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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q/A

 

☒	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2020
OR
☐	TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

Commission file number 001-34142

 

OAK VALLEY BANCORP

(Exact name of registrant as specified in its charter)

 

California		26-2326676
State or other jurisdiction of		I.R.S. Employer
incorporation or organization		Identification No.

 

125 N. Third Ave., Oakdale, CA  95361

(Address of principal executive offices)

 

(209) 848-2265

Issuer’s telephone number

 

Not applicable

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

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class	Trading Symbol(s)	Name of each exchange on which registered
Common Stock	OVLY	The Nasdaq Stock Market, LLC

 

Indicate by check mark whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 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 definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer ☐		Accelerated filer ☒
Non-accelerated filer ☐		Smaller reporting company ☒
		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 ☒

 

APPLICABLE ONLY TO CORPORATE ISSUERS

 

State the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:  8,216,714 shares of common stock outstanding as of May 1, 2020.

 

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(in thousands)		March 31,				December 31,
		2020				2019
ASSETS
Cash and due from banks		$	72,884			$	133,809
Federal funds sold			19,930				13,785
Cash and cash equivalents			92,814				147,594
Securities - available for sale			245,155				190,088
Securities - equity investments			3,371				3,297
Loans, net of allowance for loan losses of $9,586 and $9,146 at March 31, 2020 and December 31, 2019, respectively			749,726				741,047
Cash surrender value of life insurance			24,805				24,631
Bank premises and equipment, net			15,174				15,229
Goodwill and other intangible assets, net			3,812				3,837
Interest receivable and other assets			21,778				22,062
		$	1,156,635			$	1,147,785
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits		$	1,026,925			$	1,019,929
Interest payable and other liabilities			15,323				15,286
Total liabilities			1,042,248				1,035,215
Shareholders’ equity
Common stock, no par value; 50,000,000 shares authorized, 8,216,714 and 8,210,147 shares issued and outstanding at at March 31, 2020 and December 31, 2019, respectively			25,435				25,435
Additional paid-in capital			3,837				3,777
Retained earnings			82,521				80,961
Accumulated other comprehensive income, net of tax			2,594				2,397
Total shareholders’ equity			114,387				112,570
		$	1,156,635			$	1,147,785

 

(in thousands, except per share amounts)		THREE MONTHS ENDED MARCH 31,
		2020				2019
INTEREST INCOME
Interest and fees on loans		$	8,791			$	8,427
Interest on securities			1,359				1,539
Interest on federal funds sold			42				51
Interest on deposits with banks			367				516
Total interest income			10,559				10,533
INTEREST EXPENSE
Deposits			331				422
Total interest expense			331				422
Net interest income			10,228				10,111
Provision for loan losses			450				0
Net interest income after provision for loan losses			9,778				10,111
NON-INTEREST INCOME
Service charges on deposits			387				393
Debit card transaction fee income			295				274
Earnings on cash surrender value of life insurance			174				125
Mortgage commissions			45				22
Gains on sales and calls of available-for-sale securities			0				109
Other			383				352
Total non-interest income			1,284				1,275
NON-INTEREST EXPENSE
Salaries and employee benefits			4,601				4,404
Occupancy expenses			868				890
Data processing fees			494				447
Regulatory assessments (FDIC & DBO)			30				110
Other operating expenses			1,456				1,382
Total non-interest expense			7,449				7,233
Net income before provision for income taxes			3,613				4,153
Total provision for income taxes			904				1,049
Net Income		$	2,709			$	3,104
Net income per share		$	0.33			$	0.38
Net income per diluted share		$	0.33			$	0.38

 

		THREE MONTHS ENDED MARCH 31,
(in thousands)		2020				2019
Net income		$	2,709			$	3,104
Other comprehensive income:
Unrealized gains on securities:
Unrealized holding gains arising during the period			279				1,721
Less: reclassification for net gains included in net income			0				(109	)
Other comprehensive income, before tax			279				1,612
Tax expense related to items of other comprehensive income			(81	)			(477	)
Total other comprehensive income			198				1,135
Comprehensive income		$	2,907			$	4,239

 

