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Section 1: 10-Q (QUARTERLY REPORT)

UNITED STATES OF AMERICA
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 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 September 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: 000-11486

CONNECTONE BANCORP, INC.
(Exact Name of Registrant as Specified in Its Charter)

New Jersey 52-1273725
(State or Other Jurisdiction of (IRS Employer
Incorporation or Organization) Identification No.)

301 Sylvan Avenue
Englewood Cliffs, New Jersey 07632
(Address of Principal Executive Offices) (Zip Code)

201-816-8900
(Registrant’s Telephone Number, Including Area Code)

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 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 (check one):

Large accelerated filer ☐ Accelerated filer ☒ Non-accelerated filer ☐ Smaller reporting company ☐
(Do not check if smaller Emerging growth company ☐
reporting company)

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 7(a)(2)(B) of the Securities Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Common Stock, no par value:
(Title of Class)
32,239,928 shares
(Outstanding as of November 1, 2018)


Table of Contents

       Page
PART I – FINANCIAL INFORMATION
 
Item 1.        Financial Statements
Consolidated Statements of Condition at September 30, 2018 (unaudited) and December 31, 2017 3
Consolidated Statements of Income for the three and nine months ended September 30, 2018 and 2017 (unaudited) 4
Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2018 and 2017 (unaudited) 5
Consolidated Statements of Changes in Stockholders’ Equity for the nine months ended September 30, 2018 and 2017 (unaudited) 6
Consolidated Statements of Cash Flows for the nine months ended September 30, 2018 and 2017 (unaudited) 7
Notes to Consolidated Financial Statements (unaudited) 8
 
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 47
 
Item 3. Qualitative and Quantitative Disclosures about Market Risks 60
 
Item 4. Controls and Procedures 61
 
PART II – OTHER INFORMATION
 
Item 1. Legal Proceedings 62
 
Item 1a. Risk Factors 62
 
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 63
 
Item 3. Defaults Upon Senior Securities 63
 
Item 4. Mine Safety Disclosures 63
 
Item 5. Other Information 63
 
Item 6. Exhibits 64
 
SIGNATURES

2


Item 1. Financial Statements

ConnectOne Bancorp, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF CONDITION

    September 30,     December 31,
2018 2017
(in thousands, except for share data) (unaudited)
ASSETS
Cash and due from banks $      37,058 $     52,565
Interest-bearing deposits with banks 118,790 97,017
Cash and cash equivalents 155,848 149,582
 
Securities available-for-sale 410,039 435,284
Equity securities 11,403 -
 
Loans held-for-sale 270 24,845
 
Loans receivable 4,462,487 4,171,456
Less: Allowance for loan losses 34,749 31,748
Net loans receivable 4,427,738 4,139,708
 
Investment in restricted stock, at cost 32,486 33,497
Bank premises and equipment, net 20,998 21,659
Accrued interest receivable 17,690 15,470
Bank owned life insurance 113,026 111,311
Other real estate owned - 538
Goodwill 145,909 145,909
Core deposit intangibles 1,881 2,364
Other assets 31,353 28,275
Total assets $ 5,368,641 $ 5,108,442
LIABILITIES
Deposits:
Noninterest-bearing $ 758,213 $ 776,843
Interest-bearing 3,230,552 3,018,285
Total deposits 3,988,765 3,795,128
Borrowings 629,979 670,077
Subordinated debentures (net of debt issuance costs of $1,681 and $456, respectively) 128,474 54,699
Other liabilities 26,552 23,101
Total liabilities 4,773,770 4,543,005
 
COMMITMENTS AND CONTINGENCIES
 
STOCKHOLDERS’ EQUITY
                 
Preferred stock, authorized 5,000,000 shares; issued -0- shares of Series B preferred stock at September 30, 2018 and December 31, 2017; outstanding -0- shares at September 30, 2018 and December 31, 2017; liquidation value of $-0- at September 30, 2018 and December 31, 2017 - -
Common stock, no par value, authorized 50,000,000 shares; issued 34,303,850 shares at September 30, 2018 and 34,135,782 at December 31, 2017; outstanding 32,239,928 shares at September 30, 2018 and 32,071,860 at December 31, 2017 412,546 412,546
Additional paid-in capital 14,625 13,602
Retained earnings 195,101 160,025
Treasury stock, at cost (2,063,922 common shares at September 30, 2018 and December 31, 2017) (16,717 ) (16,717 )
Accumulated other comprehensive loss (10,684 ) (4,019 )
Total stockholders’ equity 594,871 565,437
Total liabilities and stockholders’ equity $ 5,368,641 $ 5,108,442

See accompanying notes to unaudited consolidated financial statements.

3


ConnectOne Bancorp, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)

Three Months Ended Nine Months Ended
September 30, September 30,
(in thousands, except for per share data)       2018       2017       2018       2017
Interest income
Interest and fees on loans $     51,699 $     43,241 $     148,218 $     121,879
Interest and dividends on investment securities:
Taxable 2,154 1,695 6,191 5,042
Tax-exempt 785 870 2,377 2,655
Dividends 530 362 1,517 982
Interest on federal funds sold and other short-term investments 183 170 607 555
Total interest income 55,351 46,338 158,910 131,113
Interest expense
Deposits 10,681 6,113 27,538 16,717
Borrowings 4,708 3,206 14,318 9,135
Total interest expense 15,389 9,319 41,856 25,852
Net interest income 39,962 37,019 117,054 105,261
Provision for loan losses 1,100 1,450 20,000 4,000
Net interest income after provision for loan losses 38,862 35,569 97,054 101,261
Noninterest income
Annuities and insurance commissions - - - 39
Income on bank owned life insurance 751 985 2,300 2,402
Net gains on sale of loans held-for-sale 2 50 31 120
Deposit, loan and other income 676 721 1,893 2,023
Net gains on sales of securities available-for-sale - - - 1,596
Total noninterest income 1,429 1,756 4,224 6,180
Noninterest expenses
Salaries and employee benefits 10,174 8,810 29,575 25,521
Occupancy and equipment 2,137 1,969 6,311 6,215
FDIC insurance 735 840 2,350 2,550
Professional and consulting 891 740 2,439 2,192
Marketing and advertising 192 225 736 770
Data processing 1,102 1,176 3,341 3,474
Merger expenses 375 - 399 -
Amortization of core deposit intangible 145 169 483 555
Other components of net periodic pension expense 7 62 21 189
Increase in valuation allowance, loans held-for-sale - 3,000 - 15,325
Change in fair value of equity securities 157 - 325 -
Other expenses 2,372 1,650 6,474 5,402
Total noninterest expenses 18,287 18,641 52,454 62,193
Income before income tax expense 22,004 18,684 48,824 45,248
Income tax expense 2,102 5,607 7,144 12,608
Net income $ 19,902 $ 13,077 $ 41,680 $ 32,640
 
Earnings per common share:
Basic $ 0.62 $ 0.41 $ 1.30 $ 1.02
Diluted 0.61 0.41 1.29 1.01
 
Dividends per common share $ 0.075 $ 0.075 $ 0.225 $ 0.225

See accompanying notes to unaudited consolidated financial statements.

