LOANS AND ALLOWANCE FOR CREDIT LOSSES |
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| LOANS AND ALLOWANCE FOR CREDIT LOSSES |
A summary of the balances of loans follows:
The net unamortized deferred loan origination costs included in total loans and leases were $7.0 million and $5.4 million as of September 30, 2022 and December 31, 2021, respectively. As of September 30, 2022 and December 31, 2021, the commercial and industrial loans included $2.1 million and $27.0 million, respectively, of U.S. Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”) loans and $69,000 and $949,000, respectively, of deferred fees on the PPP loans. PPP loans are fully guaranteed by the U.S. government. The Company has transferred a portion of its originated commercial loans to participating lenders. The amounts transferred have been accounted for as sales and are therefore not included in the Company’s accompanying unaudited interim Consolidated Balance Sheets. The Company and participating lenders share ratably in cash flows and any gains or losses that may result from a borrower’s lack of compliance with contractual terms of the loan. The Company continues to service the loans on behalf of the participating lenders and, as such, collects cash payments from the borrowers, remits payments to participating lenders and disburses required escrow funds to relevant parties. At September 30, 2022 and December 31, 2021, the Company was servicing commercial loans for participants in the aggregate amount of $338.7 million and $288.9 million, respectively. Adoption of Topic 326 Effective January 1, 2022, the Company adopted the provisions of Topic 326 using the modified retrospective method. Therefore, prior period comparative information has not been adjusted and continues to be reported under GAAP in effect prior to the adoption of Topic 326. As a result of adopting Topic 326, the Company decreased the ACL on loans by $1.3 million on January 1, 2022. Accounting Policy Updates Effective January 1, 2022, the Company has modified its accounting policy for the ACL on loans as described below. The Company has made an accounting policy election to exclude accrued interest from the amortized cost basis of loans and reports accrued interest separately in other assets in the Unaudited Consolidated Balance Sheets. The Company also excludes accrued interest from the estimate of credit losses. Accrued interest receivable on loans totaled $11.5 million and $9.6 million, respectively, as of September 30, 2022 and December 31, 2021. The ACL on loans is management’s estimate of expected credit losses over the expected life of the loans at the reporting date. The ACL on loans is increased through a provision for credit losses recognized in the Unaudited Consolidated Statements of Income and by recoveries of amounts previously charged off. The ACL on loans is reduced by charge-offs on loans. Loan charge-offs are recognized when management believes the collectability of the principal balance outstanding is unlikely. Full or partial charge-offs on collateral-dependent individually analyzed loans are generally recognized when the collateral is deemed to be insufficient to support the carrying value of the loan. The level of the ACL on loans is based on management’s ongoing review of all relevant information, from internal and external sources, relating to past events, current conditions and reasonable and supportable forecasts. Historical credit loss experience provides the basis for the calculation of loss given default and the estimation of expected credit losses. As discussed further below, adjustments to historical information are made for differences in specific risk characteristics, such as differences in underwriting standards, portfolio mix, delinquency level, or term, as well as for changes in environmental conditions, that may not be reflected in historical loss rates. Management employs a process and methodology to estimate the ACL on loans that evaluates both quantitative and qualitative factors. The methodology for evaluating quantitative factors consists of two basic components. The first component involves pooling loans into portfolio segments for loans that share similar risk characteristics. Pooled loan portfolio segments include commercial real estate, commercial and industrial, commercial construction, residential real estate (including homeowner construction), home equity and consumer loans. The second component involves individually analyzed loans that do not share similar risk characteristics with loans that are pooled into portfolio segments. Individually analyzed loans include non-accrual loans, commercial loans risk-rated 8 or greater, loans classified as a TDR and certain other loans based on the underlying risk characteristics and the discretion of management to individually analyze such loans. For loans that are individually analyzed, the ACL is measured using a discounted cash flow (“DCF”) methodology based upon the loan’s contractual effective interest rate, or at the loan’s observable market price, or, if the loan is collateral-dependent, at the fair value of the collateral. Factors management considers when measuring the extent of expected credit loss include payment status, collateral value, borrower financial condition, guarantor support and the probability of collecting scheduled principal and interest payments when due. For collateral-dependent loans for which repayment is to be provided substantially through the sale of the collateral, management adjusts the fair value for estimated costs to sell. For collateral-dependent loans for which repayment is to be provided substantially through the operation