		THREE MONTHS ENDED MARCH 31, 2020 AND 2019
																		Accumulated
										Additional								Other				Total
		Common Stock								Paid-in				Retained				Comprehensive				Shareholders’
(dollars in thousands)		Shares				Amount				Capital				Earnings				Income (Loss)				Equity
Balances, January 1, 2019			8,194,805			$	25,429			$	3,358			$	70,686			$	(435	)		$	99,038
Stock options exercised			1,000				6																6
Restricted stock issued			20,845																				0
Restricted stock forfeited			(1,500	)																			0
Restricted stock surrendered for tax withholding			(5,400	)							(90	)											(90	)
Cash dividends declared $0.135 per share of common stock															(1,106	)							(1,106	)
Stock based compensation											131												131
Other comprehensive income																			1,135				1,135
Net income																							3,104
Balances, March 31, 2019			8,209,750			$	25,435			$	3,399			$	72,684			$	700			$	102,218
Balances, January 1, 2020			8,210,147			$	25,435			$	3,777			$	80,961			$	2,397			$	112,570
Restricted stock issued			14,006																				0
Restricted stock forfeited			(1,500	)																			0
Restricted stock surrendered for tax withholding			(5,939	)							(100	)											(100	)
Cash dividends declared $0.140 per share of common stock															(1,149	)							(1,149	)
Stock based compensation											160												160
Other comprehensive income																			197				197
Net income															2,709								2,709
Balances, March 31, 2020			8,216,714			$	25,435			$	3,837			$	82,521			$	2,594			$	114,387

 

		THREE MONTHS ENDED MARCH 31,
(dollars in thousands)		2020				2019
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income		$	2,709			$	3,104
Adjustments to reconcile net income to net cash from operating activities:
Provision for loan losses			450				0
Increase (decrease) in deferred fees/costs, net			6				(33	)
Depreciation			265				272
Amortization of investment securities, net			134				280
Stock based compensation			160				131
Gain on sales and calls of available for sale securities			0				(109	)
Earnings on cash surrender value of life insurance			(174	)			(125	)
Increase in interest payable and other liabilities			278				5,568
(Increase) decrease in interest receivable			(259	)			392
Decrease (increase) in other assets			487				(1,476	)
Net cash from operating activities			4,056				8,004
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of available for sale securities			(67,627	)			(7,176	)
Purchases of available-for-sale securities			(21	)			(22	)
Proceeds from maturities, calls, and principal paydowns of securities available for sale			12,651				11,657
Investment in LIHTC			(241	)			(202	)
Net (increase) decrease in loans			(9,135	)			4,485
Purchases of bank premises and equipment			(210	)			(2	)
Net cash (used in) from investing activities			(64,583	)			8,740
CASH FLOWS FROM FINANCING ACTIVITIES:
Shareholder cash dividends paid			(1,149	)			(1,106	)
Net increase (decrease) in demand deposits and savings accounts			8,757				(44,967	)
Net decrease in time deposits			(1,761	)			(2,785	)
Proceeds from exercise of stock options			0				6
Tax withholding payments on vested restricted shares surrendered			(100	)			(90	)
Net cash from (used in) financing activities			5,747				(48,942	)
NET DECREASE IN CASH AND CASH EQUIVALENTS			(54,780	)			(32,198	)
CASH AND CASH EQUIVALENTS, beginning of period			147,594				126,145
CASH AND CASH EQUIVALENTS, end of period		$	92,814			$	93,947
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the period for:
Interest		$	317			$	423
NON-CASH INVESTING ACTIVITIES:
Change in unrealized gain on securities		$	278			$	1,612
Change in contributions payable to LIHTC limited partner investment		$	(241	)		$	(202	)
Lease right-of-use assets		$	241			$	4,817
NON-CASH FINANCING ACTIVITIES:
Present value of lease obligations		$	(255	)		$	5,246

 

NOTE 1 – BASIS OF PRESENTATION

 

On July 3, 2008 (the “Effective Date”), a bank holding company reorganization was completed whereby Oak Valley Bancorp (“the Company”, “us”, “our”) became the parent holding company for Oak Valley Community Bank (the “Bank”).  On the Effective Date, a tax-free exchange was completed whereby each outstanding share of the Bank was converted into one share of the Company and the Bank became the sole wholly-owned subsidiary of the holding company.

 

The consolidated financial statements include the accounts of the parent company and its wholly-owned bank subsidiary. Unless otherwise stated, the “Company” refers to the consolidated entity, Oak Valley Bancorp, while the “Bank” refers to Oak Valley Community Bank. All material intercompany transactions have been eliminated. The interim consolidated financial statements included in this report are unaudited but reflect all adjustments which, in the opinion of management, are necessary for a fair presentation of the financial position and results of operations for the interim periods presented. All such adjustments are of a normal recurring nature. The results of operations for the three-month period ended March 31, 2020 are not necessarily indicative of the results of a full year’s operations. Certain prior year amounts have been reclassified to conform to the current year presentation. There was no effect on net income or shareholders’ equity as previously reported as a result of reclassifications. For further information, refer to the audited consolidated financial statements and footnotes included in the Company’s Form 10-K for the year ended December 31, 2019.

