UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
☒
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended June 30, 2021
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 August 3, 2021, there were 42,797,720 shares of the registrant’s voting common stock outstanding and 510,327 shares of the registrant’s non-voting common stock outstanding.
Live Oak Bancshares, Inc.
Form 10-Q
For the Quarterly Period Ended June 30, 2021
TABLE OF CONTENTS
Page
PART I. FINANCIAL INFORMATION
Item 1.
Financial Statements (Unaudited)
1
Condensed Consolidated Balance Sheets as of June 30, 2021 and December 31, 2020
Condensed Consolidated Statements of Income for the Three and Six Months Ended June 30, 2021 and 2020
2
Condensed Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2021 and 2020
3
Condensed Consolidated Statements of Changes in Shareholders’ Equity for the Three and Six Months Ended June 30, 2021 and 2020
4
Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2021 and 2020
6
Notes to Unaudited Condensed Consolidated Financial Statements
8
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
36
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
59
Item 4.
Controls and Procedures
60
PART II. OTHER INFORMATION
Legal Proceedings
61
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Mine Safety Disclosures
Item 5.
Other Information
Item 6.
Exhibits
62
Index to Exhibits
Signatures
63
Item 1. Financial Statements
Condensed Consolidated Balance Sheets
As of June 30, 2021 (unaudited) and December 31, 2020*
(Dollars in thousands)
June 30,
2021
December 31,
2020
Assets
Cash and due from banks
$
428,907
297,167
Federal funds sold
9,917
21,153
Certificates of deposit with other banks
6,000
6,500
Investment securities available-for-sale
817,896
750,098
Loans held for sale (includes $29,048 and $36,111 measured at fair value,
respectively)
1,064,911
1,175,470
Loans and leases held for investment (includes $743,226 and $815,374 measured
at fair value, respectively)
5,441,423
5,144,930
Allowance for credit losses on loans and leases
(57,848
)
(52,306
Net loans and leases
5,383,575
5,092,624
Premises and equipment, net
249,069
259,267
Foreclosed assets
1,793
4,155
Servicing assets
36,966
33,918
Other assets
244,152
231,951
Total assets
8,243,186
7,872,303
Liabilities and Shareholders’ Equity
Liabilities
Deposits:
Noninterest-bearing
89,768
75,287
Interest-bearing
6,431,065
5,637,541
Total deposits
6,520,833
5,712,828
Borrowings
1,012,431
1,542,093
Other liabilities
52,575
49,532
Total liabilities
7,585,839
7,304,453
Shareholders’ equity
Preferred stock, no par value, 1,000,000 shares authorized, none issued or outstanding
at June 30, 2021 and December 31, 2020
—
Class A common stock, no par value, 100,000,000 shares authorized, 42,754,133
and 41,344,689 shares issued and outstanding at June 30, 2021 and
December 31, 2020, respectively
299,809
298,890
Class B common stock, no par value, 10,000,000 shares authorized, 510,327 and
1,107,757 shares issued and outstanding at June 30, 2021 and
5,404
11,729
Retained earnings
339,011
235,724
Accumulated other comprehensive income
13,123
21,507
Total shareholders’ equity
657,347
567,850
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 and six months ended June 30, 2021 and 2020 (unaudited)
(Dollars in thousands, except per share data)
Three Months Ended
Six Months Ended
Interest income
Loans and fees on loans
84,780
62,022
169,773
120,983
Investment securities, taxable
2,975
3,786
5,904
7,548
Other interest earning assets
244
1,009
547
1,759
Total interest income
87,999
66,817
176,224
130,290
Interest expense
Deposits
14,820
25,121
31,764
48,376
1,717
798
3,048
855
Total interest expense
16,537
25,919
34,812
49,231
Net interest income
71,462
40,898
141,412
81,059
Provision for loan and lease credit losses
7,846
9,958
6,973
21,750
Net interest income after provision for loan
and lease credit losses
63,616
30,940
134,439
59,309
Noninterest income
Loan servicing revenue
6,218
6,691
12,652
13,113
Loan servicing asset revaluation
(3,181
(1,571
(1,688
(6,263
Net gains on sales of loans
16,234
10,695
28,163
21,807
Net gain (loss) on loans accounted for under the fair value
option
1,135
(1,089
5,353
(11,727
Equity method investments income (loss)
(2,278
(2,243
(3,435
(4,721
Equity security investments gains (losses), net
44,253
161
44,358
97
Gain on sale of investment securities available-for-sale, net
734
655
Lease income
2,616
2,635
5,215
5,259
Management fee income
1,473
1,206
3,407
2,850
Other noninterest income
3,641
5,192
7,143
7,083
Total noninterest income
70,111
22,411
101,168
28,153
Noninterest expense
Salaries and employee benefits
32,900
30,782
64,266
58,845
Travel expense
1,549
364
2,208
2,145
Professional services expense
3,329
1,385
7,160
3,322
Advertising and marketing expense
875
624
1,527
1,985
Occupancy expense
2,224
1,955
4,336
4,376
Data processing expense
4,234
2,764
8,128
5,921
Equipment expense
4,385
4,652
8,739
9,287
Other loan origination and maintenance expense
3,307
2,492
6,634
4,948
Renewable energy tax credit investment impairment
3,127
FDIC insurance
1,704
1,721
3,469
3,231
Other expense
3,051
1,361
6,236
3,531
Total noninterest expense
57,558
48,100
115,830
97,591
Income (loss) before taxes
76,169
5,251
119,777
(10,129
Income tax expense (benefit)
12,587
1,474
16,768
(6,304
Net income (loss)
63,582
3,777
103,009
(3,825
Basic earnings (loss) per share
1.48
0.09
2.40
(0.10
Diluted earnings (loss) per share
1.41
2.29
Condensed Consolidated Statements of Comprehensive Income
Other comprehensive income (loss) before tax:
Net unrealized gain (loss) on investment securities
arising during the period
5,257
10,673
(11,031
18,522
Reclassification adjustment for gain on sale of
securities available-for-sale included in net income (loss)
(734
(655
Other comprehensive income (loss) before tax
9,939
17,867
Income tax (expense) benefit
(1,262
(2,385
2,647
(4,288
Other comprehensive income (loss), net of tax
3,995
7,554
(8,384
13,579
Total comprehensive income
67,577
11,331
94,625
9,754
Condensed Consolidated Statements of Changes in Shareholders’ Equity
Common stock
Accumulated
other
Shares
Retained
comprehensive
Total
Class A
Class B
Amount
earnings
income
equity
Balance at March 31, 2021
42,259,091
692,253
305,855
275,377
9,128
590,360
Net income
Other comprehensive income
Issuance of restricted stock
124,607
Tax withholding related to vesting of
restricted stock and other
(5,713
Stock option exercises
188,509
951
Stock option based compensation expense
353
Restricted stock expense
3,767
Non-voting common stock converted to
voting common stock in private sale
181,926
(181,926
Transfer from retained earnings to other assets
for pro rata portion of equity method
investee stock compensation expense
1,349
Cash dividends ($0.03 per share)
(1,297
Balance at June 30, 2021
42,754,133
510,327
305,213
Balance at March 31, 2020
37,664,670
2,715,531
343,747
172,276
17,749
533,772
21,965
(61
33,539
148
406
2,933
Issuance of common stock in connection with
acquisition of wholly-owned subsidiary
89,927
1,122
(1,216
Balance at June 30, 2020
37,810,101
348,295
174,837
25,303
548,435
Condensed Consolidated Statements of Changes in Shareholders’ Equity (Continued)
income (loss)
Balance at December 31, 2020
41,344,689
1,107,757
310,619
Other comprehensive loss
416,823
(17,000
Employee stock purchase program
5,686
296
389,505
2,164
697
8,437
597,430
(597,430
Transfer from retained earnings to other
assets for pro rata portion of equity method
2,857
Cash dividends ($0.06 per share)
(2,579
Balance at December 31, 2019
37,401,443
2,915,531
340,397
180,265
11,724
532,386
Net loss
29,389
(109
25,161
232
64,181
772
5,475
200,000
(200,000
Cumulative effect of accounting change for
Accounting Standards Update 2016-13
822
(2,425
5
Condensed Consolidated Statements of Cash Flows
For the six months ended June 30, 2021 and 2020 (unaudited)
Cash flows from operating activities
Adjustments to reconcile net income (loss) to net cash used by operating activities:
Depreciation and amortization
10,566
11,194
Amortization of premium on securities, net of accretion
3,489
636
Deferred tax expense (benefit)
6,481
(11,164
Originations of loans held for sale
(654,707
(483,741
Proceeds from sales of loans held for sale
456,873
391,706
Net gains on sale of loans held for sale
(28,163
(21,807
Net gain on sale of foreclosed assets
(100
(10
Net (gain) loss on loans accounted for under fair value option
(5,353
11,727
Net (increase) decrease in servicing assets
(3,048
1,531
Net gain on disposal of long-lived asset
(114
Net (gain) loss on disposal of property and equipment
(48
38
Impairment on premises and equipment, net
904
Equity method investments (income) loss
3,435
4,721
Equity security investments (gains) losses, net
(44,358
(97
Stock based compensation excess tax benefit (shortfall)
8,430
(93
Changes in assets and liabilities:
Lease right-of-use assets and liabilities, net
(2
4,626
(15,123
(185
16,886
Net cash used by operating activities
(119,031
(70,078
Cash flows from investing activities
Purchases of securities available-for-sale
(212,935
(292,825
Proceeds from sales, maturities, calls, and principal paydown of
securities available-for-sale
130,617
70,962
Proceeds from SBA reimbursement/sale of foreclosed assets
3,141
2,026
Maturities of certificates of deposits with other banks
500
Business combination, net of cash acquired
(895
Loan and lease originations and principal collections, net
38,141
(1,946,676
Proceeds from sale of long-lived asset
8,988
Proceeds from sale of equity security investment
15,000
Proceeds from sale of premises and equipment
84
Purchases of premises and equipment, net
(1,232
(1,196
Net cash used by investing activities
(17,696
(2,168,604
Condensed Consolidated Statements of Cash Flows (Continued)
Cash flows from financing activities
Net increase in deposits
808,005
1,646,312
Proceeds from borrowings
594,791
1,781,966
Repayment of borrowings
(1,128,446
(60,951
Withholding cash issued in lieu of restricted stock
Shareholder dividend distributions
Net cash provided by financing activities
257,231
3,365,431
Net increase in cash and cash equivalents
120,504
1,126,749
Cash and cash equivalents, beginning
318,320
221,397
Cash and cash equivalents, ending
438,824
1,348,146
Supplemental disclosures of cash flow information
Interest paid
35,687
49,397
Income tax paid, net
9,043
460
Supplemental disclosures of noncash operating, investing, and financing activities
Unrealized holding (losses) gains on available-for-sale securities, net of taxes
Transfers from loans and leases to foreclosed real estate and other
repossessions or SBA receivable
9,837
11,178
Net transfers between foreclosed real estate and SBA receivable
150
30
Transfer of loans held for sale to loans and leases held for investment
434,322
98,002
Transfer of loans and leases held for investment to loans held for sale
156,698
22,948
Transfer from retained earnings to other assets for pro rata portion of equity
method investee stock compensation expense
Recording of secured borrowing
3,993
Equity security investment commitments
2,250
Business combination:
Assets acquired (excluding goodwill)
2,523
Liabilities assumed
2,074
Goodwill recorded
1,797
7
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 the State 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 lending and deposit related services to small businesses nationwide. The Bank identifies and extends 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’s ("USDA") Rural Energy for America Program ("REAP"), Water and Environmental Program (“WEP”) and Business & Industry ("B&I") loan programs.
The Company’s wholly owned subsidiaries are the Bank, Government Loan Solutions (“GLS”), Live Oak Grove, LLC (“Grove”), Live Oak Ventures, Inc. (“Live Oak Ventures”), and Canapi Advisors, LLC (“Canapi Advisors”).
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. Live Oak Number One, Inc. holds properties foreclosed on by the Bank. LOCEF provides financing to entities for renewable energy applications. Live Oak Private Wealth, LLC and its wholly owned subsidiary, Jolley Asset Management, LLC (“JAM”), provide high-net-worth individuals and families with strategic wealth and investment management services.
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. Canapi Advisors provides investment advisory services to a series of funds focused on providing venture capital to new and emerging financial technology companies.
