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 March 31, 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: 001-37497
LIVE OAK BANCSHARES, INC.
(Exact name of registrant as specified in its charter)
North Carolina
26-4596286
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
1741 Tiburon Drive
Wilmington, North Carolina
28403
(Address of principal executive offices)
(Zip Code)
(910) 790-5867
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
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 registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES ☐ NO ☒
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Trading Symbol(s)
Name of each exchange on which registered
Voting Common Stock, no par value per share
LOB
The NASDAQ Stock Market LLC
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
As of May 5, 2020, there were 37,793,904 shares of the registrant’s voting common stock outstanding and 2,715,531 shares of the registrant’s non-voting common stock outstanding.
Live Oak Bancshares, Inc.
Form 10-Q
For the Quarterly Period Ended March 31, 2020
TABLE OF CONTENTS
Page
PART I. FINANCIAL INFORMATION
Item 1.
Financial Statements (Unaudited)
1
Condensed Consolidated Balance Sheets as of March 31, 2020 and December 31, 2019
Condensed Consolidated Statements of Income for the Three Months Ended March 31, 2020 and 2019
2
Condensed Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2020 and 2019
3
Condensed Consolidated Statements of Changes in Shareholders’ Equity for the Three Months Ended March 31, 2020 and 2019
4
Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2020 and 2019
5
Notes to Unaudited Condensed Consolidated Financial Statements
7
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
36
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
53
Item 4.
Controls and Procedures
PART II. OTHER INFORMATION
Legal Proceedings
54
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
56
Defaults Upon Senior Securities
Mine Safety Disclosures
Item 5.
Other Information
Item 6.
Exhibits
57
Index to Exhibits
Signatures
58
Item 1. Financial Statements
Condensed Consolidated Balance Sheets
As of March 31, 2020 (unaudited) and December 31, 2019*
(Dollars in thousands)
March 31,
2020
December 31,
2019
Assets
Cash and due from banks
$
256,824
126,752
Federal funds sold
158,226
96,787
Certificates of deposit with other banks
7,250
Investment securities available-for-sale
574,168
540,045
Loans held for sale (includes $19,151 and $16,198 measured at fair value,
respectively)
996,050
966,447
Loans and leases held for investment (includes $831,426 and $824,520 measured
at fair value, respectively)
2,817,491
2,627,286
Allowance for credit losses on loans and leases
(35,906
)
(28,234
Net loans and leases
2,781,585
2,599,052
Premises and equipment, net
274,177
279,099
Foreclosed assets
6,744
5,612
Servicing assets
33,532
35,365
Operating lease right-of-use assets
2,236
2,427
Other assets
185,524
156,134
Total assets
5,276,316
4,814,970
Liabilities and Shareholders’ Equity
Liabilities
Deposits:
Noninterest-bearing
54,022
54,107
Interest-bearing
4,588,126
4,175,015
Total deposits
4,642,148
4,229,122
Borrowings
50,012
14
Operating lease liabilities
2,416
2,619
Other liabilities
47,968
50,829
Total liabilities
4,742,544
4,282,584
Shareholders’ equity
Preferred stock, no par value, 1,000,000 authorized, none issued or outstanding
at March 31, 2020 and December 31, 2019
—
Class A common stock, no par value, 100,000,000 shares authorized, 37,664,670
and 37,401,443 shares issued and outstanding at March 31, 2020 and
December 31, 2019, respectively
314,994
309,526
Class B common stock, no par value, 10,000,000 shares authorized, 2,715,531 and
2,915,531 shares issued and outstanding at March 31, 2020 and December 31, 2019,
respectively
28,753
30,871
Retained earnings
172,276
180,265
Accumulated other comprehensive income
17,749
11,724
Total shareholders’ equity
533,772
532,386
Total liabilities and shareholders’ equity
*Derived from audited consolidated financial statements.
See Notes to Unaudited Condensed Consolidated Financial Statements
Condensed Consolidated Statements of Income
For the three months ended March 31, 2020 and 2019 (unaudited)
(Dollars in thousands, except per share data)
Three Months Ended
Interest income
Loans and fees on loans
58,961
44,966
Investment securities, taxable
3,762
3,317
Other interest earning assets
750
1,639
Total interest income
63,473
49,922
Interest expense
Deposits
23,255
19,317
Total interest expense
23,312
Net interest income
40,161
30,605
Provision for loan and lease credit losses
11,792
3,031
Net interest income after provision for loan and lease credit losses
28,369
27,574
Noninterest income
Loan servicing revenue
6,422
7,410
Loan servicing asset revaluation
(4,692
(4,040
Net gains on sales of loans
11,112
4,198
Net (loss) gain on loans accounted for under the fair value option
(10,638
2,083
Equity method investments income (loss)
(2,478
(2,014
Equity security investments (losses) gains, net
(64
103
(Loss) gain on sale of investment securities available-for-sale
(79
Lease income
2,624
2,325
Management fee income
1,644
Construction supervision fee income
390
779
Other noninterest income
1,501
2,467
Total noninterest income
5,742
13,316
Noninterest expense
Salaries and employee benefits
28,063
21,855
Travel expense
1,781
1,200
Professional services expense
1,937
2,182
Advertising and marketing expense
1,361
1,364
Occupancy expense
2,421
1,609
Data processing expense
3,157
2,399
Equipment expense
4,635
3,325
Other loan origination and maintenance expense
2,456
FDIC insurance
1,510
635
Other expense
2,170
1,993
Total noninterest expense
49,491
38,201
(Loss) income before taxes
(15,380
2,689
Income tax (benefit) expense
(7,778
317
Net (loss) income
(7,602
2,372
Basic (loss) earnings per share
(0.19
0.06
Diluted (loss) earnings per share
Condensed Consolidated Statements of Comprehensive Income
Other comprehensive income before tax:
Net unrealized gain on investment securities
arising during the period
7,849
3,518
Reclassification adjustment for loss (gain) on sale of
securities available-for-sale included in net income
79
(5
Other comprehensive income before tax
7,928
3,513
Income tax expense
(1,903
(843
Other comprehensive income, net of tax
6,025
2,670
Total comprehensive (loss) income
(1,577
5,042
Condensed Consolidated Statements of Changes in Shareholders’ Equity
Common stock
Accumulated
other
Shares
Retained
comprehensive
Total
Class A
Class B
Amount
earnings
income (loss)
equity
Balance at December 31, 2019
37,401,443
2,915,531
340,397
Net loss
Other comprehensive income
Issuance of restricted stock
7,424
Withholding cash issued in lieu of
restricted stock issuance
(48
Employee stock purchase program
25,161
232
Stock option exercises
30,642
258
Stock option based compensation expense
366
Restricted stock expense
2,542
Non-voting common stock converted to
voting common stock in private sale
200,000
(200,000
Cumulative effect of accounting change for
Accounting Standards Update 2016-13
822
Cash dividends ($0.03 per share)
(1,209
Balance at March 31, 2020
37,664,670
2,715,531
343,747
Balance at December 31, 2018
35,512,262
4,643,530
328,113
167,124
(1,677
493,560
Net income
2,140
14,059
182
3,088
470
2,388
Accounting Standards Update 2016-02
(66
(1,205
Balance at March 31, 2019
35,531,549
331,162
168,225
993
500,380
Condensed Consolidated Statements of Cash Flows
Cash flows from operating activities
Adjustments to reconcile net (loss) income to net cash used by operating activities:
Depreciation and amortization
5,621
4,034
Amortization of premium on securities, net of accretion
269
105
Deferred tax expense (benefit)
1,264
(632
Originations of loans held for sale
(274,678
(206,440
Proceeds from sales of loans held for sale
203,340
80,931
Net gains on sale of loans held for sale
(11,112
(4,198
Net loss on sale of foreclosed assets
49
Net loss (gain) on loans accounted for under fair value option
10,638
(2,083
Net decrease in servicing assets
1,833
Loss (gain) on sale of securities available-for-sale
Net gain on disposal of long-lived asset
(357
Net loss on disposal of property and equipment
38
Equity method investments (income) loss
2,478
2,014
Equity security investments losses (gains), net
64
(103
Stock based compensation expense tax shortfall
(34
(8
Changes in assets and liabilities:
Lease right-of-use assets and liabilities, net
(12
114
(31,962
7,867
(6,493
(605
Net cash used by operating activities
(91,520
(107,788
Cash flows from investing activities
Purchases of securities available-for-sale
(52,757
(198,384
Proceeds from sales, maturities, calls, and principal paydown of
securities available-for-sale
26,214
12,548
Proceeds from SBA reimbursement/sale of foreclosed assets
613
393
Loan and lease originations and principal collections, net
(152,559
(113,064
Proceeds from sale of long-lived asset
10,895
Purchases of premises and equipment, net
(737
(13,315
Net cash used by investing activities
(179,226
(300,927
Condensed Consolidated Statements of Cash Flows (Continued)
Cash flows from financing activities
Net increase in deposits
413,026
378,822
Proceeds from borrowings
50,000
Repayment of borrowings
(2
(49
Withholding cash issued in lieu of restricted stock
Shareholder dividend distributions
Net cash provided by financing activities
462,257
377,759
Net increase (decrease) in cash and cash equivalents
191,511
(30,956
Cash and cash equivalents, beginning
223,539
316,823
Cash and cash equivalents, ending
415,050
285,867
Supplemental disclosures of cash flow information
Interest paid
23,858
17,837
Income tax paid (received)
362
(13,654
Supplemental disclosures of noncash operating, investing, and financing activities
Unrealized holding gains on available-for-sale securities, net of taxes
Transfers from loans and leases to foreclosed real estate and other repossessions
1,764
707
Net transfers between foreclosed real estate and SBA receivable
30
Right-of-use assets obtained in exchange for lessee operating lease liabilities
2,241
Transfer of loans held for sale to loans and leases held for investment
35,233
50,055
Transfer of loans and leases held for investment to loans held for sale
2,949
8,845
6
Note 1. Basis of Presentation
Nature of Operations
Live Oak Bancshares, Inc. (the “Company” or “LOB”) is a bank holding company headquartered in Wilmington, North Carolina incorporated under the laws of North Carolina in December 2008. The Company conducts business operations primarily through its commercial bank subsidiary, Live Oak Banking Company (the “Bank”). The Bank was organized and incorporated under the laws of the State of North Carolina on February 25, 2008 and commenced operations on May 12, 2008. The Bank specializes in providing lending services to small businesses nationwide. The Bank identifies and grows lending to credit-worthy borrowers both within specific industries, also called verticals, through expertise within those industries, and more broadly to select borrowers outside of those industries. A significant portion of the loans originated by the Bank are guaranteed by the Small Business Administration (“SBA”) under the 7(a) Loan Program and the U.S. Department of Agriculture ("USDA") Rural Energy for America Program ("REAP"), Water and Environmental Program (“WEP”) and Business & Industry ("B&I") loan programs.
The Bank’s wholly owned subsidiaries are Live Oak Number One, Inc., Live Oak Clean Energy Financing LLC (“LOCEF”), and Live Oak Private Wealth, LLC.
The Company’s wholly owned subsidiaries are the Bank, Government Loan Solutions (“GLS”), Live Oak Grove, LLC (“the Grove”), Live Oak Ventures, Inc. (“Live Oak Ventures”), and Canapi Advisors, LLC (“Canapi”).
Live Oak Number One, Inc. holds properties foreclosed on by the Bank. GLS is a management and technology consulting firm that advises and offers solutions and services to participants in the government guaranteed lending sector. GLS primarily provides services in connection with the settlement, accounting, and securitization processes for government guaranteed loans, including loans originated under the SBA 7(a) loan programs and USDA guaranteed loans. The Grove provides Company employees and business visitors an on-site restaurant location. Live Oak Ventures’ purpose is investing in businesses that align with the Company's strategic initiative to be a leader in financial technology. LOCEF provides financing to entities for renewable energy applications and became a wholly owned subsidiary of the Bank during the first quarter of 2019. Live Oak Private Wealth, LLC provides high-net-worth individuals and families with strategic wealth and investment management services. Canapi provides investment advisory services to a series of new funds focused on providing venture capital to new and emerging financial technology companies.
The Company jointly formed 504 Fund Advisors, LLC (“504FA”) to serve as the investment adviser for the 504 Fund, a closed-end mutual fund organized to invest in SBA section 504 loans. 504FA exited as advisor for the 504 Fund in May 2019 and the Company subsequently dissolved this legal entity.
The Company generates revenue primarily from net interest income and secondarily through the origination and sale of government guaranteed loans. Income from the retention of loans is comprised of interest income. The Company elects to account for certain loans under the fair value option with interest reported in interest income and changes in fair value reported in the net (loss) gain on loans accounted for under the fair value option line item of the consolidated statements of income. Income from the sale of loans is comprised of loan servicing revenue and revaluation of related servicing assets along with net gains on sales of loans. Offsetting these revenues are the cost of funding sources, provision for loan and lease credit losses, any costs related to foreclosed assets and other operating costs such as salaries and employee benefits, travel, professional services, advertising and marketing and tax expense.
General
In the opinion of management, all adjustments necessary for a fair presentation of the financial position and results of operations for the periods presented have been included, and all intercompany transactions have been eliminated in consolidation. Results of operations for the three months ended March 31, 2020 are not necessarily indicative of the results of operations that may be expected for the year ending December 31, 2020. The condensed consolidated balance sheet as of December 31, 2019 has been derived from the audited consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2019, filed with the Securities Exchange Commission on February 27, 2020 (SEC File No. 001-37497) (the "2019 Annual Report"). A summary description of the significant accounting policies followed by the Company is set forth in Note 1 of the Notes to Consolidated Financial Statements in the Company’s 2019 Annual Report. These unaudited interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes in the Company's 2019 Annual Report.
The preparation of financial statements in conformity with United States generally accepted accounting principles, or GAAP, requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. Actual results could differ significantly from those estimates.
Amounts in all tables in the Notes to Unaudited Condensed Consolidated Financial Statements have been presented in thousands, except percentage, time period, stock option, share and per share data or where otherwise indicated.
Business Segments
Management has determined that the Company has one significant operating segment, which is providing a lending platform for small businesses nationwide. In determining the appropriateness of segment definition, the Company considers the materiality of a potential segment, the components of the business about which financial information is available, and components for which management regularly evaluates relative to resource allocation and performance assessment.
Reclassifications
Certain reclassifications have been made to the prior period’s consolidated financial statements to place them on a comparable basis with the current year. Net income and shareholders’ equity previously reported were not affected by these reclassifications. Current period reclassifications were primarily related to fair value presentation requirements for loans in which the fair value option had previously been elected and included a reclassification of amounts representing the credit component of the fair value discount that was previously reported as a component of the allowance for credit losses on loans and leases to be netted directly against loans and leases held for investment on the Company’s consolidated balance sheet. Amounts reclassified from the allowance for credit losses on loans and leases to net directly against total loans and leases held for investment was $20.0 million, as of December 31, 2019. In addition, the change in the credit component of the fair value discount was previously reported in the provision for loan and lease credit losses while the change in the liquidity component of the fair value discount was previously reported in the loan servicing asset revaluation in the consolidated statements of income, but both have now been reclassified to net (loss) gain on loans accounted for under the fair value option. Amounts reclassified from the provision for loan and lease credit losses and the loan servicing asset revaluation to net (loss) gain on loans accounted for under the fair value option were $(289) thousand and $(1.8) million, respectively, for the quarter ended March 31, 2019.
8
The effect of the above discussed reclassifications on the consolidated balance sheets, consolidated statements of income, and consolidated statements of cash flows for each period are presented below, with additional parenthetical disclosures added:
As Reported
As Reclassified
Consolidated Balance Sheet as of December 31, 2019
Loans held for sale
Loans and leases held for investment
2,647,299
(20,013
(48,247
20,013
Consolidated Statement of Income for the three months ended
March 31, 2019
2,742
289
27,863
(289
(2,246
(1,794
13,027
Consolidated Statement of Cash Flows for the three months ended
Change in discount on unguaranteed loans
(1,319
1,319
(107,313
(475
(113,539
475
(301,402
Adoption of New Accounting Standard
On January 1, 2020, the Company adopted Accounting Standards Update (“ASU”) No. 2016-13 “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” (“ASU 2016-13”) along with its amendments, which replaces the incurred loss impairment methodology in current standards with the current expected credit loss methodology (“CECL”) and requires consideration of a broader range of information to determine credit loss estimates. ASU 2016-13 requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts and requires enhanced disclosures related to the significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an organization’s portfolio. In addition, ASU 2016-13 amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. One such change is to require credit losses to be presented as an allowance rather than as a write-down on available-for-sale debt securities management does not intend to sell.
