Attached files
| file | filename |
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| EX-32 - EXHIBIT 32 - Howard Bancorp Inc | tv487877_ex32.htm |
| EX-31.(B) - EXHIBIT 31(B) - Howard Bancorp Inc | tv487877_ex31b.htm |
| EX-31.(A) - EXHIBIT 31(A) - Howard Bancorp Inc | tv487877_ex31a.htm |
| EX-23.2 - EXHIBIT 23.2 - Howard Bancorp Inc | tv487877_ex23-2.htm |
| EX-23.1 - EXHIBIT 23.1 - Howard Bancorp Inc | tv487877_ex23-1.htm |
| EX-21 - EXHIBIT 21 - Howard Bancorp Inc | tv487877_ex21.htm |
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2017
Commission file number: 001-35489
HOWARD BANCORP, INC.
(Exact name of registrant as specified in its charter)
| Maryland | 20-3735949 | |
| State or other jurisdiction | (I.R.S. Employer | |
| of incorporation or organization | Identification No.) |
| 3301 Boston Street, Baltimore, MD | 21224 | |
| (Address of principal executive offices) | (Zip Code) |
(410) 750-0020
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
| Name of each exchange | ||
| Title of each class | on which registered | |
| Common Stock, par value $0.01 per share | The Nasdaq Stock Market LLC |
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act Yes ¨ No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
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 x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨ Smaller reporting company ¨ Emerging growth company ¨
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x
The aggregate market value of the voting common stock of the registrant held by non-affiliates on June 30, 2017, was approximately $168.7 million. At February 28, 2018, the number of outstanding shares of Common Stock, $0.01 par value, of the Corporation was 9,827,072.
DOCUMENTS INCORPORATED BY REFERENCE
Part III of this Form 10-K incorporates by reference certain information from the registrant’s definitive Proxy Statement for the 2018 Annual Meeting of Stockholders.
TABLE OF CONTENTS
As used in this report, “the Company,” “we,” “us,” and “ours” refer to Howard Bancorp, Inc. and its subsidiaries. References to the “Bank” refer to Howard Bank.
This report contains forward-looking statements, which can be identified by the use of words such as “estimate,” “project,” “believe,” “intend,” “anticipate,” “plan,” “seek,” “expect,” “will,” “may,” “should” and words of similar meaning. You can also identify them by the fact that they do not relate strictly to historical or current facts.
These forward-looking statements include, but are not limited to:
| · | statements of our goals, intentions and expectations, particularly with respect to our business plan and strategies, including our planned new branch in Columbia, Maryland, opening of additional branches, expansion into new markets, potential acquisitions, increasing capital, market share, loan, investments and asset growth, revenue and profit growth and expanding client relationships; |
| · | statements with respect to expected benefits and other impacts of our acquisition of First Mariner Bank, including expected increases in non-interest expenses resulting from the merger; |
| · | impact of recent branch closures and the opening of our anticipated new branch on expenses; |
| · | statements regarding the asset quality of our investment portfolios and anticipated recovery and collection of unrealized losses on securities available for sale; |
| · | expected continued focus on commercial customers as well as continuing to originate residential real estate loans and both maintaining our residential mortgage loan portfolio and continuing to sell loans into the secondary market; |
| · | the expected impact of the recently enacted Tax Cuts and Jobs Act; |
| · | expected increases in occupancy and equipment expenses; |
| · | statements with respect to our allowance for credit losses, and the adequacy thereof; |
| · | our expectations regarding the pending sale of OREO properties, including the timing and impact thereof; |
| · | statement with respect to having adequate liquidity levels and future sources of liquidity; |
| · | our belief that we will retain a large portion of maturing certificates of deposit; |
| · | the impact on us of recent changes to accounting standards; |
| · | future cash requirements relating to commitments to extend credit; and |
| · | the impact of interest rate changes on our net interest income. |
These forward-looking statements are based on our current beliefs and expectations and are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. We are under no duty to and do not undertake any obligation to update any forward-looking statements after the date of this report.
The following factors, among others, could cause actual results to differ materially from the anticipated results or other expectations expressed in the forward-looking statements:
| · | potential problems in connection with the recent acquisition of First Mariner Bank, as further discussed in “Item 1A. Risk Factors”; |
| · | deterioration in general economic conditions, either nationally or in our market area, or a return to recessionary conditions; |
| · | competition among depository and other financial institutions; |
| · | inflation and changes in the interest rate environment that reduce our margins or reduce the fair value of financial instruments; |
| · | adverse changes in the securities markets; |
| · | changes in laws or government regulations or policies affecting financial institutions, including changes in regulatory fees and capital requirements; |
| · | our ability to enter new markets successfully and capitalize on growth opportunities, and to otherwise implement our growth strategy; |
| · | our ability to successfully integrate acquired entities, if any; |
| · | changes in consumer spending, borrowing and savings habits; |
| · | changes in accounting policies and practices, as may be adopted by the bank regulatory agencies, the Financial Accounting Standards Board, the Securities and Exchange Commission and the Public Company Accounting Oversight Board; |
| · | changes in our organization, compensation and benefit plans; |
| · | loss of key personnel; and |
| · | other risk discussed in this report. |
Because of these and a wide variety of other uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements. You should not put undue reliance on any forward-looking statements.
Howard Bancorp, Inc.
Howard Bancorp, Inc., the parent company of Howard Bank, was incorporated in April 2005 under the laws of the State of Maryland to serve as the bank holding company of Howard Bank.
Howard Bank
Howard Bank is a Maryland-chartered trust company that was formed in March 2004 and commenced banking operations in August 2004. Howard Bank has currently chosen not to seek and exercise trust powers, and our business, powers and regulatory structure are the same as a Maryland-chartered commercial bank. The Bank is subject to regulation, supervision and regular examination by the Maryland Office of the Commissioner of Financial Regulation (the “Commissioner”) and the Federal Deposit Insurance Corporation (“FDIC”), and our deposits are insured by the FDIC. The Bank has four operating subsidiaries, three of which hold foreclosed real estate and the other of which owns and manages real estate that we use for one of our branch locations and that also contains office and retail space.
Howard Bank is headquartered in Ellicott City, which is located in Howard County, Maryland. The Bank has branches in Howard County as well as in Anne Arundel County, Baltimore County, Baltimore City, Cecil County and Harford County in Maryland. We operate a general commercial banking business, making various types of loans and accepting deposits. We originally focused on marketing our financial services to small and medium sized businesses and their owners, professionals and executives, and high-net-worth individuals (the “mass affluent”) and, while this remains our primary marketing focus, during the last few years we have expanded our deposit and mortgage offerings to meet the financial needs of consumers generally.
Our core business strategy involves driving organic growth by delivering advice and superior customer service to clients through local decision makers. We combine the Bank’s specialized focus on both local markets and small and medium-sized business related market segments with a broad array of products, new technology and seasoned banking professionals to position the Bank differently from most competitors. Our experienced executives establish a relationship with each client and bring value to all phases of a client’s business and personal banking needs. To develop this strategy, we have established long-standing relationships with key customers in the community and with local business leaders who can create business opportunities. It is this philosophy toward the business that has afforded the Company great success in attracting and retaining top-tier, high quality lending teams from other institutions.
Our primary source of revenue is net interest income, with fees generated by lending, mortgage banking and depository service charges constituting a smaller, but growing, percentage of revenues. We have positioned our balance sheet to hold a high percentage of earning assets and, in turn, to have those earning assets dominated by loans rather than investment securities. Generally speaking, our loans earn more attractive returns than investments and are a key source of product cross sales and customer referrals. Our underwriting and lending teams have allowed us to be successful in gaining market share while continuing to maintain solid asset quality ratios, an approach that is fundamental to our culture. In our efforts to drive revenue growth, we continue to invest in our infrastructure and talent with the long-term view of building the dominant Greater Baltimore bank. At all times, our revenue-generating activities and expenditures are viewed with an eye towards investor returns while not exceeding risk tolerance thresholds set by management and our board of directors.
Our leadership team is deep and experienced both as it relates to tenure with the Company as well as industry experience. Our Chairman and CEO, Mary Ann Scully, founded the Company and has over 35 years of banking experience, mainly in senior executive roles with larger financial institutions. In addition, the Company employs a strong stable of next level senior leadership, which it believes is critical for successful implementation of our strategic initiatives. It is this leadership experience that has driven the Company’s growth since its founding. In addition to organic growth, the Company has completed and integrated one whole bank acquisition, one FDIC-assisted transaction and two branch acquisition transactions, as further discussed below. We consider this to be a critical component of furthering future growth and will continue to cultivate and pursue strategic initiatives provided they generate meaningful long-term stockholder returns.
Our strategic plan focuses on enhancing stockholder value through market share growth as reflected in balance sheet growth, related revenue growth and resulting growth in operating profits. During the past several years we have expanded our branch locations both through opening new branches and acquiring branch offices via acquisition, as we have done with the 14 branches acquired in the First Mariner Bank merger, discussed below. While we anticipate opening additional branches in the counties where we now operate and in contiguous counties over the next several years, other than a planned new location in Columbia, Maryland, we currently have no definitive plans or agreements in place with respect to any additional branches. Our long-term vision includes supplementing our historically organic growth with strategically significant acquisitions. We believe that acquiring other financial institutions - in whole or in part (through business line spin-offs, branch sales or the hiring of teams of individuals) will allow us to expand our market, achieve certain operating efficiencies, and grow our stockholder base and thus our share value and liquidity. We believe that our demonstrated expertise in commercial lending and deposit gathering (especially non-interest bearing transactional deposits), our demonstrated ability to attract additional investment and capital, and community leadership positions us as an attractive acquirer. We also anticipate that increasing our capital levels will give us the ability to continue our organic asset growth and expand our relationships with key clients through a larger legal lending limit.
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General Development of the Business
On February 1, 2017, Howard Bancorp closed an underwritten public offering pursuant to which, including the exercise in full by the underwriters of their option to purchase an additional 360,000 shares, we sold 2,760,000 shares of our common stock at the public offering price of $15.00 per share. Gross proceeds raised in the offering, before underwriting discounts and expenses of the offering, was approximately $41.4 million.
On May 6, 2016, we redeemed all of the 12,562 shares of the Series AA Preferred Stock that we had previously issued to the U.S. Department of the Treasury (“Treasury”) under its Small Business Lending Fund (“SBLF”) program. The aggregate redemption price of the Series AA Preferred Stock was approximately $12.7 million, including dividends accrued but unpaid through the redemption date.
On August 28, 2015, we completed our acquisition of Patapsco Bancorp, Inc., the parent company of The Patapsco Bank, through the merger of Patapsco Bancorp with and into Howard Bancorp pursuant to the Agreement and Plan of Merger dated as of March 2, 2015, as amended, by and between the Company and Patapsco Bancorp. As a result of the merger, each outstanding share of common stock of Patapsco Bancorp was converted into the right to receive, at the holder’s election, $5.09 in cash or 0.3547 shares of our common stock, provided that (i) cash was paid in lieu of any fractional shares of our common stock and (ii) 20% of the shares of common stock of Patapsco Bancorp outstanding at the time of the merger were exchanged for cash in the merger, with the remaining shares of Patapsco Bancorp common stock exchanged for an aggregate of 560,891 shares of our common stock. The aggregate merger consideration was $10.064 million. In connection with the merger, immediately thereafter Patapsco Bank merged with and into the Bank, with the Bank the surviving bank. We acquired The Patapsco Bank’s four branches in the merger.
In October 2014, the Bank assumed all of the deposits and acquired essentially all of the assets of NBRS Financial Bank (“NBRS”) from the FDIC, as receiver for NBRS, pursuant to the terms of the Purchase and Assumption Agreement, dated as of October 17, 2014, by and among the FDIC, Receiver of NBRS, the FDIC and Howard Bank. We acquired five new branch locations, located in Harford and Cecil Counties in Maryland and Lancaster County in Pennsylvania (the Pennsylvania location was later closed), as a result of this acquisition. The acquisition added $135.6 million in assets and generated a bargain purchase gain of $16.1 million before tax and expanded our geographic reach.
In August 2014 Howard Bank purchased from NBRS its branch located at 800 Revolution Street, Havre de Grace, Maryland. Pursuant to the branch purchase, the Bank acquired $16.1 million in loans and $18.7 million in deposits. In connection with its purchase of the branch, the Bank made a net cash payment of $2.4 million, including a premium of approximately $384,000.
In August 2013, the Bank purchased from Cecil Bank its branch located at 3 West Bel Air Avenue, Aberdeen, Maryland. Pursuant to the transaction, the Bank acquired $37.1 million in loans and $35.2 million in deposits from Cecil Bank, as well as the branch premises and equipment at their book value. In connection with its purchase of the branch from Cecil Bank, the Bank made a net cash payment to Cecil Bank of $3.2 million, including a premium of approximately $240,000.
Recent Developments
On March 1, 2018, we completed our acquisition of First Mariner Bank (“First Mariner”) through the merger of First Mariner with and into Howard Bank pursuant to the Agreement and Plan of Reorganization dated as August 14, 2017, as amended, by and between the Company, Howard Bank and First Mariner. As a result of the merger, each outstanding share of common stock of First Mariner was converted into the right to receive 1.6624 shares of Howard Bancorp common stock, provided that cash was paid in lieu of any fractional shares. The aggregate merger consideration of $173.8 million included $9.2 million of cash and 9,143,230 shares of our common stock, which was valued at approximately $164.6 million based on Howard Bancorp’s closing stock price of $18.00 on February 28, 2018. As indicated previously, we acquired 14 branch locations in this merger.
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Our Market Area
Our headquarters are located in Ellicott City, Maryland, and we consider our primary market area to be the Greater Baltimore Metropolitan Area in Maryland. We also have loans in our loan portfolio that are outside our market area, although to grow our loan portfolio we do not actively solicit business outside our primary market.
As of December 31, 2017, we had 14 full services branches, located throughout Maryland:
| HOWARD COUNTY | |||
| Snowden River | Maple Lawn | Centennial Place | |
| 6011 University Blvd. | 10985 Johns Hopkins Rd. | 10161 Baltimore National Pk. | |
| Suite 150 | Laurel, MD 20723 | Ellicott City, MD 21042 | |
| Ellicott City, MD 21043 |
| ANNE ARUNDEL COUNTY | |
| Defense Highway | |
| 116 Defense Hwy. | |
| Annapolis, MD 21401 |
| BALTIMORE COUNTY | ||
| Towson | Dundalk | Parkville |
| 22 W Pennsylvania Ave. | 1301 Merritt Blvd. | 2028 E. Joppa Rd. |
| Towson, MD 21204 | Baltimore, MD 21222 | Baltimore, MD 21234 |
| BALTIMORE CITY | |
| Hampden | Remington |
| 821 W. 36th St. | 2700 Remington Ave. Suite 100 |
| Baltimore, MD 21211 | Baltimore, MD 21211 |
| HARFORD COUNTY | ||
| Aberdeen | Havre de Grace | Dublin |
| 3 West Bel Air Ave. | 800 Revolution St. | 3535 Conowingo Rd. |
| Aberdeen, MD 21001 | Havre de Grace, MD 21078 | Street, MD 21154 |
| CECIL COUNTY | |
| Rising Sun | Elkton |
| 6 Pearl St. | 305 Augustine Herman Hwy. |
| Rising Sun, MD 21911 | Elkton, MD 21921 |
Competitive Position
We believe that our position as a community bank with over $1 billion in assets positions us well to navigate the ongoing market consolidation and heightened regulatory environment. We continue to have the ability to outsource certain activities (internal audit, compliance review, information security monitoring) and to source new products and services in a highly efficient manner and thus avoid the risk of impairment of operating earnings faced by some banks that, we believe, are locked into legacy systems and are finding the onslaught of new regulations and evolving consumer expectations challenging. Strategic partnerships for these outsourced activities include contractual relationships with some of the largest and strongest providers of item processing, data processing, information monitoring and payment systems alternatives. We believe that this provides the Bank with the best of technology and product selection without sacrificing the more intimate delivery advantages of a community bank. We further believe the current economic and regulatory environment will continue to result in greater consolidation among financial institutions, including community banks. Some of that consolidation will occur with larger banks, thus exacerbating the scarcity of banks able to underwrite traditionally and offer advice in interactions with customers as we do, which we believe gives us a wider window of opportunity to extend our brand and value proposition. We believe, however, that to the extent some of that consolidation occurs between and among smaller banks, the resulting combined institutions will be better positioned to differentiate themselves.
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We believe that our “Hands On” approach to delivering small and medium-sized businesses a very broad and deep array of competitive credit and cash management services through a team of experienced advisors and providing them with access to local policy and decision makers fills a “white space” between the sophisticated but distracted large banks whose best personnel work with the largest companies and the small banks who are very responsive but less capable of being proactive in providing advice. Our relationship managers, team leaders and executive management generally have decades of banking experiences and are well established in the communities that they serve. They are able to interface with clients directly to share that experience and to provide connections with their own network of other specialized advisors. We believe we also benefit from our committed leadership at both the executive management and board level who bring a broad array of skills and experiences to our company and are able to position the Bank for consistent profitable growth.
Lending Activities
General
Our primary market focus is on making loans to and gathering deposits from small and medium size businesses and their owners, professionals and executives, and high-net-worth individuals in our primary market area. Our loans are made to customers primarily in the Greater Baltimore market. Our lending activities consist generally of short to medium term commercial lending, commercial mortgage lending for both owner occupied and investment properties, residential mortgage lending and consumer lending, both secured and unsecured. A substantial portion of our loan portfolio consists of loans to businesses secured by real estate and/or other business assets.
Credit Policies and Administration
We have adopted a comprehensive lending policy that includes stringent underwriting standards for all types of loans. Our lending teams follow pricing guidelines established periodically by our management team. In an effort to manage risk, only small lending authority is given to individual loan officers. Most loan officers can approve loans of up to $100,000. The Chief Lending Officer, the Chief Credit Officer and a select number of senior managers can approve loans up to $750,000, or any two together can approve loans up to $1,500,000. Our Chief Executive Officer can approve loans of up to $2,000,000. Loans above these amounts must be reviewed and approved by an officers’ loan committee. Under the leadership of our executive management team, we believe that we employ experienced lending officers, secure appropriate collateral and carefully monitor the financial conditions of our borrowers and the concentration of loans in our portfolio.
In addition to the normal repayment risks, all loans in the portfolio are subject to the state of the economy and the related effects on the borrower and/or the real estate market. Generally, longer-term loans have periodic interest rate adjustments and/or call provisions. Senior management monitors the loan portfolio closely to ensure that we minimize past due loans and that we swiftly deal with potential problem loans.
Howard Bank also retains an outside, independent firm to review the loan portfolio. This firm performs a detailed annual review. We use the results of the firm’s report primarily to validate the risk ratings applied to loans in the portfolio and identify any systemic weaknesses in underwriting, documentation or management of the portfolio. Results of the annual review are presented to executive management, the Asset Quality Committee of the board and the full board of directors and are available to and used by regulatory examiners when they review the Bank’s asset quality. We currently use the firm of CliftonLarsenAllen to perform this review.
The Bank maintains the normal checks and balances on the loan portfolio not only through the underwriting process but through the utilization of an internal credit administration group that both assists in the underwriting and serves as an additional reviewer of underwriting. The separately-managed loan administration group also has oversight for documentation, compliance and timeliness of collection activities. Our outsourced internal audit firm also reviews documentation, compliance and file management.
Commercial Lending
Our commercial lending consists of lines of credit, revolving credit facilities, accounts receivable and inventory financing, term loans, equipment loans, small business administration (“SBA”) loans, stand-by letters of credit and unsecured loans. We originate commercial loans for any business purpose, including the financing of leasehold improvements and equipment, the carrying of accounts receivable, general working capital, contract administration and acquisition activities. These loans typically have maturities of seven years or less. We have a diverse client base and we do not have a concentration of these types of loans in any specific industry segment. We generally secure commercial business loans with accounts receivable and inventory, equipment, indemnity deeds of trust and other collateral such as marketable securities, cash value of life insurance, and time deposits at Howard Bank. Commercial business loans have a higher degree of risk than residential mortgage loans because the availability of funds for repayment generally depends on the success of the business. To help manage this risk, we establish parameters/ covenants at the inception of the loan to provide early warning systems before payment default. We normally seek to obtain appropriate collateral and personal guarantees from the borrower’s principal owners. We are able, given our business model, to proactively monitor the financial condition of the business.
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Commercial Mortgage Lending
We finance commercial real estate for our clients, for both owner-occupied properties and investment properties (including residential properties). We generally will finance owner occupied commercial real estate at a maximum loan–to-value of 85% and non-owner occupied at a maximum loan-to-value of 80%. Our underwriting policies and processes focus on the underlying credit of the owner for owner occupied real estate and on the rental income stream (including rent terms and strength of tenants) for non-owner occupied real estate as well as an assessment of the underlying real estate. Risks inherent in managing a commercial real estate portfolio relate to vacancy rates/absorption rates for surrounding properties, sudden or gradual drops in property values as well as changes in the economic climate. We attempt to mitigate these risks by carefully underwriting loans of this type as well as by following appropriate loan-to-value standards. We are cash flow lenders and never rely solely on property valuations in reaching a lending decision. Personal guarantees are often required for commercial real estate loans as they are for other commercial loans. Most of our real estate loans carry fixed interest rates and amortize over 20 - 25 years but have five- to seven-year maturities. Properties securing our commercial real estate loans primarily include office buildings, office condominiums, distribution facilities and manufacturing plants. Substantially all of our commercial real estate loans are secured by properties located in our market area.
Commercial real estate loans generally carry higher interest rates and have shorter terms than one- to four-family residential mortgage loans. Commercial real estate loans, however, entail significant additional risks as compared with residential mortgage lending, as they typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. In addition, the payment of loans secured by income-producing properties typically depends on the successful operation of the property, as repayment of the loan generally is dependent, in large part, on sufficient income from the property to cover operating expenses and debt service. Changes in economic conditions that are not in the control of the borrower or lender could affect the value of the collateral for the loan or the future cash flow of the property. Additionally, any decline in real estate values may be more pronounced for commercial real estate than residential properties.
Construction Lending
Construction lending can cover funding for land acquisition, land development and/or construction of residential or commercial structures. Our construction loans generally bear a variable rate of interest and have terms of one to two years. Funds are advanced on a percentage-of-completion basis. These loans are generally repaid at the end of the development or construction phase, although loans for both residential and commercial construction will often convert into a permanent mortgage loan at the end of the term of the loan. Loan to value parameters range from 65% of the value of land to 75% for developed land, 80% for commercial or multifamily construction and 85% for residential construction. These loan-to-value ratios represent the upper limit of advance rates to remain in compliance with Bank policy. Typically, loan-to-value ratios should be somewhat lower than these upper limits, requiring the borrower to provide significant equity at the inception of the loan. Our underwriting looks not only at the value of the property but the expected cash flows to be generated by sale of the parcels or completed construction. The borrower must have solid experience in this type of construction and personal guarantees are usually required.
Construction lending entails significant risks compared with residential mortgage lending. These risks involve larger loan balances concentrated with single borrowers with funds advanced upon the security of the land or the project under construction. The value of the project is estimated prior to the completion of construction. Thus, it is more difficult to evaluate accurately the total loan funds required to complete a project and related loan to value ratios. If the estimate of construction or development cost proves to be inaccurate, we may be required to advance additional funds beyond the amount originally committed in order to protect the value of the property. Moreover, if the estimated value of the completed project proves to be inaccurate, the borrower may hold a property with a value that is insufficient to assure full repayment. To mitigate these risks, in addition to the underwriting considerations noted above, we maintain an in-house construction monitoring unit that has oversight for the projects and we require both site visits and frequent reporting before funds are advanced.
Residential Mortgage Lending
We offer a variety of consumer-oriented residential real estate loans. Residential mortgage loans consist primarily of first mortgage loans to individuals, most of which have a loan to value not exceeding 85%. The remainder of this portion of our portfolio consists of home equity lines of credit and fixed rate home equity loans.
Our residential mortgage loans are generally for owner-occupied single family homes. These loans are generally for a primary residence although we will occasionally originate loans for a second home where the borrower has extremely strong credit. We originate adjustable rate residential mortgage loans with initial fixed-rate terms of five to seven years, as well as fixed rate residential mortgage loans with primarily 15 or 30 year terms.
Our home equity loans and home equity lines of credit are primarily secured by a second mortgage on owner occupied one-to four-family residences. Our home equity loans are originated at fixed interest rates and with terms of between five and 30 years for primary residences and between five and 15 years for secondary and rental properties, and are fully amortizing. Our home equity lines allow for the borrower to draw against the line for ten years, after which the line is refinanced into a ten-year fixed loan, with the possibility of a one-time extension of five years. Home equity lines of credit carry a variable rate of interest and minimum monthly payments during the draw period, which are the greater of (i) $50.00 or (ii) depending on credit score, loan-to-value and debt-to-income ratios, either the interest due or interest due plus 1% of the outstanding loan balance. Home equity loans and lines of credit are generally underwritten with a maximum loan-to-value ratio of 85% (80% when appraised value is greater than $1 million) for a primary residence when combined with the principal balance of the existing mortgage loan; for home equity loans on secondary and rental properties, the maximum loan-to-value ratio is 65%. We require appraisals on all real estate loans – both commercial and residential. At the time we close a home equity loan or line of credit, we record a mortgage to perfect our security interest in the underlying collateral.
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Home equity loans and lines of credit generally have greater risk than one- to four-family residential mortgage loans. In these cases, we face the risk that collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance. In particular, because home equity loans are secured by second mortgages, decreases in real estate values could adversely affect the value of the property serving as collateral for these loans. Thus, the recovery of such property could be insufficient to repay us for the value of these loans.
Loans secured by second mortgages have greater risk than owner-occupied residential loans secured by first mortgages. When customers default on their loans we attempt to foreclose on the property. However, the value of the collateral may not be sufficient to repay the amount of the unpaid loan, and we may be unsuccessful in recovering the remaining balance from these customers. In addition, decreases in property values could adversely affect the value of properties used as collateral for the loans. These second lien loans represent a smaller portion of our portfolio than our first lien residential mortgage loans.
Our home equity and home improvement loan portfolio gives us a diverse client base. Although most of these loans are in our primary market area, the diversity of the individual loans in the portfolio reduces our potential risk.
Consumer Lending
We offer various types of secured and unsecured consumer loans. Generally, our consumer loans are made for personal, family or household purposes as a convenience to our customer base. As a general guideline, a consumer’s total debt service should not exceed 40% of their gross income. The underwriting standards for consumer loans include a determination of the applicant’s payment history on other debts and an assessment of his or her ability to meet existing obligations and payments on the proposed loan.
Consumer loans may present greater credit risk than residential mortgage loans because many consumer loans are unsecured or are secured by rapidly depreciating assets. Repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance because of the greater likelihood of damage, loss or depreciation. Consumer loan collections also depend on the borrower’s continuing financial stability. If a borrower suffers personal financial difficulties, the loan may not be repaid. Also, various federal and state laws, including bankruptcy and insolvency laws, may limit the amount we can recover on such loans.
Loan Originations, Purchases, Sales, Participations and Servicing
All loans that we originate are underwritten pursuant to our policies and procedures, which incorporate standard underwriting guidelines. We originate both fixed and variable rate loans. Our loan origination activity may be adversely affected by a rising interest rate environment that typically results in decreased loan demand. We generally retain in our portfolio the majority of loans that we originate, except for first lien residential mortgage loans where we sell the majority of the loans into the secondary market. We do not retain the servicing rights on sold loans.
We occasionally sell participations in commercial loans to correspondent banks if the amount of the loan exceeds our internal limits. More rarely, we purchase loan participations from correspondent banks in the local market as well. Those loans are underwritten in-house with the same care of loans directly originated.
Loan Approval Procedures and Authority
Our lending activities follow written, non-discriminatory underwriting standards and loan origination procedures established by our board of directors. The loan approval process is intended to assess the borrower’s ability to repay the loan, the viability of the loan, and the adequacy of the value of the collateral that will secure the loan, if applicable. To assess a business borrower’s ability to repay, we review and analyze, among other factors, current income, credit history including the Bank’s prior experience with the borrower, cash flow, any secondary sources of repayment, other debt obligations in regards to the equity/net worth of the borrower and collateral available to the Bank to secure the loan.
We require appraisals of all real property securing one- to four-family residential and commercial real estate loans and home equity loans and lines of credit. All appraisers are state-licensed or state-certified appraisers, and our practice is to have local appraisers approved by the board of directors annually.
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Mortgage Banking
Our residential mortgage loans consist of residential first and second mortgage loans, residential construction loans and home equity lines of credit and term loans secured by the residences of borrowers. Borrowers use second mortgage and home equity lines of credit for home improvements, education and other personal expenditures. We make mortgage loans with a variety of terms, including fixed, floating and variable interest rates, with maturities ranging from three months to 30 years.
In general, we make residential mortgage loans based on the borrower’s ability to repay the loan from his or her salary and other income; such loans are secured by residential real estate, the value of which is generally readily ascertainable. We make these loans consistent with our appraisal and real estate lending policies, which detail maximum loan-to-value ratios and maturities. We generally make residential mortgage loans and home equity lines of credit secured by owner-occupied property within the guidelines of our regular purchasers of these loans.
Howard Bank generates revenue by providing an extensive line of consumer real estate products and services to customers nationwide. We offer products available to customers through a retail network of mortgage loan officers and bankers as well as a sales force offering our customers direct telephone access to our products.
The Bank originates residential mortgage loans primarily as a correspondent lender. Activity in the residential mortgage loan market is highly sensitive to changes in interest rates and product availability. While the Bank does have delegated underwriting authority from most of its loan purchasers, at times it also employs the services of the purchaser to underwrite the loans. Because the loans are originated within purchaser guidelines and designated automated underwriting and product specific requirements as part of the loan application, the loans sold have a limited recourse provision. Most contracts with investors contain recourse periods. In general, the Bank may be required to repurchase a previously sold mortgage loan or indemnify the purchaser if there is non-compliance with defined loan origination or documentation standards, including fraud, negligence or material misstatement in the loan documents. In addition, the Bank may have an obligation to repurchase a loan if the mortgagor has defaulted early in the loan term. The potential default repurchase period varies by purchaser but can be up to approximately 12 months after sale of the loan to the purchaser. The recourse period for fraud, material misstatement, breach of representations and warranties, noncompliance with law, or similar matters could be as long as the term of the loan. Mortgages subject to recourse are collateralized by single-family residential properties, follow purchaser guidelines, and carry private mortgage insurance, where applicable.
The Bank enters into commitments to originate residential mortgage loans whereby the interest rate on the loan is determined prior to funding (i.e. rate lock commitments). Such rate lock commitments on mortgage loans to be sold in the secondary market are considered to be derivatives. To protect against the price risk inherent in residential mortgage loan commitments, the Bank utilizes “best efforts” in delivering to purchasers. Under a “best efforts” contract, the Bank commits to deliver an individual mortgage loan of a specified principal amount and quality to a purchaser and the purchaser commits to a price that it will purchase the loan from the Bank if the loan to the underlying borrower closes. The Bank protects itself from changes in interest rates through the use of best efforts forward delivery commitments, whereby the purchaser commits to purchase a loan at a price representing a premium on the day the borrower commits to an interest rate with the intent that the purchaser has assumed the interest rate risk on the loan. As a result, the Bank is not generally exposed to losses on loans sold utilizing best efforts. Nor will it realize gains related to rate lock commitments due to changes in interest rates. The market values of rate lock commitments and best efforts contracts are not readily ascertainable with precision because rate lock commitments and best efforts contracts are not actively traded. Because of the high correlation between rate lock commitments and best efforts contracts, we do not expect to incur any gain or loss on the rate lock commitments.
Investments and Funding
We balance our liquidity needs based on loan and deposit growth via the investment portfolio and both short and long term borrowings. It is our goal to provide adequate liquidity to support our loan growth. We use the generally short term investments that represent our liquidity to generate additional positive earnings. Howard Bank’s primary source of funds is, and will continue to be, core deposits generated from the local marketplace. Additional funding is provided by customer repurchase agreements, Federal Home Loan Bank of Atlanta (“FHLB”) advances, the Board of Governors of the Federal Reserve (the “FRB”) Discount Window, and other purchased funds. Other purchased funds may include certificates of deposit over $100,000, federal funds purchased, and institutional or brokered deposits. Lines of credit are maintained to protect liquidity levels resulting from unexpected deposit withdrawals and natural-market credit demand.
Our investment policy is reviewed annually by our board of directors. The board of directors has appointed its Executive Committee to serve as the Investment Committee, and the Executive Committee therefore meets at regular intervals (not less than quarterly) and provides a report on the investment portfolio performance to the full board of directors. The investment officer is designated by the President and is responsible for managing the day-to-day activities of the liquidity and investments in accordance with the policies approved by the board of directors. We actively monitor our investment portfolio and we classify the majority of the portfolio as “available for sale.” In general, under such a classification, we may sell investment instruments as management deems appropriate.
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Other Banking Products
We offer our customers wire transfer services, ATM and check cards, automated teller machines at all of our branch locations, safe deposit boxes at most branches and credit cards through a third party processor. Additionally, we provide Internet banking capabilities to our customers and merchant card services for our business customers. With our Internet banking service, our customers may view their accounts on line and electronically remit bill payments including an option for same day payment. Our commercial account services include an overnight sweep service and remote deposit capture service.
We complement our existing Internet banking services with Mobiliti Mobile Banking, PopMoney and eStatement products. These state of the art products provide the Bank's consumer customers the ability to view account information and pay bills from their mobile device, easily make payments directly to individuals and, with eStatements, to replace their paper monthly statement with an electronically delivered statement.
Deposit Activities
Deposits are the major source of our funding. We offer a broad array of consumer and business deposit products that include demand, money market, savings and individual retirement accounts, as well as certificates of deposit. We offer through key technology partnerships a competitive array of commercial cash management products, which in combination with our in-house courier service and remote deposit/ check imaging service, allow us to attract demand deposits. We believe that we pay competitive rates on our interest bearing deposits. As a relationship-oriented organization, we generally seek to obtain deposit relationships with our loan clients.
We also use customer repurchase agreements, FHLB advances, the FRB Discount Window and other purchased funds as a funding mechanism. Other purchased funds may include certificates of deposits over $100,000, federal funds purchased and institutional or brokered deposits.
Employees
Howard Bank has 300 full-time and six part-time employees as of December 31, 2017. None of our employees are represented by any collective bargaining unit, and we believe that relations with our employees are good. Howard Bancorp has no employees.
Lending Limit
The Bank’s legal lending limit for loans to one borrower was $18.7 million as of December 31, 2017, and we further monitor our exposure to one borrower through a policy to limit our “in-house” lending limit to $15.0 million (as of December 31, 2017), which in-house limit can be exceeded on a limited basis. As part of our risk management strategy, we may attempt to participate a portion of larger loans to other financial institutions. This strategy allows us to maintain customer relationships yet observe the legal lending limit and manage credit exposure. However, this strategy may not always be available.
Competition
Our primary market area is highly competitive and heavily branched by other financial institutions of all sizes. We also compete with Internet-based banks. Competition for loans to small and medium sized businesses and their owners, professionals and executives, and high-net-worth individuals is intense, and pricing is important. We believe that acquisitions of several local competitors by larger institutions headquartered outside of the State of Maryland during the last several years have enhanced the Bank’s position as a locally headquartered and managed community bank, but many of these competitors now have substantially greater resources and lending limits than we do and offer services, such as extensive and established branch networks and trust services, that we do not expect to provide in the near future or ever. Moreover, larger institutions operating in our primary market area may have access to borrowed funds at a lower rate than is available to us. Deposit competition is also strong among institutions in our primary market area.
However, recent mergers of other area banks into large regional and national financial institutions have created opportunities for community-focused and prudently managed community banks. While our board of directors is aware of the competition that these larger institutions and alternative providers of financial services offer, we believe that local independent banks play and will continue to play a significant role in our primary market area. Our board of directors believes it is a significant and distinct advantage to be a locally owned and operated state bank interested in serving the needs of small and medium sized businesses and their owners, professionals and executives, and high-net-worth individuals.
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SUPERVISION AND REGULATION
Howard Bancorp, Inc.
We are a bank holding company under the Bank Holding Company Act of 1956, as amended (the “BHC Act”). We are subject to regulation and examination by the FRB and the Commissioner, and are required to file periodic reports and any additional information that the FRB and the Commissioner may require. In addition, the FRB and the Commissioner have enforcement authority over Howard Bancorp, Inc., which includes the power to remove officers and directors and the authority to issue cease and desist orders to prevent Howard Bancorp from engaging in unsafe or unsound practices or violating laws or regulations governing its business. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with regulatory authorities.
Under FRB regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. Under this requirement, Howard Bancorp in the future could be required to provide financial assistance to Howard Bank should Howard Bank experience financial distress. In addition, in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company’s failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the FRB to be an unsafe and unsound banking practice, a violation of FRB regulations or both. The FRB may require a bank holding company to terminate any activity or relinquish control of a nonbank subsidiary (other than a nonbank subsidiary of a bank) upon the FRB’s determination that such activity or control constitutes a serious risk to the financial soundness or stability of any subsidiary depository institution of the bank holding company. Further, federal bank regulatory authorities have additional discretion to require a bank holding company to divest itself of any bank or nonbank subsidiary if the agency determines that divestiture may aid the depository institution’s financial condition.
The BHC Act requires regulatory filings by a stockholder or other party that seeks to acquire direct or indirect “control” of a bank, as defined in the BHC Act. The determination whether an investor “controls” bank is based on all of the facts and circumstances surrounding the investment. As a general matter, a party is deemed to control a bank or other company if the party: (i) owns or controls 25% or more of any class of voting securities of the bank or other company; (ii) can elect or appoint a majority of the board of directors, or similar body, of the bank or other company; or (iii) exercises a "controlling influence" over the bank or other company. Subject to rebuttal, a party may be presumed to control a depository institution or other company if the investor owns or controls 10% or more of any class of voting stock and (i) the institution has registered securities under Section 12 of the Securities Exchange Act of 1934 and (ii) no other person owns, controls or has the power to vote a greater percentage of that class of voting securities. Ownership by affiliated parties, or parties acting in concert, is typically aggregated for these purposes. If a party’s ownership of Howard Bancorp were to exceed certain thresholds, the investor could be deemed to “control” Howard Bancorp for regulatory purposes. This could subject the investor to regulatory filings or other regulatory consequences.
Pursuant to provisions of the BHC Act and regulations promulgated by the FRB thereunder, Howard Bancorp, Inc. may only engage in or own companies that engage in activities deemed by the FRB to be so closely related to the business of banking or managing or controlling banks as to be a proper incident thereto, and the holding company must obtain permission from the FRB prior to engaging in most new business activities. In addition, bank holding companies like Howard Bancorp must be well capitalized and well managed in order to engage in the expanded financial activities permissible only for a financial holding company.
The FRB has adopted guidelines regarding the capital adequacy of bank holding companies, which require bank holding companies to maintain specified minimum ratios of capital to total assets and capital to risk weighted assets. See “— Capital Requirements.” The FRB has issued a policy statement regarding the payment of dividends by bank holding companies. In general, the FRB’s policies provide that dividends should be paid only out of current earnings and only if the prospective rate of earnings retention by the bank holding company appears consistent with the organization’s capital needs, asset quality, and overall financial condition. Under the prompt corrective action rules, the ability of a bank holding company to pay dividends may be restricted if a subsidiary bank becomes undercapitalized. These regulatory policies could affect the ability of Howard Bancorp, Inc. to pay dividends or otherwise engage in capital distributions.
The status of Howard Bancorp, Inc. as a registered bank holding company under the BHC Act and a Maryland-chartered bank holding company does not exempt it from certain federal and state laws and regulations applicable to corporations generally, including, without limitation, certain provisions of the federal securities laws.
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Howard Bank
Howard Bank is a Maryland-chartered trust company (with all powers of a commercial bank), and its deposit accounts are insured by the FDIC up to the maximum legal limits. It is subject to regulation, supervision and regular examination by the Commissioner and the FDIC. The regulations of these agencies govern most aspects of Howard Bank’s business, including required reserves against deposits, loans, investments, mergers and acquisitions, borrowing, dividends and location and number of branch offices. The laws and regulations governing Howard Bank generally have been promulgated to protect depositors and the FDIC’s Deposit Insurance Fund (“DIF”), and not for the purpose of protecting Howard Bancorp, Inc. or its stockholders.
Set forth below is a brief description of the material regulatory requirements that are or will be applicable to Howard Bank and Howard Bancorp, Inc. The description below is limited to the material aspects of the statutes and regulations addressed, and is not intended to be a complete description of such statutes and regulations and their effects on Howard Bank and Howard Bancorp, Inc.
Financial Institutions Article of the Maryland Annotated Code
The Financial Institutions Article of the Maryland Annotated Code (the “Banking Code”) contains detailed provisions governing the organization, operations, corporate powers, commercial and investment authority, branching rights and responsibilities of directors, officers and employees of Maryland banking institutions. The Banking Code delegates extensive rulemaking power and administrative discretion to the Commissioner in its supervision and regulation of state-chartered banking institutions. The Commissioner may order any banking institution to discontinue any violation of law or unsafe or unsound business practice.
Capital Requirements
Federal regulations require FDIC-insured depository institutions to meet several minimum capital standards: a common equity Tier 1 capital to risk-based assets ratio of 4.5%, a Tier 1 capital to risk-based assets ratio of 6.0%, a total capital to risk-based assets of 8.0%, and a 4.0% Tier 1 capital to total assets leverage ratio. The existing capital requirements were effective January 1, 2015 and are the result of a final rule implementing regulatory amendments based on recommendations of the Basel Committee on Banking Supervision and certain requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”).
There are two main categories of capital under the capital adequacy guidelines. Tier 1 capital generally consists of the sum of common stockholders’ equity and perpetual preferred stock (subject in the case of the latter to limitations on the kind and amount of such stock) and, in certain circumstances and subject to certain limitations, minority investments in certain subsidiaries, less goodwill and other non-qualifying intangible assets, and certain other deductions. Tier 2 capital consists of perpetual preferred stock that is not otherwise eligible to be included as Tier 1 capital, hybrid capital instruments, term subordinated debt and intermediate-term preferred stock and, subject to limitations, general allowances for credit losses. Tier 2 capital is limited to the amount of Tier 1 capital. Accumulated other comprehensive income (positive or negative) must be reflected in regulatory capital.
Additionally, subject to a transition schedule, the regulations limit a banking organization’s ability to make capital distributions, engage in share repurchases and pay certain discretionary bonus payments if the banking organization does not hold a “capital conservation buffer” consisting of 2.5% of common equity Tier 1 capital to risk-weighted assets in addition to the amount necessary to meet its minimum risk-based capital requirements. The regulations also require unrealized gains and losses on certain “available-for-sale” securities holdings to be included for purposes of calculating regulatory capital unless Howard Bank elects to opt-out from this treatment, which it has.
Prompt Corrective Action
Under federal prompt corrective action regulations, the bank regulatory agencies are authorized and, under certain circumstances, required, to take various “prompt corrective actions” to resolve the problems of any bank subject to their jurisdiction that is not adequately capitalized, as set forth in the next sentence. Pursuant to the Federal Deposit Insurance Corporation Improvement Act the agencies have established five capital tiers for depository institutions: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. Under the prompt corrective action regulations, a bank is considered “well capitalized” if it: (i) has a total risk-based capital ratio of 10.0% or greater; (ii) a Tier 1 risk-based capital ratio of 8.0% or greater; (iii) a common equity Tier 1 ratio of 6.5% or greater; (iv) a leverage capital ratio of 5.0% or greater; and (iv) is not subject to any written agreement, order, capital directive, or prompt corrective action directive to meet and maintain a specific capital level for any capital measure. As of December 31, 2017, Howard Bank remained “well capitalized” for this purpose and its capital exceeded all applicable requirements.
Howard Bank has been “well capitalized” since it commenced its business operations.
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The bank regulatory agencies may impose higher capital requirements on certain banks, and future regulatory change could impose higher capital standards as a routine matter. The regulators may also set higher capital requirements for holding companies whose circumstances warrant it. For example, holding companies experiencing internal growth or making acquisitions are expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.
