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| Loans and Allowance for Credit Losses | NOTE 3: Loans and Allowance for Credit Losses Classes of loans are summarized as follows:
The Company’s lending activities consist of origination of loans secured by mortgages on one- to four-family residences and commercial and agricultural real estate, construction loans on residential and commercial properties, commercial and agricultural business loans and consumer loans. At June 30, 2024, the Bank had purchased participation interests in 71 loans totaling $178.5 million, as compared to 86 loans totaling $155.6 million at June 30, 2023, with the increase due primarily to participations acquired in the Citizens merger. Residential Mortgage Lending. The Company actively originates loans for the acquisition or refinance of one- to four-family residences. This category includes both fixed-rate and adjustable-rate mortgage (“ARM”) loans amortizing over periods of up to 30 years, and the properties securing such loans may be owner-occupied or non-owner-occupied. Single-family residential loans do not generally exceed 90% of the lower of the appraised value or purchase price of the secured property. Substantially all of the one- to four-family residential mortgage originations in the Company’s portfolio are located within the Company’s primary lending area. General risks related to one- to four-family residential lending include stability of borrower income and collateral values. The Company also originates loans secured by multi-family residential properties that are often located outside the Company’s primary lending area but made to borrowers who operate within the Company’s primary market area. The majority of the multi-family residential loans that are originated by the Company are amortized over periods generally up to 25 years, with balloon maturities typically up to ten years. Both fixed and adjustable interest rates are offered and it is typical for the Company to include an interest rate “floor” and “ceiling” in the loan agreement. Generally, multi-family residential loans do not exceed 85% of the lower of the appraised value or purchase price of the secured property. General risks related to multi-family residential lending include rental demand and supply, rental rates, and vacancies, as well as collateral values and borrower leverage. Commercial Real Estate Lending. The Company actively originates loans secured by owner- and non-owner-occupied commercial real estate including farmland, single- and multi-tenant retail properties, restaurants, hotels, land (improved and unimproved), nursing homes and other healthcare facilities, warehouses and distribution centers, convenience stores, automobile dealerships and other automotive-related services, and other businesses. These properties are typically owned and operated by borrowers headquartered within the Company’s primary lending area, however, the property may be located outside the Company’s primary lending area. Approximately $626.3 million of the Company’s $1.6 billion in commercial real estate loans are secured by properties located outside our primary lending area. Risks to owner-occupied commercial real estate lending generally include the continued profitable operation of the borrower’s enterprise, as well as general collateral values, and may be heightened by unique, specific uses of the property serving as collateral. Non-owner-occupied commercial real estate lending risks include tenant demand and performance, lease rates, and vacancies, as well as collateral values and borrower leverage. These factors may be influenced by general economic conditions in the region, or in the United States generally. Risks to lending on farmland include unique factors such as commodity prices, yields, input costs, and weather, as well as farmland values. Most commercial real estate loans originated by the Company generally are based on amortization schedules of up to 25 years with monthly principal and interest payments. Generally, the interest rate received on these loans is fixed for a maturity for up to ten years, with a balloon payment due at maturity. Alternatively, for some loans, the interest rate adjusts at least annually after an initial period up to seven years. The Company typically includes an interest rate “floor” in the loan agreement. Generally, improved commercial real estate loan amounts do not exceed 80% of the lower of the appraised value or the purchase price of the secured property. Agricultural real estate terms offered differ slightly, with amortization schedules of up to 25 years with an 80% loan-to-value ratio, or 30 years with a 75% loan-to-value ratio. Construction Lending. The Company originates real estate loans secured by property or land that is under construction or development. Construction loans originated by the Company are generally to finance the construction of owner occupied residential real estate, or to finance speculative construction of residential real estate, land development, or owner-operated or non-owner occupied commercial real estate. During construction, these loans typically require monthly interest-only payments, with single-family residential construction loans