The Company adopted Accounting Standards Codification (“ASC”) 326 using the modified retrospective method for all financial assets measured at amortized cost and off-balance-sheet credit exposures. Results for reporting periods beginning after January 1, 2020 are presented under ASC 326 while prior period amounts continue to be reported in accordance with previously applicable GAAP. The Company recorded a net increase to retained earnings of $822 thousand, comprised of a $1.3 million decrease in the allowance for credit losses combined with a $499 thousand increase in reserve on unfunded commitments, as of January 1, 2020 for the cumulative effect of adopting ASC 326.
9
Allowance for Credit Losses – Loans and Leases Held for Investment
The allowance for credit losses (“ACL”) is a valuation account that is deducted from, or added to, the amortized cost basis of loans and leases to present a net amount expected to be collected. The ACL excludes loans held for sale and loans accounted for under the fair value option. 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 on loans and leases is estimated using relevant information, from internal and external sources, relating to past events, current conditions, and reasonable and supportable forecasts. The Company’s historical credit loss experience provides the basis for the estimation of expected credit losses. Management adjusts historical loss information for differences in current risk characteristics such as portfolio risk grading, delinquency levels, or portfolio mix as well as for changes in environmental conditions such as changes in unemployment rates.
The ACL is measured on a pooled basis when similar risk characteristics are present in the portfolio. The Company has identified portfolio segments based on industry and whether the receivable is secured by real estate or another form of collateral. Additional information related to the portfolio segments can be found in the Company’s 2019 Form 10-K. Expected credit losses for pooled loans and leases are estimated using a discounted cash flow (“DCF”) methodology.
Loans or leases that do not share risk characteristics are evaluated on an individual basis and are excluded from the pooled evaluation. This generally occurs when, based on current information and events, it is probable that the Company will be unable to collect all interest and principal payments due according to the originally contracted, or reasonably modified, terms of the loan or lease agreement. The Company has determined that loans and leases meeting the criteria defined below must be reviewed quarterly to determine if they should be evaluated for expected credit losses on an individual basis.
•
All commercial loans and leases classified substandard or worse.
Any loan or lease that is on nonaccrual, or any loan or lease that is delinquent greater than 90 days past due and still accruing interest.
Any loan or lease that it meets the definition of a troubled debt restructuring (“TDR”).
Expected credit losses are estimated over the contractual term of the loan or lease, adjusted for expected prepayments when appropriate. The contractual term excludes expected extensions, renewals, and modifications unless management has a reasonable expectation at the reporting date that a TDR will be executed with an individual borrower or the extension or renewal options are included in the contract at the reporting date and are not unconditionally cancellable by the Company.
When the ACL, for pooled or individually evaluated loans and leases, is estimated using the DCF method, the effective interest rate used to discount expected cash flows is adjusted for expected prepayments.
Past due status of loans and leases is determined based on contractual terms. Loans and leases are placed in nonaccrual status and interest accrual is discontinued if they become 90 days delinquent or there is evidence that the borrower’s ability to make the required payments is impaired. When interest accrual is discontinued, all unpaid accrued interest is reversed. Management has made the accounting policy election to exclude accrued interest receivable on loans from the estimate of credit losses.
A loan or lease is accounted for as a TDR if the Company, for reasons related to the borrower’s financial difficulties, restructures a loan or lease, and grants a concession to the borrower that it would not otherwise grant. A TDR typically involves a more than short-term modification of terms such as a reduction of the interest rate below the current market rate for a loan or lease with similar risk characteristics or the waiving of certain financial covenants without corresponding offsetting compensation or additional support.
When management determines that foreclosure is probable or when the borrower is experiencing financial difficulty at the reporting date and repayment is expected to be provided substantially through the operation or sale of the collateral, expected credit losses are based on the fair value of the collateral at the reporting date, adjusted for selling costs as appropriate.
10
Allowance for Credit Losses – Off-Balance Sheet Credit Exposures
Expected credit losses on off-balance sheet credit exposures is estimated over the contractual period in which the Company is exposed to such losses, unless the obligation to extend credit is unconditionally cancellable. The estimate of off-balance sheet credit exposures 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 losses. The estimate is influenced by historical loss experience, adjusted for current risk characteristics, and economic forecasts.
Allowance for Credit Losses – Available-for-Sale Securities
When available-for-sale debt securities are 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. Available-for-sale debt securities that do not meet the aforementioned criteria are evaluated to determine 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, any changes to the rating of the security by a rating agency, 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 from the security is less than the amortized cost basis, a credit loss exists and an 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 an allowance for credit losses is recognized in other comprehensive income. Changes in the ACL are recorded as provision for (or reversal of) credit loss expense. Losses are charged against the allowance when management believes the uncollectibility of an available-for-sale security is confirmed or when either of the criteria regarding intent or requirement to sell is met. Management has made the accounting policy election to exclude accrued interest receivable on available-for-sale debt securities from the estimate of credit losses. Available-for-sale securities are charged-off against the allowance or, in the absence of any allowance, written down through income when deemed uncollectible by management or when either of the aforementioned criteria regarding intent or requirement to sell is met.
Common Stock
On March 15, 2020, the Board of Directors of the Company authorized the repurchase of up to $20,000,000 in shares of the Company’s voting common stock from time to time through December 31, 2020 (the “Repurchase Program”). The Repurchase Program enables the Company to acquire shares through open market purchases or privately negotiated transactions, including through a Rule 10b5-1 plan, at the discretion of management and on terms (including quantity, timing, and price) that management determines to be advisable. Actions in connection with the repurchase program will be subject to various factors, including the Company’s capital and liquidity positions, regulatory and accounting considerations, the Company’s financial and operational performance, alternative uses of capital, the trading price of the Company’s common stock, and market conditions. The repurchase program does not obligate the Company to acquire a specific dollar amount or number of shares and may be extended, modified, or discontinued at any time. There were no shares repurchased during the three months ended March 31, 2020.
Note 2. Recent Accounting Pronouncements
In August 2018, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2018-13, “Fair Value Measurement (Topic 820): Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement” (“ASU 2018-13”). ASU 2018-13 removes, modifies and adds certain fair value disclosure requirements on fair value measurements. The Company adopted the standard on January 1, 2020 with no material effect on its consolidated financial statements.
In August 2018, the FASB issued ASU No. 2018-15, “Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40): Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract” (“ASU 2018-15”). ASU 2018-15 aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software. The Company adopted the standard on January 1, 2020 with no material effect on its consolidated financial statements.
11
In March 2019, the FASB issued ASU No. 2019-01, “Leases (Topic 842): Codification Improvements” (“ASU 2019-01”). ASU 2019-01 provides updates to Topic 842 including: (i) guidance on how to determine fair value of leased items for lessors who are not dealers or manufacturers, (ii) cash flow presentation for lessors of sales-type and direct financing leases and (iii) clarifies certain transition disclosures. The Company adopted the standard on January 1, 2020 with no material effect on its consolidated financial statements.
In April 2019, the FASB issued ASU No. 2019-04, “Codification Improvements to Topic 326, Financial Instruments-Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments” (“ASU 2019-04”). ASU 2019-04 provides clarification and minor improvements related to ASU 2016-01 “Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities,” ASU 2016-13 “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” and ASU 2017-12 “Derivatives and Hedging (Topic 815) - Targeted Improvements to Accounting for Hedging Activities.” The Company adopted the standard on January 1, 2020 with no material effect on its consolidated financial statements.
In January 2020, the FASB issued ASU No. 2020-01, “Investments-Equity Securities (Topic 321), Investments-Equity Method and Joint Ventures (Topic 323), and Derivatives and Hedging (Topic 815)-Clarifying the Interactions between Topic 321, Topic 323, and Topic 815” (“ASU 2020-01”). ASU 2020-01 clarifies the interaction between accounting standards related to equity securities, equity method investments, and certain derivatives including accounting for the transition into and out of the equity method and measuring certain purchased options and forward contracts to acquire investments. The amendments in this standard will be effective for the Company on January 1, 2021. The Company does not expect this standard to have a material effect on its consolidated financial statements.
In March 2020, the FASB issued ASU No. 2020-03, “Codification Improvements to Financial Instruments” (“ASU 2020-03”). The amendments represent clarification and improvements to the codification and correct unintended application. This standard was effective immediately upon issuance and its adoption did not have a material effect on the Company’s consolidated financial statements.
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” (“ASU 2020-04”). ASU 2020-04 provides optional guidance for a limited period of time to ease the potential burden in accounting for (or recognizing the effects of) reference rate reform on financial reporting. The amendments are effective for the Company as of March 12, 2020 through December 31, 2022. The Company does not believe this standard will have a material impact on its consolidated financial statements.
Note 3. Earnings Per Share
Basic and diluted earnings per share are computed based on the weighted average number of shares outstanding during each period. Diluted earnings per share reflects the potential dilution that could occur, upon the exercise of stock options or upon the vesting of restricted stock grants, any of which would result in the issuance of common stock that would then be shared in the net income of the Company.
Basic (loss) earnings per share:
Net (loss attributable to) income available to common shareholders
Weighted-average basic shares outstanding
40,334,179
40,160,118
Diluted (loss) earnings per share:
Net (loss attributable to) income available to common shareholders,
for diluted (loss) earnings per share
Total weighted-average basic shares outstanding
Add effect of dilutive stock options and restricted stock grants
739,870
761,705
Total weighted-average diluted shares outstanding
41,074,049
40,921,823
Anti-dilutive shares
1,839,601
1,597,589
12
Note 4. Investment Securities
The carrying amount of investment securities and their approximate fair values are reflected in the following table:
March 31, 2020
Amortized
Cost
Unrealized
Gains
Losses
Allowance for Credit Losses
Fair
Value
US treasury securities
4,992
51
5,043
US government agencies
22,444
23,079
Mortgage-backed securities
514,899
22,950
558
537,291
Municipal bonds
8,479
283
8,755
550,814
23,919
565
December 31, 2019
4,988
27
5,015
335
22,779
488,694
15,530
927
503,297
8,493
469
8,954
524,619
16,361
935
During the three months ended March 31, 2020, two mortgage-backed securities totaling $4.5 million were sold resulting in a net loss of $79 thousand. During the three months ended March 31, 2019, $900 thousand of one municipal bond was sold resulting in a net gain of $5 thousand.
Accrued interest receivable on available-for-sale securities totaled $1.8 million and $1.6 million at March 31, 2020 and December 31, 2019, respectively, and is included in other assets in the accompanying consolidated balance sheet.
The following tables show debt securities available-for-sale in an unrealized loss position for which an allowance for credit losses has not been recorded, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position.
Less Than 12 Months
12 Months or More
36,320
213
25,032
345
61,352
93
25,125
352
61,445
42,835
460
36,518
467
79,353
92
36,610
79,445
Management evaluates available-for-sale debt securities to determine whether the unrealized loss is due to credit related factors or non-credit related factors. The evaluation considers the extent to which the security’s fair value is less than cost, the financial condition and near-term prospects of the issuer, and intent and ability of the Company to retain its investment in the security for a period of time sufficient to allow for any anticipated recovery in fair value.
At March 31, 2020, there were fifteen mortgage-backed securities and one municipal bond in unrealized loss positions for greater than 12 months and twelve mortgage-backed securities in unrealized loss positions for less than 12 months. Unrealized losses at December 31, 2019 were comprised of twenty-two mortgage-backed securities and one municipal bond in unrealized loss positions for greater than 12 months and twenty mortgage-backed securities in unrealized loss positions for less than 12 months.
13
These unrealized losses are primarily the result of non-credit related volatility in the market and market interest rates. Since none of the unrealized losses relate to marketability of the securities or the issuer’s ability to honor redemption obligations and the Company has the intent and ability to hold the securities for a sufficient period of time to recover unrealized losses, none of the losses have been recognized in the Company’s consolidated statements of income.
All mortgage-backed securities in the Company’s portfolio at March 31, 2020 and December 31, 2019 were backed by U.S. government sponsored enterprises (“GSEs”).
The following is a summary of investment securities by maturity:
cost
value
Within one year
7,007
7,070
One to five years
12,518
12,901
Five to ten years
2,919
3,108
4,700
4,853
178,652
191,718
After 10 years
331,547
340,720
The table above reflects contractual maturities. Actual results will differ as the loans underlying the mortgage-backed securities may repay sooner than scheduled.
There were no securities pledged at March 31, 2020 or December 31, 2019.
Note 5. Loans and Leases Held for Investment and Credit Quality
The following tables present total loans and leases and an aging analysis for the Company’s portfolio segments. Loans and leases are considered past due if the required principal and interest payments have not been received as of the date such payments were due.
Current or Less than 30 Days Past Due
30-89 Days
Past Due
90 Days or More Past Due
Total Past Due
Total Carried at Amortized Cost1
Loans Accounted for Under the Fair Value Option2
Total Loans and Leases
Commercial & Industrial
Agriculture
10,370
10,371
361
10,732
Funeral Home & Cemetery
15,092
12,036
27,128
Healthcare
26,877
1,719
1,322
3,041
29,918
19,826
49,744
Independent Pharmacies
25,320
78,540
103,860
Registered Investment Advisors
40,269
58,016
98,285
Veterinary Industry
31,336
481
31,817
20,643
52,460
Other Industries
442,930
10,271
5,637
15,908
458,838
172,072
630,910
592,194
12,472
6,959
19,431
611,625
361,494
973,119
Construction & Development
45,333
9,146
97,404
3,387
100,791
720
2,564
20,862
193,181
369,210
372,597
Commercial Real Estate
1,291
762
2,053
58,699
58,611
117,310
140,375
4,498
144,873
107,437
252,310
8,609
9,431
17,182
26,613
2,635
4,591
7,226
68,831
2,953
1,089
4,042
72,873
71,129
144,002
427,669
6,326
1,849
8,175
435,844
92,105
527,949
708,109
9,279
8,258
17,537
725,646
351,817
1,077,463
Commercial Land
268,096
270,266
118,115
388,381
1,937,609
25,138
17,387
42,525
1,980,134
831,426
2,811,560
Net Deferred Costs
5,931
Loan and Leases, Net of unearned
15
8,941
396
9,337
14,086
12,343
26,429
21,746
812
1,497
2,309
24,055
20,999
45,054
25,348
79,787
105,135
42,421
56,769
99,190
28,728
504
29,232
21,799
51,031
399,723
6,579
3,856
10,435
410,158
141,220
551,378
540,993
7,895
5,353
13,248
554,241
333,313
887,554
44,571
9,033
94,742
443
2,404
22,132
173,993
347,318
30,066
19,975
50,041
53,426
1,817
55,243
58,171
113,414
125,622
130,120
115,887
246,007
8,070
930
9,000
17,013
26,013
2,543
4,913
7,456
65,928
1,727
1,088
2,815
68,743
76,154
144,897
361,394
4,585
365,979
93,537
459,516
647,049
9,059
5,586
14,645
661,694
385,650
1,047,344
234,133
105,557
339,690
1,769,493
16,954
10,939
27,893
1,797,386
824,520
2,621,906
5,380
Total loans and leases include $665.1 million of U.S. government guaranteed loans as of March 31, 2020, of which $12.0 million is greater than 90 days or more past due, $19.4 million is past due 30-89 days and $633.7 million are current. Total loans and leases include $622.6 million of U.S. government guaranteed loans as of December 31, 2019, of which $6.4 million is greater than 90 days or more past due, $13.6 million is past due 30-89 days and $602.6 million are current.