As an additional means to identify problems in the financial management of depository institutions, the Federal Deposit Insurance Act requires federal bank regulatory agencies to establish certain non-capital safety and soundness standards for institutions for which they are the primary federal regulator. The standards relate generally to operations and management, asset quality, interest rate exposure and executive compensation. The agencies are authorized to take action against institutions that fail to meet such standards.
Dividends
Howard Bancorp, Inc. is a legal entity separate and distinct from Howard Bank. Virtually all of Howard Bancorp’s revenue available for the payment of dividends on its common stock results from dividends paid to Howard Bancorp by Howard Bank. Under Maryland law, Howard Bank may declare a cash dividend, after providing for due or accrued expenses, losses, interest and taxes, from its undivided profits or, with the prior approval of the Commissioner, from its surplus in excess of 100% of its required capital stock. Also, if Howard Bank’s surplus is less than 100% of its required capital stock, then, until its surplus is 100% of its capital stock, Howard Bank must transfer to its surplus annually at least 10% of its net earnings and may not declare or pay any cash dividends that exceed 90% of its net earnings. In addition to these specific restrictions, the bank regulatory agencies have the ability to prohibit or limit proposed dividends if such regulatory agencies determine the payment of such dividends would result in Howard Bank being in an unsafe and unsound condition.
Deposit Insurance Assessments
Howard Bank’s deposit accounts are insured by the FDIC generally up to a maximum of $250,000 per separately insured depositor. FDIC-insured depository institutions are required to pay deposit insurance assessments to the FDIC. The amount of a particular institution’s deposit insurance assessment is based on that institution’s risk classification under an FDIC risk-based assessment system. An institution’s risk classification is assigned based on its capital levels and the level of supervisory concern the institution poses to the regulators. Assessment rates (inclusive of possible adjustments) currently range from 1.5 to 30 basis points of each institution’s total assets less tangible capital. The FDIC may increase or decrease the range of assessments uniformly, except that no adjustment can deviate more than two basis points from the base assessment rate without notice and comment rulemaking. The FDIC’s current system represents a change, required by the Dodd-Frank Act, from its prior practice of basing the assessment on an institution’s aggregate deposits. The FDIC may terminate insurance of deposits upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.
Maryland Regulatory Assessment
The Commissioner annually assesses state banking institutions to cover the expense of regulating banking institutions. The Bank’s asset size determines the amount of the assessment.
Liquidity
Howard Bank is subject to the reserve requirements imposed by the State of Maryland. A Maryland banking institution is required to have at all times a reserve equal to at least 15% of its demand deposits. Howard Bank is also subject to the uniform reserve requirements of the FRB’s Regulation D, which applies to all depository institutions with transaction accounts or non-personal time deposits. During 2017, amounts in transaction accounts above $15.5 million and up to $99.6 million were required to have reserves held against them in the ratio of 3% of such amounts. Amounts above $99.6 million required reserves of $2,988,000 plus 10% of the amount in excess of $99.6 million. The FRB changes its reserve requirements on an annual basis and Howard Bank is subject to new requirements for 2018. Howard Bank was in compliance with its reserve requirements at December 31, 2017 and is in compliance with its current reserve requirements.
Loans-to-One-Borrower Limitation
With certain limited exceptions, a Maryland banking institution may lend to a single or related group of borrowers an amount equal to 15% of its unimpaired capital and surplus. An additional amount may be lent, equal to 10% of unimpaired capital and surplus, if such loan is secured by readily marketable collateral, which is defined to include certain securities and bullion, but generally does not include real estate. Howard Bank is in compliance with the loans-to-one borrower limitations.
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Community Reinvestment Act and Fair Lending Laws
Under the Community Reinvestment Act of 1977 (“CRA”), the FDIC is required to assess the record of all financial institutions regulated by it to determine if such institutions are meeting the credit needs of the community (including low and moderate income neighborhoods) which they serve. CRA performance evaluations are based on a four-tiered rating system: Outstanding, Satisfactory, Needs to Improve and Substantial Noncompliance. CRA performance evaluations are considered in evaluating applications for such things as mergers, acquisitions and applications to open branches. Howard Bank has a CRA rating of “Satisfactory.” In addition, the Equal Credit Opportunity Act and the Fair Housing Act prohibit lenders from discriminating in their lending practices on the basis of characteristics specified in those statutes. The failure to comply with the Equal Credit Opportunity Act and the Fair Housing Act could result in enforcement actions by the FDIC, the Department of Housing and Urban Development, and the Department of Justice, and in private civil actions by borrowers.
Transactions with Related Parties
Transactions between banks and their related parties or affiliates are limited by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a bank is any company or entity that controls, is controlled by or is under common control with the bank. In a holding company context, the parent bank holding company and any companies which are controlled by such parent holding company are affiliates of the bank.
Generally, Section 23A of the Federal Reserve Act and the FRB’s Regulation W limit the extent to which a bank or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10.0% of such bank’s capital stock and surplus, and contain an aggregate limit on all such transactions with all affiliates to an amount equal to 20.0% of such bank’s capital stock and surplus. The term ‘‘covered transaction’’ includes the making of loans, purchase of assets, issuance of guarantees and other similar transactions. In addition, loans or other extensions of credit by the bank to an affiliate are required to be collateralized in accordance with regulatory requirements and the bank’s transactions with affiliates must be consistent with safe and sound banking practices and may not involve the purchase by the bank of any low-quality asset. Section 23B applies to covered transactions as well as certain other transactions and requires that all such transactions be on terms substantially the same, or at least as favorable, to the institution or subsidiary as those provided to non-affiliates.
Section 22(h) of the Federal Reserve Act and the FRB’s Regulation O govern extensions of credit made by a bank to its directors, executive officers, and principal stockholders (‘‘insiders’’). Among other things, these provisions require that extensions of credit to insiders be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with unaffiliated persons and that do not involve more than the normal risk of repayment or present other unfavorable features. Further, such extensions may not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of Howard Bank’s capital. Extensions of credit in excess of certain limits must also be approved by the board of directors.
Standards for Safety and Soundness
Federal law requires each federal banking agency to prescribe certain standards for all insured depository institutions. These standards relate to, among other things, internal controls, information systems and audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, compensation, and other operational and managerial standards as the agency deems appropriate. Interagency guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. If the appropriate federal banking agency determines that an institution fails to meet any standard prescribed by the guidelines, the agency may require the institution to submit to the agency an acceptable plan to achieve compliance with the standard. If an institution fails to meet these standards, the appropriate federal banking agency may require the institution to implement an acceptable compliance plan. Failure to implement such a plan can result in further enforcement action, including the issuance of a “cease and desist” order or the imposition of civil money penalties.
Anti-Money Laundering and OFAC
Under federal law, financial institutions must maintain anti-money laundering programs that include established internal policies, procedures and controls; a designated compliance officer; an ongoing employee training program; testing of the program by an independent audit function; and enhanced due diligence of certain customers. Financial institutions must take reasonable steps to conduct enhanced scrutiny of account relationships to guard against money laundering and to report any suspicious transactions, and law enforcement authorities have been granted increased access to financial information maintained by financial institutions. Bank regulators routinely examine institutions for compliance with these obligations, and they must consider an institution’s compliance in connection with the regulatory review of applications, including applications for banking mergers and acquisitions. The regulatory authorities have imposed “cease and desist” orders and civil money penalty sanctions against institutions found to be violating these obligations.
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The Office of Foreign Assets Control, (“OFAC”) is responsible for helping to ensure that U.S. entities do not engage in transactions with certain prohibited parties, as defined by various Executive Orders and Acts of Congress. OFAC sends bank regulatory agencies lists of persons and organizations suspected of aiding, harboring or engaging in terrorist acts, known as Specially Designated Nationals and Blocked Persons. If Howard Bancorp or Howard Bank finds a name on any transaction, account or wire transfer that is on an OFAC list, Howard Bancorp or Howard Bank must freeze such account, file a suspicious activity report and notify the appropriate authorities.
Consumer Protection Laws
Howard Bank is subject to a number of federal and state laws designed to protect borrowers and promote lending to various sectors of the economy. These laws include the Equal Credit Opportunity Act, the Fair Housing Act, the Fair Credit Reporting Act, the Fair and Accurate Credit Transactions Act, the Truth in Lending Act, the Home Mortgage Disclosure Act, and the Real Estate Settlement Procedures Act, and various state law counterparts. Further, the Dodd-Frank Act established the Consumer Financial Protection Bureau (“CFPB”), which has the responsibility for making rules and regulations under the federal consumer protection laws relating to financial products and services. The CFPB also has a broad mandate to prohibit unfair, deceptive or abusive acts and practices and is specifically empowered to require certain disclosures to consumers and draft model disclosure forms. Failure to comply with consumer protection laws and regulations can subject financial institutions to enforcement actions, fines and other penalties. The FDIC will examine Howard Bank for compliance with CFPB rules and will enforce CFPB rules with respect to Howard Bank.
In addition, federal law currently contains extensive customer privacy protection provisions. Under these provisions, a financial institution must provide to its customers, at the inception of the customer relationship and annually thereafter, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. These provisions also provide that, except for certain limited exceptions, a financial institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure. Further, under the ‘‘Interagency Guidelines Establishing Information Security Standards,’’ banks must implement a comprehensive information security program that includes administrative, technical, and physical safeguards to ensure the security and confidentiality of customer information. Federal law makes it a criminal offense, except in limited circumstances, to obtain or attempt to obtain customer information of a financial nature by fraudulent or deceptive means.
Effect of Governmental Monetary Policies
Our earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. The FRB’s monetary policies have had, and are likely to continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to curb inflation or combat a recession. The monetary policies of the FRB affect the levels of bank loans, investments and deposits through the FRB’s control over the issuance of United States government securities, its regulation of the discount rate applicable to member banks and its influence over reserve requirements to which member banks are subject. We cannot predict the nature or impact of future changes in monetary and fiscal policies.
Federal and State Securities Laws
Our common stock is registered with the Securities and Exchange Commission under the Securities Exchange Act of 1934 (the “Exchange Act”). As such, we are subject to the information, proxy solicitation, insider trading restrictions and other requirements of the Exchange Act.
Further, if we wish to sell common stock or other securities to raise capital in the future, we will be subject to the registration, anti-fraud, and other applicable provisions of state and federal securities laws. For example, we will have to register the sales of such securities under the Securities Act, the Maryland Securities Act, and the applicable securities laws of each state in which we offer or sell the securities, unless an applicable exemption from registration exists with respect to such sales. Such exemptions may, among other things, limit the number and types of persons we could sell such securities to and the manner in which we could market the securities. We would also be subject to federal and state anti-fraud requirements with respect to any statements we make to potential purchasers in connection with the offer and sale of such securities.
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Sarbanes-Oxley Act of 2002
The Sarbanes Oxley Act of 2002 addresses, among other issues, corporate governance, auditing and accounting, executive compensation, and enhanced and timely disclosure of corporate information. We have prepared policies, procedures and systems designed to ensure compliance with the Sarbanes Oxley Act and related regulations.
You should consider carefully the following risks, along with the other information contained in and incorporated into this annual report. The risks and uncertainties described below are not the only ones that may affect us. Additional risks and uncertainties also may adversely affect our business and operations. If any of the following events actually occur, our business and financial results could be materially adversely affected.
Risk Factors Related to the Recent Merger with First Mariner Bank
Combining the two banks may be more difficult, costly or time-consuming than expected.
The success of the merger will depend, in part, on our ability to successfully combine the business of the former First Mariner into the business of Howard Bank. To realize the anticipated benefits of the merger, we must successfully integrate First Mariner’s business into our own. It is possible that the integration process could result in the loss of key employees, the disruption of our business or inconsistencies in standards, controls, procedures and policies that adversely affect the combined bank’s ability to maintain relationships with clients, customers, depositors and employees or to achieve the anticipated benefits of the merger. The loss of key employees could adversely affect our ability to successfully conduct our business in our markets, particularly in the areas in which the former First Mariner branches are located, which could have an adverse effect on our financial results and the value of our common stock. If we experience difficulties with the integration process, the anticipated benefits of the merger may not be realized fully or at all, or may take longer to realize than expected. As with any merger of financial institutions, there also may be business disruptions that cause us to lose customers, including former customers of First Mariner, or cause customers, including former First Mariner customers, to remove their accounts from Howard Bank and move their business to competing financial institutions. Integration efforts will also divert management attention and resources. These integration matters could have an adverse effect on us during this transition period and for an undetermined period following the recent after consummation of the merger.
We may fail to realize the anticipated cost savings resulting from the merger.
While we believe that we will achieve cost savings from the merger when the two banks have been fully integrated, it is possible that the estimates of the potential cost savings could turn out to be incorrect. The actual integration may result in additional and unforeseen expenses, and therefore we may not realize the anticipated cost savings of the merger. Actual growth and cost savings, if achieved, may be lower than what we expect and may take longer to achieve than we anticipate. If we are not able to adequately address integration challenges, we may be unable to successfully integrate Howard Bank’s and First Mariner’s former operations or to realize the anticipated benefits of the integration of the two banks.
The market price of our common stock may be affected by factors different from those that affected our shares prior to the merger.
Our business differs in important respects from that conducted by First Mariner prior to the merger and, accordingly, the results of operations of the combined bank and the market price of our common stock may be affected by factors different from those that affected Howard Bancorp’s independent results of operations and the market price of our common stock prior to the merger.
The market price of Howard common stock may decline as a result of the merger.
The market price of our common stock may decline as a result of the merger if we do not achieve the perceived benefits of the merger or the effect of the merger on our financial results is not consistent with the expectations of financial or industry analysts. In addition, existing Howard Bancorp stockholders, including former First Mariner stockholders, may not wish to continue to invest in the combined entity, or for other reasons may wish to dispose of some or all of their shares of Howard Bancorp; significant sales of our common stock following the merger, or the expectation that such sales may occur, may depress the market price of our common stock.
Our management has broad discretion as to the use of assets acquired from First Mariner, and may not use these assets effectively.
Our management has broad discretion in the application of the assets acquired in the merger and could utilize the assets in ways that do not improve our results of operations or enhance the value of our common stock. Our failure to utilize these assets effectively could have a material adverse effect on the Company, delay the development of products and cause the price of our common stock to decline.
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Risk Factors Relating to Our Business and Our Common Stock
Because our loan portfolio consists largely of commercial business and commercial real estate loans, our portfolio carries a higher degree of risk than would a portfolio composed primarily of residential mortgage loans.
Our loan portfolio is made up largely of commercial business loans and commercial real estate loans, most of which is collateralized by real estate. These types of loans generally expose a lender to a higher degree of credit risk of non-payment and loss than do residential mortgage loans because of several factors, including dependence on the successful operation of a business or a project for repayment, the collateral securing these loans may not be sold as easily as residential real estate, and loan terms with a balloon payment rather than full amortization over the loan term. In addition, commercial real estate and commercial loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to one- to four-family residential mortgage loans. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss compared to an adverse development with respect to a one- to four-family residential mortgage loan. Underwriting and portfolio management activities cannot completely eliminate all risks related to these loans. Any significant failure to pay on time by our customers or a significant default by our customers would materially and adversely affect us.
We make both secured and some unsecured commercial and industrial loans. Unsecured loans generally involve a higher degree of risk of loss than do secured loans because, without collateral, repayment is wholly dependent upon the success of the borrowers’ businesses. Secured commercial and industrial loans are generally collateralized by accounts receivable, inventory, equipment or other assets owned by the borrower and include a personal guaranty of the business owner. Compared to real estate, that type of collateral is more difficult to monitor, its value is harder to ascertain, it may depreciate more rapidly and it may not be as readily saleable if repossessed. Further, commercial and industrial loans generally will be serviced primarily from the operation of the business, which may not be successful, and commercial real estate loans generally will be serviced from income on the properties securing the loans.
While any declines in the value of our real estate collateral securing loans have been reflected in existing reserves, the discounts and reserves we have taken against our loan portfolio based on our internal review of economic conditions and their impact on real estate values in our market areas may be insufficient. Further deterioration in the real estate market or a prolonged economic recovery could adversely affect the value of the properties securing the loans or revenues from borrowers’ businesses, thereby increasing the risk of non-performing loans and increased portfolio losses that could materially and adversely affect us.
The small businesses that make up the majority of our commercial borrowers generally do not have the cash reserves to help cushion them from an economic slowdown to the same extent that large borrowers do and thus may be more heavily impacted by an economic downturn. A continued sluggish economy or another economic slowdown may have a negative effect on the ability of our commercial borrowers to make timely repayments of their loans, which could have an adverse impact on our earnings.
Construction loans are subject to risks during the construction phase that are not present in standard residential real estate and commercial real estate loans. These risks include:
| · | the viability of the contractor; |
| · | the value of the project being subject to successful completion; |
| · | the contractor’s ability to complete the project, to meet deadlines and time schedules and to stay within cost estimates; and |
| · | concentrations of such loans with a single contractor and its affiliates. |
Real estate construction and land loans also present risks of default in the event of declines in property values or volatility in the real estate market during the construction phase. If we are forced to foreclose on a project prior to completion, we may not be able to recover the entire unpaid portion of the loan, may be required to fund additional amounts to complete a project and may have to hold the property for an indeterminate amount of time. If any of these risks were to occur, it could adversely affect our financial condition, results of operations and cash flows.
The federal banking agencies have issued guidance regarding high concentrations of commercial real estate loans within bank loan portfolios. The guidance requires financial institutions that exceed certain levels of commercial real estate lending compared with their total capital to maintain heightened risk management practices that address the following key elements: including board and management oversight and strategic planning, portfolio management, development of underwriting standards, risk assessment and monitoring through market analysis and stress testing, and maintenance of increased capital levels as needed to support the level of commercial real estate lending. If there is any deterioration in our commercial real estate or real estate construction and land portfolios or if our regulators conclude that we have not implemented appropriate risk management practices, it could adversely affect our business and result in a requirement of increased capital levels, and such capital may not be available at that time.
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We are subject to security and operational risks relating to our use of technology that could damage our reputation and our business.
We are subject to certain operational risks including, but not limited to, data processing system failures and errors, inadequate or failed internal processes, customer or employee fraud and catastrophic failures resulting from terrorist acts or natural disasters. We rely heavily on data processing, software, communication, and information systems on a variety of computing platforms and networks and over the Internet to conduct our business. Despite instituted safeguards, we cannot be certain that all of our systems are entirely free from vulnerability to attack or other technological difficulties or failures. Information security risks have increased significantly due to the use of online, telephone and mobile banking channels by clients and the increased sophistication and activities of organized crime, hackers, terrorists and other external parties. Our technologies, systems, networks and our clients’ devices have been subject to, and are likely to continue to be the target of, cyber-attacks, computer viruses, malicious code, phishing attacks or information security breaches that could result in the unauthorized release, gathering, monitoring, misuse, loss or destruction of our or our clients’ confidential, proprietary and other information, the theft of client assets through fraudulent transactions or disruption of our or our clients’ or other third parties’ business operations. System failure or errors, security breaches in our Internet banking activities or other communication and information systems, or other technology difficulties or failures, could result in information being lost or misappropriated, interrupt of our operations, damage our reputation, result in a loss of customer business, cause us to incur expenses to rectify, subject us to additional regulatory scrutiny or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations. We rely on standard Internet and other security systems to provide the security and authentication necessary to effect secure transmission of data. These precautions may not protect our systems from damage or compromises or breaches of our security measures. We continue to monitor developments in this area and consider whether additional protective measures are necessary or appropriate, and we have obtained insurance protection intended to cover losses due to network security breaches; there is no guarantee, however, that such insurance would cover all costs associated with any breach, damage or failure of our computer systems and network infrastructure.
We rely on certain external vendors. Our business is dependent on the use of outside service providers that support our day-to-day operations including data processing and electronic communications.
Our business is dependent on the use of outside service providers that support our day-to-day operations including data processing and electronic communications. Our operations are exposed to the risk that a service provider may not perform in accordance with established performance standards required in our agreements for any number of reasons including equipment or network failure, a change in their senior management, their financial condition, their product line or mix and how they support existing customers, or a simple change in their strategic focus. While we have comprehensive policies and procedures in place to mitigate risk at all phases of service provider management from selection to performance monitoring and renewals, the failure of a service provider to perform in accordance with contractual agreements could be disruptive to our business, which could have a material adverse effect on our financial conditions and results of operations.
Because our loan portfolio includes residential real estate loans, our earnings are sensitive to the credit risks associated with these types of loans.
We originate and retain in our portfolio residential mortgage loans and intend to increase our origination of these types of loans. While residential real estate loans are more diversified than loans to commercial borrowers, and our local real estate market and economy have performed better than many other markets, a downturn could cause higher unemployment, more delinquencies, and could adversely affect the value of properties securing loans in our portfolio. In addition, should values begin to decline again, the real estate market may take longer to recover or not recover to previous levels. These risks increase the probability of an adverse impact on our financial results as fewer borrowers would be eligible to borrow and property values could be below necessary levels required for adequate coverage on the requested loan.
Our residential lending department may not continue to provide us with significant noninterest income.
We sell in the secondary market most residential mortgage loans that we originate, earning noninterest income in the form of gains on sale and fees in connection with originating these loans. The residential mortgage business is highly competitive and highly susceptible to changes in market interest rates, consumer confidence levels, employment statistics, the capacity and willingness of secondary market purchasers to acquire and hold or securitize loans, and other factors beyond our control. Additionally, in many respects, the mortgage origination business is relationship-based and dependent on the services of individual mortgage loan officers. The loss of services of one or more loan officers could have the effect of reducing the level of our mortgage production or the rate of growth of production. Further, when interest rates rise, as is expected in the near term, the demand for mortgage loans tends to fall and may reduce the number of loans available for sale. In addition to interest rate levels, weak or deteriorating economic conditions also tend to reduce loan demand. As a result of these factors we cannot be certain that we will not be able to continue to increase the volume or percentage of revenue or net income produced by the residential mortgage business.
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Our financial condition, earnings and asset quality could be adversely affected if we are required to repurchase loans originated for sale by our residential lending department.
As discussed in “Item 1. Business — Mortgage Banking,” most loans that we sell in the secondary market are with recourse. Therefore, we may be required to repurchase a previously sold mortgage loan or indemnify the purchaser if there is non-compliance with defined loan origination or documentation standards, including fraud, negligence or material misstatement in the loan documents, if the mortgagor has defaulted early in the loan term, or noncompliance with applicable law. While to date we have had to repurchase only a minimal amount of loans previously sold, should repurchases become a material issue, our earnings and asset quality could be adversely impacted, which could adversely impact the market price of our common stock.
If our allowance for credit losses is not sufficient to cover actual loan losses, our earnings would decrease.
We maintain an allowance for credit losses that we believe is adequate for absorbing any potential losses in our loan portfolio. Management, through a periodic review and consideration of our loan portfolio, determines the amount of the allowance for credit losses. We cannot, however, predict with certainty the amount of probable losses in our portfolio or be sure that our allowance will be adequate in the future. If management’s assumptions and judgments prove to be incorrect and the allowance for credit losses is inadequate to absorb future losses, our losses will increase and our earnings will suffer.
In particular, it is more difficult to estimate loan losses for those types of loans - commercial and commercial real estate - that constitute the majority of our portfolio as compared to, for example, residential mortgage loans. Also, because these types of loans tend to have large loan balances, a loss on a single loan could have a significant adverse effect on our operations.
We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. In determining the amount of the allowance for credit losses, we review our loans and our loss and delinquency experience, and we evaluate economic conditions. If our assumptions are incorrect, our allowance for credit losses may not be sufficient to cover probable incurred losses in our loan portfolio, resulting in additions to the allowance and a corresponding decrease to earnings. Material additions to the allowance could materially decrease our net income. If delinquencies and defaults should increase, we may be required to further increase our provision for loan losses.
In addition, if the loans we acquired in our acquisitions of First Mariner or Patapsco Bancorp do not perform as we have estimated, our allowance for credit losses may not be adequate. See “We have relatively limited or no experience with the performance of loans acquired in our acquisitions of Patapsco Bancorp and First Mariner. Certain of our estimates related to accounting for acquired loans may differ from actual results,” below.
Significant increases to our allowance materially decrease our net income. In addition, bank regulators periodically review our allowance for credit losses and may require us to increase our provision for credit losses or recognize further loan charge-offs to the allowance for credit losses. Any increase in the allowance for credit losses or loan charge-offs might have a material adverse effect on our financial condition and results of operations.
The Financial Accounting Standards Board has adopted a new accounting standard that will become effective for us on January 1, 2020. This standard, referred to as Current Expected Credit Loss, or CECL, will require financial institutions to determine periodic estimates of lifetime expected credit losses on loans and recognize the expected credit losses as allowances for credit losses. This will change the current method of providing allowances for credit losses that are probable, which would likely require us to increase our allowance for credit losses, and to greatly increase the types of data we would need to collect and review to determine the appropriate level of the allowance for credit losses.
We have relatively limited experience with the performance of loans acquired in our recent acquisitions of First Mariner and Patapsco Bancorp. Certain of our estimates related to accounting for acquired loans may differ from actual results.
We acquired First Mariner on March 1, 2018 and Patapsco Bancorp in August 2015. It is difficult to assess the future performance of loans recently added to our portfolio as part of these acquisitions because our relatively limited experience with such loans does not provide us with a significant history from which to judge future collectability. These loans may experience higher delinquency or charge-off levels than our historical loan portfolio experience, which could adversely affect our future performance.
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In addition, under generally accepted principles for business combinations, there is no loan loss allowance initially recorded for acquired loans, which are recorded at net fair value on the acquisition date. This net fair value generally includes embedded loss estimates for acquired loans with deteriorated credit quality. These estimates are based on projections of expected cash flows for these problem loans, which in many cases rely on estimates deriving from the liquidation of collateral.
If the estimates we have made regarding the performance of loans we have acquired are inaccurate, the fair value estimates may exceed the actual collectability of the balances, and this may result in the related loans being considered by us as impaired, which would result in a reduction in interest income. The tangible book value we measure is based in part on these estimates, and if fair value estimates differ from actual collectability, then subsequent earnings may also differ from original estimates. Measures of tangible book value and earnings impact of business combinations are frequently used in evaluating the merits and value of business combinations. Numerous assumptions and estimates are integral to purchased loan accounting, and actual results could be different from prior estimates.
Our growth strategy may not be successful, may be dilutive and may have other adverse consequences.
As previously mentioned, a key component of our growth strategy is to pursue acquisitions of other financial institutions or branches of other financial institutions. As consolidation of the banking industry continues, the competition for suitable acquisition candidates may increase. We compete with other banking companies for acquisition opportunities, and there are a limited number of candidates that meet our acquisition criteria. Consequently, we may not be able to identify suitable candidates for acquisitions. If we are unable to locate suitable acquisition candidates willing to sell on terms acceptable to us, our net income could decline and we would be required to find other methods to grow our business. We may also open additional branches organically and expand into new markets or offer new products and services. These activities would involve a number of risks, including:
| · | the time and expense associated with identifying and evaluating potential acquisitions and merger partners; |
| · | using inaccurate estimates and judgments to evaluate credit, operations, management and market risks with respect to the target institution or its branches or assets; |
| · | diluting our existing stockholders in an acquisition; |
| · | the time and expense associated with evaluating new markets for expansion, hiring experienced local management and opening new offices or branches as there may be a substantial time lag between these activities before we generate sufficient assets and deposits to support the costs of the expansion; |
| · | operating in markets in which we have had no or only limited experience; |
| · | taking a significant amount of time negotiating a transaction or working on expansion plans, resulting in management’s time and attention being diverted from the operation of our existing business; |
| · | we may not be able to correctly identify profitable or growing markets for new branches; |
| · | the time and expense associated with integrating the operations and personnel of the combined businesses; |
| · | the ability to realize the anticipated benefits of the acquisition; |
| · | creating an adverse short-term effect on our results of operations; |
| · | losing key employees and customers as a result of an acquisition that is poorly received; |
| · | time and costs associated with regulatory approvals; |
| · | lack of information on a target institution or its branches or assets; |
| · | inability to obtain additional financing (including by issuing additional common equity), if necessary, on favorable terms or at all; and |
| · | unforeseen adjustments, write-downs, write-offs or restructuring or other impairment charges. |
In addition, we may not be able to integrate successfully or operate profitably any financial institutions we may acquire. We may experience disruption and incur unexpected expenses in integrating acquisitions. Any acquisitions we do make may not enhance our cash flows, business, financial condition, results of operations or prospects and may have an adverse effect on our results of operations, particularly during periods in which the acquisitions are being integrated into our operations.
Also, the costs to lease and start up new branch facilities or to acquire existing financial institutions or branches, and the additional costs to operate these facilities, may increase our noninterest expense. It also may be difficult to adequately and profitably manage the anticipated growth from the new branches. We can provide no assurance that any new branch sites will successfully attract a sufficient level of deposits and other banking business to offset their operating expenses.
Further, we plan to continue to make investments in our infrastructure in the future. We also currently plan to open additional branches in the areas where we now operate and in other markets over the next few years. We anticipate that this will have the short-term effect of, at least temporarily, increasing our expenses at a faster rate than revenue growth, which will have an adverse effect on net income.
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If we grow too quickly and are not able to control costs and maintain asset quality, growth could materially and adversely affect our financial condition and results of operations. Further, we may not be successful in our growth strategy, which would negatively impact our financial condition and results of operations.
Consumers may decide not to use banks to complete their financial transactions.
Technology and other changes are allowing consumers to complete financial transactions through alternative methods that historically have involved banks. For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts, mutual funds or general-purpose reloadable prepaid cards. Consumers can also complete transactions such as paying bills and transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, which may increase as consumers become more comfortable with these new technologies and offerings, could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost of deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.
Strong competition within our market area may limit our growth and profitability.
Competition in the banking and financial services industry within our market area is intense. In our market area, we compete with, among others, commercial banks, savings institutions, mortgage brokerage firms, credit unions, mutual funds, insurance companies and brokerage and investment banking firms operating locally and elsewhere. There are also a number of smaller community-based banks that pursue similar operating strategies as Howard Bank. In addition, some of our competitors have recently offered loans with lower fixed rates and on more attractive terms than we have been willing to offer. Our continued profitability depends upon our continued ability to successfully compete in our market area. The greater resources and broader range of deposit and loan products offered by our competition may limit our ability to increase our interest earning assets and profitability. See “Item 1. Business -Competition” for more information about competition in our market area.
We expect competition to remain intense in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. Increased competition among financial services companies due to the recent consolidation of certain competing financial institutions may adversely affect our ability to market our products and services. Also, technological advances have lowered barriers to entry and made it possible for banks to compete in our market without a retail footprint by offering competitive rates and for non-banks to offer products and services that have traditionally been provided by banks. Additionally, due to their size, many of our competitors may offer a broader range of products and services as well as better pricing for certain products and services than we can, which could affect our ability to grow and remain profitable on a long-term basis. Our profitability depends upon our ability to successfully compete in our market area, and competition for deposits and the origination of loans could limit our ability to successfully implement our business plan, and could adversely affect our results of operations in the future. Further, if we must raise interest rates paid on deposits or lower interest rates charged on our loans, our net interest margin and profitability could be adversely affected.
Furthermore, competition in the banking and financial services industry is coming not only from traditional competitors but from technology-oriented financial services (“FinTech”) companies, which are subject to limited regulation. They offer user friendly front-end, quick turnaround times for loans and other benefits. While we are considering the possibility of developing relationships with FinTech companies for efficiency in processing and/or as a source of loans and other benefits, we cannot limit the possibility that our customers or future prospects will work directly with a FinTech company instead. This could impact our growth and profitability going forward.
We continually encounter technological change.
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology driven by new or modified products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse effect on our business and, in turn, our financial condition and results of operations.
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We must comply with extensive and complex governmental regulation, which could have an adverse effect on our business and our growth strategy, and we may be adversely affected by changes in laws and regulations.
The banking industry is subject to extensive regulation by state and federal banking authorities. Many of these regulations are intended to protect depositors, the public or the FDIC insurance funds, not stockholders. Regulatory requirements affect our lending practices, capital structure, investment practices, dividend policy and many other aspects of our business. These requirements may constrain our operations, and changes in regulations could adversely affect us. The burden imposed by these federal and state regulations may place banks in general, and Howard Bank specifically, at a competitive disadvantage compared to less regulated competitors. In addition, the cost of compliance with regulatory requirements could adversely affect our ability to operate profitably or increase profitability. See “Supervision and Regulation” for more information about applicable banking laws and regulations. Further, if we are not in compliance with such requirements, we could be subject to fines or other regulatory action that could restrict our ability to operate or otherwise have a material adverse effect on our business and financial condition. Although we believe we are in material compliance with all applicable regulations, it is possible there are violations of which we are unaware that could be discovered by our regulators in the course of an examination or otherwise, which could trigger such fines or other adverse consequences.
Further, regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on our operations, classification of our assets and determination of the level of our allowance for credit losses. If regulators require Howard Bank to charge off loans or increase its allowance for credit losses, our earnings would suffer. Any change in such regulation and oversight, whether in the form of regulatory policy, regulation, legislation or supervisory action, may have a material impact on our operations. For a further discussion, see “Supervision and Regulation.”
In addition, because regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot forecast how federal or state regulation of financial institutions may change in the future and impact our operations. Changes in regulation and oversight, including in the form of changes to statutes, regulations or regulatory policies or changes in interpretation or implementation of statutes, regulations or policies, could affect the services and products we offer, increase our operating expenses, increase compliance challenges and otherwise adversely impact our financial performance and condition. In addition, the burden imposed by these federal and state regulations may place banks in general, and Howard Bank specifically, at a competitive disadvantage compared to less regulated competitors.
The Company and the Bank have implemented an enhanced organizational structure to ensure that our risk management activities are scaled to the entire enterprise. The office of strategic risk management, reporting to an executive vice president with direct reporting to the CEO and a dotted line reporting to the full board, is responsible for credit, compliance and operational, physical and IT security, legal, reputational and other on and off balance sheet risks.
Further, as a public company, we incur significant legal, accounting, insurance and other expenses in connection with compliance with rules of the SEC and The Nasdaq Stock Market LLC.
Non-Compliance with the USA PATRIOT Act, the Bank Secrecy Act or other laws and regulations could result in fines or sanctions.
Financial institutions are required under the USA PATRIOT and Bank Secrecy Acts to develop programs to prevent financial institutions from being used for money-laundering and terrorist activities. Financial institutions are also obligated to file suspicious activity reports with Treasury’s Department's Office of Financial Crimes Enforcement Network if such activities are detected. These rules also require financial institutions to establish procedures for identifying and verifying the identity of customers seeking to open new financial accounts. Failure or the inability to comply with these regulations could result in fines or penalties, curtailment of expansion opportunities, intervention or sanctions by regulators and costly litigation or expensive additional controls and systems. During the last few years, several banking institutions have received large fines for non-compliance with these laws and regulations. In addition, the U.S. Government has previously imposed laws and regulations relating to residential and consumer lending activities that create significant new compliance burdens and financial risks. While we have developed policies and procedures designed to assist in compliance with these laws and regulations, we cannot assure you that these policies and procedures will be effective in preventing violations of these laws and regulations.
Adverse changes in economic conditions could adversely affect our business, results of operations and financial condition.
Our business and earnings are affected by general business conditions in the United States as well as in our local market area. We continue to operate in a challenging and uncertain economic environment. Since the recession ended almost nine years ago, economic growth has been slow by historic standards and uneven. Further, the current expansion is already the third longest in U.S. history, and many economists believe that the risk of a recession in the medium-term (2019-2020) is increasing. A return to recessionary conditions or prolonged stagnant or deteriorating economic conditions could significantly affect the markets in which we do business, the demand for our products and services, the value of our loans and investments, and our ongoing operations, costs and profitability. Economic uncertainties even outside of a recession, including concerns about U.S. debt levels, tariffs on imports into the United States, Congress’ inability to pass yearly budgets, and cuts in government spending, may negatively impact economic conditions going forward. A return to elevated levels of unemployment, declines in the values of real estate, or other events that negatively affect household and/or corporate incomes may result in higher than expected loan delinquencies, increases in our nonperforming and criticized classified assets and a decline in demand for our products and services. These events may cause us to incur losses and may adversely affect our financial condition and results of operations.
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Our profitability depends on interest rates, and changes in interest rates could have an adverse impact on our results of operations and financial condition.
Our results of operations depends to a large extent on our “net interest income,” which is the difference between the interest income received from our interest-earning assets, such as loans and investment securities, and the interest expense incurred in connection with our interest-bearing liabilities, such as interest on deposit accounts. Changes in interest rates can increase or decrease our net interest income, because different types of assets and liabilities may react differently, and at different times, to market interest rate changes. When interest bearing liabilities mature or reprice more quickly than interest earning assets in a period, an increase in interest rates could reduce net interest income. Similarly, when interest earning assets mature or reprice more quickly than interest bearing liabilities, falling interest rates could reduce net interest income. Additionally, an increase in interest rates may, among other things, reduce loan demand and our ability to originate loans (which would also decrease our ability to generate noninterest income through the sale of loans into the secondary market), and make it more difficult for borrowers to repay adjustable-rate loans or otherwise decrease loan repayment rates. A decrease in the general level of interest rates may affect us through, among other things, increased prepayments on our loan and mortgage-backed securities portfolios and increased competition for deposits. Accordingly, changes in the level of market interest rates affect our net yield on interest earning assets, loan origination volume, loan and mortgage-backed securities portfolios, and our overall results. Fluctuations in interest rates are highly sensitive to many factors that are not predictable or controllable. Therefore, while we attempt to manage our risk from changes in market interest rates by adjusting the rates, maturity, repricing, and balances of the different types of interest-earning assets and interest bearing liabilities, we might not be able to maintain a consistent positive spread between the interest that we receive and the interest that we pay. As a result, a rapid increase or decrease in interest rates could have an adverse effect on our net interest margin and results of operations.
In addition, as market interest rates rise, we will have competitive pressures to increase the rates we pay on deposits. Because interest rates we pay on our deposits could be expected to increase more quickly than the increase in the yields we earn on our interest-earning assets, our net interest income would be adversely affected.
Furthermore, the FRB, in an attempt to help the overall economy, has among other things kept interest rates low through its targeted federal funds rate and the purchase of Treasury and mortgage-backed securities. If the FRB continues to increase the federal funds rate in the near term, as is expected, overall interest rates will likely rise, which may negatively impact the housing markets and the U.S. economic growth. If rates remain relatively low it could create deflationary pressures, which while possibly lowering our operating costs, could have a negative impact on our borrowers, especially our commercial borrowers, and the values of collateral securing our loans, which could negatively affect our financial performance.
We also are subject to reinvestment risk associated with changes in interest rates. Changes in interest rates may affect the average life of loans and mortgage-related securities. Decreases in interest rates can result in increased prepayments of loans and mortgage-related securities, as borrowers refinance to reduce borrowing costs. Under these circumstances, we are subject to reinvestment risk to the extent that we are unable to reinvest the cash received from such prepayments at rates that are comparable to the interest rates on existing loans and securities.
Requirements to hold more capital could have a material adverse effect on our financial condition and operations.
In July 2013, the bank regulators adopted a final rule for the Basel III capital framework. These rules apply to all depository institutions, top-tier bank holding companies with total consolidated assets of $1 billion or more and top-tier savings and loan holding companies and substantially amend the regulatory risk-based capital rules applicable to us. The rules apply to Howard Bank and Howard Bancorp. The rules include a capital conservation buffer that phases in over a period of years that began in 2016 and will become fully effective in 2019. Failure to satisfy any of the capital requirements, including with the applicable “buffer” amount, will result in limits on paying dividends, engaging in share repurchases and paying discretionary bonuses. The rules establish a maximum percentage of eligible retained income that could be utilized for such actions if the capital requirements of the buffer are not fully satisfied. Beginning January 1, 2018, Howard Bancorp and the Bank’s risk-based capital requirements, with the applicable buffer, are (i) a common equity Tier 1 ratio of 6.375%, (ii) a Tier 1 capital (common Tier 1 capital plus Additional Tier 1 capital) ratio of 7.875% and (iii) a total capital ratio of 9.875%. The capital conservation buffer does not apply to our leverage ratio requirement, which will remain at 4.0%. Once the capital conservation buffer is fully phased in on January 1, 2019, the resulting requirements will be a common equity Tier 1 ratio of 7.0%, a Tier 1 ratio of 8.5%, and a total capital ratio of 10.5%. These increased capital requirements may have a material adverse impact on our liquidity and results of operations, or the failure to satisfy such requirements may result in our inability to pay dividends on or repurchase shares of our common stock, which could also negatively impact the market price of our stock, and may negatively impact our ability to retain personnel if our ability to pay retention bonuses is compromised.
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Our business may be adversely affected by increasing prevalence of fraud and other financial crimes.
As a financial institution, we are subject to risk of loss due to fraud and other financial crimes. Nationally, reported incidents of fraud and other financial crimes have increased. We believe we have controls in place to detect and prevent such losses, but in some cases multi-party collusion or other sophisticated methods of hiding fraud may not be readily detected or detectable, and could result in losses that affect our financial condition and results of operations.
Financial crime is not limited to the financial services industry. Our customers could experience fraud in their businesses, which could materially impact their ability to repay their loans, and deposit customers in all financial institutions are constantly and unwittingly solicited by others in fraud schemes that vary from easily detectable and obvious attempts to high-level and very complex international schemes that could drain an account of millions of dollars and require detailed financial forensics to unravel. While we have controls in place, contractual agreements with our customers partitioning liability, and insurance to help mitigate the risk, none of these are guarantees that we will not experience a loss, potentially a loss that could have a material adverse effect on our financial condition, reputation and results of operations.
Monetary policy and general economic conditions will influence our results of operations.
Governmental economic and monetary policy will influence our results of operations. The rates of interest payable on deposits and chargeable on loans are affected by fiscal policy as determined by various governmental and regulatory authorities, in particular the FRB, as well as by national, state and local economic conditions. In addition, adverse general economic conditions may impair the ability of our borrowers to repay loans.
Because the Bank serves a limited market area, we are susceptible to economic downturns in our market area.
Our lending and deposit operations are concentrated in the Greater Baltimore Metropolitan Area. Broad geographic diversification is not currently part of our community bank focus. As a result, our success depends in part on economic conditions in our markets. Adverse changes in economic conditions in our primary market area could reduce our deposit base and demand for our services and products and negatively impact growth in our loans and deposits, impair our ability to collect on our outstanding loans, increase credit losses, problem loans and charge-offs, and otherwise negatively affect our performance and financial condition. Declines in real estate values could cause some of our residential and commercial real estate loans to be inadequately collateralized, which would expose us to a greater risk of loss in the event that the recovery on amounts due on defaulted loans is resolved by selling the real estate collateral. In addition, adverse changes in economic conditions in and around our market area may more severely impact our business and financial condition than are our larger, more geographically diverse competitors. Our larger bank competitors, for example, serve more geographically diverse market areas, parts of which may not be affected by the same economic conditions that may exist in our market areas.
Further, unexpected changes in the national and local economy may adversely affect our ability to attract deposits and to make loans. In particular, due to the proximity of our primary and secondary market areas to Washington, D.C., decreases in spending by the Federal government or cuts to Federal government employment could impact us to a greater degree than banks that serve a larger or a different geographical area. Such risks are beyond our control and may have a material adverse effect on our financial condition and results of operations and, in turn, the value of our common stock.
The small to medium-sized businesses that the Bank lends to may have fewer resources to weather a downturn in the economy, which may impair a borrower’s ability to repay a loan to the Bank that could materially harm our operating results.
The Bank targets its business development and marketing strategy primarily to serve the banking and financial services needs of small to medium-sized businesses. These small to medium-sized businesses frequently have a smaller market share than their competition, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience significant volatility in operating results. Any one or more of these factors may impair their ability to repay a loan. In addition, the success of a small to medium-sized business often depends on the management talents and efforts of one or two persons or a small group of persons, and the death, disability or resignation of one or more of these persons could have a material adverse impact on its business and its ability to repay a loan. As a result, economic downturns and other events that negatively impact our market areas could cause the Bank to incur substantial credit losses that could negatively affect our results of operations and financial condition.
| 23 |
Changes in tax laws may negatively impact our financial performance.
