Pathfinder Bancorp, Inc.: Form 10-Q for the period ended Mar 31, 2020

General

The Company is a Maryland corporation headquartered in Oswego, New York. The Company is 100% owned by public shareholders. The primary business of the Company is its investment in Pathfinder Bank (the "Bank"), a New York State chartered commercial bank, which is 100% owned by the Company. The Bank has two wholly owned operating subsidiaries, Pathfinder Risk Management Company, Inc. (“PRMC”) and Whispering Oaks Development Corp. All significant inter-company accounts and activity have been eliminated in consolidation. Although the Company owns, through its subsidiary PRMC, 51% of the membership interest in FitzGibbons Agency, LLC (“Agency”), the Company is required to consolidate 100% of FitzGibbons within the consolidated financial statements. The 49% of which the Company does not own is accounted for separately as noncontrolling interests within the consolidated financial statements. At March 31, 2020, the Company and subsidiaries had total assets of $1.1 billion, total liabilities of $1.0 billion and shareholders' equity of $88.0 million plus noncontrolling interest of $305,000, which represents the 49% of FitzGibbons not owned by the Company.

The following discussion reviews the Company's financial condition at March 31, 2020 and the results of operations for the three month periods ended March 31, 2020 and 2019. Operating results for the three months ended March 31, 2020 are not necessarily indicative of the results that may be expected for the year ending December 31, 2020.

The following material under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations" is written with the presumption that the users of the interim financial statements have read, or have access to, the Company's latest audited financial statements and notes thereto, together with Management's Discussion and Analysis of Financial Condition and Results of Operations included in the 2019 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 23, 2020 (“the consolidated annual financial statements”) as of December 31, 2019 and 2018 and for the two years then ended. Therefore, only material changes in financial condition and results of operations are discussed in the remainder of Item 2.

Statement Regarding Forward-Looking Statements

Certain statements contained herein are “forward looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. This report contains forward-looking statements that are based on assumptions and may describe future plans, strategies and expectations of the Company. These forward-looking statements are generally identified by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project” or similar expressions. The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to:

• Credit quality and the effect of credit quality on the adequacy of our allowance for loan losses;
• Deterioration in financial markets that may result in impairment charges relating to our securities portfolio;
• Competition in our primary market areas;
• Changes in interest rates and national or regional economic conditions;
• Changes in monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board;
• Significant government regulations, legislation and potential changes thereto;
• A reduction in our ability to generate or originate revenue-producing assets as a result of compliance with heightened capital standards;
• Increased cost of operations due to greater regulatory oversight, supervision and examination of banks and bank holding companies, and higher deposit insurance premiums;
• Cyberattacks, computer viruses and other technological threats that may breach the security of our websites or other systems;
• Technological changes that may be more difficult or expensive than expected;
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• Limitations on our ability to expand consumer product and service offerings due to anticipated stricter consumer protection laws and regulations; and
• Other risks described herein and in the other reports and statements we file with the SEC.

In addition to the risk factors enumerated above, the economic impact of the COVID-19 outbreak could adversely affect our financial condition and results of operations. The COVID-19 pandemic has caused significant economic dislocation in the United States as many state and local governments have ordered non-essential businesses to close and residents to shelter in place at home. This has resulted in an unprecedented slow-down in economic activity and a related increase in unemployment.

Given the ongoing and dynamic nature of the circumstances, it is difficult to predict the full impact of the COVID-19 outbreak on our business. The extent of such impact will depend on future developments, which are highly uncertain, including when the coronavirus can be controlled and abated and when and how the economy may be reopened. As the result of the COVID-19 pandemic and the related adverse local and national economic consequences, we could be subject to any of the following additional risks, any of which could have a material, adverse effect on our business, financial condition, liquidity, and results of operations:

• Demand for our products and services may decline, making it difficult to grow assets and income;
• If the economy is unable to substantially reopen, and high levels of unemployment continue for an extended period of time, loan delinquencies, problem assets, and foreclosures may increase, resulting in increased charges and reduced income;
• Collateral for loans, especially real estate, may decline in value, which could cause loan losses to increase;
• Our allowance for loan losses may have to be increased if borrowers experience financial difficulties beyond forbearance periods, which will adversely affect our net income;
• The net worth and liquidity of loan guarantors may decline, impairing their ability to honor commitments to us;
• As the result of the decline in the Federal Reserve Board’s target federal funds rate to near 0%, the yield on our assets may decline to a greater extent than the decline in our cost of interest-bearing liabilities, reducing our net interest margin and spread and reducing net income;
• A material decrease in net income or a net loss over several quarters could result in a decrease in the rate of our quarterly cash dividend;
• Our cyber security risks are increased as the result of an increase in the number of employees working remotely;
• We rely on third party vendors for certain services and the unavailability of a critical service due to the COVID-19 outbreak could have an adverse effect on us; and
• Federal Deposit Insurance Corporation premiums may increase if the agency experiences additional resolution costs.

Moreover, our future success and profitability substantially depends on the management skills of our executive officers and directors, many of whom have held officer and director positions with us for many years. The unanticipated loss or unavailability of key employees due to the outbreak could harm our ability to operate our business or execute our business strategy. We may not be successful in finding and integrating suitable successors in the event of key employee loss or unavailability.

Any one or a combination of the factors identified above could negatively impact our business, financial condition and results of operations and prospects.

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, the Company does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events.

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COVID-19 Response

In early January 2020, the World Health Organization issued an alert that a novel coronavirus outbreak was emanating from the Wuhan Province in China. Over the course of the next several weeks, the outbreak continued to spread to various regions of the world prompting the World Health Organization to declare COVID-19 a global pandemic on March 11, 2020. In the United States, the rapid spread of the COVID-19 virus invoked various Federal and New York State authorities to make emergency declarations and issue executive orders to limit the spread of the disease. Measures included restrictions on international and domestic travel, limitations on public gatherings, implementation of social distancing protocols, school closings, orders to shelter in place and mandates to close all non-essential businesses to the public. As a result, the spread of the coronavirus has caused us to modify our business practices, including employee travel, employee work locations, and cancellation of physical participation in meetings, events and conferences. The Company has many employees working remotely and we will take further actions as may be required by government authorities or that we determine are in the best interests of our employees, customers and business partners.

Concerns about the spread of the disease and its anticipated negative impact on economic activity, severely disrupted both domestic and international financial markets prompting the world’s central banks to inject significant amounts of monetary stimulus into their respective economies. In the United States, the Federal Reserve System’s Federal Open Market Committee, swiftly cut the target Federal Funds rate to a range of 0% to 0.25%, including a 50 basis point reduction in the target federal funds rate on March 3, 2020 and an additional 100 basis point reduction on March 15, 2020. In addition, the Federal Reserve initiated various market support programs to ease the stress on financial markets.

The Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”), signed into law on March 27, 2020, provides financial assistance in various forms to both businesses and consumers. In addition, the CARES Act also created many directives affecting the operations of financial services providers, such as the Company, including a forbearance program for federally-backed mortgage loans and protections for borrowers from negative credit reporting due to loan accommodations related to the national emergency. The banking regulatory agencies have likewise issued guidance encouraging financial institutions to work prudently with borrowers who are, or may be, unable to meet their contractual payment obligations because of the effects of COVID-19. The Company has begun working with its business and individual customers affected by COVID-19 and expects a significant amount of modifications across many of its loan portfolios in the near term. Through May 15, 2020, the Bank granted payment deferral requests primarily for 90 days, on 540 loans representing approximately $142.9 million of existing loan balances. For more information on the Bank’s loan concentrations, please see Note 15 to the Unaudited Consolidated Financial Statements above.

The Bank also has and continues to participate in the Paycheck Protection Program (“PPP”), a $650 billion specialized low-interest loan program funded by the U.S. Treasury Department and administered by the U.S. Small Business Administration (“SBA”). An eligible business can generally apply for a PPP loan up to the greater of: 2.5 times its average monthly payroll costs, or $10.0 million. PPP loans will have an interest rate of 1.0%, a two-year loan term to maturity, and principal and interest payments deferred for six months from the date of disbursement. The SBA will guarantee 100% of the PPP loans made to eligible borrowers. The entire principal amount of the borrower’s PPP loan, including any accrued interest, is eligible to be reduced by the loan forgiveness amount under the PPP so long as employee and compensation levels of the business are maintained and 75% of the loan proceeds are used for payroll expenses, with the remaining 25% of the loan proceeds used for other qualifying expenses. Through May 15, 2020, the Bank has submitted to and received approval from the SBA for 619 loans totaling approximately $73.5 million through this program. The Bank continues to be in the process of submitting a limited number of additional applications utilizing the latest round of available authorizations from the SBA and believes that it has sufficient liquidity to support current and anticipated funding requests from borrowers.

The COVID-19 crisis is expected to continue to impact the Company’s financial results, as well as demand for its services and products during the second quarter of 2020 and potentially beyond. The short- and long-term implications of the COVID-19 crisis, possibly muted by offsetting governmental monetary and fiscal stimulus measures, on the Company’s future revenues, earnings results, allowance for credit losses, capital reserves, and liquidity are unknown at this time.

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Application of Critical Accounting Policies

The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and follow practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated annual financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain accounting 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. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and information used to record valuation adjustments for certain assets and liabilities are based on quoted market prices or are provided by unaffiliated third-party sources, when available. When third party information is not available, valuation adjustments are estimated in good faith by management.

The most significant accounting policies followed by the Company are presented in Note 1 to the annual audited consolidated financial statements. 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 consolidated annual financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the allowance for loan losses, deferred income taxes, pension obligations, the evaluation of investment securities for other than temporary impairment, the estimation of fair values for accounting and disclosure purposes, and the evaluation of goodwill for impairment to be the accounting areas that require the most subjective and complex judgments. These areas could be the most subject to revision as new information becomes available.

The allowance for loan losses represents management's estimate of probable loan losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment on the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change.

Our Allowance for Loan and Lease Losses policy establishes criteria for selecting loans to be measured for impairment based on the following:

Residential and Consumer Loans:

• All loans rated substandard or worse, on nonaccrual, and above our total related credit (“TRC”) threshold balance of $300,000.
• All Troubled Debt Restructured Loans.

Commercial Lines and Loans, Commercial Real Estate and Tax-exempt loans:

• All loans rated substandard or worse, on nonaccrual, and above our TRC threshold balance of $100,000.
• All Troubled Debt Restructured Loans.

Impairment is measured by determining the present value of expected future cash flows or, for collateral-dependent loans, the fair value of the collateral adjusted for market conditions and selling expenses as compared to the loan carrying value. For all other loans and leases, the Company uses the general allocation methodology that establishes an allowance to estimate the probable incurred loss for each risk-rating category.

Deferred income tax assets and liabilities are determined using the liability method. Under this method, the net deferred tax asset or liability is recognized for the future tax consequences. This is attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases as well as net operating and capital loss carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates applied

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to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income tax expense in the period that includes the enactment date. If current available evidence about the future raises doubt about the likelihood of a deferred tax asset being realized, a valuation allowance is established. The judgment about the level of future taxable income, including that which is considered capital, is inherently subjective and is reviewed on a continual basis as regulatory and business factors change.

Effective in January 2018, the Company adopted a modification methodology, made available following changes to the New York State tax code, affecting how the Company’s state income tax liability is computed. Under this adopted methodology it is unlikely that the Company will pay income taxes to New York in future periods and it is therefore probable that the Company’s deferred tax assets related to New York State income taxes are unlikely to further reduce the Company’s state income tax rate in the future. Accordingly, a valuation allowance against the value of those deferred tax assets was established to reduce the net deferred tax asset related to New York income taxes to $0. Therefore, as of January 1, 2019, the Company established, through a charge to earnings, a valuation allowance in the amount of $136,000 in order to reserve against deferred tax assets related to New York State income taxes.

In the quarter ended March 31, 2020, Management determined that the Company, under the current New York State (“NYS”) tax code, was highly unlikely to incur a material NYS tax liability in the foreseeable future. As a result, certain net current and deferred tax assets, related to GAAP vs. tax timing differences under previous NYS tax law, were no longer going to provide any future tax benefit. The substantial majority of these net deferred tax assets were offset by a related valuation allowance established in prior periods. Upon analysis of all factors related to the expected future filings of NYS tax returns, the Company eliminated its remaining NYS net deferred tax asset balances and the related valuation allowance on January 1, 2020. The effect of these eliminations required an adjustment to other comprehensive income of $206,000 and had no effect on first quarter 2020 reported earnings. At March 31, 2019, the Company had a valuation allowance of $33,000 established against the future projected benefits of deferred tax assets related to New York State income tax obligations.

The Company’s effective tax rate typically differs from the 21% federal statutory tax rate due primarily to tax-exempt income from specific types of investment securities and loans, bank owned life insurance, and, to a much lesser degree, the utilization of low income housing tax credits, as well as a the effects of transitional adjustments related to state income taxes and certain taxes payable to states other than New York. The effective tax rate was 22.0% for the three month period ended March 31, 2020.

We maintain a noncontributory defined benefit pension plan covering most employees. The plan provides defined benefits based on years of service and final average salary. On May 14, 2012, we informed our employees of our decision to freeze participation and benefit accruals under the plan, primarily to reduce some of the volatility in earnings that can accompany the maintenance of a defined benefit plan. Pension and post-retirement benefit plan liabilities and expenses are based upon actuarial assumptions of future events; including fair value of plan assets, interest rates, and the length of time the Company will have to provide those benefits. The assumptions used by management are discussed in Note 14 to the consolidated annual financial statements.