of the collateral, such as accruing TDRs, estimated costs to sell are not incorporated into the measurement. Management may also adjust appraised values to reflect estimated market value declines or apply other discounts to appraised values for unobservable factors resulting from its knowledge of circumstances associated with the collateral. For pooled loans, the Company utilizes a DCF methodology to estimate credit losses over the expected life of the loan. The life of the loan excludes expected extensions, renewal and modifications, unless: (1) the extension or renewal options are included in the original or modified contract terms and not unconditionally cancellable by the Company; or (2) management reasonably expects at the reporting date that a TDR will be executed with an individual borrower. The methodology incorporates the probability of default and loss given default, which are identified by default triggers such as past due by 90 or more days, whether a charge-off has occurred, the loan is non-accrual, the loan has been modified in a TDR or the loan is risk-rated as special mention, substandard, or doubtful. The probability of default for the life of the loan is determined by the use of an econometric factor. Management utilizes the national unemployment rate as an econometric factor with a one-year forecast period and one-year straight-line reversion period to the historical mean of its macroeconomic assumption in order to estimate the probability of default for each loan portfolio segment. Utilizing a third-party regression model, the forecasted national unemployment rate is correlated with the probability of default for each loan portfolio segment. The DCF methodology combines the probability of default, the loss given default, maturity date and prepayment speeds to estimate a reserve for each loan. The sum of all the loan level reserves are aggregated for each portfolio segment and a loss rate factor is derived. Quantitative loss factors are also supplemented by certain qualitative risk factors reflecting management’s view of how losses may vary from those represented by quantitative loss rates. These qualitative risk factors include: (1) changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere in estimating credit losses; (2) changes in international, national, regional, and local economic and business conditions and developments that affect the collectability of the portfolio, including the condition of various market segments; (3) changes in the nature of the portfolio and in the volume of past due loans; (4) changes in the experience, ability, and depth of lending management and other relevant staff; (5) changes in the quality of the loan review system; (6) changes in the value of underlying collateral for collateral-dependent loans; (7) the existence and effect of any concentrations of credit, and changes in the level of such concentrations; and (8) the effect of other external factors such as legal and regulatory requirements on the level of estimated credit losses in the institution’s existing portfolio. Qualitative loss factors are applied to each portfolio segment and determined based on the risk characteristics of each segment. Because the methodology is based upon historical experience and trends, current economic data, reasonable and supportable forecasts, as well as management’s judgment, factors may arise that result in different estimations. Deteriorating conditions or assumptions could lead to further increases in the ACL on loans. In addition, various regulatory agencies periodically review the ACL on loans. Such agencies may require additions to the allowance based on their judgments about information available to them at the time of their examination. The ACL on loans is an estimate, and ultimate losses may vary from management’s estimate. The following table presents the activity in the ACL on loans for the three and nine months ended September 30, 2022:
For the accounting policy on the allowance for loan losses that was in effect prior to the adoption of Topic 326, see Note 1 to our Annual Report on Form 10-K for the fiscal year ended December 31, 2021. The following is the activity in the allowance for loan losses for the three and nine months ended September 30, 2021:
Effective January 1, 2022, individually analyzed loans include non-accrual loans, loans classified as TDRs, and certain other loans based on the underlying risk characteristics and the discretion of management to individually analyze such loans. As of September 30, 2022, the carrying value of individually analyzed loans amounted to $32.2 million, with a related allowance of $3.7 million, and $23.1 million were considered collateral-dependent. For collateral-dependent loans where management has determined that foreclosure of the collateral is probable, or where the borrower is experiencing financial difficulty and repayment of the loan is to be provided substantially through the operation or sale of the collateral, the ACL is measured based on the difference between the fair value of the collateral and the amortized cost basis of the loan as of the measurement date. The following table presents the carrying value of collateral-dependent individually analyzed loans as of September 30, 2022:
Prior to January 1, 2022, a loan was considered impaired when, based on current information and events, it was probable that Company would not be able to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Impaired loans included non-accrual loans and loans restructured in a TDR. The Company identified loss allocations for impaired loans on an individual-loan basis. The following is a summary of impaired loans.