Changes in tax laws contained in the Tax Cuts and Jobs Act, which was enacted in December 2017, contain a number of provisions that could have an impact on the banking industry, borrowers and the market for single family residential and multifamily residential real estate. Among the changes are: lower limits on the deductibility of mortgage interest on single family residential mortgages; limitations on deductibility of business interest expense; and limitations on the deductibility of property taxes and state and local income taxes. Such changes may have an adverse effect on the market for and valuation of single family residential properties and multifamily residential properties, as well as on the demand for such loans in the future. If home ownership or multifamily residential property ownership become less attractive, demand for mortgage loans would decrease, which could have a material adverse effect on our mortgage banking operations and as a result on our revenues, net income, operating results and financial condition. In addition, the value of the properties securing loans in our portfolio may be adversely impacted as a result of the changing economics of home ownership and multifamily residential ownership, which could require an increase in our provision for credit losses, which would reduce our profitability and could materially adversely affect our business, financial condition and results of operations. Additionally, certain borrowers could become less able to service their debts as a result of higher tax obligations. These changes could adversely affect our business, financial condition and results of operations.
We are subject to liquidity risks.
Market conditions could negatively affect the level or cost of available liquidity, which would affect our ongoing ability to accommodate liability maturities and deposit withdrawals, meet contractual obligations, and fund asset growth and new business transactions at a reasonable cost, in a timely manner, and without adverse consequences. Core deposits are our primary source of funding, but this is supplemented by FHLB advances, the FRB Discount Window, and other purchased funds. A significant decrease in our core deposits, an inability to renew FHLB advances or access the Discount Window, an inability to obtain alternative funding to core deposits or our other traditional sources of funds, or a substantial, unexpected, or prolonged change in the level or cost of liquidity could have a negative effect on our business, financial condition and results of operations.
We depend heavily on six key employees, Mary Ann Scully, Robert A. Altieri, George C. Coffman, Steven M. Poynot, Charles E. Schwabe and James D. Witty, to continue the implementation of our long-term business strategy and the loss of their services could disrupt our operations and result in reduced earnings.
Ms. Scully is our President and Chief Executive Officer, Mr. Altieri is an Executive Vice President, President of our Mortgage Banking Division and our Chief Specialty Lending Officer, Mr. Coffman is an Executive Vice President and our Chief Financial Officer, Mr. Poynot is an Executive Vice President and Chief Administrative Officer, Mr. Schwabe is an Executive Vice President, our Secretary and our Chief Risk Officer, and Mr. Witty is an Executive Vice President and our Chief Lending Officer. We believe that our continued growth and future success will depend in large part on the skills of our senior management team. We believe our senior management team possesses valuable knowledge about and experience in the banking industry and that their knowledge and relationships would be difficult to replicate. We have entered into an employment agreement with each of Ms. Scully, Mr. Altieri, Mr. Coffman, Mr. Poynot, Mr. Schwabe and Mr. Witty and acquired key-person life insurance on each such executive officer, but the existence of such agreements and insurance does not assure that we will be able to retain their services or recover losses associated with the loss of their services. The unexpected loss of the services of Ms. Scully, Mr. Altieri, Mr. Coffman, Mr. Poynot, Mr. Schwabe or Mr. Witty could have a material adverse effect on our business, operations, financial condition and operating results, as well as the value of our common stock.
Federal and state banking agencies periodically conduct examinations of our business, including compliance with laws and regulations, and our failure to comply with any supervisory actions to which we are or become subject as a result of such examinations may adversely affect us.
State and federal banking agencies, including the FRB, the FDIC and the Commissioner, periodically conduct examinations of our business, including compliance with laws and regulations. If, as a result of an examination, a state or federal banking agency were to determine that our financial condition, capital resources, asset quality, earnings prospects, management, liquidity or other aspects of any of our operations had become unsatisfactory, or that we or our management was in violation of any law or regulation, it may take a number of different remedial actions as it deems appropriate. These actions include the power to enjoin “unsafe or unsound” practices, to require affirmative actions to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in our capital, to restrict our growth, to assess civil monetary penalties against our officers or directors, to remove officers and directors and, if it is concluded that such conditions cannot be corrected or there is an imminent risk of loss to depositors, to terminate the Bank’s deposit insurance. If we become subject to such regulatory actions, our business, results of operations and reputation may be negatively impacted.
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Our expansion plans will require regulatory approvals, and failure to obtain them may restrict our growth.
We intend to complement and expand our business by continuing to pursue strategic acquisitions of banks and other financial institutions. We must generally receive regulatory approval before we can acquire an institution or business. Such regulatory approvals may not be granted on terms that are acceptable to us, or at all. We may also be required to sell branches as a condition to receiving regulatory approval, which condition may not be acceptable to us or, if acceptable to us, may reduce the benefit of any acquisition.
In addition to the acquisition of existing financial institutions, as opportunities arise, we plan to continue de novo branching as a part of our internal growth strategy and possibly enter into new markets through de novo branching. De novo branching and any acquisition carries with it numerous risks, including the inability to obtain all required regulatory approvals. The failure to obtain these regulatory approvals for potential future strategic acquisitions and de novo branches may impact our business plans and restrict our growth.
We may be required to raise additional capital in the future, but that capital may not be available when it is needed on attractive terms, or at all.
We are required by regulatory authorities to maintain adequate levels of capital to support our operations. Our capital requirements for the foreseeable future are currently satisfied. We may at some point, however, need to raise additional capital to support our continued growth or if our liquidity is adversely affected by external factors such as worsening economic conditions or continued slow economic growth. Our ability to raise additional capital, if needed, will depend in part on conditions in the capital markets at that time, which are outside our control. Accordingly, we cannot assure you of our ability to raise additional capital, if needed, on terms acceptable to us. If we cannot raise additional capital when needed, our ability to further expand our operations could be materially impaired, or the failure to raise additional capital could have a material adverse effect on our liquidity, financial condition or results of operations. In addition, if we decide to raise additional equity capital, your interest in Howard Bancorp could be diluted. Furthermore, if we raise additional capital through the issuance of debt securities, there can be no assurance that sufficient revenues or cash flow will exist to service such debt.
Our investment securities portfolio is subject to credit risk, market risk, and liquidity risk.
Our investment securities portfolio is subject to risks beyond our control that may significantly influence its fair value. These include, but are not limited to, rating agency downgrades of the securities, defaults of the issuers of the securities, lack of market pricing of the securities, and instability in the credit markets. Lack of market activity with respect to some securities has, in certain circumstances, required us to base their fair market valuation on unobservable inputs. Any changes in these risk factors, in current accounting principles or interpretations of these principles could impact our assessment of fair value and thus the determination of other-than-temporary impairment of the securities in the investment securities portfolio. Investment securities that previously were determined to be other-than-temporarily impaired could require further write-downs due to continued erosion of the creditworthiness of the issuer. Write-downs of investment securities would negatively affect our earnings and regulatory capital ratios.
Further, most of our securities investment portfolio as of December 31, 2017 has been designated as available for sale pursuant to Statement of Financial Accounting Standards, Accounting Standards Codification (“ASC”) Topic 320 – “Investments.” ASC Topic 320 requires that unrealized gains and losses in the estimated value of the available for sale portfolio be “marked to market” and reflected as a separate item in stockholders’ equity, net of tax. If the market value of the investment portfolio declines, this could cause a corresponding decline in stockholders’ equity.
Our lending limit may limit our growth.
We are limited in the amount we can loan to a single borrower by the amount of our capital. Generally, under current law, we may lend up to 15% of our unimpaired capital and surplus to any one borrower. Based upon our current capital levels, such amount is significantly less than that of many of our competitors and may discourage potential borrowers who have credit needs in excess of our lending limit from doing business with us. We accommodate larger loans by selling participations in those loans to other financial institutions, but this strategy may not always be available.
The failure to maintain our reputation may materially adversely affect our ability to grow and generate revenue.
Our reputation is one of the most valuable components of our business. Damage to our reputation could undermines the confidence of clients and prospects in our ability to serve them and therefore could negatively affect our earnings. Damage to our reputation also could affect the confidence of rating agencies, regulators, stockholders and other parties in a wide range of transactions that are important to our business. Failure to maintain our reputation ultimately would have an adverse effect on our ability to maintain and grow our business. Actions by the financial services industry generally or by other members of or individuals in the financial services industry also could impact our reputation negatively. The considerable expansion in the use of social media over recent years has increased the risk that our reputation could be negatively impacted in a short amount of time. If we are unable to quickly and effectively respond to any incidents negatively impacting our reputation, it could have a material and long-term negative impact on our business and, therefore, our operating results.
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Anti-takeover provisions in our corporate documents and in federal and state law may make it difficult and expensive to remove current management.
Anti-takeover provisions in our articles of incorporation and bylaws and federal and state banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire Howard Bancorp, even if doing so would be perceived to be beneficial to our stockholders. The combination of these provisions effectively inhibits a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of our common stock. These provisions could also discourage proxy contests and make it more difficult and expensive for holders of our common stock to elect directors other than the candidates nominated by our board of directors or otherwise remove existing directors and management, even if current management is not performing adequately.
Our articles of incorporation limit the liability of our directors and officers and the rights of us and our stockholders to take action against our directors and officers.
Our articles of incorporation eliminates our directors’ and officers’ liability to us and our stockholders for money damages to the fullest extent permitted by Maryland law. Our articles of incorporation and bylaws also require us to indemnify our directors and officers for liability resulting from actions taken by them in those capacities to the maximum extent permitted by Maryland law. As a result, we and our stockholders may have more limited rights against our directors and officers than might otherwise exist under common law. In addition, we may be obligated to fund the defense costs incurred by our directors and officers.
The market price for our common stock may be volatile.
The market price of our common stock could be subject to significant fluctuations due to changes in sentiment in the market regarding our operations or business prospects. Factors that may affect market sentiment include:
| · | operating results that vary from the expectations of our management or of securities analysts and investors; |
| · | developments in our business or in the financial service sector generally; |
| · | regulatory or legislative changes affecting our industry generally or our business and operations in particular; |
| · | operating and securities price performance of companies that investors consider to be comparable to us; |
| · | changes in estimates or recommendations by securities analysts; |
| · | announcements of strategic developments, acquisitions, dispositions, financings and other material events by us or our competitors; and |
| · | changes in financial markets and national and local economies and general market conditions, such as interest rates and stock, commodity, credit or asset valuations or volatility. |
While the U.S. and other governments continue efforts to restore confidence in financial markets and promote economic growth, market and economic turmoil could still occur in the near- or long-term, negatively affecting our business, financial condition and results of operations, as well as the price, trading volume and volatility of our common stock.
We may be unable to, or choose not to, pay dividends on our common stock.
We cannot assure you of our ability to pay dividends. Our ability to pay dividends depends on the following factors, among others:
| · | We may not have sufficient earnings as our primary source of income, the payment of dividends to Howard Bancorp by Howard Bank, is subject to federal and state laws that limit the ability of that bank to pay dividends; |
| · | FRB policy requires bank holding companies to pay cash dividends on common stock only out of net income available over the past year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition; and |
| · | our board of directors may determine that, even though funds are available for dividend payments, retaining the funds for internal uses, such as expansion of our operations, is a better strategy. |
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If we fail to pay dividends in the future, capital appreciation, if any, of our common stock may be the sole opportunity for gains on an investment in our common stock. In addition, in the event the Bank becomes unable to pay dividends to Howard Bancorp, we may not be able to service our debt or pay our other obligations or pay dividends on our common stock. Accordingly, Howard Bancorp’s inability to receive dividends from Howard Bank could also have a material adverse effect on our business, financial condition and results of operations and the value of your investment in our common stock.
We can sell additional shares of common stock without consulting stockholders and without offering shares to existing stockholders, which would result in dilution of stockholders’ interests in Howard Bancorp and could depress our stock price.
Our articles of incorporation currently authorize an aggregate of 20 million shares of common stock, 9,827,072 of which are outstanding as of February 28, 2018. Our board of directors has the authority to amend our articles of incorporation, without stockholder approval, to increase or decrease the aggregate number of shares of stock or the number of shares of any class of stock that we have the authority to issue. The board of directors is further authorized to issue additional shares of common stock and preferred stock, at such times and for such consideration as it may determine, without stockholder action. The ability of the board of directors to increase our authorized shares of capital stock, and the existence of authorized but unissued shares of common stock and preferred stock, could have the effect of rendering more difficult or discouraging hostile takeover attempts, or of facilitating a negotiated acquisition and could affect the market for and price of our common stock. Because our common stockholders do not have preemptive rights to purchase shares of our capital stock (that is, the right to purchase a stockholder’s pro rata share of any securities issued by Howard Bancorp), any future offering of capital stock could have a dilutive effect on holders of our common stock.
Item 1B. Unresolved Staff Comments
None
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Our headquarters are located in Ellicott City, Maryland. As of December 31, 2017, the Bank owns eight full-service branches and leased its remaining branches. See Note 9 to the Consolidated Financial Statements, “Premises and Equipment,” for additional information.
At December 31, 2017, we owned the following properties, which had a book value of $15.2 million:
| Branch Location | Address | Description | ||
| Maple Lawn 1 | 10985 Johns Hopkins Road | Full service branch with drive-thru | ||
| Laurel, MD 20723 | ||||
| Centennial | 10161 Baltimore National Pike | Full service branch with drive-thru | ||
| Ellicott City, MD 21042 | ||||
| Aberdeen | 3 West Bel Air Avenue | Full service branch with drive-thru | ||
| Aberdeen, MD 21001 | ||||
| Rising Sun | 6 Pearl Street | Full service branch with drive-thru | ||
| Rising Sun, MD 21911 | ||||
| Elkton 1 | 305 Augustine Herman Highway | Full service branch with drive-thru | ||
| Elkton, MD 21921 | ||||
| Dublin | 3535 Conowingo Road | Full service branch with drive-thru | ||
| Street, MD 21154 | ||||
| Dundalk | 1301 Merritt Boulevard | Full service branch with drive-thru | ||
| Dundalk, MD 21222 | ||||
| Parkville 1 | 2028 East Joppa Road | Full service branch with drive-thru | ||
| Parkville, MD 21235 | ||||
| Office Location | Address | Description | ||
| Innovation Center | 10161 Baltimore National Pike | Information technology and other | ||
| Ellicott City, MD 21042 | support functions |
| (1) | The premises are owned, but are subject to a ground lease. |
We leased the following branches at December 31, 2017:
| Branch Location | Address | Description | ||
| Snowden River | 6011 University Boulevard, Suite 150 | Full service branch with drive-thru | ||
| Ellicott City, MD 21043 | ||||
| Defense Highway | 116 Defense Highway | Full service branch with drive-thru | ||
| Annapolis, MD 21401 | ||||
| Towson | 22 West Pennsylvania Avenue | Full service branch with drive-thru | ||
| Baltimore, MD 21204 | ||||
| Havre de Grace | 800 Revolution Street | Full service branch with drive-thru | ||
| Havre de Grace, MD 21078 | ||||
| Hampden | 821 West 36th Street | Full service branch | ||
| Baltimore, MD 21211 | ||||
| Remington | 2700 Remington Avenue, Suite 100 | Full service branch | ||
| Baltimore, MD 21211 |
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We lease the following facilities unless otherwise noted:
| Office Location | Address | Description | ||
| Corporate Office | 6011 University Boulevard, Suite 370 | Corporate headquarters | ||
| Ellicott City, MD 21043 | ||||
| Towson Office | 22 West Pennsylvania Avenue, Suite 102 | Regional headquarters | ||
| Baltimore, MD 21204 | ||||
| Annapolis Office | 1997 Annapolis Exchange Parkway, Suite 140 | Regional banking office and regional | ||
| Annapolis, MD 21401 | mortgage banking office | |||
| Columbia Mortgage Office | 8820 Columbia 100 Parkway | Regional mortgage banking office | ||
| Columbia, MD 21045 | ||||
| Timonium Mortgage Office | 1954 Greenspring Drive, Suite 165 | Regional mortgage banking office | ||
| Timonium, MD 21093 | ||||
| Rockville Mortgage Office | 1572 Crabb Branch Way, Suite 2D | Regional mortgage banking office | ||
| Rockville, MD 20855 | ||||
| Reisterstown Mortgage Office | 118 Westminster Pike, Suite 106 | Regional mortgage banking office | ||
| Reisterstown, MD 21136 | ||||
| Dundalk | 1301 Merritt Boulevard | Deposit operation services | ||
| Dundalk, MD 21222 | ||||
| Parkville 1 | 2028 East Joppa Road | Loan operation services | ||
| Parkville, MD 21235 |
| (1) | The premises are owned, but are subject to a ground lease. |
From time to time, we may be involved in litigation relating to claims arising out of our normal course of business. As of the date of this report, we are not aware of any material pending litigation matters.
Item 4. Mine Safety Disclosures
Not applicable
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Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchase of Equity Securities
Our common stock is listed on The Nasdaq Stock Market under the symbol “HBMD.”
The following table reflects the high and low sale prices for the periods presented. Quotations are based on Nasdaq listings and reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions.
| 2017 | 2016 | |||||||||||||||
| Stock price range | Stock price range | |||||||||||||||
| Quarter | High | Low | High | Low | ||||||||||||
| First | $ | 19.00 | $ | 14.75 | $ | 13.33 | $ | 11.65 | ||||||||
| Second | 20.70 | 17.60 | 13.27 | 12.01 | ||||||||||||
| Third | 21.50 | 16.70 | 13.75 | 12.24 | ||||||||||||
| Fourth | 23.50 | 18.20 | 15.25 | 12.85 | ||||||||||||
At February 28, 2018, we had 428 stockholders of record.
Dividends
We have not declared or paid any dividends on our common stock. We currently intend to retain all of our future earnings, if any, for use in our business and do not anticipate paying cash dividends on our common stock in the foreseeable future; however, our board of directors may decide to declare dividends in the future. Payments of future dividends, if any, will be at the discretion of our board of directors after taking into account various factors, including our business, operating results and financial condition, current and anticipated cash needs, plans for expansion, tax considerations, general economic conditions and any legal or contractual limitations on our ability to pay dividends. We are not obligated to pay dividends on our common stock.
As a bank holding company, our ability to declare and pay cash dividends is dependent upon, among other things, restrictions imposed by the reserve and capital requirements of Maryland and federal law and regulations, our income and financial condition, tax considerations and general business conditions. In addition, because we are a holding company, we are dependent upon the payment of dividends by the Bank to us as our principal source of funds to pay dividends in the future, if any, and to make other payments.
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Item 6. Selected Financial Data
| Year ended December 31, | ||||||||||||||||||||
| (in thousands, except per share data.) | 2017 | 2016 | 2015 | 2014 | 2013 | |||||||||||||||
| Statements of operations data: | ||||||||||||||||||||
| Interest income | $ | 43,026 | $ | 38,741 | $ | 33,349 | $ | 23,360 | $ | 17,711 | ||||||||||
| Interest expense | 5,167 | 4,562 | 3,072 | 2,402 | 1,901 | |||||||||||||||
| Provision for credit losses | 1,831 | 2,037 | 1,836 | 3,255 | 950 | |||||||||||||||
| Noninterest income | 19,524 | 14,796 | 11,935 | 23,256 | 1,324 | |||||||||||||||
| Noninterest expense | 45,200 | 38,699 | 38,261 | 23,694 | 13,239 | |||||||||||||||
| Federal and state income tax expense | 3,152 | 2,936 | 973 | 6,853 | 984 | |||||||||||||||
| Net income | 7,200 | 5,303 | 1,142 | 10,412 | 1,961 | |||||||||||||||
| Dividends | - | 166 | 126 | 126 | 165 | |||||||||||||||
| Net income available to common shareholders | 7,200 | 5,137 | 1,016 | 10,286 | 1,796 | |||||||||||||||
| Per share data and shares outstanding: | ||||||||||||||||||||
| Net income per common share, basic | $ | 0.75 | $ | 0.74 | $ | 0.16 | $ | 2.53 | $ | 0.44 | ||||||||||
| Net income per common share, diluted | $ | 0.75 | $ | 0.73 | $ | 0.16 | $ | 2.48 | $ | 0.44 | ||||||||||
| Book value per common share at period end | $ | 13.47 | $ | 12.27 | $ | 11.54 | $ | 11.36 | $ | 8.80 | ||||||||||
| Average common shares outstanding | 9,555,952 | 6,975,662 | 6,160,005 | 4,073,077 | 4,036,291 | |||||||||||||||
| Diluted average common shares outstanding | 9,596,804 | 6,998,982 | 6,223,496 | 4,143,101 | 4,076,470 | |||||||||||||||
| Shares outstanding at period end | 9,820,592 | 6,991,072 | 6,962,139 | 4,145,547 | 4,095,650 | |||||||||||||||
| Financial Condition data: | ||||||||||||||||||||
| Total assets | $ | 1,149,950 | $ | 1,026,957 | $ | 946,759 | $ | 691,416 | $ | 499,918 | ||||||||||
| Loans receivable (gross) | 936,608 | 821,524 | 757,002 | 552,917 | 403,875 | |||||||||||||||
| Allowance for credit losses | 6,159 | 6,428 | 4,869 | 3,602 | 2,506 | |||||||||||||||
| Other interest-earning assets | 152,343 | 152,075 | 138,137 | 99,261 | 60,481 | |||||||||||||||
| Total deposits | 863,908 | 808,734 | 747,408 | 554,039 | 388,949 | |||||||||||||||
| Borrowings | 148,920 | 127,574 | 98,828 | 67,628 | 61,658 | |||||||||||||||
| Total stockholders’ equity | 132,253 | 85,790 | 92,899 | 59,643 | 48,624 | |||||||||||||||
| Common equity | 132,253 | 85,790 | 80,337 | 47,081 | 36,062 | |||||||||||||||
| Average assets | 1,072,943 | 970,710 | 782,441 | 557,602 | 428,961 | |||||||||||||||
| Average stockholders' equity | 123,763 | 86,221 | 76,143 | 50,674 | 47,717 | |||||||||||||||
| Average common stockholders' equity | 123,763 | 81,896 | 63,581 | 38,112 | 35,155 | |||||||||||||||
| Selected performance ratios: | ||||||||||||||||||||
| Return on average assets | 0.67 | % | 0.55 | % | 0.15 | % | 1.87 | % | 0.46 | % | ||||||||||
| Return on average common equity | 5.82 | % | 6.48 | % | 1.80 | % | 27.32 | % | 5.58 | % | ||||||||||
| Net interest margin(1) | 3.73 | % | 3.73 | % | 4.08 | % | 3.97 | % | 3.93 | % | ||||||||||
| Efficiency ratio(2) | 78.77 | % | 79.01 | % | 90.64 | % | 53.59 | % | 77.27 | % | ||||||||||
| Asset quality ratios: | ||||||||||||||||||||
| Nonperforming loans to gross loans | 1.41 | % | 1.17 | % | 1.37 | % | 0.77 | % | 0.79 | % | ||||||||||
| Allowance for credit losses to loans | 0.66 | % | 0.78 | % | 0.64 | % | 0.65 | % | 0.62 | % | ||||||||||
| Allowance for credit losses to nonperforming loans | 46.70 | % | 69.24 | % | 46.95 | % | 84.69 | % | 78.76 | % | ||||||||||
| Nonperforming assets to loans and other real estate | 1.57 | % | 1.41 | % | 1.68 | % | 1.21 | % | 1.37 | % | ||||||||||
| Nonperforming assets to total assets | 1.28 | % | 1.16 | % | 1.35 | % | 0.97 | % | 1.11 | % | ||||||||||
| Capital ratios: | ||||||||||||||||||||
| Leverage ratio | 11.70 | % | 8.36 | % | 9.90 | % | 8.60 | % | 9.93 | % | ||||||||||
| Tier I risk-based capital ratio | 12.77 | % | 9.71 | % | 11.47 | % | 10.11 | % | 11.45 | % | ||||||||||
| Total risk-based capital ratio | 13.72 | % | 10.83 | % | 12.09 | % | 10.73 | % | 12.05 | % | ||||||||||
| Average equity to average assets | 11.53 | % | 8.88 | % | 9.73 | % | 9.09 | % | 11.12 | % | ||||||||||
| (1) | Net interest margin is net interest income divided by average earning assets. |
| (2) | Efficiency ratio is noninterest expense divided by the sum of net interest income and noninterest income. |
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This section is intended to help current and potential investors understand our financial performance through a discussion of the factors affecting our consolidated financial condition at December 31, 2017 and 2016 and our consolidated results of operations for the years ended December 31, 2017, 2016 and 2015. This section should be read in conjunction with the Consolidated Financial Statements and notes to the consolidated financial statements that appear elsewhere in this report.
Overview
Howard Bancorp, Inc. is the holding company for Howard Bank. Howard Bank was formed in 2004. Howard Bank’s business has consisted primarily of originating both commercial and real estate loans secured by property in our market area. Typically, commercial real estate and business loans involve a higher degree of risk and carry a higher yield than one-to four-family residential loans. Although we plan to continue to focus on commercial customers, we intend to continue our origination of one- to four-family residential mortgage loans, maintaining our portfolio of mortgage lending and also selling select loans into the secondary markets.
We are headquartered in Ellicott City, Maryland and we consider our primary market area to be the Greater Baltimore Metropolitan Area. We engage in a general commercial banking business, making various types of loans and accepting deposits. We market our financial services primarily to small to medium sized businesses and their owners, professionals and executives, and high-net-worth individuals. Our loans are primarily funded by core deposits of customers in our market.
Our results of operations depend mainly on our net interest income, which is the difference between the interest income we earn on our loan and investment portfolios and the interest expense we pay on deposits and borrowings. Results of operations are also affected by provisions for credit losses, noninterest income and noninterest expense. Our noninterest expense consists primarily of compensation and employee benefits, as well as office occupancy, deposit insurance and general administrative and data processing expenses. Our operations are significantly affected by general economic and competitive conditions, particularly with respect to changes in interest rates, government policies and actions of regulatory authorities. Future changes in applicable laws, regulations or government policies may materially affect our financial condition and results of operations.
In August 2015, we acquired Patapsco Bancorp, the parent company of The Patapsco Bank, through the merger of Patapsco Bancorp with and into Howard Bancorp, immediately followed by the merger of Patapsco Bank with and into the Bank.
In May 2016, we redeemed all of the 12,562 shares of the Series AA Preferred Stock that we had previously issued to Treasury under its SBLF program for approximately $12.7 million, including dividends accrued but unpaid through the redemption date. The redemption of the Series AA Preferred Stock was funded with variable rate debt with Raymond James Bank, N.A.
On February 1, 2017, we sold 2,760,000 shares of our common stock resulting in aggregate net proceeds of approximately $38.4 million. We used the proceeds of the offering to pay off the loan to Raymond James Bank, N.A. and retained the remainder. This had a positive impact on our liquidity and capital position in 2017 and provided funds that will continue to allow us to grow our loans and investments.
On March 1, 2018, we acquired First Mariner through the merger of First Mariner with and into Howard Bank. The aggregate merger consideration of $173.8 million included $9.2 million of cash and 9,143,230 shares of our common stock, which was valued at approximately $164.6 million.
Financial highlights for the year ended December 31, 2017 are as follows:
| · | Primarily as a result of the capital offering, our total stockholders’ equity increased $46.5 million or 54.2%. As anticipated, all of our regulatory capital ratios increased dramatically as a result of the offering. |
| · | Total assets increased $123.0 million or 12.0%, to $1.1 billion. |
| · | Loans and leases held in our portfolio grew $115.1 million or 14.0%, to $936.6 million. |
| · | Deposits increased $55.2 million or 6.8% to $863.9 million, including noninterest-bearing deposit growth of $35.3 million or 19.3%. |
| · | Net income available to common stockholders increased $2.1 million or 40.1% compared the year ended December 31, 2016. |
| · | Book value per share increased to $13.47 at December 31, 2017 compared to $12.27 at December 31, 2016. |
Tax Cuts and Jobs Act. The Tax Cuts and Jobs Act was enacted on December 22, 2017. Among other things, the new law (i) establishes a reduced, flat corporate federal statutory income tax rate of 21%, (ii) eliminates the corporate alternative minimum tax and allows the use of any tax net operating loss carryforwards to offset regular tax liability for any taxable year, (iii) limits the deduction for net interest expense incurred by U.S. corporations, (iv) allows businesses to immediately expense, for tax purposes, the cost of new investments in certain qualified depreciable assets, (v) eliminates or reduces certain deductions related to meals and entertainment expenses, (vi) modifies the limitation on excessive employee remuneration to eliminate the exception for performance-based compensation and clarifies the definition of a covered employee and (vii) limits the deductibility of deposit insurance premiums. The Tax Cuts and Jobs Act also significantly changes U.S. tax law related to foreign operations, but such changes do not currently impact us.
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Critical Accounting Policies
Our accounting and financial reporting policies conform to the accounting principles generally accepted in the United States of America (“GAAP”) and general practice within the banking industry. Accordingly, preparation of the financial statements requires management to exercise significant judgment or discretion and make significant assumptions and estimates based on the information available that have, or could have, a material impact on the carrying value of certain assets or on income. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the periods presented. In reviewing and understanding financial information for us, you are encouraged to read and understand the significant accounting policies used in preparing our financial statements. The accounting policies we view as critical are those relating to the allowance for credit losses, goodwill and other intangible assets, income taxes and share based compensation.
Allowance for Credit Losses
The allowance for credit losses is established through a provision for credit losses charged against income. Loans are charged against the allowance for credit losses when management believes that the collectability of the principal is unlikely. Subsequent recoveries are added to the allowance. The allowance is an amount that represents the amount of probable and reasonably estimable known and inherent losses in the loan portfolio, based on evaluations of the collectability of loans. The evaluations take into consideration such factors as changes in the types and amount of loans in the loan portfolio, historical loss experience, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, estimated losses relating to specifically identified loans, and current economic conditions. This evaluation is inherently subjective as it requires material estimates including, among others, exposure at default, the amount and timing of expected future cash flows on impaired loans, value of collateral, estimated losses on our loan portfolios as well as consideration of general loss experience. Based on our estimate of the level of allowance for credit losses required, we record a provision for credit losses to maintain the allowance for credit losses at an appropriate level.
We cannot predict with certainty the amount of loan charge-offs that we will incur. We do not currently determine a range of loss with respect to the allowance for credit losses. In addition, our regulatory agencies, as an integral part of their examination processes, periodically review our allowance for credit losses. Such agencies may require that we recognize additions to the allowance for credit losses based on their judgments about information available to them at the time of their examination. To the extent that actual outcomes differ from management’s estimates, additional provisions to the allowance for credit losses may be required that would adversely impact earnings in future periods.
Goodwill and Other Intangible Assets
Goodwill represents the excess of the purchase price over the sum of the estimated fair values of tangible and identifiable intangible assets acquired less the estimated fair value of the liabilities assumed. Core deposit intangibles represent the estimated value of long-term deposit relationships acquired in a business combination. The core deposit intangible is amortized over the estimated useful lives of the acquired long-term deposits acquired, and the remaining amounts of the core deposit intangible are periodically reviewed for reasonableness. Goodwill has an indefinite useful life and is evaluated for impairment annually or more frequently if events and circumstances indicate that the asset might be impaired. We perform a qualitative assessment annually to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing updated qualitative factors, the Company determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, it does not have to perform the two step impairment test. Determining the fair value under the first step of the goodwill impairment test and determining the fair value if individual assets and liabilities of a reporting unit under the second step of the goodwill impairment test are judgmental and often involve the use of significant estimates and assumptions. Similarly, estimates and assumptions are used in determining the fair value of other intangible assets. Estimates of fair value are primarily determined using discounted cash flows, market comparisons and recent transactions. Significant estimates and assumptions include projected future cash flows, discount rates, reflective market rate of return, projected growth rates and determination and evaluation of appropriate market comparables. Future events could cause the Company to conclude that goodwill or other intangible assets have become impaired, which would result in the Company recording an impairment loss. Any resulting impairment loss could have a material impact on the Company’s financial condition and results of operations. Based on the results of qualitative assessment, the Company determined that there was not an impairment of the carrying value of either the goodwill or core deposit intangible at December 31, 2017.
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Income Taxes
We account for income taxes under the asset/liability method. We recognize deferred tax assets and liabilities for the future consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as operating loss and tax credit carry-forwards. We measure deferred tax assets and liabilities using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. We recognize the effect on deferred tax assets and liabilities of a change in tax rates in income in the period indicated by the enactment date. We establish a valuation allowance for deferred tax assets when, in the judgment of management, it is more likely than not that such deferred tax assets will not become realizable. The judgment about the level of future taxable income is dependent to a great extent on matters that may, at least in part, be beyond our control. It is at least reasonably possible that management’s judgment about the need for a valuation allowance for deferred tax assets could change in the near term.
Share Based Compensation
We follow the provisions of ASC Topic 718 “Compensation – Stock Compensation,” which requires the expense recognition over the respective service period for the fair value of share based compensation awards, such as stock options, restricted stock, and performance based shares. This standard allows management to establish modeling assumptions as to expected stock price volatility, option terms, forfeiture rates and dividend rates which directly impact estimated fair value. The accounting standard also allows for the use of alternative option pricing models which may impact fair value as determined. Our practice is to utilize reasonable and supportable assumptions that are reviewed with the appropriate board committee.
Balance Sheet Analysis and Comparison of Financial Condition
A comparison between December 31, 2017 and December 31, 2016 balance sheets is presented below.
General
Total assets increased $123.0 million, or 12.0%, to $1.1 billion at December 31, 2017 compared to assets of $1.0 billion at December 31, 2016. This asset growth consisted primarily of increases in our portfolio loans of $115.1 million and investment securities of $38.5 million, partially offset by declines of $19.5 million in interest bearing deposits in banks, $10.4 million in cash and cash equivalents, and $8.9 million in loans held for sale. The primary source of funding for the asset growth was an increase in deposit levels. Customer deposits increased from $808.7 million at December 31, 2016 to $863.9 million at December 31, 2017, an increase of $55.2 million or 6.8%. Supplementing this deposit growth, our borrowings increased $21.3 million during 2017. Primarily as a result of the proceeds from our 2017 capital offering, total stockholders’ equity increased $46.5 million or 54.2% during 2017. As anticipated, all of our regulatory capital ratios increased dramatically as a result of the capital raised in the offering.
Investment Securities
Available for sale
Available for sale securities are reported at fair value. We currently hold U.S. agency and treasury securities, mortgage backed securities, and mutual fund investments in our securities portfolio, which are categorized as available for sale. The investment in mutual funds is a supplement to our community reinvestment program activities. We use our securities portfolio to provide the required collateral for funding via commercial customer overnight securities sold under agreement to repurchase (“repurchase agreements”) as well as to provide sufficient liquidity to fund our loans and provide funds for withdrawals of deposits.
Held to maturity
Held to maturity securities are reported at amortized cost. The only investments that we have classified as held to maturity are corporate debentures. These investments are intended to be held until maturity.
In addition to our available for sale and held to maturity securities, at December 31, 2017 and December 31, 2016 we held an investment in stock of the Federal Home Loan Bank of $6.5 million and $5.1 million, respectively. This investment is required for continued Federal Home Loan Bank membership and is based partially upon the amount of borrowings outstanding from the FHLB. This Federal Home Loan Bank stock is carried at cost.
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The following table sets forth the composition of our investment securities portfolio at the dates indicated.
| December 31, | ||||||||||||||||||||||||
| (in thousands) | 2017 | 2016 | 2015 | |||||||||||||||||||||
| Amortized | Estimated | Amortized | Estimated | Amortized | Estimated | |||||||||||||||||||
| Cost | Fair Value | Cost | Fair Value | Cost | Fair Value | |||||||||||||||||||
| Available for sale | ||||||||||||||||||||||||
| U.S. Government | ||||||||||||||||||||||||
| Agencies | $ | 68,082 | $ | 67,740 | $ | 34,584 | $ | 34,463 | $ | 48,467 | $ | 48,422 | ||||||||||||
| Treasuries | 1,505 | 1,494 | 1,512 | 1,504 | - | - | ||||||||||||||||||
| Mortgage-backed | 2,541 | 2,479 | 1,366 | 1,298 | 54 | 57 | ||||||||||||||||||
| Other investments | 2,579 | 2,543 | 1,500 | 1,463 | 1,100 | 1,094 | ||||||||||||||||||
| $ | 74,707 | $ | 74,256 | $ | 38,962 | $ | 38,728 | $ | 49,621 | $ | 49,573 | |||||||||||||
| Held to maturity Corporate debentures | $ | 9,250 | $ | 9,421 | $ | 6,250 | $ | 6,584 | $ | 3,000 | $ | 3,328 | ||||||||||||
We had available for sale securities of $74.3 million and $38.7 million at December 31, 2017 and December 31, 2016, respectively, which were recorded at fair value. This represents an increase of $35.5 million, or 91.7%, for the year ended December 31, 2017 from the prior year end. The increase in the size of the portfolio was intended to provide additional collateral for certain funding sources, and to provide additional liquidity for the Bank. Nearly $35.0 million of our securities portfolio matures in one year or less, giving us the capacity to fund future loan growth while maintaining an appropriate amount of securities to provide the required collateral under our repurchase agreements. We did not record any gains or losses on sales or calls of securities in 2017. In 2016 we sold an equity security with a carrying value of $100 thousand issued by a local small financial institution that resulted in a gain upon sale of $96 thousand.
We had securities held to maturity of $9.3 million and $6.3 million at December 31, 2017 and December 31, 2016, respectively, which were recorded at amortized cost. This represents an increase of $3.0 million during 2017, consisting of additional investments in corporate debentures.
With respect to our portfolio of securities available for sale, the portfolio contained 38 securities with unrealized losses of $451 thousand and 12 securities with unrealized losses of $240 thousand at December 31, 2017 and 2016, respectively. Changes in the fair value of these securities resulted primarily from interest rate fluctuations. We do not intend to sell these securities nor is it more likely than not that we would be required to sell these securities before their anticipated recovery, and we believe the collection of the investment and related interest is probable. Based on this analysis, we do not consider any of the unrealized losses to be other than temporary impairment losses. One held to maturity securities was in a loss position at December 31, 2017 while none were in a loss position at December 31, 2016.
Portfolio Maturities and Yields
The composition and maturities of the investment securities portfolio (with respect to those securities that have a fixed maturity date) at December 31, 2017 is summarized in the following table. Maturities are based on the final contractual payment dates, and do not reflect the impact of prepayments or early redemptions that may occur.
| As of December 31, 2017 | ||||||||||||||||||||||||||||||||||||||||
| After one | After five | |||||||||||||||||||||||||||||||||||||||
| (in thousands) | One year or less | through five years | through ten years | After ten years | Total | |||||||||||||||||||||||||||||||||||
| Weighted | Weighted | Weighted | Weighted | Weighted | ||||||||||||||||||||||||||||||||||||
| Amortized | Average | Amortized | Average | Amortized | Average | Amortized | Average | Amortized | Average | |||||||||||||||||||||||||||||||
| Cost | Yield | Cost | Yield | Cost | Yield | Cost | Yield | Cost | Yield | |||||||||||||||||||||||||||||||
| Available for sale | ||||||||||||||||||||||||||||||||||||||||
| U.S. Government | ||||||||||||||||||||||||||||||||||||||||
| Agencies | $ | 33,600 | 1.18 | % | $ | 34,482 | 1.48 | % | $ | - | - | % | $ | - | - | % | $ | 68,082 | 1.33 | % | ||||||||||||||||||||
| Treasury | 1,505 | 0.83 | - | - | - | - | - | - | 1,505 | 0.83 | ||||||||||||||||||||||||||||||
| Mortgage-backed | - | - | 8 | 4.55 | 7 | 4.98 | 2,526 | 2.68 | 2,541 | 2.69 | ||||||||||||||||||||||||||||||
| $ | 35,105 | 1.16 | % | $ | 34,490 | 1.48 | % | $ | 7 | 4.98 | % | $ | 2,526 | 2.68 | % | $ | 72,128 | 1.37 | % | |||||||||||||||||||||
| Held to maturity Corporate debentures | $ | - | - | $ | - | - | $ | 9,250 | 6.16 | $ | - | - | $ | 9,250 | % | |||||||||||||||||||||||||
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Loan and Lease Portfolio
Total loans and leases increased $115.1 million, or 14.0%, to $936.6 million at December 31, 2017 from $821.5 million at December 31, 2016. This organic growth during 2017 was primarily due to growth in commercial real estate loans (including construction and land development), which increased $81.6 million or 19.3% from 2016 levels. Additionally, commercial and industrial loans grew $26.0 million and residential junior lien loans increased $8.0 million. Residential real estate loans and the consumer loan portfolio declined $609 thousand or less than 1% during 2017 from their year-end 2016 levels.
The following table sets forth the composition of our loan portfolio at the dates indicated.
| December 31, | ||||||||||||||||||||||||||||||||||||||||
| (dollars in thousands) | 2017 | 2016 | 2015 | 2014 | 2013 | |||||||||||||||||||||||||||||||||||
| Amount | Percent | Amount | Percent | Amount | Percent | Amount | Percent | Amount | Percent | |||||||||||||||||||||||||||||||
| Real Estate | ||||||||||||||||||||||||||||||||||||||||
| Construction and land | $ | 74,398 | 7.9 | % | $ | 72,973 | 8.9 | % | $ | 69,385 | 9.1 | % | $ | 64,158 | 11.6 | % | $ | 50,884 | 12.6 | % | ||||||||||||||||||||
| Residential - first lien | 194,896 | 20.8 | 195,032 | 23.7 | 182,988 | 24.1 | 88,293 | 16.0 | 39,249 | 9.7 | ||||||||||||||||||||||||||||||
| Residential - junior lien | 43,047 | 4.6 | 35,009 | 4.3 | 27,477 | 3.6 | 19,301 | 3.5 | 8,266 | 2.0 | ||||||||||||||||||||||||||||||
| Total residential real estate | 237,943 | 25.4 | 230,041 | 28.0 | 210,465 | 27.7 | 107,594 | 19.5 | 47,515 | 11.7 | ||||||||||||||||||||||||||||||
| Commercial - owner occupied | 170,408 | 18.2 | 134,213 | 16.3 | 131,114 | 17.3 | 112,826 | 20.4 | 90,333 | 22.4 | ||||||||||||||||||||||||||||||
| Commercial - non-owner occupied | 260,802 | 27.8 | 216,781 | 26.4 | 181,361 | 23.9 | 123,958 | 22.4 | 113,559 | 28.1 | ||||||||||||||||||||||||||||||
| Total commercial real estate | 431,210 | 46.0 | 350,994 | 42.7 | 312,475 | 41.2 | 236,784 | 42.8 | 203,892 | 50.5 | ||||||||||||||||||||||||||||||
| Total real estate loans | 743,551 | 79.3 | 654,008 | 79.6 | 592,325 | 78.0 | 408,536 | 73.9 | 302,291 | 74.8 | ||||||||||||||||||||||||||||||
| Commercial loans and leases | 188,729 | 20.2 | 162,715 | 19.8 | 160,424 | 21.4 | 139,669 | 25.2 | 100,410 | 24.9 | ||||||||||||||||||||||||||||||
| Consumer loans | 4,328 | 0.5 | 4,801 | 0.6 | 4,253 | 0.6 | 4,712 | 0.9 | 1,174 | 0.3 | ||||||||||||||||||||||||||||||
| Total loans and leases | $ | 936,608 | 100.0 | % | $ | 821,524 | 100.0 | % | $ | 757,002 | 100.0 | % | $ | 552,917 | 100.0 | % | $ | 403,875 | 100.0 | % | ||||||||||||||||||||
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Loan Portfolio Maturities
The following table summarizes the scheduled repayments of our loan portfolio and sets forth the scheduled repayments of fixed and adjustable rate loans in our portfolio at December 31, 2017.
| At December 31, 2017 | ||||||||||||||||
| After one | ||||||||||||||||
| (dollars in thousands) | One year or less | through five years | After five years | Total | ||||||||||||
| Real Estate | ||||||||||||||||
| Construction and land | $ | 38,571 | $ | 30,023 | $ | 5,804 | $ | 74,398 | ||||||||
| Residential - first lien | 42 | 3,608 | 191,246 | 194,896 | ||||||||||||
| Residential - junior lien | 247 | 848 | 41,952 | 43,047 | ||||||||||||
| Total residential real estate | 289 | 4,456 | 233,198 | 237,943 | ||||||||||||
| Commercial - owner occupied | 14,685 | 61,354 | 94,369 | 170,408 | ||||||||||||
| Commercial - non-owner occupied | 34,163 | 62,802 | 163,837 | 260,802 | ||||||||||||
| Total commercial real estate | 48,848 | 124,156 | 258,206 | 431,210 | ||||||||||||
| Total real estate loans | 87,708 | 158,635 | 497,208 | 743,551 | ||||||||||||
| Commercial loans and leases | 24,614 | 60,897 | 103,218 | 188,729 | ||||||||||||
| Consumer loans | 100 | 593 | 3,635 | 4,328 | ||||||||||||
| Total | $ | 112,422 | $ | 220,125 | $ | 604,061 | $ | 936,608 | ||||||||
| Rate terms: | ||||||||||||||||
| Fixed rate | $ | 69,415 | $ | 162,303 | $ | 323,326 | $ | 555,044 | ||||||||
| Adjustable rate | 43,007 | 57,822 | 280,735 | 381,564 | ||||||||||||
| Total | $ | 112,422 | $ | 220,125 | $ | 604,061 | $ | 936,608 | ||||||||
Loans Held for Sale
We sell the majority of residential mortgage loans originated by the Bank. Loans held for sale decreased $8.9 million to $42.2 million at December 31, 2017 from $51.1 million at December 31, 2016. Mortgage loan origination volumes continue to be strong, with $673.4 million in loans originated in 2017 compared to $599.3 million in 2016. The decrease in the level of loans held for sale at December 31, 2017 compared to the prior year was largely the result of the purchasers of the loans executing on the sales at a faster pace, so that we held the loans for a shorter period of time.
