Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
☑ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2020
or
☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number 001-14585
FIRST HAWAIIAN, INC.
(Exact Name of Registrant as Specified in its Charter)
Delaware
99-0156159
(State or Other Jurisdiction of Incorporation or Organization)
(I.R.S. Employer Identification No.)
999 Bishop Street, 29th Floor
Honolulu, HI
96813
(Address of Principal Executive Offices)
(Zip Code)
(808) 525-7000
(Registrant’s telephone number, including area code)
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, par value $0.01 per share
FHB
NASDAQ Global Select Market
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ⌧ No ◻.
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ⌧ No ◻.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large Accelerated Filer ⌧
Accelerated filer ◻
Non-accelerated filer ◻
Smaller reporting company ☐
Emerging growth company ☐
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ◻
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒.
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 129,886,137 shares of Common Stock, par value $0.01 per share, were outstanding as of July 27, 2020.
TABLE OF CONTENTS
INDEX
Part I Financial Information
Page No.
Item 1.
Financial Statements (unaudited)
2
Consolidated Statements of Income for the three and six months ended June 30, 2020 and 2019
Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2020 and 2019
3
Consolidated Balance Sheets as of June 30, 2020 and December 31, 2019
4
Consolidated Statements of Stockholders' Equity for the three and six months ended June 30, 2020 and 2019
5
Consolidated Statements of Cash Flows for the six months ended June 30, 2020 and 2019
7
Notes to Consolidated Financial Statements (unaudited)
8
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
48
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
93
Item 4.
Controls and Procedures
Part II Other Information
Legal Proceedings
Item 1A.
Risk Factors
Item 6.
Exhibits
94
Exhibit Index
Signatures
95
1
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
FIRST HAWAIIAN, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Three Months Ended
Six Months Ended
June 30,
(dollars in thousands, except per share amounts)
2020
2019
Interest income
Loans and lease financing
$
122,298
146,883
257,269
291,289
Available-for-sale securities
17,529
24,784
38,739
49,270
Other
792
2,151
3,143
5,820
Total interest income
140,619
173,818
299,151
346,379
Interest expense
Deposits
8,583
23,693
24,183
46,890
Short-term and long-term borrowings
4,214
4,512
8,463
8,787
Total interest expense
12,797
28,205
32,646
55,677
Net interest income
127,822
145,613
266,505
290,702
Provision for credit losses
55,446
3,870
96,646
9,550
Net interest income after provision for credit losses
72,376
141,743
169,859
281,152
Noninterest income
Service charges on deposit accounts
5,927
8,123
14,877
16,183
Credit and debit card fees
10,870
16,629
25,819
33,284
Other service charges and fees
7,912
9,403
16,451
18,532
Trust and investment services income
8,664
8,931
18,255
17,549
Bank-owned life insurance
4,432
3,390
6,692
7,203
Investment securities (losses) gains, net
(211)
21
(126)
(2,592)
8,062
2,276
12,916
5,686
Total noninterest income
45,656
48,773
94,884
95,845
Noninterest expense
Salaries and employee benefits
42,414
42,185
87,243
87,045
Contracted services and professional fees
15,478
14,303
31,533
27,948
Occupancy
7,302
7,286
14,545
14,272
Equipment
5,207
4,544
9,915
8,828
Regulatory assessment and fees
2,100
2,149
4,046
3,596
Advertising and marketing
1,402
1,980
3,225
3,946
Card rewards program
5,163
7,664
12,178
14,396
12,384
13,179
25,231
25,882
Total noninterest expense
91,450
93,290
187,916
185,913
Income before provision for income taxes
26,582
97,226
76,827
191,084
Provision for income taxes
6,533
24,793
17,913
48,727
Net income
20,049
72,433
58,914
142,357
Basic earnings per share
0.15
0.54
0.45
1.06
Diluted earnings per share
Basic weighted-average outstanding shares
129,856,730
134,420,380
129,876,218
134,655,217
Diluted weighted-average outstanding shares
130,005,195
134,652,008
130,163,722
134,924,331
The accompanying notes are an integral part of these unaudited interim consolidated financial statements.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(dollars in thousands)
Other comprehensive income, net of tax:
Net change in pensions and other benefits
—
(594)
(96)
Net change in investment securities
48,602
47,364
84,576
100,805
Other comprehensive income
46,770
84,480
100,211
Total comprehensive income
68,651
119,203
143,394
242,568
CONSOLIDATED BALANCE SHEETS
December 31,
(dollars in thousands, except share amount)
Assets
Cash and due from banks
347,592
360,375
Interest-bearing deposits in other banks
1,507,630
333,642
Investment securities, at fair value (amortized cost: $5,025,433 as of June 30, 2020 and $4,080,663 as of December 31, 2019)
5,135,775
4,075,644
Loans held for sale
6,698
904
Loans and leases
13,764,030
13,211,650
Less: allowance for credit losses
192,120
130,530
Net loans and leases
13,571,910
13,081,120
Premises and equipment, net
322,919
316,885
Other real estate owned and repossessed personal property
446
319
Accrued interest receivable
58,420
45,239
458,720
453,873
Goodwill
995,492
Mortgage servicing rights
11,595
12,668
Other assets
576,518
490,573
Total assets
22,993,715
20,166,734
Liabilities and Stockholders' Equity
Deposits:
Interest-bearing
12,481,543
10,564,922
Noninterest-bearing
6,880,091
5,880,072
Total deposits
19,361,634
16,444,994
Short-term borrowings
200,000
400,000
Long-term borrowings
200,019
Retirement benefits payable
138,624
138,222
Other liabilities
391,541
343,241
Total liabilities
20,291,818
17,526,476
Commitments and contingent liabilities (Note 13)
Stockholders' equity
Common stock ($0.01 par value; authorized 300,000,000 shares; issued/outstanding: 140,140,542 / 129,866,898 as of June 30, 2020; issued/outstanding: 139,917,150 / 129,928,479 as of December 31, 2019)
1,401
1,399
Additional paid-in capital
2,509,271
2,503,677
Retained earnings
415,296
437,072
Accumulated other comprehensive income (loss), net
52,731
(31,749)
Treasury stock (10,273,644 shares as of June 30, 2020 and 9,988,671 shares as of December 31, 2019)
(276,802)
(270,141)
Total stockholders' equity
2,701,897
2,640,258
Total liabilities and stockholders' equity
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
Three Months Ended June 30, 2020
Accumulated
Additional
Common Stock
Paid-In
Retained
Comprehensive
Treasury
(dollars in thousands, except share amounts)
Shares
Amount
Capital
Earnings
Income
Stock
Total
Balance as of March 31, 2020
129,827,968
2,506,477
429,323
4,129
(276,645)
2,664,685
Cash dividends declared ($0.26 per share)
(33,765)
Equity-based awards
38,930
2,794
(311)
(157)
2,326
Other comprehensive income, net of tax
Balance as of June 30, 2020
129,866,898
Six Months Ended June 30, 2020
Income (Loss)
Balance as of December 31, 2019
129,928,479
Cumulative-effect adjustment of a change in accounting principle, net of tax: ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments
(12,517)
Cash dividends declared ($0.52 per share)
(67,547)
156,178
5,594
(626)
(1,661)
3,309
Common stock repurchased
(217,759)
(5,000)
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (continued)
Three Months Ended June 30, 2019
Loss
Balance as of March 31, 2019
135,012,015
2,497,770
326,451
(78,754)
(133,664)
2,613,202
(34,916)
6,043
2,176
(220)
(4)
1,952
(1,509,846)
(40,000)
Balance as of June 30, 2019
133,508,212
2,499,946
363,748
(31,984)
(173,668)
2,659,441
Six Months Ended June 30, 2019
Balance as of December 31, 2018
134,874,302
1,397
2,495,853
291,919
(132,195)
(132,135)
2,524,839
(69,984)
143,756
4,093
(544)
(1,533)
2,018
6
CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash flows from operating activities
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation, amortization and accretion, net
34,058
32,959
Deferred (benefits) income taxes
(13,786)
15,724
Stock-based compensation
5,596
3,551
Other gains
(33)
(8)
Originations of loans held for sale
(123,331)
(4,091)
Proceeds from sales of loans held for sale
120,970
4,343
Net gains on sales of loans originated for investment and held for sale
(4,581)
(35)
Net losses on investment securities
126
2,592
Change in assets and liabilities:
Net decrease in other assets
18,272
1,145
Net decrease in other liabilities
(84,298)
(63,844)
Net cash provided by operating activities
108,553
144,243
Cash flows from investing activities
Available-for-sale securities:
Proceeds from maturities and principal repayments
597,670
322,954
Proceeds from calls and sales
644,703
905,605
Purchases
(2,195,832)
(999,491)
Other investments:
Proceeds from sales
18,346
4,854
(27,562)
(12,693)
Loans:
Net (increase) decrease in loans and leases resulting from originations and principal repayments
(698,069)
21,111
Proceeds from sales of loans originated for investment
132,011
Purchases of loans
(40,611)
(222,816)
Proceeds from bank-owned life insurance
1,845
2,557
Purchases of premises, equipment and software
(20,646)
(16,269)
Proceeds from sales of other real estate owned
316
759
(1,951)
(1,429)
Net cash (used in) provided by investing activities
(1,589,780)
5,142
Cash flows from financing activities
Net increase (decrease) in deposits
2,916,640
(357,990)
Repayment of short-term borrowings
(200,000)
Dividends paid
Stock tendered for payment of withholding taxes
Net cash provided by (used in) financing activities
2,642,432
(469,507)
Net increase (decrease) in cash and cash equivalents
1,161,205
(320,122)
Cash and cash equivalents at beginning of period
694,017
1,003,637
Cash and cash equivalents at end of period
1,855,222
683,515
Supplemental disclosures
Interest paid
37,370
51,421
Income taxes paid, net of income tax refunds
4,242
41,593
Noncash investing and financing activities:
Operating lease right-of-use assets obtained in exchange for new lease obligations
1,965
680
Transfers from loans and leases to loans held for sale
130,863
Obligation to fund low-income housing partnerships
11,369
32,897
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Basis of Presentation
First Hawaiian, Inc. (“FHI” or the “Parent”), a bank holding company, owns 100% of the outstanding common stock of First Hawaiian Bank (“FHB” or the “Bank”), its only direct, wholly owned subsidiary. FHB offers a comprehensive suite of banking services, including loans, deposit products, wealth management, insurance, trust, retirement planning, credit card and merchant processing services, to consumer and commercial customers.
The accompanying unaudited interim consolidated financial statements of First Hawaiian, Inc. and Subsidiary (the “Company”) have been prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations.
The accompanying unaudited interim consolidated financial statements and notes thereto should be read in conjunction with the Company’s audited consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019.
In the opinion of management, all adjustments, which consist of normal recurring adjustments necessary for a fair presentation of the interim period consolidated financial information, have been made. Results of operations for interim periods are not necessarily indicative of results to be expected for the entire year. Intercompany account balances and transactions have been eliminated in consolidation.
Use of Estimates in the Preparation of Financial Statements
The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Management bases its estimates on historical experience and various other assumptions believed to be reasonable. Although these estimates are based on management’s best knowledge of current events, actual results may differ from these estimates.
Investment Securities
As of June 30, 2020 and December 31, 2019, investment securities were comprised of debt, mortgage-backed securities and collateralized mortgage obligations issued by the U.S. Government, its agencies and government-sponsored enterprises. The Company amortizes premiums and accretes discounts using the interest method over the expected lives of the individual securities. Premiums on callable debt securities are amortized to their earliest call date. All investment securities transactions are recorded on a trade-date basis. All of the Company’s investment securities were categorized as available-for-sale as of June 30, 2020 and December 31, 2019. Available-for-sale investment securities are reported at fair value, with unrealized gains and losses reported in accumulated other comprehensive income. Gains and losses realized on sales of investment securities are determined using the specific identification method.
For available-for-sale debt securities in an unrealized loss position, the Company first assesses whether it intends to sell, or it is more likely than not that it will be required to sell the security before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the security’s amortized cost basis is written down to fair value through income. For available-for-sale debt securities that do not meet the aforementioned criteria, the Company evaluates at the individual security level whether the decline in fair value has resulted from credit losses or other factors. In making this assessment, management considers the extent to which fair value is less than amortized cost and adverse conditions specifically related to the security, among other factors. If this assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security are compared to the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an allowance for credit losses is recorded for the credit loss, limited by the amount that the fair value is less than the amortized cost basis. Any impairment that has not been recorded through an allowance for credit losses is recognized in other comprehensive income.
Changes in the allowance for credit losses, if any, are recorded as a provision for (or reversal of) credit losses. Losses are charged against the allowance when management believes the uncollectibility of an available-for-sale investment security is confirmed or when either of the criteria regarding intent or requirement to sell is met. As noted above, as of June 30, 2020, the Company’s available-for-sale investment securities were comprised entirely of debt, mortgage-backed securities and collateralized mortgage obligations issued by the U.S. Government, its agencies and government-sponsored enterprises. Management has concluded that the long history with no credit losses from these issuers indicates an expectation that nonpayment of the amortized cost basis is zero. The Company’s available-for-sale investment securities are explicitly or implicitly fully guaranteed by the U.S. government. The U.S. government can print its own currency and its currency is routinely held by central banks and other major financial institutions. The dollar is used in international commerce, and commonly is viewed as a reserve currency, all of which qualitatively indicates that historical credit loss information should be minimally affected by current conditions and reasonable and supportable forecasts. Thus, the Company has not recorded an allowance for credit losses for its available-for-sale debt securities as of June 30, 2020.
Accrued interest receivable related to available-for-sale investment securities was $9.7 million as of June 30, 2020 and is recorded separately from the amortized cost basis of investment securities on the Company’s interim consolidated balance sheet.
Loans and Leases
Loans are reported at amortized cost which includes the principal amount outstanding, net of deferred loan fees and costs and cumulative net charge-offs. Interest income is recognized on an accrual basis. Loan origination fees, certain direct costs and unearned discounts and premiums, if any, are deferred and are generally accreted or amortized into interest income as yield adjustments using the interest method over the contractual life of the loan. Other credit-related fees are recognized as fee income, a component of noninterest income, when earned.
Direct financing leases are carried at the aggregate of lease payments receivable plus the estimated residual value of leased property, less unearned income. Unearned income on direct financing leases is amortized over the lease term by methods that approximate the interest method. Residual values on leased assets are periodically reviewed for impairment.
Accrued interest receivable related to loans and leases was $48.7 million as of June 30, 2020 and is recorded separately from the amortized cost basis of loans and leases on the Company’s interim consolidated balance sheet.
Nonaccrual Loans and Leases
The Company generally places a loan or lease on nonaccrual status when management believes that collection of principal or interest has become doubtful or when a loan or lease becomes 90 days past due as to principal or interest, unless it is well secured and in the process of collection. A full or partial charge-off is recorded in the period in which the loan or lease is deemed uncollectible. When the Company places a loan or lease on nonaccrual status, previously accrued and uncollected interest is concurrently reversed against interest income. When the Company receives an interest payment on a nonaccrual loan or lease, the payment is applied as a reduction of the principal balance. Nonaccrual loans and leases are generally returned to accrual status when they become current as to principal and interest and future payments are reasonably assured.
Allowance for Credit Losses
The allowance for credit losses for loans and leases (the “ACL”) is a valuation account that is deducted from the amortized cost basis of loans and leases to present the net amount expected to be collected from loans and leases. Loans and leases are charged-off against the ACL when management believes the uncollectibility of a loan or lease balance is confirmed. Expected recoveries do not exceed the aggregate of amounts previously charged-off and expected to be charged-off. The Company’s ACL and the reserve for unfunded commitments under the Current Expected Credit Losses (“CECL”) approach utilizes both quantitative and qualitative components. The Company’s methodology utilizes a quantitative model based on a single forward-looking macroeconomic forecast. The quantitative estimation is overlaid with qualitative adjustments to account for current conditions and forward-looking events not captured in the quantitative model. Qualitative adjustments that are considered include adjustments for regulatory determinants, model limitations, model maturity, and other current or forecasted events that are not captured in the Company’s historical loss experience.
9
The Company generally evaluates loans and leases on a collective or pool basis when similar risk characteristics exist. However, loans and leases that do not share similar risk characteristics are evaluated on an individual basis. Such loans and leases evaluated individually are excluded from the collective evaluation. Individually assessed loans are measured for estimated credit loss (“ECL”) based on the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral, less estimated selling costs, if the loan is collateral-dependent.
Management reviews relevant available information, from internal and external sources, relating to past events, current conditions, and reasonable and supportable forecasts about the future. Historical credit loss experience provides the basis for the estimation of expected credit losses. Adjustments to historical loss information are made for differences in current loan-specific risk characteristics such as differences in underwriting standards, portfolio mix, delinquency levels, or term as well as for changes in environmental conditions, such as changes in unemployment rates, property values, or other relevant factors.
The Company utilizes a Probability of Default (“PD”)/Loss Given Default (“LGD”) framework to estimate the ACL and the reserve for unfunded commitments. The PD represents the percentage expectation to default, measured by assessing loans and leases that migrate to default status (i.e., nonaccrual status, troubled debt restructurings (“TDRs”), 90 days or more past due, partial or full charge-offs or bankruptcy). LGD is defined as the percentage of the exposure at default (“EAD”) lost at the time of default, net of any recoveries, and will be unique to each of the collateral types securing the Company’s loans. PD and LGD’s are based on past experience of the Company and management’s expectations of the future. The ECL on loans and leases is calculated by taking the product of the credit exposure, lifetime default probability (“LDP”) and the LGD.
The ECL model is applied to current credit exposures at the account level, using assumptions calibrated at the portfolio segment level using internal historical loan and lease level data. The Company estimates the default risk of a credit exposure over the remaining life of each account using a transition probability matrix approach which captures both the average rate of up/down-grade and default transitions, as well as withdrawal rates which capture the historical rate of exposure decline due to loan and lease amortization and prepayment. To apply the transition matrices, each credit exposure’s remaining life is split into two time segments. The first time segment is for the reasonable and supportable forecast period over which the transition matrices which are applied have been adjusted to incorporate current and forecasted conditions over that period. Management has determined that using a one year time horizon for the reasonable and supportable forecast period for all classes of loans and leases is a reasonable forecast horizon given the difficulty in predicting future economic conditions with a high degree of certainty. The second time segment is the reversion period from the end of the reasonable and supportable forecast period to the maturity of the exposure, over which long-run average transition matrices are applied. Management elected to use an immediate reversion to the mean approach. Lifetime loss rates are applied against the amortized cost basis of loans and leases and unfunded commitments to estimate the ACL and the reserve for unfunded commitments.
On a quarterly basis, management convenes the Bank’s forecasting team which is responsible for qualitatively forecasting the economic outlook over the reasonable and supportable forecast period within the context of forecasting credit losses. Management reviews local and national economic forecasts and other pertinent materials to inform the team in establishing their best estimate of the economic outlook over the reasonable and supportable forecast period. The team considers unemployment rates, gross domestic product, personal income per capita, visitor arrivals and expenditures and home prices along with other relevant information. The results from the Bank’s forecasting team dictates the direction of the economic forecast compared to current economic conditions (i.e., better or worse) and the magnitude of the forecast adjustment (e.g., mild, medium or severe). The direction of the economic forecast and magnitude are used to qualitatively adjust the modifier that is applied to the long-run default rates over the reasonable and supportable forecast period.
The Company has identified three portfolio segments in estimating the ACL: commercial, residential real estate and consumer lending. The Company’s commercial portfolio segment is comprised of four distinct classes: commercial and industrial loans, commercial real estate loans, construction loans and lease financing. The key risk drivers related to this portfolio segment include risk rating, collateral type, and remaining maturity. The Company’s residential real estate portfolio segment is comprised of two distinct classes: residential real estate loans and home equity lines of credit. Specific risk characteristics related to this portfolio include the value of the underlying collateral, credit score and remaining maturity. Finally, the Company’s consumer portfolio segment is not further segmented, but consists primarily of automobile loans, credit cards and other installment loans. Automobile loans constitute the majority of this segment and are monitored using credit scores, collateral values and remaining maturity. The remainder of the consumer portfolio is predominantly unsecured.
10
Reserve for Unfunded Commitments
The Company estimates expected credit losses over the contractual period in which the Company is exposed to credit risk via a contractual obligation to extend credit, unless that obligation is unconditionally cancellable by the Company. The reserve for unfunded commitments is adjusted through the provision for credit losses. The estimate includes consideration of the likelihood that funding will occur and an estimate of expected credit losses on commitments expected to be funded over its estimated life.
Accounting Standards Adopted in 2020
In June 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-13, Financial Instruments – Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments. This guidance eliminates the probable recognition threshold for credit losses on financial assets measured at amortized cost. For loans and held-to-maturity debt securities, this guidance requires a CECL approach to determine an ACL. CECL requires loss estimates for the remaining estimated life of the financial asset using historical experience, current conditions, and reasonable and supportable forecasts. CECL also applies to off-balance sheet (“OBS”) credit exposures (e.g., unfunded loan commitments), except for unconditionally cancellable commitments. In addition, this guidance modifies the other-than-temporary-impairment model for available-for-sale debt securities to require an allowance for credit losses instead of a direct write-down, which allows for a reversal of credit losses in future periods. In April 2019, the FASB also issued ASU No. 2019-04, Codification Improvements to Topic 326, Financial Instruments – Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments. As it relates to CECL, this guidance amended certain provisions contained in ASU No. 2016-13, particularly with regards to the inclusion of accrued interest in the definition of amortized cost, as well as clarifying that extension and renewal options that are not unconditionally cancelable by the entity that are included in the original or modified contract should be considered in the entity’s determination of expected credit losses. As permitted by ASU No. 2016-13, the Company elected the practical expedient to use the fair value of collateral at the reporting date when recording the net carrying amount of the asset and determining the ACL for a financial asset for which the repayment is expected to be provided substantially through the operation or sale of the collateral when the borrower is experiencing financial difficulty based on the Company’s assessment as of the reporting date. Furthermore, as permitted by ASU No. 2019-04, the Company made accounting policy elections to not measure an ACL on accrued interest receivable, write-off accrued interest receivable by reversing interest income and present accrued interest receivable separately from the related financial asset on the balance sheet.
The implementation of CECL required significant operational changes, particularly in data collection and analysis. The Company formed a working group comprised of teams from different disciplines, including credit, finance and information technology, to evaluate the requirements of the new standard and the impact it will have on the Company’s existing processes. The Company also engaged a software vendor and had run several CECL parallel run productions during 2019. The Company adopted the provisions of ASU No. 2016-13 and related amendments by recording a cumulative effect adjustment to retained earnings as of January 1, 2020. Note that the Company did not opt to delay the implementation of CECL requirements as permitted under the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), which allows entities to delay implementation until the earlier of (1) the date on which the national emergency concerning the Coronavirus Disease 2019 (“COVID-19”) terminates, or (2) December 31, 2020.
The following table presents the impact of adopting ASC Topic 326 as of January 1, 2020:
Prior to the
Adjustment
Adoption of
to Adopt
After Adoption of
ASC Topic 326
Assets:
Allowance for Credit Losses - Loans and Leases
770
131,300
Liabilities:
Reserve for Unfunded Commitments(1)
600
16,300
16,900
Pretax Cumulative Effect Adjustment of a Change in Accounting Principle
17,070
Less: Income Taxes
(4,553)
Cumulative-Effect Adjustment of a Change in Accounting Principle, Net of Tax
12,517
11
In January 2017, the FASB issued ASU No. 2017-04, Intangibles – Goodwill and Other (Topic 350), Simplifying the Test for Goodwill Impairment. This guidance simplifies the subsequent measurement of goodwill by eliminating Step 2 from the current two-step goodwill impairment test. This guidance provides that a goodwill impairment test be conducted by comparing the fair value of a reporting unit with its carrying amount. Entities are to recognize an impairment charge for goodwill by the amount by which the carrying amount exceeds the reporting unit’s fair value. Entities will continue to have the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. The Company adopted the provisions of ASU No. 2017-04 on January 1, 2020 and it did not have a material impact on the Company’s consolidated financial statements.
In August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820), Disclosure Framework – Changes to the Disclosure Requirements for Fair Value Measurement. This guidance is a part of the FASB’s disclosure framework project to improve disclosure effectiveness. This guidance eliminates certain disclosure requirements for fair value measurements: the amount of and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy, an entity’s policy for the timing of transfers between levels of the fair value hierarchy and an entity’s valuation processes for Level 3 fair value measurements. This guidance also adds new disclosure requirements for public entities: changes in unrealized gains and losses for the period included in other comprehensive income for recurring Level 3 fair value measurements of instruments held at the end of the reporting period, and the range and weighted average of significant unobservable inputs used to develop recurring and nonrecurring Level 3 fair value measurements, including how the weighted average is calculated. Furthermore, this guidance modifies certain requirements which will involve disclosing: transfers into and out of Level 3 of the fair value hierarchy, purchases and issuances of Level 3 assets and liabilities, and information about the measurement uncertainty of Level 3 fair value measurements as of the reporting date. The Company adopted the provisions of ASU No. 2018-13 on January 1, 2020 and it did not have a material impact on the Company’s consolidated financial statements. See “Note 17. Fair Value” for required disclosures related to this new guidance.
Recent Accounting Pronouncements
The following ASU has been issued by the FASB and is applicable to the Company in future reporting periods.
In March 2020, the FASB issued ASU No. 2020-04, Reference Rate Reform (Topic 848), Facilitation of the Effects of Reference Rate Reform on Financial Reporting. The relief provided by this guidance is elective and applies to all entities, subject to meeting certain criteria, that have contracts, hedging relationships, and other transactions that reference the London Interbank Offered Rate (“LIBOR”) or another reference rate expected to be discontinued because of reference rate reform. The guidance provides that changes in contract terms that are made to effect the reference rate reform transition are considered related to the replacement of a reference rate if they are not the result of a business decision that is separate from or in addition to changes to the terms of a contract to effect that transition. The guidance also provides an optional expedient for loans that would permit the Company to account for the modification as if it was only minor and not an extinguishment in accordance with GAAP. For leases, the guidance provides an optional expedient for modifications to not trigger reassessment of lease classification and the discount rate or require the entity to remeasure lease payments or perform the other reassessments or remeasurements that would otherwise be triggered by a modification under GAAP when the modification is not accounted for as a separate contract. The optional amendments in ASU No. 2020-04 are effective for all entities as of March 12, 2020 through December 31, 2022. As of June 30, 2020, the Company did not elect any of the optional expedients provided for by this guidance. The Company is in the process of evaluating the optional expedients and the impact that this new guidance may have on the Company’s consolidated financial statements.
2. Investment Securities
As of June 30, 2020 and December 31, 2019, investment securities consisted predominantly of the following investment categories:
U.S. Treasury and debt securities – includes U.S. Treasury notes and debt securities issued by agencies and government-sponsored enterprises.
Mortgage-backed securities – includes securities backed by notes or receivables secured by mortgage assets with cash flows based on actual or scheduled payments.
Collateralized mortgage obligations – includes securities backed by a pool of mortgages with cash flows distributed based on certain rules rather than pass through payments.
