MID Penn Bancorp Inc: Form 10-Q for the period ended Jun 30, 2022

The following is Management’s Discussion and Analysis of Consolidated Financial Condition as of June 30, 2022, compared to year-end 2021, and the Results of Operations for the three and six months ended June 30, 2022, compared to the same periods in 2021. For comparative purposes, the June 30, 2021 and December 31, 2021 balances have been reclassified when, and if necessary, to conform to the 2022 presentation. Such reclassifications had no impact on net income or shareholders’ equity. This discussion should be read in conjunction with the financial tables, statistics, and the audited financial statements and notes thereto included in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2021 (the “2021 Annual Report”). The results of operations for interim periods are not necessarily indicative of operating results expected for the full year.

Caution About Forward-Looking Statements

Forward-looking statements involve risks, uncertainties and assumptions. Although Mid Penn generally does not make forward-looking statements unless Mid Penn’s management believes its management has a reasonable basis for doing so, Mid Penn cannot guarantee the accuracy of any forward-looking statements. Actual results may differ materially from those expressed in any forward-looking statements due to a number of uncertainties and risks, including the risks described in this Quarterly Report on Form 10-Q, the 2021 Annual Report, and other unforeseen risks. You should not put undue reliance on any forward-looking statements. These statements speak only as of the date of this Quarterly Report on Form 10-Q, even if subsequently made available by us on Mid Penn’s website or otherwise, and Mid Penn undertakes no obligation to update or revise these statements to reflect events or circumstances occurring after the date of this Quarterly Report on Form 10-Q.

Certain of the matters discussed in this document and in documents incorporated by reference herein, including matters discussed under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, may constitute forward-looking statements for purposes of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, and as such may involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of Mid Penn to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. The words “expect”, “anticipates”, “intend”, “plan”, “believe”, “estimate”, and similar expressions are intended to identify such forward-looking statements. Mid Penn’s actual results may differ materially from the results anticipated in these forward-looking statements due to a variety of factors, including, without limitation:

• the effects of potentially slowing or volatile future economic conditions on Mid Penn and its customers;
• governmental monetary and fiscal policies, as well as legislative and regulatory changes;
• future actions or inactions of the federal or state governments, including a failure to increase the government debt limit or a prolonged shutdown of the federal government, or a federal or state government-mandated shutdown of significant segments of the economy;
• business or economic disruptions from national or global epidemic or pandemic events, including those from the COVID-19 pandemic;
• the risks associated with our acquisition of Riverview, including we may fail to realize the anticipated benefits of the merger, and the future results of the combined company may suffer if the expanded operations are not effectively managed;
• an increase in the Pennsylvania Bank Shares Tax to which Mid Penn Bank’s capital stock is currently subject, or imposition of any additional taxes on Mid Penn or Mid Penn Bank;
• changes in the capitalization of the Corporation, including the impacts of any capital and liquidity requirements imposed by regulatory pronouncements and rules;
• the effect of changes in accounting policies and practices, as may be adopted by the supervisory agencies, as well as the Public Company Accounting Oversight Board, Financial Accounting Standards Board, and other accounting standard setters;
• the risks of changes in interest rates and the yield curve on the level and composition of deposits and other funding sources, loan demand and yields, values of loan collateral, securities and yields, and interest rate protection agreements;
• the effects of competition from other commercial banks, thrifts, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and other mutual funds and other financial institutions operating in Mid Penn’s market area and elsewhere, including institutions operating locally, regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone, computer and the internet;
• the costs and effects of litigation and of unexpected or adverse outcomes in such litigation;
• technological changes and changes to data security systems including those with third-party information technology providers;
• our ability to implement business strategies, including our acquisition strategy;
• our ability to implement organic branch, product and service expansion strategies;
• our current and future acquisition strategies may not be successful in locating or acquiring advantageous targets at favorable prices;
• our ability to successfully integrate any banks, companies, assets, liabilities, customers, systems and management personnel we acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames;
• potential goodwill impairment charges, future impairment charges and fluctuations in the fair values of reporting units or of assets in the event projected financial results are not achieved within expected time frames;
• our ability to attract and retain qualified management and personnel;
• our ability to maintain the value and image of our brand and protect our intellectual property rights;
• results of regulatory examination and supervision processes;
• our ability to maintain compliance with the exchange rules of The NASDAQ Stock Market LLC;
• the failure of assumptions underlying the establishment of reserves for loan and lease losses and estimations of values of collateral and various financial assets and liabilities;
• acts of war or terrorism; disruptions due to flooding, severe weather, or other natural disasters or Acts of God
• volatility in the securities markets; and
• other risks and uncertainties, including those detailed in our Annual Report on Form 10-K for the year ended December 31, 2021, under the sections “Risk Factors” and “Management Discussion and Analysis of Financial Condition and Results of Operations” and in subsequent filings with the SEC.

The above list of factors that may affect future performance is illustrative, but by no means exhaustive. Accordingly, all forward-looking statements should be evaluated with this understanding of inherent uncertainty.

Critical Accounting Estimates

Mid Penn’s consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and conform to general practices within the banking industry. Application of these principles involves significant judgments and estimates by management that have a material impact on the carrying value of certain assets and liabilities. The judgments and estimates that we used are also based on historical experiences and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and estimates that we have made, actual results could differ from these judgments and estimates, which could have a material impact on the carrying values of assets and liabilities and the results of our operations. Management of the Corporation considers the accounting judgments relating to the allowance, the evaluation of the Corporation’s investment securities for other-than-temporary impairment, the valuation of the Corporation’s goodwill and other merger-related intangible assets for impairment, and the valuation of assets acquired and liabilities assumed in business combinations, to be the accounting areas that require the most subjective and complex judgments.

The allowance represents management’s estimate of probable incurred credit losses inherent in the loan and lease portfolio. Determining the amount of the allowance is considered a critical accounting estimate because it requires significant judgment and 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. The loan and lease portfolio also represents the largest asset type on the consolidated balance sheet. Throughout the remainder of this report, the terms “loan” or “loans” refers to both loans and leases.

Valuations for the investment portfolio are determined using quoted market prices, where available. If quoted market prices are not available, investment valuation is based on pricing models, quotes for similar investment securities, and observable yield curves and spreads. In addition to securities valuation, management must assess whether there are any declines in value below the carrying value of the investments that should be considered other than temporary or require an adjustment in carrying value and recognition of the loss in the consolidated statement of income.

Certain intangible assets generated in connection with acquisitions are periodically assessed for impairment. Goodwill is tested annually for impairment, and if certain events occur which indicate goodwill might be impaired between annual tests, goodwill must be tested when such events occur. In making this assessment, Mid Penn considers a number of factors including operating results, business plans, economic projections, anticipated future cash flows, current market data, stock price, etc. Similarly, the amortized basis of the core deposit intangible asset is periodically assessed for impairment. There are inherent uncertainties related to these factors and Mid Penn’s judgment in applying them to the analysis of core deposit intangible, trade name intangible, and goodwill impairment. Changes in economic and operating conditions could result in goodwill, core deposit intangible, customer list intangible, or trade name intangible impairment in future periods.

Valuations of assets acquired and liabilities assumed in business combinations are measured at fair value as of the acquisition date. In many cases, determining the fair value of the assets acquired and liabilities assumed requires Mid Penn to estimate cash flows expected to result from these assets and liabilities and to discount these cash flows at appropriate rates of interest, which require the utilization of significant estimates and judgment in accounting for the acquisition.

See “Note 2 - Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements for additional information.

Riverview Acquisition

On November 30, 2021, Mid Penn announced the successful completion of the merger acquisition of Riverview Financial Corporation. The acquisition of Riverview impacted periods presented within this report. Refer to “Note 3 - Acquisition of Riverview Financial Corporation” in the Notes to Consolidated Financial Statements, as well as the Company’s Current Report on Form 8-K filed on December 1, 2021, for more information.