 

Oak Valley Community Bank is a California state-chartered bank. The Company was incorporated under the laws of the State of California on May 31, 1990 and began operations in Oakdale on May 28, 1991. The Company operates branches in Oakdale, Sonora, Bridgeport, Bishop, Mammoth Lakes, Modesto, Manteca, Patterson, Turlock, Ripon, Stockton, Escalon, and Sacramento, California. The Bridgeport, Mammoth Lakes, and Bishop branches operate as a separate division, Eastern Sierra Community Bank. The Company’s primary source of revenue is providing loans to customers who are predominantly middle-market businesses.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant accounting estimates reflected in the Company’s consolidated financial statements include the allowance for loan losses and fair value measurements. The estimates and assumptions may change as new events occur, as more experience is acquired, as additional information is obtained and as the Company’s operating environment changes. Actual results may differ from these estimates due to the uncertainty around the magnitude and duration of the COVID-19 pandemic, as well as other factors.

 

   

 

NOTE 2 – RECENT ACCOUNTING PRONOUNCEMENTS

   

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). This ASU was issued to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities, including leases classified as operating leases under previous GAAP, on the balance sheet and requiring additional disclosures of key information about leasing arrangements. ASU 2016-02 is effective for annual periods, including interim periods within those annual periods beginning after December 15, 2018 and was adopted under the current period adjustment method, which allows for prior period accumulated amounts to be recorded as of the effective date. The Company adopted this ASU effective January 1, 2019 and determined that the gross-up of its balance sheet from recording a right-of-use (“ROU”) asset and a lease liability for each lease as a result of adopting this ASU, did not have a material impact on the Company’s consolidated financial statements. See Note 5 for further discussion of the Company’s leases and the impact of this ASU.

 

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326). This update changes the methodology used by financial institutions under current U.S. GAAP to recognize credit losses in the financial statements.  Currently, U.S. GAAP requires the use of the incurred loss model, whereby financial institutions recognize in current period earnings, incurred credit losses and those inherent in the financial statements, as of the date of the balance sheet.    This guidance results in a new model for estimating the allowance for loan and lease losses, commonly referred to as the Current Expected Credit Loss (“CECL”) model.  Under the CECL model, financial institutions are required to estimate future credit losses and recognize those losses in current period earnings.  The amendments within the update are effective for fiscal years and all interim periods beginning after December 15, 2019, with early adoption permitted.  In October 2019, FASB approved an amendment that will delay the adoption of this ASU for three years for certain entities including the Company since we are classified as a Small Reporting Company. Accordingly, this ASU will become effective for the Company on January 1, 2023. Upon adoption of the amendments within this update, the Company will be required to make a cumulative-effect adjustment to the opening balance of retained earnings in the year of adoption. The Company is currently in the process of evaluating the impact the adoption of this update will have on its financial statements. While the Company has not quantified the impact of this ASU, it does expect changing from the current incurred loss model to an expected loss model will result in an earlier recognition of losses.

 

 

In January 2017, the FASB issued ASU 2017-04, Intangibles Goodwill and Other (Subtopic 350): Simplifying the Test for Goodwill Impairment. The provisions of the update eliminate the existing second step of the goodwill impairment test which provides for the allocation of reporting unit fair value among existing assets and liabilities, with the net leftover amount representing the implied fair value of goodwill. In replacement of the existing goodwill impairment rule, the update will provide that impairment should be recognized as the excess of any of the reporting unit’s goodwill over the fair value of the reporting unit. Under the provisions of this update, the amount of the impairment is limited to the carrying value of the reporting unit’s goodwill. For public business entities that are SEC filers, the amendments of the update will become effective in fiscal years beginning after December 15, 2019. This ASU did not have a material impact on our financial condition or results of operations.

 

In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Subtopic 820): Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement. The primary focus of ASU 2018-13 is to improve the effectiveness of the disclosure requirements for fair value measurements. The changes affect all companies that are required to include fair value measurement disclosures. In general, the amendments in ASU 2018-13 are effective for all entities for fiscal years and interim periods within those fiscal years, beginning after December 15, 2019. An entity is permitted to early adopt the removed or modified disclosures upon the issuance of ASU 2018-13 and may delay adoption of the additional disclosures, which are required for public companies only, until their effective date. This ASU did not have a significant impact on the Company's consolidated financial statements.