12
As of June 30, 2020 and December 31, 2019, all of the Company’s investment securities were classified as available-for-sale. Amortized cost and fair value of securities as of June 30, 2020 and December 31, 2019 were as follows:
June 30, 2020
December 31, 2019
Amortized
Unrealized
Fair
Cost
Gains
Losses
Value
U.S. Treasury and government agency debt securities
94,414
504
94,918
29,832
56
29,888
Government-sponsored enterprises debt securities
101,697
19
(277)
101,439
Mortgage-backed securities:
Residential - Government agency
224,764
7,853
232,617
290,131
2,224
(1,146)
291,209
Residential - Government-sponsored enterprises
375,118
15,794
390,912
395,039
6,126
(1,673)
399,492
Commercial - Government agency
612,811
17,324
(456)
629,679
Commercial - Government-sponsored enterprises
312,293
10,703
322,996
101,798
555
(634)
101,719
Collateralized mortgage obligations:
Government agency
1,887,701
39,538
(655)
1,926,584
2,390,143
7,483
(16,348)
2,381,278
Government-sponsored enterprises
1,518,332
20,194
(457)
1,538,069
772,023
2,505
(3,909)
770,619
Total available-for-sale securities
5,025,433
111,910
(1,568)
4,080,663
18,968
(23,987)
Proceeds from calls and sales of investment securities were $26.7 million and $539.5 million, respectively, for the three months ended June 30, 2020, and $101.7 million and $543.0 million, respectively, for the six months ended June 30, 2020. Proceeds from calls and sales of investment securities were nil and $42.6 million, respectively, for the three months ended June 30, 2019 and nil and $905.6 million, respectively, for the six months ended June 30, 2019. The Company recorded gross realized gains of $0.5 million and gross realized losses of $0.8 million for the three months ended June 30, 2020 and gross realized gains of $0.6 million and gross realized losses of $0.8 million for the six months ended June 30, 2020. The Company recorded gross realized gains of $0.1 million and gross realized losses of $0.1 million for the three months ended June 30, 2019 and gross realized gains of $0.1 million and gross realized losses of $2.7 million for the six months ended June 30, 2019. The income tax benefit related to the Company’s net realized loss on the sale of investment securities was $0.1 million and nil, respectively, during the three and six months ended June 30, 2020. The income tax expense related to the net realized gains on the sale of investment securities was nil for the three months ended June 30, 2019. The income tax benefit related to the Company's net realized loss on the sale of investment securities was $0.7 million for the six months ended June 30, 2019. Gains and losses realized on sales of securities are determined using the specific identification method.
Interest income from taxable investment securities was $17.5 million and $24.8 million, respectively, for the three months ended June 30, 2020 and 2019, and $38.7 million and $49.3 million, respectively, for the six months ended June 30, 2020 and 2019. Interest income from non-taxable investment securities was nil during both the three and six months ended June 30, 2020 and 2019.
The amortized cost and fair value of debt securities issued by the U.S. Treasury and government agencies as of June 30, 2020, by contractual maturity, are shown below. Mortgage-backed securities and collateralized mortgage obligations are disclosed separately in the table below as remaining expected maturities will differ from contractual maturities as borrowers have the right to prepay obligations.
13
Due in one year or less
Due after one year through five years
30,442
30,941
Due after five years through ten years
Due after ten years
63,972
63,977
Total mortgage-backed securities
1,524,986
1,576,204
Total collateralized mortgage obligations
3,406,033
3,464,653
At June 30, 2020, pledged securities totaled $3.2 billion, of which $3.0 billion was pledged to secure public deposits and $237.2 million was pledged to secure other financial transactions. At December 31, 2019, pledged securities totaled $1.8 billion, of which $1.5 billion was pledged to secure public deposits and $242.3 million was pledged to secure other financial transactions.
The Company held no securities of any single issuer, other than debt securities issued by the U.S. government, government agencies and government-sponsored enterprises, taken in the aggregate, which were in excess of 10% of stockholders’ equity as of June 30, 2020 or December 31, 2019.
The following table presents the unrealized gross losses and fair values of securities in the available-for-sale portfolio by length of time that the 16 and 118 individual securities in each category have been in a continuous loss position as of June 30, 2020 and December 31, 2019, respectively. The unrealized losses on investment securities were attributable to changes in interest rates, relative to when the investment securities were purchased, and not due to the credit quality of the investment securities. At June 30, 2020, the Company did not have any securities with the intent to sell and determined it was more likely than not that the Company would not be required to sell the securities prior to recovery of the amortized cost basis.
Time in Continuous Loss as of June 30, 2020
Less Than 12 Months
12 Months or More
Fair Value
90,834
(603)
200,395
(52)
9,212
209,607
(430)
124,283
(27)
8,813
133,096
Total available-for-sale securities with unrealized losses
(1,489)
415,512
(79)
18,025
433,537
14
Time in Continuous Loss as of December 31, 2019
49,716
109,614
(115)
76,481
(1,558)
109,025
185,506
38,062
(8,049)
969,762
(8,299)
565,764
1,535,526
(583)
180,785
(3,326)
209,752
390,537
(9,658)
1,314,806
(14,329)
994,155
2,308,961
Visa Class B Restricted Shares
In 2008, the Company received 394,000 Visa Class B restricted shares as part of Visa’s IPO. Visa Class B restricted shares are not currently convertible to publicly traded Visa Class A common shares, and only transferable in limited circumstances, until the settlement of certain litigation which are indemnified by Visa members, including the Company. As there are existing transfer restrictions and the outcome of the aforementioned litigation is uncertain, these shares were included in the consolidated balance sheets at their historical cost of $0.
In 2016, the Company recorded a $22.7 million net realized gain related to the sale of 274,000 Visa Class B restricted shares. Concurrent with the sale of the Visa Class B restricted shares, the Company entered into an agreement with the buyer that requires payment to the buyer in the event Visa reduces each member bank’s Class B conversion rate to unrestricted Class A common shares. On June 28, 2018, Visa additionally funded its litigation escrow account, thereby reducing each member bank’s Class B conversion rate to unrestricted Class A common shares. Accordingly, on July 5, 2018, Visa announced a decrease in conversion rate from 1.6483 to 1.6298, effective June 28, 2018. In July 2018, the Company made a payment of approximately $0.7 million to the buyer as a result of the reduction in the Visa Class B conversion rate. On September 27, 2019, Visa additionally funded its litigation escrow account, thereby further reducing each member bank’s Class B conversion rate to unrestricted Class A common shares. Accordingly, on September 30, 2019, Visa announced a decrease in conversion rate from 1.6298 to 1.6228, effective September 27, 2019. In October 2019, the Company made a payment of approximately $0.3 million to the buyer as a result of the reduction in the Visa Class B conversion rate. See “Note 12. Derivative Financial Instruments” for more information.
The Company held approximately 120,000 Visa Class B restricted shares as of both June 30, 2020 and December 31, 2019. These shares continued to be carried at $0 cost basis as of both June 30, 2020 and December 31, 2019.
3. Loans and Leases
As of June 30, 2020 and December 31, 2019, loans and leases were comprised of the following:
Commercial and industrial
3,423,708
2,743,242
Commercial real estate
3,423,499
3,463,953
Construction
617,935
519,241
Residential:
Residential mortgage
3,691,950
3,768,936
Home equity line
876,491
893,239
Total residential
4,568,441
4,662,175
Consumer
1,492,160
1,620,556
Lease financing
238,287
202,483
Total loans and leases
Outstanding loan balances are reported net of deferred loan costs and fees of $15.5 million and $41.0 million at June 30, 2020 and December 31, 2019, respectively.
15
As of June 30, 2020, residential real estate loans totaling $2.9 billion were pledged to collateralize the Company’s borrowing capacity at the Federal Home Loan Bank of Des Moines (“FHLB”), and consumer, commercial and industrial and commercial real estate loans totaling $1.8 billion were pledged to collateralize the Company’s borrowing capacity at the Federal Reserve Bank of San Francisco (“FRB”). As of December 31, 2019, residential real estate loans totaling $2.9 billion were pledged to collateralize the Company’s borrowing capacity at the FHLB, and consumer, commercial and industrial and commercial real estate loans totaling $953.2 million were pledged to collateralize the Company’s borrowing capacity at the FRB. Residential real estate loans collateralized by properties that were in the process of foreclosure totaled $3.1 million and $4.1 million as of June 30, 2020 and December 31, 2019, respectively.
In the course of evaluating the credit risk presented by a customer and the pricing that will adequately compensate the Company for assuming that risk, management may require a certain amount of collateral support. The type of collateral held varies, but may include accounts receivable, inventory, land, buildings, equipment, income-producing commercial properties and residential real estate. The Company applies the same collateral policy for loans whether they are funded immediately or on a delayed basis. The loan and lease portfolio is principally located in Hawaii and, to a lesser extent, on the U.S. Mainland, Guam and Saipan. The risk inherent in the portfolio depends upon both the economic strength and stability of the state or territories, which affects property values, and the financial strength and creditworthiness of the borrowers.
4. Allowance for Credit Losses
The Company maintains an ACL that is deducted from the amortized cost basis of loans and leases to present the net carrying value of loans and leases expected to be collected. The measurement of expected credit losses is based on relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount of loans and leases.
The Company also maintains an estimated reserve for unfunded commitments on the unaudited interim consolidated balance sheets. The reserve for unfunded commitments is reduced in the period in which the OBS financial instruments expire, loan funding occurs, or is otherwise settled.
In response to the COVID-19 pandemic, on March 27, 2020, the CARES Act was signed into law. The CARES Act creates a forbearance program for federally backed mortgage loans, protects borrowers from negative credit reporting due to loan accommodations related to the National Emergency, and provides financial institutions the option to temporarily suspend certain requirements under GAAP related to TDRs for a limited period of time to account for the effects of COVID-19. Financial institutions accounting for eligible loans under the CARES Act are not required to report such loans as TDRs in accordance with GAAP. In addition, Interagency Statements were issued on March 22, 2020 and April 7, 2020 to encourage financial institutions to work prudently with borrowers and to describe the agencies’ interpretation of how current accounting rules under GAAP apply to certain COVID-19 related modifications. The agencies confirmed with the FASB that short-term modifications (e.g., six months or less) for payment deferrals, fee waivers, extensions of repayment terms, or delays in payment that are insignificant and made on a good faith basis in response to borrowers impacted by COVID-19 who were current prior to any relief are not TDRs under GAAP. The agencies also confirmed that these short-term modifications should not be reported as being on nonaccrual status and should not be considered past due during the period of the deferral. The Company has adopted the provisions of both the CARES Act and Interagency Statements. The Company is first applying the CARES Act guidance in determining if certain loan modifications are not required to be reported as TDRs. If the loan modification does not qualify under the CARES Act, then the Interagency Statement guidance is applied. The interim consolidated financial information below reflects the application of this guidance.
16
Rollforward of the Allowance for Credit Losses
The following presents the activity in the ACL by class of loans and leases for the three and six months ended June 30, 2020:
Commercial Lending
Residential Lending
Commercial
Home
and
Real
Lease
Residential
Equity
Industrial
Estate
Financing
Mortgage
Line
Allowance for credit losses:
Balance at beginning of period
20,884
42,838
8,824
851
30,021
6,556
56,039
166,013
Charge-offs
(13,974)
(2,723)
(379)
(14)
(8,907)
(25,997)
Recoveries
100
30
17
2,456
2,611
Increase (decrease) in Provision
14,289
13,007
(3,199)
2,986
3,850
1,071
17,489
49,493
Balance at end of period
21,299
53,122
5,276
3,837
33,874
7,635
67,077
Unallocated
28,975
22,325
4,844
424
29,303
9,876
34,644
139
Adoption of ASU No. 2016-13
(16,105)
10,559
(1,803)
207
(2,793)
(4,731)
15,575
(139)
(14,175)
(17,504)
(34,803)
320
140
152
130
4,539
5,281
Increase in Provision
22,284
22,961
2,474
3,206
7,226
2,368
29,823
90,342
The following presents the activity in the ACL by class of loans and leases for the three and six months ended June 30, 2019, presented in accordance with Topic 310, Receivables:
31,793
21,197
5,381
411
44,911
35,099
2,754
141,546
(2,000)
(7,505)
(9,505)
25
32
185
2,382
2,624
1,870
975
(367)
35
(1,676)
3,662
(629)
31,688
22,204
5,014
43,420
33,638
2,125
138,535
34,501
19,725
5,813
432
44,906
35,813
528
141,718
(24)
(16,103)
(18,127)
62
63
435
4,834
5,394
(875)
2,416
(799)
38
(1,921)
9,094
1,597
The disaggregation of the ACL and recorded investment in loans by impairment methodology as of December 31, 2019, presented in accordance with Topic 310, Receivables, was as follows:
Individually evaluated for impairment
46
27
203
Collectively evaluated for impairment
28,929
22,298
39,049
130,327
39,179
Loans and leases:
4,951
723
14,964
20,638
2,738,291
3,463,230
4,647,211
13,191,012
Rollforward of the Reserve for Unfunded Commitments
The following presents the activity in the Reserve for Unfunded Commitments for the three and six months ended June 30, 2020:
Reserve for unfunded commitments:
4,791
696
4,813
6,927
23
17,251
472
1,095
963
31
5,953
8,181
1,168
5,908
7,890
54
23,204
5,390
778
4,119
6,587
(581)
2,791
390
1,789
1,303
6,304
Credit Quality Information
The Company performs an internal loan review and grading or scoring procedures on an ongoing basis. The review provides management with periodic information as to the quality of the loan portfolio and effectiveness of the Company’s lending policies and procedures. The objective of the loan review and grading or scoring procedures is to identify, in a timely manner, existing or emerging credit quality issues so that appropriate steps can be initiated to avoid or minimize future losses.
Loans and leases subject to grading primarily include: commercial and industrial loans, commercial real estate loans, construction loans and lease financing. Other loans subject to grading include installment loans to businesses or individuals for business and commercial purposes, overdraft lines of credit, commercial credit cards, and other credits as may be determined. Credit quality indicators for internally graded loans and leases are generally updated on an annual basis or on a quarterly basis for those loans and leases deemed to be of potentially higher risk.
An internal credit risk rating system is used to determine loan grade and is based on borrower credit risk and transactional risk. The loan grading process is a mechanism used to determine the risk of a particular borrower and is based on the following factors of a borrower: character, earnings and operating cash flow, asset and liability structure, debt capacity, management and controls, borrowing entity, and industry and operating environment.
Pass – “Pass” (uncriticized) loans and leases, are not considered to carry greater than normal risk. The borrower has the apparent ability to satisfy obligations to the Company, and therefore no loss in ultimate collection is anticipated.
Special Mention – Loans and leases that have potential weaknesses deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for assets or in the institution’s credit position at some future date. Special mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.
Substandard – Loans and leases that are inadequately protected by the current financial condition and paying capacity of the obligor or by any collateral pledged. Loans and leases so classified must have a well-defined weakness or weaknesses that jeopardize the collection of the debt. They are characterized by the distinct possibility that the bank may sustain some loss if the deficiencies are not corrected.
Doubtful – Loans and leases that have weaknesses found in substandard borrowers with the added provision that the weaknesses make collection of debt in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
18
Loss – Loans and leases classified as loss are considered uncollectible and of such little value that their continuance as an asset is not warranted. This classification does not mean that the loan or lease has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be effected in the future.
Loans that are primarily monitored for credit quality using FICO scores include: residential real estate loans, home equity lines and consumer loans. FICO scores are calculated primarily based on a consideration of payment history, the current amount of debt, the length of credit history available, a recent history of new sources of credit and the mix of credit type. FICO scores are updated on a monthly, quarterly or bi-annual basis, depending on the product type.
The amortized cost basis by year of origination and credit quality indicator of the Company's loans and leases as of June 30, 2020 was as follows:
Revolving
Loans
Converted
Term Loans
to Term
Amortized Cost Basis by Origination Year
2018
2017
2016
Prior
Cost Basis
Commercial and Industrial
Risk rating:
Pass
989,501
349,261
271,941
76,742
62,113
68,468
1,182,299
39,617
3,039,942
Special Mention
28,136
9,235
8,460
841
335
27,174
113,642
509
188,332
Substandard
16,621
1,724
1,836
2,000
4,321
9,788
52,225
938
89,453
Other (1)
9,091
16,661
12,574
7,884
3,199
811
55,761
105,981
Total Commercial and Industrial
1,043,349
376,881
294,811
87,467
69,968
106,241
1,403,927
41,064
Commercial Real Estate
171,445
618,501
523,149
440,549
296,474
927,232
33,878
3,011,228
113,286
53,391
62,165
47,790
66,008
2,999
345,639
16,304
14,617
1,655
6,630
17,947
8,970
66,123
Total Commercial Real Estate
748,091
591,157
504,369
350,894
1,011,696
45,847
16,615
135,963
192,016
96,137
24,106
41,457
29,297
535,591
2,152
4,782
10,850
196
17,980
541
1,840
1,000
3,909
8,415
31,038
8,546
5,562
1,795
4,514
585
60,455
Total Construction
25,030
167,001
203,255
108,321
26,429
57,821
30,078
Lease Financing
45,489
67,806
11,965
18,915
3,764
59,364
207,303
9,142
1,931
4,626
1,545
1,440
5,854
24,538
2,697
1,651
368
1,207
523
6,446
Total Lease Financing
57,328
71,388
16,959
21,667
5,204
65,741
Total Commercial Lending
1,297,152
1,363,361
1,106,182
721,824
452,495
1,241,499
1,479,852
7,703,429
(continued)
Residential Mortgage
FICO:
740 and greater
300,079
411,883
353,197
411,670
362,197
988,771
2,827,797
680 - 739
50,937
72,139
64,920
65,992
43,666
161,897
459,551
620 - 679
6,098
12,708
12,060
12,648
10,789
55,000
109,303
550 - 619
2,006
1,824
3,533
3,389
3,032
13,329
27,113
Less than 550
1,204
1,907
6,324
9,963
No Score (3)
15,676
21,603
24,182
23,736
16,298
51,943
153,438
Other (2)
8,244
20,308
22,241
23,435
12,412
17,063
579
503
104,785
Total Residential Mortgage
383,040
540,465
481,337
542,777
448,922
1,294,327
Home Equity Line
626,897
858
627,755
169,547
1,283
170,830
48,655
1,013
49,668
14,276
562
14,838
6,661
212
6,873
6,527
Total Home Equity Line
872,563
3,928
Total Residential Lending
873,142
4,431
Consumer Lending
65,206
141,704
120,178
71,525
35,932
12,451
109,702
556,698
47,584
109,728
87,056
48,728
24,478
10,094
83,021
410,689
24,185
65,310
43,282
31,318
16,144
7,013
42,511
229,763
5,881
26,220
22,891
20,874
10,869
5,467
18,429
110,631
1,562
12,306
13,110
10,628
5,397
2,567
7,777
53,347
3,799
124
125
34,281
38,483
594
9,160
96
2,225
72
6,804
73,598
92,549
Total Consumer Lending
148,811
364,552
286,738
185,424
92,919
44,397
369,319
Total Loans and Leases
1,829,003
2,268,378
1,874,257
1,450,025
994,336
2,580,223
2,722,313
45,495
There were no loans and leases graded as Loss as of June 30, 2020.
The amortized cost basis of revolving loans that were converted to term loans during the three and six months ended June 30, 2020 was as follows:
294
Total Revolving Loans Converted to Term Loans During the Period
4,222
28,522
296
32,746
20
The credit risk profiles by internally assigned grade for loans and leases as of December 31, 2019, presented in accordance with Topic 310, Receivables, were as follows:
Grade:
2,585,908
3,327,659
515,993
201,461
6,631,021
Special mention
91,365
106,331
127
1,022
198,845
65,969
29,963
3,121
99,053
6,928,919
There were no loans and leases graded as Loss as of December 31, 2019.
The credit risk profiles based on payment activity for loans and leases that were not subject to loan grading as of December 31, 2019 presented in accordance with Topic 310, Receivables, were as follows:
Consumer - Auto
Credit Cards
Performing
3,759,799
886,879
219,046
1,016,142
347,264
6,229,130
Non-performing and delinquent
9,137
6,360
7,258
24,326
6,520
53,601
226,304
1,040,468
353,784
6,282,731
Past-Due Status
The Company continually updates its aging analysis for loans and leases to monitor the migration of loans and leases into past due categories. The Company considers loans and leases that are delinquent for 30 days or more to be past due. As of June 30, 2020, the aging analysis of the amortized cost basis of the Company’s past due loans and leases was as follows:
Past Due
Loans and
Greater
Leases Past
Than or
Due 90 Days
30-59
60-89
Equal to
or More and
Days
90 Days
Total Loans
Still Accruing
Current
and Leases
Interest
2,535
2,501
2,374
7,410
3,416,298
2,309
2,761
4,510
3,418,989
900
2,737
2,292
5,029
612,906
248
2,630
4,778
4,152
11,560
3,680,390
2,041
1,591
4,496
8,128
868,363
11,053
3,103
2,167
16,323
1,475,837
23,757
12,067
17,136
52,960
13,711,070
10,120
As of December 31, 2019, the aging analysis of the Company’s past due loans and leases, presented in accordance with Topic 310, Receivables, was as follows:
Accruing Loans and Leases
Total Non
Accruing
Past
Due
Leases
Outstanding
1,525
808
1,429
3,762
2,739,448
2,743,210
1,664
1,125
3,802
3,460,121
3,463,923
2,367
516,874
3,258
399
74
3,731
3,763,530
5,406
2,971
394
2,995
26,810
7,022
4,272
38,104
1,582,452
36,228
9,748
12,150
58,126
13,148,056
13,206,182
5,468
The Company generally places a loan or lease on nonaccrual status when management believes that collection of principal or interest has become doubtful or when a loan or lease becomes 90 days past due as to principal or interest, unless it is well secured and in the process of collection. The Company charges off a loan or lease when facts indicate that the loan or lease is considered uncollectible.
The amortized cost basis of loans and leases on nonaccrual status as of June 30, 2020 and January 1, 2020 and the amortized cost basis of loans and leases on nonaccrual status with no allowance for credit losses as of June 30, 2020 were as follows:
January 1, 2020
Nonaccrual
With No
Allowance
for Credit Losses
11,494
11,559
13,088
13,168
2,043
1,475
6,059
Total Nonaccrual Loans and Leases
27,897
32,829
For both the three and six months ended June 30, 2020, the Company recognized interest income of $0.1 million on nonaccrual loans and leases. Furthermore, for the three and six months ended June 30, 2020, the amount of accrued interest receivables written off by reversing interest income was $0.5 million and $0.9 million, respectively.
Collateral-Dependent Loans and Leases
Collateral-dependent loans and leases are those for which repayment (on the basis of the Company’s assessment as of the reporting date) is expected to be provided substantially through the operation or sale of the collateral and the borrower is experiencing financial difficulty. As of June 30, 2020, the amortized cost basis of collateral-dependent loans was $55.9 million. These loans were primarily collateralized by commercial and residential real estate property and borrower assets. As of June 30, 2020, the fair value of collateral on substantially all collateral-dependent loans were significantly in excess of their amortized cost basis.
22
Impaired Loans
The total carrying amounts and the total unpaid principal balances of impaired loans and leases as of December 31, 2019, presented in accordance with Topic 310, Receivables, were as follows:
Unpaid
Recorded
Principal
Related
Investment
Balance
Impaired loans with no related allowance recorded:
3,825
3,841
10,425
10,718
14,280
14,589
Impaired loans with a related allowance recorded:
1,126
693
4,819
6,358
6,638
Total impaired loans:
4,967
15,537
21,227
The following table provides information with respect to the Company’s average balances, and of interest income recognized from, impaired loans for the three and six months ended June 30, 2019, presented in accordance with Topic 310, Receivables:
June 30, 2019
Average
Recognized
3,833
4,038
175
3,102
40
3,740
7,948
92
8,336
191
14,883
226
16,114
578
5,645
61
5,187
117
715
719
7,220
103
7,147
199
13,580
174
13,053
336
9,478
155
9,225
292
3,817
50
4,459
232
15,168
195
15,483
28,463
400
29,167
914
Modifications
Commercial and industrial loans modified in a TDR may involve temporary interest-only payments, term extensions, and converting revolving credit lines to term loans. Modifications of commercial real estate and construction loans in a TDR may involve reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, or substituting or adding a new borrower or guarantor. Modifications of construction loans in a TDR may also involve extending the interest-only payment period. Interest continues to accrue on the missed payments and as a result, the effective yield on the loan remains unchanged. As the forbearance period usually involves an insignificant payment delay, lease financing modifications typically do not meet the reporting criteria for a TDR. Residential real estate loans modified in a TDR may be comprised of loans where monthly payments are lowered to accommodate the borrowers' financial needs for a period of time, normally two years. Generally, consumer loans
are not classified as a TDR as they are normally charged off upon reaching a predetermined delinquency status that ranges from 120 to 180 days and varies by product type.
Loans modified in a TDR may already be on nonaccrual status and in some cases partial charge-offs may have already been taken against the outstanding loan balance. Loans modified in a TDR are evaluated for impairment. As a result, this may have a financial effect of increasing the specific ACL associated with the loan. An ACL for impaired commercial loans, including commercial real estate and construction loans, that have been modified in a TDR is measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or if the loan is collateral dependent, the estimated fair value of the collateral, less any selling costs. An ACL for impaired residential real estate loans that have been modified in a TDR is measured based on the estimated fair value of the collateral, less any selling costs. Management exercises significant judgment in developing these estimates.
The following presents, by class, information related to loans modified in a TDR during the three and six months ended June 30, 2020 and 2019:
Number of
Contracts
Investment(1)
500
906
41
351
1,257
55
The above loans were modified in a TDR through an extension of maturity dates, temporary interest-only payments, reduced payments, or below-market interest rates.
The Company had commitments to extend credit, standby letters of credit, and commercial letters of credit totaling $6.3 billion and $6.1 billion as of June 30, 2020 and December 31, 2019, respectively. Of the $6.3 billion at June 30, 2020, there were no commitments related to borrowers who had loan terms modified in a TDR. Of the $6.1 billion at December 31, 2019, there were commitments of $4.5 million related to borrowers who had loan terms modified in a TDR.
The following table presents, by class, loans modified in TDRs that have defaulted in the current period within 12 months of their permanent modification date for the periods indicated. The Company is reporting these defaulted TDRs based on a payment default definition of 30 days past due:
Commercial and industrial(2)
Residential mortgage(3)
24
Foreclosure Proceedings
As of June 30, 2020, there were no residential mortgage loans collateralized by real estate property that was modified in a TDR that was in process of foreclosure. As of December 31, 2019, there was one residential mortgage loan collateralized by real estate property of $0.3 million that was modified in a TDR that was in process of foreclosure.
Foreclosed Property
As of June 30, 2020, residential real estate property held from one foreclosed residential real estate loan was held and included in other real estate owned and repossessed personal property with a carrying value of $0.4 million on the unaudited interim consolidated balance sheets. As of December 31, 2019, residential real estate properties from two foreclosed residential real estate loans were held and included in other real estate owned and repossessed personal property with a carrying value of $0.3 million on the unaudited interim consolidated balance sheets.
5. Mortgage Servicing Rights
Mortgage servicing activities include collecting principal, interest, tax, and insurance payments from borrowers while accounting for and remitting payments to investors, taxing authorities, and insurance companies. The Company also monitors delinquencies and administers foreclosure proceedings.
Mortgage loan servicing income is recorded in noninterest income as a part of other service charges and fees and amortization of the servicing assets is recorded in noninterest income as part of other income. The unpaid principal amount of residential real estate loans serviced for others was $2.4 billion and $2.3 billion as of June 30, 2020 and December 31, 2019, respectively. Servicing fees include contractually specified fees, late charges, and ancillary fees, and were $1.4 million and $1.6 million for the three months ended June 30, 2020 and 2019, respectively, and $2.9 million and $3.2 million for the six months ended June 30, 2020 and 2019, respectively.