The Company carries all of its available-for-sale investments at fair value with any unrealized gains or losses reported, net of tax, as an adjustment to shareholders' equity and included in accumulated other comprehensive income (loss), except for the credit-related portion of debt securities impairment losses and other-than-temporary impairment (“OTTI”) of equity securities which are charged to earnings. The Company's ability to fully realize the value of its investments in various securities, including corporate debt securities, is dependent on the underlying creditworthiness of the issuing organization. In evaluating the debt securities (both available-for-sale and held-to-maturity) portfolio for other-than-temporary impairment losses, management considers (1) if we intend to sell the security; (2) if it is “more likely than not” we will be required to sell the security before recovery of its amortized cost basis; or (3) if the present value of expected cash flows is not sufficient to recover the entire amortized cost basis. When the fair value of a held-to-maturity or available-for-sale security is less than its amortized cost basis, an assessment is made as to whether OTTI is present. The Company considers numerous factors when determining whether a potential OTTI exists and the period over which the debt security is expected to recover. The principal factors considered are (1) the length of time and the extent to which the fair value has been less than the amortized cost basis, (2) the financial condition of the issue and (guarantor, if any) and adverse conditions specifically related to the security, industry or geographic area, (3) failure of the issuer of the security

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to make scheduled interest or principal payments, (4) any changes to the rating of the security by a nationally recognized statistical rating organization (“NRSRO”), and (5) the presence of credit enhancements, if any, including the guarantee of the federal government or any of its agencies.

The estimation of fair value is significant to several of our assets; including available-for-sale and marketable equity investment securities, intangible assets, foreclosed real estate, and the value of loan collateral when valuing loans. These are all recorded at either fair value, or the lower of cost or fair value. Fair values are determined based on third party sources, when available. Furthermore, accounting principles generally accepted in the United States require disclosure of the fair value of financial instruments as a part of the notes to the annual audited consolidated financial statements. Fair values on our available-for-sale securities may be influenced by a number of factors; including market interest rates, prepayment speeds, discount rates, and the shape of yield curves.

Fair values for securities available-for-sale are obtained from unaffiliated third party pricing services. Where available, fair values are based on quoted prices on a nationally recognized securities exchange. If quoted prices are not available, fair values are measured using quoted market prices for similar benchmark securities. Management made no adjustments to the fair value quotes that were provided by the pricing sources. Fair values for marketable equity securities are based on quoted prices on a nationally recognized securities exchange for similar benchmark securities. The fair values of foreclosed real estate and the underlying collateral value of impaired loans are typically determined based on evaluations by third parties, less estimated costs to sell. When necessary, appraisals are updated to reflect changes in market conditions.

Management performs an annual evaluation of our goodwill for possible impairment at each of our reporting units. Based on the results of the December 31, 2019 evaluation, management has determined that the carrying value of goodwill was not impaired as of that date. Management will continuously evaluate all relevant economic and operational factors potentially affecting the Bank or the fair value of its assets, including goodwill. Should the current pandemic, or the future economic consequences thereof, require a significant and sustained change in the operations of the Bank, re-evaluations of the Bank’s goodwill valuation will be conducted on a more frequent basis. The evaluation approach is described in Note 10 of the consolidated annual financial statements. Further information on the estimation of fair values can be found in Note 22 to the consolidated annual financial statements.

Recent Events

On March 23, 2020, the Company announced that its Board of Directors had declared a cash dividend of $0.06 per common and preferred share, and a cash dividend of $0.06 per notional share for the issued common stock Warrant. The dividend was payable on May 8, 2020 to shareholders of record on April 16, 2020.

Overview and Results of Operations

The following represents the significant highlights of the Company’s operating results between the first quarter of 2020 and the first quarter of 2019.

• Net income increased $1.2 million, or 228.8%, to $1.7 million.
• Basic and diluted earnings per share both increased $0.17 to $0.29 per share.
• Return on average assets increased 40 basis points to 0.62% as the increase in income outpaced the increase in average assets.
• Net interest income, after provision for loan losses, increased $309,000, or 4.8%, to $6.7 million. This increase in was primarily due to the increase in average balances of interest-earning assets, offset by a significant increase in the provision for loan losses, which is reflective of an increase in average loan balances. Additional provisioning for loan losses was also applied as a reflection of the substantial increase in economic uncertainty and the resultant potential for increased credit losses in future periods as a consequence of the COVID-19 pandemic.
• Net interest margin increased by eleven basis points to 3.03%, primarily a result of an eight basis point increase in the average yield earned on average loans, along with a 12 basis point decrease in the average interest rate paid on average interest-bearing liabilities.
• Total average interest-earning assets were $1.0 billion, an increase of $128.4 million, or 14.3%.
• Total deposits increased $94.3 million, or 11.7%, to $899.9 million.
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• The effective income tax rate decreased 11.8% to 22.0% for the three months ended March 31, 2020, as compared to 33.8% for the same three month period in 2019. This decrease was primarily related to the 2019 nonrecurring establishment, through a charge to earnings, of a $136,000 valuation allowance to reserve against deferred tax assets related to New York State income taxes.

The following reflects the significant changes in financial condition between March 31, 2019, December 31, 2019 and March 31, 2020.

• Total assets increased $132.6 million, or 13.6%, to $1.1 billion at March 31, 2020 from $975.1 million at March 31, 2019. The increase was primarily due to increases in loans and cash and cash equivalents. The increases in loans were funded largely by increases in deposits, including brokered deposits.
• Asset quality metrics remained stable in comparison to recent reporting periods. The Company’s consistent asset quality metrics are reflective of its disciplined risk management process, along with continued relative economic stability for the Central New York State region. In light of the COVID-19 challenges faced by its customer base, the Bank is monitoring this situation and working closely with customers to help navigate through the current economic challenges. The annualized net loan charge-offs to average loans ratio was 0.07% for the first quarter of 2020, compared to 0.10% for the first quarter of 2019, and 0.09% for the fourth quarter of 2019. Nonperforming loans to total loans increased 11 basis points to 0.62% at March 31, 2020, compared to 0.51% at March 31, 2019. Nonperforming loans to total loans decreased 5 basis points to 0.62% at March 31, 2020, compared to 0.67% at December 31, 2019. Correspondingly, the ratio of the allowance for loan losses to nonperforming loans for first quarter 2020 was 205.87%, as compared to 215.18%, at March 31, 2019, and 165.25% at December 31, 2019.

The Company had net income of $1.7 million for the three months ended March 31, 2020 compared to net income of $514,000 for the three months ended March 31, 2019. The $1.2 million increase in net income was due primarily to a $1.4 million increase in interest and dividend income, a $655,000 increase in noninterest income, and a $466,000 decrease in noninterest expense. These fluctuations were partially offset by a $923,000 increase in the provision for loan losses, a $204,000 increase in income tax expense, and a $142,000 increase in interest expense.