 

In March 2019, the FASB issued ASU 2019-01, Leases (Topic 842): Codification Improvements. This ASU addresses two lessor implementation issues and clarifies that lessees and lessors are exempt from certain interim disclosure requirements associated with adopting ASU 2016-02. The amendments related to the lessor implementation issues are effective for public business entities for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. Early application is permitted. As the ASU's amendments applicable to us only relate to disclosures, the adoption of ASU 2019-01 will not impact our financial condition or results of operations.

 

In April 2019, the FASB issued ASU 2019-04, Codification Improvements to Topic 326, Financial Instruments - Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments that clarifies and improves areas of guidance related to recently issued standards on credit losses, hedging and recognition and measurement. The provisions of this ASU are effective January 1, 2020 and contain various methods of adoption. This ASU did not have a material impact on our financial condition or results of operations.

 

In May 2019, the FASB issued ASU 2019-05, Financial Instruments - Credit Losses (Topic 326): Targeted Transition Relief. This ASU allows an option for entities to irrevocably elect the fair value option on an instrument-by-instrument basis for eligible financial assets measured at amortized cost basis upon adoption of the credit loss standards. This amendment provides relief for those entities electing the fair value option on newly originated or purchased financial assets, while maintaining existing similar financial assets at amortized cost, avoiding the requirement to maintain dual measurement methods for similar assets. The fair value option does not apply to held-to-maturity debt securities. The effective date for this ASU is the same as for ASU 2016-13, as discussed above. We will evaluate this ASU in conjunction with ASU 2016-13 to determine its impact on our financial condition and results of operations.

 

In March 2020, FASB issued ASU 2020-04 - Reference Rate Reform (Subtopic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting. This ASU provides optional expedients and exceptions for contracts, hedging relationships, and other transactions that reference LIBOR or other reference rates expected to be discontinued because of reference rate reform. The ASU is effective for all entities as of March 12, 2020 through December 31, 2022. The Company is in the process of evaluating the provisions of this ASU and its effects on our consolidated financial statements.

 

 

 

NOTE 3 – SECURITIES

 

Equity Securities

 

The Company held equity securities with fair values of $3,371,000 and $3,297,000 as of March 31, 2020 and December 31, 2019, respectively. There were no sales of equity securities during the three-month periods ended March 31, 2020 and 2019. Consistent with ASU 2016-01, these securities are carried at fair value with the changes in fair value recognized in the consolidated statements of income. Accordingly, the Company recognized a gain of $53,000 during the three months ended March 31, 2020, as compared to a loss of $43,000 during the three months ended March 31, 2019.

 

 

Debt Securities

 

Debt securities have been classified in the financial statements as available for sale. The amortized cost and estimated fair values of debt securities as of March 31, 2020 are as follows:

 

 

The following tables detail the gross unrealized losses and fair values of debt securities aggregated by investment category and the length of time that individual securities have been in a continuous unrealized loss position as of March 31, 2020.

 

 

As of March 31, 2020, six corporate debts, one U.S. agency, five Small Business Administration pools and ten asset backed securities make up the total debt securities in an unrealized loss position for greater than 12 months. As of March 31, 2020, sixteen asset backed securities, one corporate debt, four U.S. agencies, two Small Business Administration pools, three municipalities and one collateralized mortgage obligation make up the total debt securities in a loss position for less than 12 months. Management periodically evaluates each available-for-sale investment security in an unrealized loss position to determine if the impairment is temporary or other than temporary. This evaluation encompasses various factors including, the nature of the investment, the cause of the impairment, the severity and duration of the impairment, credit ratings and other credit related factors such as third party guarantees and the volatility of the security’s fair value. Management has determined that no investment security is other than temporarily impaired. The unrealized losses are due primarily to asset backed securities that are backed by federal government guaranteed student loans that are repaying slower than expected due to legislation that allows borrowers to extend payment schedules based on their income level. The Company does not intend to sell the securities and it is not likely that the Company will be required to sell the securities before the earlier of the forecasted recovery or the maturity of the underlying investment security.

 

 

 

The amortized cost and estimated fair value of debt securities as of March 31, 2020, segregated by contractual maturity or call date, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

 

The amortized cost and estimated fair values of debt securities as of December 31, 2019 are as follows:

 

 

The following tables detail the gross unrealized losses and fair values of debt securities segregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2019.

 

 

At December 31, 2019, one municipality, three U.S. agencies, six corporate debts, five Small Business Administration pools, one collateralized mortgage obligations and eleven asset backed securities make up the total debt securities in an unrealized loss position for greater than 12 months. At December 31, 2019, three U.S. agencies, eight asset backed securities, two Small Business Administration pools and two corporate debts make up the total debt securities in a loss position for less than 12 months.