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 had historically elected 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 gain (loss) on loans accounted for under the fair value option line item of the consolidated statements of income. During the first quarter of 2021, the Company chose not to elect fair value for all retained participating interests arising from new government guaranteed loan sales. 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. The Company also has less routinely generated gains and losses arising from its financial technology investments in its fintech segment.
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 six months ended June 30, 2021 are not necessarily indicative of the results of operations that may be expected for the year ending December 31, 2021. The Unaudited Condensed Consolidated Balance Sheet as of December 31, 2020 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, 2020, filed with the Securities Exchange Commission on February 25, 2021 (SEC File No. 001-37497) (the "2020 Form 10-K"). 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 2020 Form 10-K. These unaudited interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and footnotes in the Company's 2020 Form 10-K.
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
Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Management has determined that the Company has two significant operating segments: Banking and Fintech, as discussed more fully in Note 12. Segments. In determining the appropriateness of segment definition, the Company considers the criteria of ASC 280, Segment Reporting.
Business Combination
On April 1, 2020, the Company acquired 100% of the equity interests of JAM, a registered investment advisor based in Rocky Mount, North Carolina. Goodwill, intangible assets and contingent consideration of $1.8 million, $2.3 million and $2.1 million, respectively, have been recorded by the Company. Intangible assets are almost entirely comprised of customer relationships that are being amortized using the straight-line method over 15 years. As a result of this acquisition, the Bank's subsidiary Live Oak Private Wealth, LLC, expects to broaden service offerings to existing high-net-worth individuals and families, attract new clients from an expanded footprint and benefit from economies of scale. The acquisition did not materially impact the Company's financial position, results of operations or cash flows. Given the impact of the above acquisition was immaterial to the Company and its result of operations, pro forma information has not been included.
Reclassifications
Certain reclassifications have been made to the prior period’s condensed 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.
Note 2. Recent Accounting Pronouncements
In December 2019, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2019-12, “Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes” (“ASU 2019-12”). ASU 2019-12 simplifies accounting for income taxes by removing specific technical exceptions in ASC 740 related to the incremental approach for intra-period tax allocation, the methodology for calculating income taxes in an interim period and the recognition for deferred tax liabilities for outside basis differences. ASU 2019-12 also simplifies aspects of the accounting for franchise taxes and enacted changes in tax laws or rates and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. The Company adopted the standard on January 1, 2021 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 Company adopted the standard on January 1, 2021 with no material effect on its 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 and can be adopted by 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.
9
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 share in the net income of the Company.
Basic earnings (loss) per share:
Weighted-average basic shares outstanding
43,173,312
40,506,671
42,924,844
40,420,425
Diluted earnings (loss) per share:
Net income (loss), for diluted earnings (loss) per share
Total weighted-average basic shares outstanding
Add effect of dilutive stock options and restricted stock
grants
1,889,080
615,354
1,956,158
677,612
Total weighted-average diluted shares outstanding
45,062,392
41,122,025
44,881,002
41,098,037
Anti-dilutive shares
9,319
2,077,886
Note 4. Securities
Available-for-Sale
The carrying amount of securities and their approximate fair values are reflected in the following table:
June 30, 2021
Amortized
Cost
Unrealized
Gains
Losses
Fair
Value
US government agencies
10,443
321
10,764
Mortgage-backed securities
786,428
21,789
5,225
802,992
Municipal bonds
3,257
387
3,640
Other debt securities
800,628
22,497
5,229
December 31, 2020
15,440
479
15,919
703,092
28,302
940
730,454
3,267
462
3,725
721,799
29,243
944
During the three months ended June 30, 2021, one US government agency matured at $5.0 million and four mortgage-backed securities totaling $10.4 million were paid off. During the three months ended June 30, 2020, one US government agency matured at $2.5 million, eleven mortgage-backed securities totaling $9.6 million were sold resulting in a net gain of $114 thousand, and two municipal bonds totaling $5.2 million were sold resulting in a net gain of $620 thousand.
During the six months ended June 30, 2021, one US government agency matured at $5.0 million and six mortgage-backed securities totaling $16.9 million were paid off. During the six months ended June 30, 2020, one US government agency matured at $2.5 million, thirteen mortgage-backed securities totaling $14.2 million were sold resulting in a net gain of $35 thousand, and two municipal bonds totaling $5.2 million were sold resulting in a net gain of $620 thousand.
10
Accrued interest receivable on available-for-sale securities totaled $1.7 million and $1.8 million at June 30, 2021 and December 31, 2020, respectively, and is included in other assets in the accompanying Unaudited Condensed Consolidated Balance Sheets.
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
356,213
4,973
16,685
252
372,898
96
16,781
256
372,994
156,904
917
1,853
23
158,757
1,949
27
158,853
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 June 30, 2021, there were four mortgage-backed securities and one municipal bond in unrealized loss positions for greater than 12 months and ninety-seven mortgage-backed securities in unrealized loss positions for less than 12 months. Unrealized losses at December 31, 2020 were comprised of three mortgage-backed securities and one municipal bond in unrealized loss positions for greater than 12 months and twenty-nine mortgage-backed securities in unrealized loss positions for less than 12 months.
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 Unaudited Condensed Consolidated Statements of Income.
All mortgage-backed securities in the Company’s portfolio at June 30, 2021 and December 31, 2020 were backed by U.S. government sponsored enterprises (“GSEs”).
11
The following is a summary of investment securities by maturity:
cost
value
One to five years
7,511
7,700
Five to ten years
2,932
3,064
Within one year
1,526
12,452
13,269
234,836
247,383
After 10 years
537,609
540,814
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 June 30, 2021 or December 31, 2020.
Other
Other investments, largely comprised of non-marketable equity investments, are generally accounted for under the equity method or equity security accounting. The below tables provide additional information related to investments accounted for under these two methods.
12
Equity Method Accounting
The carrying amount and ownership percentage of each equity investment over which the Company has significant influence at June 30, 2021 and December 31, 2020 is reflected in the following table:
Ownership %
Apiture, Inc.
53,175
39.1
%
53,344
Canapi Ventures SBIC Fund, LP (1) (3)
16,025
2.9
14,843
3.1
Canapi Ventures Fund, LP (2) (3)
1,832
1.5
1,686
Other fintech investments in private companies (4)
6,450
Various
1,634
Other (5)
4,588
6,421
82,070
77,928
(1)
Includes unfunded commitments of $8.9 million and $11.3 million as of June 30, 2021 and December 31, 2020, respectively.
(2)
Includes unfunded commitments of $1.0 million as of June 30, 2021 and December 31, 2020.
(3)
Investee is accounted for under equity method due to the Company's participation as an investment advisor.
(4)
Other fintech investments include Finxact, Inc., Payrailz, Inc. and Kwipped, Inc.
(5)
Includes unfunded commitments of $2.9 million at December 31, 2020.
Equity Security Accounting
The carrying amount of the Company’s investments in non-marketable equity securities with no readily determinable fair value and amounts recognized in earnings for the six months ended June 30, 2021, and on a cumulative basis is reflected in the following table:
As of and for the six month period ended June 30, 2021
Cumulative Adjustments
Carrying value (1)
62,341
Carrying value adjustments:
Impairment
Upward changes for observable prices (2)
30,197
48,469
Downward changes for observable prices
(86
Net upward change
48,383
Includes $2.7 million in unfunded commitments.
Excludes $13.9 million in realized cash gains for the sale of an investment in the second quarter of 2021.
13
Note 5. Loans and Leases Held for Investment and Credit Quality
The following tables present total loans and leases held for investment 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
Small Business Banking
860,509
10,579
6,527
17,106
877,615
285,236
1,162,851
Specialty Lending
588,792
69,892
658,684
Paycheck Protection Program
951,438
2,400,739
2,417,845
355,128
2,772,973
Construction & Development
228,833
1,069
1,366
2,435
231,268
82,318
311,151
313,586
Commercial Real Estate
1,396,199
2,692
8,609
11,301
1,407,500
294,728
1,702,228
205,770
1,820
1,564
3,384
209,154
20,270
229,424
1,601,969
4,512
10,173
14,685
1,616,654
314,998
1,931,652
Commercial Land
365,852
2,055
367,907
73,100
441,007
4,679,711
16,160
20,121
36,281
4,715,992
743,226
5,459,218
Net deferred (fees) costs
(17,795
Loan and Leases, Net
14
695,090
10,341
10,765
21,106
716,196
308,341
1,024,537
341,952
337
342,289
71,090
413,379
1,528,180
2,565,222
10,678
21,443
2,586,665
379,431
2,966,096
183,087
88,890
3,723
92,613
271,977
275,700
987,358
3,730
12,339
999,697
321,352
1,321,049
148,264
5,374
1,693
7,067
155,331
20,317
175,648
1,135,622
9,104
10,302
19,406
1,155,028
341,669
1,496,697
329,638
2,243
331,881
94,274
426,155
4,302,459
19,782
27,033
46,815
4,349,274
815,374
5,164,648
(19,718
Total loans and leases include $2.51 billion of U.S. government guaranteed loans as of June 30, 2021, of which $10.3 million is 90 days or more past due, $12.8 million is past due 30-89 days and $2.49 billion are current. Total loans and leases include $2.61 billion of U.S. government guaranteed loans as of December 31, 2020, of which $12.9 million is 90 days or more past due, $16.7 million is past due 30-89 days and $2.58 billion 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.
15
Credit Quality Indicators
The following tables presents asset quality indicators by portfolio class and origination year. See Note 5. Loans and Leases Held for Investment and Credit Quality in the Company’s 2020 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
2019
2018
2017
Prior
Revolving Loans Amortized Cost Basis
Revolving Loans Converted to Term
Total1,2
Risk Grades 1 - 4
437,742
806,119
539,418
323,537
273,230
165,069
30,937
2,577,578
Risk Grade 5
416
24,801
84,862
65,503
42,018
14,691
8,880
528
241,699
Risk Grades 6 - 8
6,274
16,895
11,385
10,345
18,921
1,024
169
65,013
438,158
837,194
641,175
400,425
325,593
198,681
40,841
2,223
2,884,290
294,907
265,948
85,965
48,495
52,687
79,332
1,074
828,408
250
7,636
7,134
5,789
16,425
2,667
343
40,244
8,228
11,612
295,157
273,584
93,099
62,512
69,112
81,999
1,417
880,264
Paycheck Protection
Program
532,775
418,663
1,266,090
1,529,441
734,274
462,937
394,705
202,065
122,840
2016
724,506
475,593
287,712
230,653
159,877
59,065
32,373
1,392
1,971,171
16,080
59,595
62,857
44,478
11,203
3,666
2,131
212
200,222
81
8,976
14,639
15,090
11,424
8,418
631
209
59,468
740,667
544,164
365,208
290,221
182,504
71,149
35,135
1,813
2,230,861
296,537
96,553
48,930
40,626
55,229
632
538,507
7,672
6,379
2,752
18,718
1,711
37,232
8,635
5,782
77
14,494
304,209
102,932
60,317
59,344
57,017
590,233
2,573,056
647,096
425,525
349,565
188,286
92,152
2,445
16
Total loans and leases include $2.51 billion of U.S. government guaranteed loans as of June 30, 2021, segregated by risk grade as follows: Risk Grades 1 – 4 = $2.33 billion, Risk Grade 5 = $144.0 million, Risk Grades 6 – 8 = $42.2 million. As of December 31, 2020, total loans and leases include $2.61 billion of U.S. government guaranteed loans, segregated by risk grade as follows: Risk Grades 1 – 4 = $2.44 billion, Risk Grade 5 = $128.0 million, Risk Grades 6 – 8 = $40.9 million. Total loans and leases exclude loans accounted for under the fair value option.
Excludes $743.2 million and $815.4 million of loans accounted for under the fair value option as of June 30, 2021 and December 31, 2020, respectively.
Nonaccrual Loans and Leases
As of June 30, 2021 and December 31, 2020 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 and six months ended June 30, 2021 and 2020. Nonaccrual loans and leases are generally included in the held for investment portfolio. Accrued interest receivable on loans totaled $32.7 million and $41.0 million at June 30, 2021 and December 31, 2020, respectively, and is included in other assets in the accompanying Unaudited Condensed Consolidated Balance Sheets.
