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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 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 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 every Interactive Data File required to be submitted 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 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    ☐ Smaller Reporting Company ☐
  Emerging Growth 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 13(a) of the Exchange Act. ☐

 

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 October 31, 2018, the registrant had 34,348,624 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 

Consolidated Statements of Comprehensive Income 

  4
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

 

 

Item 1 – Financial Statements (Unaudited) 

 

  

EAGLE BANCORP, INC.

Consolidated Balance Sheets (Unaudited)

(dollars in thousands, except per share data)

 

Assets  September 30, 2018   December 31, 2017 
Cash and due from banks  $4,459   $7,445 
Federal funds sold   17,284    15,767 
Interest bearing deposits with banks and other short-term investments   162,734    167,261 
Investment securities available-for-sale, at fair value   722,674    589,268 
Federal Reserve and Federal Home Loan Bank stock   37,257    36,324 
Loans held for sale   18,728    25,096 
Loans   6,844,672    6,411,528 
Less allowance for credit losses   (68,189)   (64,758)
Loans, net   6,776,483    6,346,770 
Premises and equipment, net   17,457    20,991 
Deferred income taxes   35,196    28,770 
Bank owned life insurance   73,007    60,947 
Intangible assets, net   106,481    107,212 
Other real estate owned   1,394    1,394 
Other assets   84,701    71,784 
Total Assets  $8,057,855   $7,479,029 
           
Liabilities and Shareholders’ Equity          
Liabilities          
Deposits:          
Noninterest bearing demand  $2,057,886   $1,982,912 
Interest bearing transaction   459,455    420,417 
Savings and money market   2,573,258    2,621,146 
Time, $100,000 or more   758,152    515,682 
Other time   523,554    313,827 
Total deposits   6,372,305    5,853,984 
Customer repurchase agreements   36,446    76,561 
Other short-term borrowings   325,000    325,000 
Long-term borrowings   217,198    216,905 
Other liabilities   45,255    56,141 
Total Liabilities   6,996,204    6,528,591 
           
Shareholders’ Equity          
Common stock, par value $.01 per share; shares authorized 100,000,000, shares issued and outstanding 34,308,473 and 34,185,163, respectively   341    340 
Additional paid in capital   526,423    520,304 
Retained earnings   544,177    431,544 
Accumulated other comprehensive loss   (9,290)   (1,750)
Total Shareholders’ Equity   1,061,651    950,438 
Total Liabilities and Shareholders’ Equity  $8,057,855   $7,479,029 

 

See notes to consolidated financial statements.

 

 

EAGLE BANCORP, INC.

Consolidated Statements of Operations (Unaudited)

(dollars in thousands, except per share data)

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
   2018   2017   2018   2017 
Interest Income                    
Interest and fees on loans  $95,570   $78,176   $270,924   $226,543 
Interest and dividends on investment securities   4,875    3,194    12,525    8,854 
Interest on balances with other banks and short-term investments   1,897    991    4,152    2,084 
Interest on federal funds sold   18    9    104    27 
Total interest income   102,360    82,370    287,705    237,508 
Interest Expense                    
Interest on deposits   16,719    7,233    39,896    19,466 
Interest on customer repurchase agreements   54    58    166    136 
Interest on short-term borrowings   1,317    164    3,425    441 
Interest on long-term borrowings   2,979    2,979    8,937    8,937 
Total interest expense   21,069    10,434    52,424    28,980 
Net Interest Income   81,291    71,936    235,281    208,528 
Provision for Credit Losses   2,441    1,921    6,060    4,884 
Net Interest Income After Provision For Credit Losses   78,850    70,015    229,221    203,644 
                     
Noninterest Income                    
Service charges on deposits   1,814    1,626    5,188    4,641 
Gain on sale of loans   1,434    2,173    4,632    6,740 
Gain on sale of investment securities       11    68    542 
Increase in the cash surrender value of bank owned life insurance   373    369    1,073    1,108 
Other income   2,019    2,605    5,536    6,846 
Total noninterest income   5,640    6,784    16,497    19,877 
Noninterest Expense                    
Salaries and employee benefits   17,157    16,905    51,827    50,451 
Premises and equipment expenses   3,889    3,846    11,691    11,613 
Marketing and advertising   1,191    732    3,419    2,873 
Data processing   2,423    2,019    7,144    6,057 
Legal, accounting and professional fees   2,130    1,240    7,282    3,539 
FDIC insurance   933    929    2,559    2,063 
Other expenses   3,891    3,845    11,102    12,153 
Total noninterest expense   31,614    29,516    95,024    88,749 
Income Before Income Tax Expense   52,876    47,283    150,694    134,772 
Income Tax Expense   13,928    17,409    38,735    50,109 
Net Income  $38,948   $29,874   $111,959   $84,663 
                     
Earnings Per Common Share                    
Basic  $1.14   $0.87   $3.26   $2.48 
Diluted  $1.13   $0.87   $3.25   $2.47 

 

See notes to consolidated financial statements.

 

 

EAGLE BANCORP, INC.

Consolidated Statements of Comprehensive Income (Unaudited)

(dollars in thousands)

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
   2018   2017   2018   2017 
                 
Net Income  $38,948   $29,874   $111,959   $84,663 
                     
Other comprehensive income, net of tax:                    
Unrealized (loss) gain on securities available for sale   (3,148)   15    (10,206)   1,243 
Reclassification adjustment for net gains included in net income       (7)   (51)   (340)
Total unrealized (loss) gain on investment securities   (3,148)   8    (10,257)   903 
Unrealized gain on derivatives   625    347    3,547    1,350 
Reclassification adjustment for amounts included in net income   (158)   (183)   (156)   (821)
Total unrealized gain on derivatives   467    164    3,391    529 
Other comprehensive (loss) income   (2,681)   172    (6,866)   1,432 
Comprehensive Income  $36,267   $30,046   $105,093   $86,095 

 

See notes to consolidated financial statements.

 

 

EAGLE BANCORP, INC.

Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)

(dollars in thousands except share data)

 

                  

Accumulated 

     
           Additional      

Other 

   Total 
   Common   Paid in    Retained   Comprehensive   Shareholders’ 
   Shares   Amount   Capital   Earnings   Income (Loss)   Equity 
                         
Balance January 1, 2018   34,185,163   $340   $520,304   $431,544   $(1,750)  $950,438 
                               
Net Income               111,959        111,959 
Other comprehensive loss, net of tax                   (6,866)   (6,866)
Stock-based compensation expense           5,174            5,174 
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   (13,681)   1    (1)            
Time based stock awards granted   94,344                     
Issuance of common stock related to employee stock purchase plan   10,417        608            608 
Reclassification of the income tax effects of the Tax Cuts and Jobs Act from AOCI (ASU 2018-02)               674    (674)    
Balance September 30, 2018   34,308,473   $341   $526,423   $544,177   $(9,290)  $1,061,651 
                               
Balance January 1, 2017   34,023,850   $338   $513,531   $331,311   $(2,381)  $842,799 
                               
Net Income               84,663        84,663 
Other comprehensive income, net of tax                   1,432    1,432 
Stock-based compensation expense           4,198    1        4,199 
Issuance of common stock related to options exercised, net of shares withheld for payroll taxes   60,925    1    258            259 
Vesting of time based stock awards issued at date of grant, net of shares withheld for payroll taxes   (16,962)   1    (2)           (1)
Time based stock awards granted   91,097                     
Issuance of common stock related to employee stock purchase plan   11,510        631            631 
Vesting of performance based stock awards, net of shares withheld for payroll taxes   3,589                     
Balance September 30, 2017   34,174,009   $340   $518,616   $415,975   $(949)  $933,982 

 

See notes to consolidated financial statements.

 

 

EAGLE BANCORP, INC.

Consolidated Statements of Cash Flows (Unaudited)

(dollars in thousands)

 

  

Nine Months Ended

September 30,

 
   2018   2017 
Cash Flows From Operating Activities:          
Net Income  $111,959   $84,663 
Adjustments to reconcile net income to net cash provided by operating activities:          
Provision for credit losses   6,060    4,884 
Depreciation and amortization   5,292    5,161 
Gains on sale of loans   (4,632)   (6,740)
Securities premium amortization (discount accretion), net   3,297    2,799 
Origination of loans held for sale   (325,109)   (481,917)
Proceeds from sale of loans held for sale   336,109    514,306 
Net increase in cash surrender value of BOLI   (1,073)   (1,108)
(Increase) decrease in deferred income tax benefit   (6,426)   1,293 
Net loss on sale of other real estate owned       301 
Net gain on sale of investment securities   (68)   (542)
Stock-based compensation expense   5,174    4,199 
Net tax benefits from stock compensation   108    460 
Increase in other assets   (11,894)   (23,059)
(Decrease) increase in other liabilities   (10,886)   9,553 
Net cash provided by operating activities   107,911    114,253 
Cash Flows From Investing Activities:          
Purchases of available for sale investment securities   (246,501)   (144,554)
Proceeds from maturities of available for sale securities   68,901    55,732 
Proceeds from sale/call of available for sale securities   31,974    70,079 
Purchases of Federal Reserve and Federal Home Loan Bank stock   (47,811)   (27,665)
Proceeds from redemption of Federal Reserve and Federal Home Loan Bank stock   46,878    18,285 
Net increase in loans   (435,773)   (408,447)
Purchases of BOLI   (10,000)    
Proceeds from sale of other real estate owned       2,144 
Bank premises and equipment acquired   (727)   (2,459)
Net cash used in investing activities   (593,059)   (436,885)
Cash Flows From Financing Activities:          
Increase in deposits   518,321    197,838 
(Decrease) increase in customer repurchase agreements   (40,115)   4,693 
Increase in short-term borrowings       200,000 
Proceeds from exercise of equity compensation plans   338    257 
Proceeds from employee stock purchase plan   608    631 
Net cash provided by financing activities   479,152    403,419 
Net (Decrease) Increase In Cash and Cash Equivalents   (5,996)   80,787 
Cash and Cash Equivalents at Beginning of Period   190,473    368,163 
Cash and Cash Equivalents at End of Period  $184,477   $448,950 
Supplemental Cash Flows Information:          
Interest paid  $53,405   $31,257 
Income taxes paid  $39,900   $52,800 
Non-Cash Investing Activities          
Transfers from loans to other real estate owned  $   $1,145 

 

See notes to consolidated financial statements.

 

 

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 nine months ended September 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 September 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 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 has 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:

 

September 30, 2018
(dollars in thousands)
  Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Estimated
Fair
Value
 
U. S. agency securities  $236,853   $   $6,528   $230,325 
Residential mortgage backed securities   448,335    140    12,126    436,349 
Municipal bonds   48,203    391    858    47,736 
Corporate bonds   8,004    61    19    8,046 
Other equity investments   218            218 
   $741,613   $592   $19,531   $722,674 

 

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 September 30, 2018 and December 31, 2017 the Company held $37.3 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 
September 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   61   $111,702   $1,909   $115,678   $4,619   $227,380   $6,528 
Residential mortgage backed securities   184    237,720    3,938    190,668    8,188    428,388    12,126 
Municipal bonds   16    16,388    352    10,440    506    26,828    858 
Corporate bonds   2    2,981    19            2,981    19 
    263   $368,791   $6,218   $316,786   $13,313   $685,577   $19,531 

 

       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 3.9 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 September 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 September 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.

 

   September 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  $119,017   $114,692   $109,893   $108,198 
After one year through five years   104,464    102,953    74,106    73,916 
Five years through ten years   13,372    12,680    14,116    13,870 
Residential mortgage backed securities   448,335    436,349    322,067    317,836 
Municipal bonds maturing:                    
One year or less   9,882    9,969    5,068    5,171 
After one year through five years   15,579    15,541    19,405    19,879 
Five years through ten years   21,675    21,094    35,432    35,846 
After ten years   1,067    1,132    1,071    1,161 
Corporate bonds maturing:                    
After one year through five years   6,504    6,546    11,510    11,673 
After ten years   1,500    1,500    1,500    1,500 
Other equity investments   218    218    218    218 
   $741,613   $722,674   $594,386   $589,268 

 

For the nine months ended September 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 nine months ended September 30, 2017, gross realized gains on sales of investments securities were $795 thousand and gross realized losses on sales of investment securities were $254 thousand. 