COVID-19 Pandemic

The COVID-19 pandemic has caused substantial disruption in economic and social activity, both in the United States and abroad. While the overt impacts from the pandemic have diminished, there remains uncertainty concerning the breadth and duration of the disruptions and their impact on the U.S. economy. For example, the adverse economic effects of the pandemic may lead to an increase in credit risk on the Corporation’s commercial and residential loan portfolios. Additionally, management continues to monitor the fluctuations in the markets as it pertains to interest rates and the fair value of our investments and is actively monitoring the global situation on the Corporation’s financial condition, liquidity, capital position, operations, industry, and workforce. If the pandemic continues to cause significant negative impacts to economic conditions, Mid Penn’s results of operations, financial condition, capital position, or liquidity for fiscal year 2022 may be adversely impacted.

Coronavirus Aid, Relief, and Economic Security Act

Mid Penn has been a significant participating lender under the Paycheck Protection Program (“PPP”), which was created when the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act was signed into law on March 27, 2020 and concluded August 8, 2020. The PPP program was reinstated under the Consolidated Appropriations Act, 2021, which was signed into law on December 27, 2020 and concluded on May 31, 2021.

Results of Operations

Overview

Net income available to common shareholders was $12,252,000 or $0.77 per common share basic and diluted for the quarter ended June 30, 2022, compared to net income of $9,313,000 or $0.93 per common share basic and diluted for the quarter ended June 30, 2021. During the six months ended June 30, 2022, net income available to common shareholders was $23,606,000 or $1.48 per common share basic and diluted compared to net income of $18,925,000 or $2.02 per common share basic and diluted for the six months ended June 30, 2021.

Net income as a percentage of average assets (return on average assets, or “ROA”) and net income as a percentage of shareholders' equity (return on average equity, or “ROE”) were as follows (calculated and reported on an annualized basis):

Net Interest Income

Net interest income, Mid Penn’s primary source of revenue, is the amount by which interest income on loans and investments exceeds interest incurred on deposits and borrowings. The amount of net interest income is affected by changes in interest rates and changes in the volume and mix of interest-sensitive assets and liabilities. Net interest income and corresponding yields are presented in the analysis below on a taxable-equivalent basis (“TE”). Income from tax-exempt assets, primarily loans to or securities issued by state and local governments, is adjusted by an amount equivalent to the federal income taxes which would have been paid if the income received on these assets was taxable at the statutory rate of 21% for the periods presented.

The following table includes average balances, amounts, and yields of interest income and rates of expense, interest rate spread, and net interest margin for the three months ended June 30, 2022 and 2021.

(Dollars in thousands)

(a) Includes TE adjustments (calculated using statutory rates of 21%) of $101,000 and $74,000 for the three months ended June 30, 2022 and 2021, respectively, resulting from tax-free municipal securities in the investment portfolio.

(b) Includes TE adjustments (calculated using statutory rates of 21%) of $91,000 and $73,000 for the three months ended June 30, 2022 and 2021, respectively, resulting from tax-free municipal loans in the commercial loan portfolio.

The following table summarizes the changes in TE interest income and interest expense resulting from changes in average balances, volume, and changes in rates for the three months ended June 30, 2022 in comparison to the same period in 2021:

(Dollars in thousands on a Taxable-Equivalent Basis)

Mid Penn’s TE net interest margin for the three months ended June 30, 2022 was 3.45% and compared to 3.34% for the three months ended June 30, 2021. TE net interest income was $35,625,000 for the three months ended June 30, 2022, an increase of $8,601,000, or 31.2%, compared to the three months ended June 30, 2021. Average interest earning assets increased $891,994,000, or 27.5%, compared to the second quarter of 2021, primarily as a result of the Riverview acquisition. This growth contributed $7,953,000 to the increase in TE net interest income and was partially offset by the lower yield on interest-earning assets, which decreased from 3.82% for the second quarter of 2021 to 3.73% for the second quarter of 2022. The lower yields on loans and leases, net were the result of a decrease of $3,457,000 in the recognition of PPP loan processing fees generated as a result of Mid Penn’s participation in the PPP compared to the second quarter of 2021. These PPP fees are recognized into interest income over the term of the respective loan, or sooner if the loans are forgiven by the Small Business Administration (“SBA”), or the borrowers otherwise pay down principal prior to a loan’s stated maturity. Mid Penn systematically added to its investment portfolio during the second quarter of 2022 to better utilize excess funds held in lower yielding accounts with the Federal Reserve, contributing to the growth in TE net interest income.

Interest expense decreased $1,065,000 during the second quarter of 2022 compared to the second quarter of 2021. The rate of interest-bearing liabilities decreased from 0.64% for the second quarter of 2021 to 0.36% for the second quarter of 2022. The decrease in rate was primarily a result of a lag in the repricing of deposits as well as the strategic decision to allow higher cost time deposits obtained through the Riverview acquisition to run-off, partially offset by an increase of $935,000 in interest expense due to the $640,850,000, or 26.4%, increase in interest-bearing liabilities compared to the same period of 2021.

The following table includes average balances, amounts, and yields of interest income and rates of expense, interest rate spread, and net interest margin for the six months ended June 30, 2022 and 2021:

(Dollars in thousands)

(a) Includes TE adjustments (calculated using statutory rates of 21%) of $190,000 and $147,000 for the six months ended June 30, 2022 and 2021, respectively, resulting from tax-free municipal securities in the investment portfolio.

(b) Includes TE adjustments (calculated using statutory rates of 21%) of $197,000 and $149,000 for the six months ended June 30, 2022 and 2021, respectively, resulting from tax-free municipal loans in the commercial loan portfolio.

The following table summarizes the changes in TE interest income and interest expense resulting from changes in average balances, volume, and changes in rates for the six months ended June 30, 2022 in comparison to the same period in 2021:

(Dollars in thousands on a Taxable-Equivalent Basis)

Mid Penn’s TE net interest margin for the six months ended June 30, 2022 was 3.33% and compared to 3.40% for the six months ended June 30, 2021. TE net interest income was $70,234,000 for the six months ended June 30, 2022, an increase of $17,736,000, or 33.8%, compared to $52,202,000 of TE net interest income for the six months ended June 30, 2021. Average interest-earning assets increased $1,136,873,000, or 36.5%, compared to the first half of 2021, primarily as a result of the Riverview acquisition. This growth contributed $16,254,000 to the increase in TE net interest income and was partially offset by the lower yield on interest-earning assets, which decreased from 3.89% for the first half of 2021 to 3.61% for the first half of 2022. The lower yields on loans and leases, net were the result of a decrease of $7,650,000 in the recognition of PPP loan processing fees generated as a result of Mid Penn’s participation in PPP compared to the first six months of 2021. Mid Penn systematically added to its investment portfolio during the first half of 2022 to better utilize excess funds held in lower yielding accounts with the Federal Reserve, contributing to the growth in TE net interest income.

Interest expense decreased $1,690,000 during the first six months of 2022 compared to the same period of 2021. The rate of interest-bearing liabilities decreased from 0.66% for the first six months of 2021 to 0.38% for the first six months of 2022. The decrease in rate was primarily a result of a lag in the repricing of deposits as well as the strategic decision to allow higher cost time deposits obtained through the Riverview acquisition to run-off. The decrease in interest expense as a result of the lower rate of interest-bearing liabilities was partially offset by an increase of $2,624,000 in interest expense as a result of a $640,850,000, or 26.4%, increase in interest-bearing liabilities compared to the same period of 2021.

