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Section 1: 10-Q (QUARTERLY REPORT)

 

 

 

UNITED STATES 

SECURITIES AND EXCHANGE COMMISSION 

Washington, DC 20549

 

FORM 10-Q

 

(Mark One)

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
  OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Quarterly Period Ended June 30, 2018

 

OR

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from _________ to_________

 

Commission File Number 0-25923

 

Eagle Bancorp, Inc. 

(Exact name of registrant as specified in its charter)

 

Maryland 52-2061461
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
   
7830 Old Georgetown Road, Third Floor, Bethesda, Maryland 20814
(Address of principal executive offices) (Zip Code)

 

(301) 986-1800 

(Registrant’s telephone number, including area code) 

(Former name, former address and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒         No ☐

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒          No ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definition of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company”) in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer ☒ 

Accelerated filer ☐ 

Non-accelerated filer ☐    (Do not mark if a smaller reporting company) 

Smaller Reporting Company ☐ 

Emerging Growth Company ☐

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act 

Yes ☐ No ☒

 

As of July 31, 2018, the registrant had 34,308,793 shares of Common Stock outstanding.

 

 

 

 

EAGLE BANCORP, INC. 

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION  
     
Item 1. Financial Statements (Unaudited) 3
  Consolidated Balance Sheets 3
  Consolidated Statements of Operations 4
  Consolidated Statements of Comprehensive Income 5
  Consolidated Statements of Changes in Shareholders’ Equity 6
  Consolidated Statements of Cash Flows 7
  Notes to Consolidated Financial Statements 8
     
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 40
     
Item 3. Quantitative and Qualitative Disclosures About Market Risk 65
     
Item 4. Controls and Procedures 65
     
PART II. OTHER INFORMATION  
     
Item 1. Legal Proceedings 66
     
Item 1A. Risk Factors 66
     
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 66
     
Item 3. Defaults Upon Senior Securities 66
     
Item 4. Mine Safety Disclosures 66
     
Item 5. Other Information 66
     
Item 6. Exhibits 66
     
Signatures 69

 

 

2

 

Item 1 – Financial Statements (Unaudited)

 

EAGLE BANCORP, INC. 

Consolidated Balance Sheets (Unaudited) 

 (dollars in thousands, except per share data)

 

  June 30, 2018   December 31, 2017 
Assets          
Cash and due from banks  $6,873   $7,445 
Federal funds sold   9,251    15,767 
Interest bearing deposits with banks and other short-term investments   249,667    167,261 
Investment securities available-for-sale, at fair value   656,942    589,268 
Federal Reserve and Federal Home Loan Bank stock   35,875    36,324 
Loans held for sale   30,493    25,096 
Loans   6,651,704    6,411,528 
Less allowance for credit losses   (66,609)   (64,758)
Loans, net   6,585,095    6,346,770 
Premises and equipment, net   19,055    20,991 
Deferred income taxes   30,562    28,770 
Bank owned life insurance   62,647    60,947 
Intangible assets, net   106,820    107,212 
Other real estate owned   1,394    1,394 
Other assets   85,343    71,784 
Total Assets  $7,880,017   $7,479,029 
           
Liabilities and Shareholders’ Equity          
Liabilities          
Deposits:          
Noninterest bearing demand  $2,022,916   $1,982,912 
Interest bearing transaction   435,484    420,417 
Savings and money market   2,658,768    2,621,146 
Time, $100,000 or more   675,528    515,682 
Other time   476,062    313,827 
Total deposits   6,268,758    5,853,984 
Customer repurchase agreements   29,135    76,561 
Other short-term borrowings   300,000    325,000 
Long-term borrowings   217,100    216,905 
Other liabilities   41,887    56,141 
Total Liabilities   6,856,880    6,528,591 
           
Shareholders’ Equity          
Common stock, par value $.01 per share; shares authorized 100,000,000, shares issued and outstanding 34,305,071 and 34,185,163, respectively   341    340 
Additional paid in capital   524,176    520,304 
Retained earnings   505,229    431,544 
Accumulated other comprehensive loss   (6,609)   (1,750)
Total Shareholders’ Equity   1,023,137    950,438 
Total Liabilities and Shareholders’ Equity  $7,880,017   $7,479,029 

 

See notes to consolidated financial statements.

 

3

  

EAGLE BANCORP, INC.  

Consolidated Statements of Operations (Unaudited)
(dollars in thousands, except per share data)

                 
   Three Months Ended June 30,   Six Months Ended June 30, 
   2018   2017   2018   2017 
Interest Income                    
Interest and fees on loans  $90,924   $75,896   $175,354   $148,367 
Interest and dividends on investment securities   4,058    2,827    7,650    5,660 
Interest on balances with other banks and short-term investments   1,274    610    2,255    1,093 
Interest on federal funds sold   40    11    86    18 
Total interest income   96,296    79,344    185,345    155,138 
Interest Expense                    
Interest on deposits   14,048    6,403    23,177    12,233 
Interest on customer repurchase agreements   62    40    112    78 
Interest on short-term borrowings   997    224    2,108    277 
Interest on long-term borrowings   2,979    2,979    5,958    5,958 
Total interest expense   18,086    9,646    31,355    18,546 
Net Interest Income   78,210    69,698    153,990    136,592 
Provision for Credit Losses   1,650    1,566    3,619    2,963 
Net Interest Income After Provision For Credit Losses   76,560    68,132    150,371    133,629 
                     
Noninterest Income                    
Service charges on deposits   1,760    1,543    3,374    3,015 
Gain on sale of loans   1,675    2,519    3,198    4,567 
Gain on sale of investment securities   26    26    68    531 
Increase in the cash surrender value of bank owned life insurance   356    372    700    739 
Other income   1,736    2,563    3,517    4,241 
Total noninterest income   5,553    7,023    10,857    13,093 
Noninterest Expense                    
Salaries and employee benefits   17,812    16,869    34,670    33,546 
Premises and equipment expenses   3,873    3,920    7,802    7,767 
Marketing and advertising   1,291    1,247    2,228    2,141 
Data processing   2,404    1,997    4,721    4,038 
Legal, accounting and professional fees   2,179    1,297    5,152    2,299 
FDIC insurance   951    590    1,626    1,134 
Other expenses   3,779    4,081    7,211    8,308 
Total noninterest expense   32,289    30,001    63,410    59,233 
Income Before Income Tax Expense   49,824    45,154    97,818    87,489 
Income Tax Expense   12,528    17,382    24,807    32,700 
Net Income  $37,296   $27,772   $73,011   $54,789 
                     
Earnings Per Common Share                    
Basic  $1.09   $0.81   $2.13   $1.61 
Diluted  $1.08   $0.81   $2.12   $1.60 

 

See notes to consolidated financial statements.

 

4

 

EAGLE BANCORP, INC.  

Consolidated Statements of Comprehensive Income (Unaudited)
(dollars in thousands)

 

   Three Months Ended June 30,   Six Months Ended June 30, 
   2018   2017   2018   2017 
                 
Net Income  $37,296   $27,772   $73,011   $54,789 
                     
Other comprehensive income, net of tax:                    
Unrealized (loss) gain on securities available for sale   (1,935)   521    (7,058)   1,227 
Reclassification adjustment for net gains included in net income   (20)   (16)   (51)   (332)
Total unrealized loss (gain) on investment securities   (1,955)   505    (7,109)   895 
Unrealized gain (loss) on derivatives   692    (75)   2,925    1,003 
Reclassification adjustment for amounts included in net income   64    (270)   (1)   (638)
Total unrealized gain (loss) on derivatives   756    (345)   2,924    365 
Other comprehensive (loss) income   (1,199)   160    (4,185)   1,260 
Comprehensive Income  $36,097   $27,932   $68,826   $56,049 

 

See notes to consolidated financial statements.

 

5

 

EAGLE BANCORP, INC. 

Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)
(dollars in thousands except share data)

 

                   Accumulated     
                   Other   Total 
   Common   Additional Paid   Retained   Comprehensive   Shareholders’ 
   Shares   Amount   in Capital   Earnings   Income (Loss)   Equity 
Balance January 1, 2018   34,185,163   $340   $520,304   $431,544   $(1,750)  $950,438 
                               
Net Income               73,011        73,011 
Other comprehensive loss, net of tax                   (4,185)   (4,185)
Stock-based compensation expense           3,143            3,143 
Issuance of common stock related to options exercised, net of shares withheld for payroll taxes   32,230        338            338 
Vesting of time based stock awards issued at date of grant, net of shares withheld for payroll taxes   (13,361)   1    (1)            
Time based stock awards granted   94,344                     
Issuance of common stock related to employee stock purchase plan   6,695        392            392 
Reclassification of the income tax effects of the Tax Cuts and Jobs Act from AOCI (ASU 2018-02)               674    (674)    
Balance June 30, 2018   34,305,071   $341   $524,176   $505,229   $(6,609)  $1,023,137 
                               
Balance January 1, 2017   34,023,850   $338   $513,531   $331,311   $(2,381)  $842,799 
                               
Net Income               54,789        54,789 
Other comprehensive income, net of tax                   1,260    1,260 
Stock-based compensation expense           3,169            3,169 
Issuance of common stock related to options exercised, net of shares withheld for payroll taxes   60,595    1    256            257 
Vesting of time based stock awards issued at date of grant, net of shares withheld for payroll taxes   (16,734)   1    (2)           (1)
Time based stock awards granted   91,097                     
Issuance of common stock related to employee stock purchase plan   7,527        402            402 
Vesting of performance based stock awards, net of shares withheld for payroll taxes   3,589                     
Balance June 30, 2017   34,169,924   $340   $517,356   $386,100   $(1,121)  $902,675 

 

See notes to consolidated financial statements.

 

6

 

EAGLE BANCORP, INC. 

Consolidated Statements of Cash Flows (Unaudited)
(dollars in thousands)

 

   Six Months Ended June 30, 
   2018   2017 
Cash Flows From Operating Activities:          
Net Income  $73,011   $54,789 
Adjustments to reconcile net income to net cash provided by operating activities:          
Provision for credit losses   3,619    2,963 
Depreciation and amortization   3,561    3,471 
Gains on sale of loans   (3,198)   (4,567)
Securities premium amortization (discount accretion), net   2,169    1,943 
Origination of loans held for sale   (224,643)   (351,318)
Proceeds from sale of loans held for sale   222,444    358,187 
Net increase in cash surrender value of BOLI   (700)   (739)
Decrease in deferred income tax benefit   1,533   1,926 
Net loss on sale of other real estate owned       361 
Net gain on sale of investment securities   (68)   (531)
Stock-based compensation expense   3,143    3,169 
Net tax benefits from stock compensation   108    460 
Increase in other assets   (12,644)   (9,386)
Decrease in other liabilities   (14,254)   (8,170)
Net cash provided by operating activities   54,081    52,558 
Cash Flows From Investing Activities:          
Purchases of available for sale investment securities   (150,528)   (55,206)
Proceeds from maturities of available for sale securities   42,144    37,466 
Proceeds from sale/call of available for sale securities   28,974    58,024 
Purchases of Federal Reserve and Federal Home Loan Bank stock   (42,179)   (19,125)
Proceeds from redemption of Federal Reserve and Federal Home Loan Bank stock   42,628    12,122 
Net increase in loans   (241,944)   (308,097)
Proceeds from sale of other real estate owned       939 
Bank premises and equipment acquired   (936)   (1,871)
Net cash used in investing activities   (321,841)   (275,748)
Cash Flows From Financing Activities:          
Increase in deposits   414,774    151,583 
(Decrease) increase in customer repurchase agreements   (47,426)   5,486 
(Decrease) increase in short-term borrowings   (25,000)   145,000 
Proceeds from exercise of equity compensation plans   338    257 
Proceeds from employee stock purchase plan   392    402 
Net cash provided by financing activities   343,078    302,728 
Net Increase In Cash and Cash Equivalents   75,318    79,538 
Cash and Cash Equivalents at Beginning of Period   190,473    368,163 
Cash and Cash Equivalents at End of Period  $265,791   $447,701 
Supplemental Cash Flows Information:          
Interest paid  $30,242   $18,648 
Income taxes paid  $31,200   $34,300 

 

See notes to consolidated financial statements.

 

7

 

EAGLE BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited) 

 

Note 1. Summary of Significant Accounting Policies

 

Basis of Presentation

 

The Consolidated Financial Statements include the accounts of Eagle Bancorp, Inc. and its subsidiaries (the “Company”), EagleBank (the “Bank”), Eagle Commercial Ventures, LLC (“ECV”), Eagle Insurance Services, LLC, and Bethesda Leasing, LLC, with all significant intercompany transactions eliminated.

 

The Consolidated Financial Statements of the Company included herein are unaudited. The Consolidated Financial Statements reflect all adjustments, consisting of normal recurring accruals that in the opinion of management, are necessary to present fairly the results for the periods presented. The amounts as of and for the year ended December 31, 2017 were derived from audited Consolidated Financial Statements. Certain information and note disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. The Company applies the accounting policies contained in Note 1 to Consolidated Financial Statements included in the Company’s Annual report on Form 10-K for the year ended December 31, 2017. There have been no significant changes to the Company’s Accounting Policies as disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017. The Company believes that the disclosures are adequate to make the information presented not misleading. Certain reclassifications have been made to amounts previously reported to conform to the current period presentation.

 

These statements should be read in conjunction with the audited Consolidated Financial Statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017. Operating results for the three and six months ended June 30, 2018 are not necessarily indicative of the results of operations to be expected for the remainder of the year, or for any other period.

 

Nature of Operations

 

The Company, through the Bank, conducts a full service community banking business, primarily in Northern Virginia, Suburban Maryland, and Washington, D.C. The primary financial services offered by the Bank include real estate, commercial and consumer lending, as well as traditional deposit and repurchase agreement products. The Bank is also active in the origination and sale of residential mortgage loans, the origination of small business loans, and the origination, securitization and sale of multifamily Federal Housing Administration (“FHA”) loans. The guaranteed portion of small business loans, guaranteed by the Small Business Administration (“SBA”), is typically sold to third party investors in a transaction apart from the loan’s origination. The Bank offers its products and services through twenty banking offices, five lending centers and various electronic capabilities, including remote deposit services and mobile banking services. Eagle Insurance Services, LLC, a subsidiary of the Bank, offers access to insurance products and services through a referral program with a third party insurance broker. Eagle Commercial Ventures, LLC, a direct subsidiary of the Company, has provided subordinated financing for the acquisition, development and construction of real estate projects; these transactions involve higher levels of risk, together with commensurate higher returns.

 

Use of Estimates

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts in the financial statements and accompanying notes. Actual results may differ from those estimates and such differences could be material to the financial statements.

 

8

 

New Authoritative Accounting Guidance

 

Accounting Standards Adopted in 2018

 

ASU 2014-09, “Revenue from Contracts with Customers (Topic 606).” The amendments in ASU 2014-09 supersede the revenue recognition requirements in Topic 605, Revenue Recognition, and most industry-specific guidance. The general principle of the amendments require an entity to recognize revenue upon the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance sets forth a five step approach to be utilized for revenue recognition. The Company completed its overall assessment of revenue streams and review of related contracts potentially affected by the ASU, including deposit related fees, interchange fees, and merchant income. Based on this assessment, the Company concluded that ASU 2014-09 did not materially change the method in which the Company currently recognizes revenue for these revenue streams. The Company also completed its evaluation of certain costs related to these revenue streams to determine whether such costs should be presented as expenses or contra-revenue (i.e., gross vs. net). Based on its evaluation, the Company did not identify revenue streams within the scope of ASC 606 that required a material change in their presentation under the gross vs. net requirement of ASC 606. The Company adopted ASU 2014-09 and its related amendments on its required effective date of January 1, 2018 utilizing the modified retrospective approach. Since there was no net income impact upon adoption of the new guidance, a cumulative effect adjustment to opening retained earnings was not deemed necessary. Consistent with the modified retrospective approach, the Company did not adjust prior period amounts.

