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

Cautionary Statement Regarding Forward-Looking Statements - This document contains a number of forward-looking statements, including statements about the financial condition, results of operations, earnings outlook and prospects of the Company. Forward-looking statements are typically identified by words such as “should,” “likely,” “plan,” “believe,” “expect,” “anticipate,” “intend,” “outlook,” “estimate,” “forecast,” “target,” “project,” “goal” and other similar words and expressions. The forward-looking statements involve certain risks and uncertainties. The ability of the Company to predict results or the actual effects of its plans and strategies is subject to inherent uncertainty.

Factors that may cause actual results or earnings to differ materially from such forward-looking statements include those set forth in Part I, Item 1A. Risk Factors in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2023, as updated by the Company’s subsequent filings with the SEC and, among others, the following:

• Changes in monetary and fiscal policies of the FRB and the U. S. Government, particularly related to changes in interest rates, money supply and inflation, may affect interest margins and the fair value of financial instruments;
• Changes in general economic conditions, either nationally or in our market areas, that are different than expected;
• The ability to enhance revenue through increased market penetration, expanded lending capacity and product offerings;
• Occurrence of natural or man-made disasters or calamities, including health emergencies, the spread of infectious diseases, pandemics such as COVID-19, or outbreaks of hostilities, such as between Russia and Ukraine and in the Middle East, or the effects of climate change, and the ability of the Company to deal effectively with disruptions caused by the foregoing;
• Legislative, regulatory or policy changes;
• Downturns in demand for loan, deposit and other financial services in the Company’s market area;
• Increased competition from other banks and non-bank providers of financial services;
• Technological changes and increased technology-related costs;
• A breach of our information systems security, including the occurrence of a cyber incident or a deficiency in cyber security; and
• Changes in accounting principles, or the application of generally accepted accounting principles.

Because these forward-looking statements are subject to assumptions and uncertainties, actual results may differ materially from those expressed or implied by these forward-looking statements. You are cautioned not to place undue reliance on these statements, which speak only as of the date of this document. All subsequent written and oral forward-looking statements concerning matters addressed in this document and attributable to the Company or any person acting on its behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this document. Except to the extent required by applicable law or regulation, the Company undertakes no obligation to update these forward-looking statements to reflect events or circumstances after the date of this document or to reflect the occurrence of unanticipated events.

Non-GAAP Disclosure - This discussion includes discussions of the Company’s tangible common equity (“TCE”) ratio, TCE, tangible assets and efficiency ratio, non-GAAP financial measures. A non-GAAP financial measure is a numerical measure of historical or future financial performance, financial position or cash flows that excludes or modifies amounts that are required to be disclosed in the most directly comparable measure calculated and presented in accordance with U.S. GAAP. The Company believes that these non-GAAP financial measures provide both management and investors a more complete understanding of the underlying operational results and trends and the Company’s marketplace performance. The presentation of this additional information is not meant to be considered in isolation or as a substitute for the numbers prepared in accordance with U.S. GAAP and may not be comparable to similarly titled measures used by other financial institutions.

With respect to the calculations and reconciliations of TCE, tangible assets and the TCE ratio, please see Liquidity and Capital Resources contained herein for a reconciliation to the most directly comparable GAAP measure.

Executive Summary – The Company is a one-bank holding company incorporated in 2016. The Company operates as the parent for its wholly owned subsidiary, the Bank, which commenced operations in 2008. The income of the Company is primarily derived through the operations of the Bank. Unless the context otherwise requires, references herein to the Company include the Company and the Bank on a consolidated basis.

The Bank operates as a locally headquartered, community-oriented bank, serving customers throughout the New York metro area from offices in Nassau, Suffolk, Queens, Kings (Brooklyn) and New York (Manhattan) Counties, New York and Freehold in Monmouth County, New Jersey. We opened the Bank’s Hauppauge Business Banking Center in Hauppauge, Suffolk County, New York in May 2023. This location is the nexus of our expanded commercial lending and deposit activities that are integral to the ongoing diversification of our balance sheet as we fill the void left by the diminishing number of commercial banks in the NYC Metro area. During the fourth calendar quarter of 2023, we began offering business banking services to the legal, licensed cannabis industry in New York and other states in which cannabis is legally licensed under applicable state laws. We offer personal and business loans on a secured and unsecured basis, SBA and USDA guaranteed loans, revolving lines of credit, commercial mortgage loans, and one- to four-family non-qualified mortgages secured by primary and secondary residences that may be owner occupied or investment properties, home equity loans, bridge loans and other personal purpose loans.