4


ConnectOne Bancorp, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(unaudited)

Three Months Ended Nine Months Ended
September 30, September 30,
(in thousands)       2018       2017       2018       2017
Net income $       19,902 $       13,077 $       41,680 $       32,640
Other comprehensive income:
Unrealized gains and losses:
Unrealized holding (losses) gains on available-for-sale securities arising during the period (2,840 ) 415 (9,639 ) 1,332
Tax effect 729 (165 ) 2,466 (525 )
Net of tax (2,111 ) 250 (7,173 ) 807
Reclassification adjustment for realized gains included in net income - - - (1,596 )
Tax effect - - - 579
Net of tax - - - (1,017 )
Unrealized gains on cash flow hedges 14 119 1,108 76
Tax effect (5 ) (48 ) (312 ) (31 )
Net of tax 9 71 796 45
Unrealized pension plan gains (losses):
Unrealized pension plan gains (losses) before reclassifications - - 236 (2 )
Tax effect - - (67 ) 1
Net of tax - - 169 (1 )
Reclassification adjustment for amortization included in net income 91 103 274 309
Tax effect (26 ) (42 ) (77 ) (126 )
Net of tax 65 61 197 183
Total other comprehensive (loss) income (2,037 ) 382 (6,011 ) 17
Total comprehensive income $ 17,865 $ 13,459 $ 35,669 $ 32,657

See accompanying notes to unaudited consolidated financial statements.

5


ConnectOne Bancorp, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
(unaudited)

Accumulated
Additional Other Total
     Preferred     Common     Paid-In      Retained     Treasury     Comprehensive     Stockholders’
(dollars in thousands, except for per share data) Stock Stock Capital Earnings Stock (Loss) Income Equity
Balance as of December 31, 2016 $     - $     412,726 $      11,407 $      126,462 $      (16,717 ) $     (2,846 ) $      531,032
Net income - - - 32,640 - - 32,640
Other comprehensive income, net of tax - - - - - 17 17
Cash dividends declared on common stock ($0.225 per share) - - - (7,251 ) - - (7,251 )
Stock issuance costs - (180 ) - - - - (180 )
Exercise of stock options (10,846 shares) - - 118 - - - 118
Restricted stock grants (57,164 shares) - - - - - - -
Stock-based compensation expense - - 1,315 - - - 1,315
 
Balance as of September 30, 2017 $ - $ 412,546 $ 12,840 $ 151,851 $ (16,717 ) $ (2,829 ) $ 557,691
 
Balance as of December 31, 2017 $ - $ 412,546 $ 13,602 $ 160,025 $ (16,717 ) $ (4,019 ) $ 565,437
  
Reclassification of stranded tax effects (ASU 2018-02) (see Note 8) - - - 709 - (709 ) -
Cumulative effect of adopting ASU 2016-01 (see Note 8) - - - (55 ) - 55 -
Net income - - - 41,680 - - 41,680
Other comprehensive loss, net of tax - - - - - (6,011 ) (6,011 )
Cash dividends declared on common stock ($0.225 per share) - - - (7,258 ) - - (7,258 )
Exercise of stock options (102,378) shares) - - 524 - - - 524
Restricted stock grants (23,018 shares) - - - - - - -
Net performance units issued (42,672 shares) - - (819 ) - - - (819 )
Stock-based compensation expense - - 1,318 - - - 1,318
  
Balance as of September 30, 2018 $ - $ 412,546 $ 14,625 $ 195,101 $ (16,717 ) $ (10,684 ) $ 594,871

See accompanying notes to unaudited consolidated financial statements.

6


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)

Nine Months Ended
September 30,
(in thousands)       2018       2017
Cash flows from operating activities
Net income $     41,680 $     32,640
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization of premises and equipment 2,336 2,364
Provision for loan losses 20,000 4,000
Increase in valuation allowance - 15,325
Amortization of intangibles 483 555
Net accretion of loans (969 ) (1,106 )
Accretion on bank premises (46 ) (58 )
Accretion on deposits (46 ) (19 )
Accretion on borrowings (98 ) (156 )
Stock-based compensation expense 499 1,315
Gains on sales of investment securities, net - (1,596 )
Change in fair value of equity securities, net 325 -
Gains on sales of loans held-for-sale, net (31 ) (120 )
Gains on sales of fixed assets, net - (8 )
Loans originated for resale (2,206 ) (6,790 )
Proceeds from sale of loans held-for-sale 2,337 12,015
Net loss on sale of other real estate owned 192 82
Net increase in cash surrender value of bank owned life insurance (1,715 ) (2,402 )
Amortization of premiums and accretion of discounts on investments securities, net 2,577 1,808
Amortization of subordinated debt issuance costs 250 124
Increase in accrued interest receivable (2,220 ) (1,876 )
Decrease in other assets 42 8,770
Increase in other liabilities 3,945 3,444
Net cash provided by operating activities 67,335 68,311
Cash flows from investing activities
Investment securities available-for-sale:
Purchases (114,457 ) (138,945 )
Sales - 29,543
Maturities, calls and principal repayments 115,757 61,700
Net redemptions (purchases) of restricted investment in bank stocks 1,011 (5,362 )
Payments on loans held-for-sale 159 2,841
Net increase in loans (283,283 ) (447,457 )
Proceeds from sales of fixed assets - 8
Purchases of premises and equipment (1,629 ) (2,148 )
Purchases of bank owned life insurance - (10,000 )
Proceeds from sale of other real estate owned 884 1,124
Net cash used in investing activities (281,558 ) (508,696 )
Cash flows from financing activities
Net increase in deposits 193,683 279,517
Increase in subordinated debentures 73,525 -
Advances of Federal Home Loan Bank (“FHLB”) borrowings 1,256,000 780,000
Repayments of FHLB borrowings (1,296,000 ) (656,000 )
Repayment of repurchase agreement - (15,000 )
Cash dividends paid on common stock (7,243 ) (7,207 )
Common stock issuance costs - (180 )
Proceeds from exercise of stock options 524 118
Net cash provided by financing activities 220,489 381,248
Net change in cash and cash equivalents 6,266 (59,137 )
Cash and cash equivalents at beginning of period 149,582 200,399
Cash and cash equivalents at end of period $ 155,848 $ 141,262
Supplemental disclosures of cash flow information
Cash payments for:
Interest paid on deposits and borrowings $ 40,200 $ 25,807
Income taxes 2,507 4,670
Supplemental disclosures of noncash investing activities
Transfer of loans to other real estate owned $ 538 $ 580
Transfer of loans held-for-investment to loans held-for-sale 21,236 34,652
Transfer of loans held-for-sale to held-for-investment 45,552 -

See accompanying notes to unaudited consolidated financial statements.

7


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 1. Nature of Operations and Principles of Consolidation

ConnectOne Bancorp, Inc. (the “Parent Corporation”) is incorporated under the laws of the State of New Jersey and is a registered bank holding company. The Parent Corporation’s business currently consists of the operation of its wholly-owned subsidiary, ConnectOne Bank (the “Bank” and, collectively with the Parent Corporation and the Parent Corporation’s subsidiaries, the “Company”). The Bank’s subsidiaries include Union Investment Co. (a New Jersey investment company), Twin Bridge Investment Co. (a Delaware investment company), ConnectOne Preferred Funding Corp. (a New Jersey real estate investment trust), Center Financial Group, LLC (a New Jersey financial services company), Center Advertising, Inc. (a New Jersey advertising company), Morris Property Company, LLC, (a New Jersey limited liability company), Volosin Holdings, LLC, (a New Jersey limited liability company), and NJCB Spec-1, LLC (a New Jersey limited liability company).