 

Proceeds from sales and calls of investment securities for the nine months ended September 30, 2018 were $32.0 million compared to $70.1 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 September 30, 2018 and December 31, 2017 was $486.9 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 September 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.

 

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.

 

13

 

 

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 September 30, 2018 the Bank had mortgage banking derivative financial instruments with a notional value of $39.9 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 September 30, 2018 was $80 thousand included in other assets and $28 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 nine months ended September 30, 2018 was a net gain of $10 thousand and a net loss of $42 thousand, respectively, relating to mortgage banking derivative instruments as compared to a net gain of $71 thousand and a net gain of $335 thousand, respectively, as of September 30, 2017. The amount included in other noninterest income for the three and nine months ended September 30, 2018 pertaining to its mortgage banking hedging activities was a net realized gain of $56 thousand and no net realized gain, respectively, as compared to a net realized loss of $14 thousand and a net realized loss of $912 thousand, respectively, as of September 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 September 30, 2018 and December 31, 2017 are summarized by type as follows:

 

   September 30, 2018   December 31, 2017 
(dollars in thousands)  Amount   %   Amount   % 
Commercial  $1,493,577    22%  $1,375,939    21%
Income producing - commercial real estate   3,189,910    46%   3,047,094    48%
Owner occupied - commercial real estate   863,162    13%   755,444    12%
Real estate mortgage - residential   104,864    2%   104,357    2%
Construction - commercial and residential   1,047,591    15%   973,141    15%
Construction - C&I (owner occupied)   56,572    1%   58,691    1%
Home equity   86,525    1%   93,264    1%
Other consumer   2,471        3,598     
Total loans   6,844,672    100%   6,411,528    100%
Less: allowance for credit losses   (68,189)        (64,758)     
Net loans  $6,776,483        $6,346,770      

 

Unamortized net deferred fees amounted to $24.5 million and $23.9 million at September 30, 2018 and December 31, 2017, respectively.

 

As of September 30, 2018 and December 31, 2017, the Bank serviced $207.3 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 September 30, 2018, owner occupied - commercial real estate and construction - C&I (owner occupied) represent approximately 14% of the loan portfolio. At September 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 84% 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 September 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. 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 September 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 21 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 $1.46 billion at September 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 77% of the outstanding ADC loan portfolio at September 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 nine months ended September 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 September 30, 2018                                        
Allowance for credit losses:                                        
Balance at beginning of period  $12,206   $27,988   $6,003   $757   $18,651   $673   $331   $66,609 
Loans charged-off   (1,174)               (643)       (15)   (1,832)
Recoveries of loans previously charged-off   60            1    899    6    5    971 
Net loans (charged-off) recoveries   (1,114)           1    256    6    (10)   (861)
Provision for credit losses   4,557    (601)   (72)   (9)   (1,368)   (48)   (18)   2,441 
Ending balance  $15,649   $27,387   $5,931   $749   $17,539   $631   $303   $68,189 
                                         
Nine Months Ended September 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   (2,435)   (121)   (132)       (1,160)       (15)   (3,863)
Recoveries of loans previously charged-off   86    2    2    4    994    133    13    1,234 
Net loans (charged-off) recoveries   (2,349)   (119)   (130)   4    (166)   133    (2)   (2,629)
Provision for credit losses   4,896    2,130    127    (199)   (787)   (272)   165    6,060 
Ending balance  $15,649   $27,387   $5,931   $749   $17,539   $631   $303   $68,189 
                                         
As of September 30, 2018                                        
Allowance for credit losses:                                        
Individually evaluated for impairment  $6,271   $3,043   $500   $   $   $   $56   $9,870 
Collectively evaluated for impairment   9,378    24,344    5,431    749    17,539    631    247    58,319 
Ending balance  $15,649   $27,387   $5,931   $749   $17,539   $631   $303   $68,189 
                                         
Three Months Ended September 30, 2017                                        
Allowance for credit losses:                                        
Balance at beginning of period  $14,225   $23,308   $4,189   $1,081   $16,727   $1,216   $301   $61,047 
Loans charged-off   (522)               (39)       (32)   (593)
Recoveries of loans previously charged-off   407    30        2    146    1    6    592 
Net loans (charged-off) recoveries   (115)   30        2    107    1    (26)   (1)
Provision for credit losses   (2,266)   (963)   1,273    (126)   4,052    (120)   71    1,921 
Ending balance  $11,844   $22,375   $5,462   $957   $20,886   $1,097   $346   $62,967 
                                         
Nine Months Ended September 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   (659)   (1,470)           (39)       (98)   (2,266)
Recoveries of loans previously charged-off   675    80    2    5    491    4    18    1,275 
Net loans (charged-off) recoveries   16    (1,390)   2    5    452    4    (80)   (991)
Provision for credit losses   (2,872)   2,660    1,450    (332)   3,947    (235)   266    4,884 
Ending balance  $11,844   $22,375   $5,462   $957   $20,886   $1,097   $346   $62,967 
                                         
As of September 30, 2017                                        
Allowance for credit losses:                                        
Individually evaluated for impairment  $3,246   $1,378   $1,005   $   $2,900   $90   $81   $8,700 
Collectively evaluated for impairment   8,598    20,997    4,457    957    17,986    1,007    265    54,267 
Ending balance  $11,844   $22,375   $5,462   $957   $20,886   $1,097   $346   $62,967 

 

17

 

 

The Company’s recorded investments in loans as of September 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
                         
September 30, 2018                                        
Recorded investment in loans:                                        
Individually evaluated for impairment  $27,370   $9,404   $5,312   $1,236   $3,030   $487   $92   $46,931 
Collectively evaluated for impairment   1,466,207    3,180,506    857,850    103,628    1,101,133    86,038    2,379    6,797,741 
Ending balance  $1,493,577   $3,189,910   $863,162   $104,864   $1,104,163   $86,525   $2,471   $6,844,672 
                                         
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 September 30, 2018, nonperforming loans acquired from Fidelity & Trust Financial Corporation (“Fidelity”) and Virginia Heritage Bank (“Virginia Heritage”) have a carrying value of $287 thousand and $394 thousand, and an unpaid principal balance of $337 thousand and $1.2 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 September 30, 2018 and December 31, 2017.