Deposits
We accept deposits primarily from the areas in which our branches and offices are located. We have consistently focused on building broader customer relationships and targeting small business customers to increase our core deposits. We also rely on our customer service to attract and retain deposits. We offer a variety of deposit accounts with a range of interest rates and terms. Customer deposits have historically provided us with a sizeable source of relatively stable and low-cost funds to support asset growth. Our deposit accounts consist of commercial and retail checking accounts, savings accounts, certificates of deposit, money market accounts, and individual retirement accounts. We do not currently accept brokered deposits other than those obtained under Promontory Interfinancial Network’s certificate of deposit account registry service program.
We review and update interest rates paid, maturity terms, service fees and withdrawal penalties on a periodic basis. Deposit rates and terms are based primarily on current operating strategies and market interest rates, liquidity requirements, anticipated short term loan demand and our deposit growth goals.
Our deposits increased from $808.7 million at December 31, 2016 to $863.9 million at December 31, 2017, an increase of $55.2 million or 6.8% for 2017, all of which is attributable to organic activities. Total demand deposits, the largest individual category of deposits growth, increased $44.4 million or 18.1%, comprised of noninterest-bearing demand deposits growth of $35.3 million and interest-bearing demand deposits growth of $9.1 million. Money market accounts increased $4.6 million or 1.9%, certificates of deposit increased $4.6 million or 1.8%, and savings accounts increased $1.6 million or 3.1%, comparing year-end 2017 levels to year-end 2016 levels.
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The following table sets forth the distribution of total deposit accounts, by account type, at the dates indicated.
| December 31, | ||||||||||||||||||||||||||||||||||||
| (dollars in thousands) | 2017 | 2016 | 2015 | |||||||||||||||||||||||||||||||||
| Weighted | Weighted | Weighted | ||||||||||||||||||||||||||||||||||
| % of | Average | % of | Average | % of | Average | |||||||||||||||||||||||||||||||
| Amount | Total | Rate | Amount | Total | Rate | Amount | Total | Rate | ||||||||||||||||||||||||||||
| Noninterest-bearing demand | $ | 218,139 | 26 | % | - | % | $ | 182,880 | 23 | % | - | % | $ | 173,689 | 23 | % | - | % | ||||||||||||||||||
| Interest-bearing checking | 71,642 | 8 | 0.25 | 62,538 | 8 | 0.23 | 54,014 | 7 | 0.21 | |||||||||||||||||||||||||||
| Money market accounts | 252,453 | 29 | 0.43 | 247,858 | 31 | 0.46 | 230,661 | 31 | 0.47 | |||||||||||||||||||||||||||
| Savings | 52,078 | 6 | 0.14 | 50,495 | 6 | 0.14 | 51,989 | 7 | 0.18 | |||||||||||||||||||||||||||
| Certificates of deposit | 269,596 | 31 | 1.05 | 264,963 | 32 | 0.87 | 237,055 | 32 | 0.75 | |||||||||||||||||||||||||||
| Total deposits | $ | 863,908 | 100 | % | 0.63 | % | $ | 808,734 | 100 | % | 0.57 | % | $ | 747,408 | 100 | % | 0.56 | % | ||||||||||||||||||
The following table sets forth the maturity of certificates of deposit of $100,000 and over at December 31, 2017.
| (in thousands) | ||||
| Three months or less | $ | 57,471 | ||
| Over three to six months | 55,658 | |||
| Over six to twelve months | 44,144 | |||
| Over twelve months | 40,488 | |||
| $ | 197,761 | |||
Borrowings
Customer deposits remain the primary source we utilize to meet funding needs, but we supplement this with short-term and long-term borrowings. Borrowings consist of overnight unsecured master notes, repurchase agreements, FHLB advances, and a junior subordinated debenture assumed in the Patapsco Bancorp acquisition. Repurchase agreements consist of overnight electronic sweep products that move customer excess funds from noninterest-bearing deposit accounts to an interest-bearing repurchase agreement, which is classified as a borrowing. Master notes similarly sweep funds from the Bank’s customer accounts to Howard Bancorp but do not require pledged collateral. Repurchase agreements sweep funds within the Bank and are secured primarily by pledges of U.S. Government Agency securities, based upon their fair value, as collateral for 100% of the principal and accrued interest of its repurchase agreements.
Patapsco Statutory Trust I, a Connecticut statutory business trust and an unconsolidated wholly-owned subsidiary of Howard Bancorp, issued $5 million of capital trust pass-through securities to investors. The interest rate currently adjusts on a quarterly basis at the rate of the three month LIBOR plus 1.48%. Patapsco Statutory Trust I purchased $5,155,000 of junior subordinated deferrable interest debentures from Patapsco Bancorp. The debentures are the sole asset of the Trust. Patapsco Bancorp also fully and unconditionally guaranteed the obligations of the Trust under the capital securities, which guarantee became an obligation of Howard Bancorp upon our acquisition of Patapsco Bancorp. The capital securities are redeemable by the Company at par. The capital securities must be redeemed upon final maturity of the subordinated debentures on December 31, 2035.
Our borrowings totaled $148.9 million at December 31, 2016 and $127.6 million at December 31, 2016. Short-term borrowings are summarized in the following table:
| December 31, | ||||||||||||||||||||||||
| 2017 | 2016 | 2015 | ||||||||||||||||||||||
| (dollars in thousands) | Amount | Rate | Amount | Rate | Amount | Rate | ||||||||||||||||||
| Securities Sold Under Agreement to Repurchase & Master Notes | ||||||||||||||||||||||||
| At period end | $ | 14,356 | 0.12 | % | $ | 11,390 | 0.13 | % | $ | 16,621 | 0.12 | % | ||||||||||||
| Average for the year | 13,460 | 0.13 | 13,626 | 0.13 | 19,434 | 0.12 | ||||||||||||||||||
| Maximum month-end balance | 16,563 | 21,764 | 23,694 | |||||||||||||||||||||
| Federal Funds Purchased and Short-term Borrowed Funds | ||||||||||||||||||||||||
| At period end | $ | 116,029 | 1.50 | % | $ | 95,666 | 1.26 | % | $ | 52,500 | 0.55 | % | ||||||||||||
| Average for the year | 75,053 | 1.14 | 49,831 | 1.16 | 27,459 | 0.47 | ||||||||||||||||||
| Maximum month-end balance | 116,029 | 95,666 | 52,500 | |||||||||||||||||||||
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Short-term borrowing totaled $130.4 million at December 31, 2017 and $107.1 million at December 31, 2016. Short-term borrowings at December 31, 2017, reflect an increase of $23.3 million or 21.8%. Short-term borrowings at December 31, 2017 consisted of repurchase agreements of $13.5 million, master notes totaling $817 thousand, and 15 short-term FHLB advances totaling $116.0 million.
Long-term borrowing totaled $18.5 million at December 31, 2017, consisting of one long-term fixed rate FHLB advance of $15.0 million and junior subordinated debt of $3.5 million.
Stockholders’ Equity
Total stockholders’ equity increased $46.5 million, or 54.2%, from $85.8 million at December 31, 2016 to $132.3 million at December 31, 2017. As previously disclosed, the increase in stockholders’ equity is primarily the result of the $38.4 million of net proceeds from our sale of 2,760,000 shares of common stock in an underwritten public offering that closed in the first quarter of 2017.
As a result of this offering, our capital position increased dramatically. Total stockholders’ equity at December 31, 2017 represents a capital to asset ratio of 11.53%, compared to 8.36% at December 31, 2016. Book value per share was $13.47 at December 31, 2017 compared to $12.27 at December 31, 2016. Leverage ratio, Tier1 risk-based capital ratio and total risk-based capital ratio were 11.70%, 12.77% and 13.72%, respectively, at December 31, 2017.
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Average Balance and Yields
The following tables set forth average balances, average yields and costs, and certain other information for the periods indicated. No tax-equivalent yield adjustments were made, as the effect thereof was not material. All average balances are daily average balances. Non-accrual loans were included in the computation of average balances, and have been reflected in the table as loans carrying a zero yield. The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income or expense.
| December 31, | ||||||||||||||||||||||||||||||||||||
| 2017 | 2016 | 2015 | ||||||||||||||||||||||||||||||||||
| Average | Income | Yield | Average | Income | Yield | Average | Income | Yield | ||||||||||||||||||||||||||||
| (dollars in thousands) | Balance | / Expense | / Rate | Balance | / Expense | / Rate | Balance | / Expense | / Rate | |||||||||||||||||||||||||||
| Earning assets | ||||||||||||||||||||||||||||||||||||
| Loans and leases: 1 | ||||||||||||||||||||||||||||||||||||
| Commercial loans and leases | $ | 177,167 | $ | 8,113 | 4.58 | % | $ | 159,230 | $ | 7,738 | 4.86 | % | $ | 142,697 | $ | 6,948 | 4.89 | % | ||||||||||||||||||
| Commercial real estate | 373,972 | 17,584 | 4.70 | 323,868 | 15,506 | 4.79 | 269,412 | 14,422 | 5.35 | |||||||||||||||||||||||||||
| Construction and land | 79,177 | 3,813 | 4.82 | 72,061 | 3,369 | 4.68 | 65,508 | 3,121 | 4.76 | |||||||||||||||||||||||||||
| Residential real estate | 234,429 | 10,151 | 4.33 | 225,054 | 9,536 | 4.24 | 144,743 | 6,382 | 4.41 | |||||||||||||||||||||||||||
| Consumer | 4,475 | 252 | 5.64 | 4,561 | 249 | 5.45 | 4,257 | 258 | 6.07 | |||||||||||||||||||||||||||
| Total loans and leases | 869,220 | 39,913 | 4.59 | 784,774 | 36,398 | 4.64 | 626,617 | 31,131 | 4.97 | |||||||||||||||||||||||||||
| Loans held for sale | 35,065 | 1,300 | 3.71 | 43,206 | 1,467 | 3.40 | 47,691 | 1,706 | 3.58 | |||||||||||||||||||||||||||
| Other earning assets 2 | 41,953 | 397 | 0.95 | 36,918 | 185 | 0.50 | 24,365 | 63 | 0.26 | |||||||||||||||||||||||||||
| Securities: 3 | ||||||||||||||||||||||||||||||||||||
| U.S. Treasury | 1,494 | 12 | 0.84 | 851 | 7 | 0.83 | 2,071 | 12 | 0.58 | |||||||||||||||||||||||||||
| U.S Gov agencies | 50,002 | 581 | 1.16 | 41,899 | 194 | 0.46 | 33,989 | 117 | 0.34 | |||||||||||||||||||||||||||
| Mortgage-backed | 1,439 | 38 | 2.63 | 213 | 6 | 2.86 | 1,275 | 3 | 0.26 | |||||||||||||||||||||||||||
| Corporate debentures | 8,750 | 541 | 6.18 | 4,386 | 288 | 6.57 | 3,000 | 180 | 6.00 | |||||||||||||||||||||||||||
| Other investments | 6,306 | 244 | 3.88 | 5,162 | 196 | 3.79 | 3,534 | 137 | 3.89 | |||||||||||||||||||||||||||
| Total securities | 67,991 | 1,416 | 2.08 | 52,511 | 691 | 1.32 | 43,869 | 449 | 1.02 | |||||||||||||||||||||||||||
| Total earning assets | 1,014,229 | 43,026 | 4.24 | 917,409 | 38,741 | 4.22 | 742,542 | 33,349 | 4.49 | |||||||||||||||||||||||||||
| Cash and due from banks | 8,903 | 7,529 | 7,342 | |||||||||||||||||||||||||||||||||
| Bank premises and equipment, net | 19,673 | 20,569 | 16,145 | |||||||||||||||||||||||||||||||||
| Other assets | 35,815 | 30,704 | 20,329 | |||||||||||||||||||||||||||||||||
| Less: allowance for credit losses | (5,677 | ) | (5,501 | ) | (3,917 | ) | ||||||||||||||||||||||||||||||
| Total assets | $ | 1,072,943 | $ | 970,710 | $ | 782,441 | ||||||||||||||||||||||||||||||
| Interest-bearing liabilities | ||||||||||||||||||||||||||||||||||||
| Deposits: | ||||||||||||||||||||||||||||||||||||
| Interest-bearing demand accounts | $ | 68,097 | 168 | 0.25 | % | $ | 57,846 | $ | 132 | 0.23 | % | $ | 48,465 | $ | 101 | 0.21 | % | |||||||||||||||||||
| Money market | 265,927 | 1,143 | 0.43 | 250,118 | 1,149 | 0.46 | 172,492 | 807 | 0.47 | |||||||||||||||||||||||||||
| Savings | 52,964 | 73 | 0.14 | 52,351 | 71 | 0.14 | 40,369 | 73 | 0.18 | |||||||||||||||||||||||||||
| Time deposits | 247,854 | 2,612 | 1.05 | 243,376 | 2,118 | 0.87 | 215,846 | 1,630 | 0.75 | |||||||||||||||||||||||||||
| Total interest-bearing deposits | 634,842 | 3,997 | 0.63 | 603,691 | 3,470 | 0.57 | 477,172 | 2,611 | 0.55 | |||||||||||||||||||||||||||
| Short-term borrowings | 88,513 | 876 | 0.99 | 63,457 | 595 | 0.94 | 47,893 | 154 | 0.32 | |||||||||||||||||||||||||||
| Long-term borrowings | 8,967 | 294 | 3.28 | 28,285 | 497 | 1.76 | 22,881 | 307 | 1.34 | |||||||||||||||||||||||||||
| Total interest-bearing funds | 732,322 | 5,167 | 0.71 | 695,433 | 4,562 | 0.66 | 547,946 | 3,072 | 0.56 | |||||||||||||||||||||||||||
| Noninterest-bearing deposits | 212,261 | 182,909 | 150,848 | |||||||||||||||||||||||||||||||||
| Other liabilities and accrued expenses | 4,597 | 6,147 | 7,505 | |||||||||||||||||||||||||||||||||
| Total liabilities | 949,180 | 884,489 | 706,299 | |||||||||||||||||||||||||||||||||
| Shareholders' equity | 123,763 | 86,221 | 76,142 | |||||||||||||||||||||||||||||||||
| Total liabilities & shareholders' equity | $ | 1,072,943 | $ | 970,710 | $ | 782,441 | ||||||||||||||||||||||||||||||
| Net interest rate spread 4 | $ | 37,859 | 3.54 | % | $ | 34,179 | 3.57 | % | $ | 30,277 | 3.93 | % | ||||||||||||||||||||||||
| Effect of noninterest-bearing funds | 0.20 | 0.16 | 0.15 | |||||||||||||||||||||||||||||||||
| Net interest margin on earning assets 5 | 3.73 | % | 3.73 | % | 4.08 | % | ||||||||||||||||||||||||||||||
| (1) | Loan fee income is included in the interest income calculation, and non-accrual loans are included in the average loan base upon which the interest rate earned on loans is calculated. |
| (2) | Includes Federal funds sold and interest-bearing deposits with banks. |
| (3) | Available for sale securities are presented at fair value, held to maturity securities are presented at amortized cost. |
| (4) | Net interest rate spread represents the difference between the yield on average interest-earning assets and the cost of average interest-bearing liabilities. |
| (5) | Net interest margin represents net interest income divided by average total interest-earning assets. |
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Rate/Volume Analysis
The following table presents the effects of changing rates and volumes on our net interest income for the periods indicated. 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 of the changes set forth in the rate and volume columns are presented in the total column.
| For the year ended December 31, | ||||||||||||||||||||||||
| 2017 vs. 2016 | 2016 vs. 2015 | |||||||||||||||||||||||
| Due to variances in | Due to variances in | |||||||||||||||||||||||
| (in thousands) | Total | Rates | Volumes 1 | Total | Rates | Volumes 1 | ||||||||||||||||||
| Interest earned on: | ||||||||||||||||||||||||
| Loans and leases: | ||||||||||||||||||||||||
| Commercial loans and leases | $ | 375 | $ | (334 | ) | $ | 709 | $ | 790 | $ | (47 | ) | $ | 837 | ||||||||||
| Commercial real estate | 2,078 | (208 | ) | 2,286 | 1,084 | (1,528 | ) | 2,612 | ||||||||||||||||
| Construction and land | 444 | 76 | 368 | 248 | (58 | ) | 306 | |||||||||||||||||
| Residential real estate | 615 | 157 | 458 | 3,154 | (249 | ) | 3,403 | |||||||||||||||||
| Consumer | 3 | 7 | (4 | ) | (9 | ) | (26 | ) | 17 | |||||||||||||||
| Loans held for sale | (167 | ) | 101 | (268 | ) | (239 | ) | (87 | ) | (152 | ) | |||||||||||||
| Securities | 725 | 301 | 424 | 242 | 129 | 113 | ||||||||||||||||||
| Other earning assets | 212 | 123 | 89 | 122 | 59 | 63 | ||||||||||||||||||
| Total interest income | 4,285 | 223 | 4,062 | 5,392 | (1,807 | ) | 7,199 | |||||||||||||||||
| Interest paid on: | ||||||||||||||||||||||||
| Savings deposits | 2 | 1 | 1 | (2 | ) | (18 | ) | 16 | ||||||||||||||||
| Interest bearing checking | 37 | 8 | 29 | 31 | 10 | 21 | ||||||||||||||||||
| Money market accounts | (6 | ) | (55 | ) | 49 | 342 | (15 | ) | 357 | |||||||||||||||
| Time deposits | 494 | 334 | 160 | 488 | 249 | 239 | ||||||||||||||||||
| Short-term borrowings | 281 | 25 | 256 | 441 | 296 | 145 | ||||||||||||||||||
| Long-term borrowings | (203 | ) | 323 | (526 | ) | 190 | 95 | 95 | ||||||||||||||||
| Total interest expense | 605 | 636 | (31 | ) | 1,490 | 617 | 873 | |||||||||||||||||
| Net interest earned | $ | 3,680 | $ | (413 | ) | $ | 4,093 | $ | 3,902 | $ | (2,424 | ) | $ | 6,326 | ||||||||||
(1) Change attributed to mix (rate and volume) are included in volume variance.
Comparison of Results of Operations
A comparison of the results of operations for the years ended December 31, 2017 and December 31, 2016 is presented below.
General
Net income available to common stockholders increased $2.1 million, or 40%, to $7.2 million for the year ended December 31, 2017 compared to $5.1 million for the year ended December 31, 2016. The increase in net income available to common stockholders was driven by increases of $3.7 million in net interest income and $4.7 million in noninterest income, partially offset by increases of $6.5 million in noninterest expense, of which nearly $600 thousand were merger-related expenses. Much of this revenue growth and the increased expenses are attributable to the balance sheet growth resulting from our continued strategic and organic growth initiatives.
Earnings per basic common share (“EPS”) for 2017 was $0.75 compared to $0.74 for 2016. Even though as noted above, net earnings for 2017 were 40.0% higher than for 2016, EPS only slightly increased primarily due to the larger number of average shares outstanding in 2017 compared to 2016 resulting from our February 2017 stock offering. Average shares outstanding increased by over 2.6 million or 37% when comparing 2017 to 2016. Also impacting earnings per share for 2017 was approximately $567 thousand in merger-related expenses associated with the pending merger with First Mariner. We estimate that these merger costs, net of taxes, reduced earnings per share by approximately $0.04 for 2017.
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Interest Income
Interest income increased $4.3 million, or 11.1%, to $43.0 million for the year ended December 31, 2017 compared to $38.7 million during the year ended December 31, 2016. The increase was primarily due to a $3.5 million, or 10.0%, increase in interest and fees on loans and leases (excluding loans held for sale), primarily as a result of an $84.4 million or 10.8% increase in the average balance of portfolio loans, partially offset by a modest five basis point decrease in the average yield on our portfolio loans and leases, which resulted from decreases in the average rates earned on our commercial loans and leases and, to a lesser extent, commercial real estate loans. Additionally, interest and dividends on investment securities increased $725 thousand and other interest income increased $212 thousand year over year as a result of increases in both the average balance and the average yield on these assets; the average yield on our securities portfolio increased 76 basis points and the average yield on our other interest earning assets increased 45 basis points year over year. Partially offsetting these increases was a decrease in income on loans held for sale of $167 thousand, or 11.4%, as a result of a decrease of $8.1 million in the average balance of our loans held for sale, partially offset by a 31 basis point increase in the average yield on our loans held for sale. Overall, the average yield on all interest earning assets during 2017 increased by 2 basis points compared to 2016.
Interest Expense
Interest expense increased $605 thousand, or 13.3%, to $5.2 million during the year ended December 31, 2017 from $4.6 million during the prior year. Interest expense on deposits increased by $527 thousand for 2017 compared to 2016, with $288 thousand of the increase resulting from increases in the average rates paid on interest-bearing deposits and $239 thousand of the increase resulting from the growth in the average balances of our interest-bearing deposits. These increase were driven primarily by the $4.5 million increase in the average balance of, and the 18 basis point increase in the rate paid on, our time deposits; we increased the interest rates on our time deposits in response to the prevailing competitive rates in the market. In addition, interest expense on borrowings increased $78 thousand in 2017 compared to 2016, primarily as a result of increases in the average balance of our short-term borrowings and in the average rate paid on our long-term borrowings, partially offset by a decrease in the average volume of our long-term borrowings. Average short-term borrowings increased by $25.1 million year over year while the average interest rate on these borrowings increased five basis points, and the average rate on long-term borrowings increased by 152 basis points as the average balance of our lower cost fixed rate long-term borrowings declined by $19.3 million, leaving only a small amount of higher cost long-term debt at the end of 2017.
Net Interest Income
Net interest income is our largest source of operating revenue. Net interest income is affected by various factors including changes in interest rates and the composition of interest-earning assets and interest-bearing liabilities and maturities. Net interest income is determined by the interest rate spread (i.e., the difference between the yields earned on interest-earning assets and the rates paid on interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities. Net interest income increased $3.7 million, or 10.8%, during the year ended December 31, 2017 compared to the year ended December 31, 2016. The increase in net interest income was primarily due to the increase in interest income driven by our continued balance sheet growth, as discussed above, while successfully controlling interest expense even with the sizable growth in deposits and borrowings year over year.
Provision for Credit Losses
We establish a provision for credit losses, which is a charge to earnings, in order to maintain the allowance for credit losses at a level we consider adequate to absorb credit losses incurred in the loan portfolio that are both probable and reasonably estimable at the balance sheet date. In determining the level of the allowance for credit losses, management considers past and current loss experience, evaluations of real estate collateral, current economic conditions, volume and type of lending, adverse situations that may affect a borrower’s ability to repay a loan and the levels of nonperforming loans. The amount of the allowance is based on estimates and actual losses may vary from such estimates as more information becomes available or economic conditions change. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as circumstances change or more information becomes available. The allowance for credit losses is assessed on at least a quarterly basis and provisions are made for credit losses as required in order to maintain the allowance.
Based on management’s evaluation of the above factors, we had a provision for credit losses of $1.8 million for 2017 compared to $2.0 million during 2016, a decrease of $206 thousand or 10.1%. The provision level for 2016 was impacted by the migration of acquired loans into our allowance for credit losses measurement process, as well as some specific provisions on individual loans. Thus, even though we continued to experience organic loan growth, the mix of specific and general provisions for the two years resulted in a provision for 2017 that was less than the provision in the prior year.
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Management analyzes the allowance for credit losses as described in the section entitled “Allowance for Credit Losses.” The provision that is recorded is sufficient, in management’s judgment, to bring the allowance for credit losses to a level that reflects the losses inherent in our loan portfolio relative to loan mix, economic conditions and historical loss experience. Management believes, to the best of its knowledge, that all known losses as of the balance sheet dates have been recorded. However, although management uses the best information available to make determinations with respect to the provisions for credit losses, additional provisions for credit losses may be required to be established in the future should economic or other conditions change substantially. In addition, as an integral part of their examination process, the Commissioner and the FDIC will periodically review the allowance for credit losses. The Commissioner and the FDIC may require us to recognize additions to the allowance based on their analysis of information available to them at the time of their examination.
Noninterest Income
Noninterest income was $19.5 million for the year ended December 31, 2017 compared to $14.8 million for the year ended December 31, 2016. The primary reason for the increase in noninterest income was our mortgage banking activities. As a result of the origination and subsequent sales of residential mortgage loans, realized and unrealized gains on the sale of loans produced approximately $11.0 million in noninterest revenues during 2017 compared to $8.1 million in 2016. Complementing the realized and unrealized gains on sale of mortgage loans was loan fee income derived from mortgage banking processing and underwriting as well as other portfolio loan fees. Loan fees realized in 2017 were $5.7 million compared to $3.9 million during 2016 as a result of both an increase in the number of loans originated and a higher fee structure during 2017 compared to 2016.
Partially offsetting these increases was a reduction in gain on the sale of portfolio loans, which for 2016 consisted of the sale of an acquired impaired loan that resulted in a gain of approximately $675 thousand. The $86 thousand net gain recorded in 2017 is comprised of a $222 thousand gain related to the sale of the guaranteed portion of small business loans held in our portfolio, partially offset by a $136 thousand loss on the sale of residential mortgages held in our portfolio that were carried at fair value. The gain recorded in 2016 benefited from a $652 thousand gain on the sale of an acquired impaired loan during the second quarter of 2016, partially offset by a $120 thousand loss on residential loans sold in the fourth quarter of 2016 that were classified as held for investment.
In 2016 we sold stock in a small financial institution, resulting in a gain of $96 thousand; there were no such securities sales in 2017.
Service charges on deposit accounts, which consist of account activity fees such as overdraft fees and other traditional banking fees, increased $229 thousand period over period, primarily as a result of increased overdraft fees resulting from the deposit growth we continue to experience
Earnings on bank owned life insurance (“BOLI”) increased $137 thousand during 2017 compared to 2016 as a result of the Bank purchasing an additional $6.5 million in BOLI early in 2017.
Other operating income, which consists mainly of non-depository account fees such as wire, merchant card and ATM services, increased $91 thousand in 2017 compared to 2016 due to increased transaction volumes resulting from our larger customer base.
Noninterest Expenses
Controlling costs and maintaining operational efficiencies remains a primary focus for us. A key performance measure is the overall efficiency ratio. The efficiency ratio is calculated by dividing noninterest expenses by the sum of net interest income and noninterest income. The efficiency ratio was 78.77% for the year ended December 31, 2017 compared to 79.01% for the year ended December 31, 2016. Noninterest expenses increased $6.5 million, or 16.8%, to $45.2 million for the year ended December 31, 2017 compared to $38.7 million for the year ended December 31, 2016.
Compensation and benefits expenses remain the largest component of noninterest expenses. Compensation and benefits expenses grew by $4.5 million or 23.9% for 2017 versus 2016. The primary driver of the increase in compensation and benefits was the expanded size of our staff, in particular, in our mortgage division, and, to a lesser extent, increased employee insurance cost, primarily health insurance. Insurance cost increased $462 thousand or 25.0% comparing 2017 with 2016.
Occupancy and equipment related costs decreased slightly, by $468 thousand, during 2017 compared to 2016. The Bank reevaluated its retail branch network and late in the second quarter of 2016 closed three locations, as digital banking use continues to increase and bank branch transaction levels at these locations had been decreasing. Further, in early 2016, we incurred approximately $500 thousand in costs to exit lease agreements related to the three closed locations, which increased occupancy costs for 2016 and for which there was no comparable expense in 2017. In late 2017 we opened a new Remington branch location in Baltimore City, Maryland and plan to consolidate our Hampden location into Remington in the first quarter 2018. Additionally, in early 2018 we plan to open our new Columbia branch in Howard County, Maryland. As a result, we expect occupancy and equipment expenses to be slightly higher in 2018 than they were in 2017.
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As we have continued to grow, many of our noninterest expenses have increased to support our expanding infrastructure, growth initiatives and enhanced delivery strategies. Cost increases related to this expansion year over year include: marketing and business development - $856 thousand driven by mortgage-related marketing and business development expenses increases; data processing - $315 thousand relating to normal service provider increases; and merger related expense - $567 thousand as the result of activities related to the First Mariner acquisition.
Loan production expense, which includes costs related to originating, closing and securitizing loans, including both loans placed in our portfolio and loans held for sale, increased $727 thousand to $3.7 million in 2017 from $3.0 million during 2016 as a result of the increased number of loans originated, both for sale and to retain in our portfolio, during 2017 compared to 2016.
Other real estate owned (“OREO”) expenses increased $558 thousand, to $655 thousand during 2017 from $97 thousand in 2016. This increase was primarily driven by valuation adjustments of $581 thousand on OREO properties upon receipt of updated appraisals. We have contracts for the sale of two OREO properties that we expect, upon closing, to reduce our OREO by $1 million, which would represent a 68% reduction from 2017 OREO levels. We anticipate that these two sales will occur in the second quarter of 2018.
Other operating expenses consist mainly of a variety of general expenses such as telephone and data lines, supplies and postage and courier services. In aggregate, these expenses decreased slightly, by $170 thousand, year over year. Supporting our expanding infrastructure increased licensing cost by $202 thousand. This increase was offset by decreases resulting from our eliminating redundancies and controlling costs during 2017, which resulted in year over year decreases of $26 thousand in materials and supplies, $94 thousand in phone and data lines and $22 thousand in bank security and armored carrier services. Additionally, as core deposit intangibles continue to amortize, expenses related to this amortization decreased $149 thousand year over year.
Income Tax Expense
Taking into consideration the above-stated changes in net interest income, the provision for credit losses, and our noninterest income and noninterest expense levels, pretax income increased by $2.1 million from $8.2 million in 2016 to $10.4 million in 2017.
Income tax expense amounted to $3.2 million for year ended December 31, 2017 and $2.9 million for year ended December 31, 2016. The effective tax rate is influenced by sources of non-taxable income, such as the income from our BOLI program, and also by certain non-deductible expense items. Certain merger and acquisition costs are deemed not deductible for income tax purposes, which increased the effective tax rate for 2017. Income tax expense for 2017 was impacted by the adjustment of our deferred tax assets and liabilities related to the reduction in the U.S. federal statutory income tax rate to 21% under the Tax Cuts and Jobs Act, which was enacted on December 22, 2017. As a result of the new law, which is more fully discussed below, we recognized net tax expense of $215 thousand. Income tax expense for 2017 was also impacted by a correction of an overstatement of taxes that resulted from incorrectly classifying certain acquired loan fair value adjustments on purchased credit impaired loans. As a result we recognized tax benefits totaling $622 thousand related to the 2015 through 2016 tax years, as detailed in the table in Note 13 to the Consolidated Financial Statements, “Income Taxes.” As a result of these effects, our effective tax rate decreased to 30.4% for 2017 from 35.6% for 2016.
Tax Cuts and Jobs Act. The Tax Cuts and Jobs Act was enacted on December 22, 2017. Among other things, the new law (i) establishes a reduced, flat corporate federal statutory income tax rate of 21%, (ii) eliminates the corporate alternative minimum tax and allows the use of any tax net operating loss carryforwards to offset regular tax liability for any taxable year, (iii) limits the deduction for net interest expense incurred by U.S. corporations, (iv) allows businesses to immediately expense, for tax purposes, the cost of new investments in certain qualified depreciable assets, (v) eliminates or reduces certain deductions related to meals and entertainment expenses, (vi) modifies the limitation on excessive employee remuneration to eliminate the exception for performance-based compensation and clarifies the definition of a covered employee and (vii) limits the deductibility of deposit insurance premiums. The Tax Cuts and Jobs Act also significantly changes U.S. tax law related to foreign operations, however, such changes do not currently impact us.
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A comparison of the results of operations for the years ended December 31, 2016 and December 31, 2015 is presented below.
General
Net income available to common stockholders increased $4.1 million, to $5.1 million for the year ended December 31, 2016 compared to $1.0 million for the year ended December 31, 2015. The increase in net income available to common stockholders was driven by increases of $5.3 million in interest income and $2.9 million in noninterest income, partially offset by increases of $1.5 million in interest expense, $201 thousand in the provision for credit losses and $432 thousand in noninterest expense. Much of this revenue growth and the increased expenses are attributable to the balance sheet growth resulting from our continued strategic and organic growth initiatives. For 2016, the dividends paid on preferred stock totaled $166 thousand compared to $126 thousand for 2015.
Interest Income
Interest income increased $5.4 million, or 16.2%, to $38.7 million for the year ended December 31, 2016 compared to $33.3 million during the year ended December 31, 2015. The increase was almost entirely due to a $5.0 million, or 15.3%, increase in interest and fees on loans and leases (including loans held for sale). The increase in interest and fees on loans and leases was a result of an increase of $158.2 million in average loans outstanding for 2016 versus 2015, largely attributable to the loans we acquired in the Patapsco Bancorp acquisition, partially offset by a decrease in the average yield on such loans. The average yield on loans and leases decreased to 4.64% from 4.97% year over year and the average yield on loans held for sale decreased to 3.40% from 3.58%, reflective of competitive conditions with respect to loan pricing that required us to lower our interest rates on loans. Commercial real estate loans reflected the largest decline in yield and was impacted by our large growth in this category with much of the growth recorded at reduced interest rates given the highly competitive pricing in our marketplace. In addition, interest income earned on investment securities increased $242 thousand as the average yield on investment securities increased to 1.32% from 1.02%, primarily as a result of changes in the portfolio mix. In addition, other interest income increased $122 thousand to $185 thousand during the year ended December 31, 2016 compared to $63 thousand during the prior year. This increase was a result of increases in both the average balance and average yield on other earning assets, which increased $12.6 million and 24 basis points, respectively, year over year. The average balance increase was a result of the Bank’s $19.5 million investment in interest bearing certificates of deposit at other financial institutions.
Interest Expense
Interest expense increased $1.5 million, or 48.5%, to $4.6 million during the year ended December 31, 2016 from $3.1 million during the prior year. Interest expense on deposits increased $859 thousand or 32.9% as a result of the $126.5 million or 26.5% increase in average interest-bearing deposits we experienced, largely attributable to the deposits we acquired in the Patapsco Bancorp acquisition. Overall, the average rate paid on our interest-bearing deposits remained relatively unchanged year over year. Average money market balances grew 45.0%, while the average rate on these deposits decreased slightly in 2016.
Interest expense on borrowings increased $631 thousand comparing 2016 to 2015, as a result of increases in both the average volume of and average rate on our borrowings. There were two main reasons for these increases. The first was an increase in the average balance of and average rate on our long-term borrowings resulting from the $3.4 million of debt we assumed in the Patapsco Bancorp acquisition and increases in FHLB advances. The second was the increase in the average balance of and the average rate paid on our short-term borrowings resulting from the $12.6 million variable rate debt we incurred to fund the redemption of our outstanding preferred stock as discussed above. It is important to note that while our Series AA Preferred Stock was outstanding we were paying a dividend on the stock, which was not a component of interest expense, while the additional $12.6 million in borrowings used to redeem the preferred stock has associated interest payments, and therefore was a component of interest expense during 2016.
Net Interest Income
Net interest income increased $3.9 million, or 12.9%, during the year ended December 31, 2016 compared to the year ended December 31, 2015. The increase in net interest income was primarily due to an increase in interest income driven by our continued balance sheet growth, while controlling interest expense even with the sizable growth in deposits and borrowings.
Provision for Credit Losses
Based on management’s evaluation of the relevant factors, as discussed above, we had a provision for credit losses of $2.0 million for 2016 compared to $1.8 million during 2015, an increase of $201 thousand or 11%. The increased provision for credit losses during 2016 resulted primarily from the 9% growth of our loan portfolio and also included the migration of acquired loans from previous years into our allowance for credit loss measurements. The provision for 2016 reflects general provisions on loans that are collectively evaluated given the continued growth in the size of our loan portfolio, as well as any specific provisions required on loans that are individually evaluated and deemed to be impaired.
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Noninterest Income
Noninterest income was $14.8 million for the year ended December 31, 2016 compared to $11.9 million for the year ended December 31, 2015. The primary reason for the increase in noninterest income was our mortgage banking activity. As a result of the origination and subsequent sales of residential mortgage loans, realized and unrealized gains on the sale of loans produced approximately $8.1 million in noninterest revenues for 2016 compared to $7.0 million in 2015. Complementing the realized and unrealized gains on sale of mortgage loans was loan fee income derived from mortgage banking processing and underwriting as well as other portfolio loan fees. The loan fees realized in 2016 were $3.9 million compared to $2.9 million for 2015 given both the increase in the number of loans originated and a higher fee structure for 2016 versus 2015.
In addition, the Bank benefited from a $652 thousand gain on the sale of an acquired impaired loan during the second quarter of 2016, partially offset by a $120 thousand loss on residential loans sold in the fourth quarter of 2016 that were classified as held for investment. Howard Bancorp had held stock in a small financial institution that we sold, resulting in a gain of $96 thousand, in 2016. In the second quarter the Bank closed three branch locations, two of which were previously acquired in acquisitions. Related to these closings the Bank recorded a $70 thousand loss on the disposal of furniture and equipment. In the fourth quarter of 2016 the Bank recorded a loss of $14 thousand on the sale of one property that was held in OREO compared to a loss of $8 thousand in 2015. Net gain on sales of loans other than loans held for sale totaled $623 thousand in 2016; there were no sales of loans other than loans held for sale in 2015.
Service charges on deposit accounts decreased $79 thousand during 2016. This decrease was partially a result of lower overdraft fee income.
Further, earnings on BOLI increased $215 thousand during 2016 compared to 2015 as a result of the Bank purchasing an additional $2.2 million in BOLI in January 2016 and the full year of earnings on the BOLI acquired in the Patapsco Bancorp acquisition.
Other operating income increased $116 thousand in 2016 compared to the same period of 2015 due to increased transaction volumes resulting from our larger customer base.
Noninterest Expenses
The efficiency ratio was 79.01% for the year ended December 31, 2016 compared with 90.64% for the year ended December 31, 2015, which decrease was primarily the result of the 2015 figure including costs related to the Patapsco Bancorp acquisition. Noninterest expenses remained relatively stable, increasing $432 thousand, or 1.1%, to $38.7 million for the year ended December 31, 2016 compared to $38.3 million for the year ended December 31, 2015. While the Patapsco Bancorp merger costs accounted for $ 4.3 million of 2015 expenses, the integration and operation of the acquired business was the primary driver of increased operating expenses for 2016.
Compensation and benefits expenses remain the largest component of noninterest expenses. Compensation and benefits expenses grew by $1.8 million or 10.7% for 2016 versus 2015. The increased compensation and benefit costs are attributed to a full year of operation with the branches and staff acquired in the Patapsco Bancorp acquisition, compared to four months of 2015, signing incentives and onboarding costs related to our successfully attracting a sizable commercial loan origination team, as well as a higher level of expenses associated with our mortgage banking activities throughout 2016.
Occupancy and equipment related costs increased by $806 thousand during 2016 compared to 2015, primarily as a result of the $500,000 in costs to exit lease agreements related to our closure of three branch locations in the second quarter of 2016.
Continued growth initiatives and the implementation of new products continued to result in increases in many of our noninterest expenses during 2016. Cost increases related to this expansion year over year include: marketing and business development - $514 thousand; professional fees - $633 thousand; data processing - $370 thousand; and FDIC assessment - $327 thousand.
Loan production expense increased $793 thousand to $3.0 million during 2016 as a result of the increased number of loans originated during 2016 compared to 2015.
We recorded a valuation write-down of $83 thousand on one OREO property in 2016 while in 2015 we had $736 thousand in similar write-downs related to three OREO properties.
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Other operating expenses in aggregate, these expenses decreased slightly, by $45 thousand, year over year. Supporting our expanding infrastructure increased insurance cost by $135 thousand, customer service expenses by $191 thousand and other operating expenses by $13 thousand. These increases were offset by decreases in other operating expenses resulting from our eliminating redundancies and controlling costs during 2016, which reduced materials and supplies by $169 thousand, postage by $48 thousand, phone and data lines by $8 thousand, bank security and armored carrier by $43 thousand and software licenses and maintenance by $56 thousand.
Nonperforming and Problem Assets
Management performs reviews of all delinquent loans and our loan officers contact customers to attempt to resolve potential credit issues in a timely manner. When in the best interests of Howard Bank and the customer, we will enter into a troubled debt restructuring with respect to a particular loan. When not possible, we seek to aggressively move loans through the legal and foreclosure process within applicable legal constraints.
Loans are placed on non-accrual status when payment of principal or interest is 90 days or more past due and the value of the collateral securing the loan, if any, is less than the outstanding balance of the loan. Loans are also placed on non-accrual status if management has serious doubt about further collectability of principal or interest on the loan, even though the loan is currently performing. When loans are placed on a non-accrual status, unpaid accrued interest is fully reversed, and further income, if any, is recognized only to the extent received. The loan may be returned to accrual status if the loan is brought current, has performed in accordance with the contractual terms for a reasonable period of time and ultimate collectability of the total contractual principal and interest is no longer in doubt.