The Company measures the carrying value of the retained portion of loans sold at fair value under ASC Subtopic 825-10. See Note 9. Fair Value of Financial Instruments for additional information.
16
Credit Quality Indicators
The following tables presents asset quality indicators by portfolio segment and origination year. See Note 5. Loans and Leases Held for Investment and Credit Quality in the Company’s 2019 Form 10-K for additional discussion around the asset quality indicators that the Company uses to manage and monitor credit risk.
Term Loans and Leases Amortized Cost Basis by Origination Year
2018
2017
2016
Prior
Revolving Loans Amortized Cost Basis
Revolving Loans Converted to Term
Total1,2
Risk Grades 1 - 4
71,188
260,917
68,136
44,091
12,455
5,108
99,612
627
562,134
Risk Grade 5
6,770
14,554
31
313
8,201
29,948
Risk Grades 6 - 8
3,300
10,968
3,852
942
19,543
270,987
93,658
47,974
5,902
108,755
706
18,172
141,380
138,387
43,656
11,128
449
2,175
355,347
7,788
8,758
16,546
704
146,175
53,118
56,428
160,097
119,640
178,714
84,876
51,762
172
653,506
14,256
7,767
22,351
5,098
200
49,672
8,246
9,822
4,400
22,468
133,896
194,727
117,049
61,260
2,017
5,626
31,404
54,474
55,682
66,166
52,576
265,928
4,334
4,338
54,478
56,910
151,414
603,868
428,207
351,501
206,798
124,521
112,947
878
17
510,508
32,462
11,271
331,135
15,477
599,298
41,573
20,823
227,377
6,756
Total loans and leases include $665.1 million of U.S. government guaranteed loans as of March 31, 2020, segregated by risk grade as follows: Risk Grades 1 – 4 = $584.5 million, Risk Grade 5 = $50.0 million, Risk Grades 6 – 8 = $30.6 million. As of December 31, 2019, total loans and leases include $622.6 million of U.S. government guaranteed loans, segregated by risk grade as follows: Risk Grades 1 – 4 = $556.8 million, Risk Grade 5 = $42.7 million, Risk Grades 6 – 8 = $23.1 million. Total loans and leases exclude loans accounted for under the fair value option.
Excludes $831.4 million and $824.5 million of loans accounted for under the fair value option as of March 31, 2020 and December 31, 2019, respectively.
18
Nonaccrual Loans and Leases
As of March 31, 2020 and December 31, 2019 there were no loans greater than 90 days past due and still accruing. There was no interest income recognized on nonaccrual loans and leases during the three month period ended March 31, 2020 or March 31, 2019. All nonaccrual loans and leases are included in the held for investment portfolio. Accrued interest receivable on loans totaled $20.8 million and $19.8 million at March 31, 2020 and December 31, 2019, respectively, and is included in other assets in the accompany consolidated balance sheets.
Nonaccrual loans and leases as of March 31, 2020 and December 31, 2019 are as follows:
Loan
Balance1
Guaranteed
Balance
Unguaranteed Balance
Unguaranteed
Exposure with No ACL
2,099
1,905
194
4,424
3,318
1,106
9,217
7,181
2,036
16,222
12,886
3,336
1,254
3,244
1,841
698
124
2,770
2,143
5,439
4,079
1,360
13,529
8,174
5,355
4,337
3,405
932
32
34,088
24,465
9,623
1,873
215
1,931
378
2,906
950
6,938
5,556
1,382
931
233
2,816
2,178
638
8,245
4,130
4,115
5,028
1,728
21,939
14,714
7,225
Excludes nonaccrual loans accounted for under the fair value option. See Note 9. Fair Value of Financial Instruments for additional information.
19
The following table presents the amortized cost basis of collateral-dependent loans and leases, which are individually evaluated to determine expected credit losses, as of March 31, 2020:
Total Collateral Dependent Loans
Unguaranteed Portion
Real Estate
Business Assets
Other
1,188
178
41
44
4,514
1,196
1,177
4,586
2,267
2,148
1,363
557
148
1,067
5,774
1,404
1,756
2,288
1,821
826
128
2,792
649
180
5,449
1,371
10,888
3,969
187
4,359
952
328
21,021
6,325
2,803
Allowance for Credit Losses - Loans and Leases
On January 1, 2020 the Company adopted ASC 326. Upon adoption, the Company’s maintains the ACL at levels management believes represents the future expected credit losses in the loan and lease portfolios as of the balance sheet date. See Note 1. Basis of Presentation for additional information around the Company’s methodology for estimating the ACL. See Note 1. Organization and Summary of Significant Accounting Policies and Note 5. Loans and Leases Held for Investment and Credit Quality in the Company’s 2019 Form 10-K for additional information related to the Company’s methodology for estimating the prior period allowance for credit losses under ASC 310.
The following table details activity in the ACL by portfolio segment allowance for the periods presented:
Construction &
Development
Commercial
& Industrial
Land
Beginning Balance, prior to adoption of ASC 326
2,732
8,427
15,757
1,318
28,234
Impact of adopting ASC 326
1,131
1,916
(4,561
193
(1,321
Charge offs
(109
(2,345
(408
(2,862
Recoveries
28
35
63
Provision
960
2,848
7,451
533
Ending Balance
4,823
13,110
16,337
1,636
35,906
Beginning Balance
2,042
5,259
6,524
607
14,432
87
112
1,679
1,046
5,379
8,282
1,653
17,550
During the three month period ended March 31, 2020, changes to the ACL were primarily related to the severity of forecasted unemployment rates as a result of the COVID-19 pandemic. Unemployment rates were forecasted for twelve months followed by a twelve-month straight-line reversion period. Additionally, the provision expense was impacted by loan and lease growth and net charge-offs during the period.
20
The following tables represent the types of TDRs that were made during the periods presented:
Three Months Ended March 31, 2020
Three Months Ended March 31, 2019
All Restructurings
Number of
Loans
Recorded investment at period end
Extended Amortization
3,489
973
Total Extend Amortization
Payment Deferral
1,487
1,853
3,589
Total Payment Deferral
5,076
6,049
5,342
Concessions made to improve a loan or lease’s performance have varying degrees of success. No TDRs that were modified within the twelve months ended March 31, 2020 and 2019 subsequently defaulted during the three months ended March 31, 2020 and 2019.
The following tables detail the recorded allowance for loan and lease losses and the investment in loans and leases related to each portfolio segment, disaggregated on the basis of impairment evaluation methodology:
Allowance for loan and lease losses:
Loans and leases individually evaluated for
impairment
2,067
3,989
748
6,821
Loans and leases collectively evaluated for
2,715
6,360
11,768
570
21,413
Total allowance for loan and lease losses
Loans and leases receivable:
719
25,389
14,052
17,347
57,507
346,599
636,305
540,189
216,786
1,739,879
Total loans and leases receivable
As of December 31, 2019, loans and leases receivable includes $622.6 million of U.S. government guaranteed loans, of which $36.0 million are considered impaired.
Loans and leases receivable exclude $824.5 million of loans accounted for under the fair value option.
21
Loans and leases classified as impaired as of the dates presented are summarized in the following tables.
Recorded
Investment
Exposure
367
152
3,760
1,829
9,421
5,348
4,073
7,998
6,054
530
189
12,677
5,101
7,576
933
235
5,907
4,707
5,872
1,793
14,585
10,804
12,898
4,449
36,011
21,496
The following table presents evaluated balances of loans and leases classified as impaired at the dates presented that carried an associated reserve as compared to those with no reserve. The recorded investment includes accrued interest and net deferred loan and lease fees or costs.
Recorded Investment
With a
Allowance
With No
Unpaid
Principal
Related
95
4,109
975
672
9,725
2,915
14,047
14,884
10,835
1,842
12,602
1,579
88
6,615
311
5,611
261
5,697
89
23,286
2,103
25,844
17,399
Total Impaired Loans and Leases
55,399
2,108
58,833
22
The following table presents the average recorded investment of impaired loans and leases for each period presented and interest income recognized during the period in which the loans and leases were considered impaired.
Average
Interest
Income
Recognized
4,492
29
632
3,532
8,662
47
9,772
101
6,282
1,588
17,642
142
21,505
196
47,809
385
23
Note 6. Leases
Lessor Equipment Leasing
The Company purchases new equipment for the purpose of leasing such equipment to customers within its verticals. Equipment purchased to fulfill commitments to commercial renewable energy projects is rented out under operating leases while leases of equipment outside of the renewable energy vertical are generally direct financing leases. Accordingly, leased assets under operating leases are included in premises and equipment while leased assets under direct financing leases are included in loans and leases held for investment.
Direct Financing Leases
Interest income on direct financing leases is recognized when earned. Unearned interest is recognized over the lease term on a basis which results in a constant rate of return on the unrecovered lease investment. The term of each lease is generally 3-7 years which is consistent with the useful life of the equipment with no residual value. The gross lease payments receivable and the net investment included in accounts receivable for such leases are as follows:
Gross direct finance lease payments receivable
13,197
13,959
Less – unearned interest
(2,334
(2,562
Net investment in direct financing leases
10,863
11,397
Future minimum lease payments under finance leases are as follows:
As of March 31, 2020
2,367
2021
2,928
2022
2,699
2023
2,259
2024
1,635
Thereafter
1,309
Interest income of $233 thousand and $234 thousand was recognized in the three months ended March 31, 2020 and 2019, respectively.
Operating Leases
The term of each operating lease is generally 10 to 15 years. The Company retains ownership of the equipment and associated tax benefits such as investment tax credits and accelerated depreciation. At the end of the lease term, the lessee has the option to renew the lease for two additional terms or purchase the equipment at the then current fair market value.
Rental revenue from operating leases is recognized on a straight-line basis over the term of the lease. Rental equipment is recorded at cost and depreciated to an estimated residual value on a straight-line basis over the estimated useful life. The useful lives generally range from 20 to 25 years and residual values generally range from 20% to 50%, however, they are subject to periodic evaluation. Changes in useful lives or residual values will impact depreciation expense and any gain or loss from the sale of used equipment. The estimated useful lives and residual values of the Company's leasing equipment are based on industry disposal experience and the Company's expectations for future sale prices.
If the Company decides to sell or otherwise dispose of rental equipment, it is carried at the lower of cost or fair value less costs to sell or dispose. Repair and maintenance costs that do not extend the lives of the rental equipment are charged to direct operating expenses at the time the costs are incurred.
24
As of March 31, 2020 and December 31, 2019, the Company had a net investment of $141.8 million and $144.3 million, respectively, in assets included in premises and equipment that are subject to operating leases. Of the net investment, the gross balance of the assets was $164.3 million as of March 31, 2020 and December 31, 2019 and accumulated depreciation was $22.5 million and $20.0 million as of March 31, 2020 and December 31, 2019, respectively. Depreciation expense recognized on these assets for the three months ended March 31, 2020 and 2019 was $2.5 million and $2.4 million, respectively.
Lease income of $2.4 million and $2.3 million was recognized in the three months ended March 31, 2020 and 2019, respectively.
A maturity analysis of future minimum lease payments under non-cancelable operating leases is as follows:
7,060
9,052
9,044
9,075
8,808
40,110
83,149
Note 7. Servicing Assets
Loans serviced for others are not included in the accompanying condensed consolidated balance sheets. The unpaid principal balances of loans serviced for others requiring recognition of a servicing asset were $2.22 billion and $2.26 billion at March 31, 2020 and December 31, 2019, respectively. The unpaid principal balance for all loans serviced for others was $2.98 billion and $2.97 billion at March 31, 2020 and December 31, 2019, respectively.
The following summarizes the activity pertaining to servicing rights:
Balance at beginning of period
47,641
Additions, net
2,859
723
Fair value changes:
Due to changes in valuation inputs or assumptions
(2,039
(524
Decay due to increases in principal paydowns or runoff
(2,653
(3,516
Balance at end of period
44,324
The fair value of servicing rights was determined using a weighted average discount rate of 13.0% on March 31, 2020 and 14.7% on March 31, 2019. The fair value of servicing rights was determined using a weighted average prepayment speed of 17.9% on March 31, 2020 and 13.1% on March 31, 2019, depending on the stratification of the specific right. Changes to fair value are reported in loan servicing asset revaluation within the consolidated statements of income.
The fair value of servicing rights is highly sensitive to changes in underlying assumptions. Changes in prepayment speed assumptions typically have the most significant impact on the fair value of servicing rights. Generally, as interest rates rise on variable rate loans, loan prepayments increase due to an increase in refinance activity, which results in a decrease in the fair value of servicing assets, however, weakening economic conditions or significant declines in interest rates can also increase loan prepayment activity. Measurement of fair value is limited to the conditions existing and the assumptions used as of a particular point in time, and those assumptions may not be appropriate if they are applied at a different time.
25
Note 8. Borrowings
Total outstanding borrowings consisted of the following:
In 2019, the Company renewed a revolving line of credit issued in 2017. The line of credit is unsecured and accrues interest at 30-day LIBOR plus 1.15% for a term of 13 months. Payments are interest only with all principal and accrued interest due on October 20, 2020. The terms of this loan require the Company to maintain minimum capital and debt service coverage ratios. This $50 million line of credit has been fully advanced and there is no available credit remaining at March 31, 2020.
In October 2017, the Company entered into a financing lease of $19 thousand with an unaffiliated equipment lease company, secured by fitness equipment which is included in other assets on the consolidated balance sheet. Payments are principal and interest due monthly starting December 15, 2017 over a term of 60 months. At the end of the lease term there is a $1.00 bargain purchase option. As of January 1, 2019, this borrowing was revised in accordance with ASU 2016-02.
Total borrowings
The Company may purchase federal funds through unsecured federal funds lines of credit with various correspondent banks, which totaled $72.5 million as of March 31, 2020 and December 31, 2019. These lines are intended for short-term borrowings and are subject to restrictions limiting the frequency and terms of advances. These lines of credit are payable on demand and bear interest based upon the daily federal funds rate. The Company had no outstanding balances on the lines of credit as of March 31, 2020 and December 31, 2019.
The Company has entered into a repurchase agreement with a third party for $5.0 million as of March 31, 2020 and December 31, 2019. At the time the Company enters into a transaction with the third party, the Company must transfer securities or other assets against the funds received. The terms of the agreement are set at market conditions at the time the Company enters into such transaction. The Company had no outstanding balance on the repurchase agreement as of March 31, 2020 and December 31, 2019.
On June 18, 2018, the Company entered into a borrowing agreement with the Federal Home Loan Bank of Atlanta. These borrowings must be secured with eligible collateral approved by the Federal Home Loan Bank of Atlanta. At March 31, 2020 and December 31, 2019, the Company had approximately $1.20 billion and $1.14 billion, respectively, in borrowing capacity available under these agreements. There is no collateral pledged and no advances outstanding as of March 31, 2020 and December 31, 2019.
The Company may borrow funds through the Federal Reserve Bank’s discount window. These borrowings are secured by a blanket floating lien on qualifying loans with a balance of $565.8 million and $526.8 million as of March 31, 2020 and December 31, 2019, respectively. At March 31, 2020 and December 31, 2019, the Company had approximately $309.1 million and $294.5 million, respectively, in borrowing capacity available under these arrangements with no outstanding balance as of March 31, 2020 and December 31, 2019.
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Note 9. Fair Value of Financial Instruments
Fair Value Hierarchy
There are three levels of inputs in the fair value hierarchy that may be used to measure fair value. Financial instruments are considered Level 1 when valuation can be based on quoted prices in active markets for identical assets or liabilities. Level 2 financial instruments are valued using quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or models using inputs that are observable or can be corroborated by observable market data of substantially the full term of the assets or liabilities. Financial instruments are considered Level 3 when their values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable and when determination of the fair value requires significant management judgment or estimation.
Recurring Fair Value
The following sections provide a description of the valuation methodologies used for instruments measured at fair value on a recurring basis, as well as the general classification of such instruments pursuant to the fair value hierarchy:
Investment securities: Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, discounted cash flow or at net asset value per share. Level 2 securities would include U.S. government agency securities, mortgage-backed securities, obligations of states and political subdivisions and certain corporate, asset backed mutual fund and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy.