 

 

The Company recognized no gains or losses during the three-month period ended March 31, 2020, on available-for-sale securities that were called, compared to gains of $109,000 recorded for the same period during 2019. There were no sales of available-for-sale securities during the three-months ended March 31, 2020 and 2019.

 

Debt securities carried at $114,812,000 and $123,381,000 as of March 31, 2020 and December 31, 2019, respectively, were pledged to secure deposits of public funds.

 

NOTE 4 – LOANS

 

The Company’s customers are primarily located in Stanislaus, San Joaquin, Tuolumne, Inyo, and Mono Counties. As of March 31, 2020, approximately 81% of the Company’s loans are commercial real estate loans which include construction loans. Approximately 11% of the Company’s loans are for general commercial uses including professional, retail, and small business. Additionally, 5% of the Company’s loans are for residential real estate and other consumer loans. The remaining 3% are agriculture loans. Loan totals were as follows:

 

 

Loan Origination/Risk Management. The Company has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentration of credit, loan delinquencies and non-performing and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions.

 

Commercial and industrial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and prudently expand its business. Underwriting standards are designed to promote relationship banking rather than transactional banking. Once it is determined that the borrower’s management possesses sound ethics and solid business acumen, the Company’s management examines current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial and industrial loans are primarily made based on the identified cash flows of the borrower and secondarily made based on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.

 

 

Commercial real estate loans are subject to underwriting standards and processes similar to commercial and industrial loans, in addition to those of real estate loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally largely dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Company’s commercial real estate portfolio are diverse in terms of type and geographic location. This diversity helps reduce the Company’s exposure to adverse economic events that affect any single market or industry. Management monitors and evaluates commercial real estate loans based on collateral, geography and risk grade criteria. As a general rule, the Company avoids financing single-purpose projects unless other underwriting factors are present to help mitigate risk. The Company also utilizes third-party experts to provide insight and guidance about economic conditions and trends affecting market areas it serves. In addition, management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans. As of March 31, 2020 and December 31, 2019, commercial real estate loans equal to approximately 38% and 39%, respectively, of the outstanding principal balance of commercial real estate loans were secured by owner-occupied properties.

 

With respect to loans to developers and builders that are secured by non-owner occupied properties that the Company may originate from time to time, the Company generally requires the borrower to have had an existing relationship with the Company and have a proven record of success. Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analyses of absorption and lease rates and financial analyses of the developers and property owners. Construction loans are generally based upon estimates of costs and value associated with the complete project. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.

 

Agricultural production, real estate and development lending is susceptible to credit risks including adverse weather conditions, pest and disease, as well as market price fluctuations and foreign competition. Agricultural loan underwriting standards are maintained by following Company policies and procedures in place to minimize risk in this lending segment. These standards consist of limiting credit to experienced farmers who have demonstrated farm management capabilities, requiring cash flow projections displaying margins sufficient for repayment from normal farm operations along with equity injected as required by policy, as well as providing adequate secondary repayment and sponsorship including satisfactory collateral support. Credit enhancement obtained through government guarantee programs may also be used to provide further support as available. 

 

The Company originates consumer loans utilizing common underwriting criteria specified in policy. To monitor and manage consumer loan risk, policies and procedures are developed and modified, as needed, jointly by line and staff personnel. This activity, coupled with relatively small loan amounts that are spread across many individual borrowers, minimizes risk. Additionally, trend and outlook reports are reviewed by management on a regular basis. Underwriting standards for 1-4 family residential loans, home equity lines and loans follow bank policy, which include, but are not limited to, a maximum loan-to-value percentage of 80%, a maximum housing and total debt ratio of 36% and 42%, respectively and other specified credit and documentation requirements.

 

The Company maintains an independent loan review program that reviews and validates the credit risk program on a periodic basis. Results of these reviews are presented to management. The loan review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel, as well as the Bank’s policies and procedures.

 

Non-Accrual 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 non-accrual 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 non-accrual status regardless of whether or not such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. 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.

 

 

Non-accrual loans, segregated by class of loans, were as follows:

 

 

Had non-accrual loans performed in accordance with their original contract terms, the Company would have recognized additional interest income of approximately $11,000 in the three-month period ended March 31, 2020, as compared to $14,000 in the same period of 2019.

 

The following table analyzes past due loans including the past due non-accrual loans in the above table, segregated by class of loans, as of March 31, 2020 (in thousands):

 

 

 

The following table analyzes past due loans including the past due non-accrual loans in the above table, segregated by class of loans, as of December 31, 2019 (in thousands):

 

 

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. There was no interest income realized on impaired loans for the three-months ended March 31, 2020 and 2019.