Amortization of mortgage servicing rights (“MSRs”) was $1.3 million and $0.8 million for the three months ended June 30, 2020 and 2019, respectively, and $3.3 million and $1.6 million for the six months ended June 30, 2020 and 2019, respectively. The estimated future amortization expenses for MSRs over the next five years are as follows:
Estimated
Amortization
Under one year
2,687
One to two years
2,088
Two to three years
1,625
Three to four years
1,292
Four to five years
1,046
The details of the Company’s MSRs are presented below:
Gross carrying amount
65,686
63,480
Less: accumulated amortization
54,091
50,812
Net carrying value
The following table presents changes in amortized MSRs for the three and six months ended June 30, 2020 and 2019:
Three Months Ended June 30,
Six Months Ended June 30,
11,979
15,399
16,155
Originations
915
2,206
(1,299)
(842)
(3,279)
(1,606)
14,573
Fair value of amortized MSRs at beginning of period
17,615
26,383
20,329
27,662
Fair value of amortized MSRs at end of period
15,159
23,398
MSRs are evaluated for impairment if events and circumstances indicate a possible impairment. No impairment of MSRs was recorded for the three and six months ended June 30, 2020 and 2019.
The quantitative assumptions used in determining the lower of cost or fair value of the Company’s MSRs as of June 30, 2020 and December 31, 2019 were as follows:
Weighted
Range
Conditional prepayment rate
14.35
%
-
24.33
16.64
10.74
23.39
11.10
Life in years (of the MSR)
1.92
5.72
4.45
2.04
6.33
5.99
Weighted-average coupon rate
3.87
7.11
3.96
7.26
4.01
Discount rate
10.00
10.01
The sensitivities surrounding MSRs are expected to have an immaterial impact on fair value.
6. Transfers of Financial Assets
The Company’s transfers of financial assets with continuing interest may include pledges of collateral to secure public deposits and repurchase agreements, FHLB and FRB borrowing capacity, automated clearing house (“ACH”) transactions and interest rate swaps.
For public deposits and repurchase agreements, the Company enters into bilateral agreements with the entity to pledge investment securities as collateral in the event of default. The right of setoff for a repurchase agreement resembles a secured borrowing, whereby the collateral pledged by the Company would be used to settle the fair value of the repurchase agreement should the Company be in default. The counterparty has the right to sell or repledge the investment securities. The Company is required by the counterparty to maintain adequate collateral levels. In the event the collateral fair value falls below stipulated levels, the Company will pledge additional investment securities. For transfers of assets with the FHLB and the FRB, the Company enters into bilateral agreements to pledge loans as collateral to secure borrowing capacity. For ACH transactions, the Company enters into bilateral agreements to collateralize possible daylight overdrafts. For interest rate swaps, the Company enters into bilateral agreements to pledge collateral when either party is in a negative fair value position to mitigate counterparty credit risk. Counterparties to ACH transactions, certain interest rate swaps, the FHLB and the FRB do not have the right to sell or repledge the collateral.
The carrying amounts of the assets pledged as collateral to secure public deposits, borrowing arrangements and other transactions as of June 30, 2020 and December 31, 2019 were as follows:
Public deposits
3,001,044
1,543,492
Federal Home Loan Bank
2,919,854
2,928,581
Federal Reserve Bank
1,759,853
953,169
ACH transactions
145,263
155,360
Interest rate swaps
57,036
43,296
7,883,050
5,623,898
As the Company did not enter into reverse repurchase agreements or repurchase agreements, no collateral was accepted or pledged as of June 30, 2020 and December 31, 2019. In addition, no debt was extinguished by in-substance defeasance.
26
7. Deposits
As of June 30, 2020 and December 31, 2019, deposits were categorized as interest-bearing or noninterest-bearing as follows:
U.S.:
11,705,106
9,782,957
6,081,910
5,188,696
Foreign:
776,437
781,965
798,181
691,376
The following table presents the maturity distribution of time certificates of deposit as of June 30, 2020:
Under
$250,000
or More
Three months or less
186,536
1,126,120
1,312,656
Over three through six months
184,540
249,181
433,721
Over six through twelve months
409,875
708,352
1,118,227
118,555
227,567
346,122
103,852
54,517
158,369
82,868
10,691
93,559
32,572
7,597
40,169
Thereafter
442
3,400
3,842
1,119,240
2,387,425
3,506,665
Time certificates of deposit in denominations of $250,000 or more, in the aggregate, were $2.4 billion and $1.4 billion as of June 30, 2020 and December 31, 2019, respectively. Overdrawn deposit accounts are classified as loans and totaled $2.1 million and $3.6 million as of June 30, 2020 and December 31, 2019, respectively.
8. Short-Term Borrowings
At June 30, 2020 and December 31, 2019, short-term borrowings were comprised of the following:
Short-term FHLB fixed-rate advances(1)
Total short-term borrowings
As of June 30, 2020 and December 31, 2019, the Company’s short-term borrowings included $200.0 million and $400.0 million, respectively, in short-term FHLB fixed-rate advances with a weighted average interest rate of 2.88% and 2.84%, respectively. The short-term FHLB fixed-rate advances require monthly interest-only payments with the principal amount due on the maturity date. The remaining short-term FHLB fixed-rate advance (as of June 30, 2020) matured in July 2020. As of June 30, 2020 and December 31, 2019, the available remaining borrowing capacity with the FHLB was $1.9 billion and $1.7 billion, respectively. The FHLB fixed-rate advances and remaining borrowing capacity were secured by residential real estate loan collateral as of June 30, 2020 and December 31, 2019. As of June 30, 2020 and December 31, 2019, the Company had an undrawn line of credit of $982.0 million and $596.8 million from the FRB, respectively. The borrowing capacity with the FRB was secured by consumer, commercial and industrial and commercial real estate loans as of June 30, 2020 and December 31, 2019. See “Note 6. Transfers of Financial Assets” for more information.
9. Long-Term Borrowings
Long-term borrowings consisted of the following as of June 30, 2020 and December 31, 2019:
Finance lease
FHLB fixed-rate advances(1)
Total long-term borrowings
As of June 30, 2020 and December 31, 2019, the Company’s long-term borrowings included $200.0 million in FHLB fixed-rate advances with a weighted average interest rate of 2.73% and maturity dates ranging from 2023 to 2024. The FHLB fixed-rate advances require monthly interest-only payments with the principal amount due on the maturity date.
As of June 30, 2020 and December 31, 2019, the Company’s long-term borrowings included a finance lease obligation with a 6.78% annual interest rate that matures in 2022.
As of June 30, 2020, future contractual principal payments and maturities of long-term borrowings were as follows:
Payments
2021
2022
2023(1)
100,000
2024(2)
10. Accumulated Other Comprehensive Income (Loss)
Accumulated other comprehensive income (loss) is defined as the revenues, expenses, gains and losses that are included in comprehensive income but excluded from net income. The Company’s significant items of accumulated other comprehensive loss are pension and other benefits and net unrealized gains or losses on investment securities.
Changes in accumulated other comprehensive income (loss) for the three and six months ended June 30, 2020 and 2019 are presented below:
Tax
Pre-tax
Benefit
Net of
(Expense)
Accumulated other comprehensive income at March 31, 2020
5,629
(1,500)
Three months ended June 30, 2020
Investment securities:
Unrealized net gains arising during the period
66,071
(17,624)
48,447
Reclassification of net losses to net income:
Investment securities losses, net
211
(56)
66,282
(17,680)
Accumulated other comprehensive income at June 30, 2020
71,911
(19,180)
28
Accumulated other comprehensive loss at December 31, 2019
(43,450)
11,701
Six months ended June 30, 2020
Change in Company tax rate
Net change in pension and other benefits
115,235
(30,751)
84,484
(34)
115,361
(30,785)
(30,881)
Accumulated other comprehensive loss at March 31, 2019
(107,779)
29,025
Three months ended June 30, 2019
Pension and other benefits:
Net actuarial losses arising during the period
(813)
219
64,841
(17,462)
47,379
Reclassification of net gains to net income:
Investment securities gains, net
(21)
(15)
64,820
(17,456)
64,007
(17,237)
Accumulated other comprehensive loss at June 30, 2019
(43,772)
11,788
Accumulated other comprehensive loss at December 31, 2018
(180,915)
48,720
Six months ended June 30, 2019
Net actuarial losses arising during the year
135,364
(36,453)
98,911
(698)
1,894
137,956
(37,151)
137,143
(36,932)
29
The following table summarizes changes in accumulated other comprehensive income (loss), net of tax, for the periods indicated:
Pensions
Benefits
Securities
(28,178)
32,307
80,909
(28,082)
(3,667)
(28,379)
(50,375)
(28,973)
(3,011)
(103,816)
11. Regulatory Capital Requirements
Federal and state laws and regulations limit the amount of dividends the Company may declare or pay. The Company depends primarily on dividends from FHB as the source of funds for the Company’s payment of dividends.
The Company and the Bank are subject to various regulatory capital requirements imposed by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s operating activities and financial condition. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and Bank must meet specific capital guidelines that involve quantitative measures of its assets and certain off-balance sheet items. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Company and Bank to maintain minimum amounts and ratios of Common Equity Tier 1 (“CET1”) capital, Tier 1 capital and total capital to risk-weighted assets, as well as a minimum leverage ratio.
The table below sets forth those ratios at June 30, 2020 and December 31, 2019:
First Hawaiian
Minimum
Well-
First Hawaiian, Inc.
Bank
Capitalized
Ratio
Ratio(1)
June 30, 2020:
Common equity tier 1 capital to risk-weighted assets
1,653,674
11.86
1,634,333
11.72
4.50
6.50
Tier 1 capital to risk-weighted assets
6.00
8.00
Total capital to risk-weighted assets
1,828,511
13.11
1,809,165
12.97
Tier 1 capital to average assets (leverage ratio)
7.75
7.66
4.00
5.00
December 31, 2019:
1,676,515
11.88
1,654,304
1,807,645
12.81
1,785,434
12.65
8.79
8.67
A capital conservation buffer requires a 2.5% capital conservation buffer designed to absorb losses during periods of economic stress. The capital conservation buffer is composed entirely of CET1, on top of these minimum risk weighted asset ratios, effectively resulting in minimum ratios of (i) 7% CET1 to risk-weighted assets, (ii) 8.5% Tier 1 capital to risk-weighted assets, and (iii) 10.5% total capital to risk-weighted assets. As of June 30, 2020, under the bank regulatory capital guidelines, the Company and Bank were both classified as well-capitalized. Management is not aware of any conditions or events that have occurred since June 30, 2020, to change the capital adequacy category of the Company or the Bank.
12. Derivative Financial Instruments
The Company enters into derivative contracts primarily to manage its interest rate risk, as well as for customer accommodation purposes. Derivatives used for risk management purposes consist of interest rate swaps that are designated as either a fair value hedge or a cash flow hedge. The derivatives are recognized on the unaudited interim consolidated balance sheets as either assets or liabilities at fair value. Derivatives entered into for customer accommodation purposes consist of various free-standing interest rate derivative products and foreign exchange contracts. The Company is party to master netting arrangements with its financial institution counterparties; however, the Company does not offset assets and liabilities under these arrangements for financial statement presentation purposes.
The following table summarizes notional amounts and fair values of derivatives held by the Company as of June 30, 2020 and December 31, 2019:
Notional
Asset
Liability
Derivatives(1)
Derivatives(2)
Derivatives designated as hedging instruments:
22,825
(1,581)
23,190
(682)
Derivatives not designated as hedging instruments:
3,023,471
170,576
2,818,803
63,527
Funding swap
88,480
(2,095)
82,900
(4,233)
Interest rate caps and floors
148,800
Foreign exchange contracts
150
1,428
Certain interest rate swaps noted above, are cleared through clearinghouses, rather than directly with counterparties. Those transactions cleared through a clearinghouse require initial margin collateral and variation margin payments depending on the contracts being in a net asset or liability position. The amount of initial margin cash collateral posted by the Company was $12.6 million and $8.7 million as of June 30, 2020 and December 31, 2019, respectively. As of June 30, 2020 and December 31, 2019, the variation margin was $170.6 million and $63.5 million, respectively.
As of June 30, 2020, the Company pledged $30.9 million in financial instruments and $26.1 million in cash as collateral for interest rate swaps. As of December 31, 2019, the Company pledged $29.9 million in financial instruments and $13.4 million in cash as collateral for interest rate swaps. As of June 30, 2020 and December 31, 2019, the cash collateral includes the excess initial margin for interest rate swaps cleared through clearinghouses and cash collateral for interest rate swaps with financial institution counterparties.
Fair Value Hedges
To manage the risk related to the Company’s net interest margin, interest rate swaps are utilized to hedge certain fixed-rate loans. These swaps have maturity, amortization and prepayment features that correspond to the loans hedged, and are designated and qualify as fair value hedges. Any gain or loss on the swaps, as well as the offsetting loss or gain on the hedged item attributable to the hedged risk, is recognized in current period earnings.
At June 30, 2020, the Company carried one interest rate swap with a notional amount of $22.8 million with a negative fair value of $1.6 million that was categorized as a fair value hedge for a commercial and industrial loan. The Company received a USD Prime floating rate and paid a fixed rate of 2.90%. The swap matures in 2023. At December 31, 2019, the Company carried one interest rate swap with a notional amount of $23.2 million with a negative fair value of $0.7 million that was categorized as a fair value hedge for a commercial and industrial loan.
The following table shows the gains and losses recognized in income related to derivatives in fair value hedging relationships for the three and six months ended June 30, 2020 and 2019:
Gains (losses) recognized in
the consolidated statements
of income line item
Gains (losses) on fair value hedging relationships recognized in interest income:
Recognized on interest rate swap
57
(424)
(898)
(766)
Recognized on hedged item
427
942
689
As of June 30, 2020 and December 31, 2019, the following amounts were recorded in the unaudited interim consolidated balance sheets related to the cumulative basis adjustments for fair value hedges:
Cumulative Amount of Fair Value
Hedging Adjustment Included in the
Carrying Amount of the Hedged Asset
Line item in the consolidated balance sheets in which the hedged item is included
25,064
24,415
1,959
1,017
Free-Standing Derivative Instruments
For the derivatives that are not designated as hedges, changes in fair value are reported in current period earnings. The following table summarizes the impact on pretax earnings of derivatives not designated as hedges, as reported on the unaudited interim consolidated statements of income for the three and six months ended June 30, 2020 and 2019:
Net gains (losses) recognized
in the consolidated statements
Derivatives Not Designated As Hedging Instruments:
Other noninterest income
(247)
109
(242)
52
(1)
As of June 30, 2020, the Company carried multiple interest rate swaps with notional amounts totaling $3.0 billion, all of which were related to the Company’s customer swap program, with a positive fair value of $170.6 million and a negative fair value of nil. The Company received floating rates ranging from 0.17% to 6.42% and paid fixed rates ranging from 2.02% to 8.73%. The swaps mature between June 2021 and June 2040. As of December 31, 2019, the Company carried multiple interest rate swaps with notional amounts totaling $2.8 billion, all of which were related to the Company’s customer swap program, with a positive fair value of $63.5 million and a negative fair value of nil. The Company received 1-month LIBOR and paid fixed rates ranging from 1.71% to 8.73%. These swaps resulted in net interest expense of nil during both the three and six months ended June 30, 2020 and 2019.
The Company’s customer swap program is designed by offering customers a variable-rate loan that is swapped to fixed-rate through an interest rate swap. The Company simultaneously executes an offsetting interest rate swap with a swap dealer. Upfront fees on the dealer swap are recorded in other noninterest income and totaled $4.6 million and $1.1 million for the three months ended June 30, 2020 and 2019, respectively, and $6.5 million and $2.0 million for the six months ended June 30, 2020 and 2019, respectively.
In conjunction with the 2016 sale of Class B restricted shares of common stock issued by Visa, the Company entered into a funding swap agreement with the buyer that requires payment to the buyer in the event Visa reduces each member bank’s Class B conversion rate to unrestricted Class A common shares. On June 28, 2018, Visa additionally funded its litigation escrow account, thereby reducing each member bank’s Class B conversion rate to unrestricted Class A common shares. Accordingly, on July 5, 2018, Visa announced a decrease in conversion rate from 1.6483 to 1.6298 effective June 28, 2018. In July 2018, the Company made a payment of approximately $0.7 million to the buyer as a result of the reduction in the Visa Class B conversion rate. On September 27, 2019, Visa additionally funded its litigation escrow account, thereby further reducing each member bank’s Class B conversion rate to unrestricted Class A common shares. Accordingly, on September 30, 2019, Visa announced a decrease in conversion rate from 1.6298 to 1.6228 effective September 27, 2019. In October 2019, the Company made a payment of approximately $0.3 million to the buyer as a result of the reduction in the Visa Class B conversion rate. Under the terms of the funding swap agreement, the Company will make monthly payments to the buyer based on Visa’s Class A stock price and the number of Visa Class B restricted shares that were sold until the date on which the covered litigation is settled. A derivative liability (“Visa derivative”) of $2.1 million and $4.2 million was included in the unaudited interim consolidated balance sheets at June 30, 2020 and December 31, 2019, respectively, to provide for the fair value of this liability. There were no sales of these shares prior to 2016. See “Note 17. Fair Value” for more information.
Counterparty Credit Risk
By using derivatives, the Company is exposed to counterparty credit risk if counterparties to the derivative contracts do not perform as expected. If a counterparty fails to perform, the Company’s counterparty credit risk is equal to the amount reported as a derivative asset, net of cash or other collateral received, and net of derivatives in a loss position with the same counterparty to the extent master netting arrangements exist. The Company minimizes counterparty credit risk through credit approvals, limits, monitoring procedures, executing master netting arrangements and obtaining collateral, where appropriate. Counterparty credit risk related to derivatives is considered in determining fair value.
The Company’s interest rate swap agreements include bilateral collateral agreements with collateral requirements, which begin with exposures in excess of $0.3 million. For each counterparty, the Company reviews the interest rate swap collateral daily. Collateral for customer interest rate swap agreements, calculated as the pledged asset less loan balance, requires
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valuation of the pledged asset. Counterparty credit risk adjustments of $0.1 million and nil were recognized during the three months ended June 30, 2020 and 2019, respectively, and $0.3 million and $0.1 million were recognized during the six months ended June 30, 2020 and 2019, respectively.
Credit-Risk Related Contingent Features
Certain of our derivative contracts contain provisions whereby if the Company’s credit rating were to be downgraded by certain major credit rating agencies as a result of a merger or material adverse change in the Company’s financial condition, the counterparty could require an early termination of derivative instruments in a net liability position. The aggregate fair value of all derivative instruments with such credit-risk related contingent features that are in a net liability position was $13.4 million and $4.0 million at June 30, 2020 and December 31, 2019, respectively, for which we posted $13.5 million and $4.7 million, respectively, in collateral in the normal course of business. If the Company’s credit rating had been downgraded as of June 30, 2020 and December 31, 2019, we may have been required to settle the contracts in an amount equal to their fair value.
13. Commitments and Contingent Liabilities
Contingencies
Various legal proceedings are pending or threatened against the Company. After consultation with legal counsel, management does not expect that the aggregate liability, if any, resulting from these proceedings would have a material effect on the Company’s unaudited interim consolidated financial position, results of operations or cash flows.
Financial Instruments with Off-Balance Sheet Risk
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby and commercial letters of credit which are not reflected in the unaudited interim consolidated financial statements.
Unfunded Commitments to Extend Credit
A commitment to extend credit is a legally binding agreement to lend funds to a customer, usually at a stated interest rate and for a specified purpose. Commitments are reported net of participations sold to other institutions. Such commitments have fixed expiration dates and generally require a fee. The extension of a commitment gives rise to credit risk. The actual liquidity requirements or credit risk that the Company will experience is expected to be lower than the contractual amount of commitments to extend credit because a significant portion of those commitments are expected to expire without being drawn upon. Certain commitments are subject to loan agreements containing covenants regarding the financial performance of the customer that must be met before the Company is required to fund the commitment. The Company uses the same credit policies in making commitments to extend credit as it does in making loans. In addition, the Company manages the potential credit risk in commitments to extend credit by limiting the total amount of arrangements, both by individual customer and in the aggregate, by monitoring the size and expiration structure of these portfolios and by applying the same credit standards maintained for all of its related credit activities. Commitments to extend credit are reported net of participations sold to other institutions of $116.8 million and $94.1 million at June 30, 2020 and December 31, 2019, respectively.
Standby and Commercial Letters of Credit
Standby letters of credit are issued on behalf of customers in connection with contracts between the customers and third parties. Under standby letters of credit, the Company assures that the third parties will receive specified funds if customers fail to meet their contractual obligations. The credit risk to the Company arises from its obligation to make payment in the event of a customer’s contractual default. Standby letters of credit are reported net of participations sold to other institutions of $11.0 million and $9.0 million at June 30, 2020 and December 31, 2019, respectively. The Company also had commitments for commercial and similar letters of credit. Commercial letters of credit are issued specifically to facilitate commerce whereby the commitment is typically drawn upon when the underlying transaction between the customer and a third-party is consummated. The maximum amount of potential future payments guaranteed by the Company is limited to the contractual amount of these letters. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held supports those commitments for which collateral is deemed necessary. The commitments outstanding as of June 30, 2020 have maturities ranging from July 2020 to May 2022. Substantially all fees received from the issuance of such commitments are deferred and amortized on a straight-line basis over the term of the commitment.
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Financial instruments with off-balance sheet risk at June 30, 2020 and December 31, 2019 were as follows:
Financial instruments whose contract amounts represent credit risk:
Commitments to extend credit
6,097,646
5,907,690
Standby letters of credit
175,009
181,412
Commercial letters of credit
3,131
7,334
Guarantees
The Company sells residential mortgage loans in the secondary market primarily to the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation that may potentially require repurchase under certain conditions. This risk is managed through the Company’s underwriting practices. The Company services loans sold to investors and loans originated by other originators under agreements that may include repurchase remedies if certain servicing requirements are not met. This risk is managed through the Company’s quality assurance and monitoring procedures. Management does not anticipate any material losses as a result of these transactions.
Foreign Exchange Contracts
The Company has forward foreign exchange contracts that represent commitments to purchase or sell foreign currencies at a future date at a specified price. The Company’s utilization of forward foreign exchange contracts is subject to the primary underlying risk of movements in foreign currency exchange rates and to additional counterparty risk should its counterparties fail to meet the terms of their contracts. Forward foreign exchange contracts are utilized to mitigate the Company’s risk to satisfy customer demand for foreign currencies and are not used for trading purposes. See “Note 12. Derivative Financial Instruments” for more information.
Reorganization Transactions
On April 1, 2016, a series of reorganization transactions were undertaken to facilitate FHI’s initial public offering. In connection with the reorganization transactions, FHI distributed its interest in BancWest Holding Inc. (“BWHI”), including Bank of the West (“BOW”) to BNP Paribas (“BNPP”) so that BWHI was held directly by BNPP. As a result of the reorganization transactions that occurred on April 1, 2016, various tax or other contingent liabilities could arise related to the business of BOW, or related to the Company’s operations prior to the restructuring when it was known as BancWest Corporation, including its then wholly owned subsidiary, BOW. The Company is not able to determine the ultimate outcome or estimate the amounts of these contingent liabilities, if any, at this time.
14. Revenue from Contracts with Customers
Revenue Recognition
In accordance with Topic 606, revenues are recognized when control of promised goods or services is transferred to customers in an amount that reflects the consideration the Company expects to be entitled to in exchange for those goods or services. To determine revenue recognition for arrangements that an entity determines are within the scope of Topic 606, the Company performs the following five steps: (i) identify the contract(s) with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when (or as) the Company satisfies a performance obligation. The Company only applies the five-step model to contracts when it is probable that the entity will collect the consideration it is entitled to in exchange for the goods or services it transfers to the customer. At contract inception, once the contract is determined to be within the scope of Topic 606, the Company assesses the goods or services that are promised within each contract and identifies those that contain performance obligations, and assesses whether each promised good or service is distinct. The Company then recognizes as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) the performance obligation is satisfied.
Disaggregation of Revenue
In 2019, the Company made changes to the internal measurement of segment operating profits for the purpose of evaluating segment performance and resource allocation. The Company has restated the selected financial information for the three and six months ended June 30, 2019 in order to conform with the current presentation. See “Note 18. Reportable Operating Segments” in the notes to the unaudited interim consolidated financial statements.
The following table summarizes the Company’s revenues, which includes net interest income on financial instruments and noninterest income, disaggregated by type of service and business segments for the periods indicated:
Retail
Banking
Net interest income(1)
96,146
33,094
(1,418)
5,469
326
132
10,122
275
10,397
4,580
215
338
5,133
1,499
112
1,667
Not in scope of Topic 606(1)
3,403
5,893
4,572
13,868
22,172
18,055
5,429
Total revenue
118,318
51,149
4,011
173,478
186,029
67,508
12,968
13,556
677
644
23,009
1,874
24,883
9,454
639
854
10,947
241
2,605
300
3,146
7,042
8,921
6,813
22,776
48,548
35,851
10,485
234,577
103,359
23,453
361,389
107,708
35,000
2,905
7,131
309
683
14,481
1,687
16,168
4,944
868
6,390
142
761
327
1,230
2,227
2,306
3,398
7,931
23,375
18,725
6,673
131,083
53,725
9,578
194,386
36
214,935
69,656
6,111
14,365
620
1,198
28,941
3,417
32,358
10,277
1,237
1,120
12,634
357
2,270
535
3,162
4,696
4,045
5,218
13,959
47,244
37,113
11,488
262,179
106,769
17,599
386,547
For the three and six months ended June 30, 2020 and 2019, substantially all of the Company’s revenues under the scope of Topic 606 were related to performance obligations satisfied at a point in time.
The following is a discussion of revenues within the scope of Topic 606.
Service Charges on Deposit Accounts
Service charges on deposit accounts relate to fees generated from a variety of deposit products and services rendered to customers. Charges include, but are not limited to, overdraft fees, non-sufficient fund fees, dormant fees and monthly service charges. Such fees are recognized concurrent with the event on a daily basis or on a monthly basis depending upon the customer’s cycle date.
Credit and Debit Card Fees
Credit and debit card fees primarily represent revenues earned from interchange fees, ATM fees and merchant processing fees. Interchange and network revenues are earned on credit and debit card transactions conducted with payment networks. ATM fees are primarily earned as a result of surcharges assessed to non-FHB customers who use an FHB ATM. Merchant processing fees are primarily earned on transactions in which FHB is the acquiring bank. Such fees are generally recognized concurrently with the delivery of services on a daily basis.
Trust and Investment Services Fees
Trust and investment services fees represent revenue earned by directing, holding and managing customers’ assets. Fees are generally computed based on a percentage of the previous period’s value of assets under management. The transaction price (i.e., percentage of assets under management) is established at the inception of each contract. Trust and investment services fees also include fees collected when the Company acts as agent or personal representative and executes security transactions, performs collection and disbursement of income, and completes investment management and other administrative tasks.
Other Fees
Other fees primarily include revenues generated from wire transfers, lockboxes, bank issuance of checks and insurance commissions. Such fees are recognized concurrent with the event or on a monthly basis.
Contract Balances
A contract liability is an entity’s obligation to transfer goods or services to a customer for which the entity has received consideration (or the amount is due) from the customer. In prior years, the Company received signing bonuses from two vendors which are being amortized over the term of the respective contracts. As of June 30, 2020 and December 31, 2019, the Company had contract liabilities of $1.4 million and $1.8 million, respectively, which will be recognized over the remaining term of the respective contracts with the vendors. For the three and six months ended June 30, 2020, the Company’s recognized revenues and contract liabilities decreased by approximately $0.2 million and $0.4 million, respectively, due to the passage of time. For the three and six months ended June 30, 2019, the Company’s recognized revenues and contract liabilities decreased by approximately $0.2 million and $0.4 million, respectively, due to the passage of time. There were no changes in contract liabilities due to changes in transaction price estimates.
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A contract asset is the right to consideration for transferred goods or services when the amount is conditioned on something other than the passage of time. As of June 30, 2020 and December 31, 2019, there were no receivables from contracts with customers or contract assets recorded on the Company’s consolidated balance sheets.
Except for the contract liabilities noted above, the Company did not have any significant performance obligations as of June 30, 2020 and December 31, 2019. The Company also did not have any material contract acquisition costs or use any significant judgments or estimates in recognizing revenue for financial reporting purposes.