Nonaccrual loans and leases held for investment as of June 30, 2021 and December 31, 2020 are as follows:
Loan and Lease
Balance1
Guaranteed
Balance
Unguaranteed Balance
Unguaranteed
Exposure with No ACL
20,960
13,055
7,905
268
1,201
165
3,490
4,856
3,655
3,513
12,017
4,814
7,203
6,333
8,122
4,940
3,182
3,005
20,139
10,385
9,338
1,541
514
48,010
25,551
22,459
13,119
17
17,992
12,046
5,946
15,085
6,725
8,360
5,327
7,068
5,533
1,535
22,153
12,258
9,895
2,242
1,728
46,110
26,032
20,078
9,050
Excludes nonaccrual loans accounted for under the fair value option. See Note 9. Fair Value of Financial Instruments for additional information.
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 June 30, 2021 and December 31, 2020:
Total Collateral Dependent Loans
Unguaranteed Portion
Real Estate
Business Assets
Allowance for Credit Losses
954
6,354
199
206
2,015
67
1,665
1,354
153
7,209
1,002
393
4,682
346
89
1,570
183
8,779
4,865
95
3,894
2,381
295
14,981
7,356
592
7,605
2,029
413
2,060
18
1,279
9,440
197
531
4,077
66
1,281
11,568
258
332
6,873
335
175
13,196
7,663
24,764
14,536
198
2,263
534
302
32,073
9,698
529
19,368
4,086
401
1,781
19
Allowance for Credit Losses - Loans and Leases
The following table details activity in the allowance for credit losses (“ACL”) by portfolio segment allowance for the periods presented:
Commercial
& Industrial
Construction &
Development
Land
Beginning Balance
26,577
5,887
18,646
1,307
52,417
Charge offs
(225
(262
(2,173
(2,660
Recoveries
137
108
245
Provision
950
607
5,582
707
Ending Balance
27,439
6,232
22,163
2,014
57,848
June 30, 2020
16,337
4,823
13,110
1,636
35,906
(1,825
29
44
6,962
2,972
(14
21,503
4,861
16,097
1,622
44,083
26,941
5,663
18,148
1,554
52,306
(377
(2,690
(12
(3,341
146
1,764
1,910
729
831
4,941
472
Beginning Balance, prior to adoption of ASC 326
15,757
2,732
8,427
1,318
28,234
Impact of adopting ASC 326
(4,561
1,131
1,916
193
(1,321
(4,170
(408
(4,687
64
43
107
14,413
998
5,820
519
During the three and six month periods ended June 30, 2021, increases to the ACL were primarily related to the severity of forecasted unemployment rates and ongoing developments 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 June 30, 2021
Interest Only
Payment Deferral
Extend Amortization
Total TDRs(1)
Number of
Loans
Recorded investment at period end
2,887
3,732
6,619
Excludes loans accounted for under the fair value option. See Note 9. Fair Value of Financial Instruments for additional information.
Six Months Ended June 30, 2021
Other(1)
Total TDRs(2)
6,097
3,782
3,124
6,906
9,879
13,003
Includes one small business banking loan with extend amortization and a rate concession TDR.
Three Months Ended June 30, 2020
439
4,921
5,360
21
Six Months Ended June 30, 2020
1,882
224
2,106
3,412
5,294
5,145
10,439
One TDR that was modified within the twelve months ended June 30, 2021 subsequently defaulted during the six months ended June 30, 2021. The TDR that defaulted was a Commercial Real Estate Small Business Banking loan that had previously been modified for a payment deferral and had a recorded investment of $50 thousand at June 30, 2021. No TDRs that were modified within the twelve months ended June 30, 2021 subsequently defaulted during the three months ended June 30, 2021.
One TDR was modified within the twelve months ended June 30, 2020 and subsequently defaulted during the three and six months ended June 30, 2020. The TDR that defaulted was a Commercial & Industrial Small Business Banking loan that had been previously modified for payment deferral and had a recorded investment of $39 thousand at June 30, 2020.
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
8,981
10,629
Less – unearned interest
(1,316
(1,685
Net investment in direct financing leases
7,665
8,944
22
Future minimum lease payments under finance leases are as follows:
As of June 30, 2021
1,388
2022
2,620
2023
2,182
2024
2025
1,104
Thereafter
117
Interest income of $172 thousand and $212 thousand was recognized in the three months ended June 30, 2021 and 2020, respectively. Interest income of $358 thousand and $445 thousand was recognized in the six months ended June 30, 2021 and 2020, 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.
As of June 30, 2021 and December 31, 2020, the Company had a net investment of $128.7 million and $134.5 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 $163.4 million and $164.3 million as of June 30, 2021 and December 31, 2020, respectively, and accumulated depreciation was $34.7 million and $29.8 million as of June 30, 2021 and December 31, 2020, respectively. Depreciation expense recognized on these assets for the three and six months ended June 30, 2021 and 2020 was $2.4 million and $4.9 million, respectively.
Lease income of $2.4 million was recognized in the three months ended June 30, 2021 and 2020. Lease income of $4.8 million was recognized in the six months ended June 30, 2021 and 2020.
A maturity analysis of future minimum lease payments to be received under non-cancelable operating leases is as follows:
3,997
9,044
9,075
8,808
8,935
31,175
71,034
Note 7. Servicing Assets
Loans serviced for others are not included in the accompanying Unaudited Condensed Consolidated Balance Sheets. The unpaid principal balances of loans serviced for others requiring recognition of a servicing asset were $2.22 billion and $2.21 billion at June 30, 2021 and December 31, 2020, respectively. The unpaid principal balance for all loans serviced for others was $3.13 billion and $3.21 billion at June 30, 2021 and December 31, 2020, respectively.
The following summarizes the activity pertaining to servicing rights:
Balance at beginning of period
37,744
33,532
35,365
Additions, net
2,403
1,873
4,736
4,732
Fair value changes:
Due to changes in valuation inputs or assumptions
(59
(123
(2,162
Decay due to increases in principal paydowns or runoff
(3,122
(1,448
(4,575
(4,101
Balance at end of period
33,834
The fair value of servicing rights was determined using a weighted average discount rate of 9.6% on June 30, 2021 and 13.4% on June 30, 2020. The fair value of servicing rights was determined using a weighted average prepayment speed of 17.5% on June 30, 2021 and 18.7% on June 30, 2020, with the actual rate depending on the stratification of the specific right. Changes to fair value are reported in loan servicing asset revaluation within the Unaudited Condensed 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.
24
Note 8. Borrowings
Total outstanding borrowings consisted of the following:
In March 2021, the Company entered into a 60-month term loan agreement of $50.0 million with a third party correspondent bank. The loan accrues interest at a fixed rate of 2.95% with a monthly payment sufficient to fully amortize the loan, with all remaining unpaid principal and interest due at maturity on March 30, 2026. The Company paid the Lender a non-refundable $325 thousand loan origination fee upon signing of the note that is presented as a direct deduction from the carrying amount of the loan and will be amortized into interest expense over the life of the loan.
47,382
In September 2020, the Company renewed a $50.0 million revolving line of credit originally issued in 2017 with a third party correspondent bank. 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 maturity at October 10, 2021. On March 31, 2021 the remaining outstanding balance of $14.5 million was paid in full. There is $50.0 million of available credit remaining at June 30, 2021.
14,488
In April 2020, the Company entered into the Federal Reserve Bank's Paycheck Protection Program Liquidity Facility ("PPPLF"). Under the PPPLF, advances must be secured by pledges of loans to small businesses originated by the Company under the U.S. Small Business Administration's 7(a) loan program titled the Paycheck Protection Program. The PPPLF accrues interest at thirty-five basis points and matures at various dates equal to the maturity date of the PPPLF collateral pledged to secure the advance, ranging from April 1, 2022 to May 5, 2026, and will be accelerated on and to the extent of any 7(a) loan forgiveness reimbursement by the SBA for any PPPLF collateral or the date of purchase by the SBA from the borrower of any PPPLF collateral. On the maturity date of each advance, the Company shall repay the advance plus accrued interest. This $961 million borrowing was fully advanced at June 30, 2021.
961,049
1,527,596
Other long term debt(1)
4,000
Total borrowings
Includes finance leases and loan participations accounted for as secured borrowings.
The Company may purchase federal funds through unsecured federal funds lines of credit with various correspondent banks, which totaled $167.5 million as of June 30, 2021 and December 31, 2020. 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 June 30, 2021 and December 31, 2020.
The Company has entered into a repurchase agreement with a third party for $5.0 million as of June 30, 2021 and December 31, 2020. 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 June 30, 2021 and December 31, 2020.
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 June 30, 2021 and December 31, 2020, the Company had approximately $2.08 billion and $2.01 billion, respectively, in borrowing capacity available under these agreements. There are no advances outstanding and no collateral pledged as of June 30, 2021 and December 31, 2020.
25
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 $2.23 billion and $2.22 billion as of June 30, 2021 and December 31, 2020, respectively. At June 30, 2021 and December 31, 2020, the Company had approximately $1.78 billion and $1.77 billion, respectively, in borrowing capacity available under these arrangements with no outstanding balance as of June 30, 2021 and December 31, 2020.
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. Due to the nature of the valuation inputs, loans held for sale are classified within Level 3 of the valuation hierarchy.
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. Due to the nature of the valuation inputs, loans held for investment are classified within Level 3 of the valuation hierarchy.
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 below 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.
26
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 the Company’s private company portfolio. Option expiration dates are modified to account for estimates of 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 table below provides a rollforward of the Level 3 equity warrant asset fair values.
Three Months Ended June 30,
Six Months Ended June 30,
Equity Warrant Assets
1,314
702
908
570
Issuances
37
179
Net gains on derivative instruments
385
138
770
106
Settlements
(135
1,580
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
3,544
Loans held for sale
29,048
Loans held for investment
Servicing assets2
Mutual fund
2,351
Equity warrant assets
Total assets at fair value
1,631,067
820,151
810,916
3,629
36,111
1,638,760
752,353
886,407
During the three and six months ended June 30, 2021, the Company recorded no fair value adjustment gain/loss. During the three and six months ended June 30, 2020, the Company recorded a fair value adjustment gain of $1 thousand and $2 thousand, respectively.
See Note 7 for a rollforward of recurring Level 3 fair values for servicing assets.
Fair Value Option
The Company has historically elected to account for retained participating interests of all 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 Unaudited Condensed Consolidated Statements of Income. Beginning in the first quarter of 2021, the Company chose not to elect fair value for all retained participating interests arising from new government guaranteed loan sales. Not electing fair value generally results in a larger discount being recorded on the date of the sale. This discount is subsequently accreted into interest income over the underlying loan’s remaining term using the effective interest method. Management made this change of election in alignment with its ongoing effort to reduce volatility and drive more predictable revenue. In accordance with accounting standards, any loans for which fair value was previously elected will continue to be measured as such.
There were no loans accounted for under the fair value option that were 90 days or more past due and still accruing interest at June 30, 2021 or December 31, 2020. The unpaid principal balance of unguaranteed exposure for nonaccruals was $7.2 million and $6.9 million at June 30, 2021 and December 31, 2020, 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 June 30, 2021 and December 31, 2020.
Total Loans
Nonaccruals
Fair Value Carrying Amount
Unpaid Principal Balance
Difference
Fair Value Option Elections
30,608
(1,560
764,648
(21,422
39,826
43,980
(4,154
23,789
26,882
(3,093
772,274
795,256
(22,982
38,135
(2,024
845,082
(29,708
35,499
39,318
(3,819
25,532
28,741
(3,209
851,485
883,217
(31,732
The following table presents the net gains (losses) from changes in fair value.
Gains (Losses) on Loans Accounted for under the Fair Value
Option
428
(106
464
(983
4,889
(11,741
Losses related to borrower-specific credit risk were $484 thousand and $293 thousand for the three and six months ended June 30, 2021, respectively, and $913 thousand and $1.8 million for the three and six months ended June 30, 2020, respectively.
28
The following tables summarize the activity pertaining to loans accounted for under the fair value option.
35,936
19,151
16,198
Issuances & repurchases
13,154
16,199
Fair value changes
Sales
(7,316
(128
(7,527
(340
32,071
790,797
831,426
824,520
16,215
37,761
21,785
99,372
(64,493
(33,602
(98,822
(77,549
834,602
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. Loans with agreed upon sales prices are classified as Level 1.
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.
Long-lived asset held for sale: Long-lived assets held for sale are carried at the lower of carrying value or fair value less selling costs. Fair value is based upon an independent market valuation of the property. Given the lack of observable market prices for identical assets and market discounts applied to market prices, the Company generally classifies long-lived assets held for sale as nonrecurring Level 3.