Although the effective interest rate impact on interest-earning assets and funding sources can be reasonably estimated at current interest rate levels, the interest-bearing product and pricing options selected by customers, and the future mix of the loan, investment, and deposit products in the Bank's portfolios, may significantly change the estimates used in Mid Penn’s asset and liability management and related interest rate risk simulation models. In addition, our net interest income may be impacted by further interest rate actions of the Federal Reserve’s Federal Open Market Committee (“FOMC”).

Provision for Loan Losses

The provision for loan and lease losses is the expense necessary to maintain the allowance at a level adequate to absorb management’s estimate of probable losses in the loan and lease portfolio. Mid Penn’s provision for loan and lease losses is based upon management’s monthly review of the loan portfolio. The purpose of the review is to assess loan quality, identify impaired loans and leases, analyze delinquencies, ascertain loan and lease growth, evaluate potential charge-offs and recoveries, and assess general economic conditions in the markets Mid Penn serves.

Mid Penn has maintained the allowance in accordance with Mid Penn’s assessment process, which takes into consideration, among other relevant factors, the risk characteristics of the loan portfolio, the growth in the loan portfolio during the first six months of 2022, economic and external factor changes, and shifting collateral values from December 31, 2021 to June 30, 2022.

Management performed a current evaluation of the adequacy of the loan and lease loss allowance and, based on this evaluation, a loan and lease loss provision of $1,725,000 and $1,150,000 was recorded for the three months ended June 30, 2022 and 2021, respectively. During the six months ended June 30, 2022, the provision for the loan and lease losses was $2,225,000 compared to $2,150,000 for the six months ended June 30, 2021. The allowance for loan and lease losses and the related provision reflect Mid Penn’s continued application of the incurred loss method for estimating credit losses as Mid Penn is not yet required to adopt the current expected credit loss (“CECL”) accounting standard. The increase in the allowance for loan and lease loss from $14,597,000 at December 31, 2021 to $16,876,000 at June 30, 2022 was primarily the result of providing for core loan growth, as well as the result of one legacy commercial relationship being downgraded from substandard accrual to substandard non-accrual during the six months ended June 30, 2022.

Noninterest Income

For the three months ended June 30, 2022, noninterest income totaled $5,230,000, a decrease of $422,000 or 7.5%, compared to noninterest income of $5,652,000 for the same period in 2021. For the six months ended June 30, 2022, noninterest income totaled $10,980,000, an increase of $616,000 or 5.9%, compared to noninterest income of $10,364,000 for the same period in 2021. Several components of noninterest income increased as a result of higher account and transaction volume due to both the Riverview acquisition and organic growth.

The following components of noninterest income showed significant changes:

(Dollars in Thousands)

(Dollars in Thousands)

Mortgage banking income was $834,000 for the six months ended June 30, 2022, a decrease of $4,386,000, compared to the $5,220,000 of mortgage banking income for the six months ended June 30, 2021. Mortgage loan originations and secondary-market loan sales and gains slowed during the first half of 2022 as a result of increases in interest rates. During the first half of 2022, the FOMC announced three rate increases, and anticipates several additional increases throughout the remainder of 2022. As a result of the corresponding mortgage rate increases and an increase in property values driven by supply shortfalls and high liquidity levels among buyers, the mortgage loan refinancing market has slowed and purchase money mortgage originations have slowed relative to the lending volumes experienced during the first half of 2021.

Income from fiduciary and wealth management activities was $2,257,000 for the six months ended June 30, 2022, an increase of $1,159,000 compared to $1,098,000 during the six months ended June 30, 2021. The additional revenue was attributable to favorable growth in trust assets under management and increased sales of retail investments products, as well as the Riverview acquisition.

Service charges on deposits were $1,134,000 for the six months ended June 30, 2022, an increase of $805,000, compared to $329,000 for the same period in 2021. This increase was driven by an increase in collected charges on a higher volume of transactional deposit accounts, including deposit accounts assumed in the Riverview acquisition.

ATM debit card interchange income was $2,185,000 for the six months ended June 30, 2022, an increase of $961,000 compared to the six months ended June 30, 2021. The additional income is a result of an increased volume of checking accounts and an increase in Mid Penn ATM and debit card activity, which included an increase in transaction volume resulting from the accounts assumed in the Riverview acquisition.

Earnings from cash surrender value of life insurance was $508,000 for the six months ended June 30, 2022, an increase of $359,000, compared to $149,000 for the same period of 2021. The increase is a result of additional policies assumed in the Riverview acquisition.

Other income was $3,792,000 for the six months ended June 30, 2022, an increase of $2,204,000, compared to $1,588,000 during the six months ended June 30, 2021. A mortgage hedging program was established in the latter half of 2021, generating $1,134,000 in mortgage hedging gains for the six months ended June 30, 2022, while no similar gains were recognized during the same six months of the prior year. Mid Penn also reflected increases in other miscellaneous income amounts as a result of the Riverview acquisition.

Noninterest Expense

For the three months ended June 30, 2022, noninterest expense totaled $23,915,000, an increase of $4,459,000, or 22.9%, compared to noninterest expense of $19,456,000 for the same period in 2021. For the six months ended June 30, 2022, noninterest expense totaled $49,660,000, an increase of $12,646,000, or 34.2%, compared to noninterest expense of $37,014,000 for the same period in 2021. Several components of noninterest expense increased as a result of higher fixed and variable expenses due to the Riverview acquisition and organic growth.

The changes were primarily a result of the following components of noninterest expense, which had significant variances when comparing results for periods ending in 2022 versus the corresponding period in 2021:

(Dollars in Thousands)

(Dollars in Thousands)

Salaries and employee benefits were $25,584,000 for the six months ended June 30, 2022, an increase of $6,053,000 versus the same period in 2021, with the increase attributable to (i) the retail staff additions at the seven retail locations added through the Riverview acquisition; (ii) the retention of various Riverview team members through the completion of the systems integration, which occurred on March 4, 2022; and (iii) the addition of wealth management professionals, commercial lending professionals, and other staff additions in alignment with Mid Penn’s core banking and nonbanking growth initiatives.

Occupancy expenses increased $657,000 during the first six months of 2022 compared to the same period in 2021. Similarly, equipment expense increased $631,000 during the six months ended June 30, 2022, compared to the six months ended June 30, 2021. These increases were driven by the facility operating costs and increased depreciation expense for building, furniture, and equipment associated with the Riverview acquisition.

Software licensing and utilization costs were $3,927,000 for the six months ended June 30, 2022, an increase of $985,000 compared to $2,942,000 for the six months ended June 30, 2021. The increase is a result of additional costs to license (i) the additional Riverview branches, (ii) upgrades to internal systems, networks, storage capabilities, cybersecurity management, and data security mechanisms to enhance data management and security capabilities responsive to both the larger company profile and the increasing complexity of information technology management, and (iii) increases in certain core processing fees as our customer base and transaction volume continue to grow.

FDIC assessment expense was $1,097,000 for the six months ended June 30, 2022, an increase of $194,000 compared to $903,000 for the six months ended June 30, 2021. As a result of the Riverview acquisition and organic growth, the increased FDIC assessment aligns with the year-over-year growth of the average assets of the Bank on which the assessment is based.

Legal and professional fees were $1,333,000 for the six months ended June 30, 2022, an increase of $352,000 compared to $981,000 for the six months ended June 30, 2021, with this increase being attributable to consulting expenses related to personnel arrangements facilitating the assimilation of Riverview. Additionally, fees were incurred for expanded loan review coverage and software consulting services in the compliance area.

Charitable contributions qualifying for state tax credits were $190,000 for the six months ended June 30, 2022, compared to $635,000 for the same six-month period during 2021. Mid Penn continues to maximize the amount of contributions qualifying for state credits that can be made during 2022 and makes qualifying contributions, as allowable.