The Bank is a community-based, full-service New Jersey-chartered commercial bank that was founded in 2005. The Bank operates from its headquarters located at 301 Sylvan Avenue in the Borough of Englewood Cliffs, Bergen County, New Jersey and through its twenty-one other banking offices. Substantially all loans are secured with various types of collateral, including business assets, consumer assets and commercial/residential real estate. Each borrower’s ability to repay its loans is dependent on the conversion of assets, cash flows generated from the borrower’s business, real estate rental and consumer wages.

The preceding unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X, and, accordingly, do not include all of the information and footnotes required by GAAP for complete financial statements. However, in the opinion of management, all adjustments considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2018 are not necessarily indicative of the results that may be expected for the full year ending December 31, 2018, or for any other interim period. The Company’s 2017 Annual Report on Form 10-K should be read in conjunction with these consolidated financial statements.

In preparing the consolidated financial statements, management has made estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the consolidated statements of condition and that affect the results of operations for the periods presented. Actual results could differ significantly from those estimates.

The consolidated financial statements have been prepared in conformity with GAAP. Some items in the prior year consolidated financial statements were reclassified to conform to current presentation. Reclassifications had no effect on prior year net income or stockholders’ equity.

8


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 2. New Authoritative Accounting Guidance

ASU 2018-15, “Intangibles—Goodwill and Other—Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract.” 'These amendments align the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal use software license). The accounting for the service element of a hosting arrangement that is a service contract is not affected by these amendments. ASU 2018-15 is effective for annual periods, including interim periods within those annual periods, beginning after December 15, 2019. We believe the adoption of this standard will not have a significant impact on our consolidated financial statements.

ASU 2018-14, “Compensation—Retirement Benefits—Defined Benefit Plans—General (Subtopic 715-20): Disclosure Framework—Changes to the Disclosure Requirements for Defined Benefit Plans.” These amendments modify the disclosure requirements for employers that sponsor defined benefit pension or other postretirement plans. ASU 2018-14 is effective for fiscal years ending after December 15, 2020. We believe the adoption of this standard will not have a significant impact on our consolidated financial statements.

ASU 2018-13, “Fair Value Measurement (Topic 820): Disclosure Framework—Changes to the Disclosure Requirements for Fair Value Measurement.” The amendments in this update modify disclosure requirements on fair value measurements by removing, modifying and adding certain disclosure requirements. The amendments primarily pertain to Level 3 fair value measurements and depending on the amendment are applied either prospectively or retrospectively. ASU 2018-13 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. We believe the adoption of this standard will not have a significant impact on our consolidated financial statements.

ASU 2018-10, “Codification Improvements to Topic 842, Leases.” These amendments affect narrow aspects of the guidance issued in the amendments in ASU 2016-02 including those regarding residual value guarantees, rate implicit in the lease, lessee reassessment of lease classification, lessor reassessment of lease term and purchase option, variable lease payments that depend on an index or a rate, investment tax credits, lease term and purchase option, transition guidance for amounts previously recognized in business combinations, certain transition adjustments, transition guidance for leases previously classified as capital leases under Topic 840, transition guidance for modifications to leases previously classified as direct financing or sales-type leases under Topic 840, transition guidance for sale and leaseback transactions, impairment of net investment in the lease, unguaranteed residual asset, effect of initial direct costs on rate implicit in the lease, and failed sale and leaseback transactions. We believe the adoption of this standard will not have a significant impact on our consolidated financial statements.

9


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 2. New Authoritative Accounting Guidance – (continued)

ASU 2018-01, “Leases (Topic 842): Land Easement Practical Expedient for Transition to Topic 842.” ASU 2018-01 provides an optional transition practical expedient for the adoption of ASU 2016-02 that, if elected, would not require an organization to reconsider their accounting for existing land easements that are not currently accounted for under the old leases standard; and clarify that new or modified land easements should be evaluated under ASU 2016-02, once an entity has adopted the new standard. ASU 2018-01 is effective for fiscal years beginning after December 15, 2018. We believe the adoption of this standard will not have a significant impact on our consolidated financial statements.

ASU No. 2017-12, “Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities.” ASU No. 2017-12 refines and expands hedge accounting for both financial (e.g., interest rate) and commodity risks. Its provisions create more transparency around how economic results are presented, both on the face of the financial statements and in the footnotes. It also makes certain targeted improvements to simplify the application of hedge accounting guidance. ASU 2017-12 will be effective for public business entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Although management continues to evaluate the potential impact of ASU 2017-12 on our consolidated financial statements, at this time, we believe the adoption of this standard will not have a significant impact on our consolidated financial statements.

ASU No. 2017-08, “'Receivables—Nonrefundable Fees and Other Costs (Subtopic 310-20), Premium Amortization on Purchased Callable Debt Securities.” ASU No. 2017-08 shortens the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount; the discount continues to be amortized to maturity. ASU 2017-08 will be effective for public business entities for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. We are currently evaluating this ASU to determine the impact on our consolidated financial statements.

ASU No. 2017-04, “Intangibles – Goodwill and Other (Topic 350).” ASU 2017-04 aims to simplify the subsequent measurement of goodwill. Under these amendments, 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. Additionally, an entity should consider income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable. The Board also eliminated the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment. An entity is required to disclose the amount of goodwill allocated to each reporting unit with a zero or negative carrying amount of net assets and still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. The amendments in this update are effective for public business entities for fiscal years beginning after December 15, 2019. Although management continues to evaluate the potential impact of ASU 2017-04 on our consolidated financial statements, at this time, we believe the adoption of this standard will not have a significant impact on our consolidated financial statements.

ASU No. 2016-13, “Financial Instruments – Credit Losses (Topic 326): Assets Measured at Amortized Cost.” ASU 2016-13 requires a financial asset (or a group of financial assets) measured at amortized cost basis to be presented at the net amount expected to be collected. The amendments in this update replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates and affects loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash. For public business entities, the amendments in this update are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The Company has formed a CECL committee that is assessing our data and system needs. The Company has engaged a third-party vendor to assist is analyzing our data and developing a CECL model. The Company has recently met with the third-party vendor and discussed our data, in terms of what is available and potential gaps. The Company also discussed modeling standards, loan segmentation, as well as potential external inputs to supplement our historical loss history. We expect to recognize a one-time cumulative effect adjustment to the allowance for loan losses as of the beginning of the first reporting period in which the ASU is effective, but cannot yet determine the magnitude of any such one-time adjustment or the overall impact of the ASU on our consolidated financial statements.