having maturities ranging from to twelve months, while multi-family or commercial construction loans typically mature in to 36 months. Once construction is completed, permanent construction loans may be converted to monthly payments using amortization schedules of up to 30 years on residential and generally up to 25 years on commercial real estate. Construction and development lending risks generally include successful timely and on-budget completion of the project, followed by the sale of the property in the case of land development or non-owner-occupied real estate, or the long-term occupancy of the property by the builder in the case of owner-occupied construction. Changes in real estate values or other economic conditions may impact the ability of a borrower to sell property developed for that purpose. While the Company typically utilizes relatively short maturity periods to closely monitor the inherent risks associated with construction loans for these loans, weather conditions, change orders, availability of materials and/or labor, and other factors may contribute to the lengthening of a project, thus necessitating the need to renew the construction loan at the balloon maturity. Such extensions are typically executed in incremental three month periods to facilitate project completion. The Company’s average term of construction loans is approximately 12 months. During construction, loans typically require monthly interest only payments which may allow the Company an opportunity to monitor for early signs of financial difficulty should the borrower fail to make a required monthly payment. Additionally, during the construction phase, the Company typically performs interim inspections which further provide the Company an opportunity to assess risk. Consumer Lending. The Company offers a variety of secured consumer loans, including home equity, direct and indirect automobile loans, second mortgages, mobile home loans and loans secured by deposits. The Company originates substantially all of its consumer loans in its primary lending area. Usually, consumer loans are originated with fixed rates for terms of up to 66 months, with the exception of home equity lines of credit, which are variable, tied to the prime rate of interest and are for a period of ten years. Home equity lines of credit (HELOCs) are secured with a deed of trust and are issued up to 90% of the appraised or assessed value of the property securing the line of credit, less the outstanding balance on the first mortgage and are typically issued for a term of ten years. Interest rates on the HELOCs are generally adjustable. Interest rates are based upon the loan-to-value ratio of the property with better rates given to borrowers with more equity. Risks related to HELOC lending generally include the stability of borrower income and collateral values. Automobile loans originated by the Company include both direct loans and a smaller amount of loans originated by auto dealers. The Company generally pays a negotiated fee back to the dealer for indirect loans. Typically, automobile loans are made for terms of up to 66 months for new and used vehicles. Loans secured by automobiles have fixed rates and are generally made in amounts up to 100% of the purchase price of the vehicle. Risks to automobile and other consumer lending generally include the stability of borrower income and borrower willingness to repay. Commercial Business Lending. The Company’s commercial business lending activities encompass loans with a variety of purposes and security, including loans to finance accounts receivable, inventory, equipment and operating lines of credit, including agricultural production and equipment loans. The Company offers both fixed and adjustable rate commercial business loans. Generally, commercial loans secured by fixed assets are amortized over periods up to five years, while commercial operating lines of credit or agricultural production lines are generally for a one year period. Commercial lending risk is primarily driven by the borrower’s successful generation of cash flow from their business enterprise sufficient to service debt, and may be influenced by factors specific to the borrower and industry, or by general economic conditions in the region or in the United States generally. Agricultural production or equipment lending includes unique risk factors such as commodity prices, yields, input costs, and weather, as well as farm equipment values. Allowance for Credit Losses. The PCL for the fiscal years ended June 30, 2024, 2023, and 2022, was $3.6 million, $17.1 million, and $1.5 million, respectively. In fiscal 2024, the company had a $6.6 million PCL for on-balance sheet exposure for loan growth and charge-offs and a $3.0 negative PCL for off-balance sheet exposures, as construction draws reduced available credit and increased on-balance sheet exposure. During the fiscal year ended June 30, 2023, the ACL required for PCD loans acquired in the Citizens merger was $1.1 million, and was funded through purchase accounting adjustments, while the ACL required for non-PCD loans acquired in the Citizens merger was $5.2 million and was funded through a charge to PCL. Additionally, the allowance for off-balance