The Bank works to provide more direct, personal attention to customers than management believes is offered by competing financial institutions, the majority of which are headquartered outside of the Bank’s primary trade area and are represented locally by branch offices. By striving to employ professional, responsive and knowledgeable staff, the Bank believes it offers a superior level of service to its customers. As a result of senior management’s availability for consultation on a daily basis, the Bank believes it offers customers quicker responses on loan applications and other banking transactions, as well as greater and earlier certainty as to whether these transactions will actually close, than competitors, whose decisions may take longer and be made in distant headquarters.

Historically, the Bank has generated additional income by strategically originating and selling residential and government guaranteed loans to other financial institutions at premiums, while also retaining servicing rights in some sales. However, with increases in interest rates in recent years, the demand by purchasers of residential loans for pools of loans declined, eliminating the Bank’s ability to sell residential loans in its portfolio on desirable terms. Commencing in late 2023, the Bank initiated development of a flow origination program under which the Bank expects to originate individual loans for sale to specific buyers, thereby positioning the Bank to resume residential loan sales and generate fee income to complement sale premiums earned from the origination of SBA loans. The Bank is an approved SBA Preferred Lender, enabling the Bank to process SBA applications under delegated authority from the SBA and enhancing the Bank’s ability to compete more effectively for SBA lending opportunities.

The pace of new residential loan applications is historically slower in the first quarter and was more so in the first quarter of 2024 due to our intentional and continued prioritization of loan pricing over loan volume. As volume builds as the year progresses and we commence originations under our flow lending program, we expect the volume of applications to grow. A more diversified residential lending program is expected to provide greater flexibility with respect to earnings, liquidity and asset management.

The Bank finances most of its activities through a combination of deposits, including non-interest-bearing demand, savings, NOW and money market deposits as well as time deposits, and both short- and long-term borrowings. The Company’s chief competition includes local banks within its market area, New York City money center banks and regional banks, as well as non-bank lenders, including fintech lenders.

Financial Performance Summary

As of or for the three months ended March 31, 2024 and 2023

(dollars in thousands, except per share data)

(1) Represents net interest income plus total non-interest income.

(2) Includes common stock and Series A preferred stock.

(3) The ratio of total stockholders’ equity to total assets is the most comparable GAAP measure to the non-GAAP tangible common equity ratio presented herein.

At March 31, 2024 the Company, on a consolidated basis, had total assets of $2.3 billion, total deposits of $1.9 billion and total stockholders’ equity of $189.5 million. The Company recorded net income of $4.1 million, or $0.55 per diluted share (including Series A preferred shares), for the three months ended March 31, 2024 compared to net income of $3.2 million, or $0.43 per diluted share (including Series A preferred shares), for the same period in 2023.

The $0.9 million increase in earnings for the three months ended March 31, 2024, versus the comparable 2023 period resulted primarily from a $1.8 million increase in non-interest income and a $0.6 million decrease in the provision for credit losses expense, which were partially offset by a $1.0 million decrease in net interest income, reflecting the continued impact of higher funding costs resulting from the rapid rise in interest rates driven by the Federal Reserve, a $0.3 million increase in income tax expense and a $0.2 million increase in non-interest expense.

The Company’s return on average assets and return on average stockholders’ equity were 0.74% and 8.70%, respectively, for the three months ended March 31, 2024, versus 0.68% and 7.24%, respectively, for the comparable 2023 period.

Total non-accrual loans at March 31, 2024 were $14.9 million, or 0.74% of total loans, compared to $14.5 million, or 0.74% of total loans at December 31, 2023 and $10.3 million, or 0.58% of total loans, at March 31, 2023. The allowance for credit losses as a percentage of total non-accrual loans amounted to 134%, 136% and 144% at March 31, 2024, December 31, 2023 and March 31, 2023, respectively.

The Company’s operating efficiency ratio was 65.4% for the three months ended March 31, 2024, versus 67.4% a year ago. The improvement in the operating efficiency ratio was due to the increase in non-interest income, which was partially offset by a decrease in net interest income resulting from the rapid rise in market interest rates and an increase in non-interest expense.