The table below sets forth the amounts and categories of our nonperforming assets, which consist of non-accrual loans, troubled debt restructurings and OREO (which includes real estate acquired through, or in lieu of, foreclosure), at the dates indicated.
| December 31, | ||||||||||||||||||||
| (in thousands) | 2017 | 2016 | 2015 | 2014 | 2013 | |||||||||||||||
| Non-accrual loans: | ||||||||||||||||||||
| Real estate loans: | ||||||||||||||||||||
| Construction and land | $ | 637 | $ | - | $ | - | $ | 1,144 | $ | - | ||||||||||
| Residential - first lien | 1,722 | 491 | 693 | 719 | 331 | |||||||||||||||
| Residential - junior lien | 396 | 37 | 63 | 57 | - | |||||||||||||||
| Commercial | 6,375 | 1,584 | 1,148 | - | 258 | |||||||||||||||
| Commercial and leases | 3,438 | 4,624 | 5,935 | 2,015 | 2,593 | |||||||||||||||
| Consumer | - | 167 | 150 | 92 | - | |||||||||||||||
| Total non-accrual loans | 12,568 | 6,903 | 7,989 | 4,027 | 3,182 | |||||||||||||||
| Accruing troubled debt restructured loans: | ||||||||||||||||||||
| Real estate loans: | ||||||||||||||||||||
| Construction and land | 125 | 125 | - | - | - | |||||||||||||||
| Residential - first lien | 287 | 294 | 301 | - | - | |||||||||||||||
| Commercial | - | 2,073 | 2,073 | 226 | - | |||||||||||||||
| Commercial and leases | 208 | 183 | 7 | - | - | |||||||||||||||
| Total accruing troubled debt restructured loans | 620 | 2,675 | 2,381 | 226 | - | |||||||||||||||
| Total non-performing loans | 13,188 | 9,578 | 10,370 | 4,253 | 3,182 | |||||||||||||||
| Other real estate owned: | ||||||||||||||||||||
| Land | 956 | 1,220 | 964 | 595 | 595 | |||||||||||||||
| Commercial | 593 | 1,130 | 1,405 | 1,877 | 1,782 | |||||||||||||||
| Total other real estate owned | 1,549 | 2,350 | 2,369 | 2,472 | 2,377 | |||||||||||||||
| Total non-performing assets | $ | 14,737 | $ | 11,928 | $ | 12,739 | $ | 6,725 | $ | 5,559 | ||||||||||
| Ratios: | ||||||||||||||||||||
| Non-performing loans to total gross loans | 1.41 | % | 1.17 | % | 1.37 | % | 0.77 | % | 0.79 | % | ||||||||||
| Non-performing assets to total assets | 1.28 | % | 1.16 | % | 1.35 | % | 0.97 | % | 1.11 | % | ||||||||||
| Loans past due 90 days still accruing: | ||||||||||||||||||||
| Real estate loans: | ||||||||||||||||||||
| Construction and land | $ | - | $ | 1 | $ | 15 | $ | 278 | $ | - | ||||||||||
| Residential - first lien | 328 | 298 | 941 | 158 | - | |||||||||||||||
| Residential - junior lien | 50 | - | 30 | - | - | |||||||||||||||
| Commercial | 3,094 | 2,703 | 681 | 150 | 159 | |||||||||||||||
| Commercial and leases | - | - | 147 | 571 | 296 | |||||||||||||||
| Consumer | - | 1 | 2 | - | - | |||||||||||||||
| $ | 3,472 | $ | 3,003 | $ | 1,816 | $ | 1,157 | $ | 455 | |||||||||||
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Included in total non-accrual loans at December 31, 2017 shown above are seven troubled debt restructured loans (“TDRs”) totaling $4.7 million that were not performing in accordance with their modified terms, and the accrual of interest has ceased. Four of these loans were added to the non-accruing TDRs in 2017 - three residential real estate loans, two first lien loans totaling $886 thousand and a junior lien loan in the amount of $398 thousand, and a commercial loan in the amount of $85 thousand. We had one commercial real estate credit for $2.2 million that was downgraded from performing to non-performing in the second quarter of 2017. Further, there were three TDRs totaling $620 thousand performing subject to their modified terms at December 31, 2017, two of which were restructured as TDRs in 2017.
Under GAAP we are required to account for certain loan modifications or restructurings as TDRs. In general, the modification or restructuring of a debt constitutes a TDR if Howard Bank, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession, such as a reduction in the effective interest rate, to the borrower that we would not otherwise consider. However, all debt restructurings or loan modifications for a borrower do not necessarily constitute troubled debt restructurings.
Interest income that would have been recorded during the years ended December 31, 2017, 2016 and 2015 if the non-accrual loans had been current and in accordance with their original terms was $461 thousand, $317 thousand and $198 thousand, respectively. No interest income was recorded on such loans during these periods.
Nonperforming assets amounted to $14.7 million or 1.28% of total assets at December 31, 2017 compared to $11.9 million or 1.16% of total assets at December 31, 2016 and $12.7 million or 1.35% of total assets at December 31, 2015. Total nonperforming assets increased $2.8 million during 2017.
The composition of our nonperforming loans is further described below:
Non-Accrual Loans:
| · | 11 residential first lien loans totaling $1.7 million. |
| · | Two residential junior lien loans totaling $396 thousand, one with a specific reserve of $30 thousand. |
| · | Two commercial owner occupied loans totaling $508 thousand. |
| · | Eight commercial non-owner occupied loans totaling $5.9 million, one with a specific reserve of $11 thousand and five of which represent two relationships. |
| · | 31 commercial loans totaling $3.4 million, five with a Small Business Administration (“SBA”) guarantee and 14 that include specific reserves totaling $668 thousand. |
| · | One construction and land loan for $637 thousand with a specific reserve of $202 thousand. |
Accruing Troubled Debt Restructured Loans:
| · | One construction and land loan in the amount of $125 thousand. |
| · | One residential real estate loan in the amount of $287 thousand. |
| · | One commercial loan in the amount of $208 thousand. |
Other Real Estate Owned
Real estate we acquire as a result of foreclosure is classified as OREO. When a property is acquired it is recorded fair value less the anticipated cost to sell at the date of foreclosure. If there is a subsequent decline in the value of real estate owned, we provide an additional allowance to reduce real estate acquired through foreclosure to its fair value less estimated disposal costs. Costs relating to holding such real estate are charged against income in the current period while costs relating to improving such real estate are capitalized until a saleable condition is reached up to the property’s net realizable value, then such costs would be charged against income in the current period.
OREO at December 31, 2017 consisted of:
| · | Several parcels of unimproved land in Baltimore County, Maryland. |
| · | One commercial building in Sussex County, Delaware. |
| · | Several lots of non-residential property in Anne Arundel County, Maryland. |
| · | Three parcels of land in Howard County, Maryland. |
We had OREO of $1.5 million at December 31, 2017 and $2.4 million at December 31, 2016 and 2015. Included in noninterest expenses were $581 thousand, $83 thousand and $736 thousand valuation allowances recorded for 2017, 2016 and 2015, respectively, as the current appraised value of OREO properties, less estimated cost to sell, was insufficient to cover the recorded OREO amount.
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Additionally, cost relating to OREO recorded in noninterest expenses were $87 thousand, $94 thousand and $75 thousand for 2017, 2016 and 2015, respectively.
Classification of Loans
Our policies, consistent with regulatory guidelines, provide for the classification of loans and other assets that are considered to be of lesser quality as Substandard, Doubtful, or Loss assets. An asset is considered Substandard if it is inadequately protected by the current net worth and paying capacity of the obligor or by the collateral pledged, if any. Substandard assets include those assets characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected. Assets classified as Doubtful have all of the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable or improbable. Assets (or portions of assets) classified as Loss are those considered uncollectible and of such little value that their continuance as assets is not warranted. Assets that do not expose us to risk sufficient to warrant classification in one of the aforementioned categories, but which possess potential weaknesses that deserve our close attention, are required to be designated as Special Mention.
We maintain an allowance for credit losses at an amount estimated to equal all credit losses incurred in our loan portfolio that are both probable and reasonable to estimate at a balance sheet date. Our determination as to the classification of our assets is subject to review by the Commissioner and the FDIC. We regularly review our asset portfolio to determine whether any assets require classification in accordance with applicable regulations.
The following table sets forth our amounts of classified loans and criticized loans (classified loans and loans designated as Special Mention) at the dates indicated.
| December 31, | ||||||||||||
| (in thousands) | 2017 | 2016 | 2015 | |||||||||
| Classified loans: | ||||||||||||
| Substandard | $ | 6,779 | $ | 3,734 | $ | 3,009 | ||||||
| Doubtful | 6,310 | 6,903 | 6,496 | |||||||||
| Total classified loans | 13,089 | 10,637 | 9,505 | |||||||||
| Special mention | 1,592 | 524 | 614 | |||||||||
| Total criticized loans | $ | 14,681 | $ | 11,161 | $ | 10,119 | ||||||
Allowance for Credit Losses
We provide for credit losses based upon the consistent application of our documented allowance for credit loss methodology. All credit losses are charged to the allowance for credit losses and all recoveries are credited to it. Additions to the allowance for credit losses are provided by charges to income based on various factors that, in our judgment, deserve current recognition in estimating probable losses. We regularly review the loan portfolio and make provisions for credit losses in order to maintain the allowance for credit losses in accordance with GAAP. The allowance for credit losses consists primarily of two components:
| 1) | Specific allowances are established for loans classified as impaired. For loans classified as impaired, the allowance is established when the net realizable value (collateral value less costs to sell) of the impaired loan is lower than the carrying amount of the loan. The amount of impairment provided for as a specific allowance is represented by the deficiency, if any, between the underlying collateral value and the carrying value of the loan. Impaired loans for which the estimated fair value of the loan, or the loan’s observable market price or the fair value of the underlying collateral, if the loan is collateral dependent, exceeds the carrying value of the loan are not considered in establishing specific allowances for credit losses; and |
| 2) | General allowances established for credit losses on a portfolio basis for loans that do not meet the definition of impaired loans. The portfolio is grouped into similar risk characteristics, primarily loan type and regulatory classification. We apply an estimated loss rate to each loan group. The loss rates applied are based upon our loss experience adjusted, as appropriate, for the qualitative factors discussed below. This evaluation is inherently subjective, as it requires material estimates that may be susceptible to significant revisions based upon changes in economic and real estate market conditions. |
The allowance for credit losses is maintained at a level to provide for losses that are probable and can be reasonably estimated. Management’s periodic evaluation of the adequacy of the allowance is based on Howard Bank’s past credit loss experience, known and inherent losses in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant change, including the amounts and timing of future cash flows expected to be received on impaired loans.
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A loan is considered past due or delinquent when a contractual payment is not paid on the day it is due. A loan is considered impaired when, based on current information and events, it is probable that Howard Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. The impairment of a loan may be measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if repayment is expected to be provided by the collateral. Generally, Howard Bank’s impairment on such loans is measured by reference to the fair value of the collateral. Interest income on impaired loans is recognized on the cash basis.
Our loan policies state that after all collection efforts have been exhausted, and the loan is deemed to be a loss, then the remaining loan balance will be charged to the established allowance for credit losses. All loans are evaluated for loss potential once it has been determined by our Watch Committee that the likelihood of repayment is in doubt. When a loan is past due for at least 90 days or a deterioration in debt service coverage ratio, guarantor liquidity, or loan-to-value ratio has occurred that would cause concern regarding the likelihood of the full repayment of principal and interest, and the loan is deemed not to be well secured, the loan should be moved to non-accrual status and a specific reserve is established if the net realizable value is less than the principal value of the loan balance(s). Once the actual loss value has been determined a charge-off against the allowance for credit losses for the amount of the loss is taken. Each loss is evaluated on its specific facts regarding the appropriate timing to recognize the loss.
The adjustments to historical loss experience are based on our evaluation of several qualitative factors, including:
| · | changes in lending policies, procedures, practices or personnel; |
| · | changes in the level and composition of construction portfolio and related risks; |
| · | changes and migration of classified assets; |
| · | changes in exposure to subordinate collateral lien positions; |
| · | levels and composition of existing guarantees on loans by SBA or other agencies; |
| · | changes in national, state and local economic trends and business conditions; |
| · | changes and trends in levels of loan payment delinquencies; and |
| · | any other factors that management considers relevant to the quality or performance of the loan portfolio. |
We evaluate the allowance for credit losses based upon the combined total of the specific and general components. Generally, when the loan portfolio increases, absent other factors, the allowance for credit loss methodology results in a higher dollar amount of estimated probable losses than would be the case without the increase. Generally, when the loan portfolio decreases, absent other factors, the allowance for credit loss methodology results in a lower dollar amount of estimated probable losses than would be the case without the decrease.
Commercial and commercial real estate loans generally have greater credit risks compared to the one- to four-family residential mortgage loans we originate, as they typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. In addition, the payment experience on loans secured by income-producing properties typically depends on the successful operation of the related business and thus may be subject to a greater extent to adverse conditions in the real estate market and in the general economy. Actual credit losses may be significantly more than the allowance for credit losses we have established, which could have a material negative effect on our financial results.
Generally, we underwrite commercial loans based on cash flow and business history and receive personal guarantees from the borrowers where appropriate. We generally underwrite commercial real estate loans and residential real estate loans at a loan-to-value ratio of 85% or less at origination. Accordingly, in the event that a loan becomes past due and, randomly with respect to performing loans, we will conduct visual inspections of collateral properties and/or review publicly available information, such as online databases, to ascertain property values. We will also obtain formal appraisals on a regular basis even if we are not considering liquidation of the property to repay a loan. It is our practice to obtain updated appraisals if there is a material change in market conditions or if we become aware of new or additional facts that indicate a potential material reduction in the value of any individual property collateral.
For impaired loans, we utilize the appraised value in determining the appropriate specific allowance for credit losses attributable to a loan. In addition, changes in the appraised value of multiple properties securing our loans may result in an increase or decrease in our general allowance for credit losses as an adjustment to our historical loss experience due to qualitative and environmental factors, as described above.
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As of December 31, 2017 and 2016, nonperforming loans amounted to $13.2 million and $9.6 million, respectively. The amount of nonperforming loans requiring specific reserves totaled $6.4 million and $3.8 million, respectively, and the amount of nonperforming loans with no specific valuation allowance totaled $6.8 million and $5.8 million, respectively, at December 31, 2017 and December 31, 2016.
Nonperforming loans are evaluated and valued at the time the loan is identified as impaired on a case by case basis, at the lower of cost or market value. Market value is measured based on the value of the collateral securing the loan. The value of real estate collateral is determined based on an appraisal by qualified licensed appraisers hired by us. Appraised values may be discounted based on management’s historical experience, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and the client’s business. The difference between the appraised value and the principal balance of the loan will determine the specific allowance valuation required for the loan, if any. Nonperforming loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly.
We evaluate the loan portfolio on at least a quarterly basis, more frequently if conditions warrant, and the allowance is adjusted accordingly. While we use the best information available to make evaluations, future adjustments to the allowance may be necessary if conditions differ substantially from the information used in making the evaluations. In addition, as an integral part of their examination process, the Commissioner and the FDIC will periodically review the allowance for credit losses. The Commissioner and the FDIC may require us to recognize additions to the allowance based on their analysis of information available to them at the time of their examination.
The following table sets forth activity in our allowance for credit losses for the twelve months ended:
| December 31, | ||||||||||||||||||||
| (in thousands) | 2017 | 2016 | 2015 | 2014 | 2013 | |||||||||||||||
| Balance at beginning of year | $ | 6,428 | $ | 4,869 | $ | 3,602 | $ | 2,506 | $ | 2,764 | ||||||||||
| Charge-offs: | ||||||||||||||||||||
| Real estate | ||||||||||||||||||||
| Construction and land loans | (155 | ) | (216 | ) | - | - | - | |||||||||||||
| Residential first lien loans | (133 | ) | - | (23 | ) | - | (183 | ) | ||||||||||||
| Residential junior lien loans | (31 | ) | - | (12 | ) | - | - | |||||||||||||
| Commercial owner occupied loans | (235 | ) | (191 | ) | - | - | - | |||||||||||||
| Commercial non-owner occupied loans | - | - | (82 | ) | (160 | ) | (375 | ) | ||||||||||||
| Commercial loans and leases | (1,605 | ) | (234 | ) | (825 | ) | (2,054 | ) | (759 | ) | ||||||||||
| Consumer loans | (108 | ) | (20 | ) | (5 | ) | (5 | ) | - | |||||||||||
| (2,267 | ) | (661 | ) | (947 | ) | (2,219 | ) | (1,317 | ) | |||||||||||
| Recoveries: | ||||||||||||||||||||
| Real estate | ||||||||||||||||||||
| Construction and land loans | 6 | - | - | - | - | |||||||||||||||
| Residential first lien loans | - | - | 3 | 1 | - | |||||||||||||||
| Residential junior lien loans | 1 | - | 1 | - | - | |||||||||||||||
| Commercial owner occupied loans | 6 | 40 | - | - | - | |||||||||||||||
| Commercial non-owner occupied loans | 6 | 5 | 318 | 4 | 29 | |||||||||||||||
| Commercial loans and leases | 113 | 101 | 52 | 55 | 80 | |||||||||||||||
| Consumer loans | 35 | 37 | 4 | - | - | |||||||||||||||
| 167 | 183 | 378 | 60 | 109 | ||||||||||||||||
| Net charge-offs | (2,100 | ) | (478 | ) | (569 | ) | (2,159 | ) | (1,208 | ) | ||||||||||
| Provision for credit losses | 1,831 | 2,037 | 1,836 | 3,255 | 950 | |||||||||||||||
| Balance at end of year | $ | 6,159 | $ | 6,428 | $ | 4,869 | $ | 3,602 | $ | 2,506 | ||||||||||
| Net charge-offs to average loans and leases | 0.24 | % | 0.06 | % | 0.09 | % | 0.48 | % | 0.34 | % | ||||||||||
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Allocation of Allowance for Credit Losses
The following tables set forth the allowance for credit losses allocated by loan category and the percent of loans in each category to total loans at the dates indicated. The allowance for credit losses allocated to each category is not necessarily indicative of future losses in any particular category and does not restrict the use of the allowance to absorb losses in other categories.
| December 31, | ||||||||||||||||||||||||||||||||||||||||
| 2017 | 2016 | 2015 | 2014 | 2013 | ||||||||||||||||||||||||||||||||||||
| (dollars in thousands) | Amount | Percent 1 | Amount | Percent 1 | Amount | Percent 1 | Amount | Percent 1 | Amount | Percent 1 | ||||||||||||||||||||||||||||||
| Real estate | ||||||||||||||||||||||||||||||||||||||||
| Construction and land loans | $ | 735 | 7.9 | % | $ | 511 | 8.9 | % | $ | 265 | 9.1 | % | $ | 174 | 11.6 | % | $ | 122 | 12.6 | % | ||||||||||||||||||||
| Residential first lien loans | 668 | 20.8 | 454 | 23.7 | 300 | 24.1 | 272 | 16.0 | 200 | 9.7 | ||||||||||||||||||||||||||||||
| Residential junior lien loans | 177 | 4.6 | 89 | 4.3 | 47 | 3.6 | 55 | 3.5 | 34 | 2.0 | ||||||||||||||||||||||||||||||
| Commercial owner occupied loans | 617 | 18.2 | 327 | 16.3 | 309 | 17.3 | 160 | 20.4 | 131 | 22.4 | ||||||||||||||||||||||||||||||
| Commercial non-owner occupied loans | 1,410 | 27.8 | 1,120 | 26.4 | 728 | 23.9 | 562 | 22.4 | 541 | 28.1 | ||||||||||||||||||||||||||||||
| Commercial loans and leases | 2,529 | 20.2 | 3,800 | 19.8 | 3,094 | 21.5 | 2,366 | 25.2 | 1,464 | 24.9 | ||||||||||||||||||||||||||||||
| Consumer loans | 23 | 0.5 | 127 | 0.6 | 126 | 0.6 | 13 | 0.9 | 14 | 0.3 | ||||||||||||||||||||||||||||||
| Total | $ | 6,159 | 100.0 | % | $ | 6,428 | 100.0 | % | $ | 4,869 | 100.0 | % | $ | 3,602 | 100.0 | % | $ | 2,506 | 100.0 | % | ||||||||||||||||||||
(1) Represents the percent of loans in each category to total loans.
Liquidity and Capital Resources
Liquidity is the ability to meet current and future financial obligations. Our primary sources of funds consist of deposit inflows, loan repayments, advances from the FHLB, and the sale of securities available for sale. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. Our Asset/Liability Committee (“ALCO”) is responsible for establishing and monitoring our liquidity targets and strategies in order to ensure that sufficient liquidity exists for meeting the borrowing needs and deposit withdrawals of our customers as well as unanticipated contingencies. We believe that we have enough sources of liquidity to satisfy our short- and long-term liquidity needs as of December 31, 2017 and December 31, 2016.
We regularly monitor and adjust our investments in liquid assets based upon our assessment of:
| · | Expected loan demand; |
| · | Expected deposit flows and borrowing maturities; |
| · | Yields available on interest-earning deposits and securities; and |
| · | The objectives of our asset/liability management program. |
Excess liquid assets are invested generally in interest-earning deposits and short-term securities.
The most liquid of all assets are cash and cash equivalents. The level of these assets is dependent on our operating, financing, lending and investing activities during any given period. At December 31, 2017 and 2016, cash and cash equivalents totaled $29.0 million and $39.4 million, respectively. The decrease at December 31, 2017 from the prior year-end resulted from funding asset growth that outpaced the growth in our deposits and other funding sources. We used cash and cash equivalents to provide additional funds needed to fund these assets.
Our cash flows are derived from operating activities, investing activities and financing activities as reported in our statements of cash flows included in our financial statements.
At December 31, 2017 and 2016, we had $219.6 million and $127.1 million, respectively, in loan commitments outstanding, including commitments issued to originate loans of $81.1 million and $46.2 million at December 31, 2017 and 2016, respectively, and $138.5 million and $80.9 million in unused lines of credit to borrowers at December 31, 2017 and 2016, respectively. In addition to commitments to originate loans and unused lines of credit, we had $10.8 million and $9.7 million in letters of credit at December 31, 2017 and 2016, respectively. Certificates of deposit due within one year totaled $195.5 million, or 22.6% of total deposits, and $178.3 million, or $22.0% of total deposits, at December 31, 2017 and 2016, respectively. If we do not retain these deposits, we may be required to seek other sources of funds, including loan and securities sales and FHLB advances. Depending on market conditions, we may be required to pay higher rates on our deposits or other borrowings than we currently pay on the certificates of deposit held in our portfolio as of December 31, 2017. We believe, however, based on historical experience and current market interest rates that we will retain upon maturity a large portion of our certificates of deposit with maturities of one year or less as of December 31, 2017. Our primary investing activity is originating loans. During the years ended December 31, 2017 and December 31, 2016, cash used to fund net loan growth was $120.3 million and $68.3 million, respectively. During these periods, we purchased $62.3 million and $88.2 million of securities, respectively. In 2016 we invested $19.5 million in interest bearing deposits with banks, while during 2017 we have received $19.5 million in cash from the maturities of interest bearing deposits with banks. Additionally, in 2017 and 2016 we purchased an additional $6.5 million and $2.2 million of BOLI, respectively.
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Financing activities consist primarily of activity in deposit accounts and FHLB advances. We experienced a net increase in cash provided from deposits of $55.1 million and $61.3 million, respectively, during the years ended December 31, 2017 and 2016. Deposit flows are affected by the overall level of interest rates, the interest rates and products offered by us and our local competitors, and by other factors.
Liquidity management is both a daily and long-term function of business management. If we require funds beyond our ability to generate them internally, borrowing agreements exist with the FHLB, which provide an additional source of funds. FHLB advances increased to $131 million at December 31, 2017 compared to $100 million at December 31, 2016. At December 31, 2017, we had the ability to borrow up to a total of $254.7 million based upon our credit availability at the FHLB, subject to collateral requirements.
The Bank is subject to various regulatory capital requirements, including a risk-based capital measure. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk-weighted assets by assigning balance sheet assets and off-balance sheet items to broad risk categories. At December 31, 2017 and 2016, the Bank exceeded all regulatory capital requirements. The Bank is considered “well capitalized” under regulatory guidelines. See “Item 1. Business—Supervision and Regulation—Howard Bank—Capital Requirements” and the Notes to our Financial Statements.
Commitments, Contingent Liabilities, and Off-Balance Sheet Arrangements
We are party to financial instruments with off-balance sheet risk in the normal course of business to meet the financial needs of our customers. These financial instruments are limited to commitments to originate loans and involve, to varying degrees, elements of credit, interest rate, and liquidity risk. These do not represent unusual risks, and management does not anticipate any losses that would have a material effect on us.
Outstanding loan commitments and lines of credit at December 31, 2017 and December 31, 2016 are as follows:
| December 31, | ||||||||
| (in thousands) | 2017 | 2016 | ||||||
| Unfunded loan commitments | $ | 81,074 | $ | 46,194 | ||||
| Unused lines of credit | 138,526 | 80,876 | ||||||
| Letters of credit | 10,839 | 9,660 | ||||||
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. We generally require collateral to support financial instruments with credit risk on the same basis as we do for balance sheet instruments. Management generally bases the collateral required on the credit evaluation of the counterparty. Commitments generally have interest rates at current market rates, expiration dates or other termination clauses and may require payment of a fee. Available credit lines represent the unused portion of lines of credit previously extended and available to the customer so long as there is no violation of any contractual condition. These lines generally have variable interest rates. Since we expect many of the commitments to expire without being drawn upon, and since it is unlikely that all customers will draw upon their lines of credit in full at any one time, the total commitment amount or line of credit amount does not necessarily represent future cash requirements. We evaluate each customer’s credit-worthiness on a case-by-case basis. Because we conservatively underwrite these facilities at inception, we have not had to withdraw any commitments. We are not aware of any loss that we would incur by funding our commitments, lines of credit or letters of credit.
The credit risk involved in these financial instruments is essentially the same as that involved in extending loan facilities to customers. No amount has been recognized in the statement of financial condition at December 31, 2017, December 31, 2016 or December 31, 2015 as a liability for credit loss related to these commitments.
We have contractual obligations to make future payments on debt and lease agreements. In the normal course of business, we enter into contractual arrangements whereby we commit to future purchases of products or services from unaffiliated parties. These purchase obligations are legally binding agreements whereby we agree to purchase products or services with a specific minimum quantity at a fixed, minimum or variable price over a specified period of time. Purchase obligations may include vendor contracts, communication services, processing services and software contracts. Contractual obligations under real property leases for the facilities we utilize are also presented below.
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Payments due by period for our contractual obligations at December 31, 2017 are as follows:
| Within | One to | Three to | Over | |||||||||||||||||
| (in thousands) | one year | three years | five years | five years | Total | |||||||||||||||
| Certificates of deposit | $ | 195,511 | $ | 63,850 | $ | 10,235 | $ | - | $ | 269,596 | ||||||||||
| Long-term borrowings | - | 15,000 | - | 3,535 | 18,535 | |||||||||||||||
| Estimated interest due on certificate of deposit and long-term borrowings | 2,436 | 1,535 | 57 | 16 | 4,044 | |||||||||||||||
| Contractual service obligations | 1,843 | 3,517 | - | - | 5,360 | |||||||||||||||
| Operating leases | 2,105 | 3,910 | 2,641 | 2,742 | 11,398 | |||||||||||||||
| $ | 201,895 | $ | 87,812 | $ | 12,933 | $ | 6,293 | $ | 308,933 | |||||||||||
Impact of Inflation and Changing Prices
Our financial statements and related notes have been prepared in accordance with GAAP. GAAP generally requires the measurement of financial position and operating results in terms of historical dollars without consideration of changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations. Unlike industrial companies, our assets and liabilities are primarily monetary in nature. As a result, changes in market interest rates have a greater impact on performance than the effects of inflation.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Liquidity and Funding
The objective of effective liquidity management is to ensure that the Company can meet customer loan requests, customer deposit maturities/withdrawals, and other cash commitments efficiently under both normal operating conditions as well as under unforeseen and unpredictable circumstances of industry or market stress. To achieve this objective, ALCO establishes and monitors liquidity guidelines requiring sufficient asset based liquidity to cover potential funding requirements and to avoid over-dependence on volatile, less reliable funding markets. The Company manages liquidity at both the parent and subsidiary levels through active management of the balance sheet.
The additional information called for by this item is incorporated herein by reference to the “Liquidity and Capital Resources” section of Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” of this Annual Report on Form 10-K.
Interest Rate Risk
Interest rate risk, one of the more prominent risks in terms of potential earnings impact, is an inevitable part of being a financial intermediary. It can occur for any one or more of the following reasons: (a) assets and liabilities may mature or reprice at different times (for example, if assets reprice faster than liabilities and interest rates are generally falling, the Company’s earnings will initially decline); (b) assets and liabilities may re-price at the same time but by different amounts (when the general level of interest rates is falling, the Company may choose for customer management, competitive, or other reasons to reduce the rates paid on checking and savings deposit accounts by an amount that is less than the general decline in market interest rates); (c) short-term and long-term market interest rates may change by different amounts (i.e. the shape of the yield curve may impact new loan yields and funding costs differently); or (d) the remaining maturity of various assets or liabilities may shorten or lengthen as interest rates change (for example, mortgage-backed securities held in the securities available for sale portfolio may prepay significantly earlier than anticipated – with an associated reduction in portfolio yield and income – if long-term mortgage rates decline sharply). In addition to the direct impact of interest rate changes on net interest income through these categories, interest rates indirectly impact earnings through their effect on loan demand, credit losses, mortgage origination fees, and other sources of the Company’s earnings.
In determining the appropriate level of interest rate risk, the Company considers the impact on earnings and capital of the current outlook on interest rates, potential changes in interest rates, regional economies, liquidity, business strategies and other factors. The Company uses a number of tools to measure interest rate risk including a model to simulate the impact of changes in interest rates on our net interest income, monitoring the sensitivity of the net present value of the balance sheet and monitoring the difference or gap between maturing or rate-sensitive assets and liabilities over various time periods.
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Management believes that short term interest rate risk is best measured by simulation modeling. This analysis calculates expected net interest income based upon historical trends, spreads to market rates, historical market relationships, prepayment behavior and current and expected product offerings using base market rates and using a rising and a falling interest rate scenario. For example, if rates were to rise 1.00% or 2.00% over the next 12 months, net interest income might decline respectively. Conversely, if rates were to decline over the next 12 months, net interest income might increase respectively.
These estimates are highly assumption-dependent, and may change regularly as the Company’s asset/liability structure and business evolves from one period to the next, results will vary as different interest rate scenarios are used and are measured relative to a base net interest income scenario that may change.
For the rising and falling interest rate scenarios, the base market interest rate forecast was increased and decreased over twelve months by 200 and 100 basis points, respectively. At December 31, 2017, our net interest income exposure related to these hypothetical changes in market interest rates was within the current guidelines established in our governing policies.
The following table presents interest sensitivity position at the dates indicated.
| Percentage Change in | ||||||||
| Net Interest Income | ||||||||
| 2017 | 2016 | |||||||
| Up 200 basis points | (1.44 | )% | (0.46 | )% | ||||
| Down 200 basis points | (2.20 | ) | (2.99 | ) | ||||
A summary of the repricing schedule of our interest-earning assets and interest-bearing liabilities as of December 31, 2017 is presented below.
| Interest Rate Sensitivity Period | ||||||||||||||||||||||||||||||||
| Less then | 30-90 | 91-180 | 181-365 | 1-2 | 2-5 | Over 5 | Total | |||||||||||||||||||||||||
| (Dollars in thousands) | 30 Days | Days | Days | Days | Years | Years | Years | Rate Sensitive | ||||||||||||||||||||||||
| Earning assets | ||||||||||||||||||||||||||||||||
| Other earning assets | $ | 993 | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | 993 | ||||||||||||||||
| Investment securities | 2,595 | 11,101 | 9,668 | 21,032 | 23,714 | 17,382 | 4,506 | 89,998 | ||||||||||||||||||||||||
| Loans and leases | 159,902 | 102,964 | 45,069 | 98,926 | 133,136 | 264,554 | 132,057 | 936,608 | ||||||||||||||||||||||||
| Loans held for sale | 42,153 | - | - | - | - | - | - | 42,153 | ||||||||||||||||||||||||
| Total earning assets | 205,643 | 114,065 | 54,737 | 119,958 | 156,850 | 281,936 | 136,563 | 1,069,752 | ||||||||||||||||||||||||
| Interest-bearing liabilities | ||||||||||||||||||||||||||||||||
| Interest-bearing checking | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | 71,642 | $ | 71,642 | ||||||||||||||||
| Money market accounts | - | 252,453 | - | - | - | - | - | 252,453 | ||||||||||||||||||||||||
| Savings | - | - | - | - | - | - | 52,078 | 52,078 | ||||||||||||||||||||||||
| Certificate of deposits | 17,201 | 51,870 | 67,819 | 58,592 | 31,999 | 42,047 | 68 | 269,596 | ||||||||||||||||||||||||
| Short-term borrowings | 67,385 | 9,000 | 2,500 | 33,500 | 3,000 | 15,000 | - | 130,385 | ||||||||||||||||||||||||
| Long-term borrowings | - | - | - | - | 15,000 | - | 3,535 | 18,535 | ||||||||||||||||||||||||
| Total interest-bearing liabilities | 84,586 | 313,323 | 70,319 | 92,092 | 49,999 | 57,047 | 127,323 | 794,689 | ||||||||||||||||||||||||
| Interest rate sensitivity gap | $ | 121,057 | $ | (199,258 | ) | $ | (15,582 | ) | $ | 27,866 | $ | 106,851 | $ | 224,889 | $ | 9,240 | $ | 275,063 | ||||||||||||||
| Cumulative interest rate sensitivity gap | $ | 121,057 | $ | (78,201 | ) | $ | (93,783 | ) | $ | (65,917 | ) | $ | 40,934 | $ | 265,823 | $ | 275,063 | |||||||||||||||
| Cumulative sensitivity gap as percent of total assets | 10.53 | % | (6.80 | )% | (8.16 | )% | (5.73 | )% | 3.56 | % | 23.12 | % | 23.92 | % | ||||||||||||||||||
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Item 8. Financial Statements and Supplementary Data
Report Of Independent Registered Public Accounting Firm
Stockholders and the Board of Howard Bancorp, Inc.
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated balance sheets of Howard Bancorp, Inc. and Subsidiary (the “Company”) as of December 31, 2017 and 2016, and the related consolidated statements of operations, comprehensive income, changes in stockholders’ equity, and cash flows for each of the two years in the period ended December 31, 2017, and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2017 and 2016, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) ("PCAOB"), the Company's internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 15, 2018 expressed an unqualified opinion thereon.
Basis for Opinion
These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
/s/ Dixon Hughes Goodman LLP
We have served as the Company’s auditor since 2016.
Baltimore, Maryland
March 15, 2018
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders and Board of Directors
Howard Bancorp, Inc.
Ellicott City, Maryland
We have audited the accompanying consolidated statement of operations, comprehensive income, changes in shareholders’ equity, and cash flows of Howard Bancorp, Inc. (the “Company”) for the year ended December 31, 2015. The Company’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the Company’s results of operations and cash flows for the year ended December 31, 2015, in conformity with accounting principles generally accepted in the United States of America.
/s/ Stegman & Company
Baltimore, Maryland
March 29, 2016
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Report Of Independent Registered Public Accounting Firm
Stockholders and the Board of Directors of Howard Bancorp, Inc.
Opinion on Internal Control Over Financial Reporting
We have audited Howard Bancorp, Inc. and Subsidiary (the “Company”)’s internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. In our opinion, Howard Bancorp, Inc. and Subsidiary maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated financial statements of Howard Bancorp, Inc. and Subsidiary as of December 31, 2017 and 2016, and for each of the years in the two years ended December 31, 2017, and our report dated March 15, 2018, expressed an unqualified opinion on those consolidated financial statements.
Basis for Opinion
The Company's management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Effectiveness of Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
Definition and Limitations of Internal Control Over Financial Reporting
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ Dixon Hughes Goodman LLP
Baltimore, Maryland
March 15, 2018
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Howard Bancorp, Inc. and Subsidiary
| Consolidated Balance Sheets |
| December 31, | ||||||||
| (in thousands, except share data) | 2017 | 2016 | ||||||
| ASSETS | ||||||||
| Cash and due from banks | $ | 28,856 | $ | 29,675 | ||||
| Federal funds sold | 116 | 9,691 | ||||||
| Total cash and cash equivalents | 28,972 | 39,366 | ||||||
| Interest bearing deposits with banks | - | 19,513 | ||||||
| Securities available for sale, at fair value | 74,256 | 38,728 | ||||||
| Securities held to maturity, at amortized cost | 9,250 | 6,250 | ||||||
| Nonmarketable equity securities | 6,492 | 5,103 | ||||||
| Loans held for sale, at fair value | 42,153 | 51,054 | ||||||
| Loans and leases, net of unearned income | 936,608 | 821,524 | ||||||
| Allowance for credit losses | (6,159 | ) | (6,428 | ) | ||||
| Net loans and leases | 930,449 | 815,096 | ||||||
| Bank premises and equipment, net | 19,189 | 20,080 | ||||||
| Goodwill | 603 | 603 | ||||||
| Core deposit intangible | 1,743 | 2,248 | ||||||
| Bank owned life insurance | 28,631 | 21,371 | ||||||
| Other real estate owned | 1,549 | 2,350 | ||||||
| Interest receivable and other assets | 6,663 | 5,195 | ||||||
| Total assets | $ | 1,149,950 | $ | 1,026,957 | ||||
| LIABILITIES | ||||||||
| Noninterest-bearing deposits | $ | 218,139 | $ | 182,880 | ||||
| Interest-bearing deposits | 645,769 | 625,854 | ||||||
| Total deposits | 863,908 | 808,734 | ||||||
| Short-term borrowings | 130,385 | 107,056 | ||||||
| Long-term borrowings | 18,535 | 20,517 | ||||||
| Accrued expenses and other liabilities | 4,869 | 4,860 | ||||||
| Total liabilities | 1,017,697 | 941,167 | ||||||
| COMMITMENTS AND CONTINGENCIES | ||||||||
| STOCKHOLDERS' EQUITY | ||||||||
| Common stock - par value of $0.01 authorized 20,000,000 shares; issued and outstanding 9,820,592 shares at December 31, 2017 and 6,991,072 at December 31, 2016 | 98 | 70 | ||||||
| Capital surplus | 110,387 | 71,021 | ||||||
| Retained earnings | 22,105 | 14,849 | ||||||
| Accumulated other comprehensive loss | (337 | ) | (150 | ) | ||||
| Total stockholders’ equity | 132,253 | 85,790 | ||||||
| Total liabilities and stockholders’ equity | $ | 1,149,950 | $ | 1,026,957 | ||||
The accompanying notes are an integral part of these consolidated financial statements.
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| Consolidated Statements of Operations |
| December 31, | ||||||||||||
| (in thousands, except share data) | 2017 | 2016 | 2015 | |||||||||
| INTEREST INCOME | ||||||||||||
| Interest and fees on loans and leases | $ | 41,213 | $ | 37,865 | $ | 32,837 | ||||||
| Interest and dividends on securities | 1,416 | 691 | 449 | |||||||||
| Other interest income | 397 | 185 | 63 | |||||||||
| Total interest income | 43,026 | 38,741 | 33,349 | |||||||||
| INTEREST EXPENSE | ||||||||||||
| Deposits | 3,997 | 3,470 | 2,611 | |||||||||
| Short-term borrowings | 876 | 595 | 154 | |||||||||
| Long-term borrowings | 294 | 497 | 307 | |||||||||
| Total interest expense | 5,167 | 4,562 | 3,072 | |||||||||
| NET INTEREST INCOME | 37,859 | 34,179 | 30,277 | |||||||||
| Provision for credit losses | 1,831 | 2,037 | 1,836 | |||||||||
| Net interest income after provision for credit losses | 36,028 | 32,142 | 28,441 | |||||||||
| NONINTEREST INCOME | ||||||||||||
| Service charges on deposit accounts | 923 | 694 | 773 | |||||||||
| Realized and unrealized gains on mortgage banking activity | 11,035 | 8,098 | 6,971 | |||||||||
| Gain on the sale of securities | - | 96 | - | |||||||||
| Gain on the sale of portfolio loans | 86 | 532 | - | |||||||||
| Loss on the disposal of bank premises & equipment | (13 | ) | (70 | ) | - | |||||||
| Income from bank owned life insurance | 760 | 623 | 408 | |||||||||
| Loan fee income | 5,722 | 3,903 | 2,979 | |||||||||
| Other operating income | 1,011 | 920 | 804 | |||||||||
| Total noninterest income | 19,524 | 14,796 | 11,935 | |||||||||
| NONINTEREST EXPENSE | ||||||||||||
| Compensation and benefits | 23,573 | 19,034 | 17,196 | |||||||||
| Occupancy and equipment | 4,154 | 4,622 | 3,816 | |||||||||
| Amortization of core deposit intangible | 505 | 655 | 462 | |||||||||
| Marketing and business development | 4,231 | 3,375 | 2,861 | |||||||||
| Professional fees | 1,968 | 2,111 | 1,478 | |||||||||
| Data processing fees | 2,038 | 1,723 | 1,353 | |||||||||
| Merger and restructuring expense | 567 | - | 4,344 | |||||||||
| FDIC assessment | 650 | 780 | 453 | |||||||||
| Other real estate owned expense | 655 | 97 | 744 | |||||||||
| Loan production expense | 3,743 | 3,016 | 2,223 | |||||||||
| Other operating expense | 3,116 | 3,286 | 3,331 | |||||||||
| Total noninterest expense | 45,200 | 38,699 | 38,261 | |||||||||
| INCOME BEFORE INCOME TAXES | 10,352 | 8,239 | 2,115 | |||||||||
| Income tax expense | 3,152 | 2,936 | 973 | |||||||||
| NET INCOME | $ | 7,200 | $ | 5,303 | $ | 1,142 | ||||||
| Preferred stock dividends | - | 166 | 126 | |||||||||
| Net income available to common stockholders | $ | 7,200 | $ | 5,137 | $ | 1,016 | ||||||
| NET INCOME PER COMMON SHARE | ||||||||||||
| Basic | $ | 0.75 | $ | 0.74 | $ | 0.16 | ||||||
| Diluted | $ | 0.75 | $ | 0.73 | $ | 0.16 | ||||||
The accompanying notes are an integral part of these consolidated financial statements.
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Consolidated Statements of Comprehensive Income
| December 31, | ||||||||||||
| (in thousands) | 2017 | 2016 | 2015 | |||||||||
| Net Income | $ | 7,200 | $ | 5,303 | $ | 1,142 | ||||||
| Other comprehensive income | ||||||||||||
| Investments available-for-sale: | ||||||||||||
| Reclassification adjustment for gains | - | (96 | ) | - | ||||||||
| Related income tax expense | - | 38 | - | |||||||||
| Unrealized holding losses | (217 | ) | (90 | ) | (22 | ) | ||||||
| Related income tax benefit | 86 | 30 | 6 | |||||||||
| Comprehensive income | $ | 7,069 | $ | 5,185 | $ | 1,126 | ||||||
| Consolidated Statements of Changes in Stockholders’ Equity |
| Accumulated | ||||||||||||||||||||||||||||
| other | ||||||||||||||||||||||||||||
| Preferred | Number of | Common | Capital | Retained | comprehensive | |||||||||||||||||||||||
| (dollars in thousands, except share data) | stock | shares | stock | surplus | earnings | loss | Total | |||||||||||||||||||||
| Balances at January 1, 2015 | $ | 12,562 | 4,145,547 | $ | 41 | $ | 38,360 | $ | 8,696 | $ | (16 | ) | $ | 59,643 | ||||||||||||||
| Net income | - | - | - | - | 1,142 | - | 1,142 | |||||||||||||||||||||
| Net unrealized loss on securities | - | - | - | - | - | (16 | ) | (16 | ) | |||||||||||||||||||
| Dividends paid on preferred stock | - | - | - | - | (126 | ) | - | (126 | ) | |||||||||||||||||||
| Forfeited restricted shares | - | (6,664 | ) | - | (34 | ) | - | - | (34 | ) | ||||||||||||||||||
| Common stock offering | - | 2,173,913 | 22 | 23,096 | - | - | 23,118 | |||||||||||||||||||||
| Director stock awards | - | 7,163 | - | 95 | - | - | 95 | |||||||||||||||||||||
| Exercise of options | - | 62,287 | 1 | 652 | - | - | 653 | |||||||||||||||||||||
| Acquisition of Patapsco Bancorp | - | 560,891 | 6 | 8,043 | - | - | 8,049 | |||||||||||||||||||||
| Stock-based compensation | - | 19,002 | - | 375 | - | - | 375 | |||||||||||||||||||||
| Balances at December 31, 2015 | 12,562 | 6,962,139 | 70 | 70,587 | 9,712 | (32 | ) | 92,899 | ||||||||||||||||||||
| Net income | - | - | - | - | 5,303 | - | 5,303 | |||||||||||||||||||||
| Net unrealized loss on securities | - | - | - | - | - | (118 | ) | (118 | ) | |||||||||||||||||||
| Dividends paid on preferred stock | - | - | - | - | (166 | ) | - | (166 | ) | |||||||||||||||||||
| Redemption of preferred stock | (12,562 | ) | - | - | - | - | - | (12,562 | ) | |||||||||||||||||||
| Director stock awards | - | 7,241 | - | 160 | - | - | 160 | |||||||||||||||||||||
| Exercise of options | - | 3,020 | - | 35 | - | - | 35 | |||||||||||||||||||||
| Stock-based compensation | - | 18,672 | - | 239 | - | - | 239 | |||||||||||||||||||||
| Balances at December 31, 2016 | - | 6,991,072 | 70 | 71,021 | 14,849 | (150 | ) | 85,790 | ||||||||||||||||||||
| Net income | - | - | - | - | 7,200 | - | 7,200 | |||||||||||||||||||||
| Net unrealized loss on securities | - | - | - | - | - | (187 | ) | (187 | ) | |||||||||||||||||||
| Reclassification of tax effects resulting from the Tax Cuts and Jobs Act | 56 | 56 | ||||||||||||||||||||||||||
| Common stock offering | - | 2,760,000 | 28 | 38,355 | - | - | 38,383 | |||||||||||||||||||||
| Director stock awards | - | 11,404 | - | 205 | - | - | 205 | |||||||||||||||||||||
| Exercise of options | - | 27,113 | - | 316 | - | - | 316 | |||||||||||||||||||||
| Stock-based compensation | - | 31,003 | - | 490 | - | - | 490 | |||||||||||||||||||||
| Balances at December 31, 2017 | $ | - | 9,820,592 | $ | 98 | $ | 110,387 | $ | 22,105 | $ | (337 | ) | $ | 132,253 | ||||||||||||||
The accompanying notes are an integral part of these consolidated financial statements.