15. Earnings per Share
For the three and six months ended June 30, 2020, the Company made no adjustments to net income for the purpose of computing earnings per share and there were 537,000 and 513,000 antidilutive securities, respectively. For the three and six months ended June 30, 2019, the Company made no adjustments to net income for the purpose of computing earnings per share and there were no antidilutive securities. For the three and six months ended June 30, 2020 and 2019, the computations of basic and diluted earnings per share were as follows:
(dollars in thousands, except shares and per share amounts)
Numerator:
Denominator:
Basic: weighted-average shares outstanding
Add: weighted-average equity-based awards
148,465
231,628
287,504
269,114
Diluted: weighted-average shares outstanding
16. Noninterest Income and Noninterest Expense
Benefit Plans
The Company sponsors an unfunded supplemental executive retirement plan (“SERP”) for certain key executives. In March 2019, the Company’s board of directors approved an amendment to the SERP to freeze the SERP, which became effective on July 1, 2019. As a result of the amendment, since the effective date, there have not been any, and there will be no, new accruals of benefits, including service accruals. Existing benefits under the SERP, as of the effective date of the amendment described above, will otherwise continue in accordance with the terms of the SERP.
The following table sets forth the components of net periodic benefit cost for the Company’s pension and postretirement benefit plans for the three and six months ended June 30, 2020 and 2019:
Income line item where recognized in
Pension Benefits
Other Benefits
the consolidated statements of income
Service cost
189
159
Interest cost
Other noninterest expense
1,621
2,044
164
206
Expected return on plan assets
(1,194)
(1,195)
Prior service credit
(13)
(107)
Recognized net actuarial loss (gain)
1,564
(26)
(76)
Total net periodic benefit cost
1,856
2,430
314
182
378
318
3,242
4,088
328
412
(2,388)
(2,390)
(214)
2,858
3,128
(152)
3,712
4,860
628
364
The Company recognized operating lease income related to lease payments of $1.6 million and $1.5 million for the three months ended June 30, 2020 and 2019, respectively, and $3.1 million and $3.0 million for the six months ended June 30, 2020 and 2019, respectively. In addition, the Company recognized $1.4 million and $1.3 million of lease income related to variable lease payments for the three months ended June 30, 2020 and 2019, respectively, and $2.9 million and $2.6 million for the six months ended June 30, 2020 and 2019, respectively.
Amortization of Software Expenses
Amortization of software expenses recorded in other noninterest expense was $1.4 million and $1.0 million for the three months ended June 30, 2020 and 2019, respectively, and $2.6 million and $2.2 million for the six months ended June 30, 2020 and 2019, respectively.
17. Fair Value
The Company determines the fair values of its financial instruments based on the requirements established in Accounting Standards Codification Topic 820 (“Topic 820”), Fair Value Measurements, which provides a framework for measuring fair value under GAAP and requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Topic 820 defines fair value as the exit price, the price that would be received for an asset or paid to transfer a liability, in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date under current market conditions.
Fair Value Hierarchy
Topic 820 establishes three levels of fair values based on the markets in which the assets or liabilities are traded and the reliability of the assumptions used to determine fair value. The levels are:
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Topic 820 requires that the Company disclose estimated fair values for certain financial instruments. Financial instruments include such items as investment securities, loans, deposits, interest rate and foreign exchange contracts, swaps and other instruments as defined by the standard. The Company has an organized and established process for determining and reviewing the fair value of financial instruments reported in the Company’s financial statements. The fair value measurements are reviewed to ensure they are reasonable and in line with market experience in similar asset and liability classes.
Additionally, the Company may be required to record at fair value other assets on a nonrecurring basis, such as other real estate owned, other customer relationships, and other intangible assets. These nonrecurring fair value adjustments typically involve the application of lower-of-cost-or-fair-value accounting or write-downs of individual assets.
Disclosure of fair values is not required for certain items such as lease financing, obligations for pension and other postretirement benefits, premises and equipment, prepaid expenses, deposit liabilities with no defined or contractual maturity, and income tax assets and liabilities.
Reasonable comparisons of fair value information with that of other financial institutions cannot necessarily be made because the standard permits many alternative calculation techniques, and numerous assumptions have been used to estimate the Company’s fair values.
Valuation Techniques Used in the Fair Value Measurement of Assets and Liabilities Carried at Fair Value
For the assets and liabilities measured at fair value on a recurring basis (categorized in the valuation hierarchy table below), the Company applies the following valuation techniques:
Available-for-sale debt securities are recorded at fair value on a recurring basis. Fair value measurement is based on quoted prices, including estimates by third-party pricing services, if available. If quoted prices are not available, fair values are measured using proprietary valuation models that utilize market observable parameters from active market makers and inter-dealer brokers whereby securities are valued based upon available market data for securities with similar characteristics. Management reviews the pricing information received from the Company’s third-party pricing service to evaluate the inputs and valuation methodologies used to place securities into the appropriate level of the fair value hierarchy and transfers of securities within the fair value hierarchy are made if necessary. On a monthly basis, management reviews the pricing information received from the third-party pricing service which includes a comparison to non-binding third-party broker quotes, as well as a review of market-related conditions impacting the information provided by the third-party pricing service. Management also identifies investment securities which may have traded in illiquid or inactive markets by identifying instances of a significant decrease in the volume or frequency of trades, relative to historical levels, as well as instances of a significant widening of the bid-ask spread in the brokered markets. As of June 30, 2020 and December 31, 2019, management did not make adjustments to prices provided by the third-party pricing services as a result of illiquid or inactive markets. The Company’s third-party pricing service has also established processes for the Company to submit inquiries regarding quoted prices. Periodically, the Company will challenge the quoted prices provided by the third-party pricing service. The Company’s third-party pricing service will review the inputs to the evaluation in light of the new market data presented by the Company. The Company’s third-party pricing service may then affirm the original quoted price or may update the evaluation on a going forward basis. The Company classifies all available-for-sale securities as Level 2.
Derivatives
Most of the Company’s derivatives are traded in over-the-counter markets where quoted market prices are not readily available. For those derivatives, the Company measures fair value on a recurring basis using proprietary valuation models that primarily use market observable inputs, such as yield curves, and option volatilities. The fair value of derivatives includes values associated with counterparty credit risk and the Company’s own credit standing. The Company classifies these derivatives, included in other assets and other liabilities, as Level 2.
Concurrent with the sale of the Visa Class B restricted shares, the Company entered into an agreement with the buyer that requires payment to the buyer in the event Visa reduces each member bank’s Class B conversion rate to unrestricted Class A common shares. On July 5, 2018, Visa announced a decrease in conversion rate from 1.6483 to 1.6298 effective June 28, 2018. On September 27, 2019, Visa additionally funded its litigation escrow account, thereby further reducing each member bank’s Class B conversion rate to unrestricted Class A common shares. Accordingly, on September 30, 2019, Visa announced a decrease in conversion rate from 1.6298 to 1.6228 effective September 27, 2019. The Visa derivative of $2.1 million and $4.2 million was included in the unaudited interim consolidated balance sheets at June 30, 2020 and
December 31, 2019, respectively, to provide for the fair value of this liability. The potential liability related to this funding swap agreement was determined based on management’s estimate of the timing and the amount of Visa’s litigation settlement and the resulting payments due to the counterparty under the terms of the contract. As such, the funding swap agreement is classified as Level 3 in the fair value hierarchy. The significant unobservable inputs used in the fair value measurement of the Company’s funding swap agreement are the potential future changes in the conversion rate, expected term and growth rate of the market price of Visa Class A common shares. Material increases (or decreases) in any of those inputs may result in a significantly higher (or lower) fair value measurement.
Assets and Liabilities Recorded at Fair Value on a Recurring Basis
Assets and liabilities measured at fair value on a recurring basis as of June 30, 2020 and December 31, 2019 are summarized below:
Fair Value Measurements as of June 30, 2020
Quoted Prices in
Significant
Active Markets for
Identical Assets
Observable
Unobservable
(Level 1)
Inputs (Level 2)
Inputs (Level 3)
Residential - Government agency(1)
Residential - Government-sponsored enterprises(1)
Other assets(2)
170,611
Liabilities
Other liabilities(3)
(1,616)
(3,711)
5,304,770
5,302,675
Fair Value Measurements as of December 31, 2019
U.S. Treasury securities
63,539
(4,915)
4,138,501
4,134,268
Changes in Fair Value Levels
For the three and six months ended June 30, 2020, there were no transfers between fair value hierarchy levels.
The changes in Level 3 liabilities measured at fair value on a recurring basis for the three and six months ended June 30, 2020 and 2019 are summarized below.
Visa Derivative
Balance as of April 1,
(1,839)
Total net gains (losses) included in other noninterest income
Settlements
1,001
907
Balance as of June 30,
(1,179)
Total net gains (losses) included in net income attributable to the change in unrealized gains or losses related to liabilities still held as of June 30,
Balance as of January 1,
(2,607)
2,029
1,670
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Assets and Liabilities Carried at Other Than Fair Value
The following tables summarize for the periods indicated the estimated fair value of the Company’s financial instruments that are not required to be carried at fair value on a recurring basis, excluding leases and deposit liabilities with no defined or contractual maturity.
Fair Value Measurements
Active Markets
for Identical
Inputs
Book Value
Assets (Level 1)
(Level 3)
Financial assets:
Cash and cash equivalents
Loans(1)
13,525,743
13,832,005
Financial liabilities:
Time deposits(2)
3,520,718
200,286
Long-term borrowings(3)
216,394
13,009,167
13,140,898
2,510,157
2,501,478
401,709
207,104
Unfunded loan and lease commitments and letters of credit are not included in the tables above. As of June 30, 2020 and December 31, 2019, the Company had $6.3 billion and $6.1 billion, respectively, of unfunded loan and lease commitments and letters of credit. A reasonable estimate of the fair value of these instruments is the carrying value of deferred fees plus the related reserve for unfunded commitments, which totaled $36.3 million and $14.4 million at June 30, 2020 and December 31, 2019, respectively. No active trading market exists for these instruments, and the estimated fair value does not include value associated with the borrower relationship. The Company does not estimate the fair values of certain unfunded loan and lease commitments that can be canceled by providing notice to the borrower. As Company-level data is incorporated into the fair value measurement, unfunded loan and lease commitments and letters of credit are classified as Level 3.
Valuation Techniques Used in the Fair Value Measurement of Assets and Liabilities Carried at the Lower of Cost or Fair Value
The Company applies the following valuation techniques to assets measured at the lower of cost or fair value:
MSRs are carried at the lower of cost or fair value and are therefore subject to fair value measurements on a nonrecurring basis. The fair value of MSRs is determined using models which use significant unobservable inputs, such as estimates of prepayment rates, the resultant weighted average lives of the MSRs and the option-adjusted spread levels. Accordingly, the Company classifies MSRs as Level 3.
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Collateral-dependent loans
Collateral-dependent loans are those for which repayment is expected to be provided substantially through the operation or sale of the collateral. These loans are measured at fair value on a nonrecurring basis using collateral values as a practical expedient. The fair values of collateral are primarily based on real estate appraisal reports prepared by third-party appraisers less estimated selling costs. The Company measures the estimated credit losses on collateral-dependent loans by performing a lower-of-cost-or-fair-value analysis. If the estimated credit losses are determined by the value of the collateral, the net carrying amount is adjusted to fair value on a nonrecurring basis as Level 3 by recognizing an allowance for credit losses.
Other real estate owned
The Company values these properties at fair value at the time the Company acquires them, which establishes their new cost basis. After acquisition, the Company carries such properties at the lower of cost or fair value less estimated selling costs on a nonrecurring basis. Fair value is measured on a nonrecurring basis using collateral values as a practical expedient. The fair values of collateral for other real estate owned are primarily based on real estate appraisal reports prepared by third-party appraisers less disposition costs, and are classified as Level 3.
Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis
The Company may be required to record certain assets at fair value on a nonrecurring basis in accordance with GAAP. These assets are subject to fair value adjustments that result from the application of lower of cost or fair value accounting or write-downs of individual assets to fair value.
The following table provides the level of valuation inputs used to determine each fair value adjustment and the fair value of the related individual assets or portfolio of assets with fair value adjustments on a nonrecurring basis as of June 30, 2020 and December 31, 2019:
Level 1
Level 2
Level 3
1,502
Total losses on collateral-dependent loans were nil and $0.4 million for the three and six months ended June 30, 2020, respectively. No losses were recognized on collateral-dependent loans for both the three and six months ended June 30, 2019.
For Level 3 assets and liabilities measured at fair value on a recurring or nonrecurring basis as of June 30, 2020 and December 31, 2019, the significant unobservable inputs used in the fair value measurements were as follows:
Quantitative Information about Level 3 Fair Value Measurements at June 30, 2020
Fair value
Valuation Technique
Unobservable Input
Appraisal Value
n/m(1)
Visa derivative
Discounted Cash Flow
Expected Conversation Rate - 1.6228(2)
1.5977-1.6228
Expected Term - 1 year(3)
0.5 to 1.5 years
Growth Rate - 13%(4)
4% - 17%
Quantitative Information about Level 3 Fair Value Measurements at December 31, 2019
Expected Conversion Rate - 1.6228
Expected Term - 1 year
Growth Rate - 13%
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18. Reportable Operating Segments
The Company’s operations are organized into three business segments – Retail Banking, Commercial Banking, and Treasury and Other. These segments reflect how discrete financial information is currently evaluated by the chief operating decision maker and how performance is assessed and resources allocated. The Company’s internal management process measures the performance of these business segments. This process, which is not necessarily comparable with similar information for any other financial institution, uses various techniques to assign balance sheet and income statement amounts to the business segments, including allocations of income, expense, the provision for credit losses, and capital. This process is dynamic and requires certain allocations based on judgment and other subjective factors. Unlike financial accounting, there is no comprehensive authoritative guidance for management accounting that is equivalent to GAAP.
The net interest income of the business segments reflects the results of a funds transfer pricing process that matches assets and liabilities with similar interest rate sensitivity and maturity characteristics and reflects the allocation of net interest income related to the Company’s overall asset and liability management activities on a proportionate basis. The basis for the allocation of net interest income is a function of the Company’s assumptions that are subject to change based on changes in current interest rates and market conditions. Funds transfer pricing also serves to transfer interest rate risk to Treasury.
The Company allocates the provision for credit losses from the Treasury and Other business segment (which is comprised of many of the Company’s support units) to the Retail and Commercial business segments. These allocations are based on direct costs incurred by the Retail and Commercial business segments.
Noninterest income and expense includes allocations from support units to the business segments. These allocations are based on actual usage where practicably calculated or by management’s estimate of such usage. Income tax expense is allocated to each business segment based on the consolidated effective income tax rate for the period shown.
In 2019, the Company made changes to the internal measurement of segment operating profits for the purpose of evaluating segment performance and resource allocation. The primary reason for the change was to align deposit balances within the business segment that directly manages them. Specifically, certain deposit balances previously included as part of the Retail Banking segment have been reclassified to the Commercial Banking segment. The reallocation of select deposit balances affected net interest income, net interest income after provision for credit losses, noninterest income, provision for income taxes and net income. The Company has reported its selected financial information using the new deposit balance alignments for the three and six months ended June 30, 2020. The Company has restated the selected financial information for the three and six months ended June 30, 2019 in order to conform with the current presentation.
Additionally, during the fourth quarter of 2019, the Company changed its assumptions embedded in allocating deposit costs to business segments. The Company has reported its selected financial information using the new deposit cost assumptions starting with the fourth quarter of 2019.
Business Segments
Retail Banking
Retail Banking offers a broad range of financial products and services to consumers and small businesses. Loan and lease products offered include residential and commercial mortgage loans, home equity lines of credit, automobile loans and leases, personal lines of credit, installment loans and small business loans and leases. Deposit products offered include checking, savings, and time deposit accounts. Retail Banking also offers wealth management services. Products and services from Retail Banking are delivered to customers through 58 banking locations throughout the State of Hawaii, Guam, and Saipan.
Commercial Banking
Commercial Banking offers products that include corporate banking, residential and commercial real estate loans, commercial lease financing, automobile loans and auto dealer financing, business deposit products and credit cards. Commercial lending and deposit products are offered primarily to middle-market and large companies locally, nationally, and internationally.
45
Treasury and Other
Treasury consists of corporate asset and liability management activities including interest rate risk management. The segment’s assets and liabilities (and related interest income and expense) consist of interest-bearing deposits, investment securities, federal funds sold and purchased, government deposits, short- and long-term borrowings and bank-owned properties. The primary sources of noninterest income are from bank-owned life insurance, net gains from the sale of investment securities, foreign exchange income related to customer-driven currency requests from merchants and island visitors and management of bank-owned properties. The net residual effect of the transfer pricing of assets and liabilities is included in Treasury, along with the elimination of intercompany transactions.
Other organizational units (Technology, Operations, Credit and Risk Management, Human Resources, Finance, Administration, Marketing, and Corporate and Regulatory Administration) provide a wide-range of support to the Company’s other income earning segments. Expenses incurred by these support units are charged to the business segments through an internal cost allocation process.
The following tables present selected business segment financial information for the periods indicated.
Net interest income (expense)
(24,311)
(25,183)
(5,952)
(55,446)
Net interest income (expense) after provision for credit losses
71,835
7,911
(7,370)
(57,639)
(20,445)
(13,366)
(91,450)
Income (loss) before (provision) benefit for income taxes
36,368
5,521
(15,307)
(Provision) benefit for income taxes
(9,331)
3,977
(6,533)
Net income (loss)
27,037
4,342
(11,330)
Total assets as of June 30, 2020
7,888,155
6,006,128
9,099,432
(44,376)
(45,967)
(6,303)
(96,646)
141,653
21,541
6,665
(119,283)
(41,950)
(26,683)
(187,916)
70,918
15,442
(9,533)
(16,854)
(3,824)
2,765
(17,913)
54,064
11,618
(6,768)
(1,752)
(2,118)
(3,870)
105,956
32,882
(59,495)
(19,741)
(14,054)
(93,290)
69,836
31,866
(4,476)
(17,658)
(8,267)
1,132
(24,793)
52,178
23,599
(3,344)
Total assets as of June 30, 2019
7,056,325
6,525,345
6,944,697
20,526,367
(4,324)
(5,226)
(9,550)
210,611
64,430
(116,662)
(39,226)
(30,025)
(185,913)
141,193
62,317
(12,426)
(35,705)
(16,188)
3,166
(48,727)
105,488
46,129
(9,260)
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Cautionary Note Regarding Forward-Looking Statements
This Quarterly Report on Form 10-Q, including the documents incorporated by reference herein, contains, and from time to time our management may make, forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements reflect our current views with respect to, among other things, future events and our financial performance. These statements are often, but not always, made through the use of words or phrases such as “may,” “might,” “should,” “could,” “predict,” “potential,” “believe,” “expect,” “continue,” “will,” “anticipate,” “seek,” “estimate,” “intend,” “plan,” “projection,” “would,” “annualized” and “outlook,” or the negative version of those words or other comparable words or phrases of a future or forward-looking nature. These forward-looking statements are not historical facts, and are based on current expectations, estimates and projections about our industry, management’s beliefs and certain assumptions made by management, many of which, by their nature, are inherently uncertain and beyond our control. Accordingly, we caution you that any such forward-looking statements are not guarantees of future performance and are subject to risks, assumptions, estimates and uncertainties that are difficult to predict. Although we believe that the expectations reflected in these forward-looking statements are reasonable as of the date made, actual results may prove to be materially different from the results expressed or implied by the forward-looking statements.
A number of important factors could cause our actual results to differ materially from those indicated in these forward-looking statements, including the following: the geographic concentration of our business; current and future economic and market conditions in the United States generally or in Hawaii, Guam and Saipan in particular, including, among other things, the rate of growth and the unemployment rate; the impact on our business, operations, financial condition, liquidity, results of operations, prospects and the trading price of our shares as a result of the COVID-19 pandemic; our dependence on the real estate markets in which we operate; concentrated exposures to certain asset classes and individual obligors; the effect of the current low interest rate environment or changes in interest rates on our business including our net interest income, net interest margin, the fair value of our investment securities, and our mortgage loan originations, mortgage servicing rights and mortgage loans held for sale; changes in the method pursuant to which LIBOR and other benchmark rates are determined or the discontinuance of LIBOR; the possibility of a deterioration in credit quality in our portfolio; the possibility we might underestimate the credit losses inherent in our loan and lease portfolio; our ability to maintain our Bank’s reputation; the future value of the investment securities that we own, especially in light of the market volatility caused by the spread of COVID-19 and governmental and regulatory responses thereto; our ability to attract and retain customer deposits; our inability to receive dividends from our bank, pay dividends to our common stockholders and satisfy obligations as they become due; the effects of severe weather, geopolitical instability, including war, terrorist attacks, pandemics (including the ongoing COVID-19 pandemic) or other severe health emergencies and man-made and natural disasters; our ability to maintain consistent growth, earnings and profitability; our ability to attract and retain skilled employees or changes in our management personnel; possible changes in trade, monetary and fiscal policies of, and other activities undertaken by, governments, agencies, central banks and similar organizations, including quantitative easing, the lowering of interest rates and the imposition of tariffs that may harm sectors to which we are particularly exposed; our ability to effectively compete with other financial services companies and the effects of competition in the financial services industry on our business; the effectiveness of our risk management and internal disclosure controls and procedures; our ability to keep pace with technological changes; any failure or interruption of our information and communications systems; our ability to identify and address cybersecurity risks; the occurrence of fraudulent activity or effect of a material breach of, or disruption to, the security of any of our or our vendors’ systems; the failure to properly use and protect our customer and employee information and data; the possibility of employee misconduct or mistakes; our ability to successfully develop and commercialize new or enhanced products and services; changes in the demand for our products and services; the effects of problems encountered by other financial institutions; our access to sources of liquidity and capital to address our liquidity needs; our use of the secondary mortgage market as a source of liquidity; risks associated with the sale of loans and with our use of appraisals in valuing and monitoring loans; the possibility that actual results may differ from estimates and forecasts; fluctuations in the fair value of our assets and liabilities and off-balance sheet exposures; the effects of the failure of any component of our business infrastructure provided by a third party; the potential for environmental liability; the risk of being subject to litigation and the outcome thereof; the impact of, and changes in, applicable laws, regulations and accounting standards and policies, including the enactment of the Tax Act (Public Law 115-97) on December 22, 2017; possible changes in trade, monetary and fiscal policies of, and other activities undertaken by, governments, agencies, central banks and similar organizations; our likelihood of success in, and the impact of, litigation or regulatory actions; our ability to continue to pay dividends on our common stock or take other capital actions, which must comply with requirements under law or those imposed by our regulators and could
impact our ability to return capital to stockholders; contingent liabilities and unexpected tax liabilities that may be applicable to us as a result of the Reorganization Transactions; and damage to our reputation from any of the factors described above.
The foregoing factors should not be considered an exhaustive list and should be read together with the risk factors and other cautionary statements included in our Annual Report on Form 10-K for the year ended December 31, 2019 and our Quarterly Report on Form 10-Q for the quarter ended March 31, 2020. If one or more events related to these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may differ materially from what we anticipate. Accordingly, you should not place undue reliance on any such forward-looking statements. Any forward-looking statement speaks only as of the date on which it is made, and we do not undertake any obligation to update or review any forward-looking statement, whether as a result of new information, future developments or otherwise, except as required by applicable law.
Company Overview
FHI is a bank holding company, which owns 100% of the outstanding common stock of FHB, its only direct, wholly owned subsidiary. FHB was founded in 1858 under the name Bishop & Company and was the first successful banking partnership in the Kingdom of Hawaii and the second oldest bank formed west of the Mississippi River. The Bank operates its business through three operating segments: Retail Banking, Commercial Banking and Treasury and Other.
References to “we,” “our,” “us,” or the “Company” refer to the Parent and its subsidiary that are consolidated for financial reporting purposes.
Basis of Presentation
The accompanying unaudited interim consolidated financial statements of the Company reflect the results of operations, financial position and cash flows of FHI and its wholly owned subsidiary, FHB. All significant intercompany accounts and transactions have been eliminated in consolidation.
The accompanying unaudited interim consolidated financial statements of the Company have been prepared in accordance with GAAP for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and accompanying notes required by GAAP for complete financial statements. In the opinion of management, the accompanying unaudited interim consolidated financial statements reflect normal recurring adjustments necessary for a fair presentation of the results for the interim periods.
The accompanying unaudited interim consolidated financial statements of the Company should be read in conjunction with the audited consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019 and filed with the U.S. Securities and Exchange Commission (the “SEC”).
Recent Developments regarding COVID-19 and the Hawaii and Global Economy
Overview
The Coronavirus Disease (“COVID-19”) has spread throughout the world and has been declared a pandemic by the World Health Organization and continues to evolve. Several countries, namely the U.S. and Brazil, have been particularly hard hit by COVID-19. Europe and other regions have also been significantly impacted by the pandemic. Through July 2020, the U.S. leads the world in the number of confirmed cases and deaths reported as a result of COVID-19. Despite efforts to control the spread of COVID-19, the U.S. has recently seen a surge in the number of confirmed COVID-19 cases. The global and U.S. economies have entered into a pandemic-driven recession. The future impact of COVID-19 on the global and U.S. economies, and the timing and robustness of any related recovery, continues to remain uncertain.
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As a result of the COVID-19 outbreak and related response, the U.S. economy has deteriorated. Beginning in March 2020, in many parts of the U.S., employees began working from home and businesses deemed nonessential were temporarily closed. Workers in the retail, restaurant, travel and leisure industries were particularly hard hit by layoffs as large parts of the U.S. remained on lockdown for more than a month. According to the Federal Reserve’s May 2020 Beige Book, declines in consumer spending were “especially severe in the leisure and hospitality sector, with very little activity at travel and tourism businesses.” The national seasonally-adjusted unemployment rate increased from 4.4% in March 2020 to 14.7% in April 2020. In May 2020, state-by-state decisions began to be made on the pace and extent of reopening local businesses. While the phased reopening of the U.S. economy brought the national seasonally-adjusted unemployment rate down to 11.1% in June 2020, new claims for unemployment insurance have remained above one million per week through July 2020. In addition, as noted above, the U.S. has recently experienced, and continues to experience, a surge in the number of confirmed COVID-19 cases, which has already stalled the reopening strategy in a number of states and may continue to impact the pace of economic recovery going forward. The U.S. real gross domestic product decreased by 5.0% in the first quarter of 2020.
Hawaii Economy
Hawaii’s economy continues to be meaningfully impacted by COVID-19 and the responses to it. Hawaii’s economy began to suffer in February 2020 with flight cancellations to Hawaii due to the global COVID-19 pandemic. On March 5, 2020, the Governor of the State of Hawaii issued an emergency proclamation declaring a state of emergency in Hawaii. On March 21, 2020, the Governor of the State of Hawaii issued a supplementary emergency proclamation ordering all individuals, both residents and visitors, arriving or returning to the State of Hawaii to a mandatory 14-day self-quarantine. The mandate, which was the first such action in the nation, essentially brought the Hawaii tourism industry to a halt. Subsequently, on March 23, 2020, the Governor of the State of Hawaii issued a third supplemental emergency proclamation that ordered all residents to stay-at-home, except for essential workers.