 

Impaired loans as of March 31, 2020 are set forth in the following table.

 

 

 

Average recorded investment in impaired loans outstanding as of March 31, 2020 and 2019 is set forth in the following table.

 

 

Impaired loans as of December 31, 2019 are set forth in the following table.

 

 

Troubled Debt Restructurings – In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed under the Company’s internal underwriting policy.

 

As of March 31, 2020, there was one loan that was considered to be a troubled debt restructuring totaling $823,000, which is included in non-accrual loans. The troubled debt restructuring as of March 31, 2020 was not related to the economic challenges caused by the COVID-19 pandemic. As of December 31, 2019, there was one loan that was considered to be a troubled debt restructuring totaling $855,000, which is included in non-accrual loans. As of March 31, 2020 and December 31, 2019, there were no unfunded commitments on loans classified as a troubled debt restructurings. The Company has allocated $680,000 of specific reserves to loans whose terms have been modified in troubled debt restructurings as of March 31, 2020 and December 31, 2019.

 

During the three-months ended March 31, 2020 and 2019, there were no loans that were modified as troubled debt restructurings. The modification of the terms of such loans typically includes one or a combination of the following: a reduction of the stated interest rate of the loan; an extension of the maturity date; or a temporary payment modification in which the payment amount allocated towards principal was reduced. In some cases, a permanent reduction of the accrued interest on the loan is conceded.

 

 

There were no loans modified as troubled debt restructurings within the previous twelve months and for which there was a payment default during the three-month periods ended March 31, 2020 and 2019. A loan is considered to be in payment default once it is ninety days contractually past due under the modified terms.

 

Loan Risk Grades– Quality ratings (Risk Grades) are assigned to all commitments and stand-alone notes. Risk grades define the basic characteristics of commitments or stand-alone note in relation to their risk. All loans are graded using a system that maximizes the loan quality information contained in loan review grades, while ensuring that the system is compatible with the grades used by bank examiners.

 

The Company grades loans using the following letter system:

 

1 Exceptional Loan

2 Quality Loan

3A Better Than Acceptable Loan

3B Acceptable Loan

3C Marginally Acceptable Loan

4 (W) Watch Acceptable Loan

5 Special Mention Loan

6 Substandard Loan

7 Doubtful Loan

8 Loss

 

1. Exceptional Loan - Loans with A+ credits that contain very little, if any, risk. Grade 1 loans are considered Pass. To qualify for this rating, the following characteristics must be present:

●

A high level of liquidity and whose debt-servicing capacity exceeds expected obligations by a substantial margin.

●

Where leverage is below average for the industry and earnings are consistent or growing without severe vulnerability to economic cycles.

●

Also included in this rating (but not mandatory unless one or more of the preceding characteristics are missing) are loans that are fully secured and properly margined by our own time instruments or U.S. blue chip securities. To be properly margined, cash collateral must be equal to, or greater than, 110% of the loan amount.

 

2. Quality Loan - Loans with excellent sources of repayment that conform in all respects to bank policy and regulatory requirements. These are also loans for which little repayment risk has been identified. No credit or collateral exceptions. Grade 2 loans are considered Pass. Other factors include:

●

Unquestionable debt-servicing capacity to cover all obligations in the ordinary course of business from well-defined primary and secondary sources.

●

Consistent strong earnings.

●

A solid equity base.

 

3A. Better than Acceptable Loan - In the interest of better delineating the loan portfolio’s true credit risk for reserve allocation, further granularity has been sought by splitting the grade 3 category into three classifications. The distinction between the three are bank-defined guidelines and represent a further refinement of the regulatory definition of a pass, or grade 3 loan. Grade 3A is characterized by:

●

Strong earnings with no loss in last three years and ample cash flow to service all debt well above policy guidelines.

●

Long term experienced management with depth and defined management succession.

●

The loan has no exceptions to policy.

●

Loan-to-value on real estate secured transactions is 10% to 20% less than policy guidelines.

●

Very liquid balance sheet that may have cash available to pay off our loan completely.

●

Little to no debt on balance sheet.

 

3B. Acceptable Loan - 3B loans are simply defined as all loans that are less qualified than 3A loans and are stronger than 3C loans. These loans are characterized by acceptable sources of repayment that conform to bank policy and regulatory requirements. Repayment risks are acceptable for these loans. Credit or collateral exceptions are minimal, are in the process of correction, and do not represent repayment risk. These loans:

●

Are those where the borrower has average financial strengths, a history of profitable operations and experienced management.