Loans held for sale: The fair values of loans held for sale are determined by discounting estimated cash flows using interest rates approximating prevailing market rates for similar loans adjusted to reflect the inherent credit risk.
Loans held for investment: The fair values of loans held for investment are typically determined based on discounted cash flow analyses using market-based interest rate spreads. Discounted cash flow analyses are adjusted, as appropriate, to reflect current market conditions and borrower-specific credit risk. If the loan is collateral dependent, the fair value is determined based on the difference between the fair value of the collateral and the amortized cost basis of the loan as of the measurement date. Fair value of the loan’s collateral is determined by appraisals, independent valuation, or management’s estimation of fair value which is then adjusted for the cost related to liquidation of the collateral.
Servicing assets: Servicing rights do not trade in an active, open market with readily observable prices. While sales of servicing rights do occur, the precise terms and conditions typically are not readily available. Accordingly, the Company estimates the fair value of servicing rights using discounted cash flow models incorporating numerous assumptions from the perspective of a market participant including servicing income, servicing costs, market discount rates and prepayment speeds. Due to the nature of the valuation inputs, servicing rights are classified within Level 3 of the valuation hierarchy.
Mutual fund: The following mutual fund is registered with the Securities and Exchange Commission as a closed-end, non-diversified management investment company and operates as an interval fund. The fund primarily invests in the unguaranteed portion of SBA504 First Lien Loans secured by owner-occupied commercial real estate. This investment is valued using quoted prices in markets that are not active and is classified as Level 2 within the valuation hierarchy.
Equity warrant assets: Fair value measurements of equity warrant assets of private companies are priced based on a Black-Scholes option pricing model to estimate the asset value by using stated strike prices, option expiration dates, risk-free interest rates and option volatility assumptions. Option volatility assumptions used in the Black-Scholes model are based on public companies that operate in similar industries as the companies in our private company portfolio. Option expiration dates are modified to account for estimates to actual life relative to stated expiration. Values are further adjusted for a general lack of liquidity due to the private nature of the associated underlying company. The Company classifies equity warrant assets within Level 3 of the valuation hierarchy.
The tables below present the recorded amount of assets and liabilities measured at fair value on a recurring basis.
Level 1
Level 2
Level 3
Municipal bonds1
19,151
Loans held for investment
Servicing assets2
Mutual fund
2,141
Equity warrant assets3
702
Total assets at fair value
1,461,120
576,216
884,904
8,862
16,198
2,206
1,418,904
542,159
876,745
During the three months ended March 31, 2020, the Company recorded a fair value adjustment gain of $1 thousand. During the three months ended March 31, 2019, the Company sold $900 thousand of a municipal bond to a third party and recorded a fair value adjustment loss of $9 thousand.
See Note 7 for a rollforward of recurring Level 3 fair values for servicing assets.
During the three months ended March 31, 2020, the Company entered into equity warrant assets with a fair value of $164 thousand at the time of issuance and recorded net losses on derivative instruments of $32 thousand. During the three months ended March 31, 2019, the Company recorded net gains on derivative instruments of $255 thousand.
Fair Value Option
The Company elects to account for retained participating interests of government guaranteed loans under the fair value option in order to align the accounting presentation with the Company’s viewpoint of the economics of the loans. Interest income on loans accounted for under the fair value option is recognized in loans and fees on loans on the Company’s consolidated statements of income. There were no loans accounted for under the fair value option that were 90 days or more past due and still accruing interest at March 31, 2020 or December 31, 2019. The unpaid principal balance of unguaranteed exposure for nonaccruals was $12.2 million and $10.7 million at March 31, 2020 and December 31, 2019, respectively.
The following tables provide more information about the fair value carrying amount and the unpaid principal outstanding of loans accounted for under the fair value option at March 31, 2020 and December 31, 2019.
Total Loans
Nonaccruals
Fair Value Carrying Amount
Unpaid Principal Balance
Difference
Fair Value Option Elections
20,056
(905
858,577
(27,151
60,558
65,303
(4,745
39,102
40,876
(1,774
850,577
878,633
(28,056
17,230
(1,032
842,456
(17,936
49,739
54,370
(4,631
26,644
28,137
(1,493
840,718
859,686
(18,968
The following table presents the net gains (losses) from changes in fair value.
Three Months Ended March 31,
Gains (Losses) on Loans Accounted for under the Fair Value Option
120
(351
(10,758
2,434
Losses related to borrower-specific credit risk were $922 thousand and $522 thousand for the three months ended March 31, 2020 and 2019, respectively.
The following tables summarize the activity pertaining to loans accounted for under the fair value option.
17,745
Issuances
3,045
13,635
Fair value changes
Sales
(5,700
Settlements
(212
(36
25,293
885,527
61,611
30,108
(43,947
(49,415
868,654
Non-recurring Fair Value
The following sections provide a description of the valuation methodologies used for instruments measured at fair value on a non-recurring basis, as well as the general classification of such instruments pursuant to the fair value hierarchy:
Collateral dependent loans: Loans are considered collateral dependent when the Company has determined that foreclosure of the collateral is probable or when a borrower is experiencing financial difficulty and the loan is expected to be repaid substantially through the operation or sale of collateral. A collateral dependent loan’s ACL is measured based on the difference between the fair value of the collateral and the amortized cost basis of the loan as of the measurement date. Fair value of the loan’s collateral is determined by appraisals, independent valuation, or management’s estimation of fair value which is then adjusted for the cost related to liquidation of the collateral. Collateral dependent loans are generally classified as Level 3 based on management’s judgment and estimation.
Foreclosed assets: Foreclosed real estate is adjusted to fair value less selling costs upon transfer of the loans to foreclosed real estate. Subsequently, foreclosed real estate is carried at the lower of carrying value or fair value less selling costs. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. Given the lack of observable market prices for identical properties and market discounts applied to appraised values, the Company generally classifies foreclosed assets as nonrecurring Level 3.
Equity security investment with a non-readily determinable fair value: The following equity security investment is measured at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for an identical or similar investment of the same issuer. When an observable price change in an orderly transaction occurs, the investment is classified as nonrecurring Level 1 within the valuation hierarchy.
The tables below present the recorded amount of assets and liabilities measured at fair value on a non-recurring basis.
Collateral dependent loans
2,349
9,093
1,245
Equity security investment with a non-readily
determinable fair value
8,738
15,595
6,857
Level 3 Analysis
For Level 3 assets and liabilities measured at fair value on a recurring or non-recurring basis as of March 31, 2020 and December 31, 2019 the significant unobservable inputs used in the fair value measurements were as follows:
Level 3 Assets with Significant
Unobservable Inputs
Fair Value
Valuation Technique
Significant
Unobservable
Inputs
Range
Recurring fair value
Municipal bond
Discounted expected cash flows
Discount rate
Prepayment speed
4.2%
5.0%
7.1% to 15.4%
WAVG 17.9%
Loans held for
investment
Discounted appraisals
Loss rate
Appraisal adjustments
0.0% to 82.5% (WAVG 1.8%)
10% to 50%
Equity warrant assets
Black-Scholes option pricing model
Volatility
Risk-free interest rate
Marketability discount
Remaining life
24.7 to 85.4%
0.7%
20.0%
7-10 years
Non-recurring fair value
Collateral dependent
loans
Appraisal adjustments (1)
10.0% to 55.0%
4.0% to 14.5%
4.6%
7.7% to 21.4%
WAVG 13.1%
0.0% to 10.9% (WAVG 1.3%)
10.0% to 70.0%
21.0-75.0%
1.90%
8-10 years
10.0% to 57.0%
10.0% to 37.0%
(1)
Appraisals may be adjusted by management for customized discounting criteria, estimated sales costs, and proprietary qualitative adjustments.
Estimated Fair Value of Other Financial Instruments
GAAP also requires disclosure of the fair value of financial instruments carried at book value on the consolidated balance sheets.
The carrying amounts and estimated fair values of the Company’s financial instruments not measured at fair value on a recurring or non-recurring basis are as follows:
Carrying
Quoted Price
In Active
Markets for
Identical Assets
/Liabilities
(Level 1)
Observable
(Level 2)
(Level 3)
Financial assets
7,755
976,899
1,044,207
Loans and leases, net of allowance for
credit losses on loans and leases
1,950,159
2,053,965
Financial liabilities
4,717,676
50,301
7,568
950,249
1,004,135
1,774,532
1,822,569
4,213,657
Note 10. Commitments and Contingencies
Litigation
In the normal course of business the Company is involved in various legal proceedings. Management believes that the outcome of such proceedings will not materially affect the financial position, results of operations or cash flows of the Company.
Financial Instruments with Off-balance-sheet Risk
The Company is 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 letters of credit. These instruments involve, to varying degrees, credit risk in excess of the amount recognized in the balance sheet.
The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as for on-balance-sheet instruments. A summary of the Company’s commitments is as follows:
Commitments to extend credit
1,732,944
1,834,449
Standby letters of credit
27,512
25,532
Operating lease commitments
803
Total unfunded off-balance-sheet credit risk
1,761,259
1,859,981
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the party. Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate and income-producing commercial properties. In 2012, the Company began issuing commitment letters after approval of the loan by the Credit Department. Commitment letters generally expire ninety days after issuance.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held varies as specified above and is required in instances which the Company deems necessary.
Operating lease commitments are non-cancelable operating lease agreements for real property entered by the Company during the period which have not commenced.
As of March 31, 2020 and December 31, 2019, the Company had unfunded commitments to provide capital contributions for on-balance-sheet investments in the amount of $16.9 million.
Concentrations of Credit Risk
Although the Company is not subject to any geographic concentrations, a substantial amount of the Company’s loans, leases, and commitments to extend credit have been granted to customers in the agriculture, healthcare and veterinary verticals. The concentrations of credit by type of loan are set forth in Note 5. The distribution of commitments to extend credit approximates the distribution of loans outstanding. The Company does not have a significant number of credits to any single borrower or group of related borrowers whereby their retained unguaranteed exposure exceeds $7.5 million, except for 30 relationships that have a retained unguaranteed exposure of $325.7 million of which $217.4 million of the unguaranteed exposure has been disbursed.
Additionally, the Company has future minimum lease payments due under non-cancelable operating leases totaling $83.1 million, of which $59.8 million is due from four relationships.
The Company from time-to-time may have cash and cash equivalents on deposit with financial institutions that exceed federally-insured limits.
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Note 11. Stock Plans
On March 20, 2015, the Company adopted the 2015 Omnibus Stock Incentive Plan which replaced the previously existing Amended Incentive Stock Option Plan and Nonstatutory Stock Option Plan. Subsequently on May 24, 2016, the 2015 Omnibus Stock Incentive Plan was amended to authorize awards covering a maximum of 7,000,000 common voting shares and has an expiration date of March 20, 2025. On May 15, 2018, the Amended and Restated 2015 Omnibus Stock Incentive Plan was amended to authorize awards covering a maximum of 8,750,000 common voting shares. Options or restricted shares granted under the Amended and Restated 2015 Omnibus Stock Incentive Plan (the "Plan") expire no more than 10 years from the date of grant. Exercise prices under the Plan are set by the Board of Directors at the date of grant, but shall not be less than 100% of fair market value of the related stock at the date of the grant. Options vest over a minimum of three years from the date of the grant. Restricted stock grants vest in equal installments ranging from immediate vesting to over a seven year period from the date of the grant. Market Restricted Stock Units also have a restriction based on the passage of time and non-market-related performance criteria, but also have a restriction based on market price criteria related to the Company’s share price closing at or above a specified price defined at time of grant.
Stock Options
There were no stock options granted during the three months ended March 31, 2020.
At March 31, 2020, unrecognized compensation costs relating to stock options amounted to $3.7 million which will be recognized over a weighted average period of 2.35 years.
Restricted Stock
Restricted stock awards are authorized in the form of restricted stock awards or units ("RSU"s) and restricted stock awards or units with a market price condition ("Market RSU"s).
RSUs have a restriction based on the passage of time and may also have a restriction based on a non-market-related performance criteria. The fair value of the RSUs is based on the closing price on the date of the grant.
Market RSUs also have a restriction based on the passage of time and non-market-related performance criteria, but also have a restriction based on market price criteria related to the Company’s share price closing at or above a specified price ranging from $34.00 to $55.00 per share for at least twenty (20) consecutive trading days at any time prior to expiration date. The amount of Market RSUs earned will not exceed 100% of the Market RSUs awarded. The fair value of the Market RSUs and the implied service period is calculated using the Monte Carlo simulation method.
For the three months ended March 31, 2020, 483,331 RSUs were granted with a weighted average grant date fair value of $17.98. Of the RSUs granted, 447,273 were awarded in connection with annual long term incentive stock compensation.
At March 31, 2020, unrecognized compensation costs relating to RSUs amounted to $16.2 million which will be recognized over a weighted average period of 4.30 years.
There were no Market RSUs granted during the three months ended March 31, 2020.
At March 31, 2020, unrecognized compensation costs relating to Market RSUs amounted to $12.6 million which will be recognized over a weighted average period of 2.94 years.
Note 12. Significant Equity Method Investments
In accordance with Rule 10-01(b)(1) of Regulation S-X, the Company must assess whether any of its equity method investments are significant equity method investments. In evaluating the significance of these investments, the Company performed the income test and the investment test described in S-X 3-05 and S-X 1-02(w). Rule 10-01(b)(1) of Regulation S-X requires summarized financial information in a quarterly report if any of the two tests exceeds 20%. Under the income test, the Company’s proportionate share of its equity method investees' aggregated net losses exceeded the applicable threshold of 20% and is accordingly required to provide summarized financial information for these investees for all periods presented in this Form 10-Q.
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The following table provides summarized balance sheet information for the Company’s equity method investments as of March 31, 2020 and December 31, 2019. The Company’s equity method investments are included in the other assets line on the consolidated balances sheet and are largely concentrated in new or emerging financial service technology companies.
Balance sheet data
Current assets
52,228
56,710
Noncurrent assets
176,472
162,304
228,700
219,014
Current liabilities
20,183
19,910
Noncurrent liabilities
664
683
20,847
20,593
Equity interests
207,853
198,421
Total liabilities and equity
The following table provides summarized income statement information for the Company’s equity method investments for the three months ended March 31, 2020 and 2019.
Summary of operations
Total revenues
15,792
13,389
(16,433
(7,120
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following presents management’s discussion and analysis of the financial condition and results of operations of Live Oak Bancshares, Inc. (the “Company” or “LOB”). This discussion should be read in conjunction with the financial statements and related notes included elsewhere in this quarterly report on Form 10-Q and with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2019 (the "2019 Annual Report"). Results of operations for the periods included in this quarterly report on Form 10-Q are not necessarily indicative of results to be obtained during any future period.