Thus far, the spread of COVID-19 has been relatively well controlled in Hawaii with quickly instituted stay-at-home orders and the implementation of the mandatory 14-day self-quarantine for residents and visitors arriving or returning to the State of Hawaii. As a result, as of July 15, 2020, Hawaii has the lowest fatality and case rates per capita in the U.S as reported by the Centers for Disease Control and Prevention. On May 5, 2020, the Governor of the State of Hawaii issued a seventh supplemental emergency proclamation which effectively ended stay-at-home orders and allowed for the reopening of certain businesses deemed to be of lower risk for COVID-19 transmissions. Subsequently, on May 18, 2020, the Governor of the State of Hawaii issued an eighth supplemental emergency proclamation which outlined a four-phase reopening strategy for Hawaii’s economy and allowing for a gradual reopening of medium-risk businesses in June 2020. Following the Governor’s issuance of a ninth supplemental emergency proclamation on June 24, 2020, which removed the 14-day self-quarantine mandate for interisland travel, the Governor of the State of Hawaii announced a program, effective September 1, 2020, that would allow passengers from the U.S. mainland with an approved negative COVID-19 test within 72 hours prior to arrival in the State of Hawaii to bypass the state’s mandatory 14-day self-quarantine requirement.
For an economy that is heavily dependent on tourism, the combination of various response measures to the COVID-19 pandemic, including the stay-at-home orders for local residents and the mandatory 14-day self-quarantine for visitors resulted in an unprecedented increase in Hawaii unemployment. The statewide seasonally-adjusted unemployment rate was 13.9% in June 2020 compared to 2.7% in June 2019, according to the State of Hawaii Department of Labor and Industrial Relations, while the national seasonally-adjusted unemployment rate was 11.1% in June 2020 compared to 3.7% in June 2019. Visitor arrivals for the first five months of 2020 decreased by 49.5% compared to the same period in 2019, according to the Hawaii Tourism Authority. Statistics on visitor spending were not available for 2020 due to insufficient data. While we may see a gradual improvement in unemployment as local businesses and the Hawaii tourism industry slowly reopen, the timing and significance of the return of air travel and the recovery of the Hawaii tourism industry is highly uncertain and beyond our control.
With regards to reports of home sales on Oahu, although volume has decreased year-over-year due to stay-at-home orders that were in place earlier in the year, prices have remained stable. For the six months ended June 30, 2020, the volume of single-family home sales decreased by 4.8%, while condominium sales decreased by 22.0% compared to the same period in 2019, according to the Honolulu Board of Realtors. The median price of single-family home sales and condominium sales on Oahu was $785,000 and $428,000, respectively, or an increase of 1.3% and 2.1%, respectively, for the six months ended June 30, 2020 as compared to the same period in 2019. As of June 30, 2020, months of inventory of single-family homes and condominiums on Oahu remained low at approximately 2.5 and 4.1 months, respectively. Lastly, state general excise and use tax revenues decreased by 8.0% for the first five months of 2020 as compared to the same period in 2019, according to the Hawaii Department of Business, Economic Development & Tourism. We expect tax revenues for the state to continue to be significantly lower when reported for the remainder of 2020.
Legislative and Regulatory Developments
Recent actions taken by the federal government and the Federal Reserve and other bank regulatory agencies to partially mitigate the economic effects of COVID-19 and related containment measures will also have an impact on our financial position and results of operations. These actions are further discussed below.
In response to market conditions resulting from the COVID-19 pandemic, the Federal Reserve has taken a number of proactive measures, including cutting its target for the federal funds rate by a total of 1.50%, bringing it down to a range of 0.00% to 0.25%. We expect that interest rates will remain at record low levels for the foreseeable future. The Federal Reserve has instituted a number of other measures, including up to $2.3 trillion in lending to support households, employers, financial markets and state and local governments. Additional actions taken by the Federal Reserve to mitigate the lasting impact from the coronavirus pandemic include the following:
The U.S. government has also enacted certain fiscal stimulus measures in several phases to counteract the economic disruption caused by COVID-19. The CARES Act, enacted on March 27, 2020, is an approximately $2 trillion emergency economic stimulus package in response to the COVID-19 outbreak. Among other provisions, the CARES Act (i) authorized the Secretary of the Treasury to make loans, loan guarantees and other investments, up to $500 billion, for assistance to eligible businesses, States and municipalities with limited, targeted relief for passenger air carriers, cargo air carriers, and businesses critical to maintaining national security, (ii) created a $670 billion loan program (the “Paycheck Protection Program” or the “PPP”) for fully guaranteed loans (which may then be forgiven) to small businesses for, among other things, payroll, group health care benefit costs and qualifying mortgage, rent and utility payments (program dollar amount includes amount approved under the original program in March 2020 and a second tranche which was approved in April 2020), (iii) provides certain credits against the 2020 personal income tax for eligible individuals and their dependents, (iv) expanded eligibility for unemployment insurance and provides eligible recipients with an additional $600 per week on top of the unemployment amount determined by each State and (v) set a 60-day foreclosure moratorium beginning on March 18, 2020 for federally backed mortgage loans (the Federal Housing Administration has subsequently announced a second extension of the foreclosure and eviction moratorium through August 31, 2020).
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The Paycheck Protection Program Flexibility Act of 2020 (the “PPPF Act”) was enacted on June 5, 2020 and modified the PPP as follows: (i) established a minimum maturity of five years for all loans made after the enactment of the PPPF Act and permits an extension of the maturity of existing loans to five years if the borrower and lender agree; (ii) extended the “covered period” of the CARES Act from June 30, 2020, to December 31, 2020; (iii) extended the eight-week “covered period” for expenditures that qualify for forgiveness to the earlier of 24 weeks following loan origination and December 31, 2020; (iv) extended the deferral period for payment of principal, interest and fees to the date on which the forgiveness amount is remitted to the lender by the SBA; (v) required the borrower to use at least 60% (down from 75%) of the proceeds of the loan for payroll costs, and up to 40% (up from 25%), for other permitted purposes, as a condition to obtaining forgiveness of the loan; (vi) delayed from June 30, 2020 to December 31, 2020, the date by which employees must be rehired to avoid a reduction in the amount of forgiveness of a loan, and creates a “rehiring safe harbor” that allows businesses to remain eligible for loan forgiveness if they make a good faith attempt to rehire employees or hire similarly qualified employees, but are unable to do so, or are able to document an inability to return to pre-COVID-19 levels of business activity due to compliance with social distancing measures; and (vii) allowed borrowers to receive both loan forgiveness under the PPP and the payroll tax deferral permitted under the CARES Act, rather than having to choose the more advantageous option.
In July 2020, the CARES Act was amended to extend, through August 8, 2020, the SBA’s authority to make commitments under the PPP. The SBA’s existing authority had previously expired on June 30, 2020. We are continuing to monitor the potential development of additional legislation and further actions taken by the U.S. government.
The State of Hawaii is expected to receive at least $1.25 billion in federal aid from the CARES Act. We expect that the majority of this federal aid will be used to help fund state and county government response efforts to COVID-19. Additional federal funding is expected to provide for unemployment assistance, direct cash payments to Hawaii residents and funding to support local schools and colleges.
Impact to our Operations
As noted above, on March 23, 2020, the Governor of the State of Hawaii issued a third supplemental emergency proclamation that ordered all residents to stay-at-home, except for essential workers. This stay-at-home order was in place until May 5, 2020. While the Bank is an essential business in Hawaii, we saw a significant decrease in customer traffic in our branches. As a result, we strategically closed 26 of our branch locations on a temporary basis. On June 1, 2020, we reopened seven of these branch locations in connection with the reopening of our local businesses. We continue to provide service to all customers and operate our businesses on all islands of Hawaii, Guam and Saipan. Additionally, as part of our contingency plans, we have established a redundant operations center for our administrative operations, and about 30% of our employees are working remotely.
Impact on our Financial Position and Results of Operations
Due to the widespread impact that COVID-19 is having on Hawaii’s economy, we expect that adverse economic conditions will continue. As Hawaii’s economy begins to reopen, we expect that local consumption of goods and services will begin to resume over an extended period of time. Additionally, the timing and significance of the return of air travel and the Hawaii tourism industry is highly uncertain and is dependent upon, among other things, the number of cases declining around the globe, in the United States and, in particular, in Hawaii, visitor receptiveness to Hawaii’s new pre-travel COVID-19 testing requirements, an extended period in which there is no subsequent “wave” of infections and the widespread availability of a vaccine, treatment or testing, tracking and tracing capabilities.
During this time of uncertainty, we remain committed to servicing our customers, caring for our employees and supporting the community. We are working with our customers impacted by COVID-19 through offering payment deferrals and forbearance on certain loan products. We will continue to closely monitor the impact that COVID-19 and the recession in Hawaii has on our customers and will adjust the means by which we assist our customers during this period of financial hardship. We are continuing to care for our employees by enabling over 50% of our employees to work from home, and for those employees who are deemed essential and unable to work from home, we continue to emphasize the importance of practicing social distancing and good hygiene practices in the workplace. We also launched an initiative to support local restaurants and, through our foundation, to donate up to $1 million to support non-profit organizations with food supply and health and human service programs for those impacted by COVID-19.
The shut-down of our tourism industry, stay-at-home measures, the recession in Hawaii and record low interest rates have and we expect will continue to have a negative impact on our financial position and results of operations. A continued decrease in interest rates, or sustained period of interest rates, would be expected to reduce our net interest margin, as, currently, our interest rate profile is such that we project net interest income will benefit from higher interest rates as our assets would reprice faster and to a greater degree than our liabilities, while in the case of lower interest rates, our assets would reprice downward and to a greater degree than our liabilities. Our net interest margin also may be reduced as a result of our participation in the PPP, with loans made thereunder that are not forgiven carrying an interest rate of 1%.
Our credit risk profile will also be adversely impacted during this period of financial hardship for our customers. We also expect that we will see temporary decreases in non-interest income, as we have taken certain measures to assist customers during the COVID-19 pandemic, including waiving non-customer ATM fees (up to June 30, 2020) and penalties for early withdrawal of certificates of deposit.
Moreover, we have seen increased draws by some of our customers on lines of credit as they have sought to improve their liquidity positions. While we expect a significant portion of loans made by the Bank through our participation in the PPP to be forgiven, we expect that a sizeable portion of such loans will remain on our balance sheet for up to two years. As a result, we expect to see higher loan volumes and reduced capital levels as a result of the COVID-19 pandemic.
In light of volatility in the capital markets and economic disruptions, we continue to carefully monitor our capital and liquidity positions. As of June 30, 2020, the Company was “well-capitalized” and met all applicable regulatory capital requirements, including a Common Equity Tier 1 capital ratio of 11.86%, compared to the minimum requirement of 4.50%. We continue to anticipate that we will have sufficient capital levels to meet all of these requirements. Additionally, we continue to access our routine short-term funding sources, such as borrowings and repurchase agreements, and to assess longer-term funding sources. For additional discussions regarding our capital and liquidity positions and related risks, refer to the sections titled “Liquidity” and “Capital” in this MD&A.
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Selected Financial Data
Our financial highlights for the periods indicated are presented in Table 1:
Financial Highlights
Table 1
For the Three Months Ended
For the Six Months Ended
(dollars in thousands, except per share data)
Income Statement Data:
Dividends declared per share
0.26
0.52
Dividend payout ratio
173.33
48.15
115.56
49.06
Supplemental Income Statement Data (non-GAAP)(1):
Core net interest income
Core noninterest income
45,867
48,752
95,010
98,437
Core noninterest expense
93,029
185,391
Core net income
20,204
72,612
59,007
144,664
Core basic earnings per share
0.16
1.07
Core diluted earnings per share
Other Financial Information / Performance Ratios:(2)
Net interest margin
2.58
3.25
2.84
3.24
Core net interest margin (non-GAAP)(1),(3)
Efficiency ratio
52.70
47.99
51.99
48.09
Core efficiency ratio (non-GAAP)(1),(4)
52.64
47.86
51.97
47.64
Return on average total assets
0.36
1.42
0.56
1.40
Core return on average total assets (non-GAAP)(1),(5)
1.43
Return on average tangible assets (non-GAAP)(11)
0.38
1.50
0.58
1.48
Core return on average tangible assets (non-GAAP)(1),(6)
Return on average total stockholders' equity
2.99
11.13
4.42
11.15
Core return on average total stockholders' equity (non-GAAP)(1),(7)
3.01
11.16
4.43
11.33
Return on average tangible stockholders' equity (non-GAAP)(11)
4.74
17.99
7.04
18.17
Core return on average tangible stockholders' equity (non-GAAP)(1),(8)
4.77
18.03
7.05
18.46
Noninterest expense to average assets
1.65
1.84
1.77
1.83
Core noninterest expense to average assets (non-GAAP)(1),(9)
Balance Sheet Data:
Investment securities
Allowance for credit losses for loans and leases
Book value per share
20.81
20.32
Tangible book value per share (non-GAAP)(11)
13.14
12.66
Asset Quality Ratios:
Non-accrual loans and leases / total loans and leases
0.24
0.04
Allowance for credit losses for loans and leases / total loans and leases
0.99
Net charge-offs / average total loans and leases(10)
0.44
0.19
Capital Ratios:
Common Equity Tier 1 Capital Ratio
Tier 1 Capital Ratio
Total Capital Ratio
Tier 1 Leverage Ratio
Total stockholders' equity to total assets
11.75
13.09
Tangible stockholders' equity to tangible assets (non-GAAP)(11)
7.76
8.58
The following table provides a reconciliation of net interest income, noninterest income, noninterest expense and net income to their “core” non-GAAP financial measures:
GAAP to Non-GAAP Reconciliation
Table 2
Core net interest income (non-GAAP)
Losses (gains) on sale of securities
Core noninterest income (non-GAAP)
One-time items(a)
(261)
(522)
Core noninterest expense (non-GAAP)
One-time noninterest expense items(a)
261
522
Tax adjustments(b)
(61)
(807)
Total core adjustments
179
2,307
Core net income (non-GAAP)
Core basic earnings per share (non-GAAP)
Core diluted earnings per share (non-GAAP)
Core efficiency ratio (non-GAAP)
The following table provides a reconciliation of these non-GAAP financial measures with their most closely related GAAP measures for the periods indicated:
Table 3
Average total stockholders' equity
2,697,775
2,610,565
2,679,293
2,575,775
Less: average goodwill
Average tangible stockholders' equity
1,702,283
1,615,073
1,683,801
1,580,283
Average total assets
22,341,654
20,390,273
21,327,479
20,442,266
Average tangible assets
21,346,162
19,394,781
20,331,987
19,446,774
Return on average total stockholders' equity(a)
Core return on average total stockholders' equity (non-GAAP)(a)
Return on average tangible stockholders' equity (non-GAAP)(a)
Core return on average tangible stockholders' equity (non-GAAP)(a)
Return on average total assets(a)
Core return on average total assets (non-GAAP)(a)
Return on average tangible assets (non-GAAP)(a)
Core return on average tangible assets (non-GAAP)(a)
Noninterest expense to average assets(a)
Core noninterest expense to average assets (non-GAAP)(a)
As of
Less: goodwill
Tangible stockholders' equity
1,706,405
1,644,766
Tangible assets
21,998,223
19,171,242
Shares outstanding
Tangible stockholders' equity to tangible assets (non-GAAP)
Tangible book value per share (non-GAAP)
Net income was $20.0 million for the three months ended June 30, 2020, a decrease of $52.4 million or 72% as compared to the same period in 2019. Basic and diluted earnings per share were both $0.15 per share for the three months ended June 30, 2020, a decrease of $0.39 per share or 72% as compared to the same period in 2019. The decrease in net income was primarily due to a $51.6 million increase in the provision for credit losses (the “Provision”), a $17.8 million decrease in net interest income and a $3.1 million decrease in noninterest income, partially offset by an $18.3 million decrease in the provision for income taxes and a $1.8 million decrease in noninterest expense for the three months ended June 30, 2020.
Our return on average total assets was 0.36% for the three months ended June 30, 2020, a decrease of 106 basis points from the same period in 2019, and our return on average total stockholders’ equity was 2.99% for the three months ended June 30, 2020, a decrease of 814 basis points from the same period in 2019. Our return on average tangible assets was 0.38% for the three months ended June 30, 2020, a decrease of 112 basis points from the same period in 2019, and our return on average tangible stockholders’ equity was 4.74% for the three months ended June 30, 2020, down from 17.99% for the same period in 2019. We continued to prudently manage our expenses, as our efficiency ratio was 52.70% for the three months ended June 30, 2020 compared to 47.99% for the same period in 2019.
Our results for the three months ended June 30, 2020 were highlighted by the following:
58
Net income was $58.9 million for the six months ended June 30, 2020, a decrease of $83.4 million or 59% as compared to the same period in 2019. Basic and diluted earnings per share were both $0.45 per share for the six months ended June 30, 2020, a decrease of $0.61 per share or 58% as compared to the same period in 2019. The decrease in net income was primarily due to a $87.1 million increase in the Provision, a $24.2 million decrease in net interest income, a $2.0 million increase in noninterest expense and a $1.0 million decrease in noninterest income, partially offset by a $30.8 million decrease in the provision for income taxes for the six months ended June 30, 2020.
Our return on average total assets was 0.56% for the six months ended June 30, 2020, a decrease of 84 basis points from the same period in 2019, and our return on average total stockholders’ equity was 4.42% for the six months ended June 30, 2020, a decrease of 673 basis points from the same period in 2019. Our return on average tangible assets was 0.58% for the six months ended June 30, 2020, a decrease of 90 basis points from the same period in 2019, and our return on average tangible stockholders’ equity was 7.04% for the six months ended June 30, 2020, down from 18.17% for the same period in 2019. Our efficiency ratio was 51.99% for the six months ended June 30, 2020 compared to 48.09% for the same period in 2019.
Our results for the six months ended June 30, 2020 were highlighted by the following:
Hawaii’s economy continues to be meaningfully impacted by COVID-19 and the responses to it. These responses included stay-at-home orders for businesses deemed nonessential, from the end of March 2020 to June 2020, and the implementation of the mandatory 14-day self-quarantine for residents and visitors arriving or returning to the State of Hawaii. For an economy that is heavily dependent on tourism, the combination of these various response measures to the COVID-19 pandemic resulted in an unprecedented increase in Hawaii unemployment. While we may see a gradual improvement in unemployment as local businesses and the Hawaii tourism industry slowly reopen, the timing and significance of the return of air travel and the recovery of the Hawaii tourism industry is highly uncertain and beyond our control. As such, we increased our Provision in order to maintain adequate reserves for expected losses. We also continued to maintain high levels of liquidity and remained well-capitalized as of June 30, 2020.
59
60
Analysis of Results of Operations
Net Interest Income
For the three months ended June 30, 2020 and 2019, average balances, related income and expenses, on a fully taxable-equivalent basis, and resulting yields and rates are presented in Table 4. An analysis of the change in net interest income, on a fully taxable-equivalent basis, is presented in Table 5.
Average Balances and Interest Rates
Table 4
Income/
Yield/
(dollars in millions)
Expense
Rate
Earning Assets
Interest-Bearing Deposits in Other Banks
1,436.2
0.4
0.10
247.2
1.4
2.35
Available-for-Sale Investment Securities
4,390.4
17.5
1.60
4,438.1
24.8
2.23
Loans Held for Sale
9.8
0.1
2.93
0.7
2.76
Loans and Leases (1)
3,601.0
24.3
2.71
3,235.0
34.3
4.26
3,438.8
28.3
3.31
3,094.4
36.0
4.67
584.1
4.9
3.35
583.6
6.9
4.73
3,682.7
35.7
3.88
3,581.2
37.2
4.16
885.2
6.8
3.07
908.5
8.6
3.79
1,526.5
20.6
5.42
1,657.7
22.7
5.48
238.4
1.7
2.88
149.3
1.2
13,956.7
122.3
3.52
13,209.7
146.9
4.46
Other Earning Assets
61.7
2.79
76.0
3.71
Total Earning Assets (2)
19,854.8
140.7
17,971.7
173.8
Cash and Due from Banks
295.1
342.6
Other Assets
2,191.8
2,076.0
Total Assets
22,341.7
20,390.3
Interest-Bearing Liabilities
Interest-Bearing Deposits
Savings
5,501.9
0.9
0.07
4,712.2
4.0
0.34
Money Market
3,270.3
1.1
0.13
3,126.7
7.4
0.95
Time
3,335.6
6.6
0.79
3,084.6
12.3
Total Interest-Bearing Deposits
12,107.8
0.29
10,923.5
23.7
0.87
Short-Term Borrowings
395.6
2.8
50.4
0.3
2.25
Long-Term Borrowings
200.0
2.77
593.5
4.2
2.86
Total Interest-Bearing Liabilities
12,703.4
12.8
0.41
11,567.4
28.2
0.98
127.9
145.6
Interest Rate Spread
2.43
2.90
Net Interest Margin
Noninterest-Bearing Demand Deposits
6,432.6
5,741.3
Other Liabilities
507.9
471.0
Stockholders' Equity
2,697.8
2,610.6
Total Liabilities and Stockholders' Equity
Analysis of Change in Net Interest Income
Table 5
Compared to June 30, 2019
Volume
Total (1)
Change in Interest Income:
(2.4)
(1.0)
(0.3)
(7.0)
(7.3)
3.6
(13.6)
(10.0)
3.7
(11.4)
(7.7)
(2.0)
1.0
(2.5)
(1.5)
(0.2)
(1.6)
(1.8)
(2.1)
0.5
7.0
(31.6)
(24.6)
(0.1)
Total Change in Interest Income
8.1
(41.2)
(33.1)
Change in Interest Expense:
0.6
(3.7)
(3.1)
(6.6)
(6.3)
(6.7)
(5.7)
1.9
(17.0)
(15.1)
Short-term Borrowings
2.4
2.5
Long-term Borrowings
(2.7)
(2.8)
Total Change in Interest Expense
1.6
(15.4)
Change in Net Interest Income
6.5
(24.2)
(17.7)
Net interest income, on a fully taxable-equivalent basis, was $127.9 million for the three months ended June 30, 2020, a decrease of $17.7 million or 12% compared to the same period in 2019. Our net interest margin was 2.58% for the three months ended June 30, 2020, a decrease of 67 basis points from the same period in 2019. The decrease in net interest income, on a fully taxable-equivalent basis, was primarily due to lower yields in all loan categories and lower yields in our investment securities portfolio, partially offset by lower deposit funding costs during the three months ended June 30, 2020. Yields on our loans and leases were 3.52% for the three months ended June 30, 2020, a decrease of 94 basis points as compared to the same period in 2019. We experienced a decrease in our yields from total loans primarily due to decreases in adjustable rate commercial and industrial and commercial real estate loans, which are typically based on the LIBOR. Decreases in the yield on commercial and industrial loans also stemmed from our participation in the PPP, as these loans have a fixed interest rate of one percent per annum. Interest income earned on PPP loans was $5.4 million for the three months ended June 30, 2020. The yield in our investment securities portfolio was 1.60% for the three months ended June 30, 2020, a decrease of 63 basis points from the same period in 2019. Deposit funding costs were $8.6 million for the three months ended June 30, 2020, a decrease of $15.1 million or 64% compared to the same period in 2019. Rates paid on our interest-bearing deposits were 29 basis points for the three months ended June 30, 2020, a decrease of 58 basis points compared to the same period in 2019.
For the six months ended June 30, 2020 and 2019, average balances, related income and expenses, on a fully taxable-equivalent basis, and resulting yields and rates are presented in Table 6. An analysis of the change in net interest income, on a fully taxable-equivalent basis, is presented in Table 7.
Table 6
976.5
2.0
0.40
376.5
4.6
2.49
4,211.8
38.7
4,428.0
49.3
2.17
Loans and Leases(1)
3,188.4
48.9
3.08
3,200.9
67.5
4.25
3,426.3
62.9
3.69
3,044.9
70.7
4.68
561.5
10.6
610.2
14.4
4.75
3,711.5
73.4
3.95
3,563.2
73.9
4.14
886.3
14.5
3.28
912.1
17.3
3.82
1,569.2
43.6
5.59
1,662.5
45.2
230.8
3.3
148.3
2.3
3.15
13,574.0
257.2
3.80
13,142.1
291.3
59.4
3.99
84.1
2.81
Total Earning Assets(2)
18,834.5
299.2
3.19
18,031.2
346.4
3.86
311.2
351.4
2,181.8
2,059.7
21,327.5
20,442.3
5,296.1
4,762.6
8.2
0.35
3,167.6
5.7
3,155.0
15.0
0.96
2,935.1
14.3
3,063.3
1.56
11,398.8
24.2
0.43
10,980.9
46.9
0.86
398.6
31.7
2.29
2.7
596.7
8.4
2.85
11,997.4
32.6
0.55
11,609.3
55.7
0.97
266.6
290.7
2.64
2.89
6,143.0
5,783.8
507.8
473.4
2,679.3
2,575.8
Table 7
Total(1)
3.4
(6.0)
(2.6)
(2.3)
(8.3)
(10.6)
(18.4)
(18.6)
8.3
(16.1)
(7.8)
(1.1)
(3.8)
2.9
(3.4)
(0.5)
(42.2)
(34.1)
(0.4)
8.9
(56.1)
(47.2)
(4.9)
(4.0)
(9.4)
(9.3)
(8.4)
(22.7)
5.2
5.3
(5.5)
(22.8)
(23.1)
9.2
(33.3)
(24.1)
Net interest income, on a fully taxable-equivalent basis, was $266.6 million for the six months ended June 30, 2020, a decrease of $24.1 million or 8% compared to the same period in 2019. Our net interest margin was 2.84% for the six months ended June 30, 2020, a decrease of 40 basis points from the same period in 2019. The decrease in net interest income, on a fully taxable-equivalent basis, was primarily due to lower yields in most loan categories and lower yields in our investment securities portfolio. This was partially offset by lower deposit funding costs. Yields on our loans and leases were 3.80% for the six months ended June 30, 2020, a decrease of 66 basis points as compared to the same period in 2019. We experienced a decrease in our yield from total loans primarily due to decreases in adjustable rate commercial and industrial and commercial real estate loans, which are typically based on LIBOR. Decreases in the yield on commercial and industrial loans also stemmed from our participation in the PPP, as these loans have a fixed interest rate of one percent per annum. Interest income earned on PPP loans was $5.4 million for the six months ended June 30, 2020. For the six months ended June 30, 2020, the yield in our investment securities portfolio was 1.84%, a decrease of 39 basis points compared to the same period in 2019. Deposit funding costs were $24.2 million for the six months ended June 30, 2020, a decrease of $22.7 million or 48% compared to the same period in 2019. Rates paid on our interest-bearing deposits were 43 basis points for the six months ended June 30, 2020, a decrease of 43 basis points compared to the same period in 2019.
The Federal Reserve influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. Our loan portfolio is affected by changes in the prime interest rate. The prime rate began in 2019 at 5.50% and decreased 50 basis points during the third quarter of 2019 (25 basis points in each of August and September) and 25 basis points in October 2019 to end the year at 4.75%. During 2020, the prime rate decreased 150 basis points in March to end the first quarter at 3.25%, where it remained as at the end of the second quarter of 2020. As noted above, our loan portfolio is also impacted by changes in the LIBOR. At June 30, 2020, the one-month and three-month U.S. dollar LIBOR interest rates were 0.16% and 0.30%, respectively, while at June 30, 2019, the one-month and three-month U.S. dollar LIBOR interest rates were 2.40% and 2.32%, respectively. The target range for the federal funds rate, which is the cost of immediately available overnight funds, began 2019 at 2.25% to 2.50% and decreased 50 basis points during the third quarter of 2019 (25 basis points in each of August and September) and 25 basis points in October 2019 to end the year at 1.50 to 1.75%. During 2020, the target range for the federal funds rate decreased 150 basis points in March to end the first quarter at 0.00% to 0.25%,
64
where it remained as at the end of the second quarter of 2020. In June 2020, the Federal Reserve indicated that it expects to maintain the targeted federal funds rate at current levels through 2022. The decrease in the target range for the federal funds rate in 2020 was largely an emergency measure by the Federal Reserve aimed at mitigating the economic impact of COVID-19.