Critical Accounting Policies, Judgments and Estimates - To prepare financial statements in conformity with U.S. GAAP, the Company’s management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and actual results could differ. Critical accounting estimates are accounting estimates where (a) the nature of the estimate is material due to levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change, and (b) the impact of the estimate on financial condition or operating performance is material. Significant accounting policies followed by the Company are presented in Note 1 – Summary of Significant Accounting Policies, to the Audited Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2023, and in Note 1 – Accounting Policies of this Form 10-Q.

Commencing on October 1, 2023 the Company adopted CECL which changed the Company’s critical accounting policies and estimates from policies regarding the calculation of the allowance for loan losses to policies regarding the calculation of an allowance for credit losses.

Allowance for Credit Losses

On October 1, 2023, the Company adopted ASU 2016-13 (Topic 326), which replaced the incurred loss methodology with CECL for financial instruments measured at amortized cost and other commitments to extend credit. The allowance for credit losses is a valuation allowance for management’s estimate of expected credit losses in the loan portfolio. The process to determine expected credit losses utilizes analytic tools and judgment and is reviewed on a quarterly basis. When management is reasonably certain that a loan balance is not fully collectable, an analysis is completed and a specific reserve may be established or a full or partial charge off could be recorded against the allowance. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance via a quantitative analysis which considers available information from internal and external sources related to past loan loss and prepayment experience and current conditions, as well as the incorporation of reasonable and supportable forecasts. Management evaluates a variety of factors including available published economic information in arriving at its forecast. Expected credit losses are estimated over the contractual term of the loans and adjusted for expected prepayments when appropriate. Also included in the allowance for credit losses are qualitative reserves that are expected, but, in management’s assessment, may not be adequately represented in the quantitative analysis or the forecasts described above. Factors may include changes in lending policies and procedures, size and composition of the portfolio, experience and depth of lending management and the effect of external factors such as competition, legal and regulatory requirements, among others. The allowance is available for any loan that, in management’s judgment, should be charged off. Although management uses the best information available, the level of the allowance for credit losses remains an estimate, which is subject to significant judgment and short-term change. Various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance for credit losses. Such agencies may require the Company to make additional provisions for credit losses based upon information available to them at the time of their examination. The Bank considers its primary lending area to be the New York metro area. A substantial portion of the Bank’s loans are secured by real estate in these areas. Accordingly, the ultimate collectability of the loan portfolio is susceptible to changes in market and economic conditions in this region. Future adjustments to the provision for credit losses and allowance for credit losses may be necessary due to economic, operating, regulatory and other conditions beyond the Company’s control.

Financial Condition – Total assets of the Company were $2.3 billion at March 31, 2024 and $2.3 billion at December 31, 2023. Total securities available for sale at March 31, 2024 was $92.7 million, an increase of $31.3 million from December 31, 2023, primarily driven by growth in U.S. Treasury securities. Total loans at March 31, 2024 were $2.0 billion, compared to total loans of $2.0 billion at December 31, 2023. Total deposits were $1.9 billion at March 31, 2024, versus $1.9 billion at December 31, 2023. Total borrowings and subordinated debt at March 31, 2024 were $173.6 million, including $126.7 million of outstanding FHLB advances, compared to $153.6 million at December 31, 2023.

For the three months ended March 31, 2024, the Company’s loan portfolio, net of sales, grew by $48.3 million to $2.0 billion. At March 31, 2024, the residential loan portfolio amounted to $756.9 million, or 37.7% of total loans. Commercial real estate loans, including multi-family loans and construction and land development loans, total $1.1 billion or 56.1% of total loans at March 31, 2024. Commercial and industrial loans, including PPP loans, totaled $123.4 million or 6.2% of total loans. The Company’s commercial real estate concentration ratio continued its steady decline, decreasing to 416% of capital at March 31, 2024 from 432% of capital at December 31, 2023, with loans secured by office space totaling 2.3% of the loan portfolio and $46.0 million. This portfolio included less than $400 thousand of exposure in Manhattan office space. A significant portion of the Bank’s commercial real estate portfolio consists of loans secured by Multi-Family and CRE-Investor owned real estate that are predominantly subject to fixed interest rates for an initial period of 5 years. The Bank’s exposure to Land/Construction loans is minor at $10 million, all at floating interest rates, and CRE-owner occupied loans have a sizable mix of floating rates.