Intangible amortization increased from $557,000 during the first half of 2021 to $1,002,000 during the first half of 2022 as a result of the customer list and core deposit intangible assets added from the Riverview acquisition.

Merger and acquisition expenses were $522,000 during the first half of 2021 prior to the completion of the Riverview acquisition. During the first six months of 2022, post-acquisition restructuring expenses were $329,000 and primarily consisted of contract termination fees related to the Riverview acquisition.

Other expenses increased $4,666,000 from $5,808,000 during the six months ended June 30, 2021, to $10,474,000 for the same period in 2022. Several categories within other expense experienced increases as a result of the Riverview acquisition and organic growth, including Pennsylvania Bank Shares taxes, marketing, telephone, postage, courier, ATM and card processing, payroll processing, employee travel costs, and director fees. In addition, the six months ended June 30, 2022, contained an impaired asset write-off of $664,000, representing the disposal of certain fixed assets and leasehold improvements from Riverview offices not being retained.

Income Taxes

The provision for income taxes was $5,336,000 during the six months ended June 30, 2022, compared to $4,477,000 of income tax provision recorded for the same period in 2021. The provision for income taxes for the six months ended June 30, 2022, reflects a combined Federal and State effective tax rate of 18.4% compared to 19.1% for the six months ended June 30, 2021. The decrease in the effective tax rate reflects (i) higher tax-exempt interest recognized due to an increase in tax-exempt securities being held in the investment security portfolio when compared to the prior year, and (ii) the favorable treatment of the increase in cash surrender value on bank owned life insurance policies, which are nontaxable for federal tax purposes. Generally, Mid Penn’s effective tax rate is below the federal statutory rate due to earnings on tax-exempt loans, investments, and earnings from the cash surrender value of life insurance, as well as the impact of federal income tax credits, including those awarded from Mid Penn’s low-income housing investments. The realization of Mid Penn’s deferred tax assets is dependent on future earnings. Mid Penn currently anticipates that future earnings will be adequate to fully realize the currently recorded deferred tax assets.

Financial Condition

Overview

Mid Penn’s total assets were $4,310,163,000 as of June 30, 2022, reflecting a decrease of $379,262,000, or 8.1%, compared to total assets of $4,689,425,000 as of December 31, 2021. Included in total assets as of June 30, 2022 are $4,966,000 of PPP loans, net of deferred fees. Comparatively, as of December 31, 2021, Mid Penn had $111,286,000 of PPP loans outstanding, net of deferred fees.

Total loans and leases, net of unearned interest totaled $3,180,033,000 as of June 30, 2022, an increase of $75,637,000, or 2.4% since December 31, 2021. The growth occurred primarily within the commercial real estate loan portfolio. Core banking loans (a non-GAAP measure calculated as loans and leases, net of unearned interest less PPP loans outstanding) totaled $3,175,067,000 as of June 30, 2022, an increase of $181,957,000, or 6.1% since December 31, 2021. The growth in core banking loans occurred primarily within the commercial real estate loan portfolio. Please refer to the section included herein under the heading “Reconciliation of Non-GAAP Measures (Unaudited)” for a discussion of our use of non-GAAP adjusted financial information, which includes a table reconciling GAAP and non-GAAP adjusted financial measures for these and certain other periods ended from June 30, 2021 through June 30, 2022.

Total deposits decreased $299,429,000 or 7.5%, from $4,002,016,000 on December 31, 2021, to $3,702,587,000 at June 30, 2022. The decrease in total deposits since December 31, 2021 was attributable to the maturity of certificates of deposit, which have renewed into lower rates, migrated to other deposit or retail investment products, or exited the Bank.

Loans and Leases, net of unearned interest

Total loans and leases, net of unearned interest as of June 30, 2022 were $3,180,033,000 compared to $3,104,396,000 as of December 31, 2021. This increase was driven by organic loan growth within Mid Penn’s commercial real estate portfolio, net of PPP loan forgiveness.

(Dollars in thousands)

Credit Quality, Credit Risk, and Allowance for Loan and Lease Losses

The allowance for loan and lease losses and the related loan and lease loss provision for the periods presented reflect Mid Penn’s continued application of the incurred loss method for estimating credit losses, as Mid Penn is not required to adopt CECL until January 1, 2023, and Mid Penn has not elected to early adopt CECL. PPP loans, both those disbursed in 2020 and those disbursed in 2021, are included in the commercial and industrial classification and, as the PPP loans are fully guaranteed by the SBA, no allowance for loan and lease losses was recorded against the $4,966,000 balance of PPP loans outstanding, net of deferred fees as of June 30, 2022.

For the six months ended June 30, 2022, Mid Penn had net recoveries of $54,000 compared to net loan charge-offs of $816,000 during the same period in 2021. Mid Penn may need to make future adjustments to the allowance and the provision for loan and lease losses if economic conditions or loan credit quality differs substantially from the assumptions used in making Mid Penn’s evaluation of the level of the allowance for loan and lease losses as compared to the balance of outstanding loans.

Changes in the allowance for the three and six months ended June 30, 2022 and 2021 are summarized as follows:

(Dollars in thousands)

Other than as described herein, Mid Penn does not believe there are any trends or events at this time that are reasonably expected to have a material impact on future results of operations, liquidity, or capital resources. Based on known information, Mid Penn believes that the effects of current and past economic conditions and other unfavorable business conditions may eventually impact some borrowers’ abilities to comply with their repayment terms. Accordingly, Mid Penn has adjusted its qualitative factors for economic and external conditions as part of its general component determination primarily in response to the current economic conditions. Mid Penn continues to monitor closely the financial strength of borrowers and the economic conditions impacting them.

Mid Penn does not ordinarily engage in practices which may be used to artificially shield certain borrowers from the negative economic or business cycle effects that may compromise their ability to repay. Mid Penn does not normally structure construction loans with interest reserve components. Mid Penn has not in the past performed any commercial real estate or other type of loan workouts whereby an existing loan was restructured into multiple new loans. Also, Mid Penn does not extend loans at maturity solely due to the existence of guarantees, without recognizing the credit as impaired. While the existence of a guarantee may be a mitigating factor in determining the proper level of allowance once impairment has been identified, the guarantee does not affect the impairment analysis.

The following table presents the change in nonperforming asset categories as of June 30, 2022, December 31, 2021, and June 30, 2021.

(Dollars in thousands)

In the table above, troubled debt restructured loans that are no longer accruing interest are included in nonaccrual loans.

Total nonperforming assets were $8,042,000 at June 30, 2022, a decrease compared to nonperforming assets of $10,497,000 and $8,693,000 at December 31, 2021 and at June 30, 2021, respectively. The decrease in nonperforming assets since December 31, 2021 was primarily the result of the successful workout of two nonaccrual home equity loans amongst one relationship totaling $2,278,000 during the first quarter of 2022. The nonperforming assets included acquired impaired loans assumed in the Riverview transaction of $3,289,000 as of December 31, 2021. One nonaccrual relationship that was resolved during the first quarter is discussed in detail below.

During the first quarter of 2022, an unrelated party acquired the real estate collateral for an amount sufficient to completely payoff the contractual outstanding principal balance of a nonaccrual loan relationship, comprised of two home equity loans acquired in 2018, totaling $2,278,000. As of June 30, 2022, the outstanding principal, any interest due, and all fees were paid off entirely, with no charge-off related to this loan relationship. These loans were transferred from accrual to nonaccrual status during the second quarter of 2020.

Given this credit, nonperforming assets were 0.25% of the total of loans plus other real estate assets as of June 30, 2022, a favorable reduction compared to 0.32% and 0.35% at December 31, 2021 and June 30, 2021, respectively. Loan loss reserves as a percentage of nonperforming loans increased to 211.66% at June 30, 2022, compared to 146.23% and 169.5% at December 31, 2021 and June 30, 2021, respectively.