Net interest income before the provision for loan losses increased $1.2 million to $7.8 million for the three months ended March 31, 2020 as compared to $6.5 million for the same three month period in 2019. The increase was due principally to a $1.4 million, or 14.2%, increase in interest and dividend income that was a result of growth in average interest-earning assets of $128.4 million compared to the prior year first quarter. Average loans for the first quarter of 2020 increased by $127.4 million, or 20.1%, over the prior year first quarter primarily as a result of growth in the commercial and consumer loan portfolios. The higher first quarter 2020 interest income was partially offset by a volume driven increase in the average balance of interest-bearing liabilities. Average interest-bearing liabilities increased by $99.6 million, or 12.8%, for the first quarter of 2020 as compared to the first quarter of 2019, however the average interest rate paid on interest-bearing liabilities decreased by 12 basis points.

The $655,000 increase in noninterest income in the quarter ended March 31, 2020, as compared to the same quarterly period in 2019, was primarily the result of an increase of $680,000 in net gains on sales of loans and foreclosed real estate. The gain on the sale of loans and foreclosed real estate was primarily the result of the sale of $35.9 million in seasoned conforming residential mortgage loans that was completed in January 2020. Also contributing to the increase in noninterest income was a $94,000 increase in insurance agency revenue and a $74,000 increase in service charges on deposit accounts for the current period. These increases in noninterest income were partially offset by a $235,000 decrease in unrealized gains on equity securities compared to the first quarter of 2019. This decrease in unrealized gains on equity securities was the result of a significant decline in the equity markets during the three months ended March 31, 2020 primarily due to the economic effects of the COVID-19 pandemic. All other noninterest income categories decreased by $42,000, or 7.9%, in the three months ended March 31, 2020, as compared to the same prior year period.

Total noninterest expense in the first quarter of 2020 was $6.2 million, a decrease of $466,000, or 6.9%, compared to $6.7 million for the same prior year quarter. The $466,000 decrease in noninterest expense in the quarter ended March 31, 2020, as compared to the same quarterly period in 2019, was primarily due to a decrease of $403,000, or 11.0%, in

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salaries and employee benefits expense and a $207,000 decrease in foreclosed real estate expenses. The decrease in salaries and employee benefits expense was primarily due to a $150,000 decrease in employee benefits expense, a $124,000 decrease in commissions and incentives expense, and a $110,000 decrease in salaries expense. The decrease in foreclosed real estate expenses was related to the final disposition of a single foreclosed commercial property in 2019. These decreases were partially offset by a $99,000 increase in building and occupancy expense related to the placement in service of a new rental property which will have an increasing level of rental income in future periods. All other noninterest expenses increased $46,000, or 2.1%, in aggregate during the quarter ended March 31, 2020, as compared to the same three-month period in 2019.

Management extensively reviews recent trends in changes in the size and composition of the loan portfolio, historical loss experience, qualitative factors, and specific reserve needs on loans individually evaluated for impairment, in its determination of the adequacy of the allowance for loan losses. We recorded $1.1 million in provision for loan losses for the three-month period ended March 31, 2020, as compared to $144,000 for the three-month period ended March 31, 2019. The $923,000 increase in the provision for loan losses in the first quarter of 2020, as compared to the same quarter in 2019, resulted from year-over-year increases in: (1) the qualitative factors used in determining the adequacy of the allowance for loan losses, (2) the size of the loan portfolio, and (3) delinquent and nonaccrual loans. The increase in the quantitative factors used in determining the provision for loan losses reflects the substantial increase in economic uncertainty and the resultant potential for increased credit losses in future periods as a consequence of the COVID-19 pandemic. Outstanding loan balances increased $92.9 million, or 14.1%, in the quarter ended March 31, 2020, as compared to the same quarter in the previous year, and therefore required a corresponding increase in the estimable and probable loan losses inherent in the loan portfolio. Finally, the provision for loan losses in the quarter ended March 31, 2020 was further increased, as compared to the same quarter in 2019, by the effects of an increase in the ratio of delinquent loans to total loans, which increased to 3.05% at March 31, 2020 as compared to 2.75% at March 31, 2019, coupled with an increase in nonaccrual loans that increased $1.2 million to $4.7 million at March 31, 2020 as compared to $3.4 million at March 31, 2019.

In comparing the year-over-year first quarter periods, the return on average assets increased 40 basis points to 0.62% due to the combined effects of the increase in net income (the numerator in the ratio) and the increase in average assets (the denominator in the ratio). The Company’s net income increased $1.2 million, or 228.8%, which outpaced the increase in average assets. Average assets increased due to increases in average loans and average taxable investment securities of $127.4 million and $23.0 million, respectively in the first quarter of 2020 as compared to the same quarter of 2019. Average deposits increased $99.4 million in the first quarter of 2020, as compared with the same quarter in 2019, due to strong growth in retail and commercial relationship deposits along with brokered deposit inflows and the seasonally-normal strong deposit inflows related to the Bank’s municipal depositor relationships.

Net Interest Income

Net interest income is the Company's primary source of operating income for payment of operating expenses and providing for loan losses. It is the amount by which interest earned on loans, interest-earning deposits, and investment securities, exceeds the interest paid on deposits and other interest-bearing liabilities. Changes in net interest income and net interest margin result from the interaction between the volume and composition of interest-earning assets, interest-bearing liabilities, related yields, and associated funding costs.

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The following table sets forth information concerning average interest-earning assets and interest-bearing liabilities and the average yields and rates thereon for the periods indicated. Interest income and resultant yield information in the table has not been adjusted for tax equivalency. Averages are computed on the daily average balance for each month in the period divided by the number of days in the period. Yields and amounts earned include loan fees. Nonaccrual loans have been included in interest-earning assets for purposes of these calculations.

(Dollars in thousands)

As indicated in the above table, net interest income, before provision for loan losses, increased $1.2 million, or 18.8%, to $7.8 million for the three months ended March 31, 2020, as compared to $6.5 million for the same prior year period. This increase was due principally to a $1.4 million, or 14.2%, increase in interest and dividend income. This increase in interest and dividend income was due principally to the $128.4 million, or 14.3%, increase in the average balance of interest-earning assets. This was primarily the result of an increase in average loans, which increased $127.4 million, or 20.1%, coupled with the eight basis point increase in the average yield earned on these loans. These positive factors on net interest income were partially offset by the increase in the average balance of interest-bearing liabilities which increased $99.6 million, or 12.8%, while the average rate paid on those interest-bearing liabilities decreased 12 basis points. The following analysis should also be viewed in conjunction with the table below which reports the changes in net interest income attributable to rate and volume.

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Interest and dividend income increased $1.4 million, or 14.2%, to $11.0 million for the three months ended March 31, 2020 compared to $9.7 million for the same three-month period in 2019. The increase in interest income was due principally to the increase the in average balances of loans and taxable investment securities which increased 20.1% and 10.2%, respectively, between the year-over-year first quarter periods. The average balance of loans increased by $127.4 million and the average yield on that portfolio improved eight basis points to 4.86%. The increase in the average balance of loans reflected the Company’s continued success in its expansion within the greater Syracuse, New York market.