Important Note Regarding Forward-Looking Statements
This quarterly report on Form 10-Q contains statements that management believes are forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995. These statements generally relate to the Company’s financial condition, results of operations, plans, objectives, future performance or business. They usually can be identified by the use of forward-looking terminology, such as “believes,” “expects,” or “are expected to,” “plans,” “projects,” “goals,” “estimates,” “will,” “may,” “should,” “could,” “would,” “continues,” “intends to,” “outlook” or “anticipates,” or variations of these and similar words, or by discussions of strategies that involve risks and uncertainties. You should not place undue reliance on these statements, as they are subject to risks and uncertainties, including but not limited to, those described in this quarterly report on Form 10-Q. When considering these forward-looking statements, you should keep in mind these risks and uncertainties, as well as any cautionary statements management may make. Moreover, you should treat these statements as speaking only as of the date they are made and based only on information actually known to the Company at the time. Management undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. Forward-looking statements contained in this quarterly report on Form 10-Q are based on current expectations, estimates and projections about the Company’s business, management’s beliefs and assumptions made by management. These statements are not guarantees of the Company’s future performance and involve certain risks, uncertainties and assumptions, which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in the forward-looking statements. These risks, uncertainties and assumptions include, without limitation:
deterioration in the financial condition of borrowers resulting in significant increases in the Company’s loan and lease losses and provisions for those losses and other adverse impacts to results of operations and financial condition;
changes in Small Business Administration ("SBA") rules, regulations and loan products, including specifically the Section 7(a) program, changes in SBA standard operating procedures or changes to the status of Live Oak Banking Company (the "Bank") as an SBA Preferred Lender;
changes in rules, regulations or procedures for other government loan programs, including those of the USDA;
changes in interest rates that affect the level and composition of deposits, loan demand and the values of loan collateral, securities, and interest sensitive assets and liabilities;
the failure of assumptions underlying the establishment of reserves for possible loan and lease losses;
changes in loan underwriting, credit review or loss reserve policies associated with economic conditions, examination conclusions, or regulatory developments;
the potential impacts of the Coronavirus Disease 2019 (COVID-19) pandemic on trade (including supply chains and export levels), travel, employee productivity and other economic activities that may have a destabilizing and negative effect on financial markets, economic activity and customer behavior;
a reduction in or the termination of the Company’s ability to use the technology-based platform that is critical to the success of the Company’s business model, including a failure in or a breach of the Company’s operational or security systems or those of its third-party service providers;
changes in financial market conditions, either internationally, nationally or locally in areas in which the Company conducts operations, including reductions in rates of business formation and growth, demand for the Company’s products and services, commercial and residential real estate development and prices, premiums paid in the secondary market for the sale of loans, and valuation of servicing rights;
changes in accounting principles, policies, and guidelines applicable to bank holding companies and banking;
fluctuations in markets for equity, fixed-income, commercial paper and other securities, which could affect availability, market liquidity levels, and pricing;
the effects of competition from other commercial banks, non-bank lenders, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and mutual funds, and other financial institutions operating in the Company’s market area and elsewhere, including institutions operating regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone and the Internet;
the Company's ability to attract and retain key personnel;
changes in governmental monetary and fiscal policies as well as other legislative and regulatory changes, including with respect to SBA or USDA lending programs and investment tax credits;
changes in political and economic conditions;
the impact of heightened regulatory scrutiny of financial products and services, primarily led by the Consumer Financial Protection Bureau and various state agencies;
the Company's ability to comply with any requirements imposed on it by regulators, and the potential negative consequences that may result;
operational, compliance and other factors, including conditions in local areas in which the Company conducts business such as inclement weather or a reduction in the availability of services or products for which loan proceeds will be used, that could prevent or delay closing and funding loans before they can be sold in the secondary market;
the effect of any mergers, acquisitions or other transactions, to which the Company or the Bank may from time to time be a party, including management’s ability to successfully integrate any businesses acquired;
other risk factors listed from time to time in reports that the Company files with the SEC, including in the Company’s 2019 Annual Report; and
the Company’s success at managing the risks involved in the foregoing.
Except as otherwise disclosed, forward-looking statements do not reflect: (i) the effect of any acquisitions, divestitures or similar transactions that have not been previously disclosed; (ii) any changes in laws, regulations or regulatory interpretations; or (iii) any change in current dividend or repurchase strategies, in each case after the date as of which such statements are made. All forward-looking statements speak only as of the date on which such statements are made, and the Company undertakes no obligation to update any statement, to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events.
Amounts in all tables in Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) have been presented in thousands, except percentage, time period, stock option, share and per share data or where otherwise indicated.
LOB is a bank holding company headquartered in Wilmington, North Carolina incorporated under the laws of North Carolina in December 2008. The Company conducts business operations primarily through its commercial bank subsidiary, Live Oak Banking Company (the “Bank”). The Bank was incorporated in February 2008 as a North Carolina-chartered commercial bank. The Bank specializes in providing lending services to small businesses nationwide. The Bank identifies and grows within selected industry sectors, or verticals, by leveraging expertise within those industries, and more broadly to select borrowers outside of those industries. A significant portion of the loans originated by the Bank are guaranteed by the SBA under the 7(a) Loan Program and the U.S. Department of Agriculture ("USDA") Rural Energy for America Program ("REAP"), Water and Environmental Program (“WEP”) and Business & Industry ("B&I") loan programs.
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Effective July 29, 2016, the Company elected to become a “financial holding company” within the meaning of the Bank Holding Company Act. A financial holding company, and the nonbank companies under its control, are permitted to engage in activities considered financial in nature or incidental to financial activities. For the Company to become and remain eligible for financial holding company status, it and the Bank must meet certain criteria, including capital, management and Community Reinvestment Act (“CRA”) requirements. The failure to meet such criteria could, depending on which requirements were not met, result in the Company facing restrictions on new financial activities or acquisitions or being required to discontinue existing activities that are not otherwise permissible for bank holding companies.
In 2018, the Company formed Canapi Advisors, LLC for the purpose of providing investment advisory services to a series of new funds focused on providing venture capital to new and emerging financial technology companies. In 2019, Live Oak Clean Energy Financing LLC (“LOCEF”) became a subsidiary of the Bank. LOCEF was formed in November 2016 as a subsidiary of the Company for the purpose of providing financing to entities for renewable energy applications. In 2018, the Bank formed Live Oak Private Wealth, LLC, a registered investment advisor that provides high-net-worth individuals and families with strategic wealth and investment management services. In 2017, the Bank entered into a joint venture, Apiture LLC (“Apiture”), with First Data Corporation for the purpose of creating next generation technology for financial institutions. In addition to the Bank, the Company owns Live Oak Ventures, Inc. (formerly known as "Canapi, Inc."), formed in August 2016 for the purpose of investing in businesses that align with the Company's strategic initiative to be a leader in financial technology; Live Oak Grove, LLC, formed in February 2015 for the purpose of providing Company employees and business visitors an on-site restaurant location; Government Loan Solutions, Inc. (“GLS”), a management and technology consulting firm that specializes in the settlement, accounting, and securitization processes for government guaranteed loans, including loans originated under the SBA 7(a) loan program and USDA-guaranteed loans; and 504 Fund Advisors, LLC (“504FA”), formed to serve as the investment advisor to The 504 Fund, a closed-end mutual fund organized to invest in SBA section 504 loans. In 2019, 504FA exited as the advisor to The 504 Fund and the Company dissolved this legal entity.
The Company generates revenue primarily from net interest income and secondarily through origination and sale of government guaranteed loans. Income from the retention of loans is comprised principally of interest income. The Company elects to account for certain loans under the fair value option with interest reported in interest income and changes in fair value reported in the net (loss) gain on loans accounted for under the fair value option line item of the consolidated statements of income. Income from the sale of loans is comprised of loan servicing revenue and revaluation of related servicing assets along with net gains on sales of loans. Offsetting these revenues are the cost of funding sources, provision for loan and lease credit losses, any costs related to foreclosed assets and other operating costs such as salaries and employee benefits, travel, professional services, advertising and marketing and tax expense.
Recent Developments
The COVID-19 pandemic in the United States is expected to have a complex and significant adverse impact on the economy, the banking industry and the Company in future fiscal periods, all subject to a high degree of uncertainty. While it is not possible to know the full universe or extent of these impacts as of the date of this filing, we are disclosing potentially material items of which we are aware.
Financial position and results of operations
Relating to our March 31, 2020 financial condition and results of operations, COVID-19 had a significant impact on the allowance for credit losses (“ACL”) on loans and leases, loans carried at fair value, loan servicing asset revaluation and net gains on sales of loans. While the Company has not yet experienced any charge-offs related to COVID-19, the ACL and loan fair value calculation and resulting provision for loan and lease credit losses and net loss on loans accounted for under the fair value option were significantly impacted by changes in forecasted economic conditions. Given that forecasted economic scenarios worsened substantially since the pandemic was declared in early March, the need for additional credit related reserves increased significantly by quarter end. Refer to the discussion of the ACL and loans at fair value in Notes 5 and 9, respectively, of the unaudited consolidated financial statements as well as further discussion in MD&A. Also impacted by deteriorating market conditions was the Company’s valuation of the loan servicing asset as discussed in Note 7 of the unaudited consolidated financial statements and net gains on sales of loans, both of which are further discussed in MD&A. Should economic conditions worsen, the Company could experience further increases in the required ACL and negative fair value marks and record additional credit or market related loss expense. It is also possible that the Company’s asset quality measures could worsen at future measurement periods if the effects of COVID-19 are prolonged.
The income from gain on sale of loans in future periods could be reduced due to COVID-19. Impacts began to be felt in the latter part of March with loan sales executed at that time as secondary markets conditions began to weaken. At this time, the Company is unable to project the materiality of such an impact but recognizes the breadth of the economic impact is likely to impact gains in future periods.
Interest income could be reduced due to COVID-19. In keeping with guidance from regulators, the Company is actively working with COVID-19 affected borrowers to help defer their payments, interest, and fees. In addition to regulatory relief on deferrals from regulators, six months of payment relief are also available from the SBA for loans guaranteed by that agency. While interest and fees will still accrue to interest, should eventual credit losses on these deferred payments emerge, interest income and fees accrued would need to be reversed. In such a scenario, interest income in future periods could be negatively impacted. At this time, we are unable to project the materiality of such an impact, but recognize the breadth of the economic impact may affect our borrowers’ ability to repay in future periods.
Capital and liquidity
As of March 31, 2020, all of the Company’s capital ratios, and the Bank’s capital ratios, were in excess of all regulatory requirements. While the Company believes that capital is sufficient to withstand an extended economic recession brought about by COVID-19, reported and regulatory capital ratios could be adversely impacted by further credit losses. The Company relies on cash on hand as well as dividends from its subsidiary bank to service our debt. If our capital deteriorates such that the Bank is unable to pay dividends to the Company for an extended period of time, the Company may not be able to service its debt.
The Company maintains access to multiple sources of liquidity. Wholesale funding markets have remained open to the Company, but rates for short term funding have recently been volatile and the secondary market for guaranteed loans, while open, has weakened as mentioned above. In addition to increased levels of loan sales, the Company also increased its levels of deposits and borrowings in the first quarter, as discussed further in MD&A. If funding costs are elevated for an extended period of time, it could have an adverse effect on the Company’s net interest margin. If an extended recession caused large numbers of the Company’s deposit customers to withdraw their funds, the Company might become more reliant on volatile or more expensive sources of funding.
The Federal Reserve has created the Paycheck Protection Lending Facility (“PPLF”) to help provide financing in response to disruptions arising from COVID-19. The PPLF extends loans to banks that have loaned money to small businesses under the Paycheck Protection Program (“PPP”), discussed in more detail below. Amounts borrowed are non-recourse and have a 100% advance rate equal to the principal amount of PPP loans pledged as security. In addition, loans financed under the PPLF have no impact on regulatory leverage capital ratios. The maturity date of a borrowing under the PPLF is equal to the maturity date of the PPP loan pledged to secure the borrowing and would be accelerated (i) if the underlying PPP loan goes into default and is transferred to the SBA to realize on the SBA guarantee or (ii) to the extent that any loan forgiveness reimbursement is received from the SBA. Borrowings under the PPLF bear interest at a rate of 0.35% and there are no fees to the Company. As of April 30, 2020, the Company had borrowed $462.7 million from the PPLF.
Lending operations and accommodations to borrowers
With the passage of the PPP, administered by the SBA, the Company has actively interpreted and implemented new loan programs and systems using its technology platform while participating in assisting its customers and other small businesses in need of resources through the program. PPP loans have a two-year term and earn interest at 1%. The Company expects that some portion of these loans will ultimately be forgiven by the SBA in accordance with the terms of the program. As of May 5, 2020, the Company has secured funding from the SBA for 9,582 PPP loans representing $1.7 billion in funding. Loans funded through the PPP program are expected to be fully guaranteed by the U.S. government. Should those circumstances change, the Company could be required to record additional credit loss expense through earnings.
With the passage of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) on March 27, 2020, the SBA will be making 6-months of principal and interest payments on all fully disbursed SBA 7(a) and SBA Express loans in regular servicing status. In addition, with regulatory guidance to work with borrowers during this unprecedented situation, the Company has also mobilized to provide a payment deferral program when needed by customers that are adversely affected by the pandemic. Depending on the demonstrated need of the client, the Company is deferring either the full loan payment or the principal component of the loan payment for 60 or 90 days. In accordance with interagency guidance issued in March 2020, these short-term deferrals are not considered troubled debt restructurings.
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Credit
While all industries have and will continue to experience adverse impacts as a result of COVID-19, the Company has exposures in the following verticals considered to be “at-risk” of significant impact as of March 31, 2020: healthcare, hotels, early education, wine and craft beverage, entertainment centers, fitness centers, and quick service restaurants each comprising $600.2 million or 15.7%, $242.3 million or 6.3%, $193.7 million or 5.1%, $175.3 million or 4.6%, $77.9 million or 2.0%, $49.7 million or 1.3%, and $29.3 million or 0.8% of total loans and leases (all at amortized cost, inclusive of loans carried at fair value), respectively. 49.9% of these amounts are government guaranteed loans.
The Company is working with customers directly affected by COVID-19. The Company is prepared to offer short-term assistance in accordance with regulatory guidelines. As a result of the current economic environment caused by COVID-19, the Company has reached out to every one of its borrowers and is engaging in more frequent communication with borrowers to better understand their situation and the challenges faced, which the Company anticipates will allow it to respond proactively as needs and issues arise.
Results of Operations
Performance Summary
Three months ended March 31, 2020 compared with three months ended March 31, 2019
For the three months ended March 31, 2020, the Company reported a net loss of $7.6 million, or $(0.19) per diluted share, compared to net earnings of $2.4 million, or $0.06 per diluted share, for the first quarter of 2019. This decrease in net income is largely due to the effects of the COVID-19 pandemic on the Company’s credit reserves and fair value adjustments, as outlined below:
The provision for loan and lease credit losses increased $8.8 million, or 289.1%; and
The net loss on loans accounted for under the fair value option increased $12.7 million, or 610.7%.
Outside of the effects of COVID-19, which were intensified by the adoption of new current expected credit losses model (“CECL”) in the first quarter of 2020, salaries and employee benefits increased $6.2 million, or 28.4%, as the Company continued to invest in its workforce to support growth and a variety of initiatives.
The primary factors partially offsetting the above net loss were:
Increase in net interest income of $9.6 million, or 31.2%, predominately driven by significant growth in total loan and lease portfolios combined with higher investment security holdings;
Net gains on sales of loans increased $6.9 million, or 164.7%, due largely to a higher volume of loans sold in the first quarter of 2020 to strengthen the Company’s capital and liquidity profile in light of the looming pandemic. The volume in guaranteed loan sales in the first quarter of 2020 increased to $162.3 million compared to $62.9 million in the first quarter of 2019; and
Income tax benefit increased $8.1 million primarily as a result of a $3.7 million estimated benefit related to the enactment of the CARES Act which allows the carryback of certain net operating losses for five years combined with the Company’s overall net pretax loss in the first quarter of 2020.
Net Interest Income and Margin
Net interest income represents the difference between the income that the Company earns on interest-earning assets and the cost it incurs on interest-bearing liabilities. The Company’s net interest income depends upon the volume of interest-earning assets and interest-bearing liabilities and the interest rates that the Company earns or pays on them, respectively. Net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as “volume changes.” It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as “rate changes.” As a bank without a branch network, the Bank gathers deposits over the Internet and in the community in which it is headquartered. Due to the nature of a branchless bank and the relatively low overhead required for deposit gathering, the rates that the Bank offers are generally above the industry average.
40
For the three months ended March 31, 2020, net interest income increased $9.6 million, or 31.2%, to $40.2 million compared to $30.6 million for the three months ended March 31, 2019. This increase was principally due to the significant growth in the combined held for sale and held for investment loan and lease portfolios along with higher investment security holdings reflecting the Company's ongoing initiative to grow recurring revenue sources and strengthen liquidity. Average interest earning assets increased by $1.13 billion, or 33.3%, to $4.53 billion for the three months ended March 31, 2020, compared to $3.40 billion for the three months ended March 31, 2019, while the yield on average interest earning assets decreased thirty-three basis points to 5.62%. The cost of funds on interest bearing liabilities for the three months ended March 31, 2020 decreased twenty-four basis points to 2.14%, and the average balance of interest bearing liabilities increased by $1.08 billion, or 32.7%, over the same period. As indicated in the rate/volume table below, increased interest earning asset volume more than offset lower yields, outpacing the higher volume and lower levels of cost declines for interest bearing liabilities, resulting in increased interest income of $13.6 million and increased interest expense of $4.0 million for the three months ended March 31, 2020 compared to the three months ended March 31, 2019. For the three months ended March 31, 2019 compared to the three months ended March 31, 2020, net interest margin decreased from 3.65% to 3.55%, respectively, principally due to the yield decline on interest earnings assets outpacing the lower cost for interest bearing liabilities. The decline in net interest margin reflects impacts of recent Fed rate cuts.