 

                   
(dollars in thousands)  Pass  

Watch and

Special Mention

   Substandard   Doubtful  

Total

Loans

 
                     
September 30, 2018                         
Commercial  $1,444,780   $21,427   $27,370   $   $1,493,577 
Income producing - commercial real estate   3,156,777    23,729    9,404        3,189,910 
Owner occupied - commercial real estate   821,647    36,203    5,312        863,162 
Real estate mortgage – residential   102,979    649    1,236        104,864 
Construction - commercial and residential   1,101,133        3,030        1,104,163 
Home equity   85,352    686    487        86,525 
Other consumer   2,379        92        2,471 
          Total  $6,715,047   $82,694   $46,931   $   $6,844,672 
                          
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 September 30, 2018 and December 31, 2017.

 

(dollars in thousands)  September 30, 2018   December 31, 2017 
         
Commercial  $7,529   $3,493 
Income producing - commercial real estate   48    832 
Owner occupied - commercial real estate   2,370    5,501 
Real estate mortgage - residential   1,522    775 
Construction - commercial and residential   3,030    2,052 
Home equity   487    494 
Other consumer   91    91 
Total nonaccrual loans (1)(2)  $15,077   $13,238 

 

(1)Excludes troubled debt restructurings (“TDRs”) that were performing under their restructured terms totaling $17.5 million at September 30, 2018 and $12.3 million at December 31, 2017.
(2)Gross interest income of $707 thousand and $802 thousand would have been recorded for the nine months ended September 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 $193 thousand and $56 thousand for the nine months ended September 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 September 30, 2018 and December 31, 2017.

 

   Loans   Loans   Loans           Total Recorded 
   30-59 Days   60-89 Days   90 Days or   Total Past   Current   Investment in 
(dollars in thousands)  Past Due   Past Due   More Past Due   Due Loans   Loans   Loans 
                         
September 30, 2018                              
Commercial  $4,297   $1,247   $7,529   $13,073   $1,480,504   $1,493,577 
Income producing - commercial real estate   763    398    48    1,209    3,188,701    3,189,910 
Owner occupied - commercial real estate   4,500    4,806    2,370    11,676    851,486    863,162 
Real estate mortgage – residential           1,522    1,522    103,342    104,864 
Construction - commercial and residential   21,947    1,849    3,030    26,826    1,077,337    1,104,163 
Home equity   326        487    813    85,712    86,525 
Other consumer   4        91    95    2,376    2,471 
          Total  $31,837   $8,300   $15,077   $55,214   $6,789,458   $6,844,672 
                               
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 September 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 
                                     
September 30, 2018                                             
Commercial  $12,943   $   $12,471   $12,471   $6,271   $10,234   $8,431   $277   $316 
Income producing - commercial real estate   9,260        9,260    9,260    3,043    9,292    9,277    120    361 
Owner occupied - commercial real estate   5,761    449    5,312    5,761    500    5,940    6,104    125    149 
Real estate mortgage – residential   1,522    1,522        1,522        1,749    1,747        2 
Construction - commercial and residential   3,030    3,030        3,030        1,515    1,694    68    68 
Home equity   487    487        487        491    492         
Other consumer   92        92    92    56    92    91         
Total  $33,095   $5,488   $27,135   $32,623   $9,870   $29,313   $27,836   $590   $896 
                                              
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 September 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 September 30, 2018 and December 31, 2017.

 

   For the Nine Months Ended September 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   10   $4,942   $9,212   $3,391   $   $17,545 
     Restructured nonaccruing   4    723                723 
Total   14   $5,665   $9,212   $3,391   $   $18,268 
                               
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 fourteen TDR’s at September 30, 2018 totaling approximately $18.3 million. Ten of these loans totaling approximately $17.5 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 nine months ended September 30, 2018, as compared to the same period in 2017, which had one default on a $237 thousand restructured loan which was charged off. 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. For the three months ended September 30, 20108, there was one loan totaling $2.4 million modified in a TDR, as compared to the three months ended September 30, 2017 which had two loans totaling $251 thousand modified in a TDR. For the nine months ended September 31, 2018, there were three loans totaling $6.4 million modified in a TDR, as compared to the nine months ended September 30, 2017 which had three loans totaling $5.1 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 September 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 $6.4 million at September 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 three and nine months ended September 30, 2018, the Company reclassified $214 and $230 thousand, respectively, related to designated cash flow hedge derivatives from accumulated other comprehensive income to decrease interest expense. During the three and nine months ended September 30, 2017, the Company reclassified $307 and $1.3 million, respectively, related to designated cash flow hedge derivatives from accumulated other comprehensive income to increase interest expense. During the next twelve months, the Company estimates (based on existing interest rates) that $2.1 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 September 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 September 30, 2018). The Company has minimum collateral posting thresholds with certain of its derivative counterparties. As of September 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 September 30, 2018, it could have been required to settle its obligations under the agreements at the termination value.

 

During the third quarter of 2018, the Company entered into credit risk participation agreements (“RPAs”) with institutional counterparties, under which the Company assumes its pro-rata share of the credit exposure associated with a borrower’s performance related to interest rate derivative contracts. The fair value of RPAs is calculated by determining the total expected asset or liability exposure of the derivatives to the borrowers and applying the borrowers’ credit spread to that exposure. Total expected exposure incorporates both the current and potential future exposure of the derivatives, derived from using observable inputs, such as yield curves and volatilities. These derivatives are not designated as hedges, are not speculative, and have a notional value of $27.5 million as of September 30. 2018. The changes in fair value for these contracts are recognized directly in earnings.

 

 25

 

 

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

 

       September 30, 2018  December 31, 2017
   Swap   Notional       Balance Sheet  Notional       Balance Sheet
   Number   Amount   Fair Value   Category  Amount   Fair Value   Category
Derivatives designated as hedging instruments                  
                           
(dollars in thousands)                               
Interest rate swap   (1)  $75,000   $1,240   Other Assets  $75,000   $598   Other Assets
Interest rate swap   (2)   100,000    2,539   Other Assets   100,000    821   Other Assets
Interest rate swap   (3)   75,000    2,648   Other Assets   75,000    837   Other Assets
     Total    $250,000   $6,427      $250,000   $2,256    
                                
Derivatives not designated as hedging instruments                      
                                
(dollars in thousands)                               
Other Contracts   (1)   27,500    29   Other Liabilities          Other Liabilities
     Total    $27,500   $29      $   $    

 

The table below presents the pre-tax net gains (losses) of the Company’s designated cash flow hedges for the three and nine months ended September 30, 2018 and 2017.

