Bancorp 34, Inc.: Form 10-Q for the period ended Mar 31, 2024

In this section, unless the context suggests otherwise, references to “we,” “us,” “our,” and “the Company” mean the combined business of Bancorp 34 and its wholly-owned subsidiary, Southwest Heritage Bank.

The purpose of this discussion and analysis is to focus on significant changes in: (i) the financial condition of Bancorp 34, Inc. and our wholly owned subsidiary, Southwest Heritage Bank, from December 31, 2023, through March 31, 2024; and (ii) on our results of operations for the three months ended March 31, 2024, and 2023. This discussion and analysis should be read in conjunction with our audited consolidated financial statements and notes thereto for the year ended December 31, 2023, included in our Annual Report on Form 10-K, and information presented elsewhere in this Quarterly Report on Form 10-Q, particularly the unaudited consolidated financial statements and related notes appearing in Item 1.

Overview

Bancorp 34, headquartered in Scottsdale, Arizona, is the holding company for Southwest Heritage Bank (formerly Bank 34). On March 19, 2024, Bancorp 34 acquired CBOA Financial, Inc. (“CBOA”). Immediately following the acquisition, CBOA’s wholly-owned subsidiary, Commerce Bank of Arizona, was merged with and into Bancorp 34’s wholly-owned subsidiary, Bank 34, a federally chartered stock covered savings association. Bank 34 was subsequently rebranded as Southwest Heritage Bank. Southwest Heritage Bank provides a variety of banking services to individuals and businesses through its eight full-service community bank branches, three in Maricopa County, Arizona, in the cities of Scottsdale and Gilbert; three in Pima County, Arizona, in the cities of Tucson and Green Valley; one branch in Otero County, New Mexico in the city of Alamogordo; and one branch in Dona Ana County New Mexico, in the city of Las Cruces.

We offer a full range of relationship-focused services to meet our clients’ business and personal financial objectives, with branches in Arizona and New Mexico. Our product lines include commercial loans, commercial real estate loans, and a variety of commercial and consumer deposit products, including noninterest bearing accounts, interest-bearing demand products, savings accounts, money market accounts and certificates of deposit. We also offer online banking and bill payment services, online cash management, safe deposit box rentals, debit card and ATM card services and the availability of a network of ATMs for our customers.

Bancorp 34 generates most of its income from interest income on loans, investment securities and deposits in other financial institutions, and service charges on customer accounts. Bancorp 34 incurs interest expense on deposits and other borrowed funds and noninterest expenses such as salaries and employee benefits, occupancy expenses, and technology expenses. Net interest income is the largest source of Bancorp 34’s revenue. Net interest spread is the difference between rates earned on interest-earning assets and rates paid on interest-bearing liabilities. Net interest margin is calculated as net interest income divided by average interest-earning assets. Because noninterest-bearing sources of funds, such as noninterest-bearing deposits and shareholders’ equity, also fund interest-earning assets, net interest margin includes the benefit of these noninterest-bearing sources.

Changes in the market interest rates and interest rates Bancorp 34 earns on interest-earning assets or pays on interest-bearing liabilities, as well as the volume and types of interest-earning assets, interest-bearing and noninterest-bearing liabilities, and shareholders’ equity, are usually the largest drivers of periodic changes in net interest spread, net interest margin, and net interest income. Fluctuations in market interest rates are driven by many factors, including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions, and conditions in domestic and foreign financial markets. Periodic changes in the volume and types of loans in Southwest Heritage Bank’s loan portfolio are affected by, among other factors, economic and competitive conditions in Arizona and New Mexico, as well as developments affecting the real estate, technology, financial services, insurance, transportation, manufacturing and homebuilding sectors within Southwest Heritage Bank’s target market.

Bancorp 34 manages its operations as one unit, and thus does not have separate operating segments.

Critical Accounting Estimates

Our consolidated financial statements are prepared based on the application of accounting policies in accordance with generally accepted accounting principles, or “GAAP,” and follow general practices within the banking industry. These policies require the reliance on estimates, assumptions and judgments, which may prove inaccurate and are subject to variations. Changes in underlying factors, estimates, assumptions or judgements could have a material impact on our future financial condition and results of operations.

Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported. We have identified the determination of the allowance for credit losses and fair value measurements to be the accounting areas that require the most subjective or complex judgments and, as such, could be most subject to revision as new or additional information becomes available or circumstances change, including overall changes in the economic climate and/or market interest rates. Therefore, we consider these policies, discussed below, to be critical accounting estimates and discuss them directly with the Audit Committee of our board of directors.

Our significant accounting policies are presented in our audited consolidated financial statements, Note 1—Nature of Operations and Significant Accounting Policies, for the year ended December 31, 2023, included in our Annual Report on Form 10-K. These policies, along with the disclosures presented in the other financial statement notes and, in this discussion, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Recent accounting pronouncements and standards that have impacted or could potentially affect us are also discussed in Note 1 of our audited consolidated financial statements, included in our 2023 Annual Report on Form 10-K.

Allowance for credit losses

One significant accounting policy is our accounting policy related to the allowance for credit losses (“ACL”). Effective January 1, 2023, we adopted ASU 2016-13, Financial Instruments – Measurement of Current Expected Credit Losses on Financial Instruments (“CECL”), using the modified retrospective method for our financial assets measured at amortized cost. CECL changed our method of accounting for credit losses from an incurred loss model to an expected credit loss model. Under the prior incurred loss model, credit losses on financial instruments were recognized when a probable loss was incurred, while CECL is an “expected credit loss” model. The expected credit loss model represents management’s estimate of expected credit losses to the full contractual maturity of the financial asset and is based on historical experience, current conditions, and reasonable and supportable forecasts. We believe the determination of the ACL involves a greater amount of judgment and complexity when compared with our other significant accounting policies.