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| Consolidated Statements of Cash Flows |
| Year Ended December 31, | ||||||||||||
| (in thousands) | 2017 | 2016 | 2015 | |||||||||
| CASH FLOWS FROM OPERATING ACTIVITIES: | ||||||||||||
| Net income | $ | 7,200 | $ | 5,303 | $ | 1,142 | ||||||
| Adjustments to reconcile net income to net cash from operating activities: | ||||||||||||
| Provision for credit losses | 1,831 | 2,037 | 1,836 | |||||||||
| Deferred income tax (benefit) | (1,132 | ) | (1,229 | ) | (3,019 | ) | ||||||
| Provision for other real estate owned | 581 | 83 | 736 | |||||||||
| Depreciation | 1,287 | 1,241 | 1,008 | |||||||||
| Stock-based compensation | 695 | 399 | 436 | |||||||||
| Net (accretion) amortization of investment securities | 81 | (3 | ) | (13 | ) | |||||||
| Net accretion of discount on purchased loans | (575 | ) | (714 | ) | (1,633 | ) | ||||||
| Gain on sales of securities | - | (96 | ) | - | ||||||||
| Loss on disposal of furniture, fixtures & equipment | 13 | 70 | - | |||||||||
| Net amortization of intangible asset | 505 | 655 | 462 | |||||||||
| Loans originated for sale | (673,448 | ) | (599,299 | ) | (591,422 | ) | ||||||
| Proceeds from sale of loans originated for sale | 693,384 | 606,020 | 591,597 | |||||||||
| Realized and unrealized gains on mortgage banking activity | (11,035 | ) | (8,098 | ) | (6,971 | ) | ||||||
| (Gain) loss on sales of other real estate owned, net | (12 | ) | 14 | 8 | ||||||||
| Gain on sales of portfolio loans, net | (86 | ) | (532 | ) | - | |||||||
| Cash surrender value of BOLI | (760 | ) | (623 | ) | (408 | ) | ||||||
| Increase in interest receivable | (672 | ) | (649 | ) | (356 | ) | ||||||
| Increase in interest payable | 124 | 5 | 90 | |||||||||
| Increase in other assets | (1,372 | ) | (817 | ) | (368 | ) | ||||||
| Increase (decrease) in other liabilities | 293 | (1,460 | ) | (2,190 | ) | |||||||
| Net cash provided by (used in) operating activities | 16,902 | 2,307 | (9,065 | ) | ||||||||
| CASH FLOWS FROM INVESTING ACTIVITIES: | ||||||||||||
| Purchase of interest bearing deposits with banks | - | (19,513 | ) | - | ||||||||
| Proceeds from maturities of interest bearing deposits with banks | 19,513 | - | - | |||||||||
| Purchases of investment securities available-for-sale | (59,347 | ) | (84,969 | ) | (42,880 | ) | ||||||
| Purchases of investment securities held-to-maturity | (3,000 | ) | (3,250 | ) | (3,000 | ) | ||||||
| Proceeds from sale/maturities of investment securities available-for-sale | 23,520 | 95,731 | 61,043 | |||||||||
| Net increase in loans and leases outstanding | (120,321 | ) | (68,273 | ) | (49,116 | ) | ||||||
| Purchase of bank owned life insurance | (6,500 | ) | (2,200 | ) | (1,800 | ) | ||||||
| Proceeds from the sale of other real estate owned | 232 | 178 | 12 | |||||||||
| Proceeds from the sale of portfolio loans | 3,798 | 4,263 | - | |||||||||
| Purchase of premises and equipment | (409 | ) | (627 | ) | (5,273 | ) | ||||||
| Acquisition activity, net of cash received | - | - | 8,884 | |||||||||
| Net cash used in investing activities | (142,514 | ) | (78,660 | ) | (32,130 | ) | ||||||
| CASH FLOWS FROM FINANCING ACTIVITIES: | ||||||||||||
| Net increase in deposits | 55,174 | 61,327 | 17,966 | |||||||||
| Net increase in short-term borrowings | 23,329 | 37,935 | 15,493 | |||||||||
| Proceeds from issuance of long-term debt | 15,016 | 2,810 | 6,914 | |||||||||
| Repayment of long-term debt | (17,000 | ) | (12,000 | ) | (9,000 | ) | ||||||
| Net proceeds from issuance of common stock, net of cost | 38,699 | 35 | 23,771 | |||||||||
| Redemption of preferred stock | - | (12,562 | ) | - | ||||||||
| Cash dividends on preferred stock | - | (166 | ) | (126 | ) | |||||||
| Net cash provided by financing activities | 115,218 | 77,379 | 55,018 | |||||||||
| Net (decrease) increase in cash and cash equivalents | (10,394 | ) | 1,026 | 13,823 | ||||||||
| Cash and cash equivalents at beginning of period | 39,366 | 38,340 | 24,517 | |||||||||
| Cash and cash equivalents at end of period | $ | 28,972 | $ | 39,366 | $ | 38,340 | ||||||
| SUPPLEMENTAL INFORMATION | ||||||||||||
| Cash payments for interest | $ | 5,044 | $ | 4,557 | $ | 2,982 | ||||||
| Cash payments for income taxes | 3,440 | 3,145 | 2,890 | |||||||||
| Transferred from loans to other real estate owned | - | 256 | 625 | |||||||||
| Assets acquired in business combination (net of cash received) | - | - | 194,828 | |||||||||
| Liabilities assumed in business combination | - | - | 204,414 | |||||||||
The accompanying notes are an integral part of these consolidated financial statements.
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Notes to Consolidated Financial Statements
Note 1: Summary of Significant Accounting Policies
Nature of Operations
On December 15, 2005, Howard Bancorp, Inc. (“Bancorp”) acquired all of the stock and became the holding company of Howard Bank (the “Bank”) pursuant to the Plan of Reorganization approved by the stockholders of the Bank and by federal and state regulatory agencies. Each share of the Bank’s common stock was converted into two shares of Bancorp common stock effected by the filing of Articles of Exchange on that date, and the stockholders of the Bank became the stockholders of Bancorp. The Bank has four subsidiaries, three of which hold foreclosed real estate and the other owns and manages real estate that is used as a branch location and has office and retail space. The accompanying consolidated financial statements of Bancorp and its wholly-owned subsidiary bank (collectively the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”).
Bancorp was incorporated in April of 2005 under the laws of the State of Maryland and is a bank holding company registered under the Bank Holding Company Act of 1956. Bancorp is a single bank holding company with one subsidiary, Howard Bank, which operates as a state trust company with commercial banking powers regulated by the Maryland Office of the Commissioner of Financial Regulation (the “Commissioner”).
On August 28, 2015, Bancorp completed its acquisition of Patapsco Bancorp, Inc. (“Patapsco Bancorp”), the parent company of The Patapsco Bank, through the merger of Patapsco Bancorp with and into Bancorp pursuant to the Agreement and Plan of Merger dated as of March 2, 2015, as amended, by and between Bancorp and Patapsco Bancorp (the “Merger Agreement”). As a result of the merger, each share of common stock of Patapsco Bancorp was converted into the right to receive, at the holder’s election, $5.09 in cash or 0.3547 shares of Bancorp common stock, provided that (i) cash was paid in lieu of any fractional shares of Bancorp common stock and (ii) 20% of the shares of common stock of Patapsco Bancorp outstanding at the time of the merger were exchanged for cash in the merger, with the remaining shares of Patapsco Bancorp common stock exchanged for 560,891 shares of Bancorp common stock. The aggregate merger consideration was $10.064 million. In connection with the merger, immediately thereafter The Patapsco Bank was merged with and into the Bank, with the Bank the surviving bank.
On May 6, 2016, Bancorp redeemed all of the 12,562 shares of the Series AA Preferred Stock that it had previously issued to the U.S. Department of the Treasury (the “Treasury”) under its Small Business Lending Fund (“SBLF”) program. The aggregate redemption price of the Series AA Preferred Stock was approximately $12.7 million, including dividends accrued but unpaid through the redemption date. The redemption of the Series AA Preferred Stock was funded with variable rate debt with Raymond James Bank, N.A. This debt matured one year from commencement, with interest only payments based upon 30 day LIBOR plus 300 basis points.
On February 1, 2017, Bancorp closed an underwritten public offering, including the exercise in full by the underwriters of their option to purchase an additional 360,000 shares, at the public offering price of $15.00 per share. The exercise of the option to purchase additional shares brought the total number of shares of common stock sold by Bancorp to 2,760,000 shares and increased the amount of gross proceeds raised in the offering, before underwriting discounts and expenses of the offering, to approximately $41.4 million.
On March 1, 2018, we completed our acquisition of First Mariner Bank (“First Mariner”) through the merger of First Mariner with and into the Bank pursuant to the Agreement and Plan of Reorganization dated as August 14, 2017, as amended, by and between Bancorp, the Bank and First Mariner. As a result of the merger, each outstanding share of common stock of First Mariner was converted into the right to receive 1.6624 shares of Bancorp common stock, provided that cash was paid in lieu of any fractional shares. The aggregate merger consideration of $173.8 million included $9.2 million of cash and 9,143,230 shares of our common stock, which was valued at approximately $164.6 million based on Bancorp’s closing stock price of $18.00 on February 28, 2018.
The Company is a diversified financial services company providing commercial banking, mortgage banking and consumer finance through banking branches, the internet and other distribution channels to businesses, business owners, professionals and other consumers located primarily in the Greater Baltimore Metropolitan Area.
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The following is a description of the Company’s significant accounting policies.
Principles of Consolidation
The consolidated financial statements include the accounts of Bancorp, its subsidiary bank and the Bank’s subsidiaries. All significant intercompany accounts and transactions have been eliminated. The parent company only financial statements report investments in the subsidiary bank under the equity method.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant changes in the near-term relate to the determination of the allowance for credit losses, other-than-temporary impairment of investment securities and the fair value of loans held for sale.
Segment Information
The Company has one reportable segment, “Community Banking.” All of the Company’s activities are interrelated, and each activity is dependent and assessed based on how each of the activities of the Company supports the others. For example, lending is dependent upon the ability of the Bank to fund itself with deposits and other borrowings and manage interest rate and credit risk. Accordingly, all significant operating decisions are based upon analysis of the Company as one segment or unit.
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand, amounts due from banks, cash items in the process of clearing, federal funds sold, and interest-bearing deposits with banks with original maturities of less than 90 days. Generally, federal funds are sold as overnight investments.
Investment Securities
Marketable equity securities and debt securities not classified as held-to-maturity are classified as available-for-sale. Investments held-to-maturity represents securities that the Company has both intent and ability to hold until maturity. Securities available-for-sale are acquired as part of the Bank's asset/liability management strategy and may be sold in response to changes in interest rates, loan demand, changes in prepayment risk and other factors. Securities available-for-sale are carried at estimated fair value, with unrealized gains or losses based on the difference between amortized cost and fair value reported as accumulated other comprehensive income (loss), net of deferred taxes, a separate component of stockholders’ equity, when appropriate. Realized gains and losses, using the specific identification method, are included as a separate component of noninterest income. Related interest and dividends are included in interest income. Held-to-maturity investments premiums and discounts are amortized to interest income using the effective interest method. Declines in the fair value of individual securities below their amortized cost that are other than temporary result in write-downs of the individual securities to their fair value. Factors affecting the determination of whether an other-than-temporary impairment has occurred include a downgrading of the security by a rating agency, a significant deterioration in the financial condition of the issuer, or that management would not have the intent and ability to hold a security for a period of time sufficient to allow for any anticipated recovery in fair value or that management would be required to sell the security before recovery in fair value.
Nonmarketable Equity Securities
Nonmarketable equity securities include equity securities that are not publicly traded or are held to meet regulatory requirements such as Federal Home Loan Bank stock. These securities are accounted for at cost. As of December 31, 2017 and 2016 none of the non-marketable equity securities were considered impaired. Due to redemptive provisions of the Federal Home Loan Bank, cost approximates fair value.
Loans Held For Sale
The Company engages in sales of residential mortgage loans originated by the Bank. The Company has elected to measure loans held for sale at fair value. Fair value is based on outstanding investor commitments or, in the absence of such commitments, on current investor yield requirements based on third party models. Gains and losses on sales of these loans are recorded as a component of noninterest income in the Consolidated Statements of Operations. The Company’s current practice is to sell residential mortgage loans on a servicing released basis, and, therefore, it has no intangible asset recorded for the value of such servicing. Interest on loans held for sale is credited to income based on the principal amounts outstanding.
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Upon sale and delivery, loans are legally isolated from the Company and the Company has no ability to restrict or constrain the ability of third party investors to pledge or exchange the mortgage loans. The Company does not have the entitlement or ability to repurchase the mortgage loans or unilaterally cause third party investors to put the mortgage loans back to the Company. Unrealized and realized gains on loan sales are determined using the specific identification method and are recognized through mortgage banking activity in the Consolidated Statements of Operations.
The Company enters into commitments to originate residential mortgage loans whereby the interest rate on the loan is determined prior to funding (i.e. rate lock commitment). Such rate lock commitments on mortgage loans to be sold in the secondary market are considered to be derivatives. The period of time between issuance of a loan commitment and closing and sale of the loan generally ranges from 15 to 60 days. The Company protects itself from changes in interest rates through the use of best efforts forward delivery commitments, whereby the Company commits to sell a loan at a premium at the time the borrower commits to an interest rate with the intent that the buyer has assumed interest rate risk on the loan.
For purposes of calculating fair value of rate lock commitments, the Bank estimates loan closing and investor delivery rate based on historical experience. The measurement of the estimated fair value of the rate lock commitments is presented as realized and unrealized gains from mortgage banking activities with the corresponding balance sheet amount presented as part of other assets.
The Company elected to measure loans held for sale at fair value to better align reported results with the underlying economic changes in value of the loans on the Company’s balance sheet. Loans held for sale that were not ultimately sold, but instead were placed into the Bank’s portfolio, are reclassified to loans held for investment and continue to be recorded at fair value.
Loans and Leases
Loans are stated at their principal balance outstanding, plus deferred origination costs, less unearned discounts and deferred origination fees. Interest on loans is credited to income based on the principal amounts outstanding. Origination fees and costs are amortized to income over the contractual life of the related loans. Generally, accrual of interest on a loan is discontinued when the loan is delinquent more than 90 days unless the collateral securing the loan is sufficient to liquidate the loan. All interest accrued but not collected for loans that are placed on non-accrual or charged-off is reversed against interest income. Interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Management considers loans impaired when, based on current information, it is probable that the Company will not collect all principal and interest payments according to contractual terms. Loans are tested for impairment no later than when principal or interest payments become 90 days or more past due and they are placed on non-accrual. Management also considers the financial condition of the borrower, cash flows of the loan and the value of the related collateral. Impaired loans do not include large groups of smaller balance homogeneous loans such as residential real estate and consumer installment loans which are evaluated collectively for impairment. Loans specifically reviewed for impairment are not considered impaired during periods of “minimal delay” in payment (90 days or less) provided eventual collection of all amounts due is expected. The impairment of a loan may be measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if repayment is expected to be provided by the collateral. Generally, the Company’s impairment on such loans is measured by reference to the fair value of the collateral. Interest income on impaired loans is recognized on the cash basis.
The segments of the Company’s loan portfolio are disaggregated to a level that allows management to monitor risk and performance. The commercial real estate (“CRE”) loan segment is further disaggregated into two classes; owner occupied loans and non-owner occupied loans. Non-owner occupied CRE loans, which include loans secured by non-owner occupied nonfarm nonresidential properties, generally have a greater risk profile than owner occupied CRE loans. The residential mortgage loan segment is further disaggregated into two classes: first lien mortgages and second or junior lien mortgages.
Allowance for Credit Losses
The allowance for credit losses is maintained at a level believed adequate by management to absorb probable losses inherent in the loan portfolio and is based on the size and current risk characteristics of the loan portfolio, an assessment of individual problem loans, actual loss experience, current economic events in specific industries and geographic areas including unemployment levels and other pertinent factors including general economic conditions. Determination of the allowance is inherently subjective as it requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, estimated losses on pools of homogenous loans based on historical loss experience and consideration of economic trends, all of which may be susceptible to significant change. Credit losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for credit losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors. Evaluations are conducted at least quarterly and more often if deemed necessary.
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The allowance for credit losses consists of a specific component and a nonspecific component. The components of the allowance for credit losses represent an estimation done pursuant to either the Financial Accounting Standards Board’s (the “FASB”) Accounting Standards Codification (“ASC”) Topic 450 Contingencies or ASC Topic 310 Receivables. The specific component of the allowance for credit losses reflects expected losses resulting from analysis developed through credit allocations for individual loans. The credit allocations are based on a regular analysis of all loans over a fixed-dollar amount where the internal credit rating is at or below a predetermined classification. The specific component of the allowance for credit losses also includes management’s determination of the amounts necessary given concentrations and changes in portfolio mix and volume.
The nonspecific portion of the allowance is determined based on management’s assessment of general economic conditions, as well as economic factors in the individual markets in which the Company operates including the strength and timing of economic cycles and concerns over the effects of a prolonged economic downturn in the current cycle. This determination inherently involves a higher risk of uncertainty and considers current risk factors that may not have yet manifested themselves in the Bank’s historical loss factors used to determine the nonspecific component of the allowance, and it recognizes knowledge of the portfolio may be incomplete. The Bank’s historic loss factors are based upon actual losses incurred by portfolio segment over the preceding 24-month period. In portfolio segments where no actual losses have been incurred within the most recent 24-month period, industry loss data for that portfolio segment, as provided by the FDIC, are utilized. In addition to historic loss factors, the Bank’s methodology for the allowance for credit losses also incorporates other risk factors that may be inherent within the portfolio segments. For each portfolio segment, in addition to the historic loss experience, the other factors that are measured and monitored in the overall determination of the allowance include:
| · | changes in lending policies, procedures, practices or personnel; |
| · | changes in the level and composition of construction portfolio and related risks; |
| · | changes and migration of classified assets; |
| · | changes in exposure to subordinate collateral lien positions; |
| · | levels and composition of existing guarantees on loans by SBA or other agencies; |
| · | changes in national, state and local economic trends and business conditions; |
| · | changes and trends in levels of loan payment delinquencies; and |
| · | any other factors that management considers relevant to the quality or performance of the loan portfolio. |
Each of these qualitative risk factors is measured based upon data generated either internally, or in the case of economic conditions utilizing independently provided data on items such as unemployment rates, commercial real estate vacancy rates, or other market data deemed relevant to the business conditions within the markets served.
The Company’s loan policies state that after all collection efforts have been exhausted, and the loan is deemed to be a loss, then the remaining loan balance will be charged to the Company’s established allowance for credit losses. All loans are evaluated for loss potential once it has been determined by the Watch Committee that the likelihood of repayment is in doubt. When a loan is past due for at least 90 days or a deterioration in debt service coverage ratio, guarantor liquidity, or loan-to-value ratio has occurred that would cause concern regarding the likelihood of the full repayment of principal and interest, and the loan is deemed not to be well secured, the loan should be moved to non-accrual status and a specific reserve is established if the net realizable value is less than the principal value of the loan balance(s). Once the actual loss value has been determined a charge-off against the allowance for credit losses for the amount of the loss is taken. Each loss is evaluated on its specific facts regarding the appropriate timing to recognize the loss.
Goodwill and Other Intangible Assets
Goodwill represents the excess of the purchase price over the sum of the estimated fair values of tangible and identifiable intangible assets acquired less the estimated fair value of the liabilities assumed. Core deposit intangibles represent the estimated value of long-term deposit relationships acquired in a business combination. The core deposit intangible is amortized over the estimated useful lives of the acquired long-term deposits acquired, and the remaining amounts of the core deposit intangible are periodically reviewed for reasonableness. Goodwill has an indefinite useful life and is evaluated for impairment annually or more frequently if events and circumstances indicate that the asset might be impaired. An impairment analysis is performed annually as of October 31st each year.
Management has determined that Bancorp has one reporting unit, and based upon the annual impairment analysis, it was determined that there was not an impairment of the carrying value of either the goodwill or core deposit intangible for 2017.
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Business Combinations
GAAP requires that the acquisition method of accounting, formerly referred to as the purchase method, be used for all business combinations and that an acquirer be identified for each business combination. Under GAAP, the acquirer is the entity that obtains control of one or more businesses in the business combination, and the acquisition date is the date the acquirer achieves control. GAAP requires that the acquirer recognize the fair value of assets acquired, liabilities assumed, and any non-controlling interest in the acquired entity at the acquisition date.
Other Real Estate Owned
Other real estate acquired through, or in lieu of, foreclosure is initially recorded at fair value less estimated cost to sell at the date of acquisition, establishing a new cost basis. Revenues and expenses from operations are included in noninterest income. Additions to the valuation allowance are included in noninterest expense. Subsequent to foreclosure, valuations are periodically performed by management and an allowance for losses is established, if necessary, by a charge to operations if the carrying value of a property exceeds its estimated fair value less estimated costs to sell.
Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation and amortization computed using the straight-line method. Premises and equipment are depreciated over the useful lives of the assets, which generally range from 3 to 10 years for furniture, fixtures and equipment and 3 to 5 years for computer software and hardware. Bank owned premises are depreciated over a range of 20 to 30 years. Leasehold improvements are amortized over the terms of the respective leases or the estimated useful lives of the improvements, whichever is shorter. The costs of major renewals and betterments are capitalized, while the costs of ordinary maintenance and repairs are included in noninterest expense.
Income Taxes
The Company uses the liability method of accounting for income taxes. Under the liability method, deferred tax assets and liabilities are determined based on differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities (i.e., temporary differences) and are measured at the enacted rates that will be in effect when these differences reverse.
As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. In addition, deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or the entire deferred tax asset will not be realized.
The Company does not have uncertain tax positions that are deemed material, and did not recognize any adjustments for unrecognized tax benefits. The Company’s policy is to recognize interest and penalties on income taxes in other non-interest expenses. The Company remains subject to examination by federal and state taxing authorities for income tax returns for the years ending after December 31, 2014.
Net Income Per Common Share
Basic net income per common share is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the year. Diluted net income per common share is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the year including any potential dilutive effects of common stock equivalents, such as options and warrants.
Share-Based Compensation
Compensation cost is recognized for stock options issued to directors and employees. Compensation cost is measured as the fair value of these awards on their date of grant. A Black-Scholes model is utilized to estimate the fair value of stock options. Compensation cost is recognized over the required service period, generally defined as the vesting period for stock option awards. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award. When an award is granted to an employee who is retirement eligible, the compensation cost of these awards is recognized over the period up to when the director or employee first becomes eligible to retire.
Compensation expense for non-vested common stock awards is based on the fair value of the awards, which is generally the market price of the common stock on the measurement date, which, for the Company, is the date of grant, and is recognized ratably over the service period of the award.
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Off-Balance Sheet Financial Instruments
In the ordinary course of business, the Company has entered into off-balance sheet financial instruments consisting of commitments to extend credit. Such financial instruments are recorded in the consolidated balance sheet when they are funded.
Comprehensive Income
Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Certain changes in assets and liabilities, such as unrealized gains and losses on securities available for sale, are reported as a separate component of the equity section of the consolidated balance sheets, such items, along with net income, are components of comprehensive income. The Company’s sole component of accumulated other comprehensive income/loss is unrealized gains/losses on available for sale securities.
Transfer of Financial Assets
Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. In certain cases, the recourse to the Bank to repurchase assets may exist but is deemed immaterial based on the specific facts and circumstances.
Reclassifications
Certain reclassifications to 2016 and 2015 financial presentation were made to conform to the 2017 presentation. These reclassifications did not affect previously reported net income or total stockholders’ equity.
New Accounting Pronouncements
The Financial Accounting Standards Board (the “FASB”) has issued Accounting Standards Update (“ASU”) 2018-02, Income Statement—Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (the “Act”) was signed into law making significant changes to the Internal Revenue Code. FASB financial reporting guidance requires deferred tax assets and liabilities to be adjusted for the effect of a change in tax laws or rates with the effect included in income from continuing operations in the reporting period that includes the enactment date inclusive of the income tax effects of items in accumulated other comprehensive income. The amendments in this Update allow a reclassification from accumulated other comprehensive income to retained earnings for standard tax effects resulting from the Act. The amendment better reflects the appropriate tax rate. ASU No. 2018-02 is effective for fiscal years beginning after December 15, 2018. Early adoption is permitted for public entities for reporting periods for which financial statements have not yet been issued. The Company early adopted this standard effective December 31, 2017 and reclassified $55 thousand that was recorded to income tax expense for 2017, due to re-measuring from 35% to 21% the federal deferred taxes on the accumulated other comprehensive income components related to available for sale securities.
The FASB has issued ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. This ASU’s objectives are to 1) improve the transparency and understanding of information conveyed to financial statements users about an entity’s risk management activities by better aligning the entity’s financial reporting for hedging relationships with those risk management activities; and 2) reduce the complexity of and simplify the application of hedge accounting by preparers. ASU 2017-12 is effective for fiscal years beginning after December 15, 2018; early adoption is permitted. The Company currently does not designate any derivative financial instruments as formal hedging relationships and therefore, does not utilize hedge accounting. However, the Company is currently evaluating this ASU to determine whether its provision will enhance the Company’s ability to employ risk management strategies, while improving the transparency and understanding of those strategies for financial statement users.
The FASB has issued ASU 2017-09, Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting. This ASU clarifies when changes to the term or conditions of a share-based payment award must be accounted for as a modification. Under this ASU, an entity will not apply modification accounting to a share-based payment award if all of the following are the same immediately before and after the change: 1) The fair value: 2) the award’s vesting conditions; and 3) the award’s classification as an equity or liability instrument. ASU No. 2017-09 is effective for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years, and is not expected to have a material impact on the Company’s Consolidated Financial Statements.
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The FASB has issued ASU 2017-08, Receivables—Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. The amendments in this Update shorten the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount; the discount continues to be amortized to maturity. The amendments in this Update are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company will evaluate the guidance in this update but does not expect it to have a significant impact on its financial position or result of operations.
The FASB has issued ASU 2017-04, Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The amendments in this Update simplify the subsequent measurement of goodwill by eliminating Step 2 from the goodwill impairment test. The Company should perform its goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. Impairment changes should be recognized for the amount by which the carrying amount exceeds the reporting unit’s fair value, however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. The impairment charge is limited to the amount of goodwill allocated to that reporting unit. The amendments in this Update are effective for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. The Company will evaluate the guidance in this update but does not expect it to have a significant impact on its financial position or result of operations.
The FASB has issued ASU 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. The amendments in this Update provide clarification on the definition of a business and provides criteria to aid in the assessment of whether a transaction should be accounted for as an acquisition or a disposal of assets or business. The amendments in this Update are effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The Company will evaluate the guidance in this update but does not expect it to have a significant impact on its financial position or result of operations.
The FASB has issued ASU 2016-13, Financial Instruments—Credit Losses (Topic 326). The main objective of this update is to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. To achieve this objective, the guidance in this update replaces the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. The measurement of expected credit losses is based on relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. An entity must use judgment in determining the relevant information and estimation methods that are appropriate in its circumstances. The guidance in this update is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The Company is currently evaluating this guidance to determine the impact on its Consolidated Financial Statements.
The FASB has issued ASU 2016-09, Compensation—Stock Compensation (Topic 718). The purpose of this guidance is to simplify the accounting for share-based payment transactions, including the income tax consequences of these transactions. Under the provisions of the update, the income tax consequences of excess tax benefits and deficiencies should be recognized in income tax expense in the reporting period in which the awards vest. Currently, excess tax benefits and deficiencies impact stockholders’ equity directly to the extent there is a cumulative excess tax benefit. In the event that a tax deficiency has occurred during the reporting period and a cumulative tax benefit does not exist, the tax deficiency is recognized in income tax expense under current GAAP. The update also provides that entities may continue to estimate forfeitures in accounting for stock based compensation or recognize them as they occur. This update became effective for interim and annual periods beginning after December 15, 2016. The Company adopted this standard effective January 1, 2017 and elected to apply this adoption prospectively. The recognition of excess tax benefits is in the provision for income taxes within the Consolidated Statements of Operations rather than paid-in capital where it had previously been recorded. Additionally, the Consolidated Statements of Cash Flows now present excess tax benefits in operating activity. The Company has elected to account for forfeitures when they occur. As allowed by the ASU the Company’s adoption was prospective, therefore, prior periods have not been adjusted.
The FASB has issued ASU 2016-02, Leases (Topic 842). The new guidance requires lessees to recognize lease assets and lease liabilities related to certain operating leases on their balance sheet and disclose key information about leasing arrangements. This guidance is effective for fiscal years beginning after December 15, 2018 and interim periods within those fiscal years. The Company is currently evaluating this guidance to determine the impact on its consolidated financial statements. The Company leases certain properties under operating leases that will result in recognition on the Company’s balance sheet. At December 31, 2017, the Company had contractual operating lease commitments of approximately $11.4 million, before considering any renewal options.
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The FASB has issued ASU No. 2016-01, Financial Instruments – Recognition and Measurement of Financial Assets and Liabilities. ASU No. 2016-01 requires equity investments to be measured at fair value with changes in fair value recognized in net income, excluding equity investments that are consolidated or accounted for under the equity method of accounting. The guidance allows equity investments without readily determinable fair values to be measured at cost minus impairment, with a qualitative assessment required to identify impairment. The guidance also: requires public companies to use exit prices to measure the fair value of financial instruments for disclosure purposes; requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements; and eliminates the disclosure requirements related to measurement assumptions for the fair value of instruments measured at amortized cost. In addition, the guidance requires that for liabilities measured at fair value under the fair value option, changes in fair value due to changes in instrument-specific credit risk be presented in other comprehensive income. ASU No. 2016-01 is effective for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years. Adoption of ASU No. 2016-01 is not expected to have a material impact on the Company’s Consolidated Financial Statements.
The FASB has issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). The guidance requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance in this update is effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. As allowed by this ASU the Company is permitted to adopt using the full retrospective transition method for all periods presented, or modified retrospective method where the guidance would only be applied to existing contracts in effect at the adoption date and new contracts going forward. The Company’s revenue stream within the scope of ASU No. 2014-09 is primarily from service charges on deposit accounts. The Company is expected to use a modified retrospective approach to uncompleted contracts at the date of adoption. Periods prior to the date of adoption are not retrospectively revised, but a cumulative effect of adoption is recognized for the impact of the ASU on uncompleted contracts at the date of adoption. The impact of guidance in this update, including method of implementation, is not expected to have a material impact on the Company’s Consolidated Financial Statements.
Note 2: Business Combinations
Patapsco Acquisition
On August 28, 2015, Bancorp completed its acquisition of Patapsco Bancorp through the merger of Patapsco Bancorp, the parent company of The Patapsco Bank, with and into Bancorp pursuant to the Merger Agreement. As a result of the merger, each share of common stock of Patapsco Bancorp was converted into the right to receive, at the holder’s election, $5.09 in cash or 0.3547 shares of Bancorp common stock, provided that (i) cash was paid in lieu of any fractional shares of Bancorp common stock and (ii) 20% of the shares of common stock of Patapsco Bancorp outstanding at the time of the merger were exchanged for cash in the merger, with the remaining shares of Patapsco Bancorp common stock exchanged for 560,891 shares of Bancorp common stock. The aggregate merger consideration was $10.064 million. In connection with the merger, immediately thereafter The Patapsco Bank was merged with and into the Bank, with the Bank the surviving bank.
The Company has accounted for the merger under the acquisition method of accounting in accordance with FASB ASC Topic 805, “Business Combinations,” whereby the acquired assets and assumed liabilities were recorded by Bancorp at their estimated fair values as of their acquisition date. Fair value estimates for loans and deposits were based on management’s acceptance of a fair market valuation analysis performed by an independent third party firm.
The acquired assets and assumed liabilities of Patapsco Bancorp were measured at estimated fair value. Management made significant estimates and exercised significant judgment in accounting for the acquisition of Patapsco Bancorp. Management judgmentally assigned risk ratings to loans based on appraisals and estimated collateral values, expected cash flows, prepayment speeds and estimated loss factors to measure fair values for loans. Deposits and borrowings were valued based upon interest rates, original and remaining terms and maturities, as well as current rates for similar funds in the same markets. Premises and equipment was valued based on recent appraised values. Management used quoted or current market prices to determine the fair value of investment securities.
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The following table provides the purchase price as of the acquisition date, the identifiable assets acquired and liabilities assumed at their estimated fair values, and the resulting goodwill of $603 thousand recorded from the acquisition:
(in thousands)
| Purchase Price Consideration | ||||
| Cash consideration | $ | 2,015 | ||
| Purchase price assigned to shares exchanged for stock | 8,049 | |||
| Total purchase price for Patapsco acquisition | $ | 10,064 | ||
| Assets acquired at fair value: | ||||
| Cash and cash equivalents | $ | 19,047 | ||
| Investment securities available for sale | 26,255 | |||
| Loans | 156,907 | |||
| Accrued interest receivable | 602 | |||
| Other assets | 9,090 | |||
| Core deposit intangible | 1,974 | |||
| Total fair value of assets acquired | $ | 213,875 | ||
| Liabilities assumed at fair value: | ||||
| Deposits | 175,083 | |||
| Borrowings | 17,737 | |||
| Accrued expenses and other liabilities | 11,594 | |||
| Total fair value of liabilities assumed | $ | 204,414 |
| Net assets acquired at fair value: | $ | 9,461 | ||
| Transaction consideration paid to Patapsco Bancorp | 10,064 | |||
| Amount of goodwill recorded from Patapsco acquisition | $ | 603 |
Acquired loans
The following table outlines the contractually required payments receivable, cash flows we expect to receive, non-accretable credit adjustments and the accretable yield for all Patapsco Bancorp loans as of the acquisition date.
| Contractually | ||||||||||||||||||||
| Required | Non-Accretable | Cash Flows | Accretable | Carring Value | ||||||||||||||||
| Payments | Credit | Expected to be | FMV | of Loans | ||||||||||||||||
| Receivable | Adjustment | Collected | Adjustment | Receivable | ||||||||||||||||
| Performing loans acquired | $ | 156,393 | $ | - | $ | 156,393 | $ | 866 | $ | 155,527 | ||||||||||
| Impaired loans acquired | 3,465 | 1,713 | 1,752 | 372 | 1,380 | |||||||||||||||
| Total loans acquired | $ | 159,858 | $ | 1,713 | $ | 158,145 | $ | 1,238 | $ | 156,907 | ||||||||||
Upon the acquisition of Patapsco Bancorp, the Company recorded all loans acquired at the estimated fair value on the purchase date with no carryover of the related allowance for credit losses. On the acquisition date, the Company segregated the loan portfolio into two loan pools, performing and non-performing loans to be retained in the Bank’s portfolio.
The Company had an independent third party determine the net discounted value of cash flows on approximately 1,000 performing loans totaling $156.4 million. The valuation took into consideration the loans’ underlying characteristics, including account types, remaining terms, annual interest rates, interest types, past delinquencies, timing of principal and interest payments, current market rates, loan-to-value ratios, loss exposures, and remaining balances. These performing loans were segregated into pools based on loan and payment type and in some cases, risk grade. The effect of this fair valuation process was a net accretable discount adjustment of $866 thousand at acquisition.
The Company also individually evaluated 13 impaired loans totaling $3.5 million to determine the fair value as of the August 28, 2015 measurement date. In determining the fair value for each individually evaluated impaired loan, a number of factors including the remaining life of the acquired loan, estimated prepayments, estimated loss ratios, estimated value of the underlying collateral and net present value of cash flows expected to be recorded were considered, among others.
The Company established a credit risk related non-accretable difference of $1.7 million relating to these acquired, credit impaired loans, reflected in the recorded net fair value. The Company further estimated the timing and amount of expected cash flows in excess of the estimated fair value and established an accretable discount adjustment of $372 thousand at acquisition relating to these impaired loans.
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Note 3: Cash and Due from Banks
Regulation D of the Federal Reserve Act requires that banks maintain reserve balances with the Federal Reserve Bank based principally on the type and amount of their deposits. During 2017 and 2016, the Company maintained balances at the Federal Reserve (in addition to vault cash) to meet the reserve requirements as well as balances to partially compensate for services. Additionally, the Company maintained balances with the Federal Home Loan Bank and other domestic correspondent financial institutions as partial compensation for services they provided to the Company.
Note 4: Investments Securities
The Company holds securities classified as available for sale and held to maturity.
The amortized cost and estimated fair values of investments are as follows:
| December 31, | ||||||||||||||||||||||||||||||||
| (in thousands) | 2017 | 2016 | ||||||||||||||||||||||||||||||
| Gross | Gross | Gross | Gross | |||||||||||||||||||||||||||||
| Amortized | Unrealized | Unrealized | Estimated | Amortized | Unrealized | Unrealized | Estimated | |||||||||||||||||||||||||
| Cost | Gains | Losses | Fair Value | Cost | Gains | Losses | Fair Value | |||||||||||||||||||||||||
| Available for sale | ||||||||||||||||||||||||||||||||
| U.S. Government | ||||||||||||||||||||||||||||||||
| Agencies | $ | 68,082 | $ | - | $ | 342 | $ | 67,740 | $ | 34,584 | $ | 5 | $ | 126 | $ | 34,463 | ||||||||||||||||
| Treasuries | 1,505 | - | 11 | 1,494 | 1,512 | - | 8 | 1,504 | ||||||||||||||||||||||||
| Mortgage-backed | 2,541 | - | 62 | 2,479 | 1,366 | 1 | 69 | 1,298 | ||||||||||||||||||||||||
| Other investments | 2,579 | - | 36 | 2,543 | 1,500 | - | 37 | 1,463 | ||||||||||||||||||||||||
| $ | 74,707 | $ | - | $ | 451 | $ | 74,256 | $ | 38,962 | $ | 6 | $ | 240 | $ | 38,728 | |||||||||||||||||
| Held to maturity | ||||||||||||||||||||||||||||||||
| Corporate debentures | $ | 9,250 | $ | 188 | $ | 17 | $ | 9,421 | $ | 6,250 | $ | 334 | $ | - | $ | 6,584 | ||||||||||||||||
Gross unrealized losses and fair value by investment category and length of time the individual securities have been in a continuous unrealized loss position at December 31, 2017 and December 31, 2016 are presented below:
| December 31, 2017 | ||||||||||||||||||||||||
| (in thousands) | Less than 12 months | 12 months or more | Total | |||||||||||||||||||||
| Gross | Gross | Gross | ||||||||||||||||||||||
| Fair | Unrealized | Fair | Unrealized | Fair | Unrealized | |||||||||||||||||||
| Value | Losses | Value | Losses | Value | Losses | |||||||||||||||||||
| Available for sale | ||||||||||||||||||||||||
| U.S. Government | ||||||||||||||||||||||||
| Agencies | $ | 54,303 | $ | 216 | $ | 13,437 | $ | 126 | $ | 67,740 | $ | 342 | ||||||||||||
| Treasuries | - | - | 1,494 | 11 | 1,494 | 11 | ||||||||||||||||||
| Mortgage-backed | 1,202 | 12 | 1,262 | 50 | 2,464 | 62 | ||||||||||||||||||
| Other investments | 2,500 | 36 | - | - | 2,500 | 36 | ||||||||||||||||||
| $ | 58,005 | $ | 264 | $ | 16,193 | $ | 187 | $ | 74,198 | $ | 451 | |||||||||||||
| Held to maturity | ||||||||||||||||||||||||
| Corporate debentures | $ | 9,250 | $ | 17 | $ | - | $ | - | $ | 9,250 | $ | 17 | ||||||||||||
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| December 31, 2016 | ||||||||||||||||||||||||
| (in thousands) | Less than 12 months | 12 months or more | Total | |||||||||||||||||||||
| Gross | Gross | Gross | ||||||||||||||||||||||
| Fair | Unrealized | Fair | Unrealized | Fair | Unrealized | |||||||||||||||||||
| Value | Losses | Value | Losses | Value | Losses | |||||||||||||||||||
| Available for sale | ||||||||||||||||||||||||
| U.S. Government | ||||||||||||||||||||||||
| Agencies | $ | 17,492 | $ | 126 | $ | - | $ | - | $ | 17,492 | $ | 126 | ||||||||||||
| Treasuries | 1,501 | 8 | - | - | 1,501 | 8 | ||||||||||||||||||
| Mortgage-backed | 1,273 | 69 | - | - | 1,273 | 69 | ||||||||||||||||||
| Other investments | 1,463 | 37 | - | - | 1,463 | 37 | ||||||||||||||||||
| $ | 21,729 | $ | 240 | $ | - | $ | - | $ | 21,729 | $ | 240 | |||||||||||||
The unrealized losses that existed were a result of market changes in interest rates since the original purchase. Management systematically evaluates investment securities for other-than-temporary declines in fair value on a quarterly basis. This analysis requires management to consider various factors, which include (1) duration and magnitude of the decline in value, (2) the financial condition of the issuer or issuers and (3) structure of the security. The portfolio contained 38 securities with unrealized losses and 12 securities with unrealized losses at December 31, 2017 and 2016, respectively.
An impairment loss is recognized in earnings if any of the following are true: (1) the Company intends to sell the debt security; (2) it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis; or (3) the Company does not expect to recover the entire amortized cost basis of the security. In situations where the Company intends to sell or when it is more likely than not that the Company will be required to sell the security, the entire impairment loss must be recognized in earnings. In all other situations, only the portion of the impairment loss representing the credit loss must be recognized in earnings, with the remaining portion being recognized in stockholders’ equity as a component of other comprehensive income, net of deferred tax.
The amortized cost and estimated fair values of investments by contractual maturity are shown below:
| December 31, | ||||||||||||||||
| (in thousands) | 2017 | 2016 | ||||||||||||||
| Amortized | Estimated Fair | Amortized | Estimated Fair | |||||||||||||
| Cost | Value | Cost | Value | |||||||||||||
| Amounts maturing: | ||||||||||||||||
| One year or less | $ | 35,105 | $ | 34,995 | $ | 16,988 | $ | 16,993 | ||||||||
| After one through five years | 34,489 | 34,248 | 19,120 | 18,985 | ||||||||||||
| After five through ten years | 9,257 | 9,428 | 6,262 | 6,596 | ||||||||||||
| After ten years | 2,526 | 2,464 | 2,842 | 2,738 | ||||||||||||
| $ | 81,377 | $ | 81,135 | $ | 45,212 | $ | 45,312 | |||||||||
At December 31, 2017 and December 31, 2016, $28.8 million and $26.8 million fair value of securities, respectively, were pledged as collateral for both repurchase agreements and deposits of local government entities that require pledged collateral as a condition of maintaining these deposit accounts. No single issuer of securities, except for Government agency securities, had outstanding balances that exceeded ten percent of stockholders’ equity at December 31, 2017.