10


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 2. New Authoritative Accounting Guidance – (continued)

ASU No. 2016-02, “Leases (Topic 842)” requires the recognition of a right of use asset and related lease liability by lessees for leases classified as operating leases under current GAAP. Topic 842, which replaces the current guidance under Topic 840, retains a distinction between finance leases and operating leases. The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee also will not significantly change from current GAAP. For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize right of use assets and lease liabilities. Topic 842 will be effective for the Company for reporting periods beginning January 1, 2019, with early adoption permitted. The Company must apply a modified retrospective transition approach for the applicable leases existing at, or entered into after, the beginning of the earliest comparative period presented in the consolidated financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. The Company is currently leasing properties as branch locations and is leasing certain office equipment. Currently, the Company is in the process of evaluating all of our leases for compliance for the new ASU. As part of that process, management is developing a systematic approach that can be used to calculate the financial statement impact starting in 2019. The adoption of ASU 2016-02 will result in increases to the Company's assets and liabilities.

Note 3. Earnings per Common Share

Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) No. 260-10-45 addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing earnings per share (“EPS”). The restricted stock awards previously granted by the Company contain non-forfeitable rights to dividends and therefore are considered participating securities. The two-class method for calculating basic EPS excludes dividends paid to participating securities and any undistributed earnings attributable to participating securities.

Earnings per common share have been computed based on the following:

Three Months Ended Nine Months Ended
September 30, September 30,
(in thousands, except for per share data)
      2018       2017       2018       2017
Income attributable to common stock $       19,860 $       13,035 $       41,582 $        32,534
Earnings allocated to participating securities 42 42 98 106
Net income $ 19,902 $ 13,077 $ 41,680 $ 32,640
Weighted average common shares outstanding, including participating securities 32,167 32,015 32,127 31,999
Weighted average participating securities (25 ) (103 ) (34 ) (104 )
Weighted average common shares outstanding 32,142 31,912 32,093 31,895
Incremental shares from assumed conversions of options, performance units and restricted shares 177 270 220 272
Weighted average common and equivalent shares outstanding 32,319 32,182 32,313 32,167
   
Earnings per common share:
Basic $ 0.62 $ 0.41 $ 1.30 $ 1.02
Diluted 0.61 0.41 1.29 1.01

There were no antidilutive share equivalents as of September 30, 2018 and September 30, 2017.

11


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 4. Securities Available-for-Sale

Securities available-for-sale are reported at fair value with unrealized gains or losses included in stockholders’ equity, net of tax. Accordingly, the carrying value of such securities reflects their fair value as of September 30, 2018 and December 31, 2017. Fair value is based upon either quoted market prices, or in certain cases where there is limited activity in the market for a particular instrument, assumptions are made to determine their fair value. See Note 7 of the Notes to Consolidated Financial Statements for a further discussion.

The following table summarizes the amortized cost and fair value of securities available-for-sale at September 30, 2018 and December 31, 2017 and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income (loss).

Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
September 30, 2018 (dollars in thousands)
Securities available-for-sale                    
Federal agency obligations $     48,963 $     14 $     (1,443 ) $     47,534
Residential mortgage pass-through securities 196,650 75 (6,174 ) 190,551
Commercial mortgage pass-through securities 3,953 - (110 ) 3,843
Obligations of U.S. states and political subdivisions 133,564 727 (3,903 ) 130,388
Corporate bonds and notes 26,305 96 (439 ) 25,962
Asset-backed securities 10,317 59 (13 ) 10,363
Certificates of deposit 420 3 - 423
Other securities 975 - - 975
Total securities available-for-sale $ 421,147 $ 974 $ (12,082 ) $ 410,039
                     
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
December 31, 2017 (dollars in thousands)
Securities available-for-sale
Federal agency obligations $ 56,297 $ 141 $ (416 ) $ 56,022
Residential mortgage pass-through securities 183,509 330 (1,948 ) 181,891
Commercial mortgage pass-through securities 4,054 3 (3 ) 4,054
Obligations of U.S. states and political subdivisions 130,723 1,739 (1,334 ) 131,128
Trust preferred securities 4,577 205 (111 ) 4,671
Corporate bonds and notes 29,801 163 (271 ) 29,693
Asset-backed securities 12,021 66 (37 ) 12,050
Certificates of deposit 621 4 - 625
Equity securities 11,843 235 (350 ) 11,728
Other securities 3,422 - - 3,422
Total securities available-for-sale $ 436,868 $ 2,886 $ (4,470 ) $ 435,284

Effective January 1, 2018, the Company implemented ASU 2016-01, “Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.” Under ASU 2016-01, equity securities, with certain exceptions, are to be measured at fair value with changes in fair value recognized in net income. As of March 31, 2018, the Company began separately presenting equity securities with readily determinable fair values on the Statements of Condition within the “Equity securities” caption. Net unrealized losses recognized on equity securities with readily determinable fair values for the three and nine months ended as of September 30, 2018 were $157 thousand and $325 thousand, respectively.

Investment securities having a carrying value of approximately $157.0 million and $157.8 million at September 30, 2018 and December 31, 2017, respectively, were pledged to secure public deposits, borrowings, Federal Reserve Discount Window borrowings and Federal Home Loan Bank advances and for other purposes required or permitted by law. As of September 30, 2018 and December 31, 2017, there were no holdings of securities of any one issuer, other than the U.S. Government and its agencies, in an amount greater than 10% of stockholders’ equity.

12


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 4. Securities Available-for-Sale – (continued)

The following table presents information for investments in securities available-for-sale at September 30, 2018, based on scheduled maturities. Actual maturities can be expected to differ from scheduled maturities due to prepayment or early call options of the issuer. Securities not due at a single maturity date are shown separately.

September 30, 2018
Amortized Fair
Cost Value
(dollars in thousands)
Securities available-for-sale:            
Due in one year or less $     4,429 $     4,425
Due after one year through five years 36,607 36,375
Due after five years through ten years 28,135 28,290
Due after ten years 150,398 145,580
Residential mortgage pass-through securities 196,650 190,551
Commercial mortgage pass-through securities 3,953 3,843
Other securities 975 975
Total securities available-for-sale $ 421,147 $ 410,039

Gross gains and losses from the sales, calls and maturities of securities for periods presented were as follows:

Three Months Ended Nine Months Ended
September 30, September 30,
(dollars in thousands)
              2018      2017        2018        2017
Proceeds $      - $      - $          - $       29,543
 
Gross gains on sales of securities - - - 1,596
Gross losses on sales of securities - - - -
Net gains on sales of securities - - - 1,596
Less: tax provision on net gains - - - (579 )
 
Net gains on sales of securities, after tax $ - $ - $ - $ 1,017

The Company reviews all securities for potential recognition of other-than-temporary impairment. The Company maintains a watch list for the identification and monitoring of securities experiencing problems that require a heightened level of review. This could include credit rating downgrades.

The Company’s assessment of whether an impairment in the portfolio is other-than temporary includes factors such as whether the issuer has defaulted on scheduled payments, announced restructuring and/or filed for bankruptcy, has disclosed severe liquidity problems that cannot be resolved, disclosed deteriorating financial condition or sustained significant losses.

13


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 4. Securities Available-For-Sale – (continued)

Temporarily Impaired Securities

The Company does not believe that any of the unrealized losses, which were comprised of 170 and 112 securities as of September 30, 2018 and December 31, 2017, respectively, represent an other-than-temporary impairment (“OTTI”). The gross unrealized losses associated with U.S. Treasury and agency securities, federal agency obligations, mortgage-backed securities, corporate bonds, tax-exempt securities, asset-backed securities, trust preferred securities, mutual funds and equity securities are not considered to be other-than-temporary because these unrealized losses are related to changes in interest rates and do not affect the expected cash flows of the underlying collateral or issuer.