Qualitative factors are used in the CECL model to address various internal and external factors that may not be captured by the quantitative modeling or historical data needed to assess the expected credit losses. Qualitative factors considered include, but may not be limited to, the following: lending policies and procedures; changes in underwriting standards; nature and volume of financial assets; changes in lending staff; volume and severity of past due or adversely classified assets; changes in collateral values; and the internal credit review function.

The Company uses a 12-month forecast that is reasonable and supportable within the ACL calculation and then reverts to historical credit loss experience on a straight-line basis over a one-year timeline. Historical credit loss experience is then used for the remaining life of the assets. The Company uses several economic variables in the calculation of the ACL, the most significant of which is the economic forecast for the national unemployment rate. In the March 31, 2024, estimate, the Company assumed a forecasted unemployment rate of 4.5%, which has improved from the December 31, 2023, forecasted rate of 4.7%. Changes in the economic forecast for unemployment rates could significantly affect the estimated credit losses which could potentially lead to materially different ACL levels from one reporting period to the next.

For our bank, CECL requires a separate ACL for each of: (i) loans held-for-investment; (ii) unfunded commitments; and (iii) held-to-maturity debt securities.

ACL – Loans held-for-investment

The level of the ACL on loans held-for-investment is calculated to maintain a credit loss reserve level that management considers sufficient to absorb estimated credit losses. Management’s determination of the adequacy of the ACL is based on the periodic evaluation of borrowers’ abilities to make loan payments, local and national economic conditions, and other subjective factors. The evaluation has subjective components requiring significant estimates that include default probabilities, expected loss given default, and estimated credit losses based on historical credit loss experience and forecasted economic conditions. All these factors may be susceptible to significant change and when actual results differ from the estimates, additional provisions for credit losses may be required, which would adversely impact profitability.

The ACL for pooled loans is estimated using a non-discounted cash flow methodology. The Bank then applies probability of default and loss given default to the cashflow methodology to calculate expected losses within the model. This allows the Bank to identify the timing of default as compared to when the actual loss event may occur. The results are then aggregated to produce segment level results and reserve requirements for each segment. The quantitative model also incorporates forward-looking macroeconomic information over a reasonable and supportable period of twelve months with a reversion to historical losses occurring on straight line basis over the next 12 months.

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

Qualitative adjustments to historical loss data are made based on management’s assessment of the risks that may lead to a future loan loss or differences in current loan-specific risk characteristics such as differences. A ratings scale is used to tie risk metrics within lending policies and procedures, economic factors note encompassed in the quantitative model, changes in nature of the volumes and terms of loans, changes in the volume and severity of past due assets, concentrations within the loan portfolio. Additional factors such staffing, loan review, collateral values, regulatory, legal, and technological risks are also reviewed on a more qualitative basis. The ratings scale used in the qualitative modeling is derived from the Bank’s historical loss percentages in which the highest risk metrics would align with the highest historical loss percentages adjusted for the expected life of the current portfolio.

Management has determined that calculating an ACL amount for accrued interest receivable on loans held-for-investment would not be significant, and this is excluded from our estimate of credit losses for loans held-for-investment. Additionally, we write off applicable accrued interest receivable balances in a timely manner when a loan is placed on non-accrual status, in which any accrued interest, not received in cash, is reversed from interest income.

The ACL also excludes loans held-for-sale and loans accounted for under the fair value option. Assets purchased with credit deterioration (“PCD”) assets represent assets that are acquired with evidence of more than insignificant credit quality deterioration since origination at the acquisition date. At acquisition, the allowance for credit losses on PCD assets is booked directly to the ACL. Any subsequent changes in the ACL on PCD assets is recorded through the provision for credit losses.

The ACL is a contra-asset on our balance sheet that is deducted from the amortized cost of loans held-for-investment to present on our balance the net amount expected to be collected. Loans are charged-off against the ACL when management believes the full or partial collectability is confirmed.

ACL – Unfunded commitments

We estimate expected credit losses on unfunded commitments over the contractual period in which we are exposed to credit risk via our contractual obligations to extend credit unless such obligations are unconditionally cancellable by us. The probability of funding such commitments in the future is based on historical utilization statistics for unfunded commitments. The credit loss rates used are calculated using the same assumptions as the associated funded balance.

The ACL on unfunded commitments is categorized in Other Liabilities on our balance sheet and, from time to time, is adjusted as a provision for credit loss expense.

ACL – Held-to-maturity debt securities

Management measures expected credit losses on held-to-maturity debt securities on a collective basis by major security type. Our held-to-maturity debt securities is comprised of bank subordinated debt. The ACL on held-to-maturity securities is adjusted through provision for credit losses and is recorded as a contra asset to held-to-maturity securities. Management has determined that calculating an ACL amount for accrued interest receivable on held-to-maturity debt securities would not be significant, and this is excluded from our estimate of credit losses for held-to-maturity debt securities.

Upon our January 1, 2023 CECL adoption, we recorded an increase to the ACL on loans held-for-investment of $604,000, established an ACL on unfunded commitments of $165,000, established an ACL on held-to-maturity investments of $38,000, recorded an increase to deferred tax assets of $153,000, and a corresponding one-time cumulative reduction to retained earnings, net of tax, of $654,000 in the consolidated balance sheet as of January 1, 2023.