 

The majority of our revenue-generating transactions are not subject to ASC 606, including revenue generated from financial instruments, such as our loans, letters of credit, derivatives and investment securities, as well as revenue related to our mortgage servicing activities, as these activities are subject to other GAAP discussed elsewhere within our disclosures. Substantially all of the Company’s revenue is generated from contracts with customers. Descriptions of our revenue-generating activities that are within the scope of ASC 606, which are presented in our income statements as components of noninterest income are as follows:

 

Service charges on deposit accounts - these represent general service fees for monthly account maintenance and activity- or transaction-based fees and consist of transaction-based revenue, time-based revenue (service period), item-based revenue or some other individual attribute-based revenue. Revenue is recognized when our performance obligation is completed which is generally monthly for account maintenance services or when a transaction has been completed (such as a wire transfer). Payment for such performance obligations are generally received at the time the performance obligations are satisfied.

 

Other Fees – generally, the Company receives compensation when a customer that it refers opens an account with certain third-parties. This category includes credit card, investment advisory, and interchange fees. The timing and amount of revenue recognition is not materially impacted by the new standard.

 

Sale of OREO – ASU 2014-09 prescribes derecognition requirements for the sale of OREO that are less prescriptive than existing derecognition requirements. Previously, the Company was required to assess 1) the adequacy of a buyer’s initial and continuing investments and 2) the seller’s continuing involvement with the property. ASU 2014-09 requires an entity to assess whether it is “probable” that it will collect the consideration to which it will be entitled in exchange for transferring the asset to the customer. The new requirements could result in earlier revenue recognition; however, such sales are infrequent and the impact of this change is not expected to be material to our financial statements.

 

A contract asset balance occurs when an entity performs a service for a customer before the customer pays consideration (resulting in a contract receivable) or before payment is due (resulting in a contract asset). A contract liability balance is an entity’s obligation to transfer a service to a customer for which the entity has already received payment (or payment is due) from the customer. The Company’s noninterest revenue streams are largely based on transactional activity, or standard month-end revenue accruals based on fee schedules. Consideration is often received immediately or shortly after the Company satisfies its performance obligation and revenue is recognized. The Company does not typically enter into long-term revenue contracts with customers, and therefore, does not have contract balances material to our financial statements. As of June 30, 2018 and December 31, 2017, the Company did not have any significant contract balances.

 

In connection with the adoption of Topic 606, an entity is required to capitalize, and subsequently amortize into expense, certain incremental costs of obtaining a contract with a customer if these costs are expected to be recovered. The incremental costs of obtaining a contract are those costs that an entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained (for example, sales commission). The Company utilizes the practical expedient which allows entities to immediately expense contract acquisition costs when the asset that would have resulted from capitalizing these costs would have been amortized in one year or less. Upon adoption of Topic 606, the Company did not capitalize any contract acquisition cost.

 

9

 

ASU 2016-01, “Financial Instruments—(Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.” ASU 2016-01 addresses certain aspects of recognition, measurement, presentation, and disclosure of financial instruments by making targeted improvements to GAAP as follows: (1) require equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. However, an entity may choose to measure equity investments that do not have readily determinable fair values at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer; (2) simplify the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment. When a qualitative assessment indicates that impairment exists, an entity is required to measure the investment at fair value; (3) eliminate the requirement to disclose the fair value of financial instruments measured at amortized cost for entities that are not public business entities; (4) eliminate the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet; (5) require public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (6) require an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments; (7) require separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (that is, securities or loans and receivables) on the balance sheet or the accompanying notes to the financial statements; and (8) clarify that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. ASU No. 2016-01 was effective for us effective January 1, 2018 and did not have a material impact on our Consolidated Financial Statements. Refer to Note 11 for the valuation of the loan portfolio using the exit price notion.

 

ASU 2016-15 “Statement of Cash Flows (Topic 230)” is intended to reduce the diversity in practice around how certain transactions are classified within the statement of cash flows. ASU 2016-15 became effective for us on January 1, 2018 and did not have a significant impact on our financial statements.

 

ASU 2017-12, “Derivatives and Hedging (Topic 815) - Targeted Improvements to Accounting for Hedging Activities.” ASU 2017-12 amends the hedge accounting recognition and presentation requirements in ASC 815 to improve the transparency and understandability of information conveyed to financial statement users about an entity’s risk management activities to better align the entity’s financial reporting for hedging relationships with those risk management activities and to reduce the complexity of and simplify the application of hedge accounting. The Company early adopted ASU 2017-12 effective January 1, 2018. The new standard did not have a material impact to our Consolidated Financial Statements.

 

ASU 2018-02, “Income Statement - Reporting Comprehensive Income (Topic 220)- Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income.” ASU 2018-02 allows a reclassification from accumulated other comprehensive income (loss) (“AOCI”) to retained earnings for the tax effects caused by the revaluation of deferred taxes resulting from the newly enacted corporate tax rate in the Tax Cuts and Jobs Act of 2017. The ASU is effective in years beginning after December 15, 2018, but permits early adoption in a period for which financial statements have not yet been issued. We have elected to early adopt the ASU as of January 1, 2018. The adoption of the guidance resulted in a $674 thousand cumulative-effect adjustment, done on a portfolio basis, to reclassify the income tax effects resulting from tax reform from AOCI to retained earnings. The adjustment increased retained earnings and decreased AOCI in the first quarter of 2018.

 

Accounting Standards Pending Adoption

 

ASU 2016-02, “Leases (Topic 842).” Under the new guidance, lessees will be required to recognize the following for all leases (with the exception of short-term leases): (1) a lease liability, which is the present value of a lessee’s obligation to make lease payments, and (2) a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. Lessor accounting under the new guidance remains largely unchanged as it is substantially equivalent to existing guidance for sales-type leases, direct financing leases, and operating leases. Leveraged leases have been eliminated, although lessors can continue to account for existing leveraged leases using the current accounting guidance. Other limited changes were made to align lessor accounting with the lessee accounting model and the new revenue recognition standard. All entities will classify leases to determine how to recognize lease-related revenue and expense. Quantitative and qualitative disclosures will be required by lessees and lessors to meet the objective of enabling users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. The intention is to require enough information to supplement the amounts recorded in the financial statements so that users can understand more about the nature of an entity’s leasing activities. ASU 2016-02 is effective for interim and annual reporting periods beginning after December 15, 2018; early adoption is permitted. All entities are required to use a modified retrospective approach for leases that exist or are entered into after the beginning of the earliest comparative period in the financial statements. They have the option to use certain relief; full retrospective application is prohibited. The Company is currently evaluating the provisions of ASU 2016-02, researching software to aid in the transition to the new leasing guidance, and will be closely monitoring developments and additional guidance to determine the potential impact the new standard will have on the Company’s Consolidated Financial Statements.

 

10

 

ASU 2016-13, “Measurement of Credit Losses on Financial Instruments (Topic 326).” This ASU significantly changes how entities will measure credit losses for most financial assets and certain other instruments that are not measured at fair value through net income. In issuing the standard, the FASB is responding to criticism that today’s guidance for determining the allowance for credit losses delays recognition of expected future credit losses. The standard will replace today’s “incurred loss” approach with an “expected loss” model. The new model, referred to as the current expected credit loss (“CECL”) model, will apply to: (1) financial assets subject to credit losses and measured at amortized cost, and (2) certain off-balance sheet credit exposures. This includes, but is not limited to, loans, leases, held-to-maturity securities, loan commitments, and financial guarantees. The CECL model does not apply to available-for-sale (“AFS”) debt securities. For AFS debt securities with unrealized losses, entities will measure credit losses in a manner similar to what they do today, except that the losses will be recognized as allowances rather than reductions in the amortized cost of the securities. The ASU also simplifies the accounting model for purchased credit-impaired debt securities and loans. ASU 2016-13 also expands the disclosure requirements regarding an entity’s assumptions, models, and methods for estimating the allowance for loan and lease losses. In addition, entities will need to disclose the amortized cost balance for each class of financial asset by credit quality indicator, disaggregated by the year of origination. ASU No. 2016-13 is effective for the Company beginning on January 1, 2020; early adoption is permitted for us beginning on January 1, 2019. Entities will apply any changes resulting from the application of the new standard’s provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective (i.e., modified retrospective approach). We have substantially concluded our data gap analysis and have contracted with a third party to develop a model to comply with CECL requirements. We have established a steering committee with representation from various departments across the enterprise. The committee has agreed to a project plan and we have regular meetings to ensure adherence to our implementation timeline. The Company is currently evaluating the provisions of ASU No. 2016-13 to determine the potential impact the new standard will have on the Company’s Consolidated Financial Statements.

