BayFirst Financial Corp.: Form 10-Q for the period ended Sep 30, 2023

The following discussion is an analysis of the results of operations for the three and nine months ended September 30, 2023 and September 30, 2022 and financial condition as of September 30, 2023 and December 31, 2022. This discussion and analysis should be read in conjunction with the consolidated financial statements and related notes.

In addition to the historical information contained herein, this Form 10-Q includes "forward-looking statements" within the meaning of such term in the Private Securities Litigation Reform Act of 1995. These statements are subject to many risks and uncertainties, including, but not limited to, the effects of health crises, global military hostilities, or climate changes, including its effects on the economic environment, its customers and its operations, as well as any changes to federal, state or local government laws, regulations or orders in connection with them; the ability of the Company to implement its strategy and expand its banking operations; changes in interest rates and other general economic, business and political conditions, including changes in the financial markets or global military hostilities; changes in business plans as circumstances warrant; risks related to mergers and acquisitions; changes in benchmark interest rates used to price loans and deposits, changes in tax laws, regulations and guidance; and other risks detailed from time to time in filings made by the Company with the SEC. Readers should note that the forward-looking statements included herein are not a guarantee of future events, and that actual events may differ materially from those made in or suggested by the forward-looking statements.

Forward-looking statements generally can be identified by the use of forward-looking terminology such as "will," "propose," "may," "plan," "seek," "expect," "intend," "estimate," "anticipate," "believe," "continue," or similar terminology. Any forward-looking statements presented herein are made only as of the date of this document, and the Company does not undertake any obligation to update or revise any forward-looking statements to reflect changes in assumptions, the occurrence of unanticipated events, or otherwise.

Overview

The following discussion and analysis presents the financial condition and results of operations on a consolidated basis. However, because the Company conducts all of its material business operations through the Bank, the discussion and analysis relates to activities primarily conducted at the subsidiary level. The following discussion should be read in conjunction with the consolidated financial statements.

As a one-bank holding company, the Company generates most of its revenue from interest on loans and gain-on-sale income derived from the sale of government guaranteed loans into the secondary market. The primary source of funding for its loans is deposits. The Company is dependent on noninterest income, which is derived primarily from net gain on the sales of the guaranteed portion of government guaranteed loans. The largest expenses are interest on those deposits and borrowings, professional fees, and salaries and commissions plus related employee benefits. The Company measures its performance through its net interest income after provision for credit losses, return on average assets, and return on average common equity, while maintaining appropriate regulatory leverage and risk-based capital ratios.

Application of Critical Accounting Policies and Estimates

The preparation of consolidated financial statements in accordance with GAAP requires the Company to make estimates and judgments that affect reported amounts of assets, liabilities, income and expenses and related disclosure of contingent assets and liabilities. The Company bases those estimates on historical experience and on various other assumptions that are believed to be reasonable under current circumstances, results of which form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily available from other sources. Estimates are evaluated on an ongoing basis. Actual results may differ from these estimates.

Accounting policies, as described in detail in the notes to the Company’s consolidated financial statements, are an integral part of the Company’s consolidated financial statements. A thorough understanding of these accounting policies is essential when reviewing the Company’s reported results of operations and financial position. Management believes that the critical accounting policies and estimates listed below require the Company to make difficult, subjective or complex judgments about matters that are inherently uncertain. At September 30, 2023, the most critical of these significant accounting policies in understanding the estimates and assumptions involved in preparing the consolidated financial statements were the policies related to the ACL, and fair value measurement of investment securities, government guaranteed servicing rights, and government guaranteed loans held for investment at fair value, which are discussed more fully below.

Allowance for Credit Losses

The ACL is calculated with the objective of maintaining a reserve sufficient to absorb estimated losses. Management's determination of the appropriateness of the allowance is based on periodic evaluations of the loan portfolio, lending-related commitments, and other relevant factors. This evaluation is inherently subjective as it requires numerous estimates, including the loss for internal risk ratings, collateral values, and the amounts and timing of expected future cash flows. The Company’s ACL on loans is estimated using relevant information, from internal and external sources, relating to past events, current conditions, and reasonable and supportable forecasts. In addition, management may include qualitative adjustments intended to capture the impact of other uncertainties in the lending environment such as underwriting standards, current economic and political conditions, and other factors affecting the credit quality. Changes to one or more of the estimates used could result in a different estimated ACL.

Fair Value Measurements

Investments and certain government guaranteed loans are recorded at fair value on a recurring basis. Additionally, from time to time, other assets and liabilities may be recorded at fair value on a nonrecurring basis, such as impaired loans, other real estate, government guaranteed servicing rights, and certain other assets and liabilities. Fair value is an estimate of the exchange price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (i.e., not a forced transaction, such as a liquidation or distressed sale) between market participants at the measurement date and is based on the assumptions market participants would use when pricing an asset or liability. Fair value measurement and disclosure guidance establishes a three-level hierarchy for disclosure of assets and liabilities recorded at fair value. Valuations generated from model-based techniques that use at least one significant assumption not observable in the market are considered Level 3 and reflect estimates of assumptions market participants would use in pricing the asset or liability.

Changes in these estimates that are likely to occur from period to period, or the use of different estimates that the Company could have reasonably used in the current period, could have a material impact on the Company’s financial position or results of operation.

Further, the Company is an emerging growth company. The JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies are required to comply with the new or revised financial accounting standards. The JOBS Act provides that an emerging growth company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such election to opt out is irrevocable. The Company has elected to take advantage of this extended transition period. This means that when a standard is issued or revised and it has different application dates for public or private companies, the Company, as an emerging growth company, can adopt the new or revised standard at the time private companies do so. This may make the Company’s financial statements not comparable with those of public companies which are neither an emerging growth company nor an emerging growth company which has opted out of using the extended transition period because of the potential differences in accounting standards used.