For further information regarding our Allowance for Credit Losses see Note 1 and Note 4—LOANS AND ALLOWANCE FOR CREDIT LOSSES in our unaudited consolidated financial statements included in Item 1. of this Quarterly Report on Form 10-Q.

Business Combinations

Assets acquired, including identified intangible assets such as core deposit intangibles, and liabilities assumed as a result of a merger or acquisition transaction are recorded at their estimated fair values. The difference between the net fair value of assets acquired and liabilities assumed, and the consideration paid is recorded as a bargain purchase gain. Management engages third-party specialists to assist in the development of fair value estimates. Significant estimates and assumptions used to value acquired assets and liabilities assumed include, but are not limited to, projected cash flows, future growth rates, repayment rates, default rates and losses assuming default, discount rates, and realizable collateral values. The allowance for credit losses for PCD loans is recognized within acquisition accounting. The allowance for credit losses for non-PCD assets is recognized as provision for credit losses in the same reporting period as the merger or acquisition. Fair value adjustments are amortized or accreted into the income statement over the estimated lives of the acquired assets and assumed liabilities. The purchase date valuations and any subsequent adjustments determine the amount of bargain purchase gain recognized in connection with the merger or acquisition.

Preliminary estimates of fair values may be adjusted for a period of time no greater than one year subsequent to the merger or acquisition date if new information is obtained about facts and circumstances that existed as of the merger or acquisition date that, if known, would have affected the measurement of the amounts recognized as of that date. Adjustments recorded during this period are recognized in the current reporting period. For further information regarding the Merger, see Note 2 in our unaudited consolidated financial statements included in Item 1. of this Quarterly Report on Form 10-Q.

Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is based on quoted market prices, or if market prices are not available, is estimated using models employing various techniques.

The significant assumptions used in the models are independently verified against observable market data where possible. When observable market data is not available, the estimate of fair value becomes more subjective and involves a high degree of judgment. In this circumstance, fair value is estimated based on our judgment regarding the value that market participants would assign to the asset or liability. Therefore, the results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there are inherent limitations to any valuation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values.

A portion of our assets and liabilities are carried at fair value on our consolidated balance sheet. The majority of these assets and liabilities are measured at fair value on a recurring basis, however, certain assets are measured at fair value on a nonrecurring basis based on the fair value of the underlying collateral.

For further information regarding the valuation of our financial instruments, see Note 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES and Note 14 – FAIR VALUE INFORMATION in our unaudited consolidated financial statements included in Item 1. of this Quarterly Report on Form 10-Q.

CBOA Financial, Inc. Merger

On March 19, 2024, Bancorp 34 completed its previously announced merger with CBOA pursuant to the Agreement and Plan of Merger, dated as of April 27, 2023, as amended (the “Merger Agreement”). Under the Merger Agreement, CBOA was merged with and into Bancorp 34, with Bancorp 34 continuing as the surviving entity (the “Merger”). Immediately following the completion of the Merger, CBOA’s wholly-owned subsidiary, Commerce Bank of Arizona, an Arizona state-chartered bank, was merged with and into the Bank, with the Bank continuing as the surviving bank.

Pursuant to the terms of the Merger Agreement, at the effective time of the Merger, each CBOA shareholder had the right to receive 0.2628 shares of Bancorp 34 common stock, for each share of CBOA common stock owned by the CBOA shareholder, with cash to be paid in lieu of fractional shares. Additionally, each outstanding CBOA restricted stock unit vested and was cancelled and converted automatically into the right to receive 0.2628 shares of Bancorp 34 common stock with respect to each share of CBOA common stock underlying such restricted stock unit. In connection with the Merger, Bancorp 34 issued 2,742,257 shares of Bancorp 34 common stock, which had a fair value of approximately $23.3 million based on a common shares valuation completed by an independent third party as of the Merger date. Each outstanding share of Bancorp 34 common stock remained outstanding and was unaffected by the Merger.

Commerce Bank of Arizona operated five full-service offices serving customers in Gilbert, Green Valley, Oro Valley, Scottsdale and Tucson, Arizona. The combined banks operate as Southwest Heritage Bank and serve customers from eight full-service offices in Arizona and southern New Mexico. The core system conversion was executed in March 2024.

We accounted for the Merger using the acquisition method of accounting in accordance the Financial Accounting Standards Board’s Accounting Standards Code 805 (“ASC 805”), Business Combinations, and accordingly, the assets and liabilities of CBOA were recorded at their respective Merger date fair values. The fair values of assets and liabilities are preliminary and subject to refinement for up to one year after the Merger date as additional information relative to the Merger date fair values becomes available. Effective in March 2024, we recognized a preliminary bargain purchase gain of $5.1 million in connection with the Merger (not taxable for income tax purposes), which is recognized in our first quarter 2024 operating results. The core deposit intangible asset of $8.9 million represents the estimated value of Commerce Bank of Arizona’s long-term deposit relationships with its customers and will be amortized over an estimated weighted average life of ten years using an accelerated method, which approximates the estimated run-off of the acquired deposits. Through March 31, 2024, Bancorp 34 incurred approximately $6.4 million of merger-related expenses, $3.3 million of which was incurred during the first quarter of 2024.

For further information regarding the Merger, see Note 2 in our unaudited consolidated financial statements included in Item 1. of this Quarterly Report on Form 10-Q.