Equity security investments with a non-readily determinable fair value: Equity security investments are 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 for an identical investment of the same issuer, the investment is generally classified as nonrecurring Level 1 within the valuation hierarchy. When an observable price change in an orderly transaction occurs for a similar investment of the same issuer, the investment is generally classified as nonrecurring Level 2 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
1,347
Equity security investments with a non-readily
determinable fair value
51,499
54,639
3,140
4,159
Long-lived asset held for sale
8,874
Equity security investment with a non-readily
25,367
42,555
8,314
Level 3 Analysis
For Level 3 assets and liabilities measured at fair value on a recurring or non-recurring basis as of June 30, 2021 and December 31, 2020 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
4.6%
5.0%
1.2% to 18.5%
WAVG 17.8%
Loans held for
investment
Discounted appraisals
Loss rate
Appraisal adjustments
0.0% to 72.6% (WAVG 1.3%)
10.0% to 65.0%
Black-Scholes option pricing model
Volatility
Risk-free interest rate
Marketability discount
Remaining life
26.4-88.7%
0.87% to 1.45%
20.0%
4-10 years
Non-recurring fair value
Collateral dependent
loans
Appraisal adjustments (1)
4.0% to 10.0%
4.3%
4.2% to 18.5%
WAVG 19.0%
0.0% to 73.2% (WAVG 1.5%)
10.0% to 83.0%
26.5-87.1%
0.36% to 0.93%
5-10 years
10.0% to 20.0%
Appraisals may be adjusted by management for customized discounting criteria, estimated sales costs, and other 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
6,295
1,035,863
1,142,966
Loans and leases, net of allowance for
credit losses on loans and leases
4,640,349
4,790,403
Financial liabilities
6,421,253
998,550
31
1,139,359
1,235,122
4,277,250
4,366,489
5,711,781
1,542,171
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.
On March 12, 2021, a purported class action was filed against the Company in the United States District Court for the Eastern District of North Carolina, Joseph McAlear, individually and on behalf of all others similarly situated v. Live Oak Bancshares, Inc. et al. The complaint alleges the existence of an agreement between the Company, nCino, Inc. and Apiture, LLC in which those companies purportedly sought to restrain the mobility of employees in violation of antitrust laws by agreeing not to solicit or hire each other’s employees. The complaint alleges violations of Section 1 of the federal Sherman Act (15 U.S.C. § 1) and violations of Sections 75-1 and 75-2 of the North Carolina General Statutes. The plaintiff seeks monetary damages, including treble damages, entitlement to restitution, disgorgement, attorneys’ fees, and pre- and post-judgment interest. Given the uncertainty of litigation, the preliminary stage of the case, and the legal standards that must be met for, among other things, class certification and success on the merits, we cannot estimate the reasonably possible loss or range of loss that may result from this action.
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
2,474,698
2,054,910
Standby letters of credit
9,844
22,913
Total unfunded off-balance-sheet credit risk
2,484,542
2,077,823
32
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. Commitment letters are issued after approval of the loan by the Credit Department and 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.
As of June 30, 2021 and December 31, 2020, the Company had unfunded commitments to provide capital contributions for on-balance-sheet investments in the amount of $12.6 million and $15.8 million, respectively.
Concentrations of Credit Risk
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 $15.0 million, except for 23 relationships that have a retained unguaranteed exposure of $552.6 million of which $255.9 million of the unguaranteed exposure has been disbursed.
Additionally, the Company has future minimum lease payments receivable under non-cancelable operating leases totaling $71.0 million, of which $21.8 million is due from one relationship.
The Company from time-to-time may have cash and cash equivalents on deposit with financial institutions that exceed federally-insured limits.
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 and May 15, 2018, the 2015 Omnibus Stock Incentive Plan was amended to authorize awards covering a maximum of 7,000,000 and 8,750,000 common voting shares, respectively. On May 11, 2021, the Amended and Restated 2015 Omnibus Stock Incentive Plan was amended to authorize awards covering a maximum of 10,750,000 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 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, but also may have non-market-related performance criteria.
Stock Options
There were no stock options granted during the three and six months ended June 30, 2021.
At June 30, 2021, unrecognized compensation costs relating to stock options amounted to $1.6 million which will be recognized over a weighted average period of 1.19 years.
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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.
For the three months ended June 30, 2021, 178,000 Market RSUs met the performance stock price condition for the $55.00 stock price for twenty (20) consecutive trading days. For the six months ended June 30, 2021, 575,500 Market RSUs met the performance stock price condition for the $45.00, $48.00, $50.00 and $55.00 stock price for twenty (20) consecutive trading days. For the three and six months ended June 30, 2021, the remaining expense of $1.6 million and $3.7 million, respectively, was fully recognized due to the accelerated vesting. The weighted average grant date fair value for the 575,500 vested Market RSUs was $7.62.
There were no Market RSUs granted during the three and six months ended June 30, 2021.
There are no remaining Market RSUs at June 30, 2021.
For the three months ended June 30, 2021, 23,683 RSUs were granted with a weighted average grant date fair value of $64.72. For the six months ended June 30, 2021, 816,576 RSUs were granted with a weighted average grant date fair value of $51.07. Of the RSUs granted in the six-month period, 288,680 were awarded in connection with annual long term incentive stock compensation and 500,000 were awarded as a special retention RSU award.
At June 30, 2021, unrecognized compensation costs relating to RSUs amounted to $50.0 million which will be recognized over a weighted average period of 4.95 years.
Note 12. Segments
The Company's management reporting process measures the performance of its operating segments based on internal operating structure, which is subject to change from time to time. Accordingly, the Company operates two reportable segments for management reporting purposes as discussed below:
Banking - This segment specializes in providing financing services to small businesses nationwide in targeted industries and deposit-related services to small businesses, consumers and other customers nationwide. The primary source of revenue for this segment is net interest income and secondarily the origination and sale of government guaranteed loans.
Fintech - This segment is involved in making strategic investments into emerging financial technology companies. The primary sources of revenue for this segment are principally gains and losses on equity method and equity security investments and management fees. The Fintech segment is comprised of the Company's wholly owned subsidiaries Live Oak Ventures and Canapi Advisors, and the investments held by those entities, as well as the Bank's investment in Apiture.
34
The following tables provide financial information for the Company's segments. The information provided under the caption “Other” represents operations not considered to be reportable segments and/or general operating expenses of the Company, and includes the parent company, other non-bank subsidiaries and elimination adjustments to reconcile the results of the operating segments to the unaudited condensed consolidated financial statements prepared in conformity with GAAP.
Banking
Fintech
Consolidated
87,974
16,135
402
71,839
(384
24,894
42,648
2,569
50,829
1,112
5,617
5,130
10,209
(2,752
32,928
31,334
(680
8,092,506
136,104
14,576
66,753
25,689
230
41,064
(166
23,121
(935
225
45,296
1,368
1,436
2,006
(247
(285
6,925
(2,056
(1,092
8,124,976
81,231
2,947
8,209,154
176,073
129
34,300
512
141,773
(490
55,418
42,644
3,106
106,454
2,132
7,244
9,780
10,214
(3,226
73,984
30,427
(1,402
130,201
48,944
287
81,257
(198
29,085
(1,815
883
91,983
2,858
2,750
Income tax benefit
(2,164
(491
(3,649
Net (loss) income
(1,227
(4,182
1,584
35
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 unaudited condensed consolidated 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, 2020 (the "2020 Form 10-K"). 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 financial condition, results of operations, plans, objectives, future performance or business of Live Oak Bancshares, Inc. (the "Company"). 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 Report. 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 Report 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 United States Department of Agriculture (“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 or to develop a next-generation banking platform, 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, including as a result of the 2020 federal elections;
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 those described under “Risk Factors” in this 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 financial holding company and a bank holding company headquartered in Wilmington, North Carolina incorporated under the laws of the state 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 and deposit related services to small businesses nationwide. The Bank identifies and extends lending to credit-worthy borrowers within both specified 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 SBA under the 7(a) Loan Program and the U.S. Department of Agriculture’s ("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. Live Oak Number One, Inc. holds properties foreclosed on by the Bank. 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 and its wholly owned subsidiary, Jolley Asset Management, LLC (“JAM”), provide high-net-worth individuals and families with strategic wealth and investment management services.
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. Canapi Advisors provides investment advisory services to a series of funds (the “Canapi Funds”) focused on providing venture capital to new and emerging financial technology companies.
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 has historically elected 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 gain (loss) on loans accounted for under the fair value option line item of the consolidated statements of income. Beginning in the first quarter of 2021, the Company chose not to elect fair value for all retained participating interests arising from new government guaranteed loan sales. 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. The Company also has generated gains and losses arising from its financial technology investments in its fintech segment, as discussed more fully later in this section entitled “Results of Segment Operations.”
Recent Developments
Indications of recovery from the COVID-19 pandemic are continuing to appear in the United States; however, the fallout continues to have a complex and significant adverse impact on certain areas of the economy, the banking industry and the Company, all of which are subject to a high degree of uncertainty. This uncertainty is magnified with the risk of a resurgence of the virus or new variants. 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 currently aware.
Financial position and results of operations
Relating to our June 30, 2021 financial condition and results of operations, improving conditions around COVID-19 continued to have a positive impact on the allowance for credit losses (“ACL”) on loans and leases, loans carried at fair value, loan servicing asset revaluation, net gains on sales of loans and net interest income, largely due to effects of U.S. government stimulus combined with improvement in economic forecasts and broader markets. With improving conditions, the ACL and resulting provision for loan and lease credit losses are slowly returning to pre-pandemic levels relative to credit exposure, while the loan fair value calculation and net gain on loans accounted for under the fair value option continue to be positively affected. The Company continues to monitor pandemic-at-risk verticals, and is seeing a substantial number of borrowers showing signs of recovery by making regular payments in the absence of payment deferrals and payment subsidies provided by the SBA. Accordingly total credit related reserves were also positively impacted by this continued improvement during the second quarter. Refer to the discussion of the ACL and loans at fair value in Notes 5 and 9, respectively, of the Unaudited Condensed Consolidated Financial Statements as well as further discussion below in MD&A. Also impacted by improving market conditions was the Company’s valuation of the loan servicing asset as discussed in Note 7 of the Notes to Unaudited Condensed Consolidated Financial Statements and net gains on sales of loans, both of which are further discussed below in MD&A. The secondary market continued to improve during the second quarter of 2021 which produced higher gains on loan sales and positive adjustments for loans carried at fair value and the loan servicing asset valuation. The net interest margin continued to be positively impacted by Paycheck Protection Program (“PPP”) lending as discussed more fully below in MD&A. Should economic conditions worsen, the Company could experience significant levels of provision in the 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 there is a significant resurgence of COVID-19 cases or variants.
While there has been a recovery in secondary market pricing, the income from gain on sale of loans in future periods could be reduced due to COVID-19, the termination of pandemic response programs or other economic factors. At this time, the Company is unable to project the materiality of such impacts but anticipates that the breadth of the economic impact could impact gains in future periods.
Interest income could be further reduced due to COVID-19. In accordance with guidance from banking regulators, the Company has worked and continues to work with COVID-19 affected borrowers to help defer their payments, interest, and fees. In addition to regulatory relief on deferrals from banking regulators, payment relief was available from the SBA for certain loans guaranteed by that agency pursuant to the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) and subsequently by the below discussed Economic Aid Act. While interest will still accrue to interest income through GAAP accounting, should eventual credit losses on these loans with deferred payments emerge, interest income accrued would need to be reversed. In such a scenario, interest income in future periods could be negatively impacted. As of June 30, 2021, the Company carried $359 thousand in accrued interest on outstanding loans with deferrals made to COVID-19 affected borrowers. At this time, the Company is unable to project the materiality of such an impact on future deferrals to COVID-19 borrowers, but recognizes the breadth of the economic impact may affect our borrowers’ ability to repay in future periods.
Capital and liquidity
As of June 30, 2021, all of the Company’s capital ratios, and the Bank’s capital ratios, were in excess of all minimum regulatory requirements. While the Company believes that capital is sufficient to withstand a double-dip economic recession if brought about by a resurgence in 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 the Bank to service any debt at the Company. 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 can be volatile and the secondary market for guaranteed loans has shown reactionary and varying responses to the changing economic environment. 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 causes 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.
39
The Federal Reserve created the Paycheck Protection Program Liquidity Facility (“PPPLF”) to help provide financing for the origination of PPP loans. The PPPLF extends loans to banks that have loaned money to small businesses under the 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 PPPLF have a neutral impact on regulatory leverage capital ratios. The maturity date of a borrowing under the PPPLF 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 PPPLF bear interest at a rate of 0.35%, and there are no fees paid by the Company. As of June 30, 2021, the Company had outstanding borrowings of $961.0 million from the PPPLF.