Average Balances and Yields. The following table presents information regarding average balances for assets and liabilities, the total dollar amounts of interest income and dividends from average interest-earning assets, the total dollar amount of interest expense on average interest-bearing liabilities, and the resulting average yields and costs. The yields and costs for the periods indicated are derived by dividing the income or expense by the average balances for assets or liabilities, respectively, for the periods presented and annualizing that result. Loan fees are included in interest income on loans.
Yield/Rate
Interest earning assets:
Federal funds sold and interest earning
balances in other banks
229,886
1.31
%
283,364
2.35
Investment securities
536,206
2.81
461,339
2.92
1,016,572
15,865
6.26
749,700
12,583
6.81
Loans and leases held for
investment(1)
2,750,351
43,096
6.28
1,905,807
32,383
6.89
Total interest earning assets
4,533,015
5.62
3,400,210
5.95
Less: Allowance for credit losses on loans
and leases
(27,003
(15,991
Non-interest earning assets
510,544
476,232
5,016,556
3,860,451
Interest bearing liabilities:
Interest bearing checking
169
Savings
1,123,882
4,844
1.73
927,579
4,786
2.09
Money market accounts
77,622
100
0.52
83,298
108
0.53
Certificates of deposit
3,162,660
18,311
2.32
2,282,709
14,423
2.56
4,364,164
2.14
3,293,755
2.38
Other borrowings
7,156
3.19
1,464
Total interest bearing liabilities
4,371,320
3,295,219
Non-interest bearing deposits
52,141
46,822
Non-interest bearing liabilities
53,494
14,449
Shareholders' equity
539,601
503,961
Total liabilities and
shareholders' equity
Net interest income and interest
rate spread
3.48
3.58
Net interest margin
3.55
3.65
Ratio of average interest-earning
assets to average interest-bearing
liabilities
103.70
103.19
Average loan and lease balances include non-accruing loans and leases.
Rate/Volume Analysis. The following table sets forth the effects of changing rates and volumes on net interest income. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The total column represents the sum of the prior columns. For purposes of this table, increases or decreases attributable to changes in both rate and volume that cannot be segregated have been allocated proportionally based on the changes due to rate and the changes due to volume.
2020 vs. 2019
Increase (Decrease) Due to
Rate
Volume
Interest income:
Federal funds sold and interest
earning balances in other banks
(647
(242
(889
(87
532
445
(1,040
4,322
3,282
(3,079
13,792
10,713
(4,853
18,404
13,551
Interest expense:
(871
929
(1
(7
(1,439
5,327
3,888
(2,277
6,272
3,995
(2,576
12,132
9,556
Provision for Loan and Lease Credit Losses
The provision for loan and lease credit losses represents the amount necessary to be charged against the current period’s earnings to maintain the allowance for credit losses (“ACL”) on loans and leases at a level that is appropriate in relation to the estimated losses inherent in the loan and lease portfolio.
Losses inherent in loan relationships are mitigated if a portion of the loan is guaranteed by the SBA or USDA. A typical SBA 7(a) loan carries a 75% guarantee while USDA guarantees range from 50% to 90% depending on loan size, which serve to reduce the risk profile of these loans. The Company believes that its focus on compliance with regulations and guidance from the SBA and USDA are key factors to managing this risk.
For the first quarter of 2020, the provision for loan and lease credit losses was $11.8 million compared to $3.0 million for the same period in 2019, an increase of $8.8 million. The Company adopted the new current expected credit losses (“CECL”) standard effective January 1, 2020 and accordingly determined to use forecasted levels of unemployment as a primary economic variable in forecasting future expected losses. Approximately $6.5 million of the first quarter 2020 provision was estimated to be based upon the severity of recent independent unemployment forecasts as a result of the COVID-19 pandemic with the remaining increase primarily due to continued growth of loans and leases held for investment combined with increased levels of criticized and classified loans and leases and charge-offs, with charge-offs in the Government Contracting vertical having a significant impact on historical loss factors.
Loans and leases held for investment at historical cost were $1.98 billion as of March 31, 2020, increasing by $870.2 million, or 78.0%, compared to March 31, 2019. This growth was fueled by strong loan origination volumes and retaining substantially more loans on the balance sheet.
Net charge-offs for loans and leases measured at historical cost were $2.8 million, or 0.58% of average quarterly loans and leases held for investment, measured at historical cost, on an annualized basis, for the three months ended March 31, 2020, compared to $87 thousand in net recoveries, or (0.03)%, for the three months ended March 31, 2019. The increase in net charge-offs was largely comprised of two loans in the Government Contracting vertical. Net charge-offs are a key element of historical experience in the Company's estimation of the allowance for credit losses on loans and leases.
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In addition, at March 31, 2020, nonperforming loans and leases not guaranteed by the SBA or USDA, excluding $8.2 million and $8.5 million accounted for under the fair value option at March 31, 2020 and 2019, respectively, totaled $9.6 million, which was 0.48% of the held for investment loan and lease portfolio measured at historical cost compared to $7.3 million, or 0.66% of loans and leases held for investment at March 31, 2019.
Noninterest Income
Noninterest income is principally comprised of net gains from the sale of SBA and USDA-guaranteed loans along with loan servicing revenue and related revaluation of the servicing asset. Revenue from the sale of loans depends upon the volume, maturity structure and rates of underlying loans as well as the pricing and availability of funds in the secondary markets prevailing in the period between completed loan funding and closing of sale. In addition, the loan servicing revaluation is significantly impacted by changes in market rates and other underlying assumptions such as prepayment speeds and default rates. Net (loss) gain on loans accounted for under the fair value option is also significantly impacted by changes in market rates, prepayment speeds and inherent credit risk. Other less common elements of noninterest income include nonrecurring gains and losses on investments.
The following table shows the components of noninterest income and the dollar and percentage changes for the periods presented.
2020/2019 Increase (Decrease)
Percent
(988
(13.33
)%
(652
(16.14
6,914
164.70
Net (loss) gain on loans accounted for under the fair
value option
(12,721
(610.71
(464
23.04
(167
(162.14
(Loss) gain on sale of investment securities
available-for-sale
(84
(1,680.00
299
12.86
100.00
(389
(49.94
(966
(39.16
(7,574
(56.88
For the three months ended March 31, 2020, noninterest income decreased by $7.6 million, or 56.9%, compared to the three months ended March 31, 2019. The decrease from the prior year is primarily the result of the aforementioned $12.7 million increase in net loss on loans accounted for under the fair value option. Partially offsetting the overall decrease in noninterest income was an increase in net gains on sales of loans combined with increased management fee income arising from Canapi performing investment advisory services for a series of new funds providing venture capital to new and emerging financial technology companies.
The following table reflects loan and lease production, sales of guaranteed loans and the aggregate balance in guaranteed loans sold. These components are key drivers of the Company's noninterest income.
For years ended December 31,
Amount of loans and leases
originated
500,634
390,851
2,001,886
1,765,680
1,934,238
1,537,010
Guaranteed portions of
loans sold
162,297
62,940
340,374
945,178
787,926
761,933
Outstanding balance of
guaranteed loans sold (1)
2,761,015
2,952,774
2,746,840
3,045,460
2,680,641
2,278,618
This represents the outstanding principal balance of guaranteed loans serviced, as of the last day of the applicable period, which have been sold into the secondary market.
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Changes in various components of noninterest income are discussed in more detail below.
Loan Servicing Revenue: While portions of the loans that the Bank originates are sold and generate gain on sale revenue, servicing rights for those sold portions are retained by the Bank. In exchange for continuing to service sold loans, the Bank receives fee income represented in loan servicing revenue equivalent to 1.0% of the outstanding balance of SBA loans sold and 0.40% of the outstanding balance of USDA loans sold. In addition, the standard cost (adequate compensation) for servicing sold loans is approximately 0.40% of the balance of the loans sold, which is included in the loan servicing revaluation computations. Unrecognized servicing revenue above the standard cost to service is reflected in a servicing asset recorded on the balance sheet. Revenues associated with the servicing of loans are recognized over the expected life of the loan through the income statement, and the servicing asset is reduced as this revenue is recognized. For the quarter ended March 31, 2020, loan servicing revenue decreased $988 thousand, or 13.3%, to $6.4 million as compared to the quarter ended March 31, 2019, as a result of the declining balance of the serviced portfolio. At March 31, 2020, the outstanding balance of guaranteed loans sold in the secondary market was $2.76 billion compared to $2.95 billion at March 31, 2019.
Loan Servicing Revaluation: The Company revalues its serviced loan portfolio at least quarterly. The revaluation considers the amortization of the portfolio, current market conditions for loan sale premiums, and current prepayment speeds. For the three months ended March 31, 2020, there was a net negative loan servicing revaluation adjustment of $4.7 million compared to a net negative adjustment of $4.0 million for the three months ended March 31, 2019. The lower revaluation amount for the quarter ended March 31, 2020 as compared to the corresponding period of 2019 was primarily a result of declining market conditions arising from COVID-19. This decline was estimated to be approximately $2 million of the negative valuation adjustment in the first quarter of 2020.
Net Gains on Sale of Loans: For the three months ended March 31, 2020, net gains on sales of loans increased $6.9 million, or 164.7%, compared to the three months ended March 31, 2019. For the three months ended March 31, 2020, the volume of guaranteed loans sold increased $99.4 million, or 157.9%, to $162.3 million from $62.9 million for the three months ended March 31, 2019. With the average net gain on guaranteed loan sales increasing from $61.3 million to $63.1 million, per million sold, in the first quarters of 2019 and 2020, respectively, the overall increase in net gains on sales of loans in the first quarter of 2020 is due to a combination of higher volume of loans sold in the first quarter of 2020 to strengthen the Company’s capital and liquidity profile in light of uncertain market conditions and higher year over year premiums. Partially offsetting the increase in net gains on sale of loans are increased losses from fair value changes in exchange-traded interest rate futures contracts which increased by $1.5 million, from $1.7 million in the first quarter of 2019 to $3.2 million in the first quarter of 2020. The increase in losses on fair value changes in exchange-traded interest rate futures contracts was also influenced by the market effects of COVID-19.
Net (Loss) Gain on Loans Accounted for Under the Fair Value Option: For the three months ended March 31, 2020 the net loss on loans accounted for under the fair value option increased $12.7 million, or 610.7%, compared to the three months ended March 31, 2019. The carrying amount of loans accounted for under the fair value option at March 31, 2020 and 2019 was $850.6 million ($19.2 million classified as held for sale and $831.4 million classified as held for investment) and $893.9 million ($25.3 million classified as held for sale and $868.7 million classified as held for investment), respectively, a decrease of $43.3 million, or 4.9%. Approximately $6.3 million of the first quarter 2020 net loss on loans accounted for under the fair value option was estimated to be based upon the severity of valuation assumptions as a result of the COVID-19 pandemic with the remainder largely a product of valuation inputs driven by increased levels of criticized and classified loans and leases and charge-offs.
Noninterest Expense
Noninterest expense comprises all operating costs of the Company, such as employee related costs, travel, professional services, advertising and marketing expenses, exclusive of interest and income tax expense.
The following table shows the components of noninterest expense and the related dollar and percentage changes for the periods presented.
6,208
28.41
Non-staff expenses:
581
48.42
(245
(11.23
(3
(0.22
50.47
758
31.60
1,310
39.40
817
49.85
875
137.80
177
8.88
Total non-staff expenses
21,428
16,346
5,082
31.09
11,290
29.55
Total noninterest expense for the three months ended March 31, 2020 increased $11.3 million, or 29.6%, compared to the same period in 2019. The increase in noninterest expense was largely driven by salaries and employee benefits and equipment expenses. Changes in various components of noninterest expense are discussed below.
Salaries and employee benefits: Total personnel expense for the three months ended March 31, 2020 increased by $6.2 million, or 28.4%, compared to the same period in 2019. While personnel expense is carefully managed, this increase is principally due to the Company’s commitment to and investment in its workforce to support growth and a variety of initiatives. Total full-time equivalent employees increased from 507 at March 31, 2019 to 622 at March 31, 2020. Salaries and employee benefits expense included $2.9 million of stock-based compensation for the three months ended March 31, 2020 and 2019. Expenses related to the employee stock purchase program, stock grants, stock option compensation and restricted stock expense are all considered stock-based compensation.
Equipment expense: For the three months ended March 31, 2020, equipment expense increased $1.3 million, or 39.4%, compared to the same period in 2019. Primary factors contributing to this increase were the depreciation of technology and infrastructure investments to support the Company’s growth initiatives.
Income Tax Expense
For the first quarter of 2020 and 2019 there was an income tax benefit of $7.8 million and income tax expense of $317 thousand, and the Company’s effective tax rates were (50.6)% and 11.8%, respectively. The negative effective rate during the first quarter of 2020 was a result of a discrete, estimated income tax benefit of $3.7 million related to the enactment of the CARES Act on March 27, 2020. The CARES Act allows taxpayers to carryback certain net operating losses to each of the five taxable years preceding the taxable year of such losses. As a result, the Company will be allowed to carryback its 2018 net operating loss which had been utilized and measured under the prior law using a 21% corporate income tax rate to pre-2018 taxable years during which the corporate income tax rate was 35%. The remaining income tax benefit in the first quarter of 2020 was predominantly driven by the Company’s overall net pretax loss. Based upon current projections, the effective tax rate for the remainder of 2020 is expected to be approximately 26.0% to 28.0%; however, there can be no assurance as to the actual amount because it will be dependent upon the nature and amount of future income and expenses, investments generating investment tax credits and transactions with discrete tax effects.
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Discussion and Analysis of Financial Condition
March 31, 2020 vs. December 31, 2019
Total assets at March 31, 2020 were $5.28 billion, an increase of $461.3 million, or 9.6%, compared to total assets of $4.81 billion at December 31, 2019. The growth in total assets was principally driven by the following:
Cash and cash equivalents, comprised of cash and due from banks and federal funds sold, increased $191.5 million as a product of increased levels of deposits, loan sales and borrowings arising from efforts to strengthen the Company’s capital and liquidity profile in light of the uncertain market conditions and the developing pandemic;
Increased investment securities available-for-sale of $34.1 million which was driven by the Company’s strategy also to enhance liquidity and improve asset-liability repricing mix; and
Growth in loans and leases held for sale and held for investment of $219.8 million resulting from $500.6 million in originations, partially offset by current quarter sales.
Cash and cash equivalents, comprised of cash and due from banks and federal funds sold, was $415.1 million at March 31, 2020, an increase of $191.5 million, or 85.7%, compared to $223.5 million at December 31, 2019. As mentioned above, this increase reflects the impact of the efforts to strengthen the Company’s capital and liquidity profile considering uncertain market conditions and the developing pandemic at quarter end.
Total investment securities increased $34.1 million during the first three months of 2020, from $540.0 million at December 31, 2019, to $574.2 million at March 31, 2020, an increase of 6.3%. The Company increased its investment securities position during the first quarter of 2020 as part of its strategy to improve the returns of an enhanced liquidity profile and improve asset-liability repricing mix. At March 31, 2020, the investment portfolio was comprised of U.S. treasury, U.S. government agency, mortgage-backed securities and municipal bonds.
Loans held for sale increased $29.6 million, or 3.1%, during the first three months of 2020, from $966.4 million at December 31, 2019, to $996.1 million at March 31, 2020. This increase reflected the impact of origination activity during the first three months of 2020, partially offset by higher levels of loan sales during the quarter.