 

ASU 2017-04, “Intangibles - Goodwill and Other (Topic 350) - Simplifying the Test for Goodwill Impairment.” ASU 2017-04 eliminates Step 2 from the goodwill impairment test which required entities to compute the implied fair value of goodwill. Under ASU 2017-04, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. ASU 2017-04 will be effective for the Company on January 1, 2020, with early adoption permitted for interim or annual impairment tests beginning in 2017, and is not expected to have a significant impact on our consolidated financial statements. We expect to implement ASU 2017-04 prior to 2018 year-end.

 

Note 2. Cash and Due from Banks

 

Regulation D of the Federal Reserve Act requires that banks maintain noninterest reserve balances with the Federal Reserve Bank based principally on the type and amount of their deposits. During 2018, the Bank maintained balances at the Federal Reserve sufficient to meet reserve requirements, as well as significant excess reserves, on which interest is paid.

 

Additionally, the Bank maintains interest bearing balances with the Federal Home Loan Bank of Atlanta and noninterest bearing balances with domestic correspondent banks as compensation for services they provide to the Bank.

 

11

 

Note 3. Investment Securities Available-for-Sale

 

Amortized cost and estimated fair value of securities available-for-sale are summarized as follows:

 

June 30, 2018
(dollars in thousands)
  Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Estimated
Fair
Value
 
U. S. agency securities  $225,610   $8   $5,467   $220,151 
Residential mortgage backed securities   389,504    283    9,481    380,306 
Municipal bonds   48,292    584    672    48,204 
Corporate bonds   8,004    60    1    8,063 
Other equity investments   218            218 
   $671,628   $935   $15,621   $656,942 

 

December 31, 2017
(dollars in thousands)
  Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Estimated
Fair
Value
 
U. S. agency securities  $198,115   $283   $2,414   $195,984 
Residential mortgage backed securities   322,067    187    4,418    317,836 
Municipal bonds   60,976    1,295    214    62,057 
Corporate bonds   13,010    163        13,173 
Other equity investments   218            218 
   $594,386   $1,928   $7,046   $589,268 

  

In addition, at June 30, 2018 and December 31, 2017 the Company held $35.9 million and $36.3 million, respectively, in equity securities in a combination of Federal Reserve Bank (“FRB”) and Federal Home Loan Bank (“FHLB”) stocks, which are required to be held for regulatory purposes and which are not marketable, and therefore are carried at cost.

 

Gross unrealized losses and fair value by length of time that the individual available-for-sale securities have been in a continuous unrealized loss position are as follows: 

               
       Less than
12 Months
   12 Months
or Greater
   Total 
June 30, 2018
(dollars in thousands)
  Number of
Securities
   Estimated
Fair
Value
   Unrealized
Losses
   Estimated
Fair
Value
   Unrealized
Losses
   Estimated
Fair
Value
   Unrealized
Losses
 
U. S. agency securities   56   $142,970   $3,004   $64,860   $2,463   $207,830   $5,467 
Residential mortgage backed securities   157    181,775    3,812    144,061    5,669    325,836    9,481 
Municipal bonds   13    23,059    672            23,059    672 
Corporate bonds   1    1,499    1            1,499    1 
    227   $349,303   $7,489   $208,921   $8,132   $558,224   $15,621 
               
       Less than
12 Months
   12 Months
or Greater
   Total 
December 31, 2017
(dollars in thousands)
  Number of
Securities
   Estimated
Fair
Value
   Unrealized
Losses
   Estimated
Fair
Value
   Unrealized
Losses
   Estimated
Fair
Value
   Unrealized
Losses
 
U. S. agency securities   38   $102,264   $1,073   $55,093   $1,341   $157,357   $2,414 
Residential mortgage backed securities   137    152,350    1,306    147,953    3,112    300,303    4,418 
Municipal bonds   8    17,446    214            17,446    214 
    183   $272,060   $2,593   $203,046   $4,453   $475,106   $7,046 

 

The unrealized losses that exist are generally the result of changes in market interest rates and interest spread relationships since original purchases. The weighted average duration of debt securities, which comprise 99.9% of total investment securities, is relatively short at 3.8 years. If quoted prices are not available, fair value is measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. The Company does not believe that the investment securities that were in an unrealized loss position as of June 30, 2018 represent an other-than-temporary impairment. The Company does not intend to sell the investments and it is more likely than not that the Company will not have to sell the securities before recovery of its amortized cost basis, which may be at maturity.

 

12

 

The amortized cost and estimated fair value of investments available-for-sale at June 30, 2018 and December 31, 2017 by contractual maturity are shown in the table below. Expected maturities for residential mortgage backed securities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

   June 30, 2018   December 31, 2017 
(dollars in thousands)  Amortized
Cost
   Estimated
Fair Value
   Amortized
Cost
   Estimated
Fair Value
 
U. S. agency securities maturing:                    
   One year or less  $111,981   $108,302   $109,893   $108,198 
   After one year through five years   91,692    90,544    74,106    73,916 
   Five years through ten years   21,937    21,305    14,116    13,870 
Residential mortgage backed securities   389,504    380,306    322,067    317,836 
Municipal bonds maturing:                    
   One year or less   6,118    6,197    5,068    5,171 
   After one year through five years   16,880    17,056    19,405    19,879 
   Five years through ten years   24,226    23,797    35,432    35,846 
   After ten years   1,068    1,154    1,071    1,161 
Corporate bonds maturing:                    
   After one year through five years   6,504    6,563    11,510    11,673 
   After ten years   1,500    1,500    1,500    1,500 
Other equity investments   218    218    218    218 
   $671,628   $656,942   $594,386   $589,268 

 

For the six months ended June 30, 2018, gross realized gains on sales of investments securities were $93 thousand and gross realized losses on sales of investment securities were $25 thousand. For the six months ended June 30, 2017, gross realized gains on sales of investments securities were $750 thousand and gross realized losses on sales of investment securities were $219 thousand.

 

Proceeds from sales and calls of investment securities for the six months ended June 30, 2018 were $29.0 million compared to $58.0 million for the same period in 2017.

 

The carrying value of securities pledged as collateral for certain government deposits, securities sold under agreements to repurchase, and certain lines of credit with correspondent banks at June 30, 2018 and December 31, 2017 was $470.2 million and $465.4 million, respectively, which is well in excess of required amounts in order to operationally provide significant reserve amounts for new business. As of June 30, 2018 and December 31, 2017, there were no holdings of securities of any one issuer, other than the U.S. Government and U.S. agency securities, which exceeded ten percent of shareholders’ equity.

 

Note 4. Mortgage Banking Derivative

 

As part of its mortgage banking activities, the Bank enters into interest rate lock commitments, which are commitments to originate loans where the interest rate on the loan is determined prior to funding and the customers have locked into that interest rate. The Bank then locks in the loan and interest rate with an investor and commits to deliver the loan if settlement occurs (“best efforts”) or commits to deliver the locked loan in a binding (“mandatory”) delivery program with an investor. Certain loans under interest rate lock commitments are covered under forward sales contracts of mortgage backed securities (“MBS”). Forward sales contracts of MBS are recorded at fair value with changes in fair value recorded in noninterest income. Interest rate lock commitments and commitments to deliver loans to investors are considered derivatives. The market value of interest rate lock commitments and best efforts contracts are not readily ascertainable with precision because they are not actively traded in stand-alone markets. The Bank determines the fair value of interest rate lock commitments and delivery contracts by measuring the fair value of the underlying asset, which is impacted by current interest rates, taking into consideration the probability that the interest rate lock commitments will close or will be funded.