Lending operations and accommodations to borrowers
With the establishment of the PPP administered by the SBA, the Company 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 earn interest at 1% and currently have a two-year or five-year contractual term depending on the origination date. For the earlier loans with a two-year term there is an option to extend to five years if agreed upon by the borrower and lender. The Company continues to receive substantial levels of forgiveness for these loans. As of June 30, 2021, the Company carried 6,580 PPP loans on its balance sheet representing a book balance of $927.3 million, which includes $24.1 million in net deferred fees, expected to be amortized and recognized in interest income over the remaining lives of the loans. The Company recognized $11.2 million and $28.4 million of interest income in the second quarter and first half of 2021, respectively, related to amortization of net PPP fees. Loans funded through the PPP are fully guaranteed by the SBA, subject to the terms and conditions of the program. Should those circumstances change, the Company could be required to record additional credit loss expense through earnings.
With the passage of the CARES Act on March 27, 2020, the SBA was making six months of principal and interest payments on all fully disbursed SBA 7(a) and SBA Express loans in regular servicing status that closed by September 25, 2020. 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 was 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 were not considered troubled debt restructurings. After 60 or 90 days, borrowers may apply for an additional deferral. In the absence of other intervening factors, such short-term modifications made on a good faith basis are not categorized as a troubled debt restructuring, nor are loans granted payment deferrals related to COVID-19 placed on non-accrual (provided the loans were not past due or on non-accrual status prior to the deferral). At June 30, 2021, and December 30, 2020, the Company estimated that as a percentage of total loans and leases at amortized cost, excluding PPP loans, 14% and 20%, respectively, of its loans were receiving the six months of payments from the SBA and that 0.4% and 11%, respectively, of its loans had a payment deferral in place. The decrease in loans on payment deferral was largely a product of the Economic Aid Act introduced late in 2020, as discussed below. The Company estimated that 9% of its loans and leases at amortized cost, excluding PPP loans, were receiving payments from the SBA and that 0.3%, had a payment deferral in place as of August 2, 2021. On October 2, 2020, the SBA began approving PPP forgiveness applications and remitting forgiveness payments to PPP lenders for PPP borrowers. As of August 2, 2021, the Company has received approximately $1.44 billion in PPP loan forgiveness from approximately 9,000, or 84% of total first draw PPP loans originated by count.
On June 5, 2020, the Paycheck Protection Program Flexibility Act (the “new Act”) was signed into law and made significant changes to the PPP to provide additional relief for small businesses. The new Act increased flexibility for small businesses that have been unable to rehire employees due to lack of employee availability or have been unable to operate as normal due to COVID-19 related restrictions. It extended the period that businesses have to use PPP funds to qualify for loan forgiveness to 24 weeks, up from 8 weeks under the original rules. The new Act also relaxed the requirements to which loan recipients must adhere in order to qualify for loan forgiveness. In addition, the new Act extended the payment deferral period for PPP loans until the date when the amount of loan forgiveness is determined and remitted to the lender. For PPP recipients who do not apply for forgiveness, the loan deferral period is 10 months after the applicable forgiveness period ends.
On December 27, 2020 the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act (the “Economic Aid Act”) was enacted which allows the SBA to make payments of up to $9,000 per month for up to six months of principal and interest payments on certain fully disbursed SBA 7(a) and SBA 504 loans in regular servicing status based upon the origination date. In addition, this legislation increased the 75% guarantee on many SBA 7(a) loans to 90%, among other things.
40
Credit
While some industries have experienced and continue to experience impacts as a result of COVID-19, the Company has $473.2 million in total unguaranteed exposure in six verticals considered by management to be “at-risk” of significant impact: hotels, wine and craft beverage, educational services, entertainment centers, fitness centers, and quick service restaurants, each comprising $126.7 million or 4.3%, $108.7 million or 3.7%, $108.0 million or 3.7%, $53.5 million or 1.8%, $41.4 million or 1.4%, and $34.9 million or 1.2% of total unguaranteed loans and leases (all at amortized cost, inclusive of loans carried at fair value) as of June 30, 2021, respectively. A substantial number of borrowers have shown signs of recovery by making regular payments in the absence of payment deferrals and payment subsidies provided by the SBA. As of June 30, 2021 there are only 4 loans with an aggregate balance of $11.5 million in at-risk verticals still on payment deferral and 275 that continue to receive SBA payment subsidies with an aggregate balance of $247.6 million. While the second quarter reflected positive signs of emerging from at-risk status, management continues to closely monitor these vulnerable verticals for signs of weakness.
The Company continues to work with customers directly affected by COVID-19 and is prepared to offer short-term assistance in accordance with regulatory guidelines. As a result of the uncertain economic environment caused by COVID-19, the Company is engaging in more frequent communication with borrowers in an effort to better understand their situation and the challenges faced as circumstances evolve, which the Company anticipates will enable it to respond proactively as needs and issues arise.
Results of Operations
Performance Summary
Three months ended June 30, 2021 compared with three months ended June 30, 2020
For the three months ended June 30, 2021, the Company reported net income of $63.6 million, or $1.41 per diluted share, compared to net income of $3.8 million, or $0.09 per diluted share, for the second quarter of 2020. This increase in net income is largely due to the following items:
Increase in net interest income of $30.6 million, or 74.7%, predominately driven by significant growth in total loan and lease portfolios which was accentuated by the origination of $2.31 billion in PPP loans beginning in the second quarter of 2020; and
Increase in equity security gains of $44.1 million associated with the Company’s investment in Greenlight Financial Technologies, Inc. (“Greenlight”). This gain is the result of an increase in the observable fair market value of the Company’s investment through an arm’s length sale of a portion of its shares in the investee.
Other factors contributing to increased levels of net income were:
A decrease in the provision for loan and lease credit losses of $2.1 million, or 21.2%;
Increased net gains on sales of loans of $5.5 million, or 51.8%; and
A net gain on loans accounted for under the fair value option of $1.1 million, increasing by $2.2 million, or 204.2%, compared to a net loss of $1.1 million for the second quarter of 2020.
Key factors partially offsetting the increase in net income for the second quarter of 2021 were:
An increase in total noninterest expense of $9.5 million, or 19.7%, comprised principally of increased salaries and employee benefits of $2.1 million, travel expense of $1.2 million, professional services of $1.9 million and data processing of $1.5 million; and
Increased income tax expense of $11.1 million primarily due to the above discussed increase in net income.
Six months ended June 30, 2021 compared with six months ended June 30, 2020
For the six months ended June 30, 2021, the Company reported a net income of $103.0 million, or $2.29 per diluted share, as compared to net loss of $3.8 million, or $(0.10) per diluted share, for the six months ended June 30, 2020. This increase in net income was largely due to the following items:
41
Increase in net interest income of $60.4 million, or 74.5%, also predominately driven by significant growth in total loan and lease portfolios which was accentuated by the origination of PPP loans since the second quarter of 2020;
A decrease in the provision for loan and lease credit losses of $14.8 million, or 67.9%;
A net gain on loans accounted for under the fair value option of $5.4 million, increasing by $17.1 million, or 145.6%, compared to a net loss of $11.7 million for the first half of 2020;
Equity method investment income increasing $1.3 million, or 27.2%, largely related to heightened levels of pro-rata income from the Company’s investment in the Canapi Funds; and
The above mentioned second quarter 2021 increase in equity security gains of $44.1 million associated with the Company’s investment in Greenlight.
A net loss on the loan servicing asset revaluation of $1.7 million, decreasing by $4.6 million, or 73.0%, compared to a net loss of $6.3 million for the first half of 2020; and
Increased net gains on sales of loans of $6.4 million, or 29.1%.
Key factors partially offsetting the increase in net income for the first half of 2021 were:
An increase in total noninterest expense of $18.2 million, or 18.7%, comprised principally of increased salaries and employee benefits of $5.4 million, professional services of $3.8 million, data processing of $2.2 million, loan related expenses of $1.7 million and renewable energy tax credit investment impairment of $3.1 million; and
Increased income tax expense of $23.1 million primarily due to the above discussed increase in net income.
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 of 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.
For the three months ended June 30, 2021, net interest income increased $30.6 million, or 74.7%, to $71.5 million compared to $40.9 million for the three months ended June 30, 2020. The increase was principally due to the significant growth in the loan and lease portfolios reflecting the Company's ongoing initiative to grow recurring revenue sources. This increase over the prior year was further enhanced by the aforementioned origination of $2.31 billion in PPP loans beginning in the second quarter of 2020 with $14.4 million in interest income arising from amortization of net deferred fees combined with a 1% annualized interest rate. Accordingly, average interest earning assets increased by $1.49 billion, or 23.3%, to $7.89 billion for the three months ended June 30, 2021, compared to $6.40 billion for the three months ended June 30, 2020, while the yield on average interest earning assets increased 28 basis points to 4.47%. The cost of funds on interest bearing liabilities for the three months ended June 30, 2021 decreased 79 basis points to 0.86%, and the average balance of interest bearing liabilities increased by $1.40 billion, or 22.3%, over the same period in 2020. The increase in average interest bearing liabilities was largely driven by funding for significant loan originations and growth from the prior year. As indicated in the rate/volume table below, increased interest earning asset volume and yields, outpacing the higher volume and greater levels of cost declines of interest bearing liabilities, resulting in increases to interest income of $21.2 million and decreases to interest expense of $9.4 million for the three months ended June 30, 2021 compared to the three months ended June 30, 2020. For the three months ended June 30, 2020, compared to the three months ended June 30, 2021, net interest margin increased from 2.56% to 3.63%, respectively, due to recognition of PPP related income, which is being accelerated with forgiveness efforts, significant loan portfolio growth and the maturity of longer term deposits which are repricing at lower rates.
42
For the six months ended June 30, 2021, net interest income increased $60.4 million, or 74.5%, to $141.4 million compared to $81.1 million for the six months ended June 30, 2020. The increase was principally due to the significant growth in the loan and lease portfolios reflecting the Company's ongoing initiative to grow recurring revenue sources. This increase over the prior year was further enhanced by the aforementioned origination of $2.31 billion in PPP loans since the second quarter of 2020 with $35.1 million in interest income coming from amortization of net deferred fees combined with a 1% annualized interest rate. Accordingly, average interest earning assets increased by $2.20 billion, or 40.3%, to $7.67 billion for the six months ended June 30, 2021, compared to $5.47 billion for the six months ended June 30, 2020, while the yield on average interest earning assets decreased 14 basis points to 4.64%. The cost of funds on interest bearing liabilities for the six months ended June 30, 2021, decreased 91 basis points to 0.94%, and the average balance of interest bearing liabilities increased by $2.16 billion, or 40.5%, over the same period in 2020. The increase in average interest bearing liabilities was largely driven by funding for significant loan originations and growth from the prior year. As indicated in the rate/volume table below, increased interest earning asset volume more than offset lower yields, outpacing the higher volume and greater levels of cost declines of interest bearing liabilities, resulting in increases to interest income of $45.9 million and decreases to interest expense of $14.4 million for the six months ended June 30, 2021, compared to the six months ended June 30, 2020. For the six months ended June 30, 2020, compared to the six months ended June 30, 2021, net interest margin increased from 2.97% to 3.72%, respectively, due primarily to recognition of PPP related income, which is being accelerated with forgiveness efforts, in combination with significant loan portfolio growth and combination with the maturity of longer term deposits which are repricing at lower rates.
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.
Average
Interest
Yield/Rate
Interest earning assets:
Interest earning balances in other banks
514,232
234
0.18
587,931
970
0.66
29,199
0.14
123,985
0.13
Investment securities
764,017
1.56
556,014
2.73
1,134,259
15,216
5.38
921,946
13,115
5.71
Loans and leases held for
investment(1)
5,447,839
69,564
5.12
4,208,063
48,907
4.66
Total interest earning assets
7,889,546
4.47
6,397,939
4.19
Less: Allowance for credit losses on loans
and leases
(51,994
(35,875
Non-interest earning assets
623,895
603,666
8,461,447
6,965,730
Interest bearing liabilities:
Interest bearing checking
60,439
86
0.57
462,977
646
0.56
Savings
3,101,733
4,309
1,398,378
1.38
Money market accounts
104,826
82
0.31
82,908
0.43
Certificates of deposit
3,078,789
10,343
1.35
3,689,041
19,572
2.13
6,345,787
0.94
5,633,304
1.79
1,368,742
0.50
676,849
0.47
Total interest bearing liabilities
7,714,529
0.86
6,310,153
1.65
Non-interest bearing deposits
85,824
41,218
Non-interest bearing liabilities
45,309
50,554
Shareholders' equity
615,785
563,805
Total liabilities and
shareholders' equity
Net interest income and interest
rate spread
3.61
2.54
Net interest margin
3.63
2.56
Ratio of average interest-earning
assets to average interest-bearing
liabilities
102.27
101.39
Average loan and lease balances include non-accruing loans and leases.