Total deposits were $1.9 billion at March 31, 2024, versus $1.9 billion at December 31, 2023, reflecting an increase of $12.7 million or 0.7%. Our loan to deposit ratio was 105% at March 31, 2024 and 103% at December 31, 2023. Core deposit balances, which consist of demand, NOW, savings and money market deposits, represented 75.8% and 72.6% of total deposits at March 31, 2024 and December 31, 2023, respectively. At those dates, demand deposit balances represented 10.6% and 10.9% of total deposits. Although core deposits grew to $1.5 billion as of March 31, 2024 from $1.4 billion as of December 31, 2023, demand deposit balances decreased from $207.8 million to $202.9 million during the same period. This decrease was confined to deposits made by residential loan borrowers in anticipation of residential loan closings. These funds comprise the equity residential borrowers are required to contribute to residential loan closings and the volume of these deposits rises and falls in proportion to the volume of anticipated residential loan closings. As the pace of residential lending increases, the volume of demand deposits will increase accordingly. Demand deposits, net of balances related to residential loan closings, grew to $180.4 million as of March 31, 2024 from $166.4 million as of December 31, 2023, an increase of 8.5%. The Company’s municipal deposit program is built on long-standing relationships developed in the local marketplace. This core deposit business will continue to provide a stable source of funding for the Company’s lending products at costs lower than both consumer deposits and market-based borrowings. The Company continues to broaden its municipal deposit base and currently services 37 customer relationships. At March 31, 2024, total municipal deposits were $576.3 million, representing 30.1% of total deposits, compared to $528.1 million at December 31, 2023, representing 27.7% of total deposits. Total municipal deposits increased by $48.3 million or 9.1% from December 31, 2023 pirmarily due to seasonal variations. The weighted average rate on the municipal deposit portfolio was 4.65% at March 31, 2024.

Borrowings at March 31, 2024 were $149.0 million, including $2.3 million in PPPLF funding, versus $129.0 million, including $2.3 million in PPPLF funding at December 31, 2023. At March 31, 2024, the Company had $126.7 million of outstanding FHLB advances as compared to $126.7 million at December 31, 2023. The Company had $20.0 million in borrowings outstanding under lines of credit with correspondent banks at March 31, 2024 and none at December 31, 2023. The Company utilizes a number of strategies to manage interest rate risk, including interest rate swap agreements which currently provide a benefit to net interest income.

Liquidity and Capital Resources – Liquidity management is defined as the ability of the Company and the Bank to meet their financial obligations on a continuous basis without material loss or disruption of normal operations. These obligations include the withdrawal of deposits on demand or at their contractual maturity, the repayment of borrowings as they mature, funding new and existing loan commitments and the ability to take advantage of business opportunities as they arise. Asset liquidity is provided by short-term investments, such as fed funds sold, the marketability of securities available for sale and interest-bearing deposits due from the Federal Reserve, FHLB and correspondent banks, which totaled $136.5 million and $177.2 million at March 31, 2024 and December 31, 2023, respectively. These liquid assets may include assets that have been pledged primarily against municipal deposits or borrowings. Liquidity is also provided by the maintenance of a base of core deposits, cash and non-interest-bearing deposits due from banks, the ability to sell or pledge marketable assets and access to lines of credit. At March 31, 2024, liquidity sources, which include cash and unencumbered securities and secured and unsecured funding capacity, totaled $644.1 million, representing approximately 265% of uninsured deposit balances.

Liquidity is continuously monitored, thereby allowing management to better understand and react to emerging balance sheet trends, including temporary mismatches with regard to sources and uses of funds. After assessing actual and projected cash flow needs, management seeks to obtain funding at the most economical cost. These funds can be obtained by converting liquid assets to cash or by attracting new deposits or other sources of funding. Many factors affect the Company’s ability to meet liquidity needs, including variations in the markets served, loan demand, its asset/liability mix, its reputation and credit standing in its markets and general economic conditions. Borrowings and the scheduled amortization of investment securities and loans are more predictable funding sources. Deposit flows and securities prepayments are somewhat less predictable as they are often subject to external factors. Among these are changes in the local and national economies, competition from other financial institutions and changes in market interest rates.