Recent Developments

Preferred Stock Offering. On September 30, 2023, the Company issued 1,835 shares of 11.0% Series C Cumulative Convertible Preferred Stock. These shares have no par value and a liquidation preference of $1,000 per share plus an amount equal to all accumulated dividends thereon (whether or not earned or declared but without interest) to the date payment of such distribution is made in full. An additional 1,995 shares and 1,760 shares were issued on October 18, 2023 and October 31, 2023, respectively. Total gross proceeds from the preferred stock offering currently totals $5.59 million, which will be used for operating expenses or to contribute capital to BayFirst National Bank to support its growth and operations.

Fourth Quarter Common Stock Dividend. On October 24, 2023, BayFirst’s Board of Directors declared a fourth quarter 2023 cash dividend of $0.08 per common share, payable December 15, 2023 to common shareholders of record as of December 1, 2023. This dividend marks the 30th consecutive quarterly cash dividend paid since BayFirst initiated cash dividends in 2016.

Fourth Quarter Preferred Series A Stock Dividend. BayFirst’s Board of Directors declared a quarterly cash dividend of $22.50 on the Series A Preferred Stock. The dividend will be payable January 2, 2024 to shareholders of record as of October 16, 2023. The amount and timing of the dividend is in accordance with the terms of the Series A Preferred Stock.

Fourth Quarter Preferred Series B Stock Dividend. BayFirst’s Board of Directors declared a quarterly cash dividend of $20.00 on the Series B Convertible Preferred Stock. The dividend will be payable January 2, 2024 to shareholders of record as of October 16, 2023. The amount and timing of the dividend is in accordance with the terms of the Series B Convertible Preferred Stock.

Fourth Quarter Preferred Series C Stock Dividend. BayFirst’s Board of Directors declared a quarterly cash dividend of $27.50 on the Series C Cumulative Convertible Preferred Stock. The dividend will be payable January 2, 2024 to shareholders of record as of October 16, 2023. The amount and timing of the dividend is in accordance with the terms of the Series C Cumulative Convertible Preferred Stock.

Selected Financial Data - Unaudited

(Dollars in thousands, except for share data)

44

(Dollars in thousands, except for share data)

GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures

Some of the financial measures included in this report are not measures of financial condition or performance recognized by GAAP. These non-GAAP financial measures include tangible common shareholders' equity and tangible book value per common share. The management team uses these non-GAAP financial measures in its analysis of its performance, and they believe that providing this information to financial analysts and investors allows them to evaluate capital adequacy.

The following presents these non-GAAP financial measures along with their most directly comparable financial measures calculated in accordance with GAAP:

Tangible Common Shareholders' Equity and Tangible Book Value Per Common Share

(Dollars in thousands, except for share data)

(Unaudited)

(Unaudited)

(Unaudited)

Results of Operations

BayFirst’s operating results depend on its net interest income, which is the difference between interest income on interest-earning assets and interest expense on interest-bearing liabilities, consisting primarily of deposits. Net interest income is determined by the difference between yields earned on interest-earning assets and rates paid on interest-bearing liabilities (“interest rate spread”) and the relative amounts of interest-earning assets and interest-bearing liabilities. The interest rate spread is affected by regulatory, economic, and competitive factors which influence interest rates, loan demand, and deposit flows. In addition, its operating results can be affected by the level of nonperforming assets, as well as the level of the noninterest income and the noninterest expenses, such as salaries and employee benefits, and occupancy and equipment costs, as well as income taxes.

The Company is dependent on noninterest income, which is derived primarily from net gain on the sales of the guaranteed portion of government guaranteed loans, as well as fair value adjustments for certain loans which management has elected the fair value option. While the Company retains some of its government guaranteed loans on the balance sheet, the Company may sell both the guaranteed balance of its government guaranteed loans, as well as a percentage of the unguaranteed portions of such loans.

In the second quarter of 2022, the Bank discontinued its primary consumer direct residential mortgage business line. In the third quarter of 2022, management decided to discontinue the nationwide residential lending business. As a result of the discontinuance, the nationwide residential line of business was reclassified as a discontinued operation and reported in the financial statements as such.

Net Income

The Company had net income for the three months ended September 30, 2023 of $1.9 million, or $0.41 per diluted common share, compared to net loss for the three months ended September 30, 2022 of $1.4 million, or $0.35 per diluted common share. The increase of $3.3 million was due to an increase in gain on sale of government guaranteed loans of $3.5 million, an increase in other noninterest income of $1.4 million, and a decrease of $4.4 million in the net loss on discontinued operations. This was partially offset by a decrease in net interest income of $0.8 million, an increase of $2.3 million in provision for credit losses and an increase in noninterest expense of $3.3 million. In the third quarter of 2022, the Company made the strategic decision to discontinue the Bank’s nationwide residential mortgage operations which resulted in the net loss from discontinued operations.

In the first nine months of 2023, net income was $4.0 million, or $0.83 per diluted common share, an increase of $5.7 million from the net loss of $1.7 million, or $0.48 per diluted common share, for the first nine months of 2022. The increase was primarily the result of higher interest income from continuing operations of $23.6 million, an increase of $7.5 million in government guaranteed loan fair value gains, an increase in other noninterest income of $1.9 million, an increase of $1.7 million in gain on sale of government guaranteed loans, and a decrease of $4.8 million in net loss from discontinued operations. This was partially offset by an increase of $16.9 million in interest expense on deposits, an increase of $9.1 million in provision for credit losses, and an increase of $7.5 million in noninterest expense.

Net Interest Income

Net interest income from continuing operations was $8.4 million in the three months ended September 30, 2023, a decrease of $0.8 million or 8.5% from $9.2 million in the three months ended September 30, 2022. The decrease was mainly due to higher interest expense on deposits of $7.2 million, partially offset by an increase in loan interest income, including fees, of $5.4 million. The margin compression was primarily from higher deposit interest expense during the current quarter, specifically the Company's 6%, 13-month time deposit special, which ended on August 31, 2023. The additional time deposits, which replaced other non-core funding, will fund current and future small dollar SBA loans currently earning Prime plus 4.75%. Although time deposit balances increased in the third quarter, $71 million of time deposits are maturing in the fourth quarter of 2023, the majority of which are not expected to renew.