Note 5: Nonmarketable Equity Securities
At December 31, 2017 and December 31, 2016, the Company’s investment in nonmarketable equity securities consisted of Federal Home Loan Bank stock, which is required for continued membership, of $6.5 million and $5.1 million, respectively. This investment is carried at cost.
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Note 6: Loans and Leases
The Company makes loans and leases to customers primarily in the Greater Baltimore Maryland metropolitan area, and surrounding communities. A substantial portion of the Company’s loan portfolio consists of loans to businesses secured by real estate and/or other business assets.
The loan portfolio segment balances at December 31, 2017 and December 31, 2016 are presented in the following table:
| December 31, | ||||||||||||||||
| (in thousands) | 2017 | % of Total | 2016 | % of Total | ||||||||||||
| Real estate | ||||||||||||||||
| Construction and land | $ | 74,398 | 7.9 | % | $ | 72,973 | 8.9 | % | ||||||||
| Residential - first lien | 194,896 | 20.8 | 195,032 | 23.7 | ||||||||||||
| Residential - junior lien | 43,047 | 4.6 | 35,009 | 4.3 | ||||||||||||
| Total residential real estate | 237,943 | 25.4 | 230,041 | 28.0 | ||||||||||||
| Commercial - owner occupied | 170,408 | 18.2 | 134,213 | 16.3 | ||||||||||||
| Commercial - non-owner occupied | 260,802 | 27.8 | 216,781 | 26.4 | ||||||||||||
| Total commercial real estate | 431,210 | 46.0 | 350,994 | 42.7 | ||||||||||||
| Total real estate loans | 743,551 | 79.3 | 654,008 | 79.6 | ||||||||||||
| Commercial loans and leases | 188,729 | 20.2 | 162,715 | 19.8 | ||||||||||||
| Consumer | 4,328 | 0.5 | 4,801 | 0.6 | ||||||||||||
| Total loans | $ | 936,608 | 100.0 | % | $ | 821,524 | 100.0 | % | ||||||||
Net loan origination fees, which are included in the amounts above, totaled $54 thousand and $122 thousand at December 31, 2017 and 2016, respectively.
Portfolio Segments
The Company currently manages its credit products and the respective exposure to credit losses (credit risk) by the following specific portfolio segments (classes) which are levels at which the Company develops and documents its systematic methodology to determine the allowance for credit losses attributable to each respective portfolio segment. These segments are:
| · | Commercial business loans & leases – Commercial loans are made to provide funds for equipment and general corporate needs. Repayment of a loan primarily uses the funds obtained from the operation of the borrower’s business. Commercial loans also include lines of credit that are utilized to finance a borrower’s short-term credit needs and/or to finance a percentage of eligible receivables and inventory. The Company’s loan portfolio also includes a small portfolio of equipment leases, which consists of leases for essential commercial equipment used by small to medium sized businesses. |
| · | Construction and land loans – Commercial acquisition, development and construction loans are intended to finance the construction of commercial and residential properties and include loans for the acquisition and development of land. Construction loans represent a higher degree of risk than permanent real estate loans and may be affected by a variety of factors such as the borrower’s ability to control costs and adhere to time schedules and the risk that constructed units may not be absorbed by the market within the anticipated time frame or at the anticipated price. The loan commitment on these loans often includes an interest reserve that allows the lender to periodically advance loan funds to pay interest charges on the outstanding balance of the loan. |
| · | Commercial owner occupied real estate loans – Commercial owner-occupied real estate loans consist of commercial mortgage loans secured by owner occupied properties where an established banking relationship exists and involves a variety of property types to conduct the borrower’s operations. The primary source of repayment for this type of loan is the cash flow from the business and is based upon the borrower’s financial health and the ability of the borrower and the business to repay. |
| · | Commercial non-owner occupied real estate loans – Commercial non-owner occupied loans consist of properties where an established banking relationship exists and involves investment properties for warehouse, retail, and office space with a history of occupancy and cash flow. This commercial real estate category contains mortgage loans to the developers and owners of commercial real estate where the borrower intends to operate or sell the property at a profit and use the income stream or proceeds from the sale(s) to repay the loan. |
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| · | Consumer loans – This category of loans includes primarily installment loans and personal lines of credit. Consumer loans include installment loans used by customers to purchase automobiles, boats and recreational vehicles. |
| · | Residential first lien mortgage loans – The residential real estate category contains permanent mortgage loans principally to consumers secured by residential real estate. Residential real estate loans are evaluated for the adequacy of repayment sources at the time of approval, based upon measures including credit scores, debt-to-income ratios, and collateral values. Loans may be either conforming or non-conforming. |
| · | Residential junior lien mortgage loans – This category of loans includes primarily home equity loans and lines. The home equity category consists mainly of revolving lines of credit to consumers which are secured by residential real estate. These loans are typically secured with second mortgages on the homes. |
Acquired Impaired Loans
As of December 31, 2017 and 2016, the Company held $851 thousand and $1.0 million in carrying amounts of acquired impaired loans.
Note 7: Credit Quality Assessment
Allowance for Credit Losses
Credit risk can vary significantly as losses, as a percentage of outstanding loans, can vary widely during economic cycles and are sensitive to changing economic conditions. The amount of loss in any particular type of loan can vary depending on the purpose of the loan and the underlying collateral securing the loan. Collateral securing commercial loans can range from accounts receivable to equipment to improved or unimproved real estate depending on the purpose of the loan. Home mortgage and home equity loans and lines are typically secured by first or second liens on residential real estate. Consumer loans may be secured by personal property, such as auto loans or they may be unsecured loan products.
To control and manage credit risk, management has an internal credit process in place to determine whether credit standards are maintained along with an in-house loan administration accompanied by oversight and review procedures. The primary purpose of loan underwriting is the evaluation of specific lending risks that involves the analysis of the borrower’s ability to service the debt as well as the assessment of the value of the underlying collateral. Oversight and review procedures include the monitoring of the portfolio credit quality, early identification of potential problem credits and the management of the problem credits. As part of the oversight and review process, the Company maintains an allowance for credit losses (the “allowance”) to absorb estimated and probable losses in the loan and lease portfolio. The allowance is based on consistent, continuous review and evaluation of the loan and lease portfolio, along with ongoing assessments of the probable losses and problem credits in each portfolio. While portions of the allowance are attributed to specific portfolio segments, the entire allowance is available for credit losses inherent in the total loan portfolio.
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The following table provides information on the activity in the allowance for credit losses by the respective loan portfolio segment for the years ended December 31, 2017, 2016 and 2015:
| December 31, 2017 | ||||||||||||||||||||||||||||||||
| Commercial | Commercial | Commercial | ||||||||||||||||||||||||||||||
| Construction | Residential | Residential | owner | non-owner | loans | Consumer | ||||||||||||||||||||||||||
| (in thousands) | and land | first lien | junior lien | occupied | occupied | and leases | loans | Total | ||||||||||||||||||||||||
| Allowance for credit losses: | ||||||||||||||||||||||||||||||||
| Beginning balance | $ | 511 | $ | 454 | $ | 89 | $ | 327 | $ | 1,120 | $ | 3,800 | $ | 127 | $ | 6,428 | ||||||||||||||||
| Charge-offs | (155 | ) | (133 | ) | (31 | ) | (235 | ) | - | (1,605 | ) | (108 | ) | (2,267 | ) | |||||||||||||||||
| Recoveries | 6 | - | 1 | 6 | 6 | 113 | 35 | 167 | ||||||||||||||||||||||||
| Provision for credit losses | 373 | 347 | 118 | 519 | 284 | 221 | (31 | ) | 1,831 | |||||||||||||||||||||||
| Ending balance | $ | 735 | $ | 668 | $ | 177 | $ | 617 | $ | 1,410 | $ | 2,529 | $ | 23 | $ | 6,159 | ||||||||||||||||
| Allowance allocated to: | ||||||||||||||||||||||||||||||||
| individually evaluated for impairment | $ | 202 | $ | - | $ | 29 | $ | - | $ | 11 | $ | 668 | $ | - | $ | 910 | ||||||||||||||||
| collectively evaluated for impairment | $ | 533 | $ | 668 | $ | 148 | $ | 617 | $ | 1,399 | $ | 1,861 | $ | 23 | $ | 5,249 | ||||||||||||||||
| Loans: | ||||||||||||||||||||||||||||||||
| Ending balance | $ | 74,398 | $ | 194,896 | $ | 43,047 | $ | 170,408 | $ | 260,802 | $ | 188,729 | $ | 4,328 | $ | 936,608 | ||||||||||||||||
| individually evaluated for impairment | $ | 761 | $ | 2,009 | $ | 396 | $ | 508 | $ | 5,867 | $ | 3,724 | $ | - | $ | 13,265 | ||||||||||||||||
| collectively evaluated for impairment | $ | 73,637 | $ | 192,887 | $ | 42,651 | $ | 169,900 | $ | 254,935 | $ | 185,005 | $ | 4,328 | $ | 923,343 | ||||||||||||||||
| December 31, 2016 | ||||||||||||||||||||||||||||||||
| Commercial | Commercial | Commercial | ||||||||||||||||||||||||||||||
| Construction | Residential | Residential | owner | non-owner | loans | Consumer | ||||||||||||||||||||||||||
| (in thousands) | and land | first lien | junior lien | occupied | occupied | and leases | loans | Total | ||||||||||||||||||||||||
| Allowance for credit losses: | ||||||||||||||||||||||||||||||||
| Beginning balance | $ | 265 | $ | 300 | $ | 47 | $ | 309 | $ | 728 | $ | 3,094 | $ | 126 | $ | 4,869 | ||||||||||||||||
| Charge-offs | (216 | ) | - | - | (191 | ) | - | (234 | ) | (20 | ) | (661 | ) | |||||||||||||||||||
| Recoveries | - | - | - | 40 | 5 | 101 | 37 | 183 | ||||||||||||||||||||||||
| Provision for credit losses | 462 | 154 | 42 | 169 | 387 | 839 | (16 | ) | 2,037 | |||||||||||||||||||||||
| Ending balance | $ | 511 | $ | 454 | $ | 89 | $ | 327 | $ | 1,120 | $ | 3,800 | $ | 127 | $ | 6,428 | ||||||||||||||||
| Allowance allocated to: | ||||||||||||||||||||||||||||||||
| individually evaluated for impairment | $ | - | $ | 7 | $ | - | $ | - | $ | - | $ | 2,076 | $ | 72 | $ | 2,155 | ||||||||||||||||
| collectively evaluated for impairment | $ | 511 | $ | 447 | $ | 89 | $ | 327 | $ | 1,120 | $ | 1,724 | $ | 55 | $ | 4,273 | ||||||||||||||||
| Loans: | ||||||||||||||||||||||||||||||||
| Ending balance | $ | 72,973 | $ | 195,032 | $ | 35,009 | $ | 134,213 | $ | 216,781 | $ | 162,715 | $ | 4,801 | $ | 821,524 | ||||||||||||||||
| individually evaluated for impairment | $ | 125 | $ | 785 | $ | 37 | $ | 509 | $ | 3,148 | $ | 5,142 | $ | 167 | $ | 9,913 | ||||||||||||||||
| collectively evaluated for impairment | $ | 72,848 | $ | 194,247 | $ | 34,972 | $ | 133,704 | $ | 213,633 | $ | 157,573 | $ | 4,634 | $ | 811,611 | ||||||||||||||||
| 76 |
| December 31, 2015 | ||||||||||||||||||||||||||||||||
| Commercial | Commercial | Commercial | ||||||||||||||||||||||||||||||
| Construction | Residential | Residential | owner | non-owner | loans | Consumer | ||||||||||||||||||||||||||
| (in thousands) | and land | first lien | junior lien | occupied | occupied | and leases | loans | Total | ||||||||||||||||||||||||
| Allowance for credit losses: | ||||||||||||||||||||||||||||||||
| Beginning balance | $ | 174 | $ | 272 | $ | 55 | $ | 160 | $ | 562 | $ | 2,366 | $ | 13 | $ | 3,602 | ||||||||||||||||
| Charge-offs | - | (23 | ) | (12 | ) | - | (82 | ) | (825 | ) | (5 | ) | (947 | ) | ||||||||||||||||||
| Recoveries | - | 3 | 1 | - | 318 | 52 | 4 | 378 | ||||||||||||||||||||||||
| Provision for credit losses | 91 | 48 | 3 | 149 | (70 | ) | 1,501 | 114 | 1,836 | |||||||||||||||||||||||
| Ending balance | $ | 265 | $ | 300 | $ | 47 | $ | 309 | $ | 728 | $ | 3,094 | $ | 126 | $ | 4,869 | ||||||||||||||||
| Allowance for credit losses: | ||||||||||||||||||||||||||||||||
| individually evaluated for impairment | $ | - | $ | - | $ | - | $ | - | $ | - | $ | 1,208 | $ | 75 | $ | 1,283 | ||||||||||||||||
| collectively evaluated for impairment | $ | 265 | $ | 300 | $ | 47 | $ | 309 | $ | 728 | $ | 1,886 | $ | 51 | $ | 3,586 | ||||||||||||||||
| Loans: | ||||||||||||||||||||||||||||||||
| Ending balance | $ | 69,385 | $ | 182,988 | $ | 27,477 | $ | 131,114 | $ | 181,361 | $ | 160,424 | $ | 4,253 | $ | 757,002 | ||||||||||||||||
| individually evaluated for impairment | $ | - | $ | 994 | $ | 63 | $ | 232 | $ | 2,989 | $ | 6,814 | $ | 150 | $ | 11,242 | ||||||||||||||||
| collectively evaluated for impairment | $ | 69,385 | $ | 181,994 | $ | 27,414 | $ | 130,882 | $ | 178,372 | $ | 153,610 | $ | 4,103 | $ | 745,760 | ||||||||||||||||
Integral to the assessment of the allowance process is an evaluation that is performed to determine whether a specific reserve on an impaired credit is warranted. At such time an action plan is agreed upon for the particular loan, an appraisal will be ordered (for real estate based collateral) depending on the time elapsed since the prior appraisal, the loan balance and/or the result of the internal evaluation. The Company’s policy is to strictly adhere to regulatory appraisal standards. If an appraisal is ordered, no more than a 45 day turnaround is requested from the appraiser, who is selected from an approved appraiser list. After receipt of the updated appraisal, the Company’s Watch Committee will determine whether a specific reserve or a charge-off should be taken based upon an impairment analysis. When potential losses are identified, a specific provision and/or charge-off may be taken, based on the then current likelihood of repayment, that is at least in the amount of the collateral deficiency, and any potential collection costs, as determined by the independent third party appraisal. Any further collateral deterioration may result in either further specific reserves being established or additional charge-offs. The President and the Chief Lending Officer have the authority to approve a specific reserve or charge-off between Watch Committee meetings to ensure that there are no significant time lapses during this process.
The Company’s systematic methodology for evaluating whether a loan is impaired begins with risk-rating credits on an individual basis and includes consideration of the borrower’s overall financial condition, resources and payment record, the sufficiency of collateral and, in a select few cases, support from financial guarantors. In measuring impairment, the Company looks to the discounted cash flows of the project itself or the value of the collateral as the primary sources of repayment of the loan. The Company will consider the existence of guarantees and the financial strength and wherewithal of the guarantors involved in any loan relationship as both a secondary source of repayment and for the potential as the primary repayment of the loan.
The Company typically relies on recent third party appraisals of the collateral to assist in measuring impairment.
Management has established a credit process that dictates that structured procedures be performed to monitor these loans between the receipt of an original appraisal and the updated appraisal. These procedures include the following:
| · | An internal evaluation is updated quarterly to include borrower financial statements and/or cash flow projections. |
| · | The borrower may be contacted for a meeting to discuss an update or revised action plan which may include a request for additional collateral. |
| · | Re-verification of the documentation supporting the Company’s position with respect to the collateral securing the loan. |
| · | At the Watch Committee meeting the loan may be downgraded and a specific reserve may be decided upon in advance of the receipt of the appraisal if it is determined that the likelihood of repayment is in doubt. |
The Company generally follows a policy of not extending maturities on non-performing loans under existing terms. The Company may extend the maturity of a performing or current loan that may have some inherent weakness associated with the loan. Maturity date extensions only occur under terms that clearly place the Company in a position to assure full collection of the loan under the contractual terms and /or terms at the time of the extension that may eliminate or mitigate the inherent weakness in the loan. These terms may incorporate, but are not limited to additional assignment of collateral, significant balance curtailments/liquidations and assignments of additional project cash flows. Guarantees may be a consideration in the extension of loan maturities, but the Company does not extend loans based solely on guarantees. As a general matter, the Company does not view extension of a loan to be a satisfactory approach to resolving non-performing credits. On an exception basis, certain performing loans that have displayed some inherent weakness in the underlying collateral values, an inability to comply with certain loan covenants which are not affecting the performance of the credit or other identified weakness may be extended.
| 77 |
Collateral values or estimates of discounted cash flows (inclusive of any potential cash flow from guarantees) are evaluated to estimate the probability and severity of potential losses. A specific amount of impairment is established based on the Company’s calculation of the probable loss inherent in the individual loan. The actual occurrence and severity of losses involving impaired credits can differ substantially from estimates.
Credit risk profile by portfolio segment based upon internally assigned risk assignments are presented below:
| December 31, 2017 | ||||||||||||||||||||||||||||||||
| Commercial | Commercial | Commercial | ||||||||||||||||||||||||||||||
| Construction | Residential | Residential | owner | non-owner | loans | Consumer | ||||||||||||||||||||||||||
| (in thousands) | and land | first lien | junior lien | occupied | occupied | and leases | loans | Total | ||||||||||||||||||||||||
| Credit quality indicators: | ||||||||||||||||||||||||||||||||
| Not classified | $ | 73,761 | $ | 193,174 | $ | 42,651 | $ | 169,900 | $ | 253,255 | $ | 184,858 | $ | 4,328 | $ | 921,927 | ||||||||||||||||
| Special mention | - | - | - | - | 1,592 | - | - | 1,592 | ||||||||||||||||||||||||
| Substandard | 637 | 1,103 | 5 | 508 | 3,725 | 801 | - | 6,779 | ||||||||||||||||||||||||
| Doubtful | - | 619 | 391 | - | 2,230 | 3,070 | - | 6,310 | ||||||||||||||||||||||||
| Total | $ | 74,398 | $ | 194,896 | $ | 43,047 | $ | 170,408 | $ | 260,802 | $ | 188,729 | $ | 4,328 | $ | 936,608 | ||||||||||||||||
| December 31, 2016 | ||||||||||||||||||||||||||||||||
| Commercial | Commercial | Commercial | ||||||||||||||||||||||||||||||
| Construction | Residential | Residential | owner | non-owner | loans | Consumer | ||||||||||||||||||||||||||
| (in thousands) | and land | first lien | junior lien | occupied | occupied | and leases | loans | Total | ||||||||||||||||||||||||
| Credit quality indicators: | ||||||||||||||||||||||||||||||||
| Not classified | $ | 72,973 | $ | 193,748 | $ | 34,972 | $ | 133,704 | $ | 212,765 | $ | 157,567 | $ | 4,634 | $ | 810,363 | ||||||||||||||||
| Special mention | - | - | - | - | - | 524 | - | 524 | ||||||||||||||||||||||||
| Substandard | - | 793 | - | - | 2,941 | - | - | 3,734 | ||||||||||||||||||||||||
| Doubtful | - | 491 | 37 | 509 | 1,075 | 4,624 | 167 | 6,903 | ||||||||||||||||||||||||
| Total | $ | 72,973 | $ | 195,032 | $ | 35,009 | $ | 134,213 | $ | 216,781 | $ | 162,715 | $ | 4,801 | $ | 821,524 | ||||||||||||||||
| · | Special Mention - A Special Mention asset has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution’s credit position at some future date. Special Mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. |
| · | Substandard - Substandard loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. |
| · | Doubtful - Loans classified Doubtful have all the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions and values, highly questionable and improbable. |
Loans classified Special Mention, Substandard, Doubtful or Loss are reviewed at least quarterly to determine their appropriate classification. All commercial loan relationships are reviewed annually. Non-classified residential mortgage loans and consumer loans are not evaluated unless a specific event occurs to raise the awareness of a possible credit deterioration.
| 78 |
An aged analysis of past due loans is as follows:
| December 31, 2017 | ||||||||||||||||||||||||||||||||
| Commercial | Commercial | Commercial | ||||||||||||||||||||||||||||||
| Construction | Residential | Residential | owner | non-owner | loans | Consumer | ||||||||||||||||||||||||||
| (in thousands) | and land | first lien | junior lien | occupied | occupied | and leases | loans | Total | ||||||||||||||||||||||||
| Analysis of past due loans: | ||||||||||||||||||||||||||||||||
| Accruing loans current | $ | 73,386 | $ | 185,135 | $ | 42,491 | $ | 169,596 | $ | 251,608 | $ | 185,239 | $ | 4,328 | $ | 911,783 | ||||||||||||||||
| Accruing loans past due: | ||||||||||||||||||||||||||||||||
| 30-59 days past due | 279 | 6,381 | 110 | 173 | - | 52 | - | 6,995 | ||||||||||||||||||||||||
| 60-89 days past due | 96 | 1,330 | - | - | 364 | - | - | 1,790 | ||||||||||||||||||||||||
| Greater than 90 days past due | - | 328 | 50 | 131 | 2,963 | - | - | 3,472 | ||||||||||||||||||||||||
| Total past due | 375 | 8,039 | 160 | 304 | 3,327 | 52 | - | 12,257 | ||||||||||||||||||||||||
| Non-accrual loans | 637 | 1,722 | 396 | 508 | 5,867 | 3,438 | - | 12,568 | ||||||||||||||||||||||||
| Total loans | $ | 74,398 | $ | 194,896 | $ | 43,047 | $ | 170,408 | $ | 260,802 | $ | 188,729 | $ | 4,328 | $ | 936,608 | ||||||||||||||||
| December 31, 2016 | ||||||||||||||||||||||||||||||||
| Commercial | Commercial | Commercial | ||||||||||||||||||||||||||||||
| Construction | Residential | Residential | owner | non-owner | loans | Consumer | ||||||||||||||||||||||||||
| (in thousands) | and land | first lien | junior lien | occupied | occupied | and leases | loans | Total | ||||||||||||||||||||||||
| Analysis of past due loans: | ||||||||||||||||||||||||||||||||
| Accruing loans current | $ | 72,775 | $ | 191,216 | $ | 34,634 | $ | 133,638 | $ | 212,537 | $ | 157,464 | $ | 4,631 | $ | 806,895 | ||||||||||||||||
| Accruing loans past due: | ||||||||||||||||||||||||||||||||
| 30-59 days past due | - | 2,653 | 334 | 66 | 466 | 593 | 1 | 4,113 | ||||||||||||||||||||||||
| 60-89 days past due | 197 | 374 | 4 | - | - | 34 | 1 | 610 | ||||||||||||||||||||||||
| Greater than 90 days past due | 1 | 298 | - | - | 2,703 | - | 1 | 3,003 | ||||||||||||||||||||||||
| Total past due | 198 | 3,325 | 338 | 66 | 3,169 | 627 | 3 | 7,726 | ||||||||||||||||||||||||
| Non-accrual loans | - | 491 | 37 | 509 | 1,075 | 4,624 | 167 | 6,903 | ||||||||||||||||||||||||
| Total loans | $ | 72,973 | $ | 195,032 | $ | 35,009 | $ | 134,213 | $ | 216,781 | $ | 162,715 | $ | 4,801 | $ | 821,524 | ||||||||||||||||
Total loans either in non-accrual status or in excess of 90 days delinquent totaled $16.0 million or 1.7% of total loans outstanding at December 31, 2017, an increase from the total of $9.9 million or 1.2% of total loans outstanding at December 31, 2016. There were two loans totaling $729 thousand in non-accrual status that were sold in 2017. Cumulative proceeds from the sale of these loans were $349 thousand.
The impaired loans for the years ended December 31, 2017 and 2016 are as follows:
| December 31, 2017 | ||||||||||||||||||||||||||||||||
| Commercial | Commercial | Commercial | ||||||||||||||||||||||||||||||
| Construction | Residential | Residential | owner | non-owner | loans | Consumer | ||||||||||||||||||||||||||
| (in thousands) | & land | first lien | junior lien | occupied | occupied | and leases | loans | Total | ||||||||||||||||||||||||
| Impaired loans: | ||||||||||||||||||||||||||||||||
| Recorded investment | $ | 761 | $ | 2,009 | $ | 396 | $ | 508 | $ | 5,867 | $ | 3,724 | $ | - | $ | 13,265 | ||||||||||||||||
| With an allowance recorded | 637 | - | 391 | - | 2,230 | 2,883 | - | 6,141 | ||||||||||||||||||||||||
| With no related allowance recorded | 124 | 2,009 | 5 | 508 | 3,637 | 841 | - | 7,124 | ||||||||||||||||||||||||
| Related allowance | 202 | - | 29 | - | 11 | 668 | - | 910 | ||||||||||||||||||||||||
| Unpaid principal | 762 | 2,034 | 403 | 509 | 5,884 | 5,293 | - | 14,885 | ||||||||||||||||||||||||
| Average balance of impaired loans | 756 | 2,100 | 403 | 519 | 5,956 | 5,988 | - | 15,722 | ||||||||||||||||||||||||
| Interest income recognized | 19 | 60 | 12 | - | 132 | 150 | - | 373 | ||||||||||||||||||||||||
| 79 |
| December 31, 2016 | ||||||||||||||||||||||||||||||||
| Commercial | Commercial | Commercial | ||||||||||||||||||||||||||||||
| Construction | Residential | Residential | owner | non-owner | loans | Consumer | ||||||||||||||||||||||||||
| (in thousands) | & land | first lien | junior lien | occupied | occupied | and leases | loans | Total | ||||||||||||||||||||||||
| Impaired loans: | ||||||||||||||||||||||||||||||||
| Recorded investment | $ | 125 | $ | 785 | $ | 37 | $ | 509 | $ | 3,148 | $ | 5,142 | $ | 167 | $ | 9,913 | ||||||||||||||||
| With an allowance recorded | - | 214 | - | - | - | 3,477 | 140 | 3,831 | ||||||||||||||||||||||||
| With no related allowance recorded | 125 | 571 | 37 | 509 | 3,148 | 1,665 | 27 | 6,082 | ||||||||||||||||||||||||
| Related allowance | - | 7 | - | - | - | 2,076 | 72 | 2,155 | ||||||||||||||||||||||||
| Unpaid principal | 125 | 1,323 | 38 | 509 | 3,286 | 5,694 | 174 | 11,149 | ||||||||||||||||||||||||
| Average balance of impaired loans | 378 | 835 | 38 | 536 | 3,452 | 6,455 | 176 | 11,870 | ||||||||||||||||||||||||
| Interest income recognized | 4 | 29 | - | 24 | 47 | 234 | 1 | 339 | ||||||||||||||||||||||||
Included in the total impaired loans above were non-accrual loans of $12.6 million and $6.9 million at December 31, 2017 and 2016, respectively. Interest income that would have been recorded if non-accrual loans had been current and in accordance with their original terms, was $898 thousand, $673 thousand and $345 thousand for the years ended December 31, 2017, 2016 and 2015, respectively.
Loans may have their terms restructured (e.g., interest rates, loan maturity date, payment and amortization period, etc.) in circumstances that provide payment relief to a borrower experiencing financial difficulty. Such restructured loans are considered impaired loans that may either be in accruing status or non-accruing status. Non-accruing restructured loans may return to accruing status provided there is a sufficient period of payment performance in accordance with the restructure terms. Loans may be removed from the restructured category in the year subsequent to the restructuring if they have performed based on all of the restructured loan terms.
The troubled debt restructured loans (“TDRs”) at December 31, 2017 and December 31, 2016 are as follows:
| December 31, 2017 | ||||||||||||||||||||
| Number | Non-Accrual | Number | Accrual | Total | ||||||||||||||||
| (dollars in thousands) | of Loans | Status | of Loans | Status | TDRs | |||||||||||||||
| Construction and land | - | $ | - | 1 | $ | 125 | $ | 125 | ||||||||||||
| Residential real estate - first lien | 2 | 886 | 1 | 287 | 1,173 | |||||||||||||||
| Residential real estate - junior lien | 1 | 398 | - | - | 398 | |||||||||||||||
| Commercial - non-owner occupied | 2 | 2,815 | - | - | 2,815 | |||||||||||||||
| Commercial loans and leases | 2 | 599 | 1 | 208 | 807 | |||||||||||||||
| 7 | $ | 4,698 | 3 | $ | 620 | $ | 5,318 | |||||||||||||
| December 31, 2016 | ||||||||||||||||||||
| Number | Non-Accrual | Number | Accrual | Total | ||||||||||||||||
| (dollars in thousands) | of Loans | Status | of Loans | Status | TDRs | |||||||||||||||
| Construction and land | - | $ | - | 1 | $ | 125 | $ | 125 | ||||||||||||
| Residential real estate - first lien | 1 | 214 | 1 | 294 | 508 | |||||||||||||||
| Commercial - non-owner occupied | 1 | 594 | 1 | 2,073 | 2,667 | |||||||||||||||
| Commercial loans and leases | 1 | 913 | 1 | 183 | 1,096 | |||||||||||||||
| Consumer | 1 | 140 | - | - | 140 | |||||||||||||||
| 4 | $ | 1,861 | 4 | $ | 2,675 | $ | 4,536 | |||||||||||||
| 80 |
A summary of TDR modifications outstanding and performance under modified terms is as follows:
| December 31, 2017 | ||||||||||||||||
| Not Performing | Performing | |||||||||||||||
| Related | to Modified | to Modified | Total | |||||||||||||
| (in thousands) | Allowance | Terms | Terms | TDRs | ||||||||||||
| Construction and land | ||||||||||||||||
| Extension or other modification | $ | - | $ | - | $ | 125 | $ | 125 | ||||||||
| Residential real estate - first lien | ||||||||||||||||
| Extension or other modification | - | 886 | 287 | 1,173 | ||||||||||||
| Residential real estate - junior lien | ||||||||||||||||
| Forbearance | 30 | 398 | - | 398 | ||||||||||||
| Commercial RE - non-owner occupied | ||||||||||||||||
| Rate modification | - | 2,815 | - | 2,815 | ||||||||||||
| Commercial loans | ||||||||||||||||
| Extension or other modification | - | 85 | 208 | 293 | ||||||||||||
| Forbearance | 32 | 514 | - | 514 | ||||||||||||
| Total troubled debt restructure loans | $ | 62 | $ | 4,698 | $ | 620 | $ | 5,318 | ||||||||
| December 31, 2016 | ||||||||||||||||
| Not Performing | Performing | |||||||||||||||
| Related | to Modified | to Modified | Total | |||||||||||||
| (in thousands) | Allowance | Terms | Terms | TDRs | ||||||||||||
| Construction and land | ||||||||||||||||
| Extension or other modification | $ | - | $ | - | $ | 125 | $ | 125 | ||||||||
| Residential real estate - first lien | ||||||||||||||||
| Extension or other modification | 7 | 214 | 294 | 508 | ||||||||||||
| Commercial RE - non-owner occupied | ||||||||||||||||
| Rate modification | - | 594 | 2,073 | 2,667 | ||||||||||||
| Commercial loans | ||||||||||||||||
| Extension or other modification | 913 | 913 | 183 | 1,096 | ||||||||||||
| Consumer | ||||||||||||||||
| Extension or other modification | 72 | 140 | - | 140 | ||||||||||||
| Total troubled debt restructure loans | $ | 992 | $ | 1,861 | $ | 2,675 | $ | 4,536 | ||||||||
There were four new loans restructured during 2017, consisting of the following:
| · | A commercial loan in the amount of $85 thousand for interest only payments for three months, followed by fixed payments until maturity. |
| · | A residential first lien mortgage loan in the amount of $398 thousand through a forbearance agreement that deferred payments. |
| · | A residential first lien mortgage loan in the amount of $683 thousand that was restructured with both an extension of the original term and a reduction of the interest rate on the remaining balance of the loan. |
| · | A commercial loan in the amount of $208 thousand for which the Bank extended the maturity and allowed for a principal and interest payment over time. |
TDRs restructured prior to 2017 consisted of the following:
| · | Two residential first lien loans totaling $491 thousand. |
| · | One commercial loan in the amount $514 thousand. |
| · | One land development loan in the amount of $125 thousand. |
| · | Two commercial real estate loans totaling $2.8 million. |
| 81 |
As a part of the modification of the land development loan restructured during 2016, the Bank agreed to forgive $215 thousand in debt, and recorded this amount as a loss. The pre-modification principal amount on this loan was $340 thousand, while the post-modification principal amount was reduced to $125 thousand. The other modifications consisted of interest rate concessions and payment term extensions, not principal reductions that resulted in a partial charge-off.
Performing TDRs were in compliance with their modified terms and there are no further commitments associated with these loans. During 2017 there were no TDRs that subsequently defaulted within twelve months of their modification dates. There was one consumer loan restructured in 2015 in the amount of $150 thousand that defaulted during the first three months of 2017. Additionally, there was one restructured credit the status of which changed from performing to non-performing during the second quarter 2017.
Management routinely evaluates other real estate owned (“OREO”) based upon periodic appraisals. For the years ended December 31, 2017, 2016 and 2015 there were additional allowances recorded of $581 thousand, $83 thousand and $736 thousand, respectively, as the current appraised value, less estimated cost to sell, was not sufficient to cover the recorded OREO amount. For 2017 and 2016 there were no new loans transferred from loans to OREO. The Company sold one property held as OREO during 2017 for a net loss of $12 thousand. At December 31, 2017 there were two residential first lien loans totaling $184 thousand in the process of foreclosure, while at December 31, 2016 no residential first lien loans were in the process of foreclosure.
Note 8: Goodwill and Other Intangible Assets
In 2015 the Company recorded $603 thousand in goodwill relating to the Patapsco Bancorp acquisition. Since goodwill has an indefinite useful life it is evaluated for impairment annually or more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value.
The Company has one segment, which is the core banking operation. The table below shows goodwill balances at December 31, 2017 and December 31, 2016.
| (in thousands) | ||||
| Goodwill | ||||
| Banking | $ | 603 | ||
Core deposit intangible is premiums paid for the acquisitions of core deposits, and are amortized based upon the estimated economic benefits received. The gross carrying amount and accumulated amortization of other intangible assets are as follows:
| December 31, 2017 | Weighted | |||||||||||||||
| Gross | Net | Average | ||||||||||||||
| Carrying | Accumulated | Carrying | Remaining Life | |||||||||||||
| (in thousands) | Amount | Amortization | Amount | (Years) | ||||||||||||
| Amortizing intangible assets: | ||||||||||||||||
| Core deposit intangible | $ | 3,540 | $ | 1,797 | $ | 1,743 | 5.60 | |||||||||
| December 31, 2016 | Weighted | |||||||||||||||
| Gross | Net | Average | ||||||||||||||
| Carrying | Accumulated | Carrying | Remaining Life | |||||||||||||
| (in thousands) | Amount | Amortization | Amount | (Years) | ||||||||||||
| Amortizing intangible assets: | ||||||||||||||||
| Core deposit intangible | $ | 3,540 | $ | 1,292 | $ | 2,248 | 6.61 | |||||||||
There were no additional intangible assets added in either 2017 or 2016.
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Estimated future amortization expense for amortizing intangibles within the years ending December 31, are as follows:
| (in thousands) | ||||
| 2018 | $ | 396 | ||
| 2019 | 314 | |||
| 2020 | 269 | |||
| 2021 | 258 | |||
| 2022 | 250 | |||
| Thereafter | 256 | |||
| Total amortizing intangible assets | $ | 1,743 | ||
Based upon an annual impairment analysis performed in 2017, it was determined that there was not an impairment of the carrying value of either the goodwill or core deposit intangible.
Note 9: Bank Premises and Equipment
Premises and equipment include the following at:
| December 31, | ||||||||
| (in thousands) | 2017 | 2016 | ||||||
| Land | $ | 4,334 | $ | 4,524 | ||||
| Building and leasehold improvements | 16,384 | 16,361 | ||||||
| Furniture and equipment | 5,015 | 4,721 | ||||||
| Software | 345 | 307 | ||||||
| 26,078 | 25,913 | |||||||
| Less: accumulated depreciation and amortization | 6,889 | 5,833 | ||||||
| Net premises and equipment | $ | 19,189 | $ | 20,080 | ||||
Depreciation and amortization expense for premises and equipment were $1.3 million, $1.2 million and $814 thousand for the years ended December 31, 2017, 2016 and 2015, respectively.
The Company occupies banking and office space in 20 locations, 16 of which are under noncancellable lease arrangements accounted for as operating leases. The initial lease periods range from 5 to 20 years and provide for one or more renewal options. Rent expense applicable to operating leases amounted to $2.0 million, $2.3 million and $2.0 million for the years ended December 31, 2017, 2016 and 2015, respectively. Rental income from owned properties and subleases totaled $387 thousand, $290 thousand and $309 thousand for the years ended December 31, 2017, 2016 and 2015, respectively.
Future minimum lease payments under noncancellable operating leases within the years ending December 31, having an initial term in excess of one year are as follows:
| (in thousands) | ||||
| 2018 | $ | 2,105 | ||
| 2019 | 2,123 | |||
| 2020 | 1,787 | |||
| 2021 | 1,370 | |||
| 2020 | 1,271 | |||
| Thereafter | 2,742 | |||
| Total minimum lease payments | $ | 11,398 | ||
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Note 10: Deposits
The following table details the composition of deposits and the related percentage mix of total deposits, respectively:
| December 31, | ||||||||||||||||
| (dollars in thousands) | 2017 | 2016 | ||||||||||||||
| % of | % of | |||||||||||||||
| Amount | Total | Amount | Total | |||||||||||||
| Noninterest-bearing demand | $ | 218,139 | 26 | % | $ | 182,880 | 23 | % | ||||||||
| Interest-bearing checking | 71,642 | 8 | 62,538 | 8 | ||||||||||||
| Money market accounts | 252,453 | 29 | 247,858 | 31 | ||||||||||||
| Savings | 52,078 | 6 | 50,495 | 6 | ||||||||||||
| Certificates of deposit $250,000 and over | 9,950 | 1 | 12,495 | 1 | ||||||||||||
| Certificates of deposit under $250,000 | 259,646 | 30 | 252,468 | 31 | ||||||||||||
| Total deposits | $ | 863,908 | 100 | % | $ | 808,734 | 100 | % | ||||||||
The following table presents the maturity schedule for time deposits maturing within years ending December 31:
| (in thousands) | ||||
| 2018 | $ | 195,511 | ||
| 2019 | 32,014 | |||
| 2020 | 21,057 | |||
| 2021 | 10,779 | |||
| 2022 | 10,235 | |||
| Total time deposits | $ | 269,596 | ||
Interest expense on deposits for the twelve months ended December 31, 2017, December 31, 2016 and December 31, 2015 was as follows:
| December 31, | ||||||||||||
| (in thousands) | 2017 | 2016 | 2015 | |||||||||
| Interest-bearing checking | $ | 168 | $ | 132 | $ | 101 | ||||||
| Savings and money market | 1,217 | 1,220 | 880 | |||||||||
| Certificates of deposit | 2,612 | 2,118 | 1,630 | |||||||||
| Total | $ | 3,997 | $ | 3,470 | $ | 2,611 | ||||||
Note 11: Short-Term Borrowings
Short-term borrowings consist of overnight unsecured master notes, overnight securities sold under agreement to repurchase and fixed term borrowings with a final remaining maturity of less than one year. Information relating to short-term borrowings at December 31, 2017 and December 31, 2016 is presented below:
| December 31, | ||||||||||||||||
| 2017 | 2016 | |||||||||||||||
| (dollars in thousands) | Amount | Rate | Amount | Rate | ||||||||||||
| At period end | 130,385 | 1.35 | % | $ | 107,056 | 1.14 | % | |||||||||
| Average for the year | 88,513 | 0.99 | 63,457 | 0.94 | ||||||||||||
| Maximum month-end balance | 130,385 | 107,056 | ||||||||||||||
The Company pledges U.S. Government Agency securities, based upon their fair value, as collateral for 100% of the principal and accrued interest of its repurchase agreements. At December 31, 2017 and 2016 there were $14.4 million and $11.4 million, respectively, in investment securities pledged under these agreements.
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If the Company should need to supplement its liquidity, it could borrow, subject to collateral requirements, up to approximately $254.7 million on a line of credit arrangement with the Federal Home Loan Bank of Atlanta (the “FHLB”). At December 31, 2017 and 2016 there were $116.0 million and $100.0 million, respectively, in advances outstanding under this arrangement. Total loans pledged as collateral towards short and long term borrowing was $330.8 million and $288.9 million at December 31, 2017 and 2016, respectively.
Note 12: Long-Term Borrowings
Long-term borrowings for the periods consisted of the following:
| December 31, | ||||||||
| (in thousands) | 2017 | 2016 | ||||||
| Federal Home Loan Bank Advances | ||||||||
| 1.88% Due 2018 1 | $ | - | $ | 2,500 | ||||
| 1.62% Due 2018 1 | - | 2,500 | ||||||
| 2.59% Due 2018 2 | - | 3,064 | ||||||
| 0.85% Due 2018 1 | - | 5,000 | ||||||
| 0.91% Due 2018 1 | - | 4,000 | ||||||
| 1.99% Due 2019 1 | 15,000 | - | ||||||
| Junior subordinated debentures | ||||||||
| 2.48% Due 2035 3 | 3,535 | 3,453 | ||||||
| Total long-term borrowings | $ | 18,535 | $ | 20,517 | ||||
| (1) | Fixed rate advances |
| (2) | Convertible to three-month LIBOR at the option of the FHLB. It is convertible on a quarterly basis upon written notice from the FHLB. |
| (3) | Junior subordinated debt. Interest adjusts quarterly at the rate of three month LIBOR plus 1.48% |
As a part of the Patapsco Bancorp acquisition, Bancorp assumed debt originally issued by Patapsco Bancorp. In 2005 Patapsco Statutory Trust I, a Connecticut statutory business trust and an unconsolidated wholly-owned subsidiary of Patapsco Bancorp and now of Bancorp, issued $5 million of capital trust pass-through securities to investors. The interest rate currently adjusts on a quarterly basis at the rate of the three month LIBOR plus 1.48%. Patapsco Statutory Trust I purchased $5,155,000 of junior subordinated deferrable interest debentures from Patapsco Bancorp. The debentures are the sole asset of the Trust. Patapsco Bancorp also fully and unconditionally guaranteed the obligations of the Trust under the capital securities, which guarantee became an obligation of Bancorp upon its acquisition of Patapsco Bancorp. The capital securities are redeemable by Bancorp at par. The capital securities must be redeemed upon final maturity of the subordinated debentures on December 31, 2035.
Note 13: Income Taxes
Federal and state income tax expense consists of the following for the years ended:
| December 31, | ||||||||||||
| (in thousands) | 2017 | 2016 | 2015 | |||||||||
| Current federal income tax | $ | 3,243 | $ | 4,171 | $ | 3,998 | ||||||
| Current state income tax | 1,038 | (6 | ) | (15 | ) | |||||||
| Deferred federal income tax | (968 | ) | (1,153 | ) | (2,832 | ) | ||||||
| Deferred state income tax | (161 | ) | (76 | ) | (178 | ) | ||||||
| Total income tax expense | $ | 3,152 | $ | 2,936 | $ | 973 | ||||||
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A reconciliation of the statutory federal income tax rate to the Company’s effective tax rate for the years ended follows:
| December 31, | ||||||||||||
| (in thousands) | 2017 | 2016 | 2015 | |||||||||
| Statutory federal income tax rate | 34.0 | % | 34.0 | % | 34.0 | % | ||||||
| State income taxes, net of federal income tax expense | 5.6 | 6.2 | 5.9 | |||||||||
| Bank owned life insurance | (2.5 | ) | (2.6 | ) | (6.5 | ) | ||||||
| Acquisition related costs | 1.1 | - | 10.7 | |||||||||
| Revalue of deferred taxes | 2.6 | - | - | |||||||||
| Correction of error | (6.5 | ) | - | - | ||||||||
| Other, net | (3.9 | ) | (2.0 | ) | 1.9 | |||||||
| Effective tax rate | 30.4 | % | 35.6 | % | 46.0 | % | ||||||
Income tax expense for 2017 was impacted by the adjustment of the Company’s deferred tax assets and liabilities related to the reduction in the U.S. federal statutory income tax rate to 21% under the Act. As a result of the new law, which is more fully discussed below, we recognized a net tax expense totaling $215 thousand. Income tax expense for 2017 was also impacted by a correction of an overstatement of taxes that resulted from incorrectly classifying certain acquired loan fair value adjustments on purchased credit impaired loans. As a result the Company recognized tax benefits totaling $622 thousand related to the 2015 through 2016 tax years.