The Company’s primary sources of funds are cash provided by deposits, which may include brokered and listing service deposits, borrowings, proceeds from maturities and sales of securities and cash provided by operating activities. At March 31, 2024, total deposits were $1.9 billion, of which $437.0 million were time deposits scheduled to mature within the next 12 months. Based on historical experience, the Company expects to be able to replace a substantial portion of those maturing deposits with comparable deposit products. Insured and collateralized deposits, which include municipal deposits, accounted for approximately 87% of total deposits at March 31, 2024. At March 31, 2024 and December 31, 2023, the Company had $149.0 million and $129.0 million, respectively, in borrowings outstanding.

The Liquidity and Wholesale Funding Policy of the Bank establishes specific policies and operating procedures governing liquidity levels to assist management in developing plans to address future and current liquidity needs. Management monitors the rates and cash flows from loan and investment portfolios while also examining the maturity structure and volatility characteristics of liabilities to develop an optimum asset/liability mix. Available funding sources include retail, commercial and municipal deposits, purchased liabilities and stockholders’ equity. Daily, management receives a current cash position update to ensure that all obligations are satisfied. On a weekly basis, appropriate senior management receives a current liquidity position report and a ninety day forecasted cash flow to ensure that all short-term obligations will be met and there is sufficient liquidity available. At March 31, 2024, the Bank had a total of $126.7 million in term and overnight borrowings outstanding with the FHLB. At March 31, 2024, the Bank had access to an additional $118.0 million in FHLB lines of credit. At March 31, 2024, the Bank’s borrowings from the Federal Reserve’s PPPLF were $2.3 million. At March 31, 2024, the Bank had access to approximately $72 million in unsecured lines of credit extended by correspondent banks, if needed, for short-term funding purposes. The Company had $20.0 million in borrowings outstanding under lines of credit with correspondent banks at March 31, 2024.

Our sources of wholesale funding included brokered certificates of deposit, listing service certificates of deposit and insured cash sweep (“ICS”) reciprocal deposits in excess of 20% of total liabilities, which balances totaled approximately $91.8 million, $8.2 million and $0, or 4.8%, 0.4% and 0.0% of total deposits, respectively, at March 31, 2024. We utilized brokered certificates of deposit and listing service certificates of deposit as alternatives to other forms of wholesale funding, including borrowings, when interest rates and market conditions favor the use of such deposits. For a portion of our brokered certificates of deposit, we utilized interest rate swap contracts to effectively extend their duration and to fix their cost.

The Company strives to maintain an efficient level of capital, commensurate with its risk profile, on which a competitive rate of return to stockholders will be realized over the short and long terms. Capital is managed to enhance stockholder value while providing flexibility for management to act opportunistically in a changing marketplace. Management continually evaluates the Company’s capital position in light of current and future growth objectives and regulatory guidelines. Total stockholders’ equity was $189.5 million at March 31, 2024 compared to $184.8 million at December 31, 2023. The $4.7 million increase was primarily due to an increase of $3.3 million in retained earnings and a decrease of $1.2 million in accumulated other comprehensive loss. The increase in retained earnings was due primarily to net income of $4.1 million for the quarter ended March 31, 2024, which was offset by $0.7 million of dividends declared. The accumulated other comprehensive loss at March 31, 2024 was 0.68% of total equity and was comprised of a $1.2 million after tax net unrealized loss on the investment portfolio and a $0.1 million after tax net unrealized loss on derivatives.

The Bank is subject to regulatory capital requirements. The Bank’s tier 1 leverage, common equity tier 1 risk-based, tier 1 risk-based and total risk-based capital ratios were 8.90%, 12.99%, 12.99% and 14.19%, respectively, at March 31, 2024, exceeding all regulatory guidelines for a well-capitalized institution, the highest regulatory capital category. Moreover, capital rules also place limits on capital distributions and certain discretionary bonus payments if a banking organization does not maintain a buffer of common equity tier 1 capital above minimum capital requirements. At March 31, 2024, the Bank’s capital buffer was in excess of requirements.