Net interest margin including discontinued operations decreased to 3.36% for the third quarter of 2023, which represented a decrease of 128 basis points from 4.63% for the third quarter of 2022.

Net interest income from continuing operations was $27.6 million for the nine months ended September 30, 2023, an increase of $6.1 million or 28.6% from $21.4 million for the nine months ended September 30, 2022. The increase was mainly due to an increase in loan interest income, including fees, of $20.7 million, partially offset by an increase in deposit interest expense of $16.9 million.

Net interest margin including discontinued operations decreased slightly to 3.89% for the nine months ended September 30, 2023, compared to 3.90% for the nine months ended September 30, 2022.

Average Balance Sheet and Analysis of Net Interest Income

The following table sets forth, for the periods indicated, information regarding: (i) the total dollar amount of interest and dividend income of BayFirst from interest-earning assets and the resultant average yields; (ii) the total dollar amount of interest expense on interest-bearing liabilities and the resultant average cost; (iii) net interest income; (iv) interest rate spread; (v) net interest margin; and (vi) ratio of average interest-earning assets to average interest-bearing liabilities. Loans in nonaccrual status, for the purposes of the following computations, are included in the average loan balances. FRB,

FHLB, and FNBB restricted equity holdings are included in other interest-earning assets. The Company did not have a significant amount of tax-exempt assets.

(Dollars in thousands)

48

(Dollars in thousands)

Rate/Volume Analysis

The table below presents the effects of volume and rate changes on interest income and expense for the periods indicated. Changes in volume are changes in the average balance multiplied by the previous period’s average rate. Changes in rate are changes in the average rate multiplied by the average balance from the previous period. The net changes attributable to the combined impact of both rate and volume have been allocated proportionately to the changes due to volume and the changes due to rate. Loans in nonaccrual status, for the purpose of the following computations, are included in the average loan balances. FRB, FHLB, and FNBB restricted equity holdings are included in other interest-earning assets. The Company did not have a significant amount of tax-exempt assets.

(Dollars in thousands)

(Dollars in thousands)

Provision for Credit Losses

The provision for credit losses is charged to operations to adjust the total allowance to a level deemed appropriate by management and is based upon the volume and type of lending the Bank conducts, industry standards, the amount of nonperforming loans, general economic conditions, particularly as they relate to its market area, economic forecasts, and other factors that may affect the ability to collect on the loans in its portfolio.

The Company recorded a provision for credit losses on loans in the three months ended September 30, 2023 of $3.0 million primarily due to net charge-offs and net loan growth. This compared to a provision of $0.8 million under the incurred loss methodology for the three months ended September 30, 2022. During the three months ended September 30, 2023, $2.2 million of net charge offs in loans were recorded compared to $0.6 million during the three months ended September 30, 2022.

The Company recorded a provision for credit losses for the nine months ended September 30, 2023 of $7.7 million compared to a $1.4 million negative provision under the incurred loss methodology for the nine months ended September 30, 2022. The increase of $9.1 million in the provision for credit losses expense was primarily due to loan growth, higher charge-offs, and the Company having reduced its ALLL under the incurred loss methodology in 2022 from the historic high levels reached in 2020 at the onset of the COVID-19 pandemic. During the nine months ended

September 30, 2023, net loan charge offs totaled $6.4 million compared to $2.3 million during the nine months ended September 30, 2022. Net charge-offs for the first three quarters of 2023 were elevated by $1.9 million due to the performance from a purchased portfolio of unsecured consumer loans. This portfolio currently has $0.9 million of loans 30-89 days past due and $0.4 million of loans 90+ days past due. The Company stopped purchasing these loans at the end of 2022 and the portfolio balances have decreased from $29.4 million to $19.6 million since the beginning of 2023.

The ACL was $13.4 million at September 30, 2023 and $9.7 million using the incurred losses methodology at September 30, 2022.

Noninterest Income

The following table presents noninterest income from continuing operations for the three and nine months ended September 30, 2023 and September 30, 2022.

(Dollars in thousands)

Noninterest income from continuing operations was $14.7 million during the three months ended September 30, 2023, an increase of $4.9 million or 49.7%, from $9.8 million during the three months ended September 30, 2022. The increase was the result of increases in fair value gains related to held for investment government guaranteed loans of $3.5 million and higher government guaranteed loan packaging fees of $1.0 million.

Noninterest income from continuing operations was $35.1 million for the nine months ended September 30, 2023, an increase of $11.9 million or 51.5% from $23.1 million for the nine months ended September 30, 2022. The increase was primarily due to higher gains on the sale of government guaranteed loans of $1.7 million, a $7.5 million increase in fair value gains related to held for investment government guaranteed loans, and an increase in government guaranteed loan packaging fees of $1.6 million. The increase in fair value gains related to held for investment government guaranteed loans was primarily related to an increase in the volume of loans held at fair value. As of September 30, 2023, the Company had $84.2 million compared to $25.0 million at September 30, 2022.

Noninterest Expense

The following table presents noninterest expense from continuing operations for the three and nine months ended September 30, 2023 and September 30, 2022.

(Dollars in thousands)

Noninterest expense from continuing operations was $17.4 million during the three months ended September 30, 2023, an increase of $3.3 million or 23.1% from $14.2 million during the three months ended September 30, 2022. The increase was primarily due to higher compensation costs of $1.7 million and higher loan origination expense of $0.9 million.

Noninterest expense was $49.2 million during the nine months ended September 30, 2023, an increase of $7.5 million or 18.0% from $41.7 million for the nine months ended September 30, 2022. The increase was primarily the result of higher compensation costs and loan origination and collection expense.