 

       Three Months Ended September 30, 2018   Three Months Ended September 30, 2017 
       Amount of   Reclassified from AOCI into Income    Amount of   Reclassified from AOCI into Income  
   Swap   Pre-tax gain      Amount of   Pre-tax (loss)      Amount of 
   Number   Recognized in OCI   Category  Gain (Loss)   Recognized in OCI   Category  (Loss) 
                           
(dollars in thousands)                           
Interest rate swap   (1)  $111    Interest Expense  $90   $26    Interest Expense  $(72)
Interest rate swap   (2)   426    Interest Expense   73    (8)   Interest Expense   (122)
Interest rate swap   (3)   312    Interest Expense   51    (56)   Interest Expense   (113)
     Total    $849      $214   $(38)     $(307)

 

        Nine Months Ended September 30, 2018   Nine Months Ended September 30, 2017 
         Reclassified from AOCI into Income      Reclassified from AOCI into Income 
    Swap Number   

Amount of

Pre-tax gain

Recognized in OCI

 Category 

Amount of

Gain (Loss)

  

Amount of

Pre-tax (loss)

Recognized in OCI

   Category 

Amount of

(Loss)

 
                                
(dollars in thousands)                           
Interest rate swap   (1)  $791    Interest Expense  $148   $(26)   Interest Expense  $(338)
Interest rate swap   (2)   1,769    Interest Expense   51    (35)   Interest Expense   (525)
Interest rate swap   (3)   1,841    Interest Expense   31    (400)   Interest Expense   (458)
     Total    $4,401      $230   $(461)     $(1,321)

  

 26

 

 

The table below presents the effect of the Company’s derivative financial instruments on the Consolidated Statements of Operations for the three and nine months ended September 30, 2018 and 2017.

                                 
   

Location and Amount of Gain or (Loss) Recognized in Income on Cash Flow Hedging Relationships

 
    Three Months Ended September 30, 2018   Three Months Ended September 30, 2017  
(dollars in thousands)   Interest Income (Expense)     Other Income (Expense)     Interest Income (Expense)     Other Income (Expense)  
Total amounts of income and expense line items presented in the Consolidated Statements of Operations in which the effects of cash flow hedges are recorded   $ 214     $     $ (307 )   $  
                                 
The effects of cash flow hedging:                                
   Gain or (loss) on cash flow hedging relationships in Subtopic 815-20                                
           Interest contracts                                
Amount of gain or (loss) reclassified from accumulated other comprehensive income into income   $ 214     $     $ (307 )   $  

                                 
    Location and Amount of Gain or (Loss) Recognized in Income on Cash Flow Hedging Relationships  
    Nine Months Ended September 30, 2018     Nine Months Ended September 30, 2017  
(dollars in thousands)   Interest Income (Expense)     Other Income (Expense)     Interest Income (Expense)     Other Income (Expense)  
Total amounts of income and expense line items presented in the Consolidated Statements of Operations in which the effects of cash flow hedges are recorded   $ 230     $     $ (1,321 )   $  
                                 
The effects of cash flow hedging:                                
   Gain or (loss) on cash flow hedging relationships in Subtopic 815-20                                
           Interest contracts                                
Amount of gain or (loss) reclassified from accumulated other comprehensive income into income   $ 230     $     $ (1,321 )   $  

  

 27

 

 

Balance Sheet Offsetting: Our designated cash flow hedge interest rate swap derivatives are eligible for offset in the Consolidated Balance Sheets and are subject to master netting arrangements. Our derivative transactions with counterparties are generally executed under International Swaps and Derivative Association (“ISDA”) master agreements which include “right of set-off” provisions. In such cases there is generally a legally enforceable right to offset recognized amounts and there may be an intention to settle such amounts on a net basis. The Company generally offsets such financial instruments for financial reporting purposes. The table below presents a gross presentation, the effects of offsetting, and a net presentation of the Company’s cash flow hedge derivatives as of September 30, 2018 and December 31, 2017.

 

As of September 30, 2018
Offsetting of Derivative Assets (dollars in thousands)
                  Gross Amounts Not Offset in the Balance Sheet 
   Gross Amounts of Recognized Assets   Gross Amounts Offset in the Balance Sheet   Net Amounts of Assets presented in the Balance Sheet   Financial Instruments   Cash Collateral Posted   Net Amount 
Counterparty 1  $5,220   $   $5,220   $   $   $5,220 
Counterparty 2   1,270       $1,270           $1,270 
Counterparty 3   (29)      $(29)          $(29)
   $6,461   $   $6,461   $   $   $6,461 

 

As of December 31, 2017
Offsetting of Derivative Assets (dollars in thousands)
                  Gross Amounts Not Offset in the Balance Sheet 
   Gross Amounts of Recognized Assets   Gross Amounts Offset in the Balance Sheet   Net Amounts of Assets presented in the Balance Sheet   Financial Instruments   Cash Collateral Posted   Net Amount 
Counterparty 1  $1,619   $   $1,619   $   $   $1,619 
Counterparty 2   582        582            582 
   $2,201   $   $2,201   $   $   $2,201 

  

Note 7. Other Real Estate Owned

 

The activity within Other Real Estate Owned (“OREO”) for the three and nine months ended September 30, 2018 and 2017 is presented in the table below. There were no residential real estate loans in the process of foreclosure as of September 30, 2018. For the three and nine months ended September 30, 2018, there were no sales of OREO property. For the three months ended September 30, 2017, proceeds on sale of OREO were $1.2 million from the sale of two OREO properties with a total carrying value of $1.1 million resulting in a net gain of $60 thousand. For the nine months ended September 30, 2017, proceeds on sale of OREO were $2.1 million from the sale of three OREO properties with a total carrying value of $2.5 million resulting in a net loss of $301 thousand.