The following table is a summary of the tax effect of temporary differences that give rise to a significant portion of deferred tax assets and liabilities:
| December, 31 | ||||||||
| (in thousands) | 2017 | 2016 | ||||||
| Deferred tax assets: | ||||||||
| Net operating loss | $ | 700 | $ | 1,115 | ||||
| Allowance for credit losses | 1,695 | 2,180 | ||||||
| Valuation on foreclosed real estate | 851 | 1,053 | ||||||
| Supplemental executive benefit plans | 372 | 519 | ||||||
| Stock-based compensation | 74 | 32 | ||||||
| Deferred loan fees and costs, net | 15 | 48 | ||||||
| Unrealized loss on securities | 124 | 84 | ||||||
| Other assets | 282 | 467 | ||||||
| Total deferred tax assets | 4,113 | 5,498 | ||||||
| Deferred tax liabilities: | ||||||||
| Acquisition activity | 2,443 | 4,327 | ||||||
| Fair value | 629 | 1,264 | ||||||
| Depreciation and amortization | 229 | 267 | ||||||
| Total deferred tax liabilities | 3,301 | 5,858 | ||||||
| Net deferred tax assets (liabilities) | $ | 812 | $ | (360 | ) | |||
Based on management’s belief that it is more likely than not that all net deferred tax assets will be realized, there was no valuation allowance at either December 31, 2017 or 2016. At December 31, 2017 and 2016, the Company had Federal tax net operating loss carryforwards, related to acquisitions, of approximately $2.5 million and $2.8 million, respectively. The loss carryforwards can be deducted annually from future taxable income through 2030, subject to an annual limitation of approximately $284 thousand. Currently, tax years from 2014 to present are considered as open for examination by Federal taxing authorities.
Tax Cuts and Jobs Act. The Tax Cuts and Jobs Act was enacted on December 22, 20 I 7. Among other things, the new law (i) establishes a new, flat corporate federal statutory income tax rate of 21%, (ii) eliminates the corporate alternative minimum tax and allows the use of any tax net operating loss carryforwards to offset regular tax liability for any taxable year, (iii) limits the deduction for net interest expense incurred by U.S. corporations, (iv) allows businesses to immediately expense, for tax purposes, the cost of new investments in certain qualified depreciable assets, (v) eliminates or reduces certain deductions related to meals and entertainment expenses, (vi) modifies the limitation on excessive employee remuneration to eliminate the exception for performance-based compensation and clarifies the definition of a covered employee and (vii) limits the deductibility of deposit insurance premiums. The Act also significantly changes U.S. tax law related to foreign operations, however, such changes do not currently impact us.
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As stated above, as a result of the enactment of the Tax Cuts and Job Act on December 22, 2017, we remeasured our deferred tax assets and liabilities based upon the newly enacted U.S. statutory federal income tax rate of 21%, which is the tax rate at which assets and liabilities are expected to reverse in the future. Notwithstanding the foregoing, we are still analyzing certain aspects of the new law and refining our calculation, which could affect the measurement of these assets and liabilities or give rise to new deferred tax amounts. Nonetheless, we recognized a tax expense related to the remeasurement of our deferred tax asset and liabilities totaling $215 thousand.
Note 14: Related Party Loans and Deposits
In the normal course of business, loans are made to officers and directors of the Company, as well as to their related interests. In the opinion of management, these loans are consistent with sound banking practices, are within regulatory lending limitations and do not involve more than the normal risk of collectability.
Total outstanding balances to the Company’s executive officers, directors and their related interests are presented below.
| December 31, | ||||||||
| (in thousands) | 2017 | 2016 | ||||||
| Balance January 1 | $ | 20,260 | $ | 14,329 | ||||
| Additions | 9,097 | 15,378 | ||||||
| Change in status | (747 | ) | 168 | |||||
| Repayments | (9,313 | ) | (9,615 | ) | ||||
| Balance December 31 | $ | 19,297 | $ | 20,260 | ||||
In addition to the outstanding balances above, total unfunded commitments to these parties at December 31, 2017 and December 31, 2016 were $18.5 million and $7.9 million, respectively. The Bank also routinely enters into deposit relationships with its officers and directors in the normal course of business. These deposit accounts bear the same terms and conditions for comparable deposit accounts of unrelated parties and totaled $12.2 million at December 31, 2017 and $15.9 million at December 31, 2016.
Note 15: Financial Instruments with Off-Balance Sheet Risk
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business. These financial instruments may include commitments to extend credit, standby letters of credit and purchase commitments. The Company uses these financial instruments to meet the financing needs of its customers. Financial instruments involve, to varying degrees, elements of credit, interest rate, and liquidity risk. These do not represent unusual risks, and management does not anticipate any losses which would have a material effect on the accompanying financial statements.
Outstanding loan commitments and lines and letters of credit are as follows:
| December 31, | ||||||||
| (in thousands) | 2017 | 2016 | ||||||
| Unfunded loan commitments | $ | 81,074 | $ | 46,194 | ||||
| Unused lines of credit | 138,526 | 80,876 | ||||||
| Letters of credit | 10,839 | 9,660 | ||||||
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. The Company generally requires collateral to support financial instruments with credit risk on the same basis as it does for on-balance sheet instruments. The collateral is based on management’s credit evaluation of the counterparty. Commitments 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 amount does not necessarily represent future cash requirements. Each customer’s credit-worthiness is evaluated on a case-by-case basis.
Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party.
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Note 16: Stock Options and Other Equity Awards
Bancorp’s equity incentive plan provide for awards of nonqualified and incentive stock options as well as vested and non-vested common stock awards. As of December 31, 2017, 639,092 shares are reserved for issuance pursuant to future grants under our stock incentive plan. Employee stock options can be granted with exercise prices at the fair market value (as defined within the plan) of the stock at the date of grant and with terms of up to ten years and typically vest over a three year period. Except as otherwise permitted in the plan, upon termination of employment for reasons other than retirement, permanent disability or death, the option exercise period is reduced or the options are canceled.
Stock awards may also be granted to non-employee members of the Board of Directors as compensation for attendance and participation at meetings of the Board of Directors and meetings of the various committees of the Board. In 2017, 2016 and 2015, Bancorp issued 11,404, 7,241 and 7,163 shares of common stock, respectively, to directors as compensation for their service.
The fair value of Bancorp’s stock options granted as compensation is estimated on the measurement date, which, for the Company, is the date of grant. The fair value of stock options is calculated using the Black-Scholes option-pricing model under which the Company estimates expected market price volatility and expected term of the options based on historical data and other factors. There were no stock options granted in 2017, 2016 or 2015. The valuation of Bancorp’s restricted stock and restricted stock units is the closing price per share of Bancorp’s common stock on the date of grant.
The following table summarizes Bancorp’s stock option activity and related information for the years ended:
| December 31, 2017 | December 31, 2016 | December 31, 2015 | ||||||||||||||||||||||
| Weighted | Weighted | Weighted | ||||||||||||||||||||||
| Average | Average | Average | ||||||||||||||||||||||
| Exercise | Exercise | Exercise | ||||||||||||||||||||||
| Shares | Price | Shares | Price | Shares | Price | |||||||||||||||||||
| Balance at January 1, | 123,593 | $ | 12.36 | 137,463 | $ | 12.30 | 264,652 | $ | 11.75 | |||||||||||||||
| Granted | - | - | - | - | - | - | ||||||||||||||||||
| Exercised | (27,113 | ) | 11.67 | (3,020 | ) | 11.64 | (62,287 | ) | 10.48 | |||||||||||||||
| Forfeited | (65,489 | ) | 13.92 | (10,850 | ) | 11.77 | (64,902 | ) | 11.83 | |||||||||||||||
| Balance at period end | 30,991 | $ | 9.69 | 123,593 | $ | 12.36 | 137,463 | $ | 12.30 | |||||||||||||||
| Exercisable at period end | 30,991 | $ | 9.69 | 123,593 | $ | 12.36 | 137,463 | $ | 12.30 | |||||||||||||||
| Weighted average fair value of options granted during the year | $ | - | $ | - | $ | - | ||||||||||||||||||
The cash received from the exercise of stock options during 2017, 2016 and 2015 was $316 thousand, $35 thousand and $653 thousand, respectively. The intrinsic value of a stock option is the amount that the market value of the underlying stock exceeds the exercise price of the option. Based upon a fair market value of $22.00 on December 31, 2017 the options outstanding had an aggregate intrinsic value of $382 thousand. At December 31, 2016, based upon fair market value of $15.10, the outstanding options outstanding had an aggregate intrinsic value of $338 thousand. The outstanding stock options as of December 31, 2017 have contractual terms that permit exercise of the options through 2019.
Restricted Stock
In the second quarter of 2013, 50,000 shares of restricted stock were granted, with 30,000 of the shares subject to a three year vesting schedule with one-third of the shares vesting each year on the grant date anniversary. The remaining 20,000 awarded shares also were subject to a three year vesting schedule, however, they only vested if certain annual performance measures were satisfactorily achieved.
At December 31, 2017 and 2016 there were no restricted stock awards outstanding, and all of the pre-tax compensation expense related to restricted stock awards has been recognized.
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A summary of the activity for Bancorp’s restricted stock for the periods indicated is presented in the following table:
| December 31, 2016 | December 31, 2015 | |||||||||||||||
| Weighted | Weighted | |||||||||||||||
| Average | Average | |||||||||||||||
| Grant Date | Grant Date | |||||||||||||||
| Shares | Fair Value | Shares | Fair Value | |||||||||||||
| Balance at January 1, | 8,330 | $ | 6.92 | 33,330 | $ | 6.89 | ||||||||||
| Granted | - | - | - | - | ||||||||||||
| Vested | (8,330 | ) | 6.92 | (18,336 | ) | 6.89 | ||||||||||
| Forfeited | - | - | (6,664 | ) | 6.85 | |||||||||||
| Balance at period end | - | $ | - | 8,330 | $ | 6.92 | ||||||||||
Restricted Stock Units
Restricted stock units (“RSUs”) are similar to restricted stock, except the recipient does not receive the stock immediately, but instead receives it according to a vesting plan and distribution schedule after achieving required performance milestones or upon remaining with the employer for a particular length of time. Each RSU that vests entitles the recipient to receive one share of Bancorp common stock on a specified issuance date. The recipient does not have any stockholder rights, including voting, dividend or liquidation rights, with respect to the shares underlying awarded RSUs until the recipient becomes the record holder of those shares.
Bancorp granted 18,500 RSUs during 2017, subject to a three-year vesting schedule. During 2016, 27,000 RSUs were granted, all of which are subject to a three-year vesting schedule. The 30,000 RSUs awarded in 2015 also are subject to a three-year vesting schedule; they only vest, however, if certain annual performance measures are satisfactorily achieved.
A summary of the activity for Bancorp’s RSUs for the periods indicated is presented in the following table:
| December 31, 2017 | December 31, 2016 | December 31, 2015 | ||||||||||||||||||||||
| Weighted | Weighted | Weighted | ||||||||||||||||||||||
| Average | Average | Average | ||||||||||||||||||||||
| Grant Date | Grant Date | Grant Date | ||||||||||||||||||||||
| Shares | Fair Value | Shares | Fair Value | Shares | Fair Value | |||||||||||||||||||
| Balance at January 1, | 65,491 | $ | 13.23 | 74,828 | $ | 13.21 | 44,500 | $ | 11.21 | |||||||||||||||
| Granted | 18,500 | 17.41 | 27,000 | 12.91 | 73,500 | 14.00 | ||||||||||||||||||
| Vested | (31,836 | ) | 12.60 | (17,838 | ) | 12.95 | (19,836 | ) | 11.64 | |||||||||||||||
| Forfeited | - | - | (18,499 | ) | 12.96 | (23,336 | ) | 12.84 | ||||||||||||||||
| Balance at period end | 52,155 | $ | 15.09 | 65,491 | $ | 13.23 | 74,828 | $ | 13.21 | |||||||||||||||
At December 31, 2017, based on RSU awards outstanding at that time, the total unrecognized pre-tax compensation expense related to unvested RSU awards was $481 thousand. Based upon the contractual terms, this expense is expected to be recognized as follows:
| (in thousands) | ||||
| 2018 | $ | 300 | ||
| 2019 | 129 | |||
| 2020 | 52 | |||
| $ | 481 | |||
Stock-Based Compensation Expense: Stock-based compensation is recognized as compensation cost in the statement of operations based on their fair values on the measurement date, which, for the Company, is the date of the grant. The amount that the Company recognized in stock-based compensation expense related to the issuance of restricted stock and RSUs and for director compensation paid in stock is presented in the following table:
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| For the year ended December 31, | ||||||||||||
| (in thousands) | 2017 | 2016 | 2015 | |||||||||
| Stock-based compensation expense | ||||||||||||
| Related to the issuance of restricted stock and RSUs | $ | 490 | $ | 239 | $ | 375 | ||||||
| Director compensation paid in stock | $ | 205 | $ | 160 | $ | 95 | ||||||
Note 17: Benefit Plans
Profit Sharing Plan
The Company sponsors a defined contribution retirement plan through a Section 401(k) profit sharing plan. Employees may contribute up to 15% of their pretax compensation. Participants are eligible for matching Company contributions up to 4% of eligible compensation dependent on the level of voluntary contributions. Company matching contributions totaled $766 thousand, $575 thousand and $520 thousand, respectively, for the years ended December 31, 2017, 2016 and 2015. The Company’s matching contributions vest immediately.
Supplemental Executive Retirement Plan (SERP)
In 2014, the Bank created a SERP for the Chief Executive Officer. This plan was amended in 2015. Under defined benefit SERP, Ms. Scully will receive $150,000 each year for 15 years after attainment of the Normal Retirement Age (as defined in the SERP). Ms. Scully will earn vesting on a graduated schedule in which she will become fully vested on August 25, 2019, which has been established for purposes of the SERP as her retirement date. Expense related to this plan totaled $275 thousand, $243 thousand and $90 thousand for 2017, 2016 and 2015, respectively. The accrued liability recorded for this SERP was $1.2 million and $959 thousand as of December 31, 2017 and December 31, 2016, respectively.
Note 18: Income per Common Share
The table below shows the presentation of basic and diluted income per common share for the years ended:
| December 31, | ||||||||||||
| (dollars in thousands, except per share data) | 2017 | 2016 | 2015 | |||||||||
| Net income | $ | 7,200 | $ | 5,303 | $ | 1,142 | ||||||
| Preferred stock dividends | - | (166 | ) | (126 | ) | |||||||
| Net income available to common stockholders (numerator) | $ | 7,200 | $ | 5,137 | $ | 1,016 | ||||||
| BASIC | ||||||||||||
| Basic average common shares outstanding (denominator) | 9,555,952 | 6,975,662 | 6,160,005 | |||||||||
| Basic income per common share | $ | 0.75 | $ | 0.74 | $ | 0.16 | ||||||
| DILUTED | ||||||||||||
| Average common shares outstanding | 9,555,952 | 6,975,662 | 6,160,005 | |||||||||
| Dilutive effect of common stock equivalents | 40,852 | 23,320 | 63,491 | |||||||||
| Diluted average common shares outstanding (denominator) | 9,596,804 | 6,998,982 | 6,223,496 | |||||||||
| Diluted income per common share | $ | 0.75 | $ | 0.73 | $ | 0.16 | ||||||
| Common stock equivalents outstanding that are anti-dilutive and thus excluded from calculation of diluted number of shares presented above | - | 74,051 | 78,001 | |||||||||
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Note 19: Regulatory Matters
In July 2013, the Federal Deposit Insurance Corporation (the “FDIC”) and the other federal bank regulatory agencies issued a final rule that revised their leverage and risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with agreements that were reached by the Basel Committee on Banking Supervision (“Basel III”) and certain provisions of the Dodd-Frank Act. The final rule, which became effective on January 1, 2015, applies to all depository institutions, top-tier bank holding companies with total consolidated assets of $1 billion or more and top-tier savings and loan holding companies. The final rule created a new common equity Tier 1 (“CET1”) minimum capital requirement (4.5% of risk-weighted assets), increased the minimum Tier 1 capital ratio (from 4% to 6% of risk-weighted assets), imposed a minimum leverage ratio of 4.0%, and changed the risk-weight of certain assets to better reflect credit risk and other risk exposures. These include, among other things, a 150% risk weight for certain high volatility commercial real estate acquisition, development and construction loans and for non-residential mortgage loans that are 90 days past due or otherwise in non-accrual status, and a 20% credit conversion factor for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancellable. The final rule also requires unrealized gains and losses on certain “available for sale” securities holdings to be included for purposes of calculating regulatory capital unless the Company elects to opt-out from this treatment. The Company has elected to permanently opt out of this treatment in the Company’s capital calculations, as permitted by the final rule.
Additionally, subject to a transition schedule, the rule limits Bancorp’s and the Bank’s ability to make capital distributions, engage in share repurchases and pay certain discretionary bonus payments if they do not hold a “capital conservation buffer” consisting of 2.5% of common equity Tier 1 capital to risk-weighted assets in addition to the amount necessary to meet its minimum risk-based capital requirements.
In addition, under revised prompt corrective action requirements, in order to be considered “well-capitalized,” Bancorp and the Bank must have a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 8.0% or greater, a common equity Tier 1 ratio of 6.5% or greater, a leverage capital ratio of 5.0% or greater, and not be subject to any written agreement, order, capital directive, or prompt corrective action directive to meet and maintain a specific capital level for any capital measure.
There are two main categories of capital under the regulatory capital guidelines. Tier 1 capital includes common stockholders’ equity, qualifying preferred stock and trust preferred securities, less goodwill and certain other deductions (including the unrealized net gains and losses, after applicable income taxes, on securities available for sale carried at fair value). Tier 2 capital includes preferred stock not qualifying as Tier 1 capital, subordinated debt, the allowance for credit losses and net unrealized gains on marketable equity securities, subject to limitations set by the guidelines. Tier 2 capital is limited to the amount of Tier 1 capital (i.e., at least half of total capital must be in the form of Tier 1 capital). Under the guidelines, capital is compared to the relative risk related to the balance sheet. To derive the risk included in the balance sheet, one of several risk weights is applied to the different balance sheet and off-balance sheet assets, primarily based on the relative credit risk of the counterparty. For example, claims guaranteed by the U.S. government or one of its agencies are risk-weighted at 0%. Off-balance sheet items, such as loan commitments, are also applied a risk weight after calculating balance sheet equivalent amounts. One of four credit conversion factors (0%, 20%, 50% and 100%) is assigned to loan commitments based on the likelihood of the off-balance sheet item becoming an asset. For example, certain loan commitments are converted at 50% and then risk-weighted at 100%. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Management believes that, as of December 31, 2017 and December 31, 2016, Bancorp and the Bank met all capital adequacy requirements to which they are subject.
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The following table reflects Bancorp’s and the Bank’s capital as of December 31, 2017 and December 31, 2016:
| To be well | ||||||||||||||||||||||||
| capitalized under | ||||||||||||||||||||||||
| the FDICIA | ||||||||||||||||||||||||
| For capital | prompt corrective | |||||||||||||||||||||||
| Actual | adequacy purposes | action provisions | ||||||||||||||||||||||
| (dollars in thousands) | Amount | Ratio | Amount | Ratio | Amount | Ratio | ||||||||||||||||||
| As of December 31, 2017: | ||||||||||||||||||||||||
| Total capital (to risk-weighted assets) | ||||||||||||||||||||||||
| Howard Bank | $ | 125,019 | 12.39 | % | $ | 80,720 | 8.00 | % | $ | 100,900 | 10.00 | % | ||||||||||||
| Howard Bancorp | $ | 139,673 | 13.72 | % | $ | 81,456 | 8.00 | % | N/A | |||||||||||||||
| Common equity tier 1 capital | ||||||||||||||||||||||||
| (to risk-weighted assets) | ||||||||||||||||||||||||
| Howard Bank | $ | 118,860 | 11.78 | % | $ | 45,405 | 4.50 | % | $ | 65,585 | 6.50 | % | ||||||||||||
| Howard Bancorp | $ | 129,979 | 12.77 | % | $ | 45,819 | 4.50 | % | N/A | |||||||||||||||
| Tier 1 capital (to risk-weighted assets) | ||||||||||||||||||||||||
| Howard Bank | $ | 118,860 | 11.78 | % | $ | 60,540 | 6.00 | % | $ | 80,720 | 8.00 | % | ||||||||||||
| Howard Bancorp | $ | 129,979 | 12.77 | % | $ | 61,092 | 6.00 | % | N/A | |||||||||||||||
| Tier 1 capital (to average assets) | ||||||||||||||||||||||||
| (Leverage ratio) | ||||||||||||||||||||||||
| Howard Bank | $ | 118,860 | 10.70 | % | $ | 44,438 | 4.00 | % | $ | 55,547 | 5.00 | % | ||||||||||||
| Howard Bancorp | $ | 129,979 | 11.70 | % | $ | 44,439 | 4.00 | % | N/A | |||||||||||||||
| As of December 31, 2016: | ||||||||||||||||||||||||
| Total capital (to risk-weighted assets) | ||||||||||||||||||||||||
| Howard Bank | $ | 94,696 | 11.02 | % | $ | 68,722 | 8.00 | % | $ | 85,902 | 10.00 | % | ||||||||||||
| Howard Bancorp | $ | 93,278 | 10.83 | % | $ | 68,903 | 8.00 | % | N/A | |||||||||||||||
| Common equity tier 1 capital | ||||||||||||||||||||||||
| (to risk-weighted assets) | ||||||||||||||||||||||||
| Howard Bank | $ | 88,267 | 10.28 | % | $ | 38,656 | 4.50 | % | $ | 55,836 | 6.50 | % | ||||||||||||
| Howard Bancorp | $ | 83,643 | 9.71 | % | $ | 38,758 | 4.50 | % | N/A | |||||||||||||||
| Tier 1 capital (to risk-weighted assets) | ||||||||||||||||||||||||
| Howard Bank | $ | 88,267 | 10.28 | % | $ | 51,541 | 6.00 | % | $ | 68,722 | 8.00 | % | ||||||||||||
| Howard Bancorp | $ | 83,643 | 9.71 | % | $ | 51,677 | 6.00 | % | N/A | |||||||||||||||
| Tier 1 capital (to average assets) | ||||||||||||||||||||||||
| (Leverage ratio) | ||||||||||||||||||||||||
| Howard Bank | $ | 88,267 | 8.82 | % | $ | 40,022 | 4.00 | % | $ | 50,027 | 5.00 | % | ||||||||||||
| Howard Bancorp | $ | 83,643 | 8.36 | % | $ | 40,030 | 4.00 | % | N/A | |||||||||||||||
Note 20: Preferred Stock
On September 22, 2011, Bancorp entered into a Securities Purchase Agreement with the Secretary of the Treasury, pursuant to which Bancorp issued and sold to the Treasury 12,562 shares of its Senior Non-Cumulative Perpetual Preferred Stock, Series AA, having a liquidation preference of $1,000 per share, for aggregate proceeds of $12,562,000. The issuance was pursuant to the SBLF program, a $30 billion fund established under the Small Business Jobs Act of 2010, which encourages lending to small businesses by providing capital to qualified community banks with assets of less than $10 billion. The Series AA Preferred Stock holders were entitled to receive non-cumulative dividends payable quarterly on each January 1, April 1, July 1 and October 1, beginning October 1, 2011. The dividend rate was initially set at 5% per annum and thereafter was set based upon the percentage change in qualified lending between each dividend period and the baseline “Qualified Small Business Lending” level established at the time the agreement was entered into. Such dividend rate could vary from 1% per annum to 5% per annum for the second through tenth dividend periods and from 1% per annum to 7% per annum for the eleventh through the eighteenth dividend periods and through March 22, 2016 with respect to the nineteenth dividend period. If the Series AA Preferred Stock remained outstanding for more than four-and-one-half years, the dividend rate was fixed at 9%. As of March 22, 2016, the dividend rate was fixed at 9%. Such dividends were not cumulative, but Bancorp could only declare and pay dividends on its common stock (or any other equity securities junior to the Series AA Preferred Stock) if it had declared and paid dividends for the current dividend period on the Series AA Preferred Stock, and was subject to other restrictions on its ability to repurchase or redeem other securities. In addition, if Bancorp had not timely declared and paid dividends on the Series AA Preferred Stock for six dividend periods or more, whether or not consecutive, the Treasury (or any successor holder of Series AA Preferred Stock) could have designated a representative to attend all meetings of Bancorp’s Board of Directors in a nonvoting observer capacity and Bancorp would have been required to give such representative copies of all notices, minutes, consents and other materials that Bancorp provided to its directors in connection with such meetings.
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On May 6, 2016, after receiving all required regulatory approvals, Bancorp redeemed the 12,562 shares of Series AA Preferred Stock for $12,562,000 in accordance with its terms. Bancorp used the proceeds of a $12,562,000 term loan with Raymond James Bank, N.A. to fund the redemption of the Series AA Preferred Stock. This debt was repaid on February 1, 2017.
Note 21: Fair Value
FASB ASC Topic 820 “Fair Value Measurements” defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC Topic 820 also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.
The Company utilizes fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures. Securities available for sale are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis, such as loans held for investment and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.
Under FASB ASC Topic 820, the Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine the fair value. These hierarchy levels are:
Level 1: Valuations for assets and liabilities traded in active exchange markets. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.
Level 2: Valuations for assets and liabilities traded in less active dealer or broker markets. Valuations are obtained from third party pricing services for identical or comparable assets or liabilities which use observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in active markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3: Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
A financial instrument's level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.
Recurring Fair Value Measurements
Except for one privately held equity investment, all other classes of investment securities available for sale are recorded at fair value using an industry-wide valuation service and therefore fall into a Level 2 of the fair value hierarchy. The service uses evaluated pricing models that vary based on asset class and include available trade, bid and other market information. Various methodologies include broker quotes, proprietary models, descriptive terms and conditions databases, and quality control programs. The privately held equity investment utilizes peer market information to estimate the unobservable inputs and then these inputs are applied to the asset.
Fair value of loans held for sale is based upon outstanding investor commitments or, in the absence of such commitments, based on current investor yield requirements or third party pricing models and are considered Level 2. Gains and losses on loan sales are determined using specific identification method. Changes in fair value are recognized in the Consolidated Statement of Operations as part of realized and unrealized gain on mortgage banking activities.
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Interest rate lock commitments are recorded at fair value determined as the amount that would be required to settle each of these derivatives at the balance sheet date. In the normal course of business, the Company enters into contractual interest rate lock commitments to extend credit to borrowers with fixed expiration dates. The commitment becomes effective when the borrowers lock in a specified interest rate within the time frames established by the mortgage division. All borrowers are evaluated for credit worthiness prior to the extension of the commitment. Market risk arises if interest rates move adversely between the time interest rate is locked by the borrower and the sale date of the loan to an investor. To mitigate this interest rate risk inherent in providing rate lock commitments to borrowers, the Company enters into best effort forward sales contracts to sell loans to investors. The forward sales contracts lock in an interest rate price for the sale of loans similar to the specific rate lock commitment. Rate lock commitments to the borrowers through to the date the loan closes are undesignated derivatives and accordingly, are marked to fair value in earnings. These valuations fall into a Level 3 of the fair value hierarchy. The rate lock commitments are deemed as Level 3 inputs because the Company applies an estimated pull-through rate, which is deemed an unobservable measure. The pull-through rate utilized is based upon historic pull-through rates that ranged from 80 percent to 90 percent.
For loans held for investment that were originally intended to be sold and previously included as loans held for sale, fair value is determined by discounting estimated cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.
The following table sets forth the Company's financial assets and liabilities that were accounted for or disclosed at fair value on a recurring basis at December 31, 2017 and December 31, 2016.
| December 31, 2017 | Quoted Price in | Significant | ||||||||||||||
| Active Markets | Other | Significant | ||||||||||||||
| Carrying | for Identical | Observable | Unobservable | |||||||||||||
| Value | Assets | Inputs | Inputs | |||||||||||||
| (in thousands) | (Fair Value) | (Level 1) | (Level 2) | (Level 3) | ||||||||||||
| Available for sale securities: | ||||||||||||||||
| U.S. Government agencies | $ | 67,740 | $ | - | $ | 67,740 | $ | - | ||||||||
| U.S. Government treasuries | 1,494 | - | 1,494 | - | ||||||||||||
| Mortgage-backed securities | 2,479 | - | 2,479 | - | ||||||||||||
| Other investments | 2,543 | - | 2,464 | 79 | ||||||||||||
| Loans held for sale | 42,153 | - | 42,153 | - | ||||||||||||
| Loans held for investment | 1,509 | - | 1,509 | - | ||||||||||||
| Rate lock commitments | 451 | - | - | 451 | ||||||||||||
| December 31, 2016 | Quoted Price in | Significant | ||||||||||||||
| Active Markets | Other | Significant | ||||||||||||||
| Carrying | for Identical | Observable | Unobservable | |||||||||||||
| Value | Assets | Inputs | Inputs | |||||||||||||
| (in thousands) | (Fair Value) | (Level 1) | (Level 2) | (Level 3) | ||||||||||||
| Available for sale securities: | ||||||||||||||||
| U.S. Government agencies | $ | 34,463 | $ | - | $ | 34,463 | $ | - | ||||||||
| U.S. Government treasuries | 1,504 | - | 1,504 | - | ||||||||||||
| Mortgage-backed securities | 1,298 | - | 1,298 | - | ||||||||||||
| Other investments | 1,463 | - | 1,463 | - | ||||||||||||
| Loans held for sale | 51,054 | - | 51,054 | - | ||||||||||||
| Loans held for investment | 6,580 | - | 6,580 | - | ||||||||||||
| Rate lock commitments | 528 | - | - | 528 | ||||||||||||
Assets under fair value option:
| December 31, 2017 | Carrying | Aggregate | ||||||||||
| Fair Value | Unpaid | |||||||||||
| (in thousands) | Amount | Principal | Difference | |||||||||
| Loans held for sale | $ | 42,153 | $ | 40,990 | $ | 1,163 | ||||||
| Loans held for investment | 1,509 | 1,476 | 33 | |||||||||
| 94 |
| December 31, 2016 | Carrying | Aggregate | ||||||||||
| Fair Value | Unpaid | |||||||||||
| (in thousands) | Amount | Principal | Difference | |||||||||
| Loans held for sale | $ | 51,054 | $ | 49,709 | $ | 1,345 | ||||||
| Loans held for investment | 6,580 | 6,794 | (214 | ) | ||||||||
The Company elected to measure the loans held for sale and the loans held for investment that were originally intended for sale, but instead were added to the Bank’s portfolio at fair value to better align reported results with the underlying economic changes in value of the loans on the Company’s balance sheet.
The following table presents a reconciliation of the assets that are measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the periods presented:
| December 31 | ||||||||
| 2017 | 2016 | |||||||
| Balance, beginning of period | $ | 528 | $ | 508 | ||||
| Privately held equity investment | 79 | - | ||||||
| Net (losses) gains included in realized and unrealized gains on mortgage banking activity in noninterest income | (77 | ) | 20 | |||||
| Balance, end of period | $ | 530 | $ | 528 | ||||
Non-recurring Fair Value Measurements
Level 3 is for positions that are not traded in active markets or are subject to transfer restrictions, valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence. In the absence of such evidence, management's best estimate is used.
Impaired loans are evaluated and valued at the time the loan is identified as impaired, at the lower of cost or market value. Market value is measured based on the value of the collateral securing these loans and is classified at a Level 3 in the fair value hierarchy. Collateral may be real estate and/or business assets including equipment, inventory and/or accounts receivable. The value of real estate collateral is determined based on appraisal by qualified licensed appraisers hired by the Company. The value of business equipment, inventory and accounts receivable collateral is based on the net book value on the business' financial statements and, if necessary, discounted based on management's review and analysis. Appraised and reported values may be discounted based on management's historical knowledge, changes in market conditions from the time of valuation, and/or management's expertise and knowledge of the client and client's business. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors identified above.
Other real estate owned acquired through, or in lieu of, foreclosure are held for sale and are initially recorded at fair value, less selling costs. Any write-downs to fair value at the time of transfer to OREO are charged to the allowance for credit losses. Values are derived from appraisals of underlying collateral and discounted cash flow analysis. There were valuation losses of $581 thousand recognized for the year ended December 31, 2017 and $83 thousand recognized for the year ended December 31, 2016. These charges were for declines in the value of OREO subsequent to foreclosure. OREO is classified within Level 3 of the hierarchy.
There was one loan for $204 thousand that was originally classified as held for sale that was downgraded to non-accrual status in 2016. Net (loss)/gain from the changes included in earnings in fair value of loans held for sale was $(181) thousand, $62 thousand, and $69 thousand at December 31, 2017, 2016 and 2015, respectively. Net gain/(loss) from the changes included in earnings in fair value of loans held for investment was $247 thousand and $(214) thousand at December 31, 2017 and 2016 respectively. There were no loans held for investment in 2015 accounted for at fair value.
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The following table sets forth the Company’s financial assets and liabilities that were accounted for or disclosed at fair value on a nonrecurring basis as of December 31, 2017 and December 31, 2016.
| December, 2017 | Quoted Price in | Significant | ||||||||||||||
| Active Markets | Other | Significant | ||||||||||||||
| Carrying | for Identical | Observable | Unobservable | |||||||||||||
| Value | Assets | Inputs | Inputs | |||||||||||||
| (in thousands) | (Fair Value) | (Level 1) | (Level 2) | (Level 3) | ||||||||||||
| Other real estate owned | $ | 1,549 | $ | - | $ | - | $ | 1,549 | ||||||||
| Impaired loans: | ||||||||||||||||
| Construction and land | 559 | - | - | 559 | ||||||||||||
| Residential - first lien | 2,009 | - | - | 2,009 | ||||||||||||
| Residential - junior lien | 367 | - | - | 367 | ||||||||||||
| Commercial - owner occupied | 508 | - | - | 508 | ||||||||||||
| Commercial - non-owner occupied | 5,856 | - | - | 5,856 | ||||||||||||
| Commercial loans and leases | 3,056 | - | - | 3,056 | ||||||||||||
| Consumer | - | - | - | - | ||||||||||||
| December 31, 2016 | Quoted Price in | Significant | ||||||||||||||
| Active Markets | Other | Significant | ||||||||||||||
| Carrying | for Identical | Observable | Unobservable | |||||||||||||
| Value | Assets | Inputs | Inputs | |||||||||||||
| (in thousands) | (Fair Value) | (Level 1) | (Level 2) | (Level 3) | ||||||||||||
| Other real estate owned | $ | 2,350 | $ | - | $ | - | $ | 2,350 | ||||||||
| Impaired loans: | ||||||||||||||||
| Construction and land | 125 | - | - | 125 | ||||||||||||
| Residential - first lien | 778 | - | - | 778 | ||||||||||||
| Residential - junior lien | 37 | - | - | 37 | ||||||||||||
| Commercial - owner occupied | 509 | - | - | 509 | ||||||||||||
| Commercial - non-owner occupied | 3,148 | - | - | 3,148 | ||||||||||||
| Commercial loans and leases | 3,066 | - | - | 3,066 | ||||||||||||
| Consumer | 95 | - | - | 95 | ||||||||||||
At December 31, 2017 OREO consisted of an outstanding balance of $4.6 million, less valuation allowance of $3.1 million. At December 31, 2016, OREO consisted of an outstanding balance of $5.0 million, less valuation allowance of $2.7 million. Related allowance on impaired loans for the years ended December 31, 2017 and 2016 were $910 thousand and $2.2 million, respectively.
Various techniques are used to value OREO and impaired loans. All loans where the underlying collateral is real estate, either construction, land, commercial, or residential, an independent appraisal is used to identify the value of the collateral. The approaches within the appraisal report include sales comparison, income, and replacement cost analysis. The resulting value will be adjusted by a selling cost of 9.5% and the residual value will be used to determine if there is an impairment. Commercial loans and leases and consumer loans utilize a liquidation approach to the impairment analysis.
The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Fair value estimates are based on quoted market prices where available or calculated using present value techniques. Since quoted market prices are not available on many of our financial instruments, estimates may be based on the present value of estimated future cash flows and estimated discount rates.
The following methods and assumptions were used to estimate the fair value of financial instruments where it is practical to estimate fair value:
Securities available for sale: Based on quoted market prices. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.
Securities held to maturity: The fair value of debt securities that are readily traded in the markets is based upon quoted prices for similar assets or externally developed models that use significant observable inputs. Debt securities that do not have readily determinable fair value discounted cash flows model are used in determining fair value.
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Nonmarketable equity securities: Because these securities are not marketable, the carrying amount approximates the fair value.
Loans held for sale: Loans held for sale are carried at fair value based on outstanding investor commitments or, in the absence of such commitments, on current investor yield requirements on third party models.
Loans held for investment: Determined by discounting estimated cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities
Rate lock commitments: Based on estimated loan closing and investor delivery rate based on historical experience.
Loans: For variable rate loans the carrying amount approximates the fair value. For fixed rate loans the fair value is calculated by discounting estimated cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. The estimated cash flows do not anticipate prepayments.
Deposits: The carrying amount of non-maturity deposits such as demand deposits, money market and saving deposits approximates the fair value. The fair value of deposits with predetermined maturity dates such as certificate of deposits is estimated by discounting the future cash flows using current rates of similar deposits with similar remaining maturities.
Short-term borrowing: The carrying amounts approximate the fair values at the reporting date.
Long-term borrowing: The fair value of fixed rate long-term borrowings was based on quoted market prices or, if a quoted market price is not available, discounted cash flow analyses based on current incremental borrowing rates for similar types of instruments.
Management has made estimates of fair value discount rates that it believes to be reasonable. However, because there is no market for many of these financial instruments, management has no basis to determine whether the fair value presented for loans would be indicative of the value negotiated in an actual sale.
The following table presents the estimated fair value of the Company’s financial instruments at the dates indicated:
| December 31, 2017 | ||||||||||||||||||||
| Quoted Price in | Significant | |||||||||||||||||||
| Active Markets | Other | Significant | ||||||||||||||||||
| for Identical | Observable | Unobservable | ||||||||||||||||||
| Carrying | Fair | Assets | Inputs | Inputs | ||||||||||||||||
| (in thousands) | Amount | Value | (Level 1) | (Level 2) | (Level 3) | |||||||||||||||
| Financial Assets | ||||||||||||||||||||
| Available for sale securities | $ | 74,256 | $ | 74,256 | $ | - | $ | 74,177 | $ | 79 | ||||||||||
| Held to maturity securities | 9,250 | 9,421 | - | - | 9,421 | |||||||||||||||
| Nonmarketable equity securities | 6,492 | 6,492 | - | 6,492 | - | |||||||||||||||
| Loans held for sale | 42,153 | 42,153 | - | 42,153 | - | |||||||||||||||
| Loans held for investment | 1,509 | 1,509 | - | 1,509 | - | |||||||||||||||
| Rate lock commitments | 451 | 451 | - | - | 451 | |||||||||||||||
| Loans and leases | 928,940 | 925,510 | - | - | 925,510 | |||||||||||||||
| Financial Liabilities | ||||||||||||||||||||
| Deposits | 863,908 | 865,182 | - | 865,182 | - | |||||||||||||||
| Short-term borrowings | 130,385 | 130,385 | - | 130,385 | - | |||||||||||||||
| Long-term borrowings | 18,535 | 18,538 | - | 18,538 | - | |||||||||||||||
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| December 31, 2016 | ||||||||||||||||||||
| Quoted Price in | Significant | |||||||||||||||||||
| Active Markets | Other | Significant | ||||||||||||||||||
| for Identical | Observable | Unobservable | ||||||||||||||||||
| Carrying | Fair | Assets | Inputs | Inputs | ||||||||||||||||
| (in thousands) | Amount | Value | (Level 1) | (Level 2) | (Level 3) | |||||||||||||||
| Financial Assets | ||||||||||||||||||||
| Available for sale securities | $ | 38,728 | $ | 38,728 | $ | - | $ | 38,728 | $ | - | ||||||||||
| Held to maturity securities | 6,250 | 6,584 | - | - | 6,584 | |||||||||||||||
| Nonmarketable equity securities | 5,103 | 5,103 | - | 5,103 | - | |||||||||||||||
| Loans held for sale | 51,054 | 51,054 | - | 51,054 | - | |||||||||||||||
| Loans held for investment | 6,580 | 6,580 | - | 6,580 | - | |||||||||||||||
| Rate lock commitments | 528 | 528 | - | - | 528 | |||||||||||||||
| Loans and leases | 808,516 | 813,981 | - | - | 813,981 | |||||||||||||||
| Financial Liabilities | ||||||||||||||||||||
| Deposits | 808,734 | 809,703 | - | 809,703 | - | |||||||||||||||
| Short-term borrowings | 107,056 | 107,056 | - | 107,056 | - | |||||||||||||||
| Long-term borrowings | 20,517 | 20,554 | - | 20,554 | - | |||||||||||||||
Note 22: Parent Company Financial Information
The condensed financial statements for Bancorp (Parent Only) are presented below:
Howard Bancorp, Inc.
Balance Sheets
| December 31, | ||||||||
| (in thousands) | 2017 | 2016 | ||||||
| ASSETS | ||||||||
| Cash and cash equivalents | $ | 15,699 | $ | 12,235 | ||||
| Investment in subsidiaries | 121,374 | 90,826 | ||||||
| Other assets | - | 40 | ||||||
| Total assets | $ | 137,073 | $ | 103,101 | ||||
| LIABILITIES | ||||||||
| Short-term borrowings | $ | 817 | $ | 13,359 | ||||
| Long-term borrowings | 3,535 | 3,453 | ||||||
| Other Liabilities | 468 | 499 | ||||||
| Total liabilities | 4,820 | 17,311 | ||||||
| SHAREHOLDERS' EQUITY | ||||||||
| Common stock-par value of $0.01 authorized 20,000,000 shares; issued and outstanding 9,820,592 shares at December 31, 2017 and 6,991,072 at December 31, 2016 | |
|
98 |
|
|
|
70 |
|
| Capital surplus | 110,387 | 71,021 | ||||||
| Retained earnings | 22,105 | 14,849 | ||||||
| Accumulated other comprehensive loss | (337 | ) | (150 | ) | ||||
| Total shareholders’ equity | 132,253 | 85,790 | ||||||
| Total liabilities and shareholders’equity | $ | 137,073 | $ | 103,101 | ||||
| 98 |
Statements of Operations
| December 31, | ||||||||||||
| (in thousands) | 2017 | 2016 | 2015 | |||||||||
| INTEREST INCOME | ||||||||||||
| Interest on securities | $ | - | $ | 1 | $ | - | ||||||
| Other interest income | - | - | 4 | |||||||||
| INTEREST EXPENSE | ||||||||||||
| Short-term borrowings | 49 | 300 | 6 | |||||||||
| Long-term borrowings | 216 | 196 | 46 | |||||||||
| NET INTEREST EXPENSE | (265 | ) | (495 | ) | (48 | ) | ||||||
| NONINTEREST INCOME | ||||||||||||
| Gain on the sale of securities | - | 96 | - | |||||||||
| NONINTEREST EXPENSE | ||||||||||||
| Compensation and benefits | 490 | 306 | 339 | |||