Discontinued Operations

Net loss on discontinued operations was $47 thousand in the three months ended September 30, 2023, which was a $4.4 million favorable change from a net loss of $4.5 million in the three months ended September 30, 2022. The loss in the third quarter of 2023 was partially due to lagging facilities costs as we seek to sublease vacant space. The $4.4 million decrease in the net loss from the year-ago quarter was primarily due to a decrease in noninterest expense of $13.9 million, partially offset by decreases in residential loan fee income of $7.1 million, interest income of $0.9 million, and income tax benefit of $1.5 million. In the third quarter of 2022, the Company recognized $3.7 million of restructuring charges from the discontinuation of the residential mortgage operations which was recorded to noninterest expense.

Net loss from discontinued operations was $207 thousand for the nine months ended September 30, 2023, which was a $4.8 million reduction from a net loss of $5.0 million for the nine months ended September 30, 2022. The majority of the discontinued loss in 2022 was recorded in the third quarter of 2022. As such, the net loss from discontinued operations for the first nine months of 2022 included restructuring charges of $4.3 million and the discontinued loss in the first nine months of 2023 represented a modest amount of trailing expenses from the discontinuation.

Income Taxes

Income tax expense from continuing operations was $674 thousand for the three months ended September 30, 2023, a decrease of $309 thousand from income tax expense of $983 thousand for the three months ended September 30, 2022. The decrease was primarily due to the decrease in pre-tax earnings from continuing operations. Income tax benefit from discontinued operations was $15 thousand for the three months ended September 30, 2023, compared to income tax benefit of $1.5 million for the three months ended September 30, 2022. The change was primarily due to the decrease in pre-tax loss from discontinued operations.

Income tax expense from continuing operations was $1.4 million for the nine months ended September 30, 2023, an increase of $0.5 million from income tax expense of $0.9 million for the nine months ended September 30, 2022. The increase was primarily due to the increase in pre-tax earnings from continuing operations. Income tax benefit from discontinued operations was $68 thousand for the nine months ended September 30, 2023, a change of $1.6 million from income tax benefit of $1.7 million for the nine months ended September 30, 2022. The change was primarily due to the decrease in pre-tax loss from discontinued operations.

At September 30, 2023, the Company had $2.7 million of federal net operating loss carryforward and $0.4 million of state net operating loss carryforward. The net operating loss carryforwards do not expire. At September 30, 2022, the Company had $2.4 million of federal net operating loss carryforward and $0.4 million of state net operating loss carryforward.

The effective income tax rate was 24.97% for the nine months ended September 30, 2023 and 31.88% for the nine months ended September 30, 2022.

Financial Condition

Investment Securities

The following table presents the fair value of the Company's investment securities portfolio classified as available for sale as of September 30, 2023 and December 31, 2022.

(Dollars in thousands)

The net unrealized loss on the investment securities AFS at September 30, 2023, was $4.9 million compared with a net unrealized loss on investment securities AFS of $5.0 million at December 31, 2022. The change in unrealized loss on investment securities AFS from December 31, 2022 to September 30, 2023 was primarily due to the change in the interest rate environment.

The following table presents the amortized cost of the Company's investment securities portfolio classified as held to maturity as of September 30, 2023 and December 31, 2022.

(Dollars in thousands)

There was a $19 thousand ACL on the corporate bonds HTM as of September 30, 2023 and no ACL as of December 31, 2022. The net unrealized loss on the investment securities HTM at September 30, 2023, was $219 thousand compared with a net unrealized loss on investment securities HTM of $247 thousand at December 31, 2022.

No investment securities were pledged as of September 30, 2023 or December 31, 2022, and there were no sales of investment securities during the three and nine months ended September 30, 2023 or three and nine months ended September 30, 2022.

The investment securities available for sale presented in the following tables are reported at amortized cost and by contractual maturity as of September 30, 2023 and December 31, 2022. Actual timing may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Additionally, residential mortgage-backed securities and collateralized mortgage obligations receive monthly principal payments, which are not reflected below.

(Dollars in thousands)

(Dollars in thousands)

The investment securities held to maturity presented in the following tables are reported at amortized cost and by contractual maturity as of September 30, 2023 and December 31, 2022. Actual timing may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Additionally, residential mortgage-backed securities receive monthly principal payments, which are not reflected below.

(Dollars in thousands)

(Dollars in thousands)

Loan Portfolio Composition

The Company offers a variety of products designed to meet the credit needs of our borrowers. Our lending activities primarily consist of government guaranteed loans, real estate loans, commercial business loans, residential mortgage, and consumer loans. Senior management and loan officers have continued to develop new sources of loan referrals, particularly among centers of local influence and real estate professionals, and have also enjoyed repeat business from loyal customers in the markets the Bank serves. The Bank has no concentration of credit in any industry that represents 10% or more of its loan portfolio. The following table sets forth the composition of its loan portfolio, including LHFS as of the dates indicated.

(Dollars in thousands)

During the nine months ended September 30, 2023, the Bank originated approximately $159.7 million in loans through conventional lending channels and $402.5 million in loans through CreditBench (its government guaranteed lending function). In addition, the Bank sold guaranteed balances of $316.3 million and unguaranteed balances of $10.9 million of government guaranteed loans. The Bank purchased $106.4 million of government guaranteed loans. Of the loans purchased during the year, $58.2 million have already been sold or paid off.

During the nine months ended September 30, 2022, the Bank originated approximately $206.8 million in loans through conventional lending channels, $276.9 million through CreditBench, and $886.6 million through the Residential Mortgage Lending Division, which is a discontinued operation. Additionally, the Bank sold guaranteed balances of $233.1 million and unguaranteed balances of $13.8 million of government guaranteed loans. The Bank purchased $16.6 million of government guaranteed loans and $34.1 million of unsecured consumer loans.

Loan Maturity/Rate Sensitivity

The following table shows the contractual maturities of our loans at September 30, 2023. Loan balances in this table include loans held for investment at fair value, loans held for investment at amortized cost, discount on retained balances of loans sold, premium and discount on loans purchased, and deferred loan costs, net.