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
(dollars in thousands)  2018   2017   2018   2017 
                 
Balance at January 1,  $1,394   $1,394   $1,394   $2,694 
Real estate acquired from borrowers       1,145        1,145 
Properties sold       (1,145)       (2,445)
Ending balance  $1,394   $1,394   $1,394   $1,394 

 

 28

 

 

Note 8. Long-Term Borrowings

 

The following table presents information related to the Company’s long-term borrowings as of September 30, 2018 and December 31, 2017.

 

(dollars in thousands)  September 30, 2018   December 31, 2017 
         
Subordinated Notes, 5.75%  $70,000   $70,000 
Subordinated Notes, 5.0%   150,000    150,000 
Less: unamortized debt issuance costs   (2,802)   (3,095)
Long-term borrowings  $217,198   $216,905 

 

On August 5, 2014, the Company completed the sale of $70.0 million of its 5.75% subordinated notes, due September 1, 2024 (the “2024 Notes”). The 2024 Notes were offered to the public at par and qualify as Tier 2 capital for regulatory purposes to the fullest extent permitted under the Basel III Rule capital requirements. The net proceeds were approximately $68.8 million, which includes $1.2 million in deferred financing costs which are being amortized over the life of the 2024 Notes.

 

On July 26, 2016, the Company completed the sale of $150.0 million of its 5.00% Fixed-to-Floating Rate Subordinated Notes, due August 1, 2026 (the “2026 Notes”). The 2026 Notes were offered to the public at par and qualify as Tier 2 capital for regulatory purposes to the fullest extent permitted under the Basel III Rule capital requirements. The net proceeds were approximately $147.35 million, which includes $2.6 million in deferred financing costs which are being amortized over the life of the 2026 Notes.

 

Note 9. Net Income per Common Share

 

The calculation of net income per common share for the three months ended September 30, 2018 and 2017 was as follows.

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
(dollars and shares in thousands, except per share data)  2018   2017   2018   2017 
Basic:                
Net income  $38,948   $29,874   $111,959   $84,663 
Average common shares outstanding   34,309    34,174    34,292    34,124 
Basic net income per common share  $1.14   $0.87   $3.26   $2.48 
                     
Diluted:                    
Net income  $38,948   $29,874   $111,959   $84,663 
Average common shares outstanding   34,309    34,174    34,292    34,124 
Adjustment for common share equivalents   152    164    152    192 
Average common shares outstanding-diluted   34,461    34,338    34,444    34,316 
Diluted net income per common share  $1.13   $0.87   $3.25   $2.47 
                     
Anti-dilutive shares   3             

 

 29

 

 

Note 10. Other Comprehensive Income

 

The following table presents the components of other comprehensive income (loss) for the three and nine months ended September 30, 2018 and 2017.

 

(dollars in thousands)  Before Tax   Tax Effect   Net of Tax 
             
Three Months Ended September 30, 2018               
Net unrealized loss on securities available-for-sale  $(4,253)  $1,105   $(3,148)
Less: Reclassification adjustment for net gains included in net income            
Total unrealized loss   (4,253)   1,105    (3,148)
                
Net unrealized gain on derivatives   846    221    625 
Less: Reclassification adjustment for losses included in net income   (211)   (53)   (158)
Total unrealized gain   635    168    467 
                
Other Comprehensive Loss  $(3,618)  $1,273   $(2,681)
                
Three Months Ended September 30, 2017               
Net unrealized gain on securities available-for-sale  $25   $10   $15 
Less: Reclassification adjustment for net gains included in net income   (11)   (4)   (7)
Total unrealized gain   14    6    8 
                
Net unrealized loss on derivatives   557    210    347 
Less: Reclassification adjustment for losses included in net income   (289)   (106)   (183)
Total unrealized loss   268    104    164 
                
Other Comprehensive Income  $282   $110   $172 
                
Nine Months Ended September 30, 2018               
Net unrealized gain on securities available-for-sale  $(13,079)  $2,873   $(10,206)
Less: Reclassification adjustment for net gains included in net income   (68)   (17)   (51)
Total unrealized loss   (13,147)   2,856    (10,257)
                
Net unrealized gain on derivatives   4,380    833    3,547 
Less: Reclassification adjustment for losses included in net income   (209)   (53)   (156)
Total unrealized gain   4,171    780    3,391 
                
Other Comprehensive Loss  $(8,976)  $3,636   $(6,866)
                
Nine Months Ended September 30, 2017               
Net unrealized gain on securities available-for-sale  $2,080   $837   $1,243 
Less: Reclassification adjustment for net gains included in net income   (542)   (202)   (340)
Total unrealized gain   1,538    635    903 
                
Net unrealized gain on derivatives   2,186    836    1,350 
Less: Reclassification adjustment for losses included in net income   (1,308)   (487)   (821)
Total unrealized gain   878    349    529 
                
Other Comprehensive Income  $2,416   $984   $1,432 

 

 30

 

 

The following table presents the changes in each component of accumulated other comprehensive loss, net of tax, for the three and nine months ended September 30, 2018 and 2017.

 

(dollars in thousands)  Securities Available For Sale   Derivatives   Accumulated Other
Comprehensive Income (Loss)
 
             
Three Months Ended September 30, 2018               
Balance at Beginning of Period  $(10,914)  $4,305   $(6,609)
Other comprehensive income (loss) before reclassifications   (3,148)   625    (2,523)
Amounts reclassified from accumulated other comprehensive income (loss)       (158)   (158)
Total other comprehensive income (loss)   (3,148)   467    (2,681)
Balance at End of Period  $(14,062)  $4,772   $(9,290)
                
Three Months Ended September 30, 2017               
Balance at Beginning of Period  $(1,060)  $(61)  $(1,121)
Other comprehensive income before reclassifications   15    347    362 
Amounts reclassified from accumulated other comprehensive income   (7)   (183)   (190)
Net other comprehensive income during period   8    164    172 
Balance at End of Period  $(1,052)  $103   $(949)
                
Nine Months Ended September 30, 2018               
Balance at Beginning of Period  $(3,131)  $1,381   $(1,750)
Other comprehensive income (loss) before reclassifications   (10,206)   3,547    (6,659)
Amounts reclassified from accumulated other comprehensive income   (51)   (156)   (207)
Total other comprehensive income (loss)   (10,257)   3,391    (6,866)
Reclassification of the Income Tax Effects of the Tax Cuts and Jobs Act from AOCI   (674)       (674)
Balance at End of Period  $(14,062)  $4,772   $(9,290)
                
Nine Months Ended September 30, 2017               
Balance at Beginning of Period  $(1,955)  $(426)  $(2,381)
Other comprehensive income before reclassifications   1,243    1,350    2,593 
Amounts reclassified from accumulated other comprehensive income   (340)   (821)   (1,161)
Net other comprehensive income during period   903    529    1,432 
Balance at End of Period  $(1,052)  $103   $(949)

 

The following table presents the amounts reclassified out of each component of accumulated other comprehensive (loss) income for the three and nine months ended September 30, 2018 and 2017.