423,252
0.25
372,534
1,503
0.81
28,703
0.11
98,367
0.52
750,164
1.59
546,110
2.77
1,152,667
30,293
5.30
963,341
28,980
6.03
5,311,939
139,480
3,485,068
92,003
5.29
7,666,725
4.64
5,465,420
4.78
(52,155
(31,439
608,923
555,554
8,223,493
5,989,535
154,698
442
0.58
231,489
2,731,224
7,821
1,261,131
9,658
1.54
105,289
0.32
80,265
189
3,114,979
23,336
1.51
3,425,850
37,883
2.22
6,106,190
1.05
4,998,735
1.94
1,398,793
0.44
342,002
7,504,983
5,340,737
1.85
83,336
45,071
33,649
52,024
601,525
551,703
3.70
2.93
3.72
2.97
102.16
102.33
45
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.
2021 vs. 2020
Increase (Decrease) Due to
Rate
Volume
Interest income:
Interest earning balances in other
banks
(658
(78
(736
(1,106
134
(972
(31
(29
(130
(110
(240
(1,924
1,113
(811
(3,857
2,213
(1,644
(833
2,934
2,101
(4,023
5,336
1,313
Loans and leases held for investment
5,537
15,120
20,657
(622
48,099
47,477
2,124
19,058
21,182
(9,738
55,672
45,934
Interest expense:
(567
(560
(217
(204
(4,620
4,115
(505
(9,571
7,734
(1,837
(27
(7
(73
49
(24
(6,585
(2,644
(9,229
(11,664
(2,883
(14,547
842
919
(279
2,472
2,193
(11,148
1,766
(9,382
(21,574
7,155
(14,419
13,272
17,292
30,564
11,836
48,517
60,353
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 ACL on loans and leases at a level that the Company believes 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. Typical SBA 7(a) and USDA guarantees range from 50% to 90% depending on loan size and type, 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 second quarter of 2021, there was a provision for loan and lease credit losses of $7.8 million compared to $10.0 million for the same period in 2020, a decrease in provision of $2.1 million. For the first half of 2021, there was a provision for loan and lease credit losses of $7.0 million compared to $21.8 million for the same period in 2020, a decrease in provision of $14.8 million. The decrease in provision for both periods was primarily the result of improved forecasts related to employment and default expectations as the economic outlook has improved significantly compared to the prior period, partially mitigated by the impact of growth in the Company’s loan and lease portfolios.
Loans and leases held for investment at historical cost were $4.70 billion as of June 30, 2021, increasing by $882 thousand, or 23.1%, compared to June 30, 2020. This growth was largely fueled by $2.31 billion in PPP loan originations since the second quarter of 2020. Excluding PPP loan originations and net unearned fees on those loans, the balance in loans and leases held for investment at historical cost was $3.77 billion at June 30, 2021, an increase of $1.64 billion, or 77.2%, over June 30, 2020. This growth outside of PPP activity was fueled by robust loan originations.
Net charge-offs for loans and leases carried at historical cost were $2.4 million, or 0.21% of average quarterly loans and leases held for investment, carried at historical cost, on an annualized basis, for the three months ended June 30, 2021, compared to net charge-offs of $1.8 million, or 0.21%, for the three months ended June 30, 2020. For the six months ended June 30, 2021, net charge-offs totaled $1.4 million compared to $4.6 million for the six months ended June 30, 2020, a decrease of $3.2 million, or 68.7%. The decrease in charge-offs was primarily driven by improving market conditions during 2020. 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, nonperforming loans and leases not guaranteed by the SBA or USDA, excluding $5.5 million and $6.4 million accounted for under the fair value option at June 30, 2021 and 2020, respectively, totaled $22.5 million, which was 0.48% of the held for investment loan and lease portfolio carried at historical cost at June 30, 2021, compared to $13.1 million, or 0.34% of loans and leases held for investment at June 30, 2020. Nonperforming loans and leases carried at historical cost which are not guaranteed by the SBA or USDA were 0.60% and 0.62% of the historical cost portion of the held for investment loan and lease portfolio, excluding PPP loans, at June 30, 2021 and 2020, respectively.
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 gain (loss) 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 less routine gains and losses on investments.
The following table shows the components of noninterest income and the dollar and percentage changes for the periods presented.
2021/2020 Increase (Decrease)
Percent
(473
(7.07
)%
(1,610
(102.48
5,539
51.79
Net gain (loss) on loans accounted for under the fair
value option
204.22
(35
(1.56
44,092
27,386.34
Gain on sale of investment securities
available-for-sale, net
(100.00
(19
(0.72
267
22.14
(1,551
(29.87
47,700
212.84
(461
(3.52
4,575
73.05
6,356
29.15
17,080
145.65
1,286
27.24
44,261
45,629.90
(44
(0.84
557
19.54
0.85
73,015
259.35
47
For the three months ended June 30, 2021, noninterest income increased by $47.7 million, compared to the three months ended June 30, 2020. The increase from the prior year is primarily the result of the aforementioned increase in in equity security gains of $44.1 million associated with the Company’s investment in Greenlight. Other primary contributors were increased gains on sales of loans of $5.5 million and an increased net gain on loans accounted for under the fair value option of $2.2 million, both a product of improved market conditions compared to the impacts of COVID-19 in 2020.
For the six months ended June 30, 2021, noninterest income increased by $73.0 million, compared to the six months ended June 30, 2020. The increase from the prior year is primarily the result of the aforementioned Greenlight gain. This was combined with a lower net loss on the loan servicing asset of $4.6 million, increased gains on sales of loans of $6.4 million, and an increased net gain on loans accounted for under the fair value option of $17.1 million which were also a product of improved market conditions.
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.
Three months ended June 30,
Three months ended March 31,
Amount of loans and leases
originated
1,153,693
2,175,055
1,180,219
500,634
Guaranteed portions
of loans sold
130,858
154,980
136,747
162,297
Outstanding balance of
guaranteed loans sold (1)
2,694,931
2,840,429
2,843,963
2,761,015
For years ended December 31,
2,333,912
2,675,689
4,450,198
2,001,886
1,765,680
1,934,238
Guaranteed portions of
loans sold
267,605
317,277
542,596
340,374
945,178
787,926
2,819,625
2,746,840
3,045,460
2,680,641
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.
Changes in various components of noninterest income are discussed in more detail below.
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 June 30, 2021, loan servicing revaluation decreased $1.6 million, or 102.48%, compared to the three months ended June 30, 2020. The lower servicing valuation for the quarter over quarter period is principally due to the amortization of the guaranteed serviced loan portfolio. For the six months ended June 30, 2021, loan servicing revaluation increased $4.6 million, or 73.0%, as compared to the six months ended June 30, 2020. The higher servicing valuation during the first half of 2021 compared to the corresponding period of 2020 was primarily a result of improving market conditions and pricing for government guaranteed loans, outpacing amortization of the serviced portfolio.
48
Net Gains on Sale of Loans: For the three months ended June 30, 2021, net gains on sales of loans increased $5.5 million, or 51.8%, compared to the three months ended June 30, 2020. For the three months ended June 30, 2021, the volume of guaranteed loans sold decreased $24.1 million, or 15.6%, to $130.9 million from $155.0 million for the three months ended June 30, 2020. For the six months ended June 30, 2021, net gains on sales of loans increased $6.4 million, or 29.1%, compared to the six months ended June 30, 2020. For the six months ended June 30, 2021, the volume of guaranteed loans sold decreased $49.7 million, or 15.7%, to $267.6 million from $317.3 million for the six months ended June 30, 2020. The average net gain on guaranteed loan sales increased from $66.8 thousand to $114.8 thousand, per million sold, in the second quarters of 2020 and 2021, respectively, and increased from $65.2 thousand to $114.8 thousand, per million sold, in the first halves of 2020 and 2021, respectively. With lower loan sale volume and higher premium levels in the secondary market in the second quarter and half of 2021 compared to the same periods of 2020, the average net gain on guaranteed loan sales increased, largely as a result of improvement in market premium levels which were magnified by stimulus associated with the SBA program which removes the ongoing guarantee fee, typically paid by the purchaser, on loans originated under the Economic Aid Act. The magnitude of the increase in net gains on sale of loans was muted somewhat due the Company’s choice to not elect fair value for all retained participating interests arising from new government guaranteed loan sales beginning in the first quarter of 2021. Not electing fair value generally results in a larger discount, which will reduce the amount of gain recognized at the date of sale. This larger discount is subsequently accreted into interest income over the underlying loan’s remaining term using the effective interest method. Management made this change of election in alignment with its ongoing effort to reduce volatility and drive more predictable revenue. In accordance with accounting standards, any loans for which fair value was previously elected continue to be measured as such.
Net Gain (Loss) on Loans Accounted for Under the Fair Value Option: For the three months ended June 30, 2021, the net gain on loans accounted for under the fair value option increased $2.2 million, or 204.2%, compared to the three months ended June 30, 2020. For the six months ended June 30, 2021, the net gain on loans accounted for under the fair value option increased $17.1 million, or 145.6%, compared to the three months ended June 30, 2020. The carrying amount of loans accounted for under the fair value option at June 30, 2021 and 2020 was $772.3 million ($29.0 million classified as held for sale and $743.2 million classified as held for investment) and $866.7 million ($32.1 million classified as held for sale and $834.6 million classified as held for investment), respectively, a decrease of $94.4 million, or 10.9%. The gain on loans accounted for under the fair value option during second quarter and half of 2021 net was largely due to improving market conditions compared to COVID-19 pandemic economic impacts in the prior year.
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.
2,118
6.88
Non-staff expenses:
1,185
325.55
1,944
140.36
251
40.22
269
13.76
1,470
53.18
(267
(5.74
815
32.70
(17
(0.99
1,690
124.17
Total non-staff expenses
24,658
17,318
7,340
42.38
9,458
19.66
5,421
9.21
2.94
3,838
115.53
(458
(23.07
(40
(0.91
2,207
37.27
(548
(5.90
34.07
100.00
238
7.37
2,705
76.61
51,564
38,746
12,818
33.08
18,239
18.69
Total noninterest expense for the three and six months ended June 30, 2021, increased $9.5 million, or 19.7%, and $18.2 million, or 18.7%, respectively, compared to the same periods in 2020. The increase in noninterest expense for the comparable three and six month periods was largely driven by various components, as discussed below.
Salaries and employee benefits: Total personnel expense for the three and six months ended June 30, 2021 increased by $2.1 million, or 6.9%, and $5.4 million, or 9.2%, respectively, compared to the same periods in 2020. The increase in salaries and employee benefits for both periods was principally related to continued investment in human resources to support strategic and growth initiatives.
Primary components of the change in salaries and employee benefits as compared to the second quarter of 2020 were $3.2 million in increased salaries and benefits combined with the vesting of 178 thousand restricted stock unit awards during the second quarter of 2021 with market price conditions that accelerated recognition of both stock compensation expense and payroll tax expense by a combined $1.8 million, partially offset by decrease of $3.0 million largely related to the 2020 performance bonus pool that was available to all employees other than executive officers.
Primary components of the change in salaries and employee benefits as compared to the first half of 2020 were $6.1 million in increased salaries and benefits combined with an increase in payroll taxes and stock expense of $4.1 million, largely related to higher salaries and the vesting of approximately 576 thousand restricted stock unit awards during the first half of 2021 with market price conditions that accelerated recognition of both stock compensation expense and payroll tax expense, all partially offset by a decrease of $2.7 million largely related to the above referenced 2020 performance bonus pool and a $2.2 million increase in deferred compensation expense related to heightened levels of lending.
Total full-time equivalent employees increased from 640 at June 30, 2020, to 701 at June 30, 2021. Salaries and employee benefits expense included $4.1 million and $9.1 million of stock-based compensation for the three and six months ended June 30, 2021, respectively, compared to $3.3 million and $6.2 million for the three and six months ended June 30, 2020, respectively. Expenses related to the employee stock purchase program, stock grants, stock option compensation and restricted stock expense are all considered stock-based compensation.