Results of Operations

General

Our results of operations depend substantially on net interest income, which is the difference between interest income on interest-earning assets, consisting primarily of interest income on loans, investment securities and other short-term investments, and interest expense on interest-bearing liabilities, consisting primarily of deposits and borrowings. Our results of operations are also dependent on our generation of non-interest income, consisting primarily of income from service charges on deposit accounts, interchange and ATM fees, and gains on sales loans. Other factors contributing to our results of operations include our provisions for credit losses, income taxes, and non-interest expenses, such as salaries and employee benefits, occupancy, amortization of intangible assets, and other operating costs.

We had a net loss of $1.5 million and net income of $0.4 million for the first quarters ended March 31, 2024, and 2023, respectively. The first quarter 2024 net loss includes: (i) a one-time preliminary bargain purchase gain on the Merger of $5.1 million (none of which is taxable); (ii) $3.3 million of Merger expenses (a portion of which is not deductible for income taxes); (iii) a $4.1 million pre-tax non-PCD loan provision related to the Merger; (iv) a $0.4 million pre-tax loss on the sale of a note associated with a loan which was classified as other real estate owned; and (v) an income tax benefit of $2 million. Our net income in the first quarter of 2023 primarily reflects net interest income of $4 million, operating expenses of $3.6 million, and an income tax provision of $0.2 million. There were no Merger expenses incurred during the first quarter of 2023.

Net Interest Income

Three months ended March 31, 2024, and 2023

Our net interest income was $3.7 million and $4.1 million for the first quarter of 2024 and 2023, respectively. This decrease of $0.4 million, or 9.9%, reflects $1.3 million from higher volumes and rates on our loans and other interest earning assets, all of which were more than offset by higher funding costs of $1.7 million, which was driven by $1.3 million due to higher funding rates, and to a lesser extent, higher certificate of deposit average volumes.

Average earning assets were $585.7 million and $543.3 million during the first quarter of 2024 and 2023. This increase of $42.4 million, or 7.8%, partially reflects the post-Merger date (March 19th, 2024) partial month of March 2024 during which the Commerce Bank of Arizona loans were legally owned by Southwest Heritage Bank. Average earning asset yields in the first quarter of 2024 and 2023 were 5.44% and 4.98%, respectively and is reflective of our loan portfolio repricing in the current interest rate environment.

Comparing average interest-bearing liabilities in the first quarter of 2024 and 2023, we experienced an increase of $35.3 million, or 8.6%. This increase reflects a continued increase in time deposits and the broader market trends in which customers have reduced non-interest- and interest-bearing demand deposits in favor of term CDs given the rising bank deposit rate environment. Additionally, this increase also includes the post-Merger date impact of Commerce Bank of Arizona deposits for the partial month of March 2024. Average brokered deposits, sometimes referred to as “brokered CDs”, are included in average time deposits and were $27.9 million in the first quarter of 2024.

Average noninterest bearing deposits increased $8.2 million, or 8.7%, from $94.3 million in the first quarter of 2024 to $102.5 million in the first quarter of 2024. This increase includes the impact of the March 19, 2024, Merger with Commerce Bank of Arizona.

The average balance sheet amounts, the related interest income or expense, and average rates earned or paid are presented in the following table. In the following table, subtotals and totals may not add up due to rounding. Rounding differences may occur in the presentation of numbers, and these variances do not impact the accuracy or reliability of the underlying financial data. All figures are presented in thousands unless otherwise stated.

(Dollars in thousands)

(1) Includes nonaccrual loans.

(2) Accretion and amortization of the fair value marks from the Merger are included in this column.

46

Rate-Volume Analysis

The table below presents the effect of volume and rate changes on interest income and expense. Changes in volume are based on the current period’s average balance multiplied by the previous period’s average rate. Changes in rate are based on the current period’s average rate multiplied by the average balance from the previous period. The net changes attributable to the combined impact of both rate and volume have been allocated proportionately to the changes due to volume and the changes due to rate. In the following table, subtotals and totals may not add up due to rounding. Rounding differences may occur in the presentation of numbers, and these variances do not impact the accuracy or reliability of the underlying financial data. All figures are presented in thousands unless otherwise stated.

2024 Compared to 2023 Volume and Rate Analysis

Allowance and Provision for Credit Losses – Loans held-for-investment

At March 31, 2024, and March 31, 2023, our ACL for loans held for investment was $10.7 million and $5.9 million, respectively, which represents 1.42% and 1.28% of loans held for investment, respectively. We maintain ACL at a level that management believes is adequate to absorb expected credit losses over the lifetime of our loans held-for-investment. Specifically, identifiable and quantifiable losses are immediately charged off against the allowance; recoveries are generally recorded only when sufficient cash payments are received subsequent to the charge-off. Our ACL at March 31, 2024, and in connection the Merger, included: (i) a $4.1 million provision expense related to the performing loans, “Non-PCD” loans of $300 million; and (ii) a $1.2 million on-balance sheet gross up of loans identified as purchased credit deteriorated loans, “PCD” loans of $30 million. For more information on the Merger, Non-PCD loans, and PCD loans, please see Note 2 in our unaudited financial statements herein.

The provision for credit losses, from time to time, includes a charge to our operating results in order to maintain the ACL at a level consistent with management’s assessment of the collectability of the loans held-for-investment in light of current economic conditions and market trends. Our provision for credit losses was $3.9 million and $1,000 in the first quarter of 2024 and 2023, respectively. The first quarter 2024 $3.9 million provision for credit loss expense primarily reflects the Merger-related $4.1 million charge for Non-PCD loans described above, partially offset by a $0.2 benefit caused by the decline in loans amounts at the existing institution. The relatively low provision for credit loss expense in the first quarter of 2023, reflects the impact from our CECL adoption effective January 1, 2023, which resulted in a one-time net of income tax charge to retained earnings of $654,000.