 

13

 

Certain additional risks arise from these forward delivery contracts in that the counterparties to the contracts may not be able to meet the terms of the contracts. The Bank does not expect any counterparty to any MBS to fail to meet its obligation. Additional risks inherent in mandatory delivery programs include the risk that, if the Bank does not close the loans subject to interest rate risk lock commitments, it will still be obligated to deliver MBS to the counterparty under the forward sales agreement. Should this be required, the Bank could incur significant costs in acquiring replacement loans or MBS and such costs could have an adverse effect on mortgage banking operations.

 

The fair value of the mortgage banking derivatives is recorded as a freestanding asset or liability with the change in value being recognized in current earnings during the period of change.

 

At June 30, 2018 the Bank had mortgage banking derivative financial instruments with a notional value of $64.4 million related to its forward contracts as compared to $37.1 million at December 31, 2017. The fair value of these mortgage banking derivative instruments at June 30, 2018 was $52 thousand included in other assets and $94 thousand included in other liabilities as compared to $43 thousand included in other assets and $10 thousand included in other liabilities at December 31, 2017.

 

Included in other noninterest income for the three and six months ended June 30, 2018 was a net gain of $55 thousand and a net loss of $31 thousand, respectively, relating to mortgage banking derivative instruments as compared to a net loss of $26 thousand and a net gain of $264 thousand, respectively, as of June 30, 2017. The amount included in other noninterest income for the three and six months ended June 30, 2018 pertaining to its mortgage banking hedging activities was a net realized loss of $147 thousand and a net realized loss of $56 thousand, respectively, as compared to a net realized loss of $53 thousand and a net realized loss of $899 thousand, respectively, as of June 30, 2017.

 

Note 5. Loans and Allowance for Credit Losses

 

The Bank makes loans to customers primarily in the Washington, D.C. metropolitan area and surrounding communities. A substantial portion of the Bank’s loan portfolio consists of loans to businesses secured by real estate and other business assets.

 

Loans, net of unamortized net deferred fees, at June 30, 2018 and December 31, 2017 are summarized by type as follows:

 

   June 30, 2018   December 31, 2017 
(dollars in thousands)  Amount   %   Amount   % 
Commercial  $1,467,089    22%  $1,375,939    21%
Income producing - commercial real estate   3,000,386    45%   3,047,094    48%
Owner occupied - commercial real estate   852,697    13%   755,444    12%
Real estate mortgage - residential   103,415    2%   104,357    2%
Construction - commercial and residential   1,087,287    16%   973,141    15%
Construction - C&I (owner occupied)   48,480    1%   58,691    1%
Home equity   89,539    1%   93,264    1%
Other consumer   2,811        3,598     
    Total loans   6,651,704    100%   6,411,528    100%
Less: allowance for credit losses   (66,609)        (64,758)     
   Net loans  $6,585,095        $6,346,770      

 

Unamortized net deferred fees amounted to $23.4 million and $23.9 million at June 30, 2018 and December 31, 2017, respectively.

 

As of June 30, 2018 and December 31, 2017, the Bank serviced $225.9 million and $195.3 million, respectively, of multifamily FHA loans, SBA loans and other loan participations which are not reflected as loan balances on the Consolidated Balance Sheets.

 

14

 

Loan Origination / Risk Management

 

The Company’s goal is to mitigate risks in the event of unforeseen threats to the loan portfolio as a result of economic downturn or other negative influences. Plans for mitigating inherent risks in managing loan assets include: carefully enforcing loan policies and procedures, evaluating each borrower’s business plan during the underwriting process and throughout the loan term, identifying and monitoring primary and alternative sources for loan repayment, and obtaining collateral to mitigate economic loss in the event of liquidation. Specific loan reserves are established based upon credit and/or collateral risks on an individual loan basis. A risk rating system is employed to proactively estimate loss exposure and provide a measuring system for setting general and specific reserve allocations.

 

The composition of the Company’s loan portfolio is heavily weighted toward commercial real estate, both owner occupied and income producing real estate. At June 30, 2018, owner occupied - commercial real estate and construction - C&I (owner occupied) represent approximately 14% of the loan portfolio. At June 30, 2018, non-owner occupied commercial real estate and real estate construction represented approximately 61% of the loan portfolio. The combined owner occupied and commercial real estate loans represent approximately 75% of the loan portfolio. Real estate also serves as collateral for loans made for other purposes, resulting in 83% of all loans being secured by real estate. These loans are underwritten to mitigate lending risks typical of this type of loan such as declines in real estate values, changes in borrower cash flow and general economic conditions. The Bank typically requires a maximum loan to value of 80% and minimum cash flow debt service coverage of 1.15 to 1.0. Personal guarantees may be required, but may be limited. In making real estate commercial mortgage loans, the Bank generally requires that interest rates adjust not less frequently than five years.

 

The Company is also an active traditional commercial lender providing loans for a variety of purposes, including working capital, equipment and account receivable financing. This loan category represents approximately 22% of the loan portfolio at June 30, 2018 and was generally variable or adjustable rate. Commercial loans meet reasonable underwriting standards, including appropriate collateral and cash flow necessary to support debt service. Personal guarantees are generally required, but may be limited. SBA loans represent approximately 2% of the commercial loan category of loans. In originating SBA loans, the Company assumes the risk of non-payment on the unguaranteed portion of the credit. The Company generally sells the guaranteed portion of the loan generating noninterest income from the gains on sale, as well as servicing income on the portion participated. SBA loans are subject to the same cash flow analyses as other commercial loans. SBA loans are subject to a maximum loan size established by the SBA as well as internal loan size guidelines.

 

Approximately 1% of the loan portfolio at June 30, 2018 consists of home equity loans and lines of credit and other consumer loans. These credits, while making up a small portion of the loan portfolio, demand the same emphasis on underwriting and credit evaluation as other types of loans advanced by the Bank.

 

Approximately 2% of the loan portfolio consists of residential mortgage loans. The repricing duration of these loans was 19 months. These credits represent first liens on residential property loans originated by the Bank. While the Bank’s general practice is to originate and sell (servicing released) loans made by its Residential Lending department, from time to time certain loan characteristics do not meet the requirements of third party investors and these loans are instead maintained in the Bank’s portfolio until they are resold to another investor at a later date or mature.

 

Loans are secured primarily by duly recorded first deeds of trust or mortgages. In some cases, the Bank may accept a recorded junior trust position. In general, borrowers will have a proven ability to build, lease, manage and/or sell a commercial or residential project and demonstrate satisfactory financial condition. Additionally, an equity contribution toward the project is customarily required.

 

Construction loans require that the financial condition and experience of the general contractor and major subcontractors be satisfactory to the Bank. Guaranteed, fixed price contracts are required whenever appropriate, along with payment and performance bonds or completion bonds for larger scale projects.

 

Loans intended for residential land acquisition, lot development and construction are made on the premise that the land: 1) is or will be developed for building sites for residential structures, and; 2) will ultimately be utilized for construction or improvement of residential zoned real properties, including the creation of housing. Residential development and construction loans will finance projects such as single family subdivisions, planned unit developments, townhouses, and condominiums. Residential land acquisition, development and construction loans generally are underwritten with a maximum term of 36 months, including extensions approved at origination.

 

15

 

Commercial land acquisition and construction loans are secured by real property where loan funds will be used to acquire land and to construct or improve appropriately zoned real property for the creation of income producing or owner user commercial properties. Borrowers are generally required to put equity into each project at levels determined by the appropriate Loan Committee. Commercial land acquisition and construction loans generally are underwritten with a maximum term of 24 months.

 

Substantially all construction draw requests must be presented in writing on American Institute of Architects documents and certified either by the contractor, the borrower and/or the borrower’s architect. Each draw request shall also include the borrower’s soft cost breakdown certified by the borrower or their Chief Financial Officer. Prior to an advance, the Bank or its contractor inspects the project to determine that the work has been completed, to justify the draw requisition.

 

Commercial permanent loans are generally secured by improved real property which is generating income in the normal course of operation. Debt service coverage, assuming stabilized occupancy, must be satisfactory to support a permanent loan. The debt service coverage ratio is ordinarily at least 1.15 to 1.0. As part of the underwriting process, debt service coverage ratios are stress tested assuming a 200 basis point increase in interest rates from their current levels.

 

Commercial permanent loans generally are underwritten with a term not greater than 10 years or the remaining useful life of the property, whichever is lower. The preferred term is between 5 to 7 years, with amortization to a maximum of 25 years.