Loans and leases held for investment increased $190.2 million, or 7.2%, during the first three months of 2020, from $2.63 billion at December 31, 2019, to $2.82 billion at March 31, 2020. The increase was primarily the result of $500.6 million in loan and lease origination activities during the first three months of 2020.
Premises and equipment, net, decreased $4.9 million, or 1.8%, during the first three months of 2020 which was primarily driven by increased levels of depreciation of facilities and infrastructure to accommodate Company growth and solar panels to meet leasing obligations in prior periods.
Other assets increased $29.4 million, or 18.8%, from $156.1 million at December 31, 2019 to $185.5 million at March 31, 2020. This increase was principally the result a $17.8 million increase in wire suspense from loan sales late in the quarter combined with an increase in taxes receivable of $8.7 million related to tax benefits recognized in the first quarter of 2020 related to the CARES Act and the Company’s overall pre-tax loss. See Income Tax Expense in Results of Operations for more information.
Total deposits were $4.64 billion at March 31, 2020, an increase of $413.0 million, or 9.8%, from $4.23 billion at December 31, 2019. The increase in deposits was driven by the combined success of deposit gathering campaigns to support the growth in loan and lease originations and balance sheet management initiatives.
Borrowings increased to $50.0 million at March 31, 2020 from $14 thousand at December 31, 2019. This increase was the result of the above mentioned efforts to strengthen the Company’s capital and liquidity profile in light of the uncertain market conditions and the developing pandemic.
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Shareholders’ equity at March 31, 2020 was $533.8 million as compared to $532.4 million at December 31, 2019. The book value per share was $13.22 at March 31, 2020 compared to $13.20 at December 31, 2019. Average equity to average assets was 10.8% for the three months ended March 31, 2020 compared to 13.1% for the three months ended December 31, 2019. The increase in shareholders’ equity was principally the result of other comprehensive income of $6.0 million and stock-based compensation expense of $2.9 million, partially offset by net loss of $7.6 million and $1.2 million in dividends.
During the first quarter of 2020, 200,000 shares of Class B common stock (non-voting) were converted to Class A common stock (voting) under a private sale. The conversion decreased the value of Class B common stock (non-voting) and increased the value of Class A common stock (voting) by $2.1 million.
Asset Quality
Management considers asset quality to be of primary importance. A formal loan review function, independent of loan origination, is used to identify and monitor problem loans. This function reports directly to the Audit & Risk Committee of the Board of Directors.
Nonperforming Assets
The Bank places loans and leases on nonaccrual status when they become 90 days past due as to principal or interest payments, or prior to that if management has determined based upon current information available to them that the timely collection of principal or interest is not probable. When a loan or lease is placed on nonaccrual status, any interest previously accrued as income but not actually collected is reversed and recorded as a reduction of loan or lease interest and fee income. Typically, collections of interest and principal received on a nonaccrual loan or lease are applied to the outstanding principal as determined at the time of collection of the loan or lease.
Troubled debt restructurings (“TDRs”) occur when, because of economic or legal reasons pertaining to the debtor’s financial difficulties, debtors are granted concessions that would not otherwise be considered. Such concessions would include, but are not limited to, the transfer of assets or the issuance of equity interests by the debtor to satisfy all or part of the debt, modification of the terms of debt or the substitution or addition of debtor(s).
Total nonperforming assets and troubled debt restructurings, including loans carried at fair value, at March 31, 2020 were $136.7 million, which represented a $37.9 million, or 38.4%, increase from December 31, 2019. These nonperforming assets, at March 31, 2020 were comprised of $99.4 million in nonaccrual loans and leases and $6.7 million in foreclosed assets. Of the $136.7 million of nonperforming assets and TDRs, $104.5 million carried an SBA guarantee, leaving an unguaranteed exposure of $32.2 million in total nonperforming assets and TDRs at March 31, 2020. This represents an increase of $2.0 million, or 6.8%, from an unguaranteed exposure of $27.2 million at December 31, 2019.
The following table provides information with respect to nonperforming assets and troubled debt restructurings, excluding loans measured at fair value, at the dates indicated.
March 31, 2020 (1)
December 31, 2019 (1)
Nonaccrual loans and leases:
Total nonperforming loans and leases (all on nonaccrual)
21,937
Total accruing loans and leases past due 90 days or more
Total troubled debt restructurings
22,537
16,566
Less nonaccrual troubled debt restructurings
(6,080
(2,225
Total performing troubled debt restructurings
16,457
14,341
Total nonperforming assets and troubled debt restructurings
57,289
41,890
Total nonperforming loans and leases to total loans and leases held for
1.72
1.22
Total nonperforming loans and leases to total assets
0.77
0.55
Total nonperforming assets and troubled debt restructurings to total assets
1.29
1.05
Nonaccrual loans and leases guaranteed by U.S. government:
Total nonperforming loans and leases guaranteed by the SBA (all on
nonaccrual)
14,713
Total accruing loans and leases past due 90 days or more guaranteed by the
SBA
Foreclosed assets guaranteed by the SBA
5,266
Total troubled debt restructurings guaranteed by the SBA
14,387
10,845
Less nonaccrual troubled debt restructurings guaranteed by the SBA
(3,062
(385
Total performing troubled debt restructurings guaranteed by SBA
11,325
10,460
Total nonperforming assets and troubled debt restructurings guaranteed
by the SBA
41,056
29,665
Total nonperforming loans and leases not guaranteed by the SBA to total
loans and leases held for investment
0.48
0.40
assets
0.22
0.18
Total nonperforming assets and troubled debt restructurings not
guaranteed by the SBA to total assets
0.37
0.31
Excludes loans measured at fair value.
Nonperforming assets and TDRs, excluding loans carried at fair value, at March 31, 2020 were $57.3 million, which represented a $15.3 million, or 36.8%, increase from December 31, 2019. These nonperforming assets, at March 31, 2020 were comprised of $34.1 million in nonaccrual loans and leases and $6.7 million in foreclosed assets. Of the $57.3 million of nonperforming assets and TDRs, $41.1 million carried an SBA guarantee, leaving an unguaranteed exposure of $16.2 million in total nonperforming assets and TDRs at March 31, 2020. This represents an increase of $4.0 million, or 32.8%, from an unguaranteed exposure of $12.2 million at December 31, 2019.
See the below discussion related to the change in potential problem and impaired loans and leases for management’s overall observations regarding growth in total nonperforming loans and leases.
As a percentage of the Bank’s total capital, nonperforming loans and leases, excluding loans measured at fair value, represented 7.1% at March 31, 2020, compared to 4.4% at December 31, 2019. Adjusting the ratio to include only the unguaranteed portion of nonperforming loans and leases at historical cost to reflect management’s belief that the greater magnitude of risk resides in this portion, the ratios at March 31, 2020 and December 31, 2019 were 2.0% and 1.5%, respectively.
48
As of March 31, 2020, and December 31, 2019, potential problem (also referred to as criticized) and classified loans and leases, excluding loans measured at fair value, totaled $143.2 million and $129.1 million, respectively. The following is a discussion of these loans and leases. Risk Grades 5 through 8 represent the spectrum of criticized and classified loans and leases. At March 31, 2020, the portion of criticized loans and leases guaranteed by the SBA or USDA totaled $80.7 million resulting in unguaranteed exposure risk of $62.6 million, or 4.8% of total held for investment unguaranteed exposure measured at historical cost. This compares to the December 31, 2019 portion of criticized loans and leases guaranteed by the SBA or USDA which totaled $65.8 million resulting in unguaranteed exposure risk of $63.3 million, or 5.4% of total held for investment unguaranteed exposure measured at historical cost. As of March 31, 2020, loans and leases measured at historical cost in Other Industries, Healthcare and Veterinary verticals comprise the largest portion of the total potential problem and classified loans and leases at 62.3%, 21.4%, and 6.3%, respectively. Of the 62.3% of total potential problem and classified loans and leases in Other Industries, 15.6% was related to Wine and Craft Beverage, 13.3% to Hotels, 8.5% to Self Storage, 5.2% to Educational Services and 4.1% to Mergers & Acquisitions. As of December 31, 2019, loans and leases in Other Industries, Healthcare, and Veterinary Industry verticals comprise the largest portion of the total potential problem and impaired loans and leases at 62.4%, 20.8%, and 7.1%, respectively. Of the 62.4% of total potential problem and impaired loans and leases in Other Industries, 14.7% was related to Hotels, 14.3% to Wine and Craft Beverage, 8.4% to Self Storage, 6.1% to Government Contracting, and 5.7% to Educational Services. Two previously impaired Government Contracting relationships were charged off in the first quarter of 2020 which resulted in a reduction in impaired loans for this vertical. The majority of the increase in potential problem and classified loans and leases was comprised of a relatively small number of borrowers largely concentrated in the Company’s more mature verticals. Furthermore, the Company believes that its underwriting and credit quality standards have improved as the business has matured. However, systemic issues which began to emerge during the latter part of 2019 related to higher than expected levels of competition in the Wine and Craft Beverage and Family Entertainment Center verticals continue to contribute to the increase in classified loans and leases. Management has implemented tighter underwriting guidelines for these verticals and will continue to monitor new origination quality.
The Bank does not classify loans and leases that experience insignificant payment delays and payment shortfalls as impaired. The Bank considers an “insignificant period of time” from payment delays to be a period of 90 days or less. The Bank would consider a modification for a customer experiencing what is expected to be a short-term event that has temporarily impacted cash flow. This could be due, among other reasons, to illness, weather, impact from a one-time expense, slower than expected start-up, construction issues or other short-term issues. In all cases, credit personnel will review the request to determine if the customer is stressed and how the event has impacted the ability of the customer to repay the loan or lease long term. To date, the only types of short-term modifications the Bank has given are payment deferral and interest only extensions. The Bank does not typically alter the rate or lengthen the amortization of the note due to insignificant payment delays. Short term modifications are not classified as TDRs, because they do not meet the definition set by the applicable accounting standards and the Federal Deposit Insurance Corporation.
Management endeavors to be proactive in its approach to identify and resolve problem loans and leases and is focused on working with the borrowers and guarantors of these loans and leases to provide loan and lease modifications when warranted. Management implements a proactive approach to identifying and classifying loans and leases as special mention (also referred to as criticized), Risk Grade 5. For example, at March 31, 2020, and December 31, 2019, Risk Grade 5 loans and leases, excluding loans measured at fair value, totaled $96.2 million and $89.5 million, respectively. The increase in Risk Grade 5 loans and leases, exclusive of loans measured at fair value, during the first quarter of 2020 was principally confined to five verticals: Senior Care ($4.2 million or 64.5%), Healthcare ($3.9 million or 59.8%), Mergers & Acquisitions ($1.4 million or 21.7%), Self Storage ($1.3 million or 20.1%), and Funeral Home & Cemetery ($1.1 million or 16.8%). At March 31, 2020, approximately 95.6% of loans and leases classified as Risk Grade 5 are performing with no current payments past due more than 30 days. While the level of nonperforming assets fluctuates in response to changing economic and market conditions, in light of the relative size and composition of the loan and lease portfolio and management’s degree of success in resolving problem assets, management believes that a proactive approach to early identification and intervention is critical to successfully managing a small business loan portfolio.
Allowance for Credit Losses on Loans and Leases
The allowance for credit losses (“ACL”) on loans and leases is a valuation account that is deducted from, or added to, the amortized cost basis of loans and leases to present a net amount expected to be collected. The ACL excludes loans held for sale and loans accounted for under the fair value option. 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. Judgment in determining the adequacy of the ACL is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available and as situations and information change.
The ACL is evaluated on a quarterly basis by management and is estimated using relevant information, from internal and external sources, relating to past events, current conditions, and reasonable and supportable forecasts. The Company’s historical credit loss experience provides the basis for the estimation of expected credit losses. Management adjusts historical loss information for differences in current risk characteristics such as portfolio risk grading, delinquency levels, or portfolio mix as well as for changes in environmental conditions such as changes in unemployment rates.
The ACL of $28.2 million at December 31, 2019 increased by $7.7 million, or 27.2%, to $35.9 million at March 31, 2020. The ACL, as a percentage of loans and leases held for investment at historical cost, amounted to 1.8% at March 31, 2020 and 1.6% at December 31, 2019. As mentioned earlier, the Company adopted the new CECL standard effective January 1, 2020. Upon adoption, the Company recorded a $1.3 million decrease in the ACL. In implementing CECL, the Company accordingly determined to use forecasted levels of unemployment as a primary economic variable in forecasting future expected losses. Based upon the severity of recent independent unemployment forecasts as a result of the COVID-19 pandemic at quarter end, the Company’s allowance for credit losses on loans and leases increased significantly, combined with the effects of the above discussed increased levels of criticized and classified loans and leases and charge-offs, as addressed more fully in the Provision for Loan and Lease Credit Losses section of Results of Operations.
Actual past due held for investment loans and leases, inclusive of loans measured at fair value, have increased by $33.2 million since December 31, 2019. These past dues represent 31 relationships spread across ten verticals with no consistent underlying origins of delinquency. Total loans and leases 90 or more days past due increased $21.2 million, or 54.3%, compared to December 31, 2019. The increase was primarily the result of an $18.1 million increase in the guaranteed portion of past due loans compared to December 31, 2019. At March 31, 2020 and December 31, 2019, total held for investment unguaranteed loans and leases past due as a percentage of total held for investment unguaranteed loans and leases, inclusive of loans measured at fair value, was 2.10% and 1.67%, respectively. Total unguaranteed loans and leases past due were comprised of $11.4 million carried at historical cost and $16.1 million measured at fair value as of March 31, 2020, each increasing $3.5 million and $4.5 million, respectively, since December 31, 2019. Management continues to actively monitor and work to improve asset quality. Management believes the ACL of $35.9 million at March 31, 2020 is appropriate in light of the risk inherent in the loan and lease portfolio. Management’s judgments are based on numerous assumptions about current and expected events that it believes to be reasonable, but which may or may not be valid. Thus, there can be no assurance that loan and lease credit losses in future periods will not exceed the current ACL or that future increases in the will not be required. No assurance can be given that management’s ongoing evaluation of the loan and lease portfolio in light of changing economic conditions and other relevant circumstances will not require significant future additions to the ACL, thus adversely affecting the Company’s operating results. Additional information on the ACL is presented in Note 5. Loans and Leases Held for Investment and Credit Quality of the Notes to the Unaudited Condensed Consolidated Financial Statements in this report.
Liquidity Management
Liquidity management refers to the ability to meet day-to-day cash flow requirements based primarily on activity in loan and deposit accounts of the Company’s customers. Liquidity is immediately available from four major sources: (a) cash on hand and on deposit at other banks; (b) the outstanding balance of federal funds sold; (c) the market value of unpledged investment securities; and (d) availability under lines of credit. At March 31, 2020, the total amount of these four items was $1.38 billion, or 26.2% of total assets, an increase of $190.2 million from $1.19 billion, or 24.8% of total assets, at December 31, 2019.
Loans and other assets are funded by loan sales, wholesale deposits and core deposits. To date, an increasing retail deposit base and an increased long term wholesale deposit base have been adequate to meet loan obligations, while maintaining the desired level of immediate liquidity. Additionally, the investment securities portfolio is available for both immediate and secondary liquidity purposes.
At March 31, 2020, none of the investment securities portfolio was pledged to secure public deposits or pledged to retail repurchase agreements, leaving $574.2 million available as lendable collateral.
50
Contractual Obligations
The following table presents the Company’s significant fixed and determinable contractual obligations by payment date as of March 31, 2020. The payment amounts represent those amounts contractually due to the recipient. The table excludes liabilities recorded where management cannot reasonably estimate the timing of any payments that may be required in connection with these liabilities.
Payments Due by Period
Less than
One Year
One to
Three Years
Three to
Five Years
More than
Deposits without stated maturity
1,270,053
Time deposits
3,372,095
2,178,839
743,385
361,933
87,938
50,004
Operating lease obligations
3,086
569
880
402
1,235
4,695,246
3,499,465
744,273
362,335
89,173
As of March 31, 2020, and December 31, 2019, the Company had unfunded commitments to provide capital contributions for on-balance sheet investments in the amount of $16.9 million.