(Dollars in thousands)

56

The following table shows the loans with contractual maturities of greater than one year that have fixed or adjustable interest rates at September 30, 2023.

(Dollars in thousands)

Credit Risk

The Bank’s primary business is making commercial, consumer, and real estate loans. This activity inevitably has risks for potential credit losses, the magnitude of which depends on a variety of economic factors affecting borrowers, which are beyond its control. The Bank has developed policies and procedures for evaluating the overall quality of its credit portfolio and the timely identification of potential problem loans. Management’s judgment as to the adequacy of the allowance is based upon a number of assumptions about the economic environment that it believes impacts credit quality as of the balance sheet date that it believes to be reasonable, but which may or may not prove accurate. Thus, there can be no assurance that charge-offs in future periods will not exceed the ACL, or that additional increases in the ACL will not be required.

Allowance for Credit Losses. In accordance with changes in generally accepted accounting principles, the Company adopted the new credit loss accounting standard known as CECL on January 1, 2023. At the time of adoption, the ACL for loans increased by $3.1 million to 1.73% of loans, the reserve on unfunded commitments increased $213 thousand, and an $18 thousand reserve was established for held to maturity investment securities.These one-time increases resulted in an after tax decrease to capital of $2.5 million, with no impact to earnings. Under CECL, the ACL is based on projected credit losses rather than on incurred losses.

The Bank must maintain an adequate ACL based on a comprehensive methodology that assesses the probable losses inherent in its loan portfolio. The Bank maintains an ACL based on a number of quantitative and qualitative factors, including levels and trends of past due and nonaccrual loans, asset classifications, loan grades, change in volume and mix of loans, collateral value, historical loss experience, size and complexity of individual credits, and economic conditions. In addition to this, the Company uses reasonable and supportable forecasts utilizing data from the Federal Open Market Committee’s median forecasts of change in national GDP and of national unemployment. Provisions for credit losses are provided on both a specific and general basis. Specific allowances are provided for individual loans that do not share similar risk characteristics with instruments evaluated using a collective (pooled) basis. General valuation allowances are determined by loan pools with a further evaluation of various quantitative and qualitative factors noted above.

The Bank periodically reviews the assumptions and formulates methodologies by which changes are made to the specific and general valuation ACL in an effort to refine such allowances in light of the current status of the factors described above.

All nonaccrual loans and modifications to loans for borrowers experiencing financial difficulty are reviewed to determine if the loans share the same risk characteristics as the pooled loans. If the loan does not share the same risk characteristics, the loan is evaluated individually for credit losses. Specific allocation of reserves for individually evaluated loans considers the value of the collateral, the financial condition of the borrower, and industry and current economic trends. The Bank reviews the collateral value, cash flow, and tertiary support on each individually evaluated credit. Any deficiency outlined by a real estate collateral evaluation analysis, or cash flow shortfall, is accounted for through a specific allocation for the loan.

Prior to January 1, 2023, the incurred loss methodology was used to estimate credit losses. Beginning with that date, the credit losses are estimated using the CECL methodology.

Nonperforming Assets. At September 30, 2023, the Company had $8.8 million in nonperforming assets, excluding government guaranteed loan balances, and their ACL represented 1.68% of total loans held for investment at amortized cost. At September 30, 2022, the Company had $4.1 million in nonperforming assets, excluding government guaranteed loan balances, and their ALLL represented 1.48% of total loans held for investment at amortized cost. Total loans held for investment at September 30, 2023 and September 30, 2022 included government guaranteed loans and loans measured at fair value, which had no reserves allocated to them. ACL as a percentage of loans held for investment at amortized cost, not including government guaranteed loan balances, was 2.03% under CECL at September 30, 2023, compared to 1.90% under the incurred loss method at September 30, 2022.

The following table sets forth certain information on nonaccrual loans and foreclosed assets, the ratio of such loans and foreclosed assets to total assets as of the dates indicated, and certain other related information.

(Dollars in thousands)

58

The following table sets forth information with respect to activity in the ACL for loans for the periods shown:

(Dollars in thousands)

59

The following table details net charge-offs to average loans outstanding by loan category for the three months ended September 30, 2023 and September 30, 2022.

(Dollars in thousands)

The following table details net charge-offs to average loans outstanding by loan category for the nine months ended September 30, 2023 and September 30, 2022.

(Dollars in thousands)

Asset quality remained stable in the third quarter of 2023. The Company recorded a provision for credit losses for the nine months ended September 30, 2023 of $7.7 million compared to a $1.4 million negative provision under the incurred loss methodology for the nine months ended September 30, 2022. The increase of $9.1 million in the provision for credit losses expense was primarily due to the loan growth, higher charge-offs, and the Company reduced its ALLL in 2022 from the historic high levels reached in 2020 at the onset of the pandemic.

Nonperforming assets to total assets, excluding government guaranteed loan balances, were 0.77% as of September 30, 2023, as compared to 0.44% as of September 30, 2022.

SBA and Other Government Guaranteed Loans

The following table sets forth, for the periods indicated, information regarding the SBA and other government guaranteed lending activity, excluding PPP loans.

(Dollars in thousands)

The Bank makes government guaranteed loans throughout the United States. The following table sets forth, at the dates indicated, information regarding the geographic disbursement of its government guaranteed loan portfolio. The “All Other” category includes states with less than 5% in any period presented.

(Dollars in thousands)

Deposits

General. In addition to deposits, sources of funds available for lending and for other purposes include loan repayments and proceeds from the sales of loans. Loan repayments are a relatively stable source of funds, while deposit inflows and outflows are influenced significantly by general interest rates and market conditions. Borrowings, as well as available lines of credit, may be used on a short-term basis to compensate for reductions in other sources, such as deposits at less than projected levels.

Deposits. Deposits are sourced principally from within its primary service area of Pinellas, Hillsborough, Manatee, Pasco, and Sarasota Counties, Florida. The Bank offers a wide selection of deposit instruments including demand deposit accounts, NOW accounts, money-market accounts, regular savings accounts, certificate of deposit accounts, and retirement savings plans (such as IRA accounts).