Provision for Credit Losses
The Provision was $55.4 million for the three months ended June 30, 2020, which represented an increase of $51.6 million compared to the same period in 2019. We recorded net charge-offs of loans and leases of $23.4 million and $6.9 million for the three months ended June 30, 2020 and 2019, respectively. This represented charge-offs of 0.67% and 0.21% of average loans and leases, on an annualized basis, for the three months ended June 30, 2020 and 2019, respectively. The Provision was $96.6 million for the six months ended June 30, 2020, which represented an increase of $87.1 million compared to the same period in 2019. This increase was primarily due to an adjustment related to COVID-19 and the impact we expect it to have on our customers. We recorded net charge-offs of loans and leases of $29.5 million and $12.7 million for the six months ended June 30, 2020 and 2019, respectively. This represented net charge-offs of 0.44% and 0.20% of average loans and leases, on an annualized basis, for the six months ended June 30, 2020 and 2019, respectively. The ACL was $192.1 million as of June 30, 2020, an increase of $61.6 million or 47% from December 31, 2019 and represented 1.40% of total outstanding loans and leases as of June 30, 2020 compared to 0.99% of total outstanding loans and leases as of December 31, 2019. The Provision is recorded to maintain the ACL at levels deemed adequate by management based on the factors noted in the “Risk Governance and Quantitative and Qualitative Disclosures About Market Risk — Credit Risk” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”).
Noninterest Income
Table 8 presents the major components of noninterest income for the three months ended June 30, 2020 and 2019 and Table 9 presents the major components of noninterest income for the six months ended June 30, 2020 and 2019:
Table 8
Dollar
Percent
Change
(2,196)
(5,759)
(1,491)
(16)
(267)
(3)
1,042
(232)
n/m
5,786
(3,117)
(6)
n/m – Denotes a variance that is not a meaningful metric to inform the change in noninterest income for the three months ended June 30, 2020 to the same period in 2019.
Table 9
(1,306)
(7,465)
(22)
(2,081)
(11)
706
(511)
(7)
2,466
7,230
(961)
n/m – Denotes a variance that is not a meaningful metric to inform the change in noninterest income for the six months ended June 30, 2020 to the same period in 2019.
65
Total noninterest income was $45.7 million for the three months ended June 30, 2020, a decrease of $3.1 million or 6% as compared to the same period in 2019. Total noninterest income was $94.9 million for the six months ended June 30, 2020, a decrease of $1.0 million or 1% as compared to the same period in 2019.
Service charges on deposit accounts were $5.9 million for the three months ended June 30, 2020, a decrease of $2.2 million or 27% as compared to the same period in 2019. This decrease was primarily due to a $2.0 million decrease in overdraft and checking account fees and a $0.5 million decrease in ATM interchange fees from customers. Service charges on deposit accounts were $14.9 million for the six months ended June 30, 2020, a decrease of $1.3 million or 8% as compared to the same period in 2019. This decrease was primarily due to a $1.9 million decrease in overdraft and checking account fees, partially offset by a $0.8 million increase in account analysis service charges.
Credit and debit card fees were $10.9 million for the three months ended June 30, 2020, a decrease of $5.8 million or 35% as compared to the same period in 2019. This decrease was primarily due to a $3.3 million decrease in interchange settlement fees from credit and debit cards, a $2.7 million decrease in merchant service revenues and a $1.3 million decrease in ATM surcharge fees. This was partially offset by a $1.9 million decrease in network association dues. Credit and debit card fees were $25.8 million for the six months ended June 30, 2020 a decrease of $7.5 million or 22% as compared to the same period in 2019. This decrease was primarily due to a $3.8 million decrease in interchange settlement fees from credit and debit cards, a $3.7 million decrease in merchant service revenues and a $1.4 million decrease in ATM surcharge fees. This was partially offset by a $1.8 million decrease in network association dues.
Other service charges and fees were $7.9 million for the three months ended June 30, 2020, a decrease of $1.5 million or 16% as compared to the same period in 2019. This decrease was primarily due to a $0.5 million decrease in service fees related to participation loans, a $0.2 million decrease in foreign exchange processing fees, a $0.2 million decrease in online banking fees and a $0.2 million decrease in fees from annuities and securities. Other service charges and fees were $16.5 million for the six months ended June 30, 2020, a decrease of $2.1 million or 11% as compared to the same period in 2019. This decrease was primarily due to a $0.6 million decrease in service fees related to participation loans, a $0.5 million decrease in insurance income, a $0.3 million decrease in online banking fees and a $0.2 million decrease in foreign exchange processing fees.
Trust and investment services income was $8.7 million for the three months ended June 30, 2020, a decrease of $0.3 million or 3% as compared to the same period in 2019. Trust and investment services income was $18.3 million for the six months ended June 30, 2020, an increase of $0.7 million or 4% as compared to the same period in 2019. This increase was primarily due to a $0.9 million increase in investment management fees.
BOLI income was $4.4 million for the three months ended June 30, 2020, an increase of $1.0 million or 31% as compared to the same period in 2019. This increase was due to a $0.7 million increase in death benefit proceeds from life insurance policies and a $0.3 million increase in BOLI earnings. BOLI income was $6.7 million for the six months ended June 30, 2020, a decrease of $0.5 million or 7% as compared to the same period in 2019. This decrease was due to a $0.8 million decrease in BOLI earnings, partially offset by a $0.3 million increase in death benefit proceeds from life insurance policies.
Net losses on the sale of investment securities were $0.2 million and nil for the three months ended June 30, 2020 and 2019, respectively. Net losses on the sale of investment securities were $0.1 million and $2.6 million for the six months ended June 30, 2020 and 2019, respectively. The decrease in losses of $2.5 million was primarily due to our investment portfolio restructuring and sale of 48 investment securities in January 2019, which contributed to the $2.6 million loss for the six months ended June 30, 2019.
Other noninterest income was $8.1 million for the three months ended June 30, 2020, an increase of $5.8 million as compared to the same period in 2019. This increase was primarily due to a $3.5 million increase in customer-related interest rate swap fees, a $1.3 million increase in gains on the sale of residential mortgage loans and a $0.9 million increase in volume-based incentives. Other noninterest income was $12.9 million for the six months ended June 30, 2020, an increase of $7.2 million as compared to the same period in 2019. This increase was primarily due to a $4.6 million increase in customer-related interest rate swap fees, a $2.5 million increase in gains on the sale of residential mortgage loans and a $0.8 million increase in volume-based incentives.
66
Noninterest Expense
Table 10 presents the major components of noninterest expense for the three months ended June 30, 2020 and 2019 and Table 11 presents the major components of noninterest expense for the six months ended June 30, 2020 and 2019:
Table 10
Percentage
229
1,175
663
(49)
(2)
(578)
(29)
(2,501)
(795)
(1,840)
Table 11
198
3,585
273
1,087
450
(721)
(18)
(2,218)
(651)
2,003
Total noninterest expense was $91.5 million for the three months ended June 30, 2020, a decrease of $1.8 million or 2% as compared to the same period in 2019. Total noninterest expense was $187.9 million for the six months ended June 30, 2020, an increase of $2.0 million or 1% as compared to the same period in 2019.
Salaries and employee benefits expense was $42.4 million for the three months ended June 30, 2020, an increase of $0.2 million or 1% as compared to the same period in 2019. Salaries and employee benefits expense was $87.2 million for the six months ended June 30, 2020, an increase of $0.2 million or less than 1% as compared to the same period in 2019.
Contracted services and professional fees were $15.5 million for the three months ended June 30, 2020, an increase of $1.2 million or 8% as compared to the same period in 2019. This increase was primarily due to a $1.0 million increase in contracted data processing expenses, primarily related to system upgrades and product enhancements. Contracted services and professional fees were $31.5 million for the six months ended June 30, 2020, an increase of $3.6 million or 13% as compared to the same period in 2019. This increase was primarily due to a $2.1 million increase in contracted data processing expenses, primarily related to system upgrades and product enhancements, a $1.0 million increase in outside services, primarily attributable to marketing and new customer services, and a $0.6 million increase in audit, legal and consultant fees.
Occupancy expense was $7.3 million for three months ended June 30, 2020, a minimal change as compared to the same period in 2019. Occupancy expense was $14.5 million for the six months ended June 30, 2020, an increase of $0.3 million or 2% as compared to the same period in 2019.
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Equipment expense was $5.2 million for the three months ended June 30, 2020, an increase of $0.7 million or 15% as compared to the same period in 2019. This increase was primarily due to a $0.6 million increase in furniture and equipment depreciation expense. Equipment expense was $9.9 million for the six months ended June 30, 2020, an increase of $1.1 million or 12% as compared to the same period in 2019. This increase was primarily due to a $0.6 million increase in furniture and equipment depreciation expense and a $0.3 million increase in technology-related license and maintenance fees.
Regulatory assessment and fees were $2.1 million for the three months ended June 30, 2020, a minimal change as compared to the same period in 2019. Regulatory assessment and fees were $4.0 million for the six months ended June 30, 2020, an increase of $0.5 million or 13% as compared to the same period in 2019.
Advertising and marketing expense was $1.4 million for the three months ended June 30, 2020, a decrease of $0.6 million or 29% as compared to the same period in 2019. This decrease was primarily due to a $0.3 million decrease due to higher vendor reimbursements and a $0.3 million decrease in advertising costs. Advertising and marketing expense was $3.2 million for the six months ended June 30, 2020, a decrease of $0.7 million or 18% as compared to the same period in 2019. This decrease was primarily due to a $0.5 million decrease in advertising costs and a $0.2 million decrease due to higher vendor reimbursements.
Card rewards program expense was $5.2 million for the three months ended June 30, 2020, a decrease of $2.5 million or 33% as compared to the same period in 2019. This decrease was primarily due to a $1.4 million decrease in priority rewards card redemptions, a $0.7 million decrease in interchange fees paid to our credit card partners and a $0.3 million decrease in credit card cash reward redemptions. Card rewards program expense was $12.2 million for the six months ended June 30, 2020, a decrease of $2.2 million or 15% as compared to the same period in 2019. This decrease was primarily due to a $1.4 million decrease in priority rewards card redemptions, a $0.5 million decrease in credit card cash reward redemptions and a $0.3 million decrease in interchange fees paid to our credit card partners.
Other noninterest expense was $12.4 million for the three months ended June 30, 2020, a decrease of $0.8 million or 6% as compared to the same period in 2019. This decrease was primarily due to a $0.5 million decrease in net periodic benefit costs. Other noninterest expense was $25.2 million for the six months ended June 30, 2020, a decrease of $0.7 million or 3% as compared to the same period in 2019. This decrease was primarily due to a $0.9 million decrease in net periodic benefit costs.
Provision for Income Taxes
The provision for income taxes was $6.5 million (an effective tax rate of 24.58%) for the three months ended June 30, 2020, compared with the provision for income taxes of $24.8 million (an effective tax rate of 25.50%) for the same period in 2019. The provision for income taxes was $17.9 million (an effective tax rate of 23.32%) for the six months ended June 30, 2020, compared with the provision for income taxes of $48.7 million (an effective tax rate of 25.50%) for the same period in 2019. The reduction in the effective tax rates for the three and six months ended June 30, 2020, compared to the same periods in 2019, was primarily due to the reduction of pretax income, which resulted in the tax credits, tax-exempt income and other tax benefit items to have proportionately higher impacts on the effective tax rates. In addition, the reduction in the effective tax rate for the six months ended June 30, 2020 also stemmed from a state tax settlement with BNP Paribas USA, Inc. related to periods during which the Company was included in the state combined returns of BNP Paribas USA, Inc.
Analysis of Business Segments
Our business segments are Retail Banking, Commercial Banking and Treasury and Other. Table 12 summarizes net income from our business segments for the three and six months ended June 30, 2020 and 2019. Additional information about operating segment performance is presented in “Note 18. Reportable Operating Segments” contained in our unaudited interim consolidated financial statements.
In 2019, the Company made changes to the internal measurement of segment operating profits for the purpose of evaluating segment performance and resource allocation. The primary reason for the change was to align deposit balances within the business segment that directly manages them. Specifically, certain deposit balances previously included as part of the Retail Banking segment have been reclassified to the Commercial Banking segment. The reallocation of select deposit balances affected net interest income, net interest income after provision for credit losses, noninterest income, provision for income taxes and net income. The Company has reported its selected financial information using the new deposit balance
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alignments for the three and six months ended June 30, 2020. The Company has restated the selected financial information for the three and six months ended June 30, 2019 in order to conform with the current presentation.
Business Segment Net Income
Table 12
Retail Banking. Our Retail Banking segment includes the financial products and services we provide to consumers, small businesses and certain commercial customers. Loan and lease products offered include residential and commercial mortgage loans, home equity lines of credit, automobile loans and leases, personal lines of credit, installment loans and small business loans and leases. Deposit products offered include checking, savings and time deposit accounts. Our Retail Banking segment also includes our wealth management services.
Net income for the Retail Banking segment was $27.0 million for the three months ended June 30, 2020, a decrease of $25.1 million or 48% as compared to the same period in 2019. The decrease in net income for the Retail Banking segment was primarily due to a $22.6 million increase in the Provision, an $11.6 million decrease in net interest income and a $1.2 million decrease in noninterest income, partially offset by a $8.3 million decrease in the provision for income taxes and a $1.9 million decrease in noninterest expense. The increase in the Provision was primarily due to the adjustment related to COVID-19 and the impact that we expect it to have on our customers. The decrease in net interest income was primarily due to a decrease in transfer pricing credits on interest expenses from deposits as a result of lower yields on our deposit portfolio. The decrease in noninterest income was primarily due to decreases in overdraft and checking account fees and other services charges and fees, partially offset by higher gains on the sale of residential mortgage loans. The decrease in the provision for income tax was primarily due to lower pretax income. The decrease in noninterest expense was primarily due to a decrease in salaries and employee benefits expense.
Net income for the Retail Banking segment was $54.1 million for the six months ended June 30, 2020, a decrease of $51.4 million or 49% as compared to the same period in 2019. The decrease in net income for the Retail Banking segment was primarily due to a $40.1 million increase in the Provision, a $28.9 million decrease in net interest income and a $2.6 million increase in noninterest expense, partially offset by a $18.9 million decrease in the provision for income taxes and a $1.3 million increase in noninterest income. The increase in the Provision was primarily due to the adjustment related to COVID-19 and the impact that we expect it to have on our customers. The decrease in net interest income was primarily due to a decrease in transfer pricing credits on interest expenses from deposits as a result of lower yields on our deposit portfolio, as well as higher transfer pricing charges related to the residential loans portfolio. The increase in noninterest expense was primarily due to higher overall expenses that were allocated to the Retail Banking segment and an increase in contracted services and professional fees, partially offset by a decrease in salaries and benefits expense. The decrease in the provision for income taxes was primarily due to the decrease in pretax income. The increase in noninterest income was primarily due to higher gains on the sale of residential mortgage loans and an increase in trust and investment services income, partially offset by decreases in other service charges and fees and overdraft and checking account fees.
The increase in total assets for the Retail Banking segment was primarily due to PPP loans during the six months ended June 30, 2020.
Commercial Banking. Our Commercial Banking segment includes our corporate banking, residential and commercial real estate loans, commercial lease financing, automobile loans and auto dealer financing, business deposit products and credit cards that we provide primarily to middle market and large companies in Hawaii, Guam, Saipan and California.
Net income for the Commercial Banking segment was $4.3 million for the three months ended June 30, 2020, a decrease of $19.3 million or 82% as compared to the same period in 2019. The decrease in net income for the Commercial Banking segment was primarily due to a $23.1 million increase in the Provision and a $1.9 million decrease in net interest income,
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partially offset by a $7.1 million decrease in the provision for income taxes. The increase in the Provision was primarily due to the adjustment related to COVID-19 and the expected impact that it will have on our customers. The decrease in net interest income was primarily due to a decrease in transfer pricing credits on interest expenses from deposits as a result of lower yields on our deposit portfolio. The decrease in the provision for income taxes was primarily due to the decrease in pretax income.
Net income for the Commercial Banking segment was $11.6 million for the six months ended June 30, 2020, a decrease of $34.5 million or 75% as compared to the same period in 2019. The decrease in net income for the Commercial Banking segment was primarily due to a $40.7 million increase in the Provision, a $2.7 million increase in noninterest expense, a $2.1 million decrease in net interest income and a $1.3 million decrease in noninterest income, partially offset by a $12.4 million decrease in the provision for income taxes. The increase in the Provision was primarily due to the adjustment related to COVID-19 and the expected impact that it will have on our customers. The increase in noninterest expense was primarily due to increases in contracted services and professional fees, salaries and benefits expense, other taxes and higher overall expenses that were allocated to the Commercial Banking segment, partially offset by a decrease in card reward expenses. The decrease in net interest income was primarily due to a decrease in transfer pricing credits on interest expenses from deposits as a result of lower yields on our deposit portfolio. The decrease in noninterest income was primarily due to a decrease in credit and debit card fees, partially offset by an increase in customer-related swap fees. The decrease in the provision for income taxes was primarily due to the decrease in pretax income.
The decrease in total assets for the Commercial Banking segment was primarily due to decreases in our Shared National Credits and dealer flooring portfolios, partially offset by higher draws on lines by existing customers and PPP loans during the six months ended June 30, 2020.
Treasury and Other. Our Treasury and Other segment includes our treasury business, which consists of corporate asset and liability management activities, including interest rate risk management. The assets and liabilities (and related interest income and expense) of our treasury business consist of interest-bearing deposits, investment securities, federal funds sold and purchased, government deposits, short- and long-term borrowings and bank-owned properties. Our primary sources of noninterest income are from bank-owned life insurance, net gains from the sale of investment securities, foreign exchange income related to customer driven currency requests from merchants and island visitors and management of bank-owned properties in Hawaii and Guam. The net residual effect of the transfer pricing of assets and liabilities is included in Treasury and Other, along with the elimination of intercompany transactions.
Other organizational units (Technology, Operations, Credit and Risk Management, Human Resources, Finance, Administration, Marketing and Corporate and Regulatory Administration) provide a wide range of support to our other income earning segments. Expenses incurred by these support units are charged to the applicable business segments through an internal cost allocation process.
Net loss for the Treasury and Other segment was $11.3 million for the three months ended June 30, 2020, an increase in loss of $8.0 million as compared to the same period in 2019. The increase in the net loss was primarily due to a $6.0 million increase in the Provision, a $4.3 million increase in net interest expense and a $1.2 million decrease in noninterest income, partially offset by a $2.8 million increase in the benefit for income taxes. The increase in the Provision was primarily due to the adjustment related to COVID-19 and the expected impact that it will have on our customers. The increase in net interest expense was primarily due to lower earnings credits as a result of lower average yields in our loan portfolio and lower average yields in our investment securities portfolio, partially offset by a decrease in transfer pricing charges as a result of lower yields on our deposit portfolio. The decrease in noninterest income was primarily due to decreases in credit and debit card fees and overdraft and checking account fees, partially offset by an increase in BOLI income. The increase in the benefit for income taxes was primarily due to the increase in pretax loss.
Net loss for the Treasury and Other segment was $6.8 million for the six months ended June 30, 2020, a decrease in loss of $2.5 million or 27% as compared to the same period in 2019. The decrease in net loss was primarily due to a $6.9 million increase in net interest income and a $3.3 million decrease in noninterest expense, partially offset by a $6.3 million increase in the Provision and a $1.0 million decrease in noninterest income. The increase in net interest income was primarily due to a decrease in transfer pricing charges as a result of lower yields on our deposit portfolio, partially offset by lower earnings credits as a result of lower average yields in our loan portfolio and lower average yields in our investment securities portfolio. The decrease in noninterest expense was primarily due to higher overall expenses that led to a larger credit allocation to the Treasury and Other segment, as well as lower other taxes and pension-related expenses, partially offset by an increase in salaries and employee benefits expense and equipment expenses. The increase in the Provision was primarily due to the
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adjustment related to COVID-19 and the expected impact that it will have on our customers. The decrease in noninterest income was primarily due to decreases in credit and debit card fees, overdraft and checking account fees, BOLI income, customer-related rate swap fees and market adjustments for foreign exchange transactions, partially offset by a decrease in net losses on the sale of investment securities as a result of the investment portfolio restructuring and sale of 48 investment securities in January 2019.
The increase in total assets for the Treasury and Other segment was primarily due to increases in interest-bearing deposits in other banks and investment securities portfolio during the six months ended June 30, 2020.
Analysis of Financial Condition
Liquidity
Liquidity refers to our ability to maintain cash flow that is adequate to fund operations and meet present and future financial obligations through either the sale or maturity of existing assets or by obtaining additional funding through liability management. We consider the effective and prudent management of liquidity to be fundamental to our health and strength. Our objective is to manage our cash flow and liquidity reserves so that they are adequate to fund our obligations and other commitments on a timely basis and at a reasonable cost.
Liquidity is managed to ensure stable, reliable and cost-effective sources of funds to satisfy demand for credit, deposit withdrawals and investment opportunities. Funding requirements are impacted by loan originations and refinancings, deposit balance changes, liability issuances and settlements and off-balance sheet funding commitments. We consider and comply with various regulatory and internal guidelines regarding required liquidity levels and periodically monitor our liquidity position in light of the changing economic environment and customer activity. Based on periodic liquidity assessments, we may alter our asset, liability and off-balance sheet positions. The Company’s Asset Liability Management Committee (“ALCO”) monitors sources and uses of funds and modifies asset and liability positions as liquidity requirements change. This process, combined with our ability to raise funds in money and capital markets and through private placements, provides flexibility in managing the exposure to liquidity risk.
Immediate liquid resources are available in cash, which is primarily on deposit with the Federal Reserve Bank of San Francisco (the “FRB”). As of June 30, 2020 and December 31, 2019, cash and cash equivalents were $1.9 billion and $0.7 billion, respectively. Potential sources of liquidity also include investment securities in our available-for-sale portfolio. The estimated fair value of our available-for-sale investment securities were $5.1 billion and $4.1 billion as of June 30, 2020 and December 31, 2019, respectively. As of June 30, 2020 and December 31, 2019, we maintained our excess liquidity primarily in collateralized mortgage obligations issued by Ginnie Mae, Fannie Mae and Freddie Mac. As of June 30, 2020, our available-for-sale investment securities portfolio was comprised of securities with a weighted average life of approximately 4.2 years. These funds offer substantial resources to meet either new loan demand or to help offset reductions in our deposit funding base. Liquidity is further enhanced by our ability to pledge loans to access secured borrowings from the FHLB and the FRB. As of June 30, 2020, we had borrowing capacity of $1.9 billion from the FHLB and $982.0 million from the FRB based on the amount of collateral pledged. As of December 31, 2019, we had borrowing capacity of $1.7 billion from the FHLB and $596.8 million from the FRB based on the amount of collateral pledged.
Our core deposits have historically provided us with a long-term source of stable and relatively lower cost of funding. Our core deposits, defined as all deposits exclusive of time deposits exceeding $250,000, totaled $17.0 billion and $15.1 billion as of June 30, 2020 and December 31, 2019, which represented 88% and 92%, respectively, of our total deposits. These core deposits are normally less volatile, often with customer relationships tied to other products offered by the Company, however, deposit levels could decrease if interest rates increase significantly or if corporate customers increase investing activities and reduce deposit balances
The Company’s routine funding requirements are expected to consist primarily of general corporate needs and capital to be returned to our shareholders. We expect to meet these obligations from dividends paid by the Bank to the Parent. Additional sources of liquidity available to us include selling residential real estate loans in the secondary market, short- and long-term borrowings and the issuance of long-term debt and equity securities. At the start of the pandemic, we increased our liquidity position through additional public time deposits in anticipation of a surge in funding needs due to our participation in the PPP and other additional liquidity needs. As of June 30, 2020, we maintained these higher levels of liquidity.
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Table 13 presents the estimated fair value of our available-for-sale investment securities portfolio as of June 30, 2020 and December 31, 2019:
Table 13
Table 14 presents the maturity distribution at amortized cost and weighted-average yield to maturity of our available-for-sale investment securities portfolio as of June 30, 2020:
Maturities and Weighted-Average Yield on Securities(1)
Table 14
1 Year or Less
After 1 Year - 5 Years
After 5 Years - 10 Years
Over 10 Years
Yield
As of June 30, 2020
30.4
0.81
64.0
1.10
94.4
1.00
94.9
Mortgage-backed securities(2):
224.8
2.46
232.6
327.3
2.59
47.8
375.1
2.57
390.9
498.3
2.33
109.3
1.71
612.8
2.22
629.7
27.7
284.6
1.85
312.3
1.95
323.0
Collateralized mortgage obligations(2):
1,644.6
1.87
150.6
1.25
62.1
1.38
1,887.7
1.80
1,926.6
73.5
2.20
765.1
679.7
1.47
1,518.3
1.67
1,538.1
Total available-for-sale securities as of June 30, 2020
103.9
2.05
3,518.2
2.02
1,272.0
1.59
131.3
1.27
5,025.4
1.90
5,135.8
The fair value of our available-for-sale investment securities portfolio was $5.1 billion as of June 30, 2020, an increase of $1.1 billion or 26% compared to December 31, 2019. Our available-for-sale investment securities are carried at fair value with changes in fair value reflected in other comprehensive income or through the Provision.
As of June 30, 2020, we maintained all of our investment securities in the available-for-sale category recorded at fair value in the unaudited interim consolidated balance sheets, with $3.5 billion invested in collateralized mortgage obligations issued by Ginnie Mae, Fannie Mae and Freddie Mac. Our available-for-sale portfolio also included $1.6 billion in mortgage-backed securities issued by Ginnie Mae, Freddie Mac, Fannie Mae and a municipal housing authority and $94.9 million in debt securities issued by the U.S Treasury and government agencies (US International Development Finance Corporation bonds).
We continually evaluate our investment securities portfolio in response to established asset/liability management objectives, changing market conditions that could affect profitability and the level of interest rate risk to which we are exposed. These evaluations may cause us to change the level of funds we deploy into investment securities and change the composition of our investment securities portfolio.
We conduct a regular assessment of our investment securities portfolio to determine whether any securities are impaired. If this assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security are compared to the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and the ACL is recorded for the credit loss, limited by the amount that the
fair value is less than the amortized cost basis. Any impairment that has not been recorded through the ACL is recognized in other comprehensive income. For the three and six months ended June 30, 2020, we did not record any credit losses related to our investment securities portfolio.
Gross unrealized gains in our investment securities portfolio were $111.9 million and $19.0 million as of June 30, 2020 and December 31, 2019, respectively. Gross unrealized losses in our investment securities portfolio were $1.6 million and $24.0 million as of June 30, 2020 and December 31, 2019, respectively. The increase in unrealized gains in our investment securities portfolio was primarily due to lower market interest rates as of June 30, 2020, relative to December 31, 2019, resulting in a higher valuation. The increase in unrealized gain positions was primarily related to our mortgage-backed securities and collateralized mortgage obligations, the fair values of which are sensitive to changes in market interest rates.
We are required to hold non-marketable equity securities, comprised of FHLB stock, as a condition of our membership in the FHLB system. Our FHLB stock is accounted for at cost, which equals par or redemption value. As of June 30, 2020 and December 31, 2019, we held FHLB stock of $26.1 million and $34.1 million, respectively, which is recorded as a component of other assets in our unaudited interim consolidated balance sheets.
See “Note 2. Investment Securities” contained in our unaudited interim consolidated financial statements for more information on our investment securities portfolio.
Table 15 presents the composition of our loan and lease portfolio by major categories as of June 30, 2020 and December 31, 2019:
Table 15
Total loans and leases were $13.8 billion as of June 30, 2020, an increase of $552.4 million or 4% from December 31, 2019 with increases in commercial and industrial loans, construction loans and lease financing. The increase in total loans and leases was primarily due to our participation in the PPP which had a total amortized cost basis of $916.4 million as of June 30, 2020. While we have not experienced declines in our loan portfolio in the second quarter, it is possible that the effects of COVID-19 on the economy could result in less demand for our loan products.