Interest expense for the three months ended March 31, 2020 increased $142,000, or 4.6%, to $3.3 million when compared to the same prior year period. Deposit interest expense increased $211,000, or 9.0%, to $2.6 million due to a $99.4 million increase in the average balance of interest-bearing deposits, partially offset by a seven basis point decrease in the average annualized rate paid on these deposits to 1.32% for the three months ended March 31, 2020, as compared with the same three-month period in 2019. The average balance of deposits increased due to an increase of $81.2 million in the average balance of time deposits during the first quarter of 2020 as compared to the same period in 2019. The decrease in the average rate of deposits was primarily due to 22 and 11 basis point decreases in the average rates paid on time deposits and money market deposit accounts (“MMDA”), respectively, during the three months ended March 31, 2020 as compared to the same time period in 2019 due to declining market rates during the first quarter of 2020. In 2019, the average rates paid on time deposits and MMDA accounts reflected the competitive environment for such deposits within the Company’s marketplace as well as a general increase in short-term interest rates nationally.

Rate/Volume Analysis

Net interest income can also be analyzed in terms of the impact of changing interest rates on interest-earning assets and interest-bearing liabilities and changes in the volume or amount of these assets and liabilities. The following table represents the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected the Company’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to: (i) changes attributable to changes in volume (change in volume multiplied by prior rate); (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume); and (iii) total increase or decrease. Changes attributable to both rate and volume have been allocated ratably.

(In thousands)

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Provision for Loan Losses

We establish a provision for loan losses, which is charged to operations, at a level management believes is appropriate to absorb probable incurred credit losses in the loan portfolio. In evaluating the level of the allowance for loan losses, management considers historical loss experience, the types of loans and the amount of loans in the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available or as future events change. The provision for loan losses represents management’s estimate of the amount necessary to maintain the allowance for loan losses at an adequate level.

Management extensively reviews recent trends in changes in the size and composition of the loan portfolio, historical loss experience, qualitative factors, and specific reserve needs on loans individually evaluated for impairment, in its determination of the adequacy of the allowance for loan losses. We recorded $1.1 million in provision for loan losses for the three-month period ended March 31, 2020, as compared to $144,000 for the three-month period ended March 31, 2019. The $923,000 increase in the provision for loan losses in the first quarter of 2020, as compared to the same quarter in 2019, resulted from year-over-year increases in: (1) the qualitative factors used in determining the adequacy of the allowance for loan losses, (2) the size of the loan portfolio, and (3) delinquent and nonaccrual loans. The increase in the quantitative factors used in determining the provision for loan losses reflects the substantial increase in economic uncertainty and the resultant potential for increased credit losses in future periods as a consequence of the COVID-19 pandemic. Outstanding loan balances increased $92.9 million, or 14.1%, in the quarter ended March 31, 2020, as compared to the same quarter in the previous year, and therefore required a corresponding increase in the estimable and probable loan losses inherent in the loan portfolio. Finally, the provision for loan losses in the quarter ended March 31, 2020 was further increased, as compared to the same quarter in 2019, by the effects of an increase in the ratio of delinquent loans to total loans, which increased to 3.05% at March 31, 2020 as compared to 2.75% at March 31, 2019, coupled with an increase in nonaccrual loans that increased $1.2 million to $4.7 million at March 31, 2020 as compared to $3.4 million at March 31, 2019.

The Company measures delinquency based on the amount of past due loans as a percentage of total loans. The ratio of delinquent loans to total loans increased to 3.05% at March 31, 2020 as compared to 2.09% at December 31, 2019. Delinquent loans increased at a rate that was modestly more than the rate of increase in total loan balances, primarily driven by an increase of $5.2 million in loans delinquent 60-89 days, an increase of $2.3 million in loans 30-59 days past due, partially offset by an $866,000 decrease in loans delinquent more than 90 days. At March 31, 2020, there were $22.8 million in loans past due including $12.0 million in loans 30-59 days past due, $6.5 million in loans 60-89 days past due and $4.3 million in loans 90 or more days past due. At December 31, 2019, there were $16.3 million in loans past due including $9.7 million in loans 30-59 days past due, $1.4 million in loans 60-89 days past due and $5.2 million in loans 90 or more days past due.

The increase of $6.6 million in total loans past due at March 31, 2020, as compared to December 31, 2019, was primarily due to an increase of $5.2 million in loans 60-89 days past due. The increase in loans 60-89 days past due at March 31, 2020 as compared to December 31, 2019 was primarily due to the addition of five commercial and industrial loans with an outstanding balance of $3.4 million and six commercial lines of credit with a total outstanding balance of $2.0 million. Total loans 30-59 days past due increased in aggregate primarily due to the addition of four commercial real estate loans in the amount of $5.1 million, which was offset by a decrease in commercial lines of credit and commercial and industrial loans of $1.6 million and $1.4 million, respectively. The decrease in loans 90 days or more past due was primarily a result of a decrease in residential mortgages and commercial loans that were 90 days or more past due.

The determination of the overall adequacy of the allowance for loan losses is also influenced by individual loan and borrower analyses that include reviews of such factors as the delinquency status of loans, assessments of underlying collateral sufficiency and/or the borrower’s documented resources outside of the specific loan relationship (referred to as the borrower’s “global” capacity to repay), personal or corporate guarantees, and the conclusions drawn from detailed discussions with borrowers. Therefore, the level of loan delinquencies, while generally indicative of the potential levels of future loan charge-offs, are not wholly-definitive in making that determination. Management believes that the allowance for loan losses was adequate at March 31, 2020, based on its analyses of the totality of factors related to making that determination.

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Noninterest Income

The Company's noninterest income is primarily comprised of fees on deposit account balances and transactions, loan servicing, commissions, including insurance agency commissions, and net gains on sales of securities, loans, and foreclosed real estate.

The following table sets forth certain information on noninterest income for the periods indicated:

(Dollars in thousands)

The $655,000, or 59.9%, increase in noninterest income in the quarter ended March 31, 2020, as compared to the same quarterly period in 2019, was primarily the result of an increase of $680,000 in net gains on sales of loans and foreclosed real estate. The gain on the sale of loans and foreclosed real estate was primarily the result of the sale of $35.9 million in seasoned conforming residential mortgage loans that was completed in January 2020. Also contributing to the increase in noninterest income was a $94,000 increase in insurance agency revenue and a $74,000 increase in service charges on deposit accounts for the current period. These increases in noninterest income were partially offset by a $235,000 decrease in unrealized gains on equity securities compared to the first quarter of 2019. This decrease in unrealized gains on equity securities was the result of a significant decline in the equity markets at March 31, 2020 primarily due to the economic effects of the COVID-19 pandemic. All other noninterest income categories decreased by $42,000, or 7.9%, in the three months ended March 31, 2020 as compared to the same prior year period.