Travel expense: For the three and six months ended June 30, 2021, travel expenses increased $1.2 million, or 325.6%, and $63thousand, or 2.9%, respectively, compared to the same periods in 2020. Travel expenses increased to support the growth in loan origination volume and customer base as travel restrictions have lessened in recent months.
Professional services expense: For the three and six months ended June 30, 2021, professional services expense increased $1.9 million, or 140.36%, and $3.8 million, or 115.5%, respectively, compared to the same periods in 2020. The increase compared to the prior periods was largely driven by an increase in legal fees related to the previously disclosed letter the Company received in December 2020 and the resulting putative class action filed against the Company and other parties in March 2021.
Data processing expense: Total data processing expense for the three and six months ended June 30, 2021 increased by $1.5 million, or 53.2%, and $2.2 million, or 37.3%, respectively, compared to the same periods in 2020. The quarter over quarter increase was principally due to enhanced investments in the Company’s internal software technology resources.
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Renewable tax credit investment impairment: For the six months ended June 30, 2021, the Company recognized $3.1 million in impairment charges related to a $3.9 million renewable energy tax credit investment that was fully funded during the quarter. Investments of this type generate a return primarily through the realization of income tax credits and other benefits; accordingly, impairment of the investment amount is recognized in conjunction with the realization of related tax benefits. This investment generated a federal investment tax credit of $3.4 million which is included in the Company’s estimated annual effective tax rate.
Income Tax Expense
For the three months ended June 30, 2021, income tax expense increased by $11.1 million, while the Company’s effective tax rates were 16.5% and 28.1%, respectively, as compared to the same period in 2020. The lower effective rate for the second quarter of 2021 is principally due to earlier discussed items related to renewable energy tax credit investments and an income tax benefit arising from the vesting of stock unit awards, as the fair value of these awards exceeded the total compensation cost recognized by the Company for book purposes.
For the six months ended June 30, 2021, income tax expense was $16.8 million compared to an income tax benefit of $6.3 million for the first half of 2020, and the Company’s effective tax rates were 14.0% and (62.2)%, respectively, as compared to the same periods in 2020. The effective rate for the first half of 2021 is principally due to the earlier discussed item related to renewable energy tax credit investments and vesting of approximately 576 thousand restricted stock unit awards with market price conditions, as the fair value of these awards exceeded the total compensation cost recognized by the Company for book purposes. The negative effective rate during the first half of 2020 was partially 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 was 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 half of 2020 was predominantly driven by the Company’s overall net pretax loss. The increase from an income tax benefit in the first half of 2020 to income tax expense for the first half of 2021 is primarily due to a significant increase in income before taxes during 2021.
Results of Segment Operations
The Company’s operations are managed along two primary operating segments Banking and Fintech. A description of each business and the methodologies used to measure financial performance is described in Note 12. Segments in the accompanying Notes to the Unaudited Condensed Consolidated Financial Statements. Net income (loss) by operating segment is presented below:
Consolidated net income (loss)
For the three and six months ended June 30, 2021, net income increased $26.0 million and $75.2 million, respectively, compared to the same periods of 2020. The increase for both periods was primarily the result of increased net interest income and increased levels of noninterest income.
For the three and six months ended June 30, 2021, net interest income increased $30.8 million, or 74.9%, and $60.5 million, or 74.5%, respectively, compared to the same periods of 2020. See the analysis of net interest income included in the above section captioned “Net Interest Income and Margin” as it is predominantly related to the Banking segment.
See the analysis of provision for loan and lease credit losses included in the above section captioned “Provision for Loan and Lease Credit Losses” as it is entirely related to the Banking segment.
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For the three and six months ended June 30, 2021, noninterest income increased $1.8 million and $26.3 million, respectively, compared to the same periods of 2020. The quarter over quarter increase was largely comprised of an increase in the net gains on sale of loans of $5.5 million, or 51.8%, and net gain on loans accounted for under the fair value option of $2.2 million, or 204.2%, while the increase over the first half of 2021 was principally comprised of a net positive increase in the loan servicing asset revaluation of $4.6 million, or 73.0% combined with an increase in net gains on sale of loans of $6.4 million, or 29.1% and the net gain on loans accounted for under the fair value option of $17.1 million, or 145.6%. See the analysis of these categories of noninterest income included in the above section captioned “Noninterest Income” for additional discussion.
For the three and six months ended June 30, 2021, noninterest expense increased $5.5 million, or 12.2%, and $14.5 million, or 15.7%, respectively, compared to same periods of 2020. See the analysis of these categories of noninterest expense included in the above section captioned “Noninterest Expense” for additional discussion.
For the three and six months ended June 30, 2021, income tax expense increased $3.1 million, or 155.7%, and $11.9 million, or 551.9%, respectively, compared to the same periods of 2020. See the above section captioned “Income Tax Expense.”
For the three and six months ended June 30, 2021, the net income increased by $33.4 million and $34.6 million, respectively, compared to same periods of 2020. The increase was principally the result of the aforementioned $44.1 million Greenlight gain recognized in the second quarter of 2021.
For the three and six months ended June 30, 2021, noninterest income increased $43.6 million and $44.5 million, respectively, compared to the same periods of 2020. This increase was largely due to the above mentioned Greenlight gain.
For the three and six months ended June 30, 2021, noninterest expense decreased $256 thousand, or 18.7%, and $726 thousand, or 25.4%, respectively, compared to the same periods of 2020. This decrease was largely due to a reduction in expenses incurred by Canapi Advisors.
For the three and six months ended June 30, 2021, income tax expense increased $10.5 million, and $10.7 million, respectively, compared to the same periods of 2020. This increase in income tax expense was principally driven by the significant increase in net income before taxes arising from the above discussed gain arising from the Company’s investment in Greenlight.
Discussion and Analysis of Financial Condition
June 30, 2021 vs. December 31, 2020
Total assets at June 30, 2021 were $8.24 billion, an increase of $370.9 million, or 4.7%, compared to total assets of $7.87 billion at December 31, 2020. 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, was $438.8 million at June 30, 2021, an increase of $120.5 million, or 37.9%, compared to $318.3 million at December 31, 2020. This increase reflects liquidity planning through increased levels of deposits for funding expected loan and lease originations; and
Growth in total loans and leases held for investment and held for sale of $185.9 million resulting from strong origination activity in the first half of 2021. Total originations during the first half of 2021 were $2.33 billion, comprised of $1.79 billion in loans and leases exclusive of PPP and an additional $547.5 million in PPP loans.
Total investment securities increased $67.8 million during the first six months of 2021, from $750.1 million at December 31, 2020, to $817.9 million at June 30, 2021, an increase of 9.0%. The Company increased its investment securities position during the first six months of 2021 largely as a part of its annual investment asset-liability planning. At June 30, 2021, the investment portfolio was comprised of U.S. government agency, U.S. government-sponsored entity mortgage-backed securities, municipal bonds and other debt securities.
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Loans and leases held for sale decreased $110.6 million, or 9.4%, during the first six months of 2021, from $1.18 billion at December 31, 2020, to $1.06 billion at June 30, 2021. The decrease was primarily the result of strong loan sales in the first half of 2021 combined with higher levels of loans being retained as held for investment.
Loans and leases held for investment increased $296.5 million, or 5.8%, during the first six months of 2021, from $5.14 billion at December 31, 2020, to $5.44 billion at June 30, 2021. The increase was primarily the result of the above-mentioned loan originations in 2021 combined with increased levels of loans retained as held for investment. All PPP loans are classified as held for investment.
Total deposits were $6.52 billion at June 30, 2021, an increase of $808.0 million, or 14.1%, from $5.71 billion at December 31, 2020. The increase in deposits was largely driven by significant loan origination efforts during the first half of 2021.
Borrowings decreased to $529.7 million at June 30, 2021 from $1.54 billion at December 31, 2020. This decrease was related principally to net curtailments of borrowings through the PPPLF in the first half of 2021 as PPP loan forgiveness outpaced new PPPLF advances. These PPPLF borrowings are used to help fund PPP loans.
Shareholders’ equity at June 30, 2021 was $657.3 million as compared to $567.9 million at December 31, 2020. The book value per share was $15.19 at June 30, 2021 compared to $13.38 at December 31, 2020. Average equity to average assets was 7.3% for the six months ended June 30, 2021 compared to 8.1% for the year ended December 31, 2020. The increase in shareholders’ equity for the first six months of 2021 was principally the result of net income of $103.0 million and stock-based compensation expense of $9.1 million, partially offset by other comprehensive income of $8.4 million and $17.0 million in cash paid in lieu of stock for employee tax obligations in settlement of vested stock grants, principally related to the approximately 576 thousand awards with market price conditions vesting the first half of 2021 discussed earlier.
During the first six months of 2021, 597,430 shares of Class B common stock (non-voting) were converted to Class A common stock (voting) in connection with private sales. The conversion decreased the value of Class B common stock (non-voting) and increased the value of Class A common stock (voting) by $6.3 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).
Nonperforming assets and TDRs, excluding loans measured at fair value, at June 30, 2021 were $90.4 million, which represented a $7.9 million, or 9.6%, increase from December 31, 2020. These nonperforming assets, at June 30, 2021 were comprised of $48.0 million in nonaccrual loans and leases and $1.8 million in foreclosed assets. Of the $90.4 million of nonperforming assets and TDRs, $45.2 million carried an SBA guarantee, leaving an unguaranteed exposure of $45.1 million in total nonperforming assets and TDRs at June 30, 2021. This represents an increase of $5.8 million, or 14.8%, from an unguaranteed exposure of $39.3 million at December 31, 2020.
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The following table provides information with respect to nonperforming assets and troubled debt restructurings, excluding loans measured at fair value, at the dates indicated.
June 30, 2021 (1)
December 31, 2020 (1)
Nonaccrual loans and leases:
Total nonperforming loans and leases (all on nonaccrual) (2)
48,009
Total accruing loans and leases past due 90 days or more
Total troubled debt restructurings (3)
52,989
39,803
Less nonaccrual troubled debt restructurings
(12,415
(7,592
Total performing troubled debt restructurings (3)
40,574
32,211
Total nonperforming assets and troubled debt restructurings (2)(3)
90,376
82,476
Total nonperforming loans and leases to total loans and leases held for
investment (2)
1.02
1.06
Total nonperforming loans and leases to total assets (2)
0.64
Total nonperforming assets and troubled debt restructurings to total
assets (2) (3)
1.21
1.17
Allowance for credit losses on loans and leases to loans and leases held for
1.23
Allowance for credit losses on loans and leases to total nonperforming loans
and leases (2)
120.49
113.44
Excludes loans measured at fair value.
The period ended December 31, 2020 excludes one $6.1 million hotel loan classified as held for sale.
The period ended December 31, 2020 excludes one $5.1 million hotel loan classified as held for sale.
Nonaccrual loans and leases guaranteed by U.S. government:
Total nonperforming loans and leases guaranteed by the U.S government (all on
nonaccrual)
Total accruing loans and leases past due 90 days or more guaranteed by the
U.S government
Foreclosed assets guaranteed by the U.S. government
1,338
3,220
Total troubled debt restructurings guaranteed by the U.S. government
24,724
18,160
Less nonaccrual troubled debt restructurings guaranteed by the U.S.
government
(6,386
(4,271
Total performing troubled debt restructurings guaranteed by U.S. government
18,338
13,889
Total nonperforming assets and troubled debt restructurings guaranteed
by the U.S. government
45,227
43,141
Total nonperforming loans and leases not guaranteed by the U.S. government to
total held for investment loans and leases
0.48
0.46
total assets
0.30
0.29
Total nonperforming assets and troubled debt restructurings not guaranteed by
the U.S. government to total assets
0.60
and leases not guaranteed by the U.S government
257.59
260.51
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Total nonperforming assets and TDRs, including loans measured at fair value, at June 30, 2021 were $169.6 million, which represented a $16.4 million, or 10.7%, increase from December 31, 2020. These nonperforming assets, at June 30, 2021 were comprised of $92.0 million in nonaccrual loans and leases and $1.8 million in foreclosed assets. Of the $169.6 million of nonperforming assets and TDRs, $107.8 million carried an SBA guarantee, leaving an unguaranteed exposure of $61.8 million in total nonperforming assets and TDRs at June 30, 2021. This represents an increase of $6.3 million, or 11.3%, from an unguaranteed exposure of $55.5 million at December 31, 2020.