Commercial and industrial loans are made primarily to corporations, middle market and small businesses for the purpose of financing equipment acquisition, expansion, working capital and other general business purposes. We also offer a variety of automobile dealer flooring lines to our customers in Hawaii and California to assist with the financing of their inventory. Commercial and industrial loans were $3.4 billion as of June 30, 2020, an increase of $680.5 million or 25% from December 31, 2019. This increase was primarily due to PPP loans totaling $916.4 million, offset by decreases in our Shared National Credits and dealer flooring portfolios during the six months ended June 30, 2020.
Commercial real estate loans are secured by first mortgages on commercial real estate at loan to value (“LTV”) ratios generally not exceeding 75% and a minimum debt service coverage ratio of 1.20 to 1. The commercial properties are predominantly apartments, neighborhood and grocery anchored retail, industrial, office, and to a lesser extent, specialized properties such as hotels. The primary source of repayment for investor property is cash flow from the property and for owner occupied property is the operating cash flow from the business. Commercial real estate loans were $3.4 billion as of June 30, 2020, a decrease of $40.5 million or 1% from December 31, 2019. This decrease was primarily due to a payoff of a commercial real estate loan totaling $50.0 million during the six months ended June 30, 2020.
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Construction loans are for the purchase or construction of a property for which repayment will be generated by the property. Loans in this portfolio are primarily for the purchase of land, as well as for the development of commercial properties, single family homes and condominiums. We classify loans as construction until the completion of the construction phase. Following completion of the construction phase, if a loan is retained by the Bank, the loan is reclassified to the commercial real estate or residential real estate classes of loans. Construction loans were $617.9 million as of June 30, 2020, an increase of $98.7 million or 19% from December 31, 2019. The increase in construction loans stemmed from various disbursements of project loans during the six months ended June 30, 2020.
Residential real estate loans are generally secured by 1-4 unit residential properties and are underwritten using traditional underwriting systems to assess the credit risks and financial capacity and repayment ability of the consumer. Decisions are primarily based on LTV ratios, debt-to-income (“DTI”) ratios, liquidity and credit scores. LTV ratios generally do not exceed 80%, although higher levels are permitted with mortgage insurance. We offer fixed rate mortgage products and variable rate mortgage products with interest rates that are subject to change every year after the first, third, fifth or tenth year, depending on the product and are based on LIBOR. Variable rate residential mortgage loans are underwritten at fully-indexed interest rates. We generally do not offer interest-only, payment-option facilities, Alt-A loans or any product with negative amortization. Residential real estate loans were $4.6 billion as of June 30, 2020, a decrease of $93.7 million or 2% from December 31, 2019. Our portfolio of residential real estate loans declined due to the sale of $132.0 million in residential mortgages during the six months ended June 30, 2020.
Consumer loans consist primarily of open- and closed-end direct and indirect credit facilities for personal, automobile and household purchases as well as credit card loans. We seek to maintain reasonable levels of risk in consumer lending by following prudent underwriting guidelines, which include an evaluation of personal credit history, cash flow and collateral values based on existing market conditions. Consumer loans were $1.5 billion as of June 30, 2020, a decrease of $128.4 million or 8% from December 31, 2019. The decrease in consumer loans was primarily due to decreases in credit card balances and indirect automobile loans.
Lease financing consists of commercial single investor leases and leveraged leases. Underwriting of new lease transactions is based on our lending policy, including but not limited to an analysis of customer cash flows and secondary sources of repayment, including the value of leased equipment, the guarantors’ cash flows and/or other credit enhancements. No new leveraged leases are being added to the portfolio and all remaining leveraged leases are running off. Lease financing was $238.3 million as of June 30, 2020, an increase of $35.8 million or 18% from December 31, 2019. The increase in lease financing was due to portfolio growth in our commercial single investor leases.
See “Note 3. Loans and Leases” and “Note 4. Allowance for Credit Losses” contained in our unaudited interim consolidated financial statements and the discussion in “Analysis of Financial Condition — Allowance for Credit Losses” of this MD&A for more information on our loan and lease portfolio.
The Company’s loan and lease portfolio includes adjustable-rate loans, primarily tied to Prime and LIBOR, hybrid-rate loans, for which the initial rate is fixed for a period from one year to as much as ten years, and fixed rate loans, for which the interest rate does not change through the life of the loan. Table 16 presents the recorded investment in our loan and lease portfolio as of June 30, 2020 by rate type:
Loans and Leases by Rate Type
Table 16
Adjustable Rate
Hybrid
Fixed
Prime
LIBOR
245,967
1,836,507
26,535
2,109,009
12,875
1,301,824
31,234
2,063,991
337
917,401
3,012,963
89,838
320,698
38,741
450,105
34,202
523,081
984
93,870
24,177
154,551
94,848
56,494
330,070
380,224
2,981,656
336,901
17,460
354,361
522,078
361,078
112,308
684,431
902,302
2,981,708
305,272
18,861
1,514
110
325,757
3,761
1,162,642
982,292
4,524,015
114,192
1,034,742
6,655,241
1,009,760
6,099,029
% by rate type at June 30, 2020
Tables 17 and 18 present the geographic distribution of our loan and lease portfolio as of June 30, 2020 and December 31, 2019:
Geographic Distribution of Loan and Lease Portfolio
Table 17
U.S.
Guam &
Foreign &
Hawaii
Mainland(1)
Saipan
1,975,998
1,184,445
215,470
47,795
2,221,441
804,164
397,656
238
282,487
330,326
5,122
3,568,419
2,446
121,085
845,095
31,323
4,413,514
2,519
152,408
1,100,888
19,826
370,284
1,162
88,081
139,141
11,065
10,082,409
2,480,421
1,152,005
49,195
Percentage of Total Loans and Leases
73%
18%
8%
1%
100%
75
Table 18
1,270,997
1,285,340
140,929
45,976
2,289,626
768,314
405,720
293
261,089
253,577
4,575
3,642,251
2,708
123,977
861,079
78
32,082
4,503,330
2,786
156,059
1,202,762
22,521
393,045
2,228
85,842
110,630
6,011
9,613,646
2,443,168
1,106,339
48,497
Our lending activities are concentrated primarily in Hawaii. However, we also have lending activities on the U.S. mainland, Guam and Saipan. Our commercial lending activities on the U.S. mainland include automobile dealer flooring activities in California, participation in the Shared National Credits Program and selective commercial real estate projects based on existing customer relationships. Our lease financing portfolio includes commercial leveraged and single investor lease financing activities both in Hawaii and on the U.S. mainland. However, no new leveraged leases are being added to the portfolio and all remaining leveraged leases are running off. Our consumer lending activities are concentrated primarily in Hawaii and, to a smaller extent, in Guam and Saipan.
Table 19 presents certain contractual loan maturity categories and sensitivities of those loans to changes in interest rates as of June 30, 2020:
Maturities for Selected Loan Categories(1)
Table 19
Due in One
Due After One
Due After
Year or Less
to Five Years
Five Years
987,725
2,189,928
246,055
274,976
274,491
Total Selected Loans
1,262,701
2,464,419
314,523
4,041,643
Total of loans with:
Adjustable interest rates
1,151,666
1,262,168
218,256
2,632,090
Hybrid interest rates
4,872
8,291
13,859
Fixed interest rates
110,339
1,197,379
87,976
1,395,694
Credit Quality
We perform an internal loan review and grading or scoring procedures on an ongoing basis. The review provides management with periodic information as to the quality of the loan portfolio and effectiveness of our lending policies and procedures. The objective of the loan review and grading or scoring procedures is to identify, in a timely manner, existing or emerging credit quality issues so that appropriate steps can be initiated to avoid or minimize future losses.
For purposes of managing credit risk and estimating the ACL, management has identified three portfolio segments (commercial, residential and consumer) that we use to develop our systematic methodology to determine the ACL. The categorization of loans for the evaluation of credit risk is specific to our credit risk evaluation process and these loan categories are not necessarily the same as the loan categories used for other evaluations of our loan portfolio. See “Note 4. Allowance for Credit Losses” contained in our unaudited interim consolidated financial statements for more information about our approach to estimating the ACL.
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The following tables and discussion address non-performing assets, loans and leases that are 90 days past due but are still accruing interest, impaired loans and loans modified in a TDR.
Non-Performing Assets and Loans and Leases Past Due 90 Days or More and Still Accruing Interest
Table 20 presents information on our non-performing assets and accruing loans and leases past due 90 days or more as of June 30, 2020 and December 31, 2019:
Non-Performing Assets and Accruing Loans and Leases Past Due 90 Days or More
Table 20
Non-Performing Assets
Non-Accrual Loans and Leases
Commercial Loans:
Total Commercial Loans
26,770
Residential Loans:
Total Residential Loans
Total Non-Accrual Loans and Leases
Other Real Estate Owned ("OREO")
Total Non-Performing Assets
33,275
5,787
Accruing Loans and Leases Past Due 90 Days or More
3,457
4,809
3,069
Total Accruing Loans and Leases Past Due 90 Days or More
Restructured Loans on Accrual Status and Not Past Due 90 Days or More
11,182
14,493
Ratio of Non-Accrual Loans and Leases to Total Loans and Leases
Ratio of Non-Performing Assets to Total Loans and Leases and OREO
Ratio of Non-Performing Assets and Accruing Loans and Leases Past Due 90 Days or More to Total Loans and Leases and OREO
0.32
0.14
Table 21 presents the activity in Non-Performing Assets (“NPAs”) for the six months ended June 30, 2020:
Table 21
Additions
48,487
Reductions
(3,712)
Return to accrual status
(567)
Sales of other real estate owned
(319)
Charge-offs/write-downs
(16,401)
Total Reductions
(20,999)
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The level of NPAs represents an indicator of the potential for future credit losses. NPAs consist of non-accrual loans and leases and other real estate owned. Changes in the level of non-accrual loans and leases typically represent increases for loans and leases that reach a specified past due status, offset by reductions for loans and leases that are charged-off, paid down, sold, transferred to other real estate owned or are no longer classified as non-accrual because they have returned to accrual status as a result of continued performance and an improvement in the borrower’s financial condition and loan repayment capabilities.
Total NPAs were $33.3 million as of June 30, 2020, an increase of $27.5 million or 475% from December 31, 2019. The ratio of our NPAs to total loans and leases and other real estate owned was 0.24% as of June 30, 2020, an increase of 20 basis points from December 31, 2019. The increase in total NPAs was primarily due to a $13.1 million increase in commercial real estate non-accrual loans, a $11.5 million increase in commercial and industrial non-accrual loans and a $2.0 million increase in construction non-accrual loans.
As of June 30, 2020, commercial real estate non-accrual loans were $13.2 million, an increase of $13.1 million from December 31, 2019. This increase was primarily due to an addition of a $15.1 million commercial real estate loan, partially offset by a $2.7 million charge-off. The increase in commercial real estate non-accruals loans was primarily due to the impact of COVID-19 and the shut-down of the tourism industry in Hawaii.
As of June 30, 2020, commercial and industrial non-accrual loans were $11.6 million, an increase of $11.5 million from December 31, 2019. This increase was primarily due to additions in commercial and industrial loans totaling $27.8 million, partially offset by $13.3 million in charge-offs and $3.0 million in payments. The increase in commercial and industrial non-accruals loans was primarily due to the impact of COVID-19 and the shut-down of the tourism industry in Hawaii.
As of June 30, 2020, construction non-accrual loans were $2.0 million, an increase of $2.0 million or 100% from December 31, 2019. This increase was primarily due to the addition of one construction non-accrual loan of $2.2 million, partially offset by a $0.4 million charge-off.
As of June 30, 2020, residential mortgage non-accrual loans were $6.1 million, an increase of $0.7 million or 12% from December 31, 2019. As of June 30, 2020, our residential mortgage non-accrual loans were comprised of 36 loans with a weighted average current LTV ratio of 51%.
Other real estate owned represents property acquired as the result of borrower defaults on loans. Other real estate owned is recorded at fair value, less estimated selling costs, at the time of foreclosure. On an ongoing basis, properties are appraised as required by market conditions and applicable regulations. As of June 30, 2020, other real estate owned was $0.4 million which was comprised of one residential real estate property. As of December 31, 2019, other real estate owned was $0.3 million which was comprised of two residential real estate properties.
Loans and Leases Past Due 90 Days or More and Still Accruing Interest. Loans and leases in this category are 90 days or more past due, as to principal or interest, and are still accruing interest because they are well secured and in the process of collection.
Loans and leases past due 90 days or more and still accruing interest were $10.1 million as of June 30, 2020, a decrease of $2.0 million or 17% as compared to December 31, 2019. Construction and consumer loans that were past due 90 days or more and still accruing interest both decreased by $2.1 million during the six months ended June 30, 2020. This was partially offset by increases of $1.5 million and $0.9 million in home equity lines and commercial and industrial loans, respectively, that were past due 90 days or more and still accruing interest during the six months ended June 30, 2020.
Impaired Loans. A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. For a loan that has been modified in a TDR, the contractual terms of the loan agreement refers to the contractual terms specified by the original loan agreement, not the contractual terms specified by the modified loan agreement.
Impaired loans were $44.7 million and $20.6 million as of June 30, 2020 and December 31, 2019, respectively. These impaired loans had a related ACL of $1.6 million and $0.2 million as of June 30, 2020 and December 31, 2019. The increase in impaired loans during the six months ended June 30, 2020 was primarily due to increases in commercial real estate, commercial and industrial and construction loans of $13.1 million, $10.2 million and $1.8 million, respectively, partially offset by a decrease in residential mortgage loans of $1.2 million. The impaired loan balance is further decreased by charge-
offs and paydowns. As of June 30, 2020 and December 31, 2019, we recorded charge-offs of $17.0 million and $0.6 million, respectively, related to our total impaired loans. Our impaired loans are considered in management’s assessment of the overall adequacy of the ACL.
If interest due on the balances of all non-accrual loans as of June 30, 2020 had been accrued under the original terms, approximately $0.5 million and $0.6 million in additional interest income would have been recorded during the three and six months ended June 30, 2020, respectively, compared to nil and $0.1 million in additional interest income that would have been recorded for the same periods in 2019. Actual interest income recorded on these loans was $0.1 million for both the three and six months ended June 30, 2020, compared to $0.4 million and $0.9 million, respectively, for the same periods in 2019.
COVID-19 Financial Hardship Relief Programs
Certain borrowers are currently unable to meet their contractual payment obligations because of the adverse effects of COVID-19. To help mitigate these effects, we have been offering various relief programs to assist customers who are experiencing financial hardship due to COVID-19. For example, for certain residential mortgage and commercial loans, various relief options are available on a case-by-case basis, including payment deferrals for up to six months. For certain consumer loans, loan assistance is being offered in the form of payment deferrals for up to three months, which extends the term of the loan by the number of months deferred, and interest will continue to accrue on the principal balance. The short-term modifications for payment deferrals, extensions of repayment terms, or delays in payment described above that are insignificant and made on a good faith basis in response to borrowers impacted by COVID-19 who were current prior to any relief are not required to be accounted for and disclosed as TDRs under GAAP. Please see “Note 4. Allowance for Credit Losses” in the notes to our unaudited interim consolidated financial statements for further discussion on short-term modifications.
Table 22 presents information on our loans and leases that received payment deferrals under our COVID-19 financial hardship relief programs as of June 30, 2020:
Loans and Leases Receiving Payment Deferrals under COVID-19 Financial Hardship Relief Programs
Table 22
Number of Loans
1,433
931,111
434
1,179,280
66,037
10,615
1,322
564,671
17,898
275,625
Total Loans and Leases Receiving Payment Deferrals under COVID-19 Financial Hardship Relief Programs
21,188
3,027,339
Ratio of Loans and Leases Receiving Payment Deferrals under COVID-19 Financial Hardship Relief Programs to Total Loans and Leases
22.0
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In addition to the relief programs described above, we have been also participating in the PPP offered by the U.S. Small Business Administration (“SBA”). The PPP is intended to help small businesses impacted by the COVID-19 pandemic by providing “fully forgivable” loans for up to $10 million to cover up to 24 weeks of payroll expenses, including employee benefits, and can also be used to make mortgage interest, rent and utility payments. PPP loans have a fixed interest rate of one percent per annum and a maturity date of up to five years, with the ability to prepay the loan in full without penalty. The first payment is deferred for 10 months or until compensation is received for forgiven amounts, and interest will continue to accrue during the initial deferment period. The borrower may apply with the Bank for loan forgiveness of the amount due on the loan in an amount equal to payroll, employee benefits, mortgage interest, rent and utility costs incurred during the 24-week period, subject to limitations, in accordance with the PPP and CARES Act. Because the purpose of the PPP is to help small businesses keep their workers employed and paid, if the business spends less than 60% of loan proceeds on payroll costs, uses the loan proceeds for non-payroll costs that are not related to mortgage interest, rent or utility payments, or significantly reduces its employee count or compensation levels without qualifying for other exceptions, a portion of the loan will not be forgiven, and the business will be required to repay that portion of the loan to the Bank over the remaining term of the loan.
Table 23 presents information on our PPP loans outstanding as of June 30, 2020 to borrowers operating in industries greatly impacted by the COVID-19 pandemic (“high impact industries”) and all other industries:
PPP Loans Outstanding to Borrowers by Industry
Table 23
Number
of Loans
High Impact Industries:
Food service
596
110,711
Automobile dealers
63,867
520
59,765
Hospitality/Hotel
56,481
Transportation
165
35,573
Total PPP Loans Outstanding to Borrowers Operating in High Impact Industries
1,452
326,397
All other industries (1)
4,564
589,999
Total PPP Loans Outstanding (2)
6,016
916,396
Ratio of PPP Loans Outstanding to Borrowers Operating in High Impact Industries to Total Loans and Leases
Ratio of PPP Loans Outstanding to Total Loans and Leases
6.7
Loans Modified in a Troubled Debt Restructuring
Table 24 presents information on loans whose terms have been modified in a TDR as of June 30, 2020 and December 31, 2019:
Table 24
3,609
4,919
675
692
Total commercial
4,284
5,611
7,865
10,487
12,149
16,098
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Loans modified in a TDR were $12.1 million as of June 30, 2020, a decrease of $3.9 million or 25% from December 31, 2019. This decrease was primarily due to decreases in residential mortgage loans of $2.6 million and commercial and industrial loans of $1.3 million. As of June 30, 2020, $11.2 million or 92% of our loans modified in a TDR were performing in accordance with their modified contractual terms and were on accrual status.
Generally, loans modified in a TDR are returned to accrual status after the borrower has demonstrated performance under the modified terms by making six consecutive timely payments. See “Note 4. Allowance for Credit Losses” contained in our unaudited interim consolidated financial statements for more information and a description of the modification programs that we currently offer to our customers.
As noted above, we have begun to provide our borrowers with opportunities to defer payments, or portions thereof. In the absence of intervening factors, such short-term modifications made on a good faith basis are not categorized as troubled debt restructurings, nor are loans granted payment deferrals related to COVID-19 reported as past due or placed on non-accrual status (provided the loans were not past due or on non-accrual status prior to the deferral).
Allowance for Credit Losses for Loans and Leases & Reserve for Unfunded Commitments
We adopted the provisions of Accounting Standards Update (“ASU”) No. 2016-13, Financial Instruments – Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments on January 1, 2020. This guidance changes the accounting for credit losses from an “incurred loss” model, which estimates a loss allowance based on current known and inherent losses within a loan portfolio to an “expected loss” model, which estimates a loss based on losses expected to be recorded over the life of the loan portfolio.
Effective January 1, 2020, we recorded a pre-tax cumulative effect adjustment to increase the ACL by $0.8 million and to increase the reserve for unfunded commitments by $16.3 million. The Company’s ACL under CECL is significantly more dependent on the quantitative model and less on the qualitative assessment, compared to the previous incurred loss model. The increase in the ACL was primarily related to our indirect auto, commercial real estate and consumer loan products. This was partially offset by the decrease in the ACL related to our commercial and industrial, home equity lines and residential real estate loan products. These directional changes were predominantly due to differences between the loss emergence periods previously used under the incurred loss methodology and the remaining life of the loan as required under CECL. The large increase to our reserve for unfunded commitments was primarily due to an increase in utilization rates estimated using our CECL methodology.
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Table 25 presents an analysis of our ACL for the periods indicated:
Table 25
Balance at Beginning of Period
Adjustment to Adopt ASC Topic 326
After Adoption of ASC Topic 326
Loans and Leases Charged-Off
(17,076)
(17,277)
(2,024)
Total Loans and Leases Charged-Off
Recoveries on Loans and Leases Previously Charged-Off
460
118
99
282
Total Recoveries on Loans and Leases Previously Charged-Off
Net Loans and Leases Charged-Off
(23,386)
(6,881)
(29,522)
(12,733)
Provision for Credit Losses - Loans and Leases
Balance at End of Period
Average Loans and Leases Outstanding
13,956,669
13,209,655
13,574,048
13,142,057
Ratio of Net Loans and Leases Charged-Off to Average Loans and Leases Outstanding(1)
0.67
0.21
0.20
Ratio of Allowance for Credit Losses for Loans and Leases to Loans and Leases Outstanding
1.04
Tables 26 and 27 present the allocation of the ACL by loan and lease category, in both dollars and as a percentage of total loans and leases outstanding as of June 30, 2020 and December 31, 2019:
Allocation of the Allowance for Credit Losses by Loan and Lease Category
Table 26
83,534
56,568
41,509
Total Allowance for Credit Losses for Loans and Leases
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Table 27
Allocated
Loan
ACL as
category as
(as a percentage of total loans
% of loan or
% of total
and leases outstanding)
lease category
loans and leases
0.62
24.88
20.76
1.55
24.87
0.64
26.22
0.85
4.49
0.93
3.93
1.61
1.73
1.53
1.08
55.97
0.82
52.44
0.92
26.82
0.78
28.53
6.37
1.11
6.76
0.91
33.19
0.84
35.29
10.84
2.14
12.27
100.00
As of June 30, 2020, the ACL was $192.1 million or 1.40% of total loans and leases outstanding, compared with an ACL of $130.5 million or 0.99% of total loans and leases outstanding as of December 31, 2019. The level of the ACL was commensurate with the adverse impacts that COVID-19 is having on the Hawaii and global economy.
Net charge-offs of loans and leases were $23.4 million, or 0.67% of total average loans and leases on an annualized basis, for the three months ended June 30, 2020 compared to $6.9 million or 0.21% of total average loans and leases, on an annualized basis, for the three months ended June 30, 2019. Net charge-offs in our commercial lending portfolio were $16.9 million and $1.9 million for the three months ended June 30, 2020 and 2019, respectively. The increase in net charge-offs in our commercial lending portfolio was primarily due to $16.0 million in charge-offs related to several loans that have been adversely impacted by the shut-down of the tourism industry in Hawaii. Net recoveries in our residential lending portfolio were nil and $0.2 million for the three months ended June 30, 2020 and 2019, respectively. Net charge-offs in our consumer lending portfolio were $6.5 million and $5.1 million for the three months ended June 30, 2020 and 2019, respectively. Net charge-offs in our consumer portfolio segment include those related to credit cards, automobile loans, installment loans and small business lines of credit and reflect the inherent risk associated with these loans.
Net charge-offs of loans and leases were $29.5 million, or 0.44% of total average loans and leases on an annualized basis, for the six months ended June 30, 2020 compared to $12.7 million or 0.20% of total average loans and leases, on an annualized basis, for the six months ended June 30, 2019. Net charge-offs in our commercial lending portfolio were $16.8 million and $1.9 million for the six months ended June 30, 2020 and 2019, respectively. The increase in net charge-offs in our commercial lending portfolio was primarily due to $16.0 million in charge-offs related to several loans that have been adversely impacted by the shut-down of the tourism industry in Hawaii. Net recoveries in our residential lending portfolio were $0.3 million and $0.4 million for the six months ended June 30, 2020 and 2019, respectively. Our net recovery position in this portfolio segment is largely attributable to rising real estate prices in Hawaii. Net charge-offs in our consumer lending portfolio were $13.0 million and $11.3 million for the six months ended June 30, 2020 and 2019, respectively. Net charge-offs in our consumer portfolio segment include those related to credit card, automobile loans, installment loans and small business lines of credit and reflect the inherent risk associated with these loans.
The increase in the ACL during the second quarter of 2020 was primarily due to the adverse economic impact that COVID-19 is having and is expected to continue to have on the global, national and local economies. Business closures and the ripple effect it has had and will continue to have on unemployment filings is expected to impact the ability of our borrowers to continue to remain current on their loans and leases. As noted earlier, a significant number of our customers (primarily individuals and small businesses) have taken advantage of payment deferral programs in assisting them while they may be temporarily unemployed or where their businesses have closed. We continue to monitor the length and severity of the shut-down of our tourism industry and the re-opening of the Hawaii economy under new guidelines. Once these measures are relaxed, we expect that local consumption of goods and services will begin to resume over an extended period of time. Additionally, the timing and significance of any return of air travel and the Hawaii tourism industry is highly uncertain and is dependent upon the number of cases declining around the globe.
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As of June 30, 2020, the higher allocation of our ACL to our commercial and consumer portfolio segments and the lower allocation to our residential portfolio segment (which is secured by real estate), is primarily due to expected credit losses related to COVID-19 and the impact that it will have on the Hawaii economy, local businesses and our customers. See “Note 4. Allowance for Credit Losses” contained in our unaudited interim consolidated financial statements for more information on the ACL.
Goodwill was $995.5 million as of both June 30, 2020 and December 31, 2019. Our goodwill originated from the acquisition of the Company by BNPP in December of 2001. Goodwill generated in that acquisition was recorded on the balance sheet of the Bank as a result of push down accounting treatment, and remains on our consolidated balance sheets. Goodwill is not amortized but is subject, at a minimum, to annual tests for impairment at a reporting unit level. Determining the amount of goodwill impairment, if any, includes assessing the fair value of the reporting unit and comparing it to the carrying amount of the reporting unit. There was no impairment in our goodwill for the three and six months ended June 30, 2020. Future events, or the continued adverse effect of ongoing events, including the COVID-19 pandemic, that could cause a significant decline in our expected future cash flows or a significant adverse change in our business or the business climate may necessitate taking charges in future reporting periods related to the impairment of our goodwill and other intangible assets.
Other assets were $576.5 million as of June 30, 2020, an increase of $85.9 million or 18% from December 31, 2019. This increase was primarily due to a $107.0 million increase in interest rate swap agreements and a $31.0 million increase in prepaid assets, partially offset by a $30.6 million decrease in current tax receivables and deferred tax assets.
Deposits are the primary funding source for the Bank and are acquired from a broad base of local markets, including both individual and corporate customers. We obtain funds from depositors by offering a range of deposit types, including demand, savings, money market and time.
Table 28 presents the composition of our deposits as of June 30, 2020 and December 31, 2019:
Table 28
Demand
5,727,367
4,998,933
3,247,511
3,055,832
Total Deposits(1)
Total deposits were $19.4 billion as of June 30, 2020, an increase of $2.9 billion or 18% from December 31, 2019. The increase in deposit balances stemmed from a $1.0 billion increase in public time deposit balances, a $1.0 billion increase in demand deposit balances and a $728.4 million increase in savings deposit balances. We increased our liquidity position in anticipation of a surge in funding needs, primarily due to our participation in the PPP.
Short-term and Long-term Borrowings
As of June 30, 2020 and December 31, 2019, short-term borrowings were $200.0 million and $400.0 million, respectively. These short-term FHLB fixed-rate advances have a weighted average interest rate of 2.88% and 2.84%, respectively. The remaining short-term FHLB fixed-rate advance (as of June 30, 2020) matured in July 2020.