Noninterest Expense

The following table sets forth certain information on noninterest expense for the periods indicated:

(Dollars in thousands)

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The $466,000, or 6.9%, decrease in noninterest expense between the year-over-year first quarter periods was principally due to a decrease in salaries and employee benefits expense. All other noninterest expenses in aggregate, decreased $63,000, or 2.1%, for the three months ended March 31, 2020, as compared to the same three-month period in 2019. The detail of the components of the overall decrease in noninterest expense follows:

• The $403,000 decrease in salaries and employee benefits expense in the first quarter of 2020, as compared to the same three-month period in 2019, was primarily due to a $150,000 decrease in employee benefits expense, a $124,000 decrease in commissions and incentives expense, and a $110,000 decrease in salaries expense. Employee benefits expense decreased primarily due to increased accrued earnings from the Company’s defined benefit pension plan reflecting higher plan asset valuations on January 1, 2020, as compared to the same date in 2019. Commissions and incentives expense declined primarily due to management’s election to suspend the substantial majority of incentive accruals in response to the uncertainties associated with the COVID-19 pandemic. Those accruals totaled $172,000 in the first quarter of 2019.
• The $99,000 increase in building and occupancy expenses was primarily due to a $40,000 increase in property taxes, a $33,000 increase in maintenance expenses, and a $30,000 increase in additional depreciation expense related to recently completed building modernization and refurbishment projects. These increases are consistent with branch and operational growth.
• The $78,000 increase in the FDIC assessment is consistent with our increase in asset size year-over-year.
• Foreclosed real estate expenses decreased $207,000 as a result of a foreclosed property that the Bank paid taxes on in 2019. This foreclosed property was sold in February 2019.
• All other noninterest expenses decreased in aggregate in the year-over-year three-month periods by a total of $33,000, or 1.6%. The Bank is continuously monitoring operating expenses to reduce the annual rate of growth in those operating expenses. The decrease in the various categories of operating expense is consistent with this initiative.

Income Tax Expense

Income tax expense increased $204,000 to $455,000, with an effective tax rate of 22.0% for the quarter ended March 31, 2020, as compared to $251,000, with an effective tax rate of 33.8%, for the same three month period in 2019. Effective in January 2018, the Company adopted a modification methodology, made available following changes to the New York State tax code, affecting how the Company’s state income tax liability is computed. Under this adopted methodology it is unlikely that the Company will pay income taxes to New York in future periods. It was therefore determined to be probable that the Company’s deferred tax assets related to New York State income taxes were unlikely to further reduce the Company’s state income tax rate in the future. Accordingly, a valuation allowance against the value of those deferred tax assets was established to reduce the net deferred tax asset related to New York income taxes to $0. As a result, in the quarter ended March 31, 2019, the Company established, through a charge to earnings, a valuation allowance in the amount of $136,000. This charge to earnings increased the Company’s effective tax rate by 18.3% in that period. In the quarter ended March 31, 2020, management further evaluated all factors related to the expected filings of future New York State tax returns and elected to eliminate its remaining New York State net deferred tax asset balances and the related, and offsetting valuation allowance on January 1, 2020. The effect of these eliminations required an adjustment to other comprehensive income balances and had no effect on first quarter 2020 reported earnings. At March 31, 2020, the Company’s net deferred tax asset related to New York income taxes was $0. At March 31, 2019, the Company had a valuation allowance of $33,000. At March 31, 2020, the Company’s net deferred tax asset related to New York income taxes was $0.

The Company’s effective tax rate typically differs from the 21% federal statutory tax rate due primarily to tax-exempt income from specific types of investment securities and loans, bank owned life insurance, and, to a much lesser degree, the utilization of low income housing tax credits, as well as the effects of transitional adjustments related to state income taxes and certain taxes payable to states other than New York. In addition, the tax effects of certain incentive stock option activity may also reduce the Company’s effective tax rate on a sporadic basis. During the quarter ended March 31, 2020, these effects reduced the Company’s effective tax rate by 0.4%. Excluding the nonrecurring charge related to the deferred tax asset valuation allowance, income tax expense in the first quarter of 2020 would have been $340,000 more than the same prior year period. The increase in income tax expense, as compared to the previous year’s same period, was primarily attributable to the year-over-year first quarter increase in pre-tax net income.

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Earnings per Share

Basic and diluted earnings per share were $0.29 for the first quarter of 2020, as compared to $0.12 per basic and diluted share for the same quarter of 2019. These $0.17 increases in basic and fully diluted earnings per share, respectively, were driven principally by the increase in net income between these two periods. Further information on earnings per share can be found in Note 3 of this Form 10-Q.

Changes in Financial Condition

Assets

Total assets increased $13.8 million, or 1.3%, to $1.11 billion at March 31, 2020, as compared to $1.09 billion at December 31, 2019. This increase was due primarily to increases in cash and cash equivalents and investment securities, partially offset by a decrease in loans.

Cash and cash equivalents increased $37.4 million, or 185.6%, to $57.6 million at March 31, 2020, as compared to $20.2 million at December 31, 2019. The $37.4 million increase in cash and cash equivalents was primarily a result of a perceived need for additional readily-available liquidity reserves in a time of unprecedented uncertainty and significant market instability, as a result of the pandemic. Total restricted cash was $1.3 million and $0 at March 31, 2020 and December 31, 2019, respectively.

Investment securities increased $7.6 million, or 3.2%, to $247.1 million at March 31, 2020, as compared to $239.5 million at December 31, 2019, due principally to purchases of securities during the first quarter of 2020.

Total net loans receivable decreased $31.9 million, or 4.1%, to $740.9 million at March 31, 2020 from $772.8 million at December 31, 2019. This decrease was primarily the result of the sale of $35.9 million in seasoned conforming residential mortgage loans that was completed in January 2020 and generated a $680,000 gain. Further contributing to the decrease in loans was a $7.4 million decrease in consumer loans. However, commercial loans increased by $11.0 million during the first quarter of 2020. Consumer loans decreased primarily due to general amortization. Commercial loans increased primarily due to increases of $7.7 million in commercial real estate loans and $3.3 million among all other commercial loan categories. This was reflective of organic loan growth and the Company’s continued success in its expansion within the greater Syracuse, New York market.

Liabilities

Total liabilities increased $16.2 million to $1.02 billion at March 31, 2020 compared to $1.00 billion at December 31, 2019. Deposits increased $17.9 million, or 2.0%, to $899.9 million at March 31, 2020, compared to $881.9 million at December 31, 2019. Noninterest-bearing deposits were up $6.0 million, or 5.6%, from the 2019 year end, primarily the result of continued growth in business banking relationships. The increase in deposits compared to December 31, 2019 was due to growth in retail and commercial relationship deposits along with brokered deposit inflows. Brokered deposits increased during the quarter ended March 31, 2020, by $42.4 million, or 56.9%, primarily as a result of the Bank’s efforts to significantly increase cash and cash equivalent balances in response to the COVID-19 pandemic. The Bank utilizes the Certificates of Deposit Account Registry Service (“CDARS”) provided by Promontory Interfinancial Network and other deposits acquired through unaffiliated financial institutions as forms of brokered deposits. At March 31, 2020, deposits obtained through the use of these services increased $6.2 million to $116.8 million as compared to $110.6 million at December 31, 2019. Borrowed funds balances from the FHLB-NY decreased $1.7 million, or 1.8%, to $91.4 million at March 31, 2020 from $93.1 million at December 31, 2019.