Certificate of deposit rates are set to encourage longer maturities as cost and market conditions will allow. Deposit account terms vary, with the primary differences being the minimum balance required, the time period the funds must remain on deposit, and the interest rate.

The Bank emphasizes commercial banking relationships in an effort to increase demand deposits as a percentage of total deposits. Deposit interest rates are set by management at least monthly or more often if conditions require it, based on a review of loan demand, recent cash flows and a survey of rates among competitors.

Brokered deposits. At times, the Bank has brokered time deposit and non-maturity deposit relationships available to diversify its funding sources. Brokered deposits offer several benefits relative to other funding sources, such as: maturity structures which cannot be duplicated in the current retail market, deposit gathering outside the market of the existing deposit base, the unsecured nature of these liabilities, and the ability to quickly generate funds. The Bank’s internal policy limits the use of brokered deposits as a funding source to no more than 15% of total assets. The Company's ability to accept or renew brokered deposits is contingent upon the Bank maintaining a capital level of "well capitalized." At September 30, 2023 and December 31, 2022, the Company had $167 thousand and $746 thousand, respectively, of brokered deposits.

The amount of each of the following categories of deposits, at the dates indicated, are as follows:

(Dollars in thousands)

At September 30, 2023, the Company held approximately $152.5 million of deposits that exceeded the FDIC insurance limit which was 15% of total deposits.

The following table provides information on the maturity distribution of the time deposits exceeding the FDIC insurance limit of $250 thousand as of September 30, 2023.

(Dollars in thousands)

Deposits increased $222.7 million or 28.01% during the first nine months of 2023, with growth in transaction accounts (noninterest bearing and interest bearing transaction accounts) of $69.5 million or 23.5% and time deposit balance of $166.1 million, or 122.1%. Savings and money market account balances decreased $12.9 million during the same period. The time deposit balance increase included a small increase of $6.4 million in short-term Certificate of Deposit Account Registry Service ("CDARS") and listing service balances. There were $244.1 million or 80.8% of total time deposits that mature within the next 18 months.

Other Borrowings

At September 30, 2023, the Company had no borrowings from the FHLB and FRB. There was $25.0 million of borrowings at 4.50% from the FRB and no borrowings from the FHLB at December 31, 2022.

The Bank is a member of the FHLB of Atlanta, which provides short- and long-term funding collateralized by mortgage-related assets to its members. FHLB short-term borrowings bear interest at variable rates set by the FHLB. Any advances that the bank were to obtain would be secured by a blanket lien on $274.9 million of real estate-related loans as of September 30, 2023. Based on this collateral and the Company's holdings of FHLB stock, the Company was eligible to borrow up to $156.5 million from the FHLB at September 30, 2023.

In addition, the Bank has a line of credit with the Federal Reserve Bank of Atlanta which was secured by $59.6 million of commercial loans as of September 30, 2023. FRB short-term borrowings bear interest at variable rates based on the Federal Open Market Committee's target range for the federal funds rate. Based on this collateral, the Company was eligible to borrow up to $40.1 million from the FRB at September 30, 2023.

In June 2021, the Company issued $6.0 million of Subordinated Debentures (the “Debentures”) that mature June 30, 2031 and are redeemable after 5 years. The Debentures carry interest at a fixed rate of 4.50% per annum for the initial 5 years of term and carry interest at a floating rate for the final 5 years of term. Under the debt agreements, the floating rates are based on a SOFR benchmark plus 3.78% per annum. The balance of Subordinated Debentures outstanding at the Company, net of offering costs, amounted to $5.9 million and $6.0 million at September 30, 2023 and December 31, 2022, respectively.

The Company has a term note with quarterly principal and interest payments with interest at Prime (8.50% at September 30, 2023). The note matures on March 10, 2029 and the balance of the note was $2.5 million and $2.8 million at September 30, 2023 and December 31, 2022, respectively. The note is secured by 100% of the stock of the Company and requires the Company to comply with certain loan covenants during the term of the note. As of September 30, 2023, the Company was in compliance with all financial debt covenants.

Capital Resources

Shareholders' equity is influenced primarily by earnings, dividends, the Company's sales and repurchases of its common and preferred stock, and changes in accumulated other comprehensive income caused primarily by fluctuations in unrealized gains or losses, net of taxes, on available for sale investment securities.

Shareholders' equity increased $2.3 million to $94.2 million at September 30, 2023 as compared to $91.9 million at December 31, 2022. The increase was primarily due to net income of $4.0 million and the issuance of preferred stock of $1.8 million. This was partially offset by the implementation of the new credit loss accounting standard. As a result of the accounting change, equity was reduced by $2.5 million.

The Company strives to maintain an adequate capital base to support its activities in a safe and sound manner while at the same time attempting to maximize shareholder value. Management assesses capital adequacy against the risk inherent in the balance sheet, recognizing that unexpected loss is the common denominator of risk and that common equity has the greatest capacity to absorb unexpected loss.

The Bank is subject to regulatory capital requirements imposed by various regulatory banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and discretionary actions by banking regulators that, if undertaken, could have a direct material effect on BayFirst’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of its assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by regulators about components, risk weightings, and other factors.

In 2020, the Federal banking regulatory agencies adopted a rule to simplify the methodology for measuring capital adequacy for smaller, uncomplicated banks. This CBLR is calculated as the ratio of tangible equity capital divided by average total consolidated assets. CBLR tangible equity is defined as total equity capital, prior to including minority interests, and excluding accumulated other comprehensive income, deferred tax assets arising from net operating loss and tax credit carryforwards, goodwill, and other intangible assets (other than mortgage servicing assets). Under the proposal, a qualifying organization may elect to use the CBLR framework if its CBLR is greater than 9%. The Bank elected not to use the CBLR framework.

At September 30, 2023 and December 31, 2022, the Bank's capital ratios were in excess of the requirement to be "well capitalized" under the regulatory guidelines.