●

Are those where the borrower can be expected to handle normal credit needs in a satisfactory manner.

 

 

3C. Marginally Acceptable Loan - 3C loans have similar characteristics as that of 3Bs with the following additional characteristics:

●

Requires collateral.

●

A credit facility where the borrower has average financial strengths, but usually lacks reliable secondary sources of repayment other than the subject collateral.

●

Other common characteristics can include some or all of the following: minimal background experience of management, lacking continuity of management, a start-up operation, erratic historical profitability (acceptable reasons-well identified), lack of or marginal sponsorship of guarantor, and government guaranteed loans.

 

4(W). Watch Acceptable Loan - Watch grade will be assigned to any credit that is adequately secured and performing but monitored for a number of indicators. These characteristics may include:

 

●

Any unexpected short-term adverse financial performance from budgeted projections or a prior period’s results (i.e., declining profits, sales, margins, cash flow, or increased reliance on leverage, including adverse balance sheet ratios, trade debt issues, etc.).

●

Any managerial or personal problems of company management, decline in the entire industry or local economic conditions, or failure to provide financial information or other documentation as requested.

●

Issues regarding delinquency, overdrafts, or renewals.

●

Any other issues that cause concern for the company.

●

Loans to individuals or loans supported by guarantors with marginal net worth and/or marginal collateral.

●

Weaknesses that are identified are short-term in nature.

●

Loans in this category are usually accounts the Bank would want to retain providing a positive turnaround can be expected within a reasonable time frame. Grade 4 loans are considered Pass.

 

5. Special Mention Loan - A special mention extension of credit is defined as having potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may, at some future date result in the deterioration of the repayment prospects for the credit or the institution’s credit position. Extensions of credit that might be detailed in this category include the following:

●

The lending officer may be unable to properly supervise the credit because of an inadequate loan or credit agreement.

●

Questions exist regarding the condition of and/or control over collateral.

●

Economic or market conditions may unfavorably affect the obligor in the future.

●

A declining trend in the obligor’s operations or an imbalanced position in the balance sheet exists, but not to the point that repayment is jeopardized.

 

6. Substandard Loan - A “substandard” extension of credit is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Extensions of credit so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard credits, does not have to exist in individual extensions of credit classified as substandard.

 

7. Doubtful Loan - An extension of credit classified as “doubtful” has all the weaknesses inherent in one 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 that may work to the advantage of and strengthen the credit, its classification as an estimated loss is deferred until its more exact status may be determined. Pending factors may include a proposed merger or acquisition, liquidation proceedings, capital injection, perfecting liens on additional collateral or refinancing plans. The entire loan need not be classified as doubtful when collection of a specific portion appears highly probable. An example of proper use of the doubtful category is the case of a company being liquidated, with the trustee-in-bankruptcy indicating a minimum disbursement of 40 percent and a maximum of 65 percent to unsecured creditors, including the Bank. In this situation, estimates are based on liquidation value appraisals with actual values yet to be realized. By definition, the only portion of the credit that is doubtful is the 25 percent difference between 40 and 65 percent.

 

A proper classification of such a credit would show 40 percent substandard, 25 percent doubtful, and 35 percent loss. A credit classified as doubtful should be resolved within a ‘reasonable’ period of time. Reasonable is generally defined as the period between examinations. In other words, a credit classified as doubtful at an examination should be cleared up before the next exam. However, there may be situations that warrant continuation of the doubtful classification a while longer.

 

8. Loss - Extensions of credit classified as “loss” are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the credit has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off, even though partial recovery may be affected in the future. It should not be the Company’s practice to attempt long-term recoveries while the credit remains on the books. Losses should be taken in the period in which they surface as uncollectible.

 

 

As of March 31, 2020 and December 31, 2019, there are no loans that are classified with a risk grade of 8- Loss.

 

The following table presents weighted average risk grades of the Company’s loan portfolio:

 

 

The following table presents risk grade totals by class of loans as of March 31, 2020 and December 31, 2019. Risk grades 1 through 4(W) have been aggregated in the “Pass” line.

 

 

Allowance for Loan Losses. The allowance for loan losses is a reserve established by the Company through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The allowance for loan loss methodology includes allowance allocations calculated in accordance with ASC Topic 310, “Receivables” and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies.” Accordingly, the methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools and specific loss allocations, with adjustments for current events and conditions. The process for determining the appropriate level of the allowance for loan losses is designed to account for credit deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to non-accrual loans, past due loans, potential problem loans, criticized loans and net charge-offs or recoveries, among other factors. The provision for loan losses also reflects the totality of actions taken on all loans for a particular period. In other words, the amount of the provision reflects not only the necessary increases in the allowance for loan losses related to newly identified criticized loans, but it also reflects actions taken related to other loans including, among other things, any necessary increases or decreases in required allowances for specific loans or loan pools.