Factors which may contribute to unrealized losses include credit risk, market risk, changes in interest rates, economic cycles, and liquidity risk. The magnitude of any unrealized loss may be affected by the relative concentration of the Company’s investment in any one issuer or industry. The Company has established policies to reduce exposure through diversification of the securities portfolio including limits on concentrations to any one issuer. The Company believes the securities portfolio is prudently diversified.

The unrealized losses included in the tables below are primarily related to changes in interest rates and credit spreads. All of the Company’s securities are performing and are expected to continue to perform in accordance with their respective contractual terms and conditions. These are largely intermediate duration holdings and, in certain cases, monthly principal payments can further reduce loss exposure resulting from an increase in rates.

The Company evaluates all securities with unrealized losses quarterly to determine whether the loss is other-than-temporary. Unrealized losses in the corporate debt securities category consist primarily of senior unsecured corporate debt securities issued by large financial institutions, insurance companies and other corporate issuers. Single issuer corporate trust preferred securities are also included, and in the case of one holding the market valuation loss is largely based upon the floating rate coupon and corresponding market valuation. Neither that trust preferred issuer, nor any other corporate issuers, have defaulted on interest payments. The unrealized loss in equity securities consists of losses on other bank equities. The decline in fair value is due in large part to the lack of an active trading market for these securities, changes in market credit spreads and rating agency downgrades. Management concluded that these securities were not OTTI at September 30, 2018.

In determining whether or not securities are OTTI, the Company must exercise considerable judgment. Accordingly, there can be no assurance that the actual results will not differ from the Company’s judgments and that such differences may not require the future recognition of OTTI charges that could have a material effect on the Company’s financial position and results of operations. In addition, the value of, and the realization of any loss on, a security is subject to numerous risks as cited above.

14


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 4. Securities Available-For-Sale – (continued)

The following tables indicate gross unrealized losses not recognized in income and fair value, aggregated by investment category and the length of time individual securities have been in a continuous unrealized loss position at September 30, 2018 and December 31, 2017:

September 30, 2018
Total Less than 12 Months 12 Months or Longer
Fair Unrealized Fair Unrealized Fair Unrealized
Value Losses Value    Losses    Value    Losses
   (dollars in thousands)
Investment Securities
Available-for-Sale:                  
Federal agency obligation $     45,057 $     (1,443 ) $     21,455 $     (513 ) $     23,602 $     (930 )
Residential mortgage pass-through securities 185,442 (6,174 ) 106,190 (2,491 ) 79,252 (3,683 )
Commercial mortgage pass-through securities 3,843 (110 ) 3,843 (110 ) - -
Obligations of U.S. states and political subdivisions 78,481 (3,903 ) 33,733 (877 ) 44,748 (3,026 )
Corporate bonds and notes 15,655 (439 ) 11,008 (124 ) 4,647 (315 )
Asset-backed securities 4,113 (13 ) 2,303 (8 ) 1,810 (5 )
Total temporarily impaired securities $ 332,591 $ (12,082 ) $ 178,532 $ (4,123 ) $ 154,059 $ (7,959 )
 
  December 31, 2017
Total Less than 12 Months 12 Months or Longer
Fair Unrealized Fair Unrealized Fair Unrealized
Value Losses Value Losses Value Losses
(dollars in thousands)
Investment Securities
Available-for-Sale:                  
Federal agency obligation $     39,813 $     (416 ) $     28,407 $     (213 ) $     11,406 $     (203 )
Residential mortgage pass-through securities 148,574 (1,948 ) 117,556 (1,146 ) 31,018 (802 )
Commercial mortgage pass-through securities 1,198 (3 ) 1,198 (3 ) - -
Obligations of U.S. states and political subdivisions 57,685 (1,334 ) 17,909 (246 ) 39,776 (1,088 )
Trust preferred securities 1,469 (111 ) - - 1,469 (111 )
Corporate bonds and notes 11,074 (271 ) 1,965 (21 ) 9,109 (250 )
Asset-backed securities 7,428 (37 ) 993 (2 ) 6,435 (35 )
Equity securities 11,116 (350 ) - - 11,116 (350 )
Total temporarily impaired securities $ 278,357 $ (4,470 ) $ 168,028 $ (1,631 ) $ 110,329 $ (2,839 )

Note 5. Derivatives

The Company utilizes interest rate swap agreements as part of its asset liability management strategy to help manage its interest rate risk position. The notional amount of the interest rate swap does not represent amounts exchanged by the parties. The amount exchanged is determined by reference to the notional amount and the other terms of the individual interest rate swap agreements.

15


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 5. Derivatives – (continued)

Interest rate swaps were entered into on April 13, 2017, August 24, 2015, December 30, 2014 and October 15, 2014, each with a respective notional amount of $25 million and were designated as cash flow hedges of a Federal Home Loan Bank (“FHLB”) advance. The swaps were determined to be fully effective during the period presented and therefore no amount of ineffectiveness has been included in net income while the aggregate fair value of the swaps is recorded in other assets (liabilities) with changes in fair value recorded in other comprehensive income (loss). The amount included in accumulated other comprehensive income (loss) would be reclassified to current earnings should the hedges no longer be considered effective. The Company expects the hedges to remain fully effective during the remaining term of the swaps.

Summary information about the interest rate swaps designated as cash flow hedges as of September 30, 2018, December 31, 2017 and September 30, 2017 are presented in the following table.

September 30, December 31, September 30,
      2018       2017       2017
(dollars in thousands)
Notional amount $      100,000 $      100,000 $      100,000
Weighted average pay rates 1.68 % 1.66 % 1.52 %
Weighted average receive rates 2.12 % 1.23 % 1.07 %
Weighted average maturity 1.7 years 2.4 years 2.7 years
 
Fair value $ 1,906 $ 798 $ 164

Net interest income recorded on these swap transactions totaled approximately $173 thousand and $326 thousand for the three and nine months ended September 30, 2018, respectively, and net interest expense recorded on these swap transactions totaled $95 thousand and $326 thousand for the three and nine months ended September 30, 2017, respectively, and is reported as a component of interest expense on FHLB advances.

Cash Flow Hedge

The following table presents the net losses recorded in other comprehensive income and the Consolidated Statements of Income relating to the cash flow derivative instruments for the following periods:

Nine Months Ended September 30, 2018
Amount of gain Amount of gain Amount of gain
recognized reclassified recognized in other
in OCI (Effective from OCI to Noninterest income
      Portion)       interest income       (Ineffective Portion)
(dollars in thousands)
Interest rate contracts $ 796 $ - $ -

Nine Months Ended September 30, 2017
Amount of gain Amount of gain Amount of gain
recognized reclassified recognized in other
in OCI (Effective from OCI to Noninterest income
      Portion)       interest income       (Ineffective Portion)
(dollars in thousands)
Interest rate contracts $ 45 $ - $ -

16


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

The following table reflects the cash flow hedges included in the consolidated statements of condition as of September 30, 2018 and December 31, 2017:

September 30, 2018 December 31, 2017
Notional Notional
      Amount       Fair Value       Amount       Fair Value
(dollars in thousands)
Interest rate swaps related to FHLB advances included in assets $      100,000 $      1,906 $      100,000 $      798

17


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses

Loans Receivable: Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs, premiums and discounts related to purchase accounting, and an allowance for loan losses. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the level-yield method without anticipating prepayments.