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 8.1% at June 30, 2021, compared to 8.8% at December 31, 2020. 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 both June 30, 2021 and December 31, 2020 were 3.8%.
As of June 30, 2021, and December 31, 2020, potential problem (also referred to as criticized) and classified loans and leases, excluding loans measured at fair value, totaled $357.0 million and $311.4 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. For a complete description of the risk grading system, see Note 5. Loans and Leases Held for Investment and Credit Quality in the Company’s 2020 Form 10-K. At June 30, 2021, the portion of criticized and classified loans and leases guaranteed by the SBA or USDA totaled $186.2 million resulting in unguaranteed exposure risk of $170.1 million, or 7.8% of total held for investment unguaranteed exposure carried at historical cost. This compares to the December 31, 2020 portion of criticized and classified loans and leases guaranteed by the SBA or USDA which totaled $168.9 million resulting in unguaranteed exposure risk of $142.5 million, or 8.2% of total held for investment unguaranteed exposure carried at historical cost. As of June 30, 2021, loans and leases carried at historical cost within the following verticals comprise the largest portion of the total potential problem and classified loans and leases: Wine and Craft Beverage at 18.8%, Educational Services at 16.3%, Entertainment Centers at 12.8%, Hotels at 12.0%, Healthcare at 8.6%, Fitness Centers at 6.3%, Self Storage at 4.2%, Veterinary at 4.1%, and General Lending at 4.1%. As of December 31, 2020, loans and leases carried at historical cost within the following verticals comprise the largest portion of the total potential problem and classified loans and leases: Educational Services at 15.3%, Wine and Craft Beverage at 14.3%, Hotels at 13.6%, Entertainment Centers at 12.5%, Healthcare at 10.3%, Fitness Centers at 7.2%, Self Storage at 6.4% and Veterinary at 4.5%. Other than Hotels which are a part of the Company’s Specialty Lending division, all of the above listed verticals are within the Company’s Small Business Banking division. The majority of the $45.6 million first six months of 2021 increase in potential problem and classified loans and leases was comprised of borrowers largely concentrated in the Company’s more mature verticals. Furthermore, the Company believes that its underwriting and credit quality standards have remained high with an emphasis on new production in pandemic resilient verticals and increased monitoring of existing loans in pandemic susceptible verticals as the impacts of COVID-19 continue to evolve.
Loans and leases that experience insignificant payment delays and payment shortfalls are generally not individually evaluated for the purpose of estimating the allowance for credit losses. The Bank generally considers an “insignificant period of time” from payment delays to be a period of 90 days or less, unless the borrower was not past due at the time of a modification as a part of a COVID-19 assistance program. 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. 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. At June 30, 2021, the Company had $5.9 million in modified unguaranteed loans and leases for borrowers impacted by the COVID-19 pandemic. These modifications were primarily short-term payment deferrals generally no more than six-months in duration and accordingly are not considered troubled debt restructurings. As of August 2, 2021, the Company’s modified unguaranteed loans and leases for borrowers impacted by the COVID-19 pandemic was approximately $4.6 million, a decrease from June 30, 2021 due to borrowers beginning to emerge from deferral needs.
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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. At June 30, 2021, and December 31, 2020, Risk Grade 5 loans and leases, excluding loans measured at fair value, totaled $281.9 million and $237.5 million, respectively. The increase in Risk Grade 5 loans and leases, exclusive of loans measured at fair value, during the first half of 2021 was principally confined to five verticals: Wine and Craft Beverage ($22.6 million or 50.7%), Educational Services ($9.3 million or 20.8%), Entertainment Centers ($7.1 million or 16.1%), General Lending ($4.7 million or 10.5%), and Hotels ($3.4 million or 7.6%). Partially offsetting the above increases were declines in Risk Grade 5 loans principally concentrated in two verticals: Senior Care ($5.0 million or 11.3%) and Self Storage ($2.0 million or 4.5%). Other than Hotels, which are a part of the Company’s Specialty Lending division, all of the above listed verticals are within the Company’s Small Business Banking division. Lower levels of Risk Grade 5 loans in Senior Care and Self Storage were principally due to two previous Risk Grade 5 relationships continuing to experience stress and being downgraded to Risk Grade 6 during the first quarter.
At June 30, 2021, approximately 100.0% of loans and leases classified as Risk Grade 5 are performing with only one relationship having 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. In conjunction with this, management believes that volumes of delinquencies may not be an accurate depiction of the borrower’s repayment abilities under the current pandemic induced circumstances due to payments being made by the SBA on behalf of borrowers with loans under its programs. As government payment assistance began to expire toward the end of 2020, borrowers with continuing difficulties arising from the pandemic were provided additional relief through payment deferrals. Management monitors these borrowers closely and has observed financial conditions continuing to improve. Management has also noted that most loans with expired government assistance have been able to resume making regular payments in the first half of 2021.
Allowance for Credit Losses on Loans and Leases
See Note 1. Organization and Summary of Significant Accounting Policies of the Notes to the Consolidated Financial Statements in the Company’s 2020 Form 10-K for a description of the methodologies used to estimate the allowance for credit losses.
The ACL of $52.3 million at December 31, 2020, increased by $5.5 million, or 10.6%, to $57.9 million at June 30, 2021. The ACL as a percentage of loans and leases held for investment at historical cost amounted to 1.2% at both June 30, 2021 and December 31, 2020. Excluding PPP loans and related reserves, the ACL as a percentage of loans and leases held for investment at historical cost amounted to 1.5% and 1.8% at June 30, 2021 and December 31, 2020, respectively. The increase in the ACL during the first half of 2021 was primarily due to impact of growth in loan and lease originations somewhat mitigated by the effects of improved forecasts related to employment and default expectations as the economic outlook has continued to improve, as addressed more fully in the above section captioned “Provision for Loan and Lease Credit Losses” in “Results of Operations.”
Actual past due held for investment loans and leases, inclusive of loans measured at fair value, have decreased by $10.0 million since December 31, 2020. Total loans and leases 90 or more days past due decreased $14.9 million, or 24.1%, compared to December 31, 2020. The decrease was comprised of a $10.9 million decrease in unguaranteed combined with a $4.0 million decrease in the guaranteed portions of past due loans compared to December 31, 2020. At June 30, 2021, and December 31, 2020, 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 0.7% and 1.1%, respectively. Total unguaranteed loans and leases past due were comprised of $13.2 million carried at historical cost, a decrease of $9.9 million, and $8.1 million measured at fair value, an increase of $1.8 million, as of June 30, 2021 compared to December 31, 2020. Management continues to actively monitor and work to improve asset quality. Management believes the ACL of $57.9 million at June 30, 2021 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, including but not limited to factors related to the above mentioned SBA delinquency effect and pandemic-susceptible verticals. Accordingly, 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.
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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 June 30, 2021, the total amount of these four items was $3.27 billion, or 39.6% of total assets, an increase of $210.8 million from $3.06 billion, or 38.8% of total assets, at December 31, 2020.
Loans and other assets are funded by loan sales, wholesale deposits, core deposits and PPPLF borrowings. To date, an increasing retail deposit base and an increased long term wholesale deposit base along with PPPLF borrowings 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 June 30, 2021, none of the investment securities portfolio was pledged to secure public deposits or pledged to retail repurchase agreements, leaving $817.4 million available to pledge as collateral.
Contractual Obligations
The following table presents the Company’s significant fixed and determinable contractual obligations by payment date as of June 30, 2021. 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
3,482,782
Time deposits
3,038,051
1,774,180
576,580
335,589
351,702
970,429
19,694
18,315
Operating lease obligations
3,108
738
981
207
1,182
7,536,372
6,228,129
597,255
354,111
356,877
As of June 30, 2021, and December 31, 2020, the Company had unfunded commitments to provide capital contributions for on-balance sheet investments in the amount of $12.6 million and $15.8 million, respectively.
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. As of June 30, 2021, the balance sheet’s total cumulative gap position was asset-sensitive at 3.5%.
The interest rate gap 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, changes in account behaviors based on the interest rate environment, nor growth. Therefore, management also uses an earnings simulation model to prepare, on a regular basis, earnings projections based on a range of interest rate scenarios to measure interest rate risk. As of June 30, 2021, the Company’s interest rate risk profile under the earnings simulation model method remained asset-sensitive. 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, rates on cash accounts that adjusts as the federal funds rate changes and the longer duration of indeterminate term deposits.
57
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 the following: to provide adequate capital to support the Company’s risk profile consistent with the risk appetite approved by the Board of Directors; to provide financial flexibility to support future growth and client needs; comply with relevant laws, regulations, and supervisory guidance; to achieve optimal ratings for the Company and its subsidiaries; and to 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 June 30, 2021, and December 31, 2020, are presented in the table below.
Actual
Minimum Capital
Requirement
Minimum To Be
Well Capitalized
Under Prompt
Corrective Action
Provisions (1)
Ratio
Consolidated - June 30, 2021
Common Equity Tier 1 (to Risk-Weighted Assets)
617,990
12.45
223,345
4.50
N/A
Total Capital (to Risk-Weighted Assets)
676,502
13.63
397,057
8.00
Tier 1 Capital (to Risk-Weighted Assets)
297,793
6.00
Tier 1 Capital (to Average Assets)
8.70
284,176
4.00
Bank - June 30, 2021
536,224
11.36
212,452
306,874
6.50
594,736
12.60
377,692
472,115
10.00
283,269
7.63
281,154
351,442
5.00
Consolidated - December 31, 2020
521,568
12.15
193,172
574,621
13.39
343,417
257,563
8.40
248,417
Bank - December 31, 2020
470,069
11.25
188,012
271,573
522,305
12.50
334,243
417,804
250,683
7.60
247,288
309,110
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.
58
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, 2020, 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;
Valuation of equity security investments where no readily available market price exists;
Consideration of significant influence for certain relationships where we have equity interests;
Income taxes;
Restricted stock unit awards with market price conditions;
Valuation of foreclosed assets; and
Business combination and goodwill.
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 June 30, 2021, 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 June 30, 2021, 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
During the three months ended June 30, 2021, the Company migrated its human capital, accounting and financial management systems to a new platform. As a result of this implementation, the Company modified existing internal controls and implemented new processes and controls related to the new platform. The Company will continue to monitor and evaluate internal controls over financial reporting as it relates to the new system.
Except as related to the implementation of the new system, there were no changes in the Company’s internal control over financial reporting during the three and six months ended June 30, 2021, 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 at times involved in legal proceedings. In the opinion of management, as of June 30, 2021, there are no material pending legal proceedings to which the Company or any of its subsidiaries is a party or of which any of their property is the subject. In addition, the Company is not aware of any threatened litigation, unasserted claims or assessments that could have a material adverse effect on its business, operating results or financial condition.
On March 12, 2021, a purported class action was filed against the Company in the United States District Court for the Eastern District of North Carolina, Joseph McAlear, individually and on behalf of all others similarly situated v. Live Oak Bancshares, Inc. et al. The complaint alleges the existence of an agreement between the Company, nCino, Inc. and Apiture, LLC in which those companies purportedly sought to restrain the mobility of employees in violation of antitrust laws by agreeing not to solicit or hire each other’s employees. The complaint alleges violations of Section 1 of the federal Sherman Act (15 U.S.C. § 1) and violations of Sections 75-1 and 75-2 of the North Carolina General Statutes. The plaintiff seeks monetary damages, including treble damages, entitlement to restitution, disgorgement, attorneys’ fees, and pre- and post-judgment interest.
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, 2020.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.
Item 3. Defaults Upon Senior Securities
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
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)
10.1.1
Amendment to Software Service Agreement dated May 21, 2021, between Live Oak Banking Company and nCino, Inc.*
10.1.2
Amendment to Software Service Agreement dated June 11, 2021, between Live Oak Banking Company and nCino, Inc.*
10.1.3
Amendment to Software Service Agreement dated July 23, 2021, between Live Oak Banking Company and nCino, Inc.*
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**
101
Interactive data files pursuant to Rule 405 of Regulation S-T, formatted in Inline XBRL: (i) Condensed Consolidated Balance Sheets as of June 30, 2021 and December 31, 2020; (ii) Condensed Consolidated Statements of Income for the Three and Six Months Ended June 30, 2021 and 2020; (iii) Condensed Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2021 and 2020; (iv) Condensed Consolidated Statements of Changes in Shareholders’ Equity for the Three and Six Months Ended June 30, 2021 and 2020; (v) Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2021 and 2020; 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: August 4, 2021
By:
/s/ S. Brett Caines
S. Brett Caines
Chief Financial Officer