As of the dates indicated, the Bank met all capital adequacy requirements to which it is subject. The Bank’s actual capital amounts and percentages are as shown in the table below:

(Dollars in thousands)

(1) Minimum to be considered “adequately capitalized” under Basel III Capital Adequacy.

(2) Minimum to be considered “well capitalized” under Prompt Corrective Actions Provisions.

Off-Balance Sheet Arrangements

The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business. These financial instruments primarily include unfunded loan commitments, unfunded lines of credit, and standby letters of credit. The Bank uses these financial instruments to meet the financing needs of its customers. These financial instruments involve, to varying degrees, elements of credit, interest rate, and liquidity risk. These do not present unusual risks and management does not anticipate any accounting losses that would have a material effect on the Bank.

A summary of the amounts of the Bank’s financial instruments, with off-balance sheet risk as of the dates indicated, is as follows:

(Dollars in thousands)

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Management evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained if deemed necessary by the Bank upon extension of credit is based on management’s credit evaluation of the customer.

Standby letters-of-credit are conditional lending commitments that the Bank issues to guarantee the performance of a customer to a third party and to support private borrowing arrangements. Essentially, letters of credit have expiration dates within one year of the issue date. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending credit. The Bank may hold collateral supporting those commitments.

In general, loan commitments and letters of credit are made on the same terms, including with respect to collateral, as outstanding loans. Each customer’s creditworthiness and the collateral required are evaluated on a case-by-case basis.

The Company maintains an ACL for its off-balance sheet loan commitments which is calculated by loan type using estimated line utilization rates based on historical usage. Loss rates for outstanding loans is applied to the estimated utilization rates to calculate the ACL for off-balance sheet loan commitments. At September 30, 2023 and December 31, 2022, ACL for off-balance sheet loan commitments totaled $844 thousand and $511 thousand, respectively.

Contractual Obligations

In the ordinary course of its operations, the Company enters into certain contractual obligations. Total contractual obligations at September 30, 2023 were $314.4 million, an increase of $139.5 million from $174.9 million at December 31, 2022. The increase was primarily due to an increase in time deposits of $166.1 million of which $4.3 million came from short-term CDARS brokered deposits.

The following tables present our contractual obligations as of September 30, 2023 and December 31, 2022.

(Dollars in thousands)

Liquidity

Liquidity management is the process by which the Bank manages the flow of funds necessary to meet its financial commitments on a timely basis and at a reasonable cost to take advantage of earnings enhancement opportunities. These financial commitments include withdrawals by depositors, credit commitments to borrowers, expenses of the operations, and capital expenditures. The Bank generally maintains a liquidity ratio of liquid assets to total assets of at least 7.0%. Liquid assets include cash and due from banks, federal funds sold, interest-bearing deposits with banks and unencumbered investment securities available for sale. The on-balance sheet liquidity ratio at September 30, 2023 was 13.99%, as compared to 12.58% at December 31, 2022.

During 2022, the Bank paid quarterly dividends totaling $1.75 million to BayFirst. During the first two quarters of 2023, the Bank paid quarterly dividends totaling $1.75 million to BayFirst. In the third quarter of 2023, BayFirst issued 1,835 shares of 11.0% Series C Cumulative Convertible Preferred Stock with gross proceeds of $1.8 million of which $1.3 million of the capital was injected to the Bank to support its growth and operations. Prior to 2021, the Bank retained its earnings to support its growth. BayFirst’s liquidity had historically been dependent solely on funds received from the issuance and sale of subordinated debt and preferred stock. BayFirst’s liquidity needs are to make interest payments on its debt obligations, dividends on shares of its Series A Preferred Stock, Series B Convertible Preferred Stock, Series C Cumulative Convertible Preferred Stock, and common stock, and payment of certain operating expenses. As of September 30, 2023, BayFirst Financial Corp. held $498 thousand in cash and cash equivalents.

The Company expects that all the liquidity needs, including the contractual commitments can be met by currently available liquid assets and cash flows. In the event any unforeseen demand or commitments were to occur, the Company would access the borrowing capacity with the FHLB, FRB, and lines of credit with other financial institutions. The Company does not rely on investment securities as the main source of liquidity and does not foresee the need to sell investment securities for cash flow purposes. In addition, the Company has the ability to obtain wholesale deposits as another source of liquidity. The Company expects that the currently available liquid assets and the ability to borrow from the FHLB, FRB, and other financial institutions would be sufficient to satisfy the liquidity needs without any material adverse effect on the Company’s liquidity.

A description of BayFirst’s and the Bank’s debt obligations is set forth above under the heading “Other Borrowings.”

Market Risk and Interest Rate Sensitivity

Market risk is the risk of loss from adverse changes in market prices and rates. Market risk arises primarily from interest-rate risk inherent in loan and deposit taking activities. To that end, the Company actively monitors and manages its interest-rate risk exposure. The measurement of market risk associated with financial instruments is meaningful only when all related and offsetting on- and off-balance sheet transactions are aggregated, and the resulting net positions are identified. Disclosures about the fair value of financial instruments, which reflect changes in market prices and rates, should also be considered.

The objective in managing interest-rate risk is to minimize the adverse impact of changes in interest rates on net interest income and capital, while adjusting the asset-liability structure to obtain the maximum yield-cost spread on that structure. The Company relies primarily on its asset-liability structure to control interest rate risk. A sudden or substantial increase in interest rates may impact its earnings, to the extent that the interest rates borne by assets and liabilities do not change at the same rate, to the same extent, or on the same basis.