The contractual outstanding principal balance of one commercial real estate-construction loan relationship accounts for $1,221,000 of the nonperforming loan balance as of June 30, 2022. This loan was acquired in the Riverview transaction in November 2021 while in nonaccrual status. This loan is collateralized primarily by commercial real estate, and given that the fair value of the remaining collateral exceeds the outstanding principal balance, no specific allowance allocation has been currently assigned to this relationship. Management expects to recover the remaining outstanding balance through the sale of real estate collateral pledged in support of the loan.

Mid Penn assesses a specific allocation for both commercial loans and commercial real estate loans prior to writing down or charging off the loan. Once the write-down is taken, the remaining balance remains a nonperforming loan with the original terms and interest rate intact and is not treated as a restructured credit.

The following table provides additional analysis of partially charged-off loans.

(Dollars in thousands)

Mid Penn considers a commercial loan or commercial real estate loan to be impaired when it becomes 90 days or more past due and not well-secured or otherwise not probable for collection. This methodology assumes the borrower cannot or will not continue to make additional payments. At that time the loan would be considered collateral dependent as the discounted cash flow method indicates no operating income is available for evaluating the collateral position; therefore, most impaired loans are deemed to be collateral dependent.

Mid Penn evaluates loans for charge-off on a monthly basis. Policies that govern the recommendation for charge-off are unique to the type of loan being considered. Commercial loans rated as nonaccrual or lower will first have a collateral evaluation completed in accordance with the guidance on impaired loans. Once the collateral evaluation has been completed, a specific allocation of allowance is made based upon the results of the evaluation. The balance remains a nonperforming loan with the original terms and interest rate intact (not restructured). In the event the loan is unsecured, the loan would have been charged-off at the recognition of impairment. Commercial real estate loans rated as impaired will also have an initial collateral evaluation completed in accordance with the guidance on impaired loans. An updated real estate valuation is ordered, and the collateral evaluation is modified to reflect any variation in value. A specific allocation of allowance is made for any anticipated collateral shortfall. The balance remains a nonperforming loan with the original terms and interest rate intact (not restructured). The process of charge-off for residential mortgage loans begins upon a loan becoming delinquent for 90 days and not in the process of collection. The existing appraisal is reviewed, and a lien search is obtained to determine lien position and any instances of intervening liens. A new appraisal of the property will be ordered if deemed necessary by management and a collateral evaluation is completed. The loan will then be charged down to the value indicated in the evaluation. Consumer loans are recommended for charge-off after reaching delinquency of 90 days and the loan is not well-secured or otherwise not probable for collection. The collateral shortfall of the consumer loan is recommended for charge-off at this point.

As noted above, Mid Penn assesses a specific allocation for both commercial loans and commercial real estate loans. The balance remains a nonperforming loan with the original terms and interest rate intact (not restructured). In addition, Mid Penn takes a preemptive step when any commercial loan or commercial real estate loan becomes classified under its internal classification system. A preliminary collateral evaluation in accordance with the guidance on impaired loans is prepared using the existing collateral information in the loan file. This process allows Mid Penn to review both the credit and documentation files to determine the status of the information needed to make a collateral evaluation. This collateral evaluation is preliminary but allows Mid Penn to determine if any potential collateral shortfalls exist.

Larger groups of small-balance loans, such as residential mortgages and consumer installment loans, are collectively evaluated for impairment. Accordingly, individual consumer and residential loans are not separately identified for impairment disclosures unless such loans are the subject of a restructuring agreement.

Mid Penn’s rating system assumes any loans classified as substandard nonaccrual to be impaired, and most of these loans are considered collateral dependent; therefore, most of Mid Penn’s impaired loans, whether reporting a specific allocation or not, are considered collateral dependent.

It is Mid Penn’s policy to obtain updated third-party valuations on all impaired loans collateralized by real estate as soon as practically possible following the credit being classified as substandard nonaccrual. Prior to receipt of the updated real estate valuation Mid Penn will use any existing real estate valuation to determine any potential allowance issues; however, no allowance recommendation will be made until such time Mid Penn is in receipt of the updated valuation. The Asset Recovery department employs an electronic tracking system to monitor the receipt of and need for updated appraisals. To date, there have been no material time lapses noted with the above processes.

In some instances, Mid Penn is not holding real estate as collateral and is relying on business assets (personal property) for repayment. In these circumstances a collateral inspection is performed by Mid Penn personnel to determine an estimated value. The value is based on net book value, as provided by the financial statements, and discounted accordingly based on determinations made by management. Occasionally, Mid Penn will employ an outside service to provide a fair estimate of value based on auction or private sales. Management reviews the estimates of these third parties and discounts them accordingly based on management’s judgment, if deemed necessary.

For impaired loans with no valuation allowance required, Mid Penn’s practice of obtaining independent third-party market valuations on the subject property as soon as practically possible of being placed on nonaccrual status sometimes indicates that the loan to value ratio is sufficient to obviate the need for a specific allocation in spite of significant deterioration in real estate values in Mid Penn’s primary market area. These circumstances are determined on a case-by-case analysis of the impaired loans.

Mid Penn actively monitors the values of collateral on impaired loans. This monitoring may require the modification of collateral values over time or changing circumstances by some factor, either positive or negative, from the original values. All collateral values will be assessed by management at least every 12 months for possible revaluation by an independent third party.

Mid Penn had loans with an aggregate balance of $8,726,000 which were deemed by management to be impaired at June 30, 2022, including $4,700,000 in loans acquired with credit deterioration in connection with the closing of the Phoenix acquisition in 2015, the Scottdale and First Priority acquisitions in 2018, and the Riverview acquisition in 2021. Of the $4,026,000 of impaired loan relationships excluding the loans acquired with credit deterioration, $507,000 were commercial and industrial relationships, $2,106,000 were commercial real estate relationships, $99,000 were home equity relationships, and $1,314,000 were residential relationships. There were specific loan loss reserve allocations of $892,000 against $1,469,000 of commercial real estate loan relationships and $118,000 of specific loan loss reserve allocations against $507,000 of commercial and industrial loan relationships. Management currently believes that the specific reserves are adequate to cover probable future losses related to these relationships.

The allowance is a reserve established in the form of a provision expense for loan and lease losses and is reduced by loan charge-offs net of recoveries. In conjunction with an internal loan review function that operates independently of the lending function, management monitors the loan portfolio to identify risk on a monthly basis so that an appropriate allowance is maintained. Based on an evaluation of the loan portfolio, management presents a monthly review of the allowance to the Board of Directors, indicating any changes in the allowance since the last review. In making the evaluation, management considers the results of recent regulatory examinations, which typically include a review of the allowance as an integral part of the examination process. As part of the examination process, federal or state regulatory agencies may require Mid Penn to recognize additions to the allowance based on their judgments about information available to them at the time of their examination, which may not be currently available to management.

In establishing the allowance, management evaluates on a quantitative basis individual classified loans and nonaccrual loans and determines an aggregate reserve for those loans based on that review. In addition, an allowance for the remainder of the loan and lease portfolio is determined based on historical loss experience within certain components of the portfolio. These allocations may be modified if current conditions indicate that loan and lease losses may differ from historical experience.