On October 5, 2023, the Company announced that the Board of Directors approved a new stock repurchase program. Under the new repurchase program, the Company may repurchase up to 366,050 shares of its common stock, or approximately 5% of its then outstanding shares. The repurchase program permits shares to be repurchased in the open market as conditions allow, or in privately negotiated transactions, and pursuant to any trading plan that may be adopted in accordance with Rule 10b5-1 of the Securities and Exchange Commission. The Company has not made any stock repurchases under the program. The remaining buyback authority under the share repurchase program remained at 366,050 shares as of March 31, 2024.

The Company’s total stockholders’ equity to total assets ratio and tangible common equity to tangible assets ratio (“TCE ratio”) were 8.21% and 7.43%, respectively, at March 31, 2024, versus 8.14% and 7.35%, respectively, at December 31, 2023 and 8.71% and 7.84%, respectively, at March 31, 2023. The ratio of total stockholders’ equity to total assets is the most comparable U.S. GAAP measure to the non-GAAP TCE ratio presented herein. The ratio of tangible common equity to tangible assets, or TCE ratio, is calculated by dividing total stockholders’ equity by total assets, after reducing both amounts by intangible assets. The TCE ratio is not required by U.S. GAAP or by applicable bank regulatory requirements, but is a metric used by management to evaluate the adequacy of our capital levels. Since there is no authoritative requirement to calculate the TCE ratio, our TCE ratio is not necessarily comparable to similar capital measures disclosed or used by other companies in the financial services industry. Tangible common equity and tangible assets are non-GAAP financial measures and should be considered in addition to, not as a substitute for or superior to, financial measures determined in accordance with U.S. GAAP. Set forth below are the reconciliations of tangible common equity to U.S. GAAP total stockholders’ equity and tangible assets to U.S. GAAP total assets at March 31, 2024 (in thousands). (See also Non-GAAP Disclosure contained herein.)

(1) The ratio of total stockholders’ equity to total assets is the most comparable GAAP measure to the non-GAAP tangible common equity ratio presented herein.

(2) TCE ratio

(3) Includes common stock and Series A preferred stock.

All dividends must conform to applicable statutory and regulatory requirements. The Company’s ability to pay dividends to stockholders depends on the Bank’s ability to pay dividends to the Company. Additionally, the ability of the Bank to pay dividends to the Company is subject to certain regulatory restrictions. Under New York law, a bank may pay a dividend on its common stock only out of net profits, and must obtain the approval of the Superintendent of the DFS if the total of all dividends declared by a bank or trust company in any calendar year exceeds the total of its net profits for that year combined with its retained net profits for the preceding two years, less any required transfer to surplus or a fund for the retirement of any preferred stock.

The Company’s Board of Directors approved the declaration of a $0.10 per share cash dividend on both common and Series A preferred shares payable on May 15, 2024 to stockholders of record on May 8, 2024.

Off-Balance Sheet Arrangements - The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated financial statements. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

Commitments to extend credit are agreements to lend to customers provided there are no violations of material conditions 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 amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the customer. Collateral required varies, but may include accounts receivable, inventory, equipment, real estate and income-producing commercial properties. At March 31, 2024 and December 31, 2023, commitments to originate loans and commitments under unused lines of credit for which the Bank is obligated amounted to approximately $136 million and $147 million, respectively.

Letters of credit are conditional commitments guaranteeing payments of drafts in accordance with the terms of the letter of credit agreements. Commercial letters of credit are used primarily to facilitate trade or commerce and are also issued to support public and private borrowing arrangements, bond financings and similar transactions. Collateral may be required to support letters of credit based upon management’s evaluation of the creditworthiness of each customer. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. At March 31, 2024 and December 31, 2023, letters of credit outstanding were approximately $0.9 million and $3.9 million, respectively.

Results of Operations – Comparison of the Three Months Ended March 31, 2024 and 2023 – The Company recorded net income of $4.1 million during the three months ended March 31, 2024, versus net income of $3.2 million in the comparable three month period a year ago. The increase in earnings for the three months ended March 31, 2024, versus the comparable 2023 quarter resulted primarily from a $1.8 million increase in non-interest income and a $0.6 million decrease in the provision for credit losses expense, which were partially offset by a $1.0 million decrease in net interest income, a $0.3 million increase in income tax expense and a $0.2 million increase in non-interest expense.