sheet credit exposures was increased by $1.8 million due to the Citizens merger and funded through a charge to PCL. Exclusive of the charges required as a result of the Citizens merger, the Company would have recorded a PCL of approximately $10.1 million for the fiscal year ended June 30, 2023, of which $8.9 million was attributable to the required ACL for loan balances outstanding, and $1.2 million was attributable to the required allowance for off-balance sheet credit exposures. During the fiscal year ended June 30, 2022, the ACL required for PCD loans acquired in the Fortune merger was $120,000, and was funded through purchase accounting adjustments, while the ACL required for non-PCD loans acquired in the Fortune merger was $1.9 million, and was funded through a charge to PCL. Additionally, the allowance for off-balance sheet credit exposures was increased by $120,000 due to the Fortune merger and funded through a charge to PCL. Exclusive of the charges required as a result of the Fortune merger, the Company would have recorded a negative PCL of approximately $533,000 in the fiscal year ended June 30, 2022. Exclusive of provisioning required by the Citizens merger, increased provisioning for loan balances outstanding in the year ended June 30, 2023 is attributable primarily to loan growth, qualitative adjustments to modeled results based on levels and trends of industry past due loans, and the unguaranteed portion of a small pool of SBA loans exhibiting signs of credit stress, partially offset by a decreased ACL estimate for classified hotel loans that had been slow to recover from the COVID-19 pandemic. Decreased provisioning for off-balance sheet credit exposures in the current year was attributable primarily to changes in the level and mix of outstanding credit commitments. The Company estimated its expected credit losses as of June 30, 2024, under ASC 326-20, and management believes the ACL as of that date was adequate based on that estimate. As a percentage of average loans outstanding, the Company recorded net charge-offs of 0.05% during the fiscal year ended June 30, 2024, as compared to 0.02% during the prior fiscal year. Specifically, management considered the following primary items in its estimate of the ACL: ● economic conditions and projections as provided by the Federal Open Market Committee (“FOMC”) were utilized in the Company’s estimate at June 30, 2024. The June 30, 2023, ACL estimate utilized projections from Moody's Analytics, incorporating both baseline and downside scenarios. This change was driven by the automated integration of data within our model. Economic factors considered in the projections included national and state levels of unemployment using the high bound of the FOMC’s central tendency, and national and state rates of inflation-adjusted growth in the gross domestic product using the low bound of the FOMC’s central tendency. Economic conditions are considered to be a moderate and stable risk factor, relative to June 30, 2023; ● the pace of growth of the Company’s loan portfolio, exclusive of acquisitions or government guaranteed loans, relative to overall economic growth. This measure is considered to be a moderate and slightly decreasing factor, relative to June 30, 2023; ● levels and trends for loan delinquencies nationally and in the region. This is considered to be a low and stable risk factor, relative to June 30, 2023; ● quantified supported model adjustments and general imprecision adjustments. This factor was added for the June 30, 2024, ACL estimate as certain model adjustments capture highly specific issues or events that are not adequately captured in model outcomes. General imprecision adjustments address other sources of imprecision that are not specifically identifiable or quantifiable to a particular loan portfolio and have not been captured by the model or by a specific model adjustment. The Company considers general imprecision in three dimensions; economic forecast imprecision, model imprecision, and process imprecision. PCD Loans. In connection with the Citizens Bancshares, Co. (“Citizens”) merger on January 20, 2023, and Fortune Financial Corporation (“Fortune”) merger on February 25, 2022, the Company acquired loans both with and without evidence of credit quality deterioration since origination. Acquired loans are recorded at their fair value at the time of acquisition with no carryover from the acquired institution’s previously recorded allowance for loan and lease losses. Acquired loans are accounted for under ASC 326, Financial Instruments – Credit Losses. The fair value of acquired loans recorded at the time of acquisition is based upon several factors, including the timing and payment of expected cash flows, as adjusted for estimated credit losses and prepayments, and then discounting these cash flows using comparable market rates. The resulting fair value adjustment is recorded in the form of a premium or discount to the unpaid principal balance of the respective loans. As it relates to acquired loans that, as of the date of acquisition, have experienced a more-than-insignificant deterioration in credit quality since origination (“PCD”), the net premium or net discount is adjusted to