 

The Company’s loan portfolio includes ADC real estate loans including both investment and owner occupied projects. ADC loans amounted to $1.41 billion at June 30, 2018. A portion of the ADC portfolio, both speculative and non-speculative, includes loan funded interest reserves at origination. ADC loans that provide for the use of interest reserves represent approximately 81% of the outstanding ADC loan portfolio at June 30, 2018. The decision to establish a loan-funded interest reserve is made upon origination of the ADC loan and is based upon a number of factors considered during underwriting of the credit including: (1) the feasibility of the project; (2) the experience of the sponsor; (3) the creditworthiness of the borrower and guarantors; (4) borrower equity contribution; and (5) the level of collateral protection. When appropriate, an interest reserve provides an effective means of addressing the cash flow characteristics of a properly underwritten ADC loan. The Company does not significantly utilize interest reserves in other loan products. The Company recognizes that one of the risks inherent in the use of interest reserves is the potential masking of underlying problems with the project and/or the borrower’s ability to repay the loan. In order to mitigate this inherent risk, the Company employs a series of reporting and monitoring mechanisms on all ADC loans, whether or not an interest reserve is provided, including: (1) construction and development timelines which are monitored on an ongoing basis which track the progress of a given project to the timeline projected at origination; (2) a construction loan administration department independent of the lending function; (3) third party independent construction loan inspection reports; (4) monthly interest reserve monitoring reports detailing the balance of the interest reserves approved at origination and the days of interest carry represented by the reserve balances as compared to the then current anticipated time to completion and/or sale of speculative projects; and (5) quarterly commercial real estate construction meetings among senior Company management, which includes monitoring of current and projected real estate market conditions. If a project has not performed as expected, it is not the customary practice of the Company to increase loan funded interest reserves.

 

16

 

The following tables detail activity in the allowance for credit losses by portfolio segment for the three and six months ended June 30, 2018 and 2017. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.

 

(dollars in thousands)  Commercial   Income Producing - Commercial Real Estate   Owner Occupied - Commercial Real Estate   Real Estate Mortgage Residential   Construction - Commercial and Residential   Home Equity   Other Consumer   Total 
Three Months Ended June 30, 2018                                        
Allowance for credit losses:                                        
Balance at beginning of period  $13,358   $26,468   $5,471   $734   $18,742   $699   $335   $65,807 
Loans charged-off   (408)               (517)           (925)
Recoveries of loans previously charged-off   23    2    1    1    35    10    5    77 
Net loans (charged-off) recoveries   (385)   2    1    1    (482)   10    5    (848)
Provision for credit losses   (767)   1,518    531    22    391    (36)   (9)   1,650 
Ending balance  $12,206   $27,988   $6,003   $757   $18,651   $673   $331   $66,609 
                                         
Six Months Ended June 30, 2018                                        
Allowance for credit losses:                                        
Balance at beginning of period  $13,102   $25,376   $5,934   $944   $18,492   $770   $140   $64,758 
Loans charged-off   (1,261)   (121)   (132)       (517)           (2,031)
Recoveries of loans previously charged-off   26    2    2    3    95    127    8    263 
Net loans (charged-off) recoveries   (1,235)   (119)   (130)   3    (422)   127    8    (1,768)
Provision for credit losses   339    2,731    199    (190)   581    (224)   183    3,619 
Ending balance  $12,206   $27,988   $6,003   $757   $18,651   $673   $331   $66,609 
                                         
As of June 30, 2018                                        
Allowance for credit losses:                                        
Individually evaluated for impairment  $4,506   $3,543   $500   $   $   $   $80   $8,629 
Collectively evaluated for impairment   7,700    24,445    5,503    757    18,651    673    251    57,980 
Ending balance  $12,206   $27,988   $6,003   $757   $18,651   $673   $331   $66,609 
                                         
Three Months Ended June 30, 2017                                        
Allowance for credit losses:                                        
Balance at beginning of period  $14,583   $21,384   $4,026   $1,106   $17,356   $1,088   $305   $59,848 
Loans charged-off       (970)                   (3)   (973)
Recoveries of loans previously charged-off   255        1    1    342    2    5    606 
Net loans (charged-off) recoveries   255    (970)   1    1    342    2    2    (367)
Provision for credit losses   (613)   2,894    162    (26)   (971)   126    (6)   1,566 
Ending balance  $14,225   $23,308   $4,189   $1,081   $16,727   $1,216   $301   $61,047 
                                         
Six Months Ended June 30, 2017                                        
Allowance for credit losses:                                        
Balance at beginning of period  $14,700   $21,105   $4,010   $1,284   $16,487   $1,328   $160   $59,074 
Loans charged-off   (137)   (1,470)                   (66)   (1,673)
Recoveries of loans previously charged-off   268    50    2    3    345    3    12    683 
Net loans (charged-off) recoveries   131    (1,420)   2    3    345    3    (54)   (990)
Provision for credit losses   (606)   3,623    177    (206)   (105)   (115)   195    2,963 
Ending balance  $14,225   $23,308   $4,189   $1,081   $16,727   $1,216   $301   $61,047 
                                         
As of June 30, 2017                                        
Allowance for credit losses:                                        
Individually evaluated for impairment  $3,070   $2,013   $350   $   $350   $90   $52   $5,925 
Collectively evaluated for impairment   11,155    21,295    3,839    1,081    16,377    1,126    249    55,122 
Ending balance  $14,225   $23,308   $4,189   $1,081   $16,727   $1,216   $301   $61,047 

 

17

 

The Company’s recorded investments in loans as of June 30, 2018 and December 31, 2017 related to each balance in the allowance for loan losses by portfolio segment and disaggregated on the basis of the Company’s impairment methodology was as follows:

 

(dollars in thousands)  Commercial   Income Producing - Commercial Real Estate   Owner occupied - Commercial Real Estate   Real Estate Mortgage Residential   Construction - Commercial and Residential   Home Equity   Other Consumer   Total 
                                 
June 30, 2018                                        
Recorded investment in loans:                                        
Individually evaluated for impairment  $13,909   $9,470   $7,441   $1,686   $4,190   $494   $91   $37,281 
Collectively evaluated for impairment   1,453,180    2,990,916    845,256    101,729    1,131,577    89,045    2,720    6,614,423 
Ending balance  $1,467,089   $3,000,386   $852,697   $103,415   $1,135,767   $89,539   $2,811   $6,651,704 
                                         
December 31, 2017                                        
Recorded investment in loans:                                        
Individually evaluated for impairment  $8,726   $10,192   $5,501   $478   $4,709   $494   $91   $30,191 
Collectively evaluated for impairment   1,367,213    3,036,902    749,943    103,879    1,027,123    92,770    3,507    6,381,337 
Ending balance  $1,375,939   $3,047,094   $755,444   $104,357   $1,031,832   $93,264   $3,598   $6,411,528 

 

At June 30, 2018, nonperforming loans acquired from Fidelity & Trust Financial Corporation (“Fidelity”) and Virginia Heritage Bank (“Virginia Heritage”) have a carrying value of $290 thousand and $427 thousand, and an unpaid principal balance of $340 thousand and $1.5 million, respectively, and were evaluated separately in accordance with ASC Topic 310-30, “Loans and Debt Securities Acquired with Deteriorated Credit Quality.” At December 31, 2017, nonperforming loans acquired from Fidelity and Virginia Heritage had a carrying value of $297 thousand and $479 thousand, respectively, and an unpaid principal balance of $347 thousand and $1.5 million, respectively, and were evaluated separately in accordance with ASC Topic 310-30. The various impaired loans were recorded at estimated fair value with any excess being charged-off or treated as a non-accretable discount. Subsequent downward adjustments to the valuation of impaired loans acquired will result in additional loan loss provisions and related allowance for credit losses.