Net Interest Income and Margin

The $1.0 million decline in net interest income for the three months ended March 31, 2024, versus the comparable 2023 quarter was largely due to the compression of the Company’s net interest margin to 2.41% in the 2024 quarter from 3.04% in the comparable 2023 quarter. The yield on interest earning assets increased to 6.03% in the 2024 quarter from 5.47% in the comparable 2023 quarter, an increase of 56 basis points. This increase was offset by a 139 basis point increase in the cost of interest-bearing liabilities to 4.33% in 2024 from 2.94% in the first quarter of 2023. The rapid rise in interest rates driven by the Federal Reserve and, to a lesser extent, the Company’s decision to maintain increased liquidity due to market conditions resulted in the higher cost of funds.

NET INTEREST INCOME ANALYSIS

For the Three Months Ended March 31, 2024 and 2023

(dollars in thousands)

(1) Annualized.

(2) Includes non-accrual loans.

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

(4) Net interest margin represents net interest income divided by average interest-earning assets.

Provision and Allowance for Credit losses

The Company recorded a $0.3 million provision for credit losses expense for the three months ended March 31, 2024, versus $1.0 million recorded for the comparable period in 2023. The allowance for credit losses increased by $0.2 million, or 1.1%, to $19.9 milion, or 0.99% of total loans at March 31, 2024, from $19.7 million, or 1.00% of total loans at December 31, 2023. The increase in the allowance for credit losses on loans is mostly attributable to additional provisioning related to increased loan volume. (See also Critical Accounting Policies, Judgments and Estimates and Asset Quality contained herein.)

Non-interest Income

Non-interest income increased by $1.8 million for the three months ended March 31, 2024 versus the comparable 2023 period. This increase was driven by a $1.5 million increase in net gain on sale of loans reflecting the strengthening of secondary market premiums for sales of SBA loans. For the three months ended March 31, 2024 and 2023, the Company sold the government guaranteed portion of SBA loans totaling approximately $26.7 million and $12.8 million, respectively, recognizing net gains of $2.5 million and $1.0 million, respectively.

Non-Interest Income

For the three months ended March 31, 2024 and 2023

(in thousands)

Non-interest Expense

Total non-interest expense increased by $0.2 million for the three months ended March 31, 2024 versus the comparable 2023 quarter. The increase in non-interest expense was primarily in occupancy and equipment.

Non-Interest Expense

For the three months ended March 31, 2024 and 2023

(in thousands)

The Company recorded income tax expense of $1.4 million for an effective tax rate of 24.9% for the three months ended March 31, 2024, versus income tax expense of $1.0 million for an effective tax rate of 23.2% in the comparable 2023 period. The increase in the effective tax rate is due to increased business in other states, related to our SBA and USDA lending program.

Asset Quality - Total non-accrual loans at March 31, 2024 were $14.9 million, or 0.74% of total loans, compared to $14.5 million, or 0.74% of total loans at December 31, 2023 and $10.3 million, or 0.58% of total loans, at March 31, 2023. The allowance for credit losses as a percentage of total non-accrual loans amounted to 134%, 136% and 144% at March 31, 2024, December 31, 2023 and March 31, 2023, respectively.

Total accruing loans delinquent 30 days or more, amounted to $16.9 million, $13.9 million and $9.0 million at March 31, 2024, December 31, 2023 and March 31, 2023, respectively.

Total loans having credit risk ratings of Special Mention and Substandard were $42.8 million at March 31, 2024, versus $42.4 million at December 31, 2023. The Company’s Special Mention and Substandard loans were comprised of residential real estate, multi-family, commercial real estate loans and commercial and industrial loans (including SBA facilities) at March 31, 2024. The Company had no loans with a credit risk rating of Doubtful for the periods presented. All loans not having credit risk ratings of Special Mention, Substandard or Doubtful are considered pass loans.

At March 31, 2024, the Company’s allowance for credit losses amounted to $19.9 million or 0.99% of period-end total loans outstanding. The allowance as a percentage of loans outstanding was 1.00% at December 31, 2023 and 0.83% at March 31, 2023. The Company recorded net loan charge-offs of $85 thousand during the three months ended March 31, 2024 versus net loan recoveries of $677 thousand for the three months ended December 31, 2023. The Company recorded net loan charge-offs of $457 thousand during the three months ended March 31, 2023.