 

Details about Accumulated Other  Amount Reclassified from   Affected Line Item in
Comprehensive Income Components  Accumulated Other   the Statement Where
(dollars in thousands)  Comprehensive (Loss) Income   Net Income is Presented
   Three Months Ended September 30,    
   2018   2017    
Realized gain on sale of investment securities  $   $(11)  Gain on sale of investment securities
Interest expense derivative deposits   (211)   (289)  Interest expense on deposits
Income tax benefit (expense)   53    110   Tax expense
Total Reclassifications for the Period  $(158)  $(190)  Net Income

              
Details about Accumulated Other  Amount Reclassified from   Affected Line Item in
Comprehensive Income Components  Accumulated Other   the Statement Where
(dollars in thousands)  Comprehensive (Loss) Income   Net Income is Presented
   Nine Months Ended September 30,    
    2018    2017    
Realized gain on sale of investment securities  $(68)  $(542)  Gain on sale of investment securities
Interest expense derivative deposits   (209)   (1,308)  Interest expense on deposits
Income tax benefit (expense)   70    689   Tax expense
Total Reclassifications for the Period  $(207)  $(1,161)  Net Income

 

 31

 

  

Note 11.  Fair Value Measurements

 

The fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for such asset or liability. In estimating fair value, the Company utilizes valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. Such valuation techniques are consistently applied. Inputs to valuation techniques include the assumptions that market participants would use in pricing an asset or liability. ASC Topic 820, “Fair Value Measurements and Disclosures,” establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

 

Level 1Quoted prices in active exchange markets for identical assets or liabilities; also includes certain U.S. Treasury and other U.S. Government and agency securities actively traded in over-the-counter markets.

 

Level 2Observable inputs other than Level 1 including quoted prices for similar assets or liabilities, quoted prices in less active markets, or other observable inputs that can be corroborated by observable market data; also includes derivative contracts whose value is determined using a pricing model with observable market inputs or can be derived principally from or corroborated by observable market data.  This category generally includes certain U.S. Government and agency securities, corporate debt securities, derivative instruments, and residential mortgage loans held for sale.

 

Level 3Unobservable inputs supported by little or no market activity for financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation; also includes observable inputs for single dealer nonbinding quotes not corroborated by observable market data. This category generally includes certain private equity investments, retained interests from securitizations, and certain collateralized debt obligations.

 

 32

 

 

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

 

The table below presents the recorded amount of assets and liabilities measured at fair value on a recurring basis as of September 30, 2018 and December 31, 2017.

 

(dollars in thousands)  Quoted Prices
(Level 1)
   Significant Other
Observable Inputs
(Level 2)
   Significant Other
Unobservable
Inputs (Level 3)
   Total
(Fair Value)
 
September 30, 2018                    
Assets:                    
Investment securities available for sale:                    
U. S. agency securities  $   $230,325   $   $230,325 
Residential mortgage backed securities       436,349        436,349 
Municipal bonds       47,736        47,736 
Corporate bonds       6,546    1,500    8,046 
Other equity investments           218    218 
Loans held for sale       18,728        18,728 
Mortgage banking derivatives           80    80 
Interest rate swap derivatives       6,427        6,427 
Total assets measured at fair value on a recurring basis as of September 30, 2018  $   $746,111   $1,798   $747,909 
Liabilities:                    
Mortgage banking derivatives  $   $   $28   $28 
Total liabilities measured at fair value on a recurring basis as of September 30, 2018  $   $   $28   $28 
December 31, 2017                    
Assets:                    
Investment securities available for sale:                    
U. S. agency securities  $   $195,984   $   $195,984 
Residential mortgage backed securities       317,836        317,836 
Municipal bonds       62,057        62,057 
Corporate bonds       11,673    1,500    13,173 
Other equity investments           218    218 
Loans held for sale       25,096        25,096 
Mortgage banking derivatives           43    43 
Interest rate swap derivatives       2,256        2,256 
Total assets measured at fair value on a recurring basis as of December 31, 2017  $   $614,902   $1,761   $616,663 
Liabilities:                    
Mortgage banking derivatives  $   $   $10   $10 
Total liabilities measured at fair value on a recurring basis as of December 31, 2017  $   $   $10   $10 

 

Investment Securities Available-for-Sale: Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. 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. Level 1 securities include those traded on an active exchange such as the New York Stock Exchange, Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include U.S. agency debt securities, mortgage backed securities issued by Government Sponsored Entities (“GSE’s”) and municipal bonds. Securities classified as Level 3 include securities in less liquid markets, the carrying amounts approximate the fair value.

 

Loans held for sale: The Company has elected to carry loans held for sale at fair value. This election reduces certain timing differences in the Consolidated Statement of Operations and better aligns with the management of the portfolio from a business perspective. Fair value is derived from secondary market quotations for similar instruments. Gains and losses on sales of residential mortgage loans are recorded as a component of noninterest income in the Consolidated Statements of Operations. Gains and losses on sales of multifamily FHA securities are recorded as a component of noninterest income in the Consolidated Statements of Operations. As such, the Company classifies loans subjected to fair value adjustments as Level 2 valuation.

 

 33

 

 

The following table summarizes the difference between the aggregate fair value and the aggregate unpaid principal balance for loans held for sale measured at fair value as of September 30, 2018 and December 31, 2017.

 

   September 30, 2018 
      Aggregate Unpaid     
(dollars in thousands)  Fair Value Principal Balance  Difference 
              
Residential mortgage loans held for sale  $18,728 $ 18,488  $240 
FHA mortgage loans held for sale  $ $   $ 

              
   December 31, 2017 
      Aggregate Unpaid     
(dollars in thousands)  Fair Value Principal Balance  Difference 
              
Residential mortgage loans held for sale  $25,096 $ 24,674  $422 
FHA mortgage loans held for sale  $ $   $ 

 

No residential mortgage loans held for sale were 90 or more days past due or on nonaccrual status as of September 30, 2018 or December 31, 2017.