 

18

 

Credit Quality Indicators

 

The Company uses several credit quality indicators to manage credit risk in an ongoing manner. The Company’s primary credit quality indicators are to use an internal credit risk rating system that categorizes loans into pass, watch, special mention, or classified categories. Credit risk ratings are applied individually to those classes of loans that have significant or unique credit characteristics that benefit from a case-by-case evaluation. These are typically loans to businesses or individuals in the classes which comprise the commercial portfolio segment. Groups of loans that are underwritten and structured using standardized criteria and characteristics, such as statistical models (e.g., credit scoring or payment performance), are typically risk rated and monitored collectively. These are typically loans to individuals in the classes which comprise the consumer portfolio segment.

 

The following are the definitions of the Company’s credit quality indicators:

 

Pass:Loans in all classes that comprise the commercial and consumer portfolio segments that are not adversely rated, are contractually current as to principal and interest, and are otherwise in compliance with the contractual terms of the loan agreement. Management believes that there is a low likelihood of loss related to those loans that are considered pass.

 

Watch:Loan paying as agreed with generally acceptable asset quality; however the obligor’s performance has not met expectations. Balance sheet and/or income statement has shown deterioration to the point that the obligor could not sustain any further setbacks. Credit is expected to be strengthened through improved obligor performance and/or additional collateral within a reasonable period of time.

 

 Special Mention:   Loans in the classes that comprise the commercial portfolio segment that have potential weaknesses that deserve management’s close attention. If not addressed, these potential weaknesses may result in deterioration of the repayment prospects for the loan. The special mention credit quality indicator is not used for classes of loans that comprise the consumer portfolio segment. Management believes that there is a moderate likelihood of some loss related to those loans that are considered special mention.

 

Classified:Classified (a) Substandard - Loans inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the company will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard loans, does not have to exist in individual loans classified substandard.

 

Classified (b) Doubtful - Loans that have all the weaknesses inherent in a loan classified substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. The possibility of loss is extremely high, but because of certain important and reasonably specific pending factors, which may work to the advantage and strengthening of the assets, its classification as an estimated loss is deferred until its more exact status may be determined.

 

19

 

The Company’s credit quality indicators are updated generally on a quarterly basis, but no less frequently than annually. The following table presents by class and by credit quality indicator, the recorded investment in the Company’s loans and leases as of June 30, 2018 and December 31, 2017.

 

(dollars in thousands)  Pass   Watch and
Special Mention
   Substandard   Doubtful   Total Loans 
                     
June 30, 2018                         
Commercial  $1,425,622   $27,558   $13,909   $   $1,467,089 
Income producing - commercial real estate   2,987,999    2,917    9,470        3,000,386 
Owner occupied - commercial real estate   808,947    36,309    7,441        852,697 
Real estate mortgage – residential   101,080    649    1,686        103,415 
Construction - commercial and residential   1,114,842    16,735    4,190        1,135,767 
Home equity   88,359    686    494        89,539 
Other consumer   2,719    1    91        2,811 
Total  $6,529,568   $84,855   $37,281   $   $6,651,704 
                          
December 31, 2017                         
Commercial  $1,333,050   $34,163   $8,726   $   $1,375,939 
Income producing - commercial real estate   3,033,046    3,856    10,192        3,047,094 
Owner occupied - commercial real estate   696,754    53,189    5,501        755,444 
Real estate mortgage – residential   103,220    659    478        104,357 
Construction - commercial and residential   1,027,123        4,709        1,031,832 
Home equity   92,084    686    494        93,264 
Other consumer   3,505    2    91        3,598 
Total  $6,288,782   $92,555   $30,191   $   $6,411,528 

 

Nonaccrual and Past Due Loans

 

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on nonaccrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on nonaccrual status regardless of whether or not such loans are considered past due. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

 

20

 

The following table presents, by class of loan, information related to nonaccrual loans as of June 30, 2018 and December 31, 2017.

 

(dollars in thousands)  June 30, 2018   December 31, 2017 
         
Commercial  $3,059   $3,493 
Income producing - commercial real estate   186    832 
Owner occupied - commercial real estate   5,071    5,501 
Real estate mortgage - residential   1,975    775 
Construction - commercial and residential       2,052 
Home equity   494    494 
Other consumer   91    91 
Total nonaccrual loans (1)(2)  $10,876   $13,238 

 

(1)Excludes troubled debt restructurings (“TDRs”) that were performing under their restructured terms totaling $15.1 million at June 30, 2018 and $12.3 million at December 31, 2017.

(2)Gross interest income of $321 thousand and $626 thousand would have been recorded for the six months ended June 30, 2018 and 2017, respectively, if nonaccrual loans shown above had been current and in accordance with their original terms, while the interest actually recorded on such loans was $6 thousand and $24 thousand for the six months ended June 30, 2018 and 2017, respectively. See Note 1 to the Consolidated Financial Statements for a description of the Company’s policy for placing loans on nonaccrual status.

 

21

 

The following table presents, by class of loan, an aging analysis and the recorded investments in loans past due as of June 30, 2018 and December 31, 2017.

 

(dollars in thousands)  Loans
30-59 Days
Past Due
   Loans
60-89 Days
Past Due
   Loans
90 Days or
More Past Due
   Total Past
Due Loans
   Current
Loans
   Total Recorded
Investment in
Loans
 
                         
June 30, 2018                              
Commercial  $6,356   $1,532   $3,059   $10,947   $1,456,142   $1,467,089 
Income producing - commercial real estate   161    4,115    186    4,462    2,995,924    3,000,386 
Owner occupied - commercial real estate   1,906    3,189    5,071    10,166    842,531    852,697 
Real estate mortgage – residential       4,188    1,975    6,163    97,252    103,415 
Construction - commercial and residential   761    9,898        10,659    1,125,108    1,135,767 
Home equity   81    137    494    712    88,827    89,539 
Other consumer   2        91    93    2,718    2,811 
          Total  $9,267   $23,059   $10,876   $43,202   $6,608,502   $6,651,704 
                               
December 31, 2017                              
Commercial  $2,705   $748   $3,493   $6,946   $1,368,993   $1,375,939 
Income producing - commercial real estate   4,398    6,930    832    12,160    3,034,934    3,047,094 
Owner occupied - commercial real estate   522    3,906    5,501    9,929    745,515    755,444 
Real estate mortgage – residential   6,993    1,244    775    9,012    95,345    104,357 
Construction - commercial and residential       5,268    2,052    7,320    1,024,512    1,031,832 
Home equity   307        494    801    92,463    93,264 
Other consumer   45    6    91    142    3,456    3,598 
          Total  $14,970   $18,102   $13,238   $46,310   $6,365,218   $6,411,528 

 

Impaired Loans

 

Loans are considered impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loan basis for other loans. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

 

22

 

The following table presents, by class of loan, information related to impaired loans for the periods ended June 30, 2018 and December 31, 2017.

                                  
   Unpaid
Contractual
   Recorded
Investment
   Recorded
Investment
   Total       Average Recorded Investment   Interest Income Recognized 
   Principal   With No   With   Recorded   Related   Quarter   Year   Quarter   Year 
(dollars in thousands)  Balance   Allowance   Allowance   Investment   Allowance   To Date   To Date   To Date   To Date 
                                     
June 30, 2018                                             
Commercial  $8,116   $   $7,997   $7,997   $4,506   $6,411   $6,116   $19   $39 
Income producing - commercial real estate   9,324        9,324    9,324    3,543    9,286    9,539    121    241 
Owner occupied - commercial real estate   6,118        6,118    6,118    500    6,275    6,382    13    24 
Real estate mortgage – residential   1,975    1,975        1,975        1,860    1,498    2    2 
Construction - commercial and residential                       1,026    1,368         
Home equity   494    494        494        494    494         
Other consumer   91        91    91    80    91    91         
   Total  $26,118   $2,469   $23,530   $25,999   $8,629   $25,443   $25,488   $155   $306 
                                              
December 31, 2017                                             
Commercial  $5,644   $1,777   $3,748   $5,525   $3,259   $5,764   $5,765   $48   $145 
Income producing - commercial real estate   10,044    781    9,263    10,044    2,380    10,068    10,127    120    493 
Owner occupied - commercial real estate   6,596    1,095    5,501    6,596    1,382    6,743    5,210    27    73 
Real estate mortgage – residential   775    775        775        538    423    17    17 
Construction - commercial and residential   2,052    1,534    518    2,052    500    3,491    3,731    (14)    
Home equity   494    494        494        544    346        2 
Other consumer   91        91    91    80    92    93         
   Total  $25,696   $6,456   $19,121   $25,577   $7,601   $27,240   $25,695   $198   $730 

 

Modifications

 

A modification of a loan constitutes a TDR when a borrower is experiencing financial difficulty and the modification constitutes a concession. The Company offers various types of concessions when modifying a loan. Commercial and industrial loans modified in a TDR often involve temporary interest-only payments, term extensions, and converting revolving credit lines to term loans. Additional collateral, a co-borrower, or a guarantor is often requested. Commercial mortgage and construction loans modified in a TDR often involve reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, or substituting or adding a new borrower or guarantor. Construction loans modified in a TDR may also involve extending the interest-only payment period. As of June 30, 2018, all performing TDRs were categorized as interest-only modifications.