 

 

The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Company’s control, including, among other things, the performance of the Company’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications.

 

The Company’s allowance for loan losses consists of three elements: (i) specific valuation allowances determined in accordance with ASC Topic 310 based on probable losses on specific loans; (ii) historical valuation allowances determined in accordance with ASC Topic 450 based on historical loan loss experience for similar loans with similar characteristics and trends, adjusted, as necessary, to reflect the impact of current conditions; and (iii) general valuation allowances determined in accordance with ASC Topic 450 based on general economic conditions and other qualitative risk factors both internal and external to the Bank and the Company.

 

The allowances established for probable losses on specific loans are based on a regular analysis and evaluation of problem loans. Loans are classified based on an internal credit risk grading process that evaluates, among other things: (i) the obligor’s ability to repay; (ii) the underlying collateral, if any; and (iii) the economic environment and industry in which the borrower operates. This analysis is performed at the relationship manager level for all commercial loans. When a loan has a calculated grade of 5 or higher, a special assets officer analyzes the loan to determine whether the loan is impaired and, if impaired, the need to specifically allocate a portion of the allowance for loan losses to the loan. Specific valuation allowances are determined by analyzing the borrower’s ability to repay amounts owed, collateral deficiencies, the relative risk grade of the loan and economic conditions affecting the borrower’s industry, among other things.

 

Historical valuation allowances are calculated based on the historical loss experience of specific types of loans and the internal risk grade of such loans at the time they were charged-off. The Company calculates historical loss ratios for pools of similar loans with similar characteristics based on the proportion of actual charge-offs experienced to the total population of loans in the pool. The historical loss ratios are periodically updated based on actual charge-off experience. A historical valuation allowance is established for each pool of similar loans based upon the product of the historical loss ratio and the total dollar amount of the loans in the pool. The Company’s pools of similar loans include similarly risk-graded groups of commercial and industrial loans, commercial real estate loans, consumer residential, consumer and agriculture.

 

General valuation allowances are based on general economic conditions and other qualitative risk factors both internal and external to the Bank and the Company. In general, such valuation allowances are determined by evaluating, among other things: (i) the experience, ability and effectiveness of the Bank’s lending management and staff; (ii) the effectiveness of the Bank’s loan policies, procedures and internal controls; (iii) changes in asset quality; (iv) changes in loan portfolio volume; (v) the composition and concentrations of credit; (vi) the impact of competition on loan structuring and pricing; (vii) the effectiveness of the internal loan review function; (viii) the impact of environmental risks on portfolio risks; and (ix) the impact of rising interest rates on portfolio risk. Management evaluates the degree of risk that each one of these components has on the quality of the loan portfolio on a quarterly basis. Each component is determined to have either a high, moderate or low degree of risk. The results are then input into a “general allocation matrix” to determine an appropriate general valuation allowance.

 

Included in the general valuation allowances are allocations for groups of similar loans with risk characteristics that exceed certain concentration limits established by management. Concentration risk limits have been established, among other things, for certain industry concentrations, large balance and highly leveraged credit relationships that exceed specified risk grades, and loans originated with policy exceptions that exceed specified risk grades.

 

Loans identified as losses by management, internal loan review and/or bank examiners are charged-off. Furthermore, consumer loan accounts are charged-off automatically based on regulatory requirements.

 

 

The following table details activity in the allowance for loan losses by portfolio segment for the three-months ended March 31, 2020 and 2019. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.

 

 

 

The following table details the allowance for loan losses and ending gross loan balances as of March 31, 2020 and December 31, 2019, summarized by collective and individual evaluation methods of impairment.

 

 

 

Changes in the reserve for off-balance-sheet commitments were as follows:

 

 

The method for calculating the reserve for off-balance-sheet loan commitments is based on a reserve percentage which is less than other outstanding loan types because they are at a lower risk level.  This reserve percentage, based on many factors including historical losses and existing economic conditions, is evaluated by management periodically and is applied to the total undisbursed loan commitment balance to calculate the reserve for off-balance-sheet commitments. Reserves for off-balance-sheet commitments are recorded in interest payable and other liabilities on the condensed consolidated balance sheets.

 

At March 31, 2020 and December 31, 2019, loans carried at $760,109,000 and $750,985,000, respectively, were pledged as collateral on advances from the Federal Home Loan Bank.