 

Interest rate swap derivatives: These derivative instruments consist of forward starting interest rate swap agreements, which are accounted for as cash flow hedges under ASC 815. The Company’s derivative position is classified within Level 2 of the fair value hierarchy and is valued using models generally accepted in the financial services industry and that use actively quoted or observable market input values from external market data providers and/or non-binding broker-dealer quotations. The fair value of the derivatives is determined using discounted cash flow models. These models’ key assumptions include the contractual terms of the respective contract along with significant observable inputs, including interest rates, yield curves, nonperformance risk and volatility. Derivative contracts are executed with a Credit Support Annex, which is a bilateral agreement that requires collateral postings when the market value exceeds certain threshold limits. These agreements protect the interests of the Company and its counterparties should either party suffer a credit rating deterioration.

 

Credit Risk Participation Agreements: The Company enters into credit risk participation agreements (“RPAs”) with institutional counterparties, under which the Company assumes its pro-rata share of the credit exposure associated with a borrower’s performance related to interest rate derivative contracts. The fair value of RPAs is calculated by determining the total expected asset or liability exposure of the derivatives to the borrowers and applying the borrowers’ credit spread to that exposure. Total expected exposure incorporates both the current and potential future exposure of the derivatives, derived from using observable inputs, such as yield curves and volatilities. Accordingly, RPAs fall within Level 2.

 

Mortgage banking derivatives: The Company relies on a third-party pricing service to value its mortgage banking derivative financial assets and liabilities, which the Company classifies as a Level 3 valuation. The external valuation model to estimate the fair value of its interest rate lock commitments to originate residential mortgage loans held for sale includes grouping the interest rate lock commitments by interest rate and terms, applying an estimated pull-through rate based on historical experience, and then multiplying by quoted investor prices determined to be reasonably applicable to the loan commitment groups based on interest rate, terms, and rate lock expiration dates of the loan commitment groups. The Company also relies on an external valuation model to estimate the fair value of its forward commitments to sell residential mortgage loans (i.e., an estimate of what the Company would receive or pay to terminate the forward delivery contract based on market prices for similar financial instruments), which includes matching specific terms and maturities of the forward commitments against applicable investor pricing.

 

 34

 

 

The following is a reconciliation of activity for assets and liabilities measured at fair value based on Significant Other Unobservable Inputs (Level 3):

 

   Investment    Mortgage Banking       
(dollars in thousands)  Securities    Derivatives    Total  
Assets:               
Beginning balance at January 1, 2018  $1,718   $43   $1,761 
Realized gain included in earnings - net mortgage banking derivatives       37    37 
    Purchases of available-for-sale securities            
    Principal redemption            
Ending balance at September 30, 2018  $1,718   $80   $1,798 
                
Liabilities:               
Beginning balance at January 1, 2018  $   $10   $10 
Realized loss included in earnings - net mortgage banking derivatives       18    18 
    Principal redemption            
Ending balance at September 30, 2018  $   $28   $28 

                
   Investment    Mortgage Banking      
(dollars in thousands)  Securities   Derivatives   Total 
Assets:               
Beginning balance at January 1, 2017  $1,718   $114   $1,832 
Realized loss included in earnings - net mortgage banking derivatives       (71)   (71)
    Purchases of available-for-sale securities            
    Principal redemption            
Ending balance at December 31, 2017  $1,718   $43   $1,761 
                
Liabilities:               
Beginning balance at January 1, 2017  $   $55   $55 
Realized loss included in earnings - net mortgage banking derivatives       (45)   (45)
    Principal redemption            
Ending balance at December 31, 2017  $   $10   $10 

 

The other equity securities classified as Level 3 consist of equity investments in the form of common stock of two local banking companies which are not publicly traded, and for which the carrying amount approximates fair value.

 

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

 

The Company measures certain assets at fair value on a nonrecurring basis and the following is a general description of the methods used to value such assets.

 

Impaired loans: The Company does not record loans at fair value on a recurring basis; however, from time to time, a loan is considered impaired and an allowance for loan loss is established. The Company considers a loan impaired when it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the note agreement, including both principal and interest. Management has determined that nonaccrual loans and loans that have had their terms restructured in a troubled debt restructuring meet this impaired loan definition. Once a loan is identified as individually impaired, management measures impairment in accordance with ASC Topic 310, “Receivables.” The fair value of impaired loans is estimated using one of several methods, including the collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring a specific allowance represent loans for which the fair value of expected repayments or collateral exceed the recorded investment in such loans. At September 30, 2018, substantially all of the Company’s impaired loans were evaluated based upon the fair value of the collateral. In accordance with ASC Topic 820, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the loan as nonrecurring Level 3. For individually evaluated impaired loans, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate or the estimated fair value of the underlying collateral for collateral-dependent loans, which the Company classifies as a Level 3 valuation.

 

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Other real estate owned: Other real estate owned is initially recorded at fair value less estimated selling costs. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral, which the Company classifies as a Level 3 valuation. Assets measured at fair value on a nonrecurring basis are included in the table below:

 

(dollars in thousands)  Quoted Prices
(Level 1)
   Significant Other
Observable Inputs
(Level 2)
   Significant Other
Unobservable
Inputs (Level 3)
   Total
(Fair Value)
 
September 30, 2018                    
Impaired loans:                    
Commercial  $   $   $6,200   $6,200 
Income producing - commercial real estate           6,217    6,217 
Owner occupied - commercial real estate           5,261    5,261 
Real estate mortgage - residential           1,522    1,522 
Construction - commercial and residential             3,030    3,030 
Home equity           487    487 
Other consumer           36    36 
Other real estate owned           1,394    1,394 
Total assets measured at fair value on  a nonrecurring basis as of September 30, 2018  $   $   $24,147   $24,147 

                     
(dollars in thousands)  Quoted Prices
(Level 1)
   Significant Other
Observable Inputs
(Level 2)
   Significant Other
Unobservable
Inputs (Level 3)<