Loan segments are defined as a group of loans, which share similar initial measurement attributes, risk characteristics, and methods for monitoring and assessing credit risk. Management has determined that the Company has five segments of loans: commercial, commercial real estate, commercial construction, residential real estate (including home equity) and consumer.

The recognition of interest income on commercial, commercial real estate, commercial construction and residential loans is discontinued at the time the loan is 90 days delinquent unless the loan is well-secured and in process of collection. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. Nonaccrual loans and loans past due 90 days still on accrual include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans. A loan is moved to nonaccrual status in accordance with the Company’s policy, typically after 90 days of non-payment.

All interest accrued but not received for loans placed on nonaccrual is reversed against interest income. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

The policy of the Company is to generally grant commercial, residential and consumer loans to residents and businesses within our market area. The borrowers’ abilities to repay their obligations are dependent upon various factors including the borrowers’ income and net worth, cash flows generated by the borrowers’ underlying collateral, value of the underlying collateral, and priority of the lender’s lien on the property. Such factors are dependent upon various economic conditions and individual circumstances beyond the control of the Company. The Company is therefore subject to risk of loss. The Company believes its lending policies and procedures adequately minimize the potential exposure to such risks and that adequate provisions for loan losses are provided for all known and inherent risks. Collateral and/or personal guarantees are required for a large majority of the Company’s loans.

Loans Held-for-Sale: Residential mortgage loans, originated and intended for sale in the secondary market, are carried at the lower of aggregate cost or estimated fair value as determined by outstanding commitments from investors. For these loans originated and intended for sale, gains and losses on loan sales (sale proceeds minus carrying value) are recorded in other income and direct loan origination costs and fees are deferred at origination of the loan and are recognized in other income upon sale of the loan.

Other loans held-for-sale are carried at the lower of aggregate cost or estimated fair value. Fair value of these loans is determined based on the terms of the loan, such as interest rate, maturity date, reset term, as well as sales of similar assets.

Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings.

Allowance for Loan Losses: The allowance for loan losses is a valuation allowance for probable incurred credit losses. Losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired.

18


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans, for which the terms have been modified, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings (“TDRs”) and classified as impaired. As part of the evaluation of impaired loans, the Company individually reviews for impairment all non-homogeneous loans internally classified as substandard or below. Generally, smaller impaired non-homogeneous loans and impaired homogeneous loans are collectively evaluated for impairment.

Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.

TDRs are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a TDR is considered to be a collateral dependent loan, impairment of the loan is measured using the fair value of the collateral. For TDRs that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses.

The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience, the primary factor, is determined by loan class and is based on the actual loss history experienced by the Bank over an actual three-year rolling calculation. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio category and with the exogenous factor adjustments based on the risks present for each loan category. These exogenous factors include consideration of the following: concentrations of credit; delinquency & nonaccrual trends; economic & business conditions including evaluation of the national and regional economies and industries with significant loan concentrations; external factors including legal, regulatory or competitive pressures that may impact the loan portfolio; changes in the experience, ability, or size of the lending staff, management, or board of directors that may impact the loan portfolio; changes in underwriting standards, collection procedures, charge-off practices, or other changes in lending policies and procedures that may impact the loan portfolio; loss and recovery trends; changes in portfolio size and mix; and trends in problem loans.

Purchased Credit-Impaired Loans: The Company acquires groups of loans in conjunction with mergers, some of which have shown evidence of credit deterioration since origination. These purchased credit-impaired loans are recorded at their estimated fair value, such that there is no carryover of the seller’s allowance for loan losses (“ALLL”). After acquisition, probable incurred credit losses are recognized by an increase in the ALLL.

Such purchased credit-impaired loans (“PCI”) are identified on an individual basis. The Company estimates the amount and timing of expected cash flows for each loan and the expected cash flows in excess of amount paid is recorded as interest income over the remaining life of the loan (accretable yield). The excess of the loan’s contractual principal and interest over expected cash flows is not recorded (nonaccretable difference).

A PCI loan may be resolved either through a sale of the loan, by working with the customer and obtaining partial or full repayment, by short sale of the collateral, or by foreclosure. A gain or loss on resolution would be recognized based on the difference between the proceeds received and the carrying amount of the loan.

PCI loans that met the criteria for nonaccrual may be considered performing, regardless of whether the customer is contractually delinquent, if management can reasonably estimate the timing and amount of the expected cash flows on such loans and if management expects to fully collect the new carrying value of the loans. As such, management may no longer consider the loans to be nonaccrual or nonperforming and may accrue interest on these loans, including the impact of any accretable discount.

19


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

Loans receivable - The following table sets forth the composition of the Company’s loan portfolio, including net deferred loan fees, at September 30, 2018 and December 31, 2017:

September 30, December 31,
      2018       2017
(dollars in thousands)
Commercial $      933,169 $      824,082
Commercial real estate 2,739,943 2,592,909
Commercial construction 494,206 483,216
Residential real estate 295,948 271,795
Consumer 2,508 2,808
Gross loans 4,465,774 4,174,810
Net deferred loan fees (3,287 ) (3,354 )
Total loans receivable $ 4,462,487 $ 4,171,456

At September 30, 2018 and December 31, 2017, loan balances of approximately $2.2 billion and $1.9 billion, respectively, were pledged to secure borrowings from the FHLB of New York.

Loans held-for-sale - The following table sets forth the composition of the Company’s loans held-for-sale portfolio at September 30, 2018 and December 31, 2017:

September 30, December 31,
      2018       2017
(dollars in thousands)
Commercial real estate $        - $        24,475
Residential real estate 270 370
Total carrying amount $ 270 $ 24,845

Valuation allowance - The following table sets forth the composition of the Company’s valuation allowance within the loans held-for-sale portfolio during the three and nine months ended September 30, 2018 and September 30, 2017:

Three Months   Three Months
Ended Ended
September 30,   September 30,
      2018       2017
(dollars in thousands)
Balance at July 1, $ - $             12,325
Reduction from loans paid off - (38 )
Increase in valuation allowance - 3,000
Balance at September 30, $ - $ 15,287

Nine Months Nine Months
Ended Ended
September 30,   September 30,
      2018       2017
(dollars in thousands)
Balance at January 1, $ - $             -
Reduction from loans paid off - (38 )
Increase in valuation allowance - 15,325
Balance at September 30, $ - $ 15,287

20


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

Purchased Credit-Impaired Loans: The Company holds purchased loans for which there was, at their acquisition date, evidence of deterioration of credit quality since their origination and it was probable, at acquisition, that all contractually required payments would not be collected. The recorded investment of those loans is as follows at September 30, 2018 and December 31, 2017.