The following information pertains to impaired loans:
Interest income recognized and interest income recognized on a cash basis in the tables above represent interest income for the three and nine months ended September 30, 2021, not for the time period designated as impaired. No additional funds are committed to be advanced in connection with impaired loans. The following is a summary of past due and non-accrual loans at September 30, 2022 and December 31, 2021:
At September 30, 2022 and December 31, 2021, there were no loans past due 90 days or more and still accruing. There was one TDR loan modification during the three and nine months ended September 30, 2022 and no material modifications during the same periods in 2021. The TDR loan modification in 2022 provided a deferral of principal. The recorded investment in TDRs was $11.7 million and $11.0 million at September 30, 2022 and December 31, 2021, respectively. Commercial TDRs totaled $2.3 million and $408,000 at September 30, 2022 and December 31, 2021, respectively. The remainder of the TDRs outstanding at the end of these periods were residential loans. Non-accrual TDRs totaled $2.9 million at September 30, 2022 and $1.0 million at December 31, 2021. Of these loans, $2.1 million and $190,000 were non-accrual commercial TDRs at September 30, 2022 and December 31, 2021, respectively. All TDR loans are considered impaired, and management performs a DCF calculation to determine the amount of impairment reserve required on each loan. TDR loans which subsequently default are reviewed to determine if the loan should be deemed collateral-dependent. In either case, any reserve required is recorded as part of the allowance for loan losses. During the three and nine months ended September 30, 2022 and 2021, there were no payment defaults on TDRs. Credit Quality Indicators Commercial The Company uses a ten-grade internal loan rating system for commercial real estate, commercial construction and commercial loans, as follows: Loans rated 1 – 6 are considered “pass”-rated loans with low to average risk. Loans rated 7 are considered “special mention.” These loans are starting to show signs of potential weakness and are being closely monitored by management. Loans rated 8 are considered “substandard.” Generally, a loan is considered substandard if it is inadequately protected by the current net worth and paying capacity of the obligors and/or the collateral pledged. There is a distinct possibility that the Company will sustain some loss if the weakness is not corrected. Loans rated 9 are considered “doubtful.” Loans classified as doubtful have all the weaknesses inherent in those classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, highly questionable and improbable. Loans rated 10 are considered “uncollectible” (loss), and of such little value that their continuance as loans is not warranted. Loans not rated consist primarily of certain smaller balance commercial real estate and commercial loans that are managed by exception. On an annual basis, or more often if needed, the Company formally reviews on a risk adjusted basis, the ratings on all commercial real estate, construction and commercial loans. Semi-annually, the Company engages an independent third party to review a significant portion of loans within these segments. Management uses the results of these reviews as part of its annual review process. Residential and Consumer On a monthly basis, the Company reviews the residential construction, residential real estate and consumer installment portfolios for credit quality primarily through the use of delinquency reports. The following table summarizes the Company’s loan portfolio by credit quality indicator and loan portfolio segment as of September 30, 2022:
The following table presents the Company’s loans by risk rating at December 31, 2021:
The Company adopted CECL using the prospective transition approach for financial assets purchased with credit deterioration (“PCD”) that were previously classified as purchased credit impaired and accounted for under ASC 310-30 Loans and Debt Securities Acquired with Deteriorated Credit Quality (“ASC 310-30”). In accordance with the standard, the Company did not reassess whether previously recognized purchased credit impaired (“PCI”) loans accounted for under prior accounting guidance met the criteria of a PCD loan as of the date of adoption. PCD loans are initially recorded at fair value along with an ACL determined using the same methodology as originated loans. The sum of the loan’s purchase price and ACL becomes its initial amortized cost basis. The difference between the initial amortized cost basis and the par value of the loan is a noncredit discount or premium, which is amortized into interest income over the life of the loan. Subsequent changes to the ACL are recorded through provision for credit losses. The amortized cost basis as of September 30, 2022 of the PCD loans was $2.4 million. Prior to January 1, 2022, ASC 310-30 required the following table that summarizes activity in the accretable yield for PCI loans:
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