Allowance for Credit Losses – Off Balance Sheet Credit Exposures and Held-to-Maturity investments

During the first quarter of 2024, we recorded $64,000 as provision credit loss expense pertaining to our held-for-investments and unfunded commitments, combined. Upon our CECL adoption effective January 1, 2023, we recorded an ACL of $38,000 and $165,000, for held-to-maturity investments and unfunded commitments, respectively.

Noninterest Income

(In thousands)

Our noninterest income for the first quarter of 2024, primarily reflects a $5.1 million one-time preliminary bargain purchase gain, none of which is taxable for income tax purposes, partially offset by a $0.4 million pre-tax loss on the sale of a note associated with a loan which was classified as other real estate owned. For further information regarding the Merger and the preliminary bargain purchase gain, see Note 2 in our unaudited consolidated financial statements included in Item 1. of this Quarterly Report on Form 10-Q.

Noninterest Expense

(In thousands)

48

Our noninterest expense increased $4.5 million from the first quarter of 2023 compared to the first quarter of 2024. This increase primarily reflects $3.3 million in Merger costs incurred in the first quarter of 2024. Included within the $3.3 million of Merger costs is $1.2 million in core processing and online banking contract termination fees. Additionally, salary and benefits, occupancy and data processing also increased across these periods.

Efficiency ratio

The efficiency ratio is one measure of profitability in the banking industry. This ratio measures the cost of generating one dollar of revenue. That is, the ratio is designed to reflect the percentage of one dollar which must be expended to generate that dollar of revenue. We calculate this ratio by dividing non-interest expense by the sum of net interest income, before provision expense for credit losses, and non-interest income.

Our efficiency ratio was 95.60% and 85.71% for the quarters ended March 31, 2024, and 2023.

Return on equity and assets

The following table sets forth our ROAA, ROAE, dividend payout and average stockholders’ equity to average assets ratio for the periods ended:

Income Taxes

We had a $2 million income tax benefit for the first quarter of 2024, which represents a 56.6% effective income tax rate. This first quarter 2024 relatively high effective income tax rate reflects two Merger-related items: (i) non-taxable preliminary bargain purchase gain of $5.1 million; and (ii) partially deductible Merger costs of $3.3 million. Our effective rate for the first quarter of 2023 was 26.3%. For further information on income taxes, please reference Note 10 in our unaudited consolidated financial statements included in Item 1. of this Quarterly Report on Form 10-Q.

Financial Condition

Balance Sheet

Our total assets were $980.2 million at March 31, 2024, and $581.3 million at December 31, 2023. Our total loans held for investment were $750.3 million at March 31, 2024, and $457 million at December 31, 2023. The 68.6% and 64.2% increase in our total assets and total loans, respectively, largely reflects total assets, as adjusted for estimated fair values of $419.3 million, and total loans, as adjusted for estimated fair values, of $310.9, which were acquired in connection with the Merger. The legacy loan portfolio reduced approximately $20 million during the first quarter of 2024 as well. For further information regarding the Merger, see Note 2 in our unaudited consolidated financial statements included in Item 1. of this Quarterly Report on Form 10-Q.

Investment Securities

Our securities portfolio is used to make various term investments, maintain a source of liquidity and serve as collateral for certain types of borrowings. We manage our investment portfolio according to written investment policies approved by our board of directors. Investment in our securities portfolio may change over time based on our funding needs and interest rate risk management objectives. Our liquidity levels take into account anticipated future cash flows and available sources of funds and are maintained at levels that we believe are appropriate to provide the necessary flexibility to meet our anticipated funding requirements.

Our investment securities portfolio consists of securities classified as available-for-sale and held-to-maturity. There were no trading securities in our investment portfolio as of March 31, 2024, and December 31, 2023.All available-for-sale securities are carried at fair value and may be used for liquidity purposes should management consider it to be in our best interest.

Our securities available-for-sale were $102.2 million and $56.7 million at March 31, 2024, and December 31, 2023, respectively. This 80.3% increase largely reflects the $58.2 million of securities available for sale, as adjusted for estimated fair values, which were acquired in connection with the Merger. For further information regarding the Merger, see Note 2 in our unaudited consolidated financial statements included in Item 1. of this Quarterly Report on Form 10-Q. After the Merger date, management liquidated the entire $58.2 million acquired investment portfolio in late March and early April, and management determined that these sales prices were the best indicator of the fair value of the investment portfolio effective as of the Merger date.

Loans

Our loan portfolio represents a broad range of borrowers primarily in our markets in Arizona and New Mexico, comprised of construction, commercial, commercial real estate, residential real estate, and consumer financing loans.

The following tables set forth the composition of our loan portfolio, as of the periods presented:

(In thousands)

Family residential real estate loans represent loans to consumers collateralized by a mortgage on a residence and include purchase money, refinancing, secondary mortgages, and home equity loans and lines of credit.

Commercial loans include commercial and industrial loans to commercial customers for use in normal business operations to finance working capital needs, equipment and inventory purchases, and other expansion projects. SBA, USDA and other small business lending products are also included. These loans are made primarily in our market areas are underwritten on the basis of the borrower’s ability to service the debt from revenue, and are generally extended under our normal credit standards, controls and monitoring systems.