September 30, December 31,
      2018       2017
(dollars in thousands)
Commercial $ 2,524 $ 2,683

For those purchased loans disclosed above, the Company did not increase the allowance for loan losses during either the three or nine months ended September 30, 2018 and September 30, 2017. There were no reversals from the allowance for loan losses during the three and nine months ended September 30, 2018 and September 30, 2017.

The following table presents interest income expected to be recognized on the purchased credit-impaired loans and the related activity for the three and nine months ended September 30, 2018 and September 30, 2017:

Three Months Three Months
Ended Ended
September 30, September 30,
      2018       2017
(dollars in thousands)
Balance at July 1, $               1,259 $               2,496
Accretion of income (63 ) (180 )
Balance at September 30, $ 1,196 $ 2,316

Nine Months Nine Months
Ended Ended
September 30, September 30,
      2018       2017
(dollars in thousands)
Balance at January 1, $              1,387 $              2,860
Accretion of income (191 ) (544 )
Balance at September 30, $ 1,196 $ 2,316

Loans Receivable on Nonaccrual Status - The following table sets forth the composition of the Company’s nonaccrual loans as of September 30, 2018 and December 31, 2017:

September 30, December 31,
      2018       2017
(dollars in thousands)
Commercial $ 29,562 $ 47,363
Commercial real estate 15,927 12,757
Commercial construction 2,934 -
Residential real estate 4,592 5,493
Total nonaccrual loans $ 53,015 $ 65,613

Nonaccrual loans and loans 90 days or greater past due and still accruing include both smaller balance homogeneous loans that are collectively evaluated for impairment and loans individually evaluated for impairment.

The decrease in nonaccruals from the year-end 2017 was mainly attributable to a $17.0 million charge-off, related to the taxi medallion loan portfolio (which is included in the Commercial loan category) that took place during the first quarter of 2018. The taxi medallion loan portfolio was classified as substandard and impaired as of September 30, 2018 and December 31, 2017.

21


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

The Company continuously monitors the credit quality of its loans receivable. In addition to its internal monitoring, the Company utilizes the services of a third-party loan review firm to periodically validate the credit quality of its loans receivable on a sample basis. Credit quality is monitored by reviewing certain credit quality indicators. Assets classified “Pass” are deemed to possess average to superior credit quality, requiring no more than normal attention. Assets classified as “Special Mention” have generally acceptable credit quality yet possess higher risk characteristics/circumstances than satisfactory assets. Such conditions include strained liquidity, slow pay, stale financial statements, or other conditions that require more stringent attention from the lending staff. These conditions, if not corrected, may weaken the loan quality or inadequately protect the Company’s credit position at some future date. Assets are classified “Substandard” if the asset has a well-defined weakness that requires management’s attention to a greater degree than for loans classified special mention. Such weakness, if left uncorrected, could possibly result in the compromised ability of the loan to perform to contractual requirements. An asset is classified as “Doubtful” if it is inadequately protected by the net worth and/or paying capacity of the obligor or of the collateral, if any, that secures the obligation. Assets classified as doubtful include assets for which there is a “distinct possibility” that a degree of loss will occur if the inadequacies are not corrected. All loans past due 90 days or greater and all impaired loans are included in the appropriate category below.

Credit Quality Indicators - The following table presents information, excluding loans held-for-sale and net deferred loan fees, about the Company’s loan credit quality at September 30, 2018 and December 31, 2017:

September 30, 2018
Special
     Pass      Mention      Substandard      Doubtful      Total
(dollars in thousands)
Commercial (1) $      887,024 $      12,639 $      33,506 $      - $      933,169
Commercial real estate 2,699,338 10,651 29,954 - 2,739,943
Commercial construction 481,226 5,458 7,522 - 494,206
Residential real estate 291,223 - 4,725 - 295,948
Consumer 2,484 - 24 - 2,508
Gross loans $ 4,361,295 $ 28,748 $ 75,731 $ - $ 4,465,774
 
December 31, 2017
Special
Pass Mention Substandard Doubtful Total
(dollars in thousands)
Commercial $ 767,020 $ 3,764 $ 53,298 $ - $ 824,082
Commercial real estate 2,534,973 34,335 23,601 - 2,592,909
Commercial construction 475,066 5,521 2,629 - 483,216
Residential real estate 266,163 - 5,632 - 271,795
Consumer 2,767 - 41 - 2,808
Gross loans $ 4,045,989 $ 43,620 $ 85,201 $ - $ 4,174,810

(1)       Reflects a $17.0 million charge-off related to the taxi medallion loans classified as “substandard”.

22


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

The following table provides an analysis of the impaired loans by category as of September 30, 2018 and December 31, 2017:

September 30, 2018
            Unpaid      
Recorded Principal Related
Investment Balance Allowance
No related allowance recorded (dollars in thousands)
Commercial $ 31,471 $ 92,452
Commercial real estate 21,483 21,636
Commercial construction 10,428 10,429
Residential real estate 2,237 2,533
Consumer - -
Total (no related allowance) $ 65,619 $ 127,050
  
With an allowance recorded
Commercial real estate $     8,529 $     8,529 $     709
Residential real estate 263 266 32
Total (with allowance) $ 8,792 $ 8,795 $ 741
  
Total
Commercial $ 31,471 $ 92,452 $ -
Commercial real estate 30,012 30,165 709
Commercial construction 10,428 10,429 -
Residential real estate 2,500 2,799 32
Consumer - - -
Total $ 74,411 $ 135,845 $ 741
  
  December 31, 2017
            Unpaid     
  Recorded Principal Related
  Investment Balance Allowance
No related allowance recorded (dollars in thousands)
Commercial $ 49,761 $ 101,066
Commercial real estate 23,905 23,976
Commercial construction 6,662 6,662
Residential real estate 3,203 3,442
Consumer - -
Total (no related allowance) $ 83,531 $ 135,146
  
With an allowance recorded
Commercial real estate $ 1,133 $ 1,133 $ 39
 
Total
Commercial $ 49,761 $ 101,066 $ -
Commercial real estate 25,038 25,109 39
Commercial construction 6,662 6,662 -
Residential real estate 3,203 3,442 -
Consumer - - -
Total $ 84,664 $ 136,279 $ 39

23


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

The following table provides an analysis related to the average recorded investment and interest income recognized on impaired loans by category as of and for the three and nine months ended September 30, 2018 and 2017:

Three Months Ended September 30, Nine Months Ended September 30,
2018 2017 2018 2017
Average Interest Average Interest Average Interest Average Interest
Recorded Income Recorded Income Recorded Income Recorded Income
    Investment      Recognized      Investment      Recognized      Investment     Recognized      Investment     Recognized
(dollars in thousands)
Impaired loans (no allowance):
Commercial (1) $    31,769 $    36 $    3,100 $    34 $    39,132 $    102 $    3,149 $    115
Commercial real estate 21,557 105 19,302 221 21,714 475 18,813 424
Commercial construction 10,297 92 4,285 63 11,718 387 4,273 215
Residential real estate 2,249 - 2,529 2 2,304 - 2,551 6
Consumer - - 48 1 - - 54 2
Total $ 65,872 $ 233 $ 29,264 $ 321 $ 74,868 $ 964 $ 28,840 $ 762
Impaired loans (allowance):
Commercial real estate $ 8,534 $ 11 $ 1,645 $ 2 $ 8,544 $ 34 $ 1,654 $ 39
Residential real estate 264 - - - 267 - - -
Total $ 8,798 $ 11 $ 1,645 $ 2 $ 8,811 $ 34 $ 1,654 $ 39
Total impaired loans:
Commercial (1) $ 31,769 $ 36 $ 3,100 $ 34 $ 39,132 $ 102 $ 3,149 $ 115
Commercial real estate 30,091 116 20,947 223 30,258 509 20,467 463
Commercial construction 10,297 92 4,285 63 11,718 387 4,273 215
Residential real estate 2,513 - 2,259 2 2,571 - 2,551 6
Consumer - - 48 1 - - 54 2
Total $ 74,670 $ 244 $ 30,909 $ 323 $ 83,679 $ 998 $ 30,494 $ 801

(1)       Reflects the entire taxi medallion portfolio moving back to the loans held-for-investment category from the loans held-for-sale category in November 2017.