 

Loans modified in a TDR for the Company may have the financial effect of increasing the specific allowance associated with the loan. An allowance for impaired consumer and commercial loans that have been modified in a TDR is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the estimated fair value of the collateral, less any selling costs, if the loan is collateral dependent. Management exercises significant judgment in developing these estimates.

 

23

 

The following table presents by class, the recorded investment of loans modified in TDRs held by the Company for the periods ended June 30, 2018 and December 31, 2017.

 

   For the Six Months Ended June 30, 2018 
          Income Producing -   Owner Occupied -   Construction -     
(dollars in thousands)  Number of
Contracts
   Commercial   Commercial Real Estate   Commercial Real Estate   Commercial Real Estate   Total 
Troubled debt restructurings                              
Restructured accruing   9   $4,938   $9,138   $1,047   $   $15,123 
Restructured nonaccruing   4    1,211                1,211 
Total   13   $6,149   $9,138   $1,047   $   $16,334 
                               
Specific allowance       $2,000   $3,500   $   $   $5,500 
                               
Restructured and subsequently defaulted       $   $937   $   $   $937 

 

   For the Year Ended December 31, 2017 
          Income Producing -   Owner Occupied -   Construction -     
(dollars in thousands)  Number of
Contracts
   Commercial   Commercial Real Estate   Commercial Real Estate   Commercial Real Estate   Total 
Troubled debt restructings                              
                               
Restructured accruing   9   $2,032   $9,212   $1,095   $   $12,339 
Restructured nonaccruing   5    867    121            988 
Total   14   $2,899   $9,333   $1,095   $   $13,327 
                               
Specific allowance       $595   $2,350   $   $   $2,945 
                               
Restructured and subsequently defaulted       $237   $   $   $   $237 

 

The Company had thirteen TDR’s at June 30, 2018 totaling approximately $16.3 million. Nine of these loans totaling approximately $15.1 million are performing under their modified terms. There were two performing TDRs totaling $937 thousand that defaulted on their modified terms which were reclassified to nonperforming loans during the six months ended June 30, 2018, as compared to the same period in 2017, which had no defaults on restructured loans. A default is considered to have occurred once the TDR is past due 90 days or more or it has been placed on nonaccrual.  Commercial and consumer loans modified in a TDR are closely monitored for delinquency as an early indicator of possible future default. If loans modified in a TDR subsequently default, the Company evaluates the loan for possible further impairment. The allowance may be increased, adjustments may be made in the allocation of the allowance, or partial charge-offs may be taken to further write-down the carrying value of the loan. There were two loans totaling $4.0 million modified in a TDR during the three months ended June 30, 2018, as compared to the three months ended June 30, 2017 which had one loan totaling $4.8 million modified in a TDR.

 

Note 6. Interest Rate Swap Derivatives

 

The Company uses interest rate swap agreements to assist in its interest rate risk management. The Company’s objective in using interest rate derivatives designated as cash flow hedges is to add stability to interest expense and to better manage its exposure to interest rate movements. To accomplish this objective, the Company entered into forward starting interest rate swaps in April 2015 as part of its interest rate risk management strategy intended to mitigate the potential risk of rising interest rates on the Bank’s cost of funds. The notional amounts of the interest rate swaps designated as cash flow hedges do not represent amounts exchanged by the counterparties, but rather, the notional amount is used to determine, along with other terms of the derivative, the amounts to be exchanged between the counterparties. The interest rate swaps are designated as cash flow hedges and involve the receipt of variable rate amounts from two counterparties in exchange for the Company making fixed payments beginning in April 2016. The Company’s intent is to hedge its exposure to the variability in potential future interest rate conditions on existing financial instruments.

 

24

 

As of June 30, 2018, the Company had three forward starting designated cash flow hedge interest rate swap transactions outstanding that had an aggregate notional amount of $250 million associated with the Company’s variable rate deposits. The net unrealized gain before income tax on the swaps was $5.8 million at June 30, 2018 compared to a net unrealized gain before income tax of $2.3 million at December 31, 2017. The unrealized gain in value since year end 2017 is due to the increase in expected net cash inflows from the swap over its remaining term due to higher market interest rates.

 

For derivatives designated as cash flow hedges, changes in the fair value of the derivative are initially reported in other comprehensive income (outside of earnings), net of tax, and subsequently reclassified to earnings when the hedged transaction affects earnings. The Company assesses the effectiveness of each hedging relationship by comparing the changes in cash flows of the derivative hedging instrument with the changes in cash flows of the designated hedged transactions.

 

Amounts reported in accumulated other comprehensive income related to designated cash flow hedge derivatives will be reclassified to interest income/expense as interest payments are made/received on the Company’s variable-rate assets/liabilities. During the quarter ended June 30, 2018, the Company reclassified $104 thousand related to designated cash flow hedge derivatives from accumulated other comprehensive income to decrease interest expense. During the next twelve months, the Company estimates (based on existing interest rates) that $1.5 million will be reclassified as a decrease in interest expense.

 

The Company is exposed to credit risk in the event of nonperformance by the interest rate swap counterparty. The Company minimizes this risk by entering into derivative contracts with only large, stable financial institutions, and the Company has not experienced, and does not expect, any losses from counterparty nonperformance on the interest rate swaps. The Company monitors counterparty risk in accordance with the provisions of ASC Topic 815, “Derivatives and Hedging.” In addition, the interest rate swap agreements contain language outlining collateral-pledging requirements for each counterparty. Collateral must be posted when the market value exceeds certain threshold limits.

 

The designated cash flow hedge interest rate swap agreements detail: 1) that collateral be posted when the market value exceeds certain threshold limits associated with the secured party’s exposure; 2) if the Company defaults on any of its indebtedness (including default where repayment of the indebtedness has not been accelerated by the lender), then the Company could also be declared in default on its derivative obligations; 3) if the Company fails to maintain its status as a well capitalized institution then the counterparty could terminate the derivative positions and the Company would be required to settle its obligations under the agreements.

 

As of June 30, 2018, the aggregate fair value of all designated cash flow hedge derivative contracts with credit risk contingent features (i.e., those containing collateral posting or termination provisions based on our capital status) that were in a net asset position totaled $5.8 million (none of these contracts were in a net liability position as of June 30, 2018). The Company has minimum collateral posting thresholds with certain of its derivative counterparties. As of June 30, 2018, the Company was not required to post collateral with its derivative counterparties against its obligations under these agreements because these agreements were in a net asset position. If the Company had breached any provisions under the agreements at June 30, 2018, it could have been required to settle its obligations under the agreements at the termination value.

 

The table below identifies the balance sheet category and fair values of the Company’s designated cash flow hedge derivative instruments as of June 30, 2018 and December 31, 2017.

 

       June 30, 2018  December 31, 2017
   Swap   Notional       Balance Sheet  Notional       Balance Sheet
   Number   Amount   Fair Value   Category  Amount   Fair Value   Category
                           
(dollars in thousands)                              
Interest rate swap  (1)  $75,000   $1,220   Other Assets  $75,000   $598   Other Assets
Interest rate swap  (2)   100,000    2,185   Other Assets   100,000    821   Other Assets
Interest rate swap  (3)   75,000    2,387   Other Assets   75,000    837   Other Assets
    Total    $250,000   $5,792      $250,000   $2,256    

 

25

  

The table below presents the pre-tax net gains (losses) of the Company&rsq