Consumer and other include direct consumer installment loans, overdrafts and other revolving loans.

Construction loans include both residential and commercial projects. Construction loan terms are dependent upon the project, but in some cases the loan will be longer term and include both the construction phase as well as longer term financing.

Commercial real estate loans include owner occupied and non-owner occupied commercial real estate mortgage loans to operating commercial businesses and include loans for long-term financing of land and buildings. No significant concentrations are present within the CRE portfolio as the bank has made an effort to diversify across various industries and geographic locations. While the majority of these loans are made primarily in our market area, some of the loans have out of market properties. In response to the deterioration of a large out of market commercial real estate loan during 2023, management engaged an external party to complete a loan review that included approximately 90% of the out of market collateral portfolio. Additionally, management reviewed the property appraisals associated with the out of market loans and plans to limit out of market lending moving forward.

Multifamily loans are for those properties that have five or more units with borrowers who are primarily commercial entities. The Bank finances loans in several different multifamily types but does not have a concentration in any one type and does not do any specialty lending in this area. These loans are made primarily in our market area.

Maturities and Sensitivity of Loans to Changes in Interest Rates

The information in the following table is based on the contractual maturities of individual loans, including loans that may be subject to renewal at their contractual maturity. Renewal of these loans is subject to review and credit approval, as well as modification of terms upon maturity. Actual repayments of loans may differ from the maturities reflected below because borrowers have the right to prepay obligations with or without prepayment penalties. The following table summarizes the loan maturity distribution by type and related interest rate characteristics as of the periods presented:

(In thousands)

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Allocation of Allowance for Credit Losses

The following tables present the allocation of the ACL on loans held-for-investment and the percentage of the total amount of loans held-for-investment in each category listed and as of the dates indicated:

(Dollars in thousands)

The ACL increase during the first quarter of 2024, primarily reflects impacts from the Merger as more fully discussed above. For further information regarding the Merger, see Note 2 in our unaudited consolidated financial statements included in Item 1. of this Quarterly Report on Form 10-Q.

Nonperforming Assets

We have established policies and procedures to guide us in originating, monitoring and maintaining the credit quality of our loan portfolio. These policies and procedures are required to be followed by our bankers and underwriters and exceptions to these policies require elevated levels of approval and are reported to our board of directors.

Nonperforming assets include all loans categorized as nonaccrual, other real estate owned and other repossessed assets. The accrual of interest on loans is discontinued, or the loan is placed on nonaccrual, when the full collection of principal and interest is in doubt. We do not generally accrue interest on loans that are 90 days or more past due. When a loan is placed on nonaccrual, previously accrued but unpaid interest is reversed and charged against interest income and future accruals of interest are discontinued. Payments by borrowers for loans on nonaccrual are applied to loan principal. Loans are returned to accrual status when, in our judgment, the borrower’s ability to satisfy principal and interest obligations under the loan agreement has improved sufficiently to reasonably assure recovery of principal and the borrower has demonstrated a sustained period of repayment performance. In general, we require a minimum of six consecutive months of timely payments in accordance with the contractual terms before returning a loan to accrual status.

Historically other real estate owned (OREO) represents assets acquired through, or in lieu of, foreclosure. The amounts reported as OREO generally are supported by recent appraisals, with the appraised values adjusted, where applicable, for expected transaction fees likely to be incurred upon sale of the property. We typically have incurred recurring expenses relating to OREO in the form of maintenance, taxes, insurance, and legal fees, among others, until the OREO parcel is disposed. While disposition efforts with respect to our OREO are generally ongoing, if these properties are appraised at lower-than-expected values or if we are unable to sell the properties at the prices for which we expect to be able to sell them, we may incur additional losses. Southwest Heritage Bank held $3 million of OREO, represented by one out of market commercial real estate property, at December 31, 2023, and no OREO at March 31, 2024.

The following tables set forth our non-performing assets, non-performing asset ratios, and net losses as a percentage of average loans for each period presented:

(Dollars in thousands)

Total nonperforming assets were $3.4 million as of March 31, 2024, compared to $5.2 million at December 31, 2023. The decrease was due to the sale of the note for the prior OREO balance, being slightly offset by the non-accrual loans acquired through the Merger.

Potential problem loans are loans which management has serious doubts as to the ability of the borrowers to comply with the present loan repayment terms. Management has not identified any potential problem loans not included in the nonperforming assets table above.

Allowance for Credit Losses – Unfunded loan commitments

The following table presents the changes in the ACL on unfunded loan commitments for the three months ended March 31, 2024:

Deposits

Deposits represent our primary source of funds. We are focused on growing our core deposits through relationship-based banking with our business and consumer clients. Total deposits increased $318.9 million as of March 31, 2024, compared to December 31, 2023. The primary reason for the increase was the Merger with CBOA. Brokered deposits decreased $11.4 million from $19.5 million on December 31, 2023, to $8.1 at March 31, 2024, through maturities that were not renewed. Total time deposits, or CDs, continued to increase and represented 27% of total deposits at March 31, 2024. Customers continued to migrate toward the higher yielding CDs to lock in yields.

The following table sets forth the average balance amounts and the average rates paid on deposits held by us for the periods presented:

(Dollars in thousands)

For the three months ended March 31, 2024, and March 31, 2023, average certificates of deposit included average brokered CD balances of $12.0 million and $1.1 million, respectively. This growth in our brokered CD deposits in 2024 was used to supplement deposit growth, to assist in the management of interest rate risk through less volatile funding costs, and to reduce the reliance on short-term FHLB borrowings.