In addition, a portion of the allowance is established for losses inherent in the loan and lease portfolio which have not been identified by the quantitative processes described above. This determination inherently involves a higher degree of subjectivity and considers risk factors that may not have yet manifested themselves in historical loss experience. These factors include:

• changes in international, national, regional, and local economic and business conditions and developments that affect the collectability of the portfolio, including the condition of various market segments (and the potential adverse impacts on the economy from the COVID-19 pandemic);
• changes in the volume and severity of past due loans, the volume of nonaccrual loans, and the volume and severity of adversely classified or graded loans;
• changes in the value of underlying collateral for collateral-dependent loans;
• changes in the experience, ability, and depth of lending management and other relevant staff;
• changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere in estimating credit losses;
• changes in the quality of the institution's loan review system;
• changes in the nature and volume of the portfolio and in the terms of loans;
• the effect of other external factors such as competition, legal and regulatory requirements, governmental restrictions impacting business activity as a result of the COVID-19 pandemic, and other factors beyond the control of Mid Penn which could affect the level of estimated credit losses in the institution's existing portfolio; and
• the existence and effect of any concentrations of credit and changes in the level of such concentrations.

While the allowance is maintained at a level believed to be adequate by management to provide for probable losses inherent in the loan and lease portfolio, determination of the allowance is inherently subjective, as it requires estimates, all of which may be susceptible to significant change. The unallocated component of the allowance for loan and lease losses covers several considerations that are not specifically measurable through either the specific or general components. For example, we believe that we could face increasing credit risks and uncertainties, not yet reflected in recent historical losses or qualitative factor assessments and underlying data and evaluations, associated with unpredictable changes in economic growth or business conditions in our markets or for certain industries in which we have commercial loan borrowers, or unanticipated stresses to the values of real estate held as collateral, including the prospective unknown impacts of the persisting COVID-19 pandemic and inflationary environment. Any or all of these additional issues can adversely affect our borrowers’ ability to timely repay their loans. Additionally, we have experienced continued strong commercial loan growth, including growth in newer markets where we have less of a loss history. Also, the unallocated component allocation recognizes the inherent imprecision in our allowance for loan and lease loss methodology, or any alternative methodology, for estimating specific and general loan losses, including the unpredictable timing and amounts of charge-offs, the fact that historical loss averages don’t necessarily correlate to future loss trends, and unexpected changes to specific-credit or general portfolio future cash flows and collateral values which could negatively impact unimpaired portfolio loss factors. Changes from these various other uncertainties and considerations may impact the provisions charged to expense in future periods.

Management believes, based on information currently available, that the allowance for loan and lease losses of $16,876,000 is adequate as of June 30, 2022 to cover specifically identifiable loan losses, as well as estimated losses inherent in our portfolio for which certain losses are probable but not specifically identifiable.

Liquidity

Mid Penn’s objective is to maintain adequate liquidity to meet funding needs at a reasonable cost and to provide contingency plans to meet unanticipated funding needs or a loss of funding sources, while minimizing interest rate risk. Adequate liquidity provides resources for credit needs of borrowers, for depositor withdrawals, and for funding corporate operations. Sources of liquidity are as follows:

• a growing core deposit base;
• proceeds from the sale or maturity of investment securities;
• payments received on loans and mortgage-backed securities;
• overnight correspondent bank borrowings on various credit lines; and
• borrowing capacity available from the FHLB and the Federal Reserve Discount Window available to Mid Penn.

Mid Penn believes its core deposits are generally stable even in periods of changing interest rates. Liquidity is measured and monitored daily, allowing management to better understand and react to balance sheet trends. These measurements indicate that liquidity generally remains stable and exceeds our minimum defined levels of adequacy. Other than the trends of continued competitive pressures and volatile interest rates, and the uncertain impact of the current inflationary environment, there are no known demands, commitments, events, or uncertainties that will result in, or that are reasonably likely to result in, liquidity increasing or decreasing in any material way.

On at least a quarterly basis, a comprehensive liquidity analysis is reviewed by the Asset Liability Committee and Board of Directors. The analysis provides a summary of the current liquidity measurements, projections, and future liquidity positions given various levels of liquidity stress. Management also maintains a detailed Contingency Funding Plan designed to respond to overall stress in the financial condition of the banking industry or a prospective liquidity problem specific to Mid Penn.

The consolidated statements of cash flows provide additional information. Mid Penn’s operating activities during the first six months of 2022 provided $19,441,000 of cash mainly due to net income, partially offset by other operating activities. Cash used in investing activities during the first six months of 2022 was $311,911,000, mainly the result of purchases of investment securities and the net increase in loans and leases. Cash used in financing activities during the first six months of 2022 totaled $384,496,000 primarily the result of a decrease in net deposits and long-term debt repayment.

Subordinated Debt

Subordinated Debt Assumed November 2021 with the Riverview Acquisition

On November 30, 2021, Mid Penn completed its acquisition of Riverview and assumed $25,000,000 of Subordinated Notes (the “Riverview Notes”). In accordance with purchase accounting principles, the Riverview Notes were assigned a fair value premium of $2,302,000. The notes are treated as Tier 2 capital for regulatory reporting purposes.

The Riverview Notes were entered into by Riverview on October 6, 2020 with certain qualified institutional buyers and accredited institutional investors. The Riverview Notes have a maturity date of October 15, 2030 and initially bear interest, payable semi-annually, at a fixed annual rate of 5.75% per annum until October 15, 2025. Commencing on that date, the interest rate applicable to the outstanding principal amount due will be reset quarterly to an interest rate per annum equal to the then current three-month secured overnight financing rate (“SOFR”) plus 563 basis points, payable quarterly until maturity. Mid Penn may redeem the Notes at par, in whole or in part, at its option, anytime beginning on October 15, 2025.

Trust Preferred Securities Assumed November 2021 with the Riverview Acquisition

As a result of the merger with Riverview, Mid Penn assumed the subordinated debentures that Riverview had assumed in its acquisition of CBT Financial Corp. (“CBT”) on October 1, 2017 (the “CBT 2017 Notes”). In 2003, a trust formed by CBT issued $5,155,000 of floating rate trust preferred securities as part of a pooled offering of such securities. The interest rate prior to Riverview entering into a fixed interest rate swap in 2020 adjusted quarterly to the three-month LIBOR rate plus 2.95%. CBT issued subordinated debentures to the trust in exchange for ownership of all of the common securities of the trust and the proceeds of the offering; the debentures represent the sole asset of the trust. CBT became eligible to redeem the subordinated debentures, in whole but not in part, beginning in 2008 at a price of 100% of face value. The subordinated debentures must be redeemed no later than 2033.

Similarly, in 2005, a trust formed by CBT issued $4,124,000 of fixed rate trust preferred securities as part of a pooled offering of such securities (the “CBT 2015 Notes”). CBT issued subordinated debentures to the trust in exchange for ownership of all of the common securities of the trust and the proceeds of the offering; the debentures represent the sole asset of the trust. CBT became eligible to redeem the subordinated debentures, in whole but not in part, beginning in 2010 at a price of 100% of face value. Interest payments on the debentures may be deferred at any time at the election of Mid Penn for up to 20 consecutive quarterly periods. Interest on the debentures will accrue during the extension period, and all accrued principal and interest must be paid at the end of the extension period. During an extension period, Mid Penn may not declare or pay any dividends or distributions on, or redeem, purchase, acquire, or make a liquidation payment with respect to any of Mid Penn’s capital stock.

In accordance with purchase accounting principles, the CBT 2017 Notes and CBT 2015 Notes assumed from Riverview were assigned a fair value premium of $6,000. The subordinated debentures are treated as Tier 1 capital for regulatory reporting purposes.

On December 22, 2020, Mid Penn Bancorp, Inc. entered into agreements for and sold, at 100% of their principal amount, an aggregate of $12,150,000 of its Subordinated Notes due December 2030 (the “December 2020 Notes”) on a private placement basis to accredited investors. The December 2020 Notes are treated as Tier 2 capital for regulatory capital purposes.