The Company established a comprehensive interest rate risk management policy which is administered by management’s Asset-Liability Committee. The policy establishes risk limits, which are quantitative measures of the percentage change in net interest income (net interest income at risk) and the fair value of equity capital (economic value of equity at risk) resulting from a hypothetical change in interest rates for maturities from one day to 30 years. Management measures the potential adverse impacts that changing interest rates may have on its short-term earnings, long-term value, and liquidity with computer-generated simulation analysis. The simulation model is designed to capture call features and interest rate caps and floors embedded in investment and loan contracts. As with any method of analyzing interest rate risk, there are certain shortcomings inherent in the interest rate modeling methodology used. When interest rates change, actual movements in different categories of interest-earning assets and interest-bearing liabilities, loan prepayments, and withdrawals of time and other deposits, may deviate significantly from the assumptions used in modeling. The methodology does not measure the impact that higher rates may have on borrowers’ ability to service their debts, or the impact of rate changes on demand for loan and deposit products.

To minimize the potential for adverse effects of changes in interest rates on the results of the operations, the Company monitors assets and liabilities to better match the maturities and repricing terms of the interest-earning assets and interest-bearing liabilities. To do this, the Company (i) emphasizes the origination of adjustable-rate and variable-rate loans to be held for investment; (ii) maintains a stable core deposit base; and (iii) maintains a significant portion of liquid assets (cash, interest-bearing deposits with other banks, and available for sale investment securities).

Management regularly reviews its exposure to changes in interest rates. Among the factors they consider are changes in the mix of interest-earning assets and interest-bearing liabilities, interest rate spreads and repricing periods. ALCO reviews, on at least a quarterly basis, its interest rate risk position.

The interest rate risk position is measured and monitored at the Bank using net interest income simulation models and economic value of equity sensitivity analysis that captures both short-term and long-term interest-rate risk exposure.

Modeling the sensitivity of net interest income and the economic value of equity to changes in market interest rates is highly dependent on numerous assumptions incorporated into the modeling process. The models used for these measurements rely on estimates of the potential impact that changes in interest rates may have on the value and prepayment speeds on all components of its loan portfolio, investment portfolio, as well as embedded options and cash flows of other assets and liabilities. Balance sheet growth assumptions are also included in the simulation modeling process. The analysis provides a framework as to what the overall sensitivity position is as of the most recent reported position and the impact that potential changes in interest rates may have on net interest income and the economic value of its equity.

Net interest income simulation involves forecasting net interest income under a variety of interest rate scenarios including instantaneous shocks.

The estimated impact on the net interest income as of September 30, 2023 and December 31, 2022, assuming immediate parallel moves in interest rates, is presented in the table below.

Management strategies may impact future reporting periods, as the actual results may differ from simulated results due to the timing, magnitude, and frequency of interest rate changes, the difference between actual experience and the characteristics assumed, as well as changes in market conditions. Market-based prepayment speeds are factored into the analysis for loan and investment securities portfolios. Rate sensitivity for transactional deposit accounts is modeled based on both historical experience and external industry studies.

The Company uses economic value of equity sensitivity analysis to understand the impact of interest rate changes on long-term cash flows, income, and capital. Economic value of equity is based on discounting the cash flows for all balance sheet instruments under different interest rate scenarios.

The table below presents the change in the economic value of equity as of September 30, 2023 and December 31, 2022, assuming immediate parallel shifts in interest rates. Changes noted between the two periods reflect recent enhancements in the asset/liability modeling, including projected values for non-maturity deposits in changing interest rate environments.

Evaluation of Disclosure Controls and Procedures

An evaluation of the Company’s disclosure controls and procedures (as defined in Rules 13(a)-15(e) and 15(d)-15(e) of the Exchange Act), was carried out under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer as of September 30, 2023, the last day of the period covered by this Quarterly Report. The Company’s Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures were effective as of September 30, 2023, in ensuring that the information required to be disclosed in the reports the Company files or submits under the Exchange Act is (i) accumulated and communicated to management (including the Company’s Chief Executive Officer and Chief Financial Officer) as appropriate to allow timely decisions regarding required disclosures, and (ii) recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms.

Changes in Internal Control Over Financial Reporting

There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rule 13a-15(f) under the Exchange Act) during the fiscal period to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

In addition to the risk factor discussed below and the other information set forth in this report, you should carefully consider the factors discussed under "Part I--Item 1A--Risk Factors" in the Company's Form 10-K for the year ended December 31, 2022. These factors could materially and adversely affect the Company's business, financial condition, liquidity, results of operations and capital position, and could cause its actual results to differ materially from its historical results or the results contemplated by the forward-looking statements contained in this report.

Loss of deposits or a change in deposit mix could increase our funding costs and adversely affect our performance.

Deposits are a low cost and stable source of funding. We compete with banks and other financial institutions for deposits and as a result, the Company could lose deposits in the future, clients may shift their deposits into higher cost products, or the Company may need to raise interest rates to avoid deposit attrition. Funding costs may also increase if deposits lost are replaced with wholesale funding. Higher funding costs reduce our net interest margin, net interest income, and net income. In recent months, the environment for maintaining and growing deposits has become more challenging. This is partially attributable to the FRB reducing the size of its balance sheet through quantitative tightening and continues to increase interest rates giving depositors an incentive to move deposits to money market funds and other higher-yielding alternatives. In addition, recent unusually high levels of withdrawals from other, larger banks, which in some cases has resulted in bank failure, may result in similar withdrawal patterns at the Company. Should we experience any of these events, we may need to rely on higher cost wholesale funding, which would adversely affect our financial performance and net income.

The Florida property insurance market is in crises and the inability of our borrowers to obtain insurance on properties securing our loans may adversely affect the value of the collateral, the performance of our loan portfolio, and our ability to make loans secured by real estate.

Florida is susceptible to hurricanes, tropical storms and related flooding and wind damage and other similar weather events. Such events can disrupt operations, result in damage to properties and negatively affect the local economies in our markets. As a result of the potential for such weather events, many of our customers have incurred significantly higher insurance premiums, or been unable to secure insurance, on their properties. This may adversely affect real estate sales and values in our markets and leave our borrowers without funds to repay their loans in the event of destructive weather events. Such events could result in a decline in loan originations, a decline in the value or destruction of properties securing loans and a decrease in credit quality, negatively impacting our business and results of operations.