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Long-term borrowings were $200.0 million as of both June 30, 2020 and December 31, 2019. The Company’s long-term borrowings included $200.0 million in FHLB fixed-rate advances with a weighted average interest rate of 2.73% and maturity dates ranging from 2023 to 2024. Long-term borrowings mature in excess of one year from the unaudited interim consolidated balance sheet date.
As of June 30, 2020 and December 31, 2019, the available remaining borrowing capacity with the FHLB was $1.9 billion and $1.7 billion, respectively. The FHLB fixed-rate advances and remaining borrowing capacity were secured by residential real estate loan collateral as of June 30, 2020 and December 31, 2019.
Pension and Postretirement Plan Obligations
We have a noncontributory qualified defined benefit pension plan, an unfunded supplemental executive retirement plan, a directors’ retirement plan (a non-qualified pension plan for eligible directors) and a postretirement benefit plan providing life insurance and healthcare benefits that we offer to our directors and employees, as applicable. The noncontributory qualified defined benefit pension plan, the unfunded supplemental executive retirement plan and the directors’ retirement plan are all frozen to new participants. On March 11, 2019, the Company’s board of directors approved an amendment to the SERP to freeze the SERP. As a result of such amendment, effective July 1, 2019, there are no new accruals of benefits, including service accruals. To calculate annual pension costs, we use the following key variables: (1) size of the employee population, length of service and estimated compensation increases; (2) actuarial assumptions and estimates; (3) expected long-term rate of return on plan assets; and (4) discount rate.
Pension and postretirement benefit plan obligations, net of pension plan assets, were $122.1 million as of June 30, 2020, an increase of $0.1 million from December 31, 2019. This increase was primarily due to net periodic benefit costs for the six months ended June 30, 2020 of $4.3 million, offset by payments of $4.2 million.
See “Note 16. Noninterest Income and Noninterest Expense” contained in our unaudited interim consolidated financial statements for more information on our pension and postretirement benefit plans.
Foreign Activities
Cross-border outstandings are defined as loans (including accrued interest), acceptances, interest-bearing deposits with other banks, other interest-bearing investments and any other monetary assets which are denominated in dollars or other non-local currency. As of June 30, 2020, there were no aggregate cross-border outstandings in countries which amounted to 0.75% to 1% of our total consolidated assets. As of December 31, 2019, aggregate cross-border outstandings in countries which amounted to 0.75% to 1% of our total consolidated assets were approximately $174.7 million to Japan and $162.1 million to Canada. There were no cross-border outstandings in excess of 1% of our total consolidated assets as of both June 30, 2020 and December 31, 2019.
The bank regulators currently use a combination of risk-based ratios and a leverage ratio to evaluate capital adequacy. The Company and the Bank are subject to the federal bank regulators’ final rules implementing Basel III and various provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Capital Rules”.)
The Capital Rules, among other things impose a capital measure called “Common Equity Tier 1” (“CET1”), to which most deductions/adjustments to regulatory capital must be made. In addition, the Capital Rules specify that Tier 1 capital consists of CET1 and “Additional Tier 1 capital” instruments meeting certain specified requirements.
Under the Capital Rules, the minimum capital ratios are as follows:
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The Capital Rules also require a 2.5% capital conservation buffer designed to absorb losses during periods of economic stress. The capital conservation buffer is composed entirely of CET1, on top of these minimum risk weighted asset ratios, effectively resulting in minimum ratios of (i) 7% CET1 to risk-weighted assets, (ii) 8.5% Tier 1 capital to risk-weighted assets, and (iii) 10.5% total capital to risk-weighted assets.
As of June 30, 2020, the Company’s capital levels remained characterized as “well capitalized” under the Capital Rules. Our regulatory capital ratios, calculated in accordance with the Capital Rules, are presented in Table 29 below. There have been no conditions or events since June 30, 2020 that management believes have changed either the Company’s or the Bank’s capital classifications.
Regulatory Capital
Table 29
Less:
Common Equity Tier 1 Capital and Tier 1 Capital
Add:
Qualifying allowance for credit losses and reserve for unfunded commitments
174,837
131,130
Total Capital
Risk-Weighted Assets
13,946,442
14,110,799
Key Regulatory Capital Ratios
Total stockholders’ equity was $2.7 billion as of June 30, 2020, an increase of $61.6 million or 2% from December 31, 2019. The increase in stockholders’ equity was primarily due to a net gain in the fair value of our investment securities of $84.6 million and earnings for the period of $58.9 million. This was partially offset by dividends declared and paid to the Company’s stockholders of $67.5 million, the cumulative effect adjustment of a change in an accounting principle of $12.5 million and common stock repurchased of $5.0 million during the six months ended June 30, 2020.
In July 2020, the Company’s Board of Directors declared a quarterly cash dividend of $0.26 per share on our outstanding shares. The dividend will be paid on September 4, 2020 to shareholders of record at the close of business on August 24, 2020.
Off-Balance Sheet Arrangements and Guarantees
Off-Balance Sheet Arrangements
We hold interests in several unconsolidated variable interest entities (“VIEs”). These unconsolidated VIEs are primarily low income housing tax credit investments in partnerships and limited liability companies. Variable interests are defined as contractual ownership or other interest in an entity that change with fluctuations in an entity’s net asset value. The primary beneficiary consolidates the VIE. Based on our analysis, we have determined that the Company is not the primary beneficiary of these entities. As a result, we do not consolidate these VIEs.
We sell residential mortgage loans on the secondary market, primarily to Fannie Mae or Freddie Mac. The agreements under which we sell residential mortgage loans to Fannie Mae or Freddie Mac contain provisions that include various representations and warranties regarding the origination and characteristics of the residential mortgage loans. Although the specific representations and warranties vary among investors, insurance or guarantee agreements, they typically cover ownership of the loan, validity of the lien securing the loan, the absence of delinquent taxes or liens against the property securing the loan, compliance with loan criteria set forth in the applicable agreement, compliance with applicable federal, state and local laws and other matters. As of both June 30, 2020 and December 31, 2019, the unpaid principal balance of our portfolio of residential mortgage loans sold was $2.3 billion. The agreements under which we sell residential mortgage loans
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require delivery of various documents to the investor or its document custodian. Although these loans are primarily sold on a non-recourse basis, we may be obligated to repurchase residential mortgage loans or reimburse investors for losses incurred if a loan review reveals that underwriting and documentation standards were potentially not met in the origination of those loans. Upon receipt of a repurchase request, we work with investors to arrive at a mutually agreeable resolution. Repurchase demands are typically reviewed on an individual loan by loan basis to validate the claims made by the investor to determine if a contractually required repurchase event has occurred. We manage the risk associated with potential repurchases or other forms of settlement through our underwriting and quality assurance practices and by servicing mortgage loans to meet investor and secondary market standards. For the six months ended June 30, 2020, there was one repurchase of a residential mortgage loan of $0.3 million and there were no pending repurchase requests.
In addition to servicing loans in our portfolio, substantially all of the loans we sell to investors are sold with servicing rights retained. We also service loans originated by other mortgage loan originators. As servicer, our primary duties are to: (1) collect payments due from borrowers; (2) advance certain delinquent payments of principal and interest; (3) maintain and administer any hazard, title or primary mortgage insurance policies relating to the mortgage loans; (4) maintain any required escrow accounts for payment of taxes and insurance and administer escrow payments; and (5) foreclose on defaulted mortgage loans, or loan modifications or short sales. Each agreement under which we act as servicer generally specifies a standard of responsibility for actions taken by the Company in such capacity and provides protection against expenses and liabilities incurred by the Company when acting in compliance with the respective servicing agreements. However, if we commit a material breach of obligations as servicer, we may be subject to termination if the breach is not cured within a specified period following notice. The standards governing servicing and the possible remedies for violations of such standards vary by investor. These standards and remedies are determined by servicing guides issued by the investors as well as the contract provisions established between the investors and the Company. Remedies could include repurchase of an affected loan. For the six months ended June 30, 2020, we had no repurchase requests related to loan servicing activities, nor were there any pending repurchase requests as of June 30, 2020.
Although to date repurchase requests related to representation and warranty provisions and servicing activities have been limited, it is possible that requests to repurchase mortgage loans may increase in frequency as investors more aggressively pursue all means of recovering losses on their purchased loans. However, as of June 30, 2020, management believes that this exposure is not material due to the historical level of repurchase requests and loss trends and thus has not established a liability for losses related to mortgage loan repurchases. As of June 30, 2020, 97% of our residential mortgage loans serviced for investors were current. We maintain ongoing communications with investors and continue to evaluate this exposure by monitoring the level and number of repurchase requests as well as the delinquency rates in loans sold to investors.
Contractual Obligations
Our contractual obligations have not changed materially since previously reported as of December 31, 2019.
Future Application of Accounting Pronouncements
For a discussion of the expected impact of accounting pronouncements recently issued but not adopted by us as of June 30, 2020, see “Note 1. Organization and Basis of Presentation — Recent Accounting Pronouncements” to the unaudited interim consolidated financial statements for more information.
Risk Governance and Quantitative and Qualitative Disclosures About Market Risk
Managing risk is an essential part of successfully operating our business. Management believes that the most prominent risk exposures for the Company are credit risk, market risk, liquidity risk management, capital management and operational risk. See “Analysis of Financial Condition — Liquidity” and “—Capital” sections of this MD&A for further discussions of liquidity risk management and capital management, respectively.
Credit Risk
Credit risk is the risk that borrowers or counterparties will be unable or unwilling to repay their obligations in accordance with the underlying contractual terms. We manage and control credit risk in the loan and lease portfolio by adhering to well-defined underwriting criteria and account administration standards established by management. Written credit policies document underwriting standards, approval levels, exposure limits and other limits or standards deemed necessary and prudent. Portfolio diversification at the obligor, industry, product, and/or geographic location levels is actively managed to
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mitigate concentration risk. In addition, credit risk management includes an independent credit review process that assesses compliance with commercial, real estate and consumer credit policies, risk ratings and other critical credit information. In addition to implementing risk management practices that are based upon established and sound lending practices, we adhere to sound credit principles. We understand and evaluate our customers’ borrowing needs and capacity to repay, in conjunction with their character and history.
Management has identified three categories of loans that we use to develop our systematic methodology to determine the Allowance: commercial, residential and consumer.
Commercial lending is further categorized into four distinct classes based on characteristics relating to the borrower, transaction and collateral. These classes are: commercial and industrial, commercial real estate, construction and lease financing. Commercial and industrial loans are primarily for the purpose of financing equipment acquisition, expansion, working capital and other general business purposes by medium to larger Hawaii based corporations, as well as U.S. mainland and international companies. Commercial and industrial loans are typically secured by non-real estate assets whereby the collateral is trading assets, enterprise value or inventory. As with many of our customers, our commercial and industrial loan customers are heavily dependent on tourism, government expenditures and real estate values. Commercial real estate loans are secured by real estate, including but not limited to structures and facilities to support activities designated as retail, health care, general office space, warehouse and industrial space. Our Bank’s underwriting policy generally requires that net cash flows from the property be sufficient to service the debt while still maintaining an appropriate amount of reserves. Commercial real estate loans in Hawaii are characterized by having a limited supply of real estate at commercially attractive locations, long delivery time frames for development and high interest rate sensitivity. Our construction lending portfolio consists primarily of land loans, single family and condominium development loans. Financing of construction loans is subject to a high degree of credit risk given the long delivery time frames for such projects. Construction lending activities are underwritten on a project financing basis whereby the cash flows or lease rents from the underlying real estate collateral or the sale of the finished inventory is the primary source of repayment. Market feasibility analysis is typically performed by assessing market comparables, market conditions and demand in the specific lending area and general community. We require presales of finished inventory prior to loan funding. However, because this analysis is typically performed on a forward looking basis, real estate construction projects typically present a higher risk profile in our lending activities. Lease financing activities include commercial single investor leases and leveraged leases used to purchase items ranging from computer equipment to transportation equipment. Underwriting of new leasing arrangements typically includes analyzing customer cash flows, evaluating secondary sources of repayment, such as the value of the leased asset, the guarantors’ net cash flows as well as other credit enhancements provided by the lessee.
Residential lending is further categorized into the following classes: residential mortgages (loans secured by 1-4 family residential properties and home equity loans) and home equity lines of credit. Our Bank’s underwriting standards typically require LTV ratios of not more than 80%, although higher levels are permitted with accompanying mortgage insurance. First mortgage loans secured by residential properties generally carry a moderate level of credit risk, with an average loan size of approximately $352,000. Residential mortgage loan production is added to our loan portfolio or is sold in the secondary market, based on management’s evaluation of our liquidity, capital and loan portfolio mix as well as market conditions. Changes in interest rates, the economic environment and other market factors have impacted, and will likely continue to impact, the marketability and value of collateral and the financial condition of our borrowers which impacts the level of credit risk inherent in this portfolio, although we remain in a supply constrained housing environment in Hawaii. Geographic concentrations exist for this portfolio as nearly all residential mortgage loans and home equity lines of credit are for residences located in Hawaii, Guam or Saipan. These island locales are susceptible to a wide array of potential natural disasters including, but not limited to, hurricanes, floods, tsunamis and earthquakes. We offer home equity lines of credit with variable rates; fixed rate lock options may be available post-closing. All lines are underwritten at 2% over the fully indexed rate. Our procedures for underwriting home equity lines of credit include an assessment of an applicant’s overall financial capacity and repayment ability. Decisions are primarily based on repayment ability via debt-to-income ratios, LTV ratios and an evaluation of credit history.
Consumer lending is further categorized into the following classes of loans: credit cards, automobile loans and other consumer-related installment loans. Consumer loans are either unsecured or secured by the borrower’s personal assets. The average loan size is generally small and risk is diversified among many borrowers. We offer a wide array of credit cards for business and personal use. In general, our customers are attracted to our credit card offerings on the basis of price, credit limit, reward programs and other product features. Credit card underwriting decisions are generally based on repayment ability of our borrower via DTI ratios, credit bureau information, including payment history, debt burden and credit scores, such as FICO, and analysis of financial capacity. Automobile lending activities include loans and leases secured by new or
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used automobiles. We originate the majority of our automobile loans and leases on an indirect basis through selected dealerships. Our procedures for underwriting automobile loans include an assessment of an applicant’s overall financial capacity and repayment ability, credit history and the ability to meet existing obligations and payments on the proposed loan or lease. Although an applicant’s creditworthiness is the primary consideration, the underwriting process also includes a comparison of the value of the collateral security to the proposed loan amount. We require borrowers to maintain full coverage automobile insurance on automobile loans and leases, with the Bank listed as either the loss payee or additional insured. Installment loans consist of open and closed end facilities for personal and household purchases. We seek to maintain reasonable levels of risk in installment lending by following prudent underwriting guidelines which include an evaluation of personal credit history and cash flow.
In addition to geographic concentration risk, we also monitor our exposure to industry risk. While the Bank, our customers and our results of operations could be adversely impacted by events affecting the tourism industry, we also monitor our other industry exposures, including, but not limited to, our exposures in the oil, gas and energy industries. As of June 30, 2020 and December 31, 2019, we did not have material exposures to customers in the oil, gas and energy industries.
Market Risk
Market risk is the potential of loss arising from changes in interest rates, foreign exchange rates, equity prices and commodity prices, including the correlation among these factors and their volatility. When the value of an instrument is tied to such external factors, the holder faces market risk. We are exposed to market risk primarily from interest rate risk, which is defined as the risk of loss of net interest income or net interest margin because of changes in interest rates.
The potential cash flows, sales or replacement value of many of our assets and liabilities, especially those that earn or pay interest, are sensitive to changes in the general level of interest rates. In the banking industry, changes in interest rates can significantly impact earnings and the safety and soundness of an entity.
Interest rate risk arises primarily from our core business activities of extending loans and accepting deposits. This occurs when our interest earning loans and interest bearing deposits mature or reprice at different times, on a different basis or in unequal amounts. Interest rates may also affect loan demand, credit losses, mortgage origination volume, pre- payment speeds and other items affecting earnings.
Many factors affect our exposure to changes in interest rates, such as general economic and financial conditions, customer preferences, historical pricing relationships and repricing characteristics of financial instruments. Our earnings are affected not only by general economic conditions, but also by the monetary and fiscal policies of the United States and its agencies, particularly the Federal Reserve. The monetary policies of the Federal Reserve can influence the overall growth of loans, investment securities and deposits and the level of interest rates earned on assets and paid for liabilities.
Market Risk Measurement
We primarily use net interest income simulation analysis to measure and analyze interest rate risk. We run various hypothetical interest rate scenarios and compare these results against a measured base case scenario. Our net interest income simulation analysis incorporates various assumptions, which we believe are reasonable but which may have a significant impact on results. These assumptions include: (1) the timing of changes in interest rates, (2) shifts or rotations in the yield curve, (3) re-pricing characteristics for market rate sensitive instruments on and off-balance sheet, (4) differing sensitivities of financial instruments due to differing underlying rate indices and (5) varying loan prepayment speeds for different interest rate scenarios. Because of limitations inherent in any approach used to measure interest rate risk, simulation results are not intended as a forecast of the actual effect of a change in market interest rates on our results but rather as a means to better plan and execute appropriate asset liability management strategies to manage our interest rate risk.
Table 30 presents, for the twelve months subsequent to June 30, 2020 and December 31, 2019, an estimate of the changes in net interest income that would result from ramps (gradual changes) and shocks (immediate changes) in market interest rates, moving in a parallel fashion over the entire yield curve, relative to the measured base case scenario. Ramp scenarios assume interest rates move gradually in parallel across the yield curve relative to the base case scenario. Shock scenarios assume an immediate and sustained parallel shift in interest rates across the entire yield curve, relative to the base case scenario. The base case scenario assumes that the balance sheet and interest rates are generally unchanged. We evaluate the sensitivity by using a static forecast, where the balance sheets as of June 30, 2020 and December 31, 2019 are held constant.
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Net Interest Income Sensitivity Profile - Estimated Percentage Change Over 12 Months
Table 30
Static Forecast
Ramp Change in Interest Rates (basis points)
+100
+50
(50)
(1.7)
(100)
(4.4)
Immediate Change in Interest Rates (basis points)
11.5
5.8
4.4
(3.2)
(9.6)
The table above shows the effects of a simulation which estimates the effect of a gradual and immediate sustained parallel shift in the yield curve of −100, −50, +50 and +100 basis points in market interest rates over a twelve-month period on our net interest income.
Currently, our interest rate profile is such that we project net interest income will benefit from higher interest rates as our assets would reprice faster and to a greater degree than our liabilities, while in the case of lower interest rates, our assets would reprice downward and to a greater degree than our liabilities.
Under the static balance sheet forecast as of June 30, 2020, our net interest income sensitivity profile is more sensitive in higher interest rate scenarios and less sensitive in lower interest rate scenarios as compared to similar forecasts as of December 31, 2019. The sensitivity impacts described above are primarily due to holding a larger federal funds position and market interest rates being lower as of June 30, 2020 as compared with December 31, 2019. A larger federal funds position has the effect of magnifying the impact of higher interest rate scenarios. Lower market interest rates have the effect of higher prepayments on loans and investment securities and reinvestments which occur at lower rates. Because market interest rates have been approaching an interest rate floor, this dampens the impact of the lower interest rate scenarios for both ramp and shock scenarios.
The comparisons above provide insight into the potential effects of changes in interest rates on net interest income. The Company believes that its approach to interest rate risk has appropriately considered its susceptibility to both rising and falling rates and has adopted strategies which minimize the impact of such risks.
We also have longer term interest rate risk exposures which may not be appropriately measured by net interest income simulation analysis. We use market value of equity (“MVE”) sensitivity analysis to study the impact of long-term cash flows on earnings and capital. MVE involves discounting present values of all cash flows of on-balance sheet and off-balance sheet items under different interest rate scenarios. The discounted present value of all cash flows represents our MVE. MVE analysis requires modifying the expected cash flows in each interest rate scenario, which will impact the discounted present value. The amount of base case measurement and its sensitivity to shifts in the yield curve allow management to measure longer term repricing option risk in the balance sheet.
Limitations of Market Risk Measures
The results of our simulation analyses are hypothetical, and a variety of factors might cause actual results to differ substantially from what is depicted. For example, if the timing and magnitude of interest rate changes differ from those projected, our net interest income might vary significantly. Non parallel yield curve shifts such as a flattening or steepening of the yield curve or changes in interest rate spreads would also cause our net interest income to be different from that depicted. An increasing interest rate environment could reduce projected net interest income if deposits and other short-term liabilities re-price faster than expected or faster than our assets re-price. Actual results could differ from those projected if we grow assets and liabilities faster or slower than estimated, if we experience a net outflow of deposits or if our mix of assets and liabilities otherwise changes. For example, while we maintain relatively high levels of liquidity, a faster than expected withdrawal of deposits out of the bank may cause us to seek higher cost sources of funding. Actual results could also differ from those projected if we experience substantially different prepayment speeds in our loan portfolio than those assumed in
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the simulation analyses. Finally, these simulation results do not consider all the actions that we may undertake in response to potential or actual changes in interest rates, such as changes to our loan, investment, deposit, funding or hedging strategies.
Market Risk Governance
We seek to achieve consistent growth in net interest income and capital while managing volatility arising from changes in market interest rates. The objective of our interest rate risk management process is to increase net interest income while operating within acceptable limits established for interest rate risk and maintaining adequate levels of funding and liquidity.
To manage the impact on net interest income, we manage our exposure to changes in interest rates through our asset and liability management activities within guidelines established by our ALCO and approved by our board of directors. The ALCO has the responsibility for approving and ensuring compliance with the ALCO management policies, including interest rate risk exposures. The objective of our interest rate risk management process is to maximize net interest income while operating within acceptable limits established for interest rate risk and maintaining adequate levels of funding and liquidity.
Through review and oversight by the ALCO, we attempt to engage in strategies that neutralize interest rate risk as much as possible. Our use of derivative financial instruments, as detailed in “Note 12. Derivative Financial Instruments” to the unaudited interim consolidated financial statements, has generally been limited. This is due to natural on balance sheet hedges arising out of offsetting interest rate exposures from loans and investment securities with deposits and other interest-bearing liabilities. In particular, the investment securities portfolio is utilized to manage the interest rate exposure and sensitivity to within the guidelines and limits established by the ALCO. We utilize natural and offsetting economic hedges in an effort to reduce the need to employ off-balance sheet derivative financial instruments to hedge interest rate risk exposures. Expected movements in interest rates are also considered in managing interest rate risk. Thus, as interest rates change, we may use different techniques to manage interest rate risk.
Management uses the results of its various simulation analyses to formulate strategies to achieve a desired risk profile within the parameters of our capital and liquidity guidelines.
Operational Risk
Operational risk is the risk of loss arising from inadequate or failed processes, people or systems, external events (such as natural disasters), or compliance, reputational or legal matters, including the risk of loss resulting from fraud, litigation and breaches in data security. Operational risk is inherent in all of our business ventures and the management of that risk is important to the achievement of our objectives. We have a framework in place that includes the reporting and assessment of any operational risk events, and the assessment of our mitigating strategies within our key business lines. This framework is implemented through our policies, processes and reporting requirements. We measure and report operational risk using the seven operational risk event types projected by the Basel Committee on Banking Supervision in Basel II: (1) external fraud; (2) internal fraud; (3) employment practices and workplace safety; (4) clients, products and business practices; (5) damage to physical assets; (6) business disruption and system failures; and (7) execution, delivery and process management. Our operational risk review process is also a core part of our assessment of material new products or activities.
Critical Accounting Policies
Our interim consolidated financial statements were prepared in accordance with GAAP and follow general practices within the industries in which we operate. The most significant accounting policies we follow are presented in “Note 1. Organization and Summary of Significant Accounting Policies” in the notes to the consolidated financial statements included in our Form 10-K for the year ended December 31, 2019. Application of these principles requires us to make estimates, assumptions and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. Most accounting policies are not considered by management to be critical accounting policies. Several factors are considered in determining whether or not a policy is critical in the preparation of the consolidated financial statements. These factors include among other things, whether the policy requires management to make difficult, subjective and complex judgments about matters that are inherently uncertain and because it is likely that materially different amounts would be reported under different conditions or using different assumptions. The accounting policies which we believe to be most critical in preparing our consolidated financial statements are those that are related to the determination of the ACL, fair value estimates, pension and postretirement benefit obligations and income taxes. An updated discussion of the ACL is presented below as a result of our adoption of the CECL standard on January 1, 2020.
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Management's evaluation of the adequacy of the ACL is often the most critical of accounting estimates for a financial institution. Our determination of the amount of the ACL is a critical accounting estimate as it requires significant reliance on the accuracy of credit risk ratings on individual borrowers, the use of estimates and significant judgment as to the amount and timing of expected future cash flows on impaired loans, significant reliance on estimated loss rates on portfolios and consideration of our quantitative and qualitative evaluation of macro-economic factors and trends. While our methodology in establishing the ACL attributes portions of the ACL to the commercial, residential real estate and consumer portfolio segments, the entire ACL is available to absorb credit losses in the total loan and lease portfolio.
The ACL is a valuation account that is deducted from the amortized cost basis of loans and leases to present the net amount expected to be collected from loans and leases. Loans and leases are charged-off against the ACL when management believes the uncollectibility of a loan or lease balance is confirmed. Expected recoveries do not exceed the aggregate of amounts previously charged-off and expected to be charged-off. Changes in the ACL and, therefore, in the related Provision, can materially affect net income. In applying the judgment and review required to determine the ACL, management considers changes in economic conditions, customer behavior, and collateral value, among other factors. From time to time, economic factors or business decisions may affect the composition and mix of the loan and lease portfolio, causing management to increase or decrease the ACL.
The following are some of the significant judgments and inherent limitations which affect the estimate of the ACL:
See “Note 1. Organization and Basis of Presentation” and “Note 4. Allowance for Credit Losses” in the notes to the interim consolidated financial statements for more information on the ACL.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See “Part I, Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Risk Governance and Quantitative and Qualitative Disclosures About Market Risk.”
ITEM 4. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
The Company’s management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of June 30, 2020. The Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2020
Changes in Internal Control over Financial Reporting
There were no changes in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarter ended June 30, 2020 that have materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting.
PART II – OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company operates in a highly regulated environment. From time to time, the Company is party to various litigation matters incidental to the conduct of our business. We are not presently party to any legal proceedings the resolution of which we believe would have a material adverse effect on our business, prospects, financial condition, liquidity, results of operation, cash flows or capital levels.
ITEM 1A. RISK FACTORS
Item 1A of Part I of the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, filed with the SEC on February 27, 2020, and Item 1A of the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2020, filed with the SEC on May 8, 2020, contain a discussion of our risk factors. Except to the extent that additional factual information disclosed in this Quarterly Report on Form 10-Q relates to such risk factors, there are no material changes from the risk factors as disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019 and the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2020.
ITEM 6. EXHIBITS
A list of exhibits to this Form 10-Q is set forth on the Exhibit Index and is incorporated herein by reference.
Exhibit Number
31.1
Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as Amended, Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as Amended, Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1
Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2
Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS
XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document
101.SCH
Inline XBRL Taxonomy Extension Schema Document
101.CAL
Inline XBRL Taxonomy Extension Calculation Linkbase Document
101.LAB
Inline XBRL Taxonomy Extension Label Linkbase Document
101.PRE
Inline XBRL Taxonomy Extension Presentation Linkbase Document
101.DEF
Inline XBRL Taxonomy Extension Definition Linkbase Document
104
Cover Page Interactive Data File – the cover page XBRL tags are embedded within the Inline XBRL document (included in Exhibit 101)
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: August 3, 2020
By:
/s/ Robert S. Harrison
Robert S. Harrison
Chairman of the Board, President and Chief Executive Officer
(Principal Executive Officer)
/s/ Ravi Mallela
Ravi Mallela
Chief Financial Officer
(Principal Financial Officer and Principal Accounting Officer)