The December 2020 Notes bear interest at a rate of 4.5% per year for the first five years and then float at the Wall Street Journal’s Prime Rate, provided that the interest rate applicable to the outstanding principal balance during the period the December 2020 Notes are floating will at no time be less than 4.5%. Interest is payable quarterly in arrears on March 31, June 30, September 30 and December 31 of each year, beginning on March 31, 2021. The December 2020 Notes will mature on December 31, 2030 and are redeemable, in whole or in part, without premium or penalty, on any interest payment date on or after December 31, 2025 and prior to December 31, 2030, subject to any required regulatory approvals. Additionally, if (i) all or any portion of the December 2020 Notes cease to be deemed Tier 2 Capital, (ii) interest on the December 2020 Notes fails to be deductible for United States federal income tax purposes, or (iii) Mid Penn will be considered an “investment company,” Mid Penn may redeem the December 2020 Notes, in whole but not in part, by giving 10 days’ notice to the holders of the December 2020 Notes. In the event of a redemption described in the previous sentence, Mid Penn will redeem the December 2020 Notes at 100% of the principal amount of the December 2020 Notes, plus accrued and unpaid interest thereon to but excluding the date of redemption.

Holders of the December 2020 Notes may not accelerate the maturity of the December 2020 Notes, except upon the bankruptcy, insolvency, liquidation, receivership or similar event of Mid Penn or Mid Penn Bank, its principal banking subsidiary. Related parties held $750,000 of the December 2020 Notes as of June 30, 2022 and December 31, 2021.

Subordinated Debt Issued March 2020

On March 20, 2020, Mid Penn Bancorp, Inc. entered into agreements with accredited investors who purchased $15,000,000 aggregate principal amount of Mid Penn Subordinated Notes due March 2030 (the “March 2020 Notes”). As a result of Mid Penn’s merger with Riverview on November 30, 2021, $6,870,000 of the March 2020 Notes balance was redeemed as Riverview was a holder of the March 2020 Notes. The balance of March 2020 Notes outstanding as of June 30, 2022 was $8,130,000. The March 2020 Notes are intended to be treated as Tier 2 capital for regulatory capital purposes.

The March 2020 Notes bear interest at a rate of 4.0% per year for the first five years and then float at the Wall Street Journal’s Prime Rate, provided that the interest rate applicable to the outstanding principal balance during the period the March 2020 Notes are floating will at no time be less than 4.25%. Interest is payable semi-annually in arrears on June 30 and December 30 of each year, beginning on June 30, 2020, for the first five years after issuance and will be payable quarterly in arrears thereafter on March 30, June 30, September 30 and December 30. The March 2020 Notes will mature on March 30, 2030 and are redeemable in whole or in part, without premium or penalty, at any time on or after March 30, 2025 and prior to March 30, 2030. Additionally, if all or any portion of the March 2020 Notes cease to be deemed Tier 2 Capital, Mid Penn may redeem, on any interest payment date, all or part of the 2020 Notes. In the event of a redemption described in the previous sentence, Mid Penn will redeem the March 2020 Notes at 100% of the principal amount of the March 2020 Notes, plus accrued and unpaid interest thereon to but excluding the date of redemption.

Holders of the March 2020 Notes may not accelerate the maturity of the March 2020 Notes, except upon the bankruptcy, insolvency, liquidation, receivership or similar event of Mid Penn or Mid Penn Bank, its principal banking subsidiary. Related parties held $1,700,000 of the March 2020 Notes as of June 30, 2022 and December 31, 2021.

On December 19, 2017, Mid Penn Bancorp, Inc. entered into agreements with investors to purchase $10,000,000 aggregate principal amount of its Subordinated Notes due 2028 (the “2017 Notes”). The 2017 Notes are intended to be treated as Tier 2 capital for regulatory capital purposes. The offering closed in December 2017.

The 2017 Notes bear interest at a rate of 5.25% per year for the first five years and then float at the Wall Street Journal’s Prime Rate plus 0.50%, provided that the interest rate applicable to the outstanding principal balance will at no time be less than 5.0%. Interest is payable semi-annually in arrears on January 15 and July 15 of each year, beginning on July 15, 2018, for the first five years after issuance and will be payable quarterly in arrears thereafter on January 15, April 15, July 15, and October 15. The 2017 Notes will mature on January 1, 2028 and are redeemable in whole or in part, without premium or penalty, at any time on or after December 21, 2022, and prior to January 1, 2028. Additionally, Mid Penn may redeem the 2017 Notes in whole at any time, or in part from time to time, upon at least 30 days’ notice if: (i) a change or prospective change in law occurs that could prevent Mid Penn from deducting interest payable on the 2017 Notes for U.S. federal income tax purposes; (ii) an event occurs that precludes the 2017 Notes from being recognized as Tier 2 capital for regulatory capital purposes; or (iii) Mid Penn becomes required to register as an investment company under the Investment Company Act of 1940, as amended. In the event of a redemption described in the previous sentence, Mid Penn will redeem the 2017 Notes at 100% of the principal amount of the 2017 Notes, plus accrued and unpaid interest thereon to but excluding the date of redemption.

Holders of the 2017 Notes may not accelerate the maturity of the 2017 Notes, except upon the bankruptcy, insolvency, liquidation, receivership or similar event of Mid Penn or Mid Penn Bank, its principal banking subsidiary. Related parties held $1,450,000 of the 2017 Notes as of June 30, 2022 and December 31, 2021.

On December 9, 2015, Mid Penn Bancorp, Inc. sold $7,500,000 aggregate principal amount of Subordinated Debt (the “2015 Notes”) due in 2025. Given that the 2015 Notes are in the sixth year since issuance, eighty percent of the principal balance of the notes is treated as Tier 2 capital for regulatory capital purposes as of June 30, 2022.

The 2015 Notes paid interest at a rate of 5.15% per year for the first five years outstanding, including the three months ended June 30, 2020. Beginning January 1, 2021, the 2015 Notes bear interest at a floating rate based on the Wall Street Journal’s Prime Rate plus 0.50%, provided that the interest rate applicable to the outstanding principal balance will at no time be less than 4.0%. Interest is payable quarterly in arrears on January 1, April 1, July 1 and October 1 of each year, beginning on January 1, 2016. The 2015 Notes will mature on December 9, 2025 and are redeemable in whole or in part, without premium or penalty, at any time on or after December 9, 2020, and prior to December 9, 2025. Additionally, Mid Penn may redeem the 2015 Notes in whole at any time, or in part from time to time, upon at least 30 days’ notice if: (i) a change or prospective change in law occurs that could prevent Mid Penn from deducting interest payable on the 2015 Notes for U.S. federal income tax purposes; (ii) an event occurs that precludes the 2015 Notes from being recognized as Tier 2 capital for regulatory capital purposes; or (iii) Mid Penn becomes required to register as an investment company under the Investment Company Act of 1940, as amended, in each case at 100% of the principal amount of the 2015 Notes, plus accrued and unpaid interest thereon to but excluding the date of redemption.

Holders of the 2015 Notes may not accelerate the maturity of the 2015 Notes, except upon Mid Penn’s or Mid Penn Bank’s bankruptcy, insolvency, liquidation, receivership or similar event. Related parties held $1,930,000 of the 2015 Notes as of June 30, 2022 and December 31, 2021.

ASC Subtopic 835-30, Simplifying the Presentation of Debt Issuance Costs, requires that debt issuance costs be reported in the balance sheet as a direct deduction from the face amount of the related liability. The unamortized debt issuance costs associated with the 2015 Notes and the 2017 Notes were collectively $31,000 at June 30, 2022 and $44,000 at December 31, 2021.