Included in impaired loans at September 30, 2018 and December 31, 2017 are loans that are deemed troubled debt restructurings. The recorded investment in loans include accrued interest receivable and other capitalized costs such as real estate taxes paid on behalf of the borrower and loan origination fees, net, when applicable. Cash basis interest and interest income recognized on accrual basis approximate each other.

24


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

The following table provides an analysis of the aging of gross loans (excluding loans held-for-sale) that are past due at September 30, 2018 and December 31, 2017 by segment:

Aging Analysis

September 30, 2018
90 Days or
Greater Past Total Past
30-59 Days 60-89 Days Due and Still Due and
    Past Due     Past Due     Accruing     Nonaccrual     Nonaccrual     Current     Gross Loans
(dollars in thousands)
Commercial $    233 $    246 $    1,648 $    29,562 $    31,689 $    901,480 $    933,169
Commercial real estate - 3,190 - 15,927 19,117 2,720,826 2,739,943
Commercial construction - - - 2,934 2,934 491,272 494,206
Residential real estate 6 - - 4,592 4,598 291,350 295,948
Consumer 288 - - - 288 2,220 2,508
Total $ 527 $ 3,436 $ 1,648 $ 53,015 $ 58,626 $ 4,407,148 $ 4,465,774
 

Included in the 90 days or greater past due and still accruing category as of September 30, 2018 are purchased credit-impaired loan, net of its fair value marks, which accretes income per its valuation at date of acquisition.

 
December 31, 2017
90 Days or
Greater Past Total Past
30-59 Days 60-89 Days Due and Still Due and
Past Due Past Due Accruing Nonaccrual Nonaccrual Current Gross Loans
(dollars in thousands)
Commercial $    1,708 $    183 $    1,664 $    47,363 $    50,918 $    773,164 $    824,082
Commercial real estate 545 1,475 - 12,757 14,777 2,578,132 2,592,909
Commercial construction - - - - - 483,216 483,216
Residential real estate 1,578 - - 5,493 7,071 264,724 271,795
Consumer 18 - - - 18 2,790 2,808
Total $ 3,849 $ 1,658 $ 1,664 $ 65,613 $ 72,784 $ 4,102,026 $ 4,174,810

Included in the 90 days or greater past due and still accruing category as of December 31, 2017 are purchased credit-impaired loan, net of its fair value marks, which accretes income per its valuation at date of acquisition.

25


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

The following tables detail, at the period-end presented, the amount of gross loans (excluding loans held-for-sale) that are evaluated individually, and collectively, for impairment, those acquired with deteriorated credit quality, and the related portion of the allowance for loan losses (“ALLL”) that are allocated to each loan portfolio segment:

September 30, 2018
Commercial Commercial Residential
      Commercial       real estate       construction       real estate       Consumer       Unallocated       Total
(dollars in thousands)
ALLL
Individually evaluated for impairment $      - $      709 $      - $      32 $      - $      - $      741
Collectively evaluated for impairment 9,749 16,569 4,790 1,183 3 564 32,858
Acquired portfolio 200 950 - - - - 1,150
Acquired with deteriorated credit quality - - - - - - -
Total $ 9,949 $ 18,228 $ 4,790 $ 1,215 $ 3 $ 564 $ 34,749
  
Gross loans
Individually evaluated for impairment $ 31,471 $ 30,012 $ 10,428 $ 2,500 $ - $ 74,411
Collectively evaluated for impairment 891,514 2,438,638 483,778 247,211 2,123 4,063,264
Acquired portfolio 7,660 271,293 - 46,237 385 325,575
Acquired with deteriorated credit quality 2,524 - - - - 2,524
Total $ 933,169 $ 2,739,943 $ 494,206 $ 295,948 $ 2,508 $ 4,465,774
 
December 31, 2017
Commercial Commercial Residential
Commercial real estate construction real estate Consumer Unallocated Total
(dollars in thousands)
ALLL
Individually evaluated for impairment $ - $ 39 $ - $ - $ - $ - $ 39
Collectively evaluated for impairment 8,032 15,472 4,747 1,051 2 605 29,909
Acquired portfolio 200 1,600 - - - - 1,800
Acquired with deteriorated credit quality - - - - - - -
Total $ 8,232 $ 17,111 $ 4,747 $ 1,051 $ 2 $ 605 $ 31,748
 
Gross loans
Individually evaluated for impairment $ 49,761 $ 25,038 $ 6,662 $ 3,203 $ - $ 84,664
Collectively evaluated for impairment 757,923 2,190,686 476,554 212,350 2,338 3,639,851
Acquired portfolio 13,715 377,185 - 56,242 470 447,612
Acquired with deteriorated credit quality 2,683 - - - - 2,683
Total $ 824,082 $ 2,592,909 $ 483,216 $ 271,795 $ 2,808 $ 4,174,810

26


CONNECTONE BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 6. Loans and the Allowance for Loan Losses – (continued)

The Company’s allowance for loan losses is analyzed quarterly. Many factors are considered, including growth in the portfolio, delinquencies, nonaccrual loan levels, and other factors inherent in the extension of credit. There have been no material changes to the allowance for loan losses (“ALLL”) methodology as disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

A summary of the activity in the ALLL is as follows:

Three Months Ended September 30, 2018
        Commercial    Commercial     Residential           
Commercial real estate construction real estate Consumer Unallocated Total
(dollars in thousands)
Balance at June 30, 2018 $     8,960 $     18,221 $     4,812 $     1,167 $     3 $     431 $     33,594
 
Charge-offs - - - - (6 ) - (6 )
 
Recoveries 56 - - - 5 - 61
 
Provision for loan losses 933 7 (22 ) 48 1 133 1,100
 
Balance at September 30, 2018 $ 9,949 $ 18,228 $ 4,790 $ 1,215 $ 3 $ 564 $ 34,749
 
Three Months Ended September 30, 2017
Commercial Commercial Residential
Commercial real estate construction real estate Consumer Unallocated Total
(dollars in thousands)
Balance at June 30, 2017 $     7,238 $     15,389 $     4,241 $985 $     2 $     546 $     28,401
 
Charge-offs - - - - (1 ) - (1 )
 
Recoveries 17 2 - - 1 - 20
 
Provision for loan losses 461 1,443 (301 ) 67 - (220 ) 1,450