Shareholders’ Equity

The Company’s shareholders’ equity, exclusive of the noncontrolling interest, decreased $2.4 million to $88.0 million at March 31, 2020 from $90.4 million at December 31, 2019. This decrease in shareholders’ equity during the quarter ended March 31, 2020 was principally due to a $4.1 million increase in accumulated comprehensive loss. The decrease in total shareholders’ equity was partially offset by a $1.3 million increase in retained earnings, a $297,000 increase in paid-in capital, and a $46,000 increase in earned ESOP shares. The comprehensive loss recorded in the quarter ended March 31,

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2020 was primarily the result of the unrealized depreciation in the fair market value of our available-for-sale investment securities during the three months ended March 31, 2020. This depreciation was primarily due to the effects of the COVID-19 pandemic on global fixed income markets at the end of March 2020, as trading activity in those markets was substantially halted and normal market-based price discovery mechanisms were temporarily, but substantially, incapacitated. As a result, available market price quotations for many of the securities within the Company’s investment securities portfolio were not reflective of the fair values that would be obtainable in normally functioning markets.

The increase in retained earnings resulted from $1.7 million in net income recorded in the first three months of 2020. Retained earnings was partially offset by $278,000 for cash dividends declared on our common stock, $69,000 for cash dividends declared on our preferred stock, and $8,000 for cash dividends declared on our issued warrant.

Capital

Capital adequacy is evaluated primarily by the use of ratios which measure capital against total assets, as well as against total assets that are weighted based on defined risk characteristics. The Company’s goal is to maintain a strong capital position, consistent with the risk profile of its banking operations. This strong capital position serves to support growth and expansion activities while at the same time exceeding regulatory standards. At March 31, 2020, the Bank met the regulatory definition of a “well-capitalized” institution, i.e. a leverage capital ratio exceeding 5%, a Tier 1 risk-based capital ratio exceeding 8%, Tier 1 common equity exceeding 6.5%, and a total risk-based capital ratio exceeding 10%.

In addition to establishing the minimum regulatory capital requirements, the regulations limit capital distributions and certain discretionary bonus payments to management if the institution does not hold a “capital conservation buffer” consisting of 2.5% of common equity Tier 1 capital to risk-weighted assets above the amount necessary to meet its minimum risk-based capital requirements. The buffer is separate from the capital ratios required under the Prompt Corrective Actions (“PCA”) standards. In order to avoid these restrictions, the capital conservation buffer effectively increases the minimum levels of the following capital to risk-weighted assets ratios: (1) Core Capital, (2) Total Capital and (3) Common Equity. The capital conservation buffer requirement is now fully implemented at 2.5% of risk-weighted assets. At March 31, 2020, the Bank exceeded all regulatory required minimum capital ratios, including the capital buffer requirements.

As a result of the recently enacted Economic Growth, Regulatory Relief, and Consumer Protection Act, the federal banking agencies developed a “Community Bank Leverage Ratio” (the ratio of a bank's tier 1 capital to average total consolidated assets) for financial institutions with assets of less than $10 billion. A “qualifying community bank” that exceeds this ratio will be deemed to be in compliance with all other capital and leverage requirements, including the capital requirements to be considered “well capitalized” under Prompt Corrective Action statutes. The federal banking agencies may consider a financial institution's risk profile when evaluating whether it qualifies as a community bank for purposes of the capital ratio requirement. The federal banking agencies have set the Community Bank Leverage Ratio at 9%. Pursuant to the CARES Act, the federal banking agencies in April 2020 issued interim final rules to set the Community Bank Leverage Ratio at 8% beginning in the second quarter of 2020 through the end of 2020. Beginning in 2021, the Community Bank Leverage Ratio will increase to 8.5% for the calendar year. Community banks will have until January 1, 2022, before the Community Bank Leverage Ratio requirement will return to 9%. A financial institution can elect to be subject to this new definition. The new rule took effect on January 1, 2020. The Bank did not elect to become subject to the Community Bank Leverage Ratio.

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Pathfinder Bank’s capital amounts and ratios as of the indicated dates are presented in the following tables:

(Dollars in thousands)

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Non-GAAP Financial Measures

Regulation G, a rule adopted by the Securities and Exchange Commission (SEC), applies to certain SEC filings, including earnings releases, made by registered companies that contain “non-GAAP financial measures.” GAAP is generally accepted accounting principles in the United States of America. Under Regulation G, companies making public disclosures containing non-GAAP financial measures must also disclose, along with each non-GAAP financial measure, certain additional information, including a reconciliation of the non-GAAP financial measure to the closest comparable GAAP financial measure (if a comparable GAAP measure exists) and a statement of the Company’s reasons for utilizing the non-GAAP financial measure as part of its financial disclosures. The SEC has exempted from the definition of “non-GAAP financial measures” certain commonly used financial measures that are not based on GAAP. When these exempted measures are included in public disclosures, supplemental information is not required. Financial institutions like the Company and its subsidiary bank are subject to an array of bank regulatory capital measures that are financial in nature but are not based on GAAP. The Company follows industry practice in disclosing its financial condition under these various regulatory capital measures, including period-end regulatory capital ratios for its subsidiary bank, in its periodic reports filed with the SEC. The Company provided an explanation of the calculations, as supplemental information, for non-GAAP measures included in the consolidated annual financial statements. In addition, the Company provides a reconciliation of its subsidiary bank’s disclosed regulatory capital measures, below.

(Dollars in thousands)

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Loan and Asset Quality and Allowance for Loan Losses

The following table represents information concerning the aggregate amount of non-performing assets at the indicated dates:

(Dollars In thousands)

Nonperforming assets include nonaccrual loans, nonaccrual troubled debt restructurings (“TDR”), and foreclosed real estate (‘‘FRE”). The Company generally places a loan on nonaccrual status and ceases accruing interest when loan payment performance is deemed unsatisfactory and the loan is past due 90 days or more. There are no loans that are past due 90 days or more and still accruing interest at the dates indicated in the table above. Loans are considered modified in a TDR when, due to a borrower’s financial difficulties, the Company makes a concession(s) to the borrower that it would not otherwise consider. These modifications may include, among others, an extension of the term of the loan, and granting a period when interest-only payments can be made, with the principal payments made over the remaining term of the loan or at maturity. TDRs are included in the above table within the categories of nonaccrual loans or accruing TDRs. There was one nonaccruing TDR loans, with an aggregate carrying value of $74,000 included among the nonaccrual loans detailed in the table above at March 31, 2020.

Pursuant to the CARES Act, financial institutions have the option to temporarily suspend certain requirements under U.S. generally accepted accounting principles related to troubled debt restructurings for a limited period of time to account for the effects of COVID-19. This provision allows a financial institution the option to not apply the guidance on accounting for troubled debt restructurings to loan modifications, such as extensions or deferrals, related to COVID-19 made between March 1, 2020 and the earlier of (i) December 31, 2020 or (ii) 60 days after the end of the COVID-19 national emergency. The relief can only be applied to modifications for borrowers that were not more than 30 days past due as of December 31, 2019. The Bank elected to adopt these provisions of the CARES Act.