The following table sets forth the portion of the Bank’s time deposits, by account, that are in excess of the FDIC insurance limit, by remaining time until maturity, as of March 31, 2024:

(In thousands)

As of March 31, 2024, and December 31, 2023, approximately $352.2 million and $195.6 million of our total deposit portfolio was uninsured. The estimates are based on the methodologies and assumptions used for the Bank’s regulatory reporting requirements.

Federal Reserve Bank and Federal Home Loan Bank Advances

Other than deposits, we also utilize Federal Home Loan Bank (FHLB) advances and Federal Reserve Bank (FRB) advances as supplementary funding sources to finance our operations. At March 31, 2024 we had $49 million of borrowings through the FRB’s Bank Term Funding Program (BTFP) established in March 2023. At December 31, 2023, we had $29 million borrowings through the BTFP. Our advances from the FRB are collateralized by pledged securities. At March 31, 2024, we had $16.2 million in availability through the FRB’s Discount Window. As of March 31, 2024, we had $144.8 million in borrowing capacity at the FHLB of San Francisco.

The following table presents certain attributes of debt. The maximum month-end balance represents the high indebtedness at any month end during the first three months of 2024.

Other Debt

In addition to our FRB advances, we also have subordinated debt amounting to $23.1 million at March 31, 2024 and $4.1 million of trust preferred securities acquired in the CBOA Merger. See Note 7—BORROWINGS in our unaudited consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.

Capital Raises

During December 2022 and January 2023, Bancorp 34 completed two private placements of common and preferred stock. Bancorp 34 issued a total of 1,359,497 shares of common stock and 820,115 shares of convertible, non-voting Series A perpetual preferred Stock at $14.00 per share each, generating net cash proceeds of approximately $28.6 million. The Company used the net proceeds from these private placements to support the acquisition of CBOA and to enhance capital ratios.

In conjunction with the private placements, Bancorp 34 issued warrants to purchase up to 211,667 shares of common stock at a price of $14.00. The approximate fair value of the warrants at the date of grant was not considered significant. The warrants are exercisable at any time after their grant date, and from time to time, in whole or in part, for seven years from their grant dates, between December 2029 and January 2030. The exercise of such warrants remains subject to certain contractual provisions and a “cashless exercise” may be executed.

For more information about these private placements, see Note 17—Private Placement of Common and Preferred Stock, in our unaudited financial statements included in Item 1. of this Quarterly Report on Form 10-Q.

Bancorp 34 (Parent Company)

Bancorp 34 has routine cash needs consisting primarily of operating expenses and debt service. Bancorp 34 can obtain funding to meet its obligations from dividends collected from its subsidiary, Southwest Heritage Bank, and through the issuance of varying forms of debt and equity. At March 31, 2024, Bancorp 34 had cash and equivalents of $17 million, a $1.5 million note receivable from the Southwest Heritage Bank ESOP, and debt outstanding of $28.7 million, which includes $5.2 million related to trust preferred debt assumed in connection with the merger with Commerce Bank of Arizona. Management believes Bancorp 34 has the ability to generate and obtain adequate amounts of liquidity to meet its requirements in the short-term and the long-term.

Federal banking laws regulate the dollar amount of dividends that may be paid by banking subsidiaries without prior approval. Southwest Heritage Bank may declare dividends without prior regulatory approval that do not exceed the total of retained net income for the current year combined with its retained net income for the preceding two years, subject to maintenance of minimum capital requirements. Prior regulatory approval to pay dividends was not required in 2022 or 2023. During the first quarter of 2024, Southwest Heritage Bank did not pay a dividend to Bancorp 34.

Southwest Heritage Bank

Southwest Heritage Bank’s liquidity management policy and our asset and liability management policy, or ALM policy, provides the framework that we use to seek to maintain adequate liquidity and sources of available liquidity at levels that will enable us to meet all reasonably foreseeable short-term, long-term, and strategic liquidity demands. Our Asset and Liability Management Committee, or ALCO, is responsible for oversight of our liquidity risk management activities in accordance with the provisions of our ALM Policy and applicable bank regulatory capital and liquidity laws and regulations. Our liquidity risk management process includes (i) ongoing analysis and monitoring of our funding requirements under various economic and interest rate scenarios, (ii) review and monitoring of lenders, depositors, brokers and other liability holders to ensure appropriate diversification of funding sources, and (iii) liquidity contingency planning to address liquidity needs in the event of unforeseen market disruption, including appropriate allocation of funds to a liquid portfolio of marketable securities and investments. We continuously monitor our liquidity position in order for our assets and liabilities to be managed in a manner that we believe will meet our immediate and long-term funding requirements. We seek to manage our liquidity position to meet the daily cash flow needs of customers, while maintaining an appropriate balance between assets and liabilities to meet the return on investment objectives of our stockholders. We also monitor our liquidity requirements in light of interest rate trends, changes in the economy, and the scheduled maturity and interest rate sensitivity of our securities and loan portfolios and deposits. Liquidity management is made more complicated because different balance sheet components are subject to varying degrees of management control. For example, the timing of maturities of our investment portfolio is fairly predictable and subject to a high degree of control when we make investment decisions.