The Company recorded a $0.3 million provision for credit losses expense for the three months ended March 31, 2024, versus $1.0 million recorded for the comparable period in 2023. Additional information regarding the ACL and the associated provisions recognized during the quarters ended March 31, 2024 and 2023 is presented in Note 4 to the unaudited consolidated financial statements. (See also Critical Accounting Policies, Judgments and Estimates contained herein).

ASSET QUALITY

March 31, 2024 versus December 31, 2023 and March 31, 2023

(dollars in thousands)

(1) Non-performing assets defined as non-accrual loans, non-accrual loans held for sale, loans greater than 90 days past due and accruing and other real estate owned.

(2) The Company adopted CECL effective October 1, 2023.

(3) Excludes loans held for sale.

The Company originates and invests in interest-earning assets and solicits interest-bearing deposit accounts. The Company’s operations are subject to market risk resulting from fluctuations in interest rates to the extent that there is a difference between the amounts of interest-earning assets and interest-bearing liabilities that are prepaid, withdrawn, matured or repriced in any given period of time. The Company’s earnings or the net value of its portfolio will change under different interest rate scenarios. The principal objective of the Company’s asset/liability management program is to maximize net interest income within an acceptable range of overall risk, including both the effect of changes in interest rates and liquidity risk.

The Company utilizes a number of strategies to manage interest rate risk including, but not limited to: (i) balancing the types and structures of interest-earning assets and interest-bearing liabilities by diversifying mix, coupons, maturities and/or repricing characteristics, (ii) reducing the overall interest rate sensitivity of liabilities by emphasizing core and/or longer-term deposits; utilizing FHLB advances and wholesale deposits for our interest rate risk profile, and (iii) entering into interest rate swap agreements.

The following presents the Company’s economic value of equity (“EVE”) and net interest income (“NII”) sensitivities at March 31, 2024 (dollars in thousands). The results are within the Company’s policy limits.

At March 31, 2024

(1) Assumes 12 month time horizon.

Certain model limitations are inherent in the methodology used in the EVE and net interest income measurements. The models require the making of certain assumptions which may tend to oversimplify the way actual yields and costs respond to changes in market interest rates. The models assume that the composition of the Company’s interest sensitive assets and liabilities existing at the beginning of a period remain constant over the period being measured, thus they do not consider the Company’s strategic plans, or any other steps it may take to respond to changes in rates over the forecasted period of time. Additionally, the models assume immediate changes in interest rates, based on yield curves as of a point-in-time, which are reflected in a parallel, instantaneous and uniform manner across all yield curves, when in reality changes may rarely be of this nature. The models also utilize data derived from historical performance and as interest rates change the actual performance of loan prepayments, rate sensitivities, and average life assumptions may deviate from assumptions utilized in the models and can impact the results. Accordingly, although the above measurements provide an indication of the Company’s interest rate risk exposure at a particular point in time, such measurements are not intended to provide a precise forecast of the effect of changes in market interest rates. Given the unique nature of the post-pandemic interest rate environment and the speed with which interest rates have been changing, the projections noted above on the Company’s EVE and net interest income can be expected to differ from actual results.

The Company carried out an evaluation, under the supervision and with the participation of its principal executive officer and principal financial officer, of the effectiveness of the design and operation of its disclosure controls and procedures as defined in Rule l3a-15(e) and Rule 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Based on this evaluation, the Company’s principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures are effective in timely alerting them to material information required to be included in the Company’s periodic reports filed with the Securities and Exchange Commission.

Effective October 1, 2023, the Company adopted ASU 2016-13, Financial Instruments — Credit Losses Topic 326: Measurement of Credit Losses on Financial Instruments. The Company designed new controls and modified existing controls as part of its adoption. These additional controls over financial reporting included controls over model creation and design, model governance, assumptions, and expanded controls over loan level data. Other than as described above, there have been no changes in the Company’s internal control over financial reporting as defined in Rule 13a-15(f) and Rule 15d-15(f) under the Exchange Act that occurred during the three months ended March 31, 2024 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

There have been no material changes to the risks disclosed in the “Risk Factors” section of the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2023, as filed with the Securities and Exchange Commission.