Regulatory Capital Changes

In July 2013, the federal banking agencies issued final rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. The final rules implemented higher minimum capital requirements, added a new common equity Tier 1 capital requirement, and established criteria that instruments must meet to be considered common equity Tier 1 capital, additional Tier 1 capital or Tier 2 capital. Under the new rules, in order to avoid limitations on capital distributions (including dividend payments and certain discretionary bonus payments to executive officers), a banking organization must hold a capital conservation buffer comprised of common equity Tier 1 capital above its minimum risk-based capital requirements, which amount must be greater than 2.5% of total risk-weighted assets.

A summary of the payout restrictions based on the capital conservation buffer is as follows:

The final rules allowed community banks to make a one-time election not to include the additional components of accumulated other comprehensive income (“AOCI”) in regulatory capital and instead use the existing treatment under the general risk-based capital rules that excludes most AOCI components from regulatory capital. Mid Penn made the election not to include the additional components of AOCI in regulatory capital.

Consistent with the Dodd-Frank Act, the new rules replaced the ratings-based approach to securitization exposures, which is based on external credit ratings, with the simplified supervisory formula approach in order to determine the appropriate risk weights for these exposures. Alternatively, banking organizations may use the existing gross-ups approach to assign securitization exposures to a risk weight category or choose to assign such exposures a 1,250% risk weight.

Under the new rules, mortgage servicing assets and certain deferred tax assets are subject to stricter limitations than those applicable under the current general risk-based capital rule. The new rules also increase the risk weights for past-due loans, certain risk weights and credit conversion factors.

Mid Penn has implemented these changes in determining and reporting the regulatory ratios of Mid Penn and the Bank and has concluded that the new rules do not have a material adverse effect on Mid Penn’s financial condition.

Capital Resources

Shareholders' equity, or capital, is evaluated in relation to total assets and the risk associated with those assets, and the desire to collectively maintain and enhance shareholders’ value, and satisfactorily address regulatory capital requirements. Accordingly, capital management has been, and will continue to be, of paramount importance to Mid Penn.

Shareholders’ equity increased by $5,759,000, or 1.2%, from $490,076,000 as of December 31, 2021 to $495,832,000 as of June 30, 2022, primarily due to earnings of $23,606,000 partially offset by a decrease in the carrying value of the available-for-sale investment portfolio of $9,917,000, dividends declared of $6,384,000 and stock repurchases of $2,181,000. As previously announced, Mid Penn completed a public offering of 2,990,000 shares of common stock at a price of $25.00 per share in May 2021, with the aggregate gross proceeds of the offering totaling $74,750,000. The net proceeds of the offering after deducting the underwriting discount and offering expenses were $70,238,000. The additional shares issued on May 4, 2021 significantly impacted the weighted average number of shares outstanding used for the earnings per share calculation for the three and six months ended June 30, 2022 compared to the three and six months ended June 30, 2021.

Banks are evaluated for capital adequacy by regulatory supervisory agencies based on the ratio of capital to risk-weighted assets and total assets. The minimum capital to risk-weighted assets requirements, including the capital conservation buffers, which became effective for Mid Penn and the Bank on January 1, 2016 are illustrated below. At June 30, 2022, regulatory capital ratios for both Mid Penn and the Bank met the definition of a “well-capitalized” institution under the regulatory framework for prompt corrective action, and exceeded the minimum capital requirements under Basel III.

Mid Penn and Mid Penn Bank maintained the following regulatory capital levels, leverage ratios, and risk-based capital ratios as of June 30, 2022 and December 31, 2021:

(Dollars in thousands)

(a) Minimum amounts and ratios include the full phase in of the capital conservation buffer of 2.5% required by the Basel III framework.

RECONCILIATION OF NON-GAAP MEASURES (Unaudited):

This Form 10-Q contains financial information determined by methods other than in accordance with GAAP. Mid Penn believes that reporting core banking loans is useful to investors as they reflect portfolio loans and related growth from traditional bank activities and excludes short-term or nonrecurring loans from special programs like the PPP. The ratio of the allowance for loan and lease losses to core banking loans is useful to investors as it highlights the true coverage ratio of the allowance excluding those loans that are 100% guaranteed by the SBA through the PPP and, therefore, do not require an allowance assessment. These non-GAAP disclosures have limitations as an analytical tool, should not be viewed as a substitute for financial measures determined in accordance with GAAP, and should not be considered in isolation or as a substitute for analysis of Mid Penn’s results and financial condition as reported under GAAP, nor is it necessarily comparable to non-GAAP performance measures that may be presented by other companies. Management believes that this non-GAAP supplemental information will be helpful in understanding Mid Penn’s ongoing operating results. This supplemental presentation should not be construed as an inference that Mid Penn’s future results will be unaffected by similar adjustments to be determined in accordance with GAAP.

(Dollars in thousands)

65

As a financial institution, Mid Penn’s primary source of market risk is interest rate risk. Interest rate risk is the exposure to fluctuations in Mid Penn’s future earnings, earnings at risk, resulting from changes in interest rates. This exposure or sensitivity is a function of the repricing characteristics of Mid Penn's portfolio of assets and liabilities. Each asset and liability reprices either at maturity or during the life of the instrument. Interest rate sensitivity is measured as the difference between the volume of assets and liabilities that are subject to repricing in a future period of time.

The principal purpose of asset-liability management is to maximize current and future net interest income within acceptable levels of interest rate risk while satisfying liquidity and capital requirements. Net interest income is increased by increasing the net interest margin and by volume growth. Thus, the goal of interest rate risk management is to maintain a balance between risk and reward such that net interest income is maximized while risk is maintained at an acceptable level.

Mid Penn utilizes an asset-liability management model to measure the impact of interest rate movements on its interest rate sensitivity position. Mid Penn’s management also reviews the traditional maturity gap analysis regularly. Mid Penn does not always attempt to achieve an exact match between interest sensitive assets and liabilities because it believes that an actively managed amount of interest rate risk is inherent and appropriate in the management of Mid Penn’s profitability.

Modeling techniques and simulation analysis involve assumptions and estimates that inherently cannot be measured with complete precision. Key assumptions in the analyses include maturity and repricing characteristics of assets and liabilities, prepayments on amortizing assets, non-maturing deposit sensitivity, and loan and deposit pricing. These assumptions are inherently uncertain due to the timing, magnitude and frequency of rate changes and changes in market conditions and management strategies, among other factors. However, the analyses are useful in quantifying risk and provide a relative gauge of Mid Penn’s interest rate risk position over time.

Management reviews interest rate risk on a quarterly basis. This analysis includes earnings scenarios whereby interest rates are increased by 100, 200, 300 and 400 basis points and decreased by 100 basis points. These scenarios, detailed in the table below, indicate that Mid Penn would experience enhanced net interest income over a one-year time frame due to upward interest rate changes, while a reduction in interest rates would result in a decline in net interest income over a one-year time frame; however, actual results could vary significantly from the calculations prepared by management. At June 30, 2022, all interest rate risk levels according to the model were within the tolerance limits of the Board-approved policy.

Evaluation of Disclosure Controls and Procedures

Mid Penn maintains controls and procedures designed to ensure that information required to be disclosed in the reports that Mid Penn files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. Based upon their evaluation of those controls and procedures as of June 30, 2022, Mid Penn’s management, with the participation of the Principal Executive Officer and Principal Financial Officer, concluded that the disclosure controls and procedures were effective as of such date.

Changes in Internal Controls

There were no changes in Mid Penn’s internal control over financial reporting that have materially affected, or are reasonable likely to materially affect, Mid Penn’s internal control over financial reporting during the six months ended June 30, 2022.

Management has reviewed the risk factors that were previously disclosed in the Annual Report on Form 10-K for the fiscal year ended December 31, 2021, to determine if there were material changes applicable to the six months ended June 30, 2022. There are no material changes to such risk factors.