Our liquidity position is supported by management of our liquid assets and liabilities and access to alternative sources of funds. Our short-term and long-term liquidity requirements are primarily to fund on-going operations, including payment of interest on deposits and debt, extensions of credit to borrowers and capital expenditures. These liquidity requirements are met primarily through our deposits, FHLB advances, subordinated debt and the principal and interest payments we receive on loans and investment securities. Cash, interest-bearing deposits in third party banks, securities available for sale and maturing or prepaying balances in our investment and loan portfolios are our most liquid assets. Other sources of liquidity that are available to us include the sale of loans we hold for investment, the ability to acquire additional national market non-core deposits, borrowings through the Federal Reserve’s discount window and the issuance of additional debt or equity securities.

At March 31, 2024, Southwest Heritage Bank’s cash and amounts due from banks and interest-bearing deposits in other financial institutions, amounted to $72.7 million, or 7.4% of Southwest Heritage Bank’s total assets, compared to $28.9 million, or 5.0% of total assets, at December 31, 2023. The increase in Southwest Heritage Bank’s liquid assets, during the first quarter of 2024, reflects: (i) $30.9 million of cash acquired in connection with the Merger; (ii) $8.4 million of proceeds received from the sale of available-for-sale debt securities; and (iii) $2.6 million of proceeds received in connection with the final sale and settlement of an out-of-market OREO property.

The liability portion of our balance sheet serves as a primary source of liquidity. We plan to meet our future cash needs primarily through the generation of deposits. Customer deposits have historically provided a sizeable source of relatively stable and low-cost funds. At March 31, 2024, net loans as a percentage of deposits were 91.7%, compared to 98.1% at December 31, 2023. For additional information related to our deposits, see the “Deposits” section above.

We also have borrowing capacity at the Federal Reserve Bank (“FRB”) of San Francisco and the FHLB of San Francisco, from which we can borrow for leverage or liquidity purposes. Both the FRB and FHLB require that securities and/or qualifying loans be pledged to secure any advances. At March 31, 2024, Southwest Heritage Bank had: (i) $49 million in advances from the FRB’s BTFP; (ii) $16.2 million in availability through the FRB’s Discount Window; (iii) $145 million in borrowing capacity at the FHLB of San Francisco; and (iv) fully available unsecured Federal funds lines-of-credit with certain other financial institutions totaling $52.8 million.

Management believes Southwest Heritage Bank has the ability to generate and obtain adequate amounts of liquidity to meet its requirements in the short-term and the long-term.

Capital Resources

Stockholders’ equity at March 31, 2024, and December 31, 2023 was $82.2 million and $60.7 million, respectively. This increase primarily reflects the $23.3 million estimated fair value of our 2.7 million common shares issued as consideration in connection with the Merger during the first quarter of 2024.

We are subject to various regulatory capital requirements administered by federal banking regulators. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by federal banking regulators that, if undertaken, could have a direct material effect on our financial statements.

Regulatory capital rules adopted in July 2013 and fully-phased in as of January 1, 2019, which we refer to as the Basel III rules, impose minimum capital requirements for bank holding companies and banks. The Basel III rules apply to all national and state banks and savings associations regardless of size and bank holding companies and savings and loan holding companies with consolidated assets of more than $3 billion. In order to avoid restrictions on capital distributions or discretionary bonus payments to executives, a covered banking organization must maintain the fully-phased in “capital conservation buffer” of 2.5% on top of its minimum risk-based capital requirements. This buffer must consist solely of common equity Tier 1 risk-based capital, but the buffer applies to all three measurements (common equity Tier 1 risk-based capital, Tier 1 capital and total capital). At March 31, 2024, Bancorp 34 and Southwest Heritage Bank exceeded the regulatory minimums and met the regulatory definition of well-capitalized.

The following table shows the regulatory capital ratios for Bancorp 34 (consolidated) at the dates indicated:

(Dollars in thousands)

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The following table shows the regulatory capital ratios for Southwest Heritage Bank at the dates indicated:

(Dollars in thousands)

Off-Balance Sheet Items

We are a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit and unused lines of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition. The contractual or notional amounts of those instruments reflect the extent of involvement we have in particular classes of financial instruments.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by us upon extension of credit, is based on management’s credit evaluation of the counterparty. Collateral is primarily obtained in the form of commercial and residential real estate, including income producing commercial properties.

Commitments to make loans are generally made for periods of 90 days or less.

Our exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual or notional amount of those instruments. We use the same credit policies in making commitments and conditional obligations as for funded instruments. We do not anticipate any material losses as a result of the commitments and standby letters of credit.

The following table summarizes commitments as of the dates presented (dollars in thousands):

Contractual Obligations

We have entered into contractual obligations in the normal course of business that involve elements of credit risk, interest rate risk and liquidity risk.

The following table summarizes our contractual obligations as of March 31, 2024, and December 31, 2023:

(In thousands)

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The Company’s management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of March 31, 2024. The Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of March 31, 2024.

During the quarter ended March 31, 2024, there was no change in the Company’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 or 15d-15 of the Exchange Act that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. The Company is continually monitoring and assessing changes in processes and activities to determine any potential impact on the design and operating effectiveness of internal controls over financial reporting.

In addition to the other information set forth in this Quarterly Report, you should carefully consider the factors discussed in “Part I – Item 1A – Risk Factors” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2023, which could materially affect its business, financial position, results of operations, cash flows, or future results. Please be aware that these risks may change over time and other risks may prove to be important in the future. New risks may emerge at any time, and we cannot predict such risks or estimate the extent to which they may affect our business, financial condition or results of operations, or the trading price of our securities. Subject to the foregoing, there have been no material changes from risk factors as previously disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2023.