As indicated in the table above, nonperforming assets at March 31, 2020 were $4.7 million and were $610,000 lower than the $5.3 million reported at December 31, 2019, due primarily to a decrease of $606,000 in nonperforming commercial and residential mortgages loans and a $30,000 decrease in FRE, partially offset by an increase of $26,000 in nonperforming consumer loans.

As indicated in the nonperforming asset table above, FRE balances decreased $30,000 at March 31, 2020 from December 31, 2019, following one sale from the portfolio and two additions to the portfolio during the three-month period ended March 31, 2020. More information regarding foreclosed real estate can be found in Note 8 of this quarterly report on Form 10-Q.

Fair values for commercial FRE are initially recorded based on market value evaluations by third parties, less costs to sell (“initial cost basis”). On a prospective basis, residential FRE assets will be initially recorded at the lower of the net amount of loan receivable or the real estate’s fair value less costs to sell. Any write-downs required when the related loan receivable is exchanged for the underlying real estate collateral at the time of transfer to FRE are charged to the allowance for loan losses. Values are derived from appraisals, similar to impaired loans, of underlying collateral or discounted cash

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flow analysis. Subsequent to foreclosure, valuations are updated periodically and assets are marked to current fair value, not to exceed the initial cost basis for the FRE property.

The allowance for loan losses represents management’s estimate of the probable losses inherent in the loan portfolio as of the date of the statement of condition. The allowance for loan losses was $9.6 million and $8.7 million at March 31, 2020 and December 31, 2019, respectively. The ratio of the allowance for loan losses to total loans increased 17 basis points to 1.28% at March 31, 2020 from 1.11% at December 31, 2019. Management performs a quarterly evaluation of the allowance for loan losses based on quantitative and qualitative factors and has determined that the current level of the allowance for loan losses is adequate to absorb the losses in the loan portfolio as of March 31, 2020.

The Company considers a loan impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan. The measurement of impaired loans is generally based upon the fair value of the collateral, with a portion of the impaired loans measured based upon the present value of future cash flows discounted at the historical effective interest rate. A specific reserve is established for an impaired loan if its carrying value exceeds its estimated fair value. The estimated fair values of the majority of the Company’s impaired loans are measured based on the estimated fair value of the loan’s collateral. For loans secured by real estate, estimated fair values are determined primarily through third-party appraisals or broker price opinions. When a loan is determined to be impaired, the Bank will reevaluate the collateral which secures the loan. For real estate, the Company will obtain a new appraisal or broker’s opinion whichever is considered to provide the most accurate value in the event of sale. An evaluation of equipment held as collateral will be obtained from a firm able to provide such an evaluation. Collateral will be inspected not less than annually for all impaired loans and will be reevaluated not less than every two years. Appraised values and broker opinion values are discounted due to the market’s perception of a reduced price of Bank-owned property and the Bank’s desire to sell the property quicker to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property.

At March 31, 2020 and December 31, 2019, the Company had $7.4 million and $7.5 million in loans, which were deemed to be impaired, having established specific reserves of $777,000 and $830,000, respectively, on these loans. There was a decrease in impaired loans and the associated specific reserve among all categories. Most notably, impaired commercial and industrial loans decreased $54,000 and the associated reserve decreased $27,000.

Management has identified potential credit problems which may result in the borrowers not being able to comply with the current loan repayment terms and which may result in those loans being included in future impaired loan reporting. Potential problem loans totaled $30.3 million as of March 31, 2020, a decrease of $1.1 million, or 3.6%, as compared to $31.5 million at December 31, 2019. These loans have been internally classified as special mention, substandard, or doubtful, yet are not currently considered impaired. Due to the adverse economic impacts of the COVID-19 pandemic on our market area and our customers, the Company expects that potential problem loans may increase during the course of fiscal 2020.

Appraisals are obtained at the time a real estate secured loan is originated. For commercial real estate held as collateral, the property is inspected every two years.

In the normal course of business, the Bank has infrequently sold residential mortgage loans and participation interests in commercial loans. As is typical in the industry, the Bank makes certain representations and warranties to the buyer. The Bank maintains a quality control program for closed loans and considers the risks and uncertainties associated with potential repurchase requirements to be minimal.

Liquidity

Liquidity management involves the Company’s ability to generate cash or otherwise obtain funds at reasonable rates to support asset growth, meet deposit withdrawals, maintain reserve requirements, and otherwise operate the Company on an ongoing basis. The Company's primary sources of funds are deposits, borrowed funds, amortization and prepayment of loans and maturities of investment securities and other short-term investments, and earnings and funds provided from operations. While scheduled principal repayments on loans are a relatively predictable source of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. The Company

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manages the pricing of deposits to maintain a desired deposit composition and balance. In addition, the Company invests excess funds in short-term interest-earning and other assets, which provide liquidity to meet lending requirements.

The Company's liquidity has been enhanced by its ability to borrow from the Federal Home Loan Bank of New York (“FHLBNY”), whose competitive advance programs and lines of credit provide the Company with a safe, reliable, and convenient source of funds. A significant decrease in deposits in the future could result in the Company having to seek other sources of funds for liquidity purposes. Such sources could include, but are not limited to, additional borrowings, brokered deposits, negotiated time deposits, the sale of "available-for-sale" investment securities, the sale of securitized loans, or the sale of whole loans. Such actions could result in higher interest expense and/or losses on the sale of securities or loans.

For the first three months of 2020, cash and cash equivalents increased by $37.4 million. The Company reported net cash flows from financing activities of $16.2 million generated by increased customer deposit balances of $37.7 million. The increase in deposits was the result of organic growth in consumer, business and municipal segments within our existing marketplace. This increase was partially offset by an aggregate decrease in net cash of $21.5 million from all other financing sources, including dividends paid to common and preferred shareholders, and decreased balances in both brokered deposits and borrowings. Additionally, $38.0 million was provided through operating activities, primarily from the sale of residential loans to the secondary market.

The Company has a number of existing credit facilities available to it. At March 31, 2020, total credit available to the Company under the existing lines of credit was approximately $150.8 million at FHLBNY, the Federal Reserve Bank, and two other correspondent banks. As of March 31, 2020, the Company had $91.4 million of the available lines of credit utilized on its existing lines of credit with $59.4 million available.

The Asset Liability Management Committee of the Company is responsible for implementing the policies and guidelines for the maintenance of prudent levels of liquidity. As of March 31, 2020, management reported to the Board of Directors that the Company is in compliance with its liquidity policy guidelines.

Off-Balance Sheet Arrangements

The Company is also 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 standby letters of credit. At March 31, 2020, the Company had $152.7 million in outstanding commitments to extend credit and standby letters of credit.

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Under the supervision and with the participation of the Company’s management, including our Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this quarterly report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. There has been no change in the Company’s internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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