Asset/Liability Management and Interest Rate Sensitivity
One of the primary objectives of asset/liability management is to maximize the net interest margin while minimizing the earnings risk associated with changes in interest rates. One method used to manage interest rate sensitivity is to measure, over various time periods, the interest rate sensitivity positions, or gaps. This method, however, addresses only the magnitude of asset and liability repricing timing differences as of the report date and does not address earnings, market value nor growth. Therefore, management uses an earnings simulation model to prepare, on a regular basis, earnings projections based on a range of interest rate scenarios to more accurately measure interest rate risk.
The balance sheet is asset-sensitive with a total cumulative gap position of 1.3% at March 31, 2020. The asset sensitivity is relatively stable from the prior quarter. An asset-sensitive position means that net interest income will generally move in the same direction as interest rates. For instance, if interest rates increase, net interest income can be expected to increase, and if interest rates decrease, net interest income can be expected to decrease. The Company attempts to mitigate interest rate risk by match funding assets and liabilities with similar rate instruments. The quarterly revaluation adjustment to the servicing asset, however, adjusts in an opposite direction to interest rate changes. Asset/liability sensitivity is primarily derived from the prime-based loans that adjust as the prime interest rate changes and the longer duration of indeterminate term deposits.
Capital
The maintenance of appropriate levels of capital is a management priority and is monitored on a regular basis. The Company’s principal goals related to the maintenance of capital are to provide adequate capital to support the Company’s risk profile consistent with the risk appetite approved by the Board of Directors; provide financial flexibility to support future growth and client needs; comply with relevant laws, regulations, and supervisory guidance; achieve optimal credit ratings for the Company and its subsidiaries; and provide a competitive return to shareholders. Management regularly monitors the capital position of the Company on both a consolidated and bank level basis. In this regard, management’s goal is to maintain capital at levels that are in excess of the regulatory “well capitalized” levels. Risk-based capital ratios, which include Tier 1 Capital, Total Capital and Common Equity Tier 1 Capital, are calculated based on regulatory guidance related to the measurement of capital and risk-weighted assets.
Capital amounts and ratios as of March 31, 2020 and December 31, 2019, are presented in the table below.
Actual
Minimum Capital
Requirement
Minimum To Be
Well Capitalized
Under Prompt
Corrective Action
Provisions (1)
Ratio
Consolidated - March 31, 2020
Common Equity Tier 1 (to Risk-Weighted Assets)
494,870
13.81
161,247
4.50
N/A
Total Capital (to Risk-Weighted Assets)
531,452
14.83
286,661
8.00
Tier 1 Capital (to Risk-Weighted Assets)
214,996
6.00
Tier 1 Capital (to Average Assets)
9.94
199,107
4.00
Bank - March 31, 2020
445,499
12.67
158,255
228,590
6.50
482,081
13.71
281,342
351,677
10.00
211,006
9.00
197,990
247,487
5.00
Consolidated - December 31, 2019
499,513
14.90
150,927
527,747
15.74
268,315
201,236
10.65
187,582
Bank - December 31, 2019
451,807
13.66
148,950
215,150
480,040
14.51
264,800
331,000
198,600
9.68
186,627
233,283
Prompt corrective action provisions are not applicable at the bank holding company level.
Critical Accounting Policies and Estimates
The preparation of consolidated financial statements in accordance with GAAP requires the Company to make estimates and judgments that affect reported amounts of assets, liabilities, income and expenses and related disclosure of contingent assets and liabilities. The Company bases estimates on historical experience and on various other assumptions that are believed to be reasonable under current circumstances, results of which form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily available from other sources. Estimates are evaluated on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions.
Accounting policies, as described in detail in the Notes to the Company’s Unaudited Condensed Consolidated Financial Statements in this report and in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, are an integral part of the Company’s consolidated financial statements. A thorough understanding of these accounting policies is essential when reviewing the Company’s reported results of operations and financial position. Management believes that the critical accounting policies and estimates listed below require the Company to make difficult, subjective or complex judgments about matters that are inherently uncertain.
Determination of the allowance for credit losses on loans and leases;
Valuation of loans accounted for under the fair value option;
Valuation of servicing assets;
Income taxes;
Restricted stock unit awards with market price conditions;
Valuation of foreclosed assets;
52
Business combination and goodwill; and
Unconsolidated joint ventures.
Changes in these estimates, that are likely to occur from period to period, or the use of different estimates that the Company could have reasonably used in the current period, would have a material impact on the Company’s financial position, results of operations or liquidity.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Management considers interest rate risk the most significant market risk. Interest rate risk is the exposure to adverse changes in net interest income due to changes in interest rates. Consistency of net interest income is largely dependent upon the effective management of interest rate risk.
The Company’s Asset/Liability Management Committee (“ALCO”), which includes senior management representatives and reports to the Board of Directors, monitors and manages interest rate risk. See “Asset/Liability Management and Interest Rate Sensitivity” in Item 2 of this Form 10-Q for further discussion.
The objective of asset/liability management is the maximization of net interest income within the Company’s risk guidelines. This objective is accomplished through management of the balance sheet composition, maturities, liquidity, and interest rate risk exposures arising from changing economic conditions, interest rates and customer preferences.
To identify and manage its interest rate risk, the Company employs an earnings simulation model to analyze net interest income sensitivity to changing interest rates. The model is based on contractual cash flows and repricing characteristics and incorporates market-based assumptions regarding the effect of changing interest rates on the prepayment rates of certain assets and liabilities. The model also includes management projections for activity levels in each of the product lines offered by the Bank. Assumptions are inherently uncertain, and the measurement of net interest income or the impact of rate fluctuations on net interest income cannot be precisely predicted. Actual results may differ materially from simulated results due to timing, magnitude, and frequency of interest rate changes as well as changes in market conditions and management strategies.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
An evaluation of the Company’s disclosure controls and procedures (as defined in Rules 13(a)-15(e) and 15(d)-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), was carried out under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer as of March 31, 2020, the last day of the period covered by this Quarterly Report. The Company’s Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures were effective as of March 31, 2020 in ensuring that the information required to be disclosed in the reports the Company files or submits under the Exchange Act is (i) accumulated and communicated to management (including the Company’s Chief Executive Officer and Chief Financial Officer) as appropriate to allow timely decisions regarding required disclosures, and (ii) recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms.
Changes in Internal Control Over Financial Reporting
Beginning January 1, 2020, the Company adopted ASU 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” The Company implemented changes to the policies, processes, and controls over the estimation of the allowance for credit losses to support the adoption of ASU 2016-13. While many controls in operation under this new standard mirror controls under prior GAAP, there were some new controls implemented. Except as related to the adoption of ASU 2016‑13, there were no changes in the Company’s internal control over financial reporting during the three months ended March 31, 2020 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Item 1. Legal Proceedings
In the ordinary course of operations, the Company is party to various legal proceedings. The Company is not involved in, nor has it terminated during the three months ended March 31, 2020, any pending legal proceedings other than nonmaterial proceedings occurring in the ordinary course of business.
Item 1A. Risk Factors
There have been no material changes in the Company’s risk factors from those disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, with the exception of the following:
The ongoing COVID-19 pandemic and measures intended to prevent its spread could have a material adverse effect on our business, results of operations, and financial condition, and such effects will depend on future developments that are highly uncertain and difficult to predict.
Global health concerns relating to the COVID-19 outbreak and related government actions taken to reduce the spread of the virus have had a significant negative impact on the macroeconomic environment, and the outbreak has significantly increased economic uncertainty and reduced economic activity. The outbreak has resulted in government authorities implementing numerous measures to try to contain the virus, such as travel bans and restrictions, quarantines, shelter-in-place or total lock-down orders and business limitations and shutdowns. Such measures have significantly contributed to rising unemployment and negatively impacted consumer and business spending. The United States government has taken steps to attempt to mitigate some of the more severe anticipated economic effects of the virus, including the passage of the Coronavirus Aid, Relief, and Economic Security Act, or the CARES Act, but there can be no assurance that such steps will be effective or achieve their desired results in a timely fashion.
The outbreak has adversely impacted and is likely to further adversely impact our operations and the operations of our borrowers, customers, and business partners. For example, as a result of the significant uncertainty due to the COVID-19 pandemic we realized a substantial build in our allowance for credit losses for the first quarter of 2020. We could also experience declining values of other financial assets and other negative impacts on our financial position, including possible constraints on liquidity and capital, as well as higher costs of capital. A number of factors impacting us or our borrowers, customers or business partners could materially adversely affect our business, results of operations, and financial condition, including but not limited to:
elevated levels of unemployment may lead to increases in loan delinquencies, losses, and charge-offs;
collateral for loans, including real estate, may decline in value, which could cause loan losses to increase;
demand for our products and services may decline, making it difficult to grow or maintain assets and income;
noninterest income from premiums paid in the secondary market for the sale of loans may be reduced due to deteriorating market conditions and a decrease in the number of potential buyers;
the net worth and liquidity of loan guarantors may decline, impairing their ability to honor commitments to us;
we may experience operational failures due to changes in our normal business practices necessitated by the outbreak and related governmental actions;
third-party vendors on which we rely may not be able to provide us critical services;
our risk management policies and practices may be negatively impacted in general, including, but not limited to, the effectiveness and accuracy of our models given the lack of data and comparable precedent;
cyber and payment fraud risk may increase as cybercriminals attempt to profit from the disruption given increased online and remote activity; and
FDIC deposit insurance premiums may increase if the agency experiences additional resolution costs.
The spread of COVID-19 has caused us to modify our business practices (including restricting employee travel and developing work-from-home and social distancing plans for our employees), and we may take further actions as may be required by government authorities or as we determine are in the best interests of our employees, customers, and business partners. There is no certainty that such measures will be sufficient to mitigate the risks posed by the virus or will otherwise be satisfactory to government authorities.
Federal, state and local governmental authorities have enacted, and may enact in the future, legislation, regulations, and protocols in response to the COVID-19 pandemic, including governmental programs intended to provide economic relief to businesses and individuals. Our participation in and execution of any such programs may cause operational, compliance, reputational, and credit risks, which could result in litigation, governmental action or other forms of loss. There remains significant uncertainty regarding the measures that authorities will enact in the future and the ultimate impact of the legislation, regulations, and protocols that have been and will be enacted. For example, the CARES Act temporarily added a new program titled the Paycheck Protection Program (the “PPP”) to the SBA’s 7(a) loan program. The PPP is intended to provide economic relief to small businesses nationwide. Under the PPP, small businesses and other entities and individuals can apply for loans from existing SBA lenders and other approved lenders that enroll in the program, subject to numerous limitations and eligibility criteria. Since the PPP launched on April 3, 2020, we have been an active participant in the program originating a substantial number and principal amount of PPP loans. Rules and guidance regarding the PPP were not readily available at the start of the program, and the SBA and other government agencies continue to release additional rules and guidance that change or update the requirements and expectations of the regulatory agencies administering the PPP and regulating participating lenders. As of the date of this report, there remains some ambiguity in the laws, rules, and guidance regarding the operation of the PPP, with a number of important aspects of the PPP where regulatory agencies have not provided adequate guidance, particularly with respect to process, procedures and criteria for forgiveness of PPP loans. Banks participating in the PPP have been subject to litigation regarding the process and procedures that such banks used in processing applications for the PPP, and we may be exposed to the risk of litigation regarding our process and procedures used in processing applications for the PPP. If any such litigation is not resolved in a manner favorable to us, it may result in significant financial liability or adversely affect our reputation. In addition, litigation can be costly, regardless of outcome. We also face credit risk on PPP loans if a determination is made by the SBA that there is a deficiency in the manner in which the loan was originated, funded, or serviced by the Bank, such as an issue with the eligibility of a borrower to receive a PPP loan. In the event of a loss resulting from a default on a PPP loan and a determination by the SBA that there was a deficiency in the manner in which the PPP loan was originated, funded, or serviced by the Company, the SBA may deny its liability under the guaranty, reduce the amount of the guaranty, or, if it has already paid under the guaranty, seek recovery of any loss related to the deficiency from the Company.
Additionally, our future success and profitability substantially depends on the management skills of our executive officers and directors. The unanticipated loss or unavailability of key employees due to the outbreak could harm our ability to operate our business or execute our business strategy. We may not be successful in finding and integrating suitable successors in the event of key employee loss or unavailability.
The extent to which the COVID-19 outbreak impacts our business, results of operations, and financial condition will depend on future developments that are highly uncertain and are difficult to predict, including, but not limited to, the duration and spread of the outbreak, its severity, the actions to contain the virus or treat its impact, and how quickly and to what extent normal economic and operating conditions can resume. Even after the COVID-19 outbreak has subsided, we may continue to experience materially adverse impacts to our business, financial condition, and results of operations and prospects as a result of the virus’s global economic impact, including the availability of credit, adverse impacts on our liquidity, and any recession that has occurred or may occur in the future.
There are no comparable recent events that provide guidance as to the effect the spread of COVID-19 as a global pandemic may have, and the ultimate impact of the outbreak is highly uncertain and subject to change. We do not yet know the full extent of the impacts on our business, our operations, or the global economy as a whole. However, the effects could have a material impact on our results of operations and heighten many of our known risks described in the “Risk Factors” section of our Annual Report on Form 10-K for the year ended December 31, 2019.
55
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
On March 15, 2020, the Board of Directors of the Company authorized the repurchase of up to $20,000,000 in shares of the Company’s voting common stock from time to time through December 31, 2020 (the “Repurchase Program”). The Repurchase Program enables the Company to acquire shares through open market purchases or privately negotiated transactions, including through a Rule 10b5-1 plan, at the discretion of management and on terms (including quantity, timing, and price) that management determines to be advisable. Actions in connection with the repurchase program will be subject to various factors, including the Company’s capital and liquidity positions, regulatory and accounting considerations, the Company’s financial and operational performance, alternative uses of capital, the trading price of the Company’s common stock, and market conditions. The repurchase program does not obligate the Company to acquire a specific dollar amount or number of shares and may be extended, modified, or discontinued at any time. As of March 31, 2020, the Company had not made any purchases of shares under the Repurchase Program.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Mine Safety Disclosures
Not applicable.
Item 5. Other Information
Item 6. Exhibits.
Exhibits to this report are listed in the Index to Exhibits section of this report.
INDEX TO EXHIBITS
Exhibit
No.
Description of Exhibit
3.1
Amended and Restated Articles of Incorporation of Live Oak Bancshares, Inc. (incorporated by reference to Exhibit 3.1 of the registration statement on Form S-1, filed on June 19, 2015)
3.2
Amended Bylaws of Live Oak Bancshares, Inc. (incorporated by reference to Exhibit 3.2 of the amended registration statement on Form S-1, filed on July 13, 2015)
4.1
Form of Common Stock Certificate (incorporated by reference to Exhibit 4.1 of the registration statement on Form S-1, filed on June 19, 2015)
4.2
Registration and Other Rights Agreement between Live Oak Bancshares, Inc. and Wellington purchasers (incorporated by reference to Exhibit 4.2 of the registration statement on Form S-1, filed on June 19, 2015)
31.1
Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*
31.2
Certification of Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*
Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002**
Interactive data files pursuant to Rule 405 of Regulation S-T, formatted in Inline XBRL: (i) Condensed Consolidated Balance Sheets as of March 31, 2020 and December 31, 2019; (ii) Condensed Consolidated Statements of Income for the Three Months Ended March 31, 2020 and 2019; (iii) Condensed Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2020 and 2019; (iv) Condensed Consolidated Statements of Changes in Shareholders’ Equity for the Three Months Ended March 31, 2020 and 2019; (v) Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2020 and 2019; and (vi) Notes to Unaudited Condensed Consolidated Financial Statements*
104
Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101)
*
Indicates a document being filed with this Form 10-Q.
**
Furnished herewith. This exhibit shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, or otherwise subject to the liability of that Section. Such exhibit shall not be deemed incorporated into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934.
SIGNATURES
Pursuant to the requirements 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.
(Registrant)
Date: May 6, 2020
By:
/s/ S. Brett Caines
S. Brett Caines
Chief Financial Officer