reflect the Company’s allowance for credit losses recorded for PCD loans at the time of acquisition, and the remaining fair value adjustment is accreted or amortized into interest income over the remaining life of the respective loans. As it relates to loans not classified as PCD (“non-PCD”) loans, the credit loss and yield components of their fair value adjustment are aggregated, and the resulting net premium or net discount is accreted or amortized into interest income over the remaining life of the respective loans. The Company records an ACL for non-PCD loans at the time of acquisition through provision expense, and therefore, no further adjustments are made to the net premium or net discount for non-PCD loans. Loans that the Company acquired from Citizens and Fortune that, at the time of acquisition, had more-than-insignificant deterioration of credit quality since origination are classified as PCD loans and presented in the table below at acquisition carrying value:
The following tables present the balance in the ACL and the recorded investment in loans (excluding unfunded commitment on contruction loans and deferred loan fees) based on portfolio segment as of June 30, 2024 and 2023, and activity in the ACL for the fiscal years ended June 30, 2024, 2023, and 2022:
The following tables present the balance in the allowance for off-balance credit exposure based on portfolio segment as of June 30, 2024 and 2023, and activity in the allowance for the fiscal years ended June 30, 2024, 2023 and 2022:
The current fiscal year-to-date gross charge-offs by loan class and year of origination is presented in the following table:
Credit Quality Indicators. The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis is performed on all loans at origination, and is updated on a quarterly basis for loans risk rated Watch, Special Mention, Substandard, or Doubtful. In addition, lending relationships of $4 million or more, exclusive of any consumer or owner-occupied residential loan, are subject to an annual credit analysis which is prepared by the loan administration department and presented to a loan committee with appropriate lending authority. A sample of lending relationships in excess of $1 million (exclusive of single-family residential real estate loans) are subject to an independent loan review annually, in order to verify risk ratings. The Company uses the following definitions for risk ratings: Watch – Loans classified as watch exhibit weaknesses that require more than usual monitoring. Issues may include deteriorating financial condition, payments made after due date but within 30 days, adverse industry conditions or management problems. Special Mention – Loans classified as special mention exhibit signs of further deterioration but still generally make payments within 30 days. This is a transitional rating and loans should typically not be rated Special Mention for more than 12 months. Substandard – Loans classified as substandard possess weaknesses that jeopardize the ultimate collection of the principal and interest outstanding. These loans may exhibit continued financial losses, ongoing delinquency, overall poor financial condition, and insufficient collateral. Doubtful – Loans classified as doubtful have all the weaknesses of substandard loans, and have deteriorated to the level that there is a high probability of substantial loss. Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be Pass rated loans. A periodic review of selected credits (based on loan size and type) is conducted to identify loans with heightened risk or probable losses and to assign risk grades. The primary responsibility for this review rests with loan administration personnel. This review is supplemented with periodic examinations of both selected credits and the credit review process by the Company’s internal audit function and applicable regulatory agencies. The information from these reviews assists management in the timely identification of problems and potential problems and provides a basis for deciding whether the credit continues to share similar risk characteristics with collectively evaluated loan pools, or whether credit losses for the loan should be evaluated on an individual loan basis. The following table presents the credit risk profile of the Company’s loan portfolio (excluding unfunded commitments on construction loans and deferred loan fees) based on rating category and year of origination as of June 30, 2024. This table includes PCD loans, which are reported according to risk categorization after acquisition based on the Company’s standards for such classification:
At June 30, 2024, PCD loans comprised $40.9 million of credits rated “Pass”; $8.4 million of credits rated “Watch”; none rated “Special Mention”; $3.1 million of credits rated “Substandard”; and none rated “Doubtful”. The following table presents the credit risk profile of the Company’s loan portfolio (excluding unfunded commitments on construction loans and deferred loan fees) based on rating category and year of origination as of June 30, 2023. This table includes PCD loans, which are reported according to risk categorization after acquisition based on the Company’s standards for such classification:
At June 30, 2023, PCD loans comprised $37.4 million of credits rated “Pass”; $12.7 million of credits rated “Watch”; none rated “Special Mention”; $6.3 million of credits rated “Substandard”; and none rated “Doubtful”. Past Due Loans. The following tables present the Company’s loan portfolio aging analysis (excluding unfunded commitments on construction loans and deferred loan fees) as of June 30, 2024 and 2023. These tables include PCD loans, which are reported according to aging analysis after acquisition based on the Company’s standards for such classification:
At June 30, 2024 there was one PCD loan totaling $560,000 that was greater than 90 days past due, and none at June 30, . Loans that experience insignificant payment delays and payment shortfalls generally are not adversely classified or determined to not share similar risk characteristics with collectively evaluated pools of loans for determination of the ACL estimate. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Significant payment delays or shortfalls may lead to a determination that a loan should be individually evaluated for estimated credit losses. Collateral-dependent Loans. The following table presents the Company’s collateral dependent loans and related ACL at June 30, 2024 and 2023:
The increase in commercial real estate collateral dependent loans is due primarily to two metropolitan area hotel relationships being individually analyzed as of June 30, 2024. In 2023, the Company was previously evaluating its non-owner occupied commercial real estate pool for qualitative adjustments related to similar loans. Nonaccrual Loans. The following table presents the Company’s amortized cost basis of nonaccrual loans segmented by class of loans at June 30, 2024 and 2023. The table excludes performing modifications to borrowers experiencing financial difficulty at June 30, 2024 and excludes performing troubled debt restructurings (“TDRs”) at June 30, 2023.
At June 30, 2024, there were no nonaccrual loans individually evaluated for which no ACL was recorded. Interest income recognized on nonaccrual loans in the periods ended June 30, 2024 and 2023, was immaterial. Modifications to Borrowers Experiencing Financial Difficulty. The Company adopted ASU 2022-02, “Financial Instruments – Credit Losses (Topic 326), Troubled Debt Restructurings and Vintage Disclosures,” effective July 1, 2023. The amendments in ASU 2022-02 eliminated the recognition and measurement of TDRs and enhanced disclosures for loan modifications to borrowers experiencing financial difficulty. During fiscal 2024, two loan modifications, totaling $859,000, were made to loans for borrowers experiencing financial difficulty. Loans classified as modifications to borrowers experiencing financial difficulty outstanding at June 30, 2024 are shown in the following table segregated by portfolio segment and type of modification. The percentage of amortized cost of loans that were modified compared to total outstanding loans is also presented below.
Both loan modifications made during fiscal 2024 were more than 90 days past due, and were classified as substandard at June 30, 2024. Both of these loans defaulted in fiscal 2024. For modifications to loans made to borrowers experiencing financial difficulty that are adversely classified, the Company determines the allowance for credit losses on an individual basis, using the same process that it utilizes for other adversely classified loans. Troubled Debt Restructurings. Prior to the adoption of ASU 2022-02, the Company’s loans that were subject to classification as TDRs were generally the result of guidance under ASU No. 2011-02, which indicated that the Company may not consider the borrower’s effective borrowing rate on the old debt immediately before the restructuring in determining whether a concession has been granted. Certain TDRs were classified as nonperforming at the time of restructuring and typically were returned to performing status after considering the borrower’s sustained repayment performance for a reasonable period of at least six months. During fiscal 2023, there were no loans modified as TDRs. Performing loans classified as TDRs and outstanding at June 30, 2023, segregated by class, are shown in the table below. Nonperforming TDRs at June 30, 2023 are shown in the nonaccrual loans table above.
Real Estate Foreclosures. The Company may obtain physical possession of real estate collateralizing a residential mortgage loan or home equity loan via foreclosure, deed in lieu, or in-substance repossession. As of June 30, 2024 and June 30, 2023, the carrying value of foreclosed residential real estate properties as a result of obtaining physical possession was $74,000 and $0, respectively. In addition, as of June 30, 2024 and 2023, the Company had residential mortgage loans and home equity loans with a carrying value of $193,000 and $1.5 million respectively, collateralized by residential real estate property for which formal foreclosure proceedings were in process. Following is a summary of loans to executive officers, directors, significant shareholders and their affiliates held by the Company at June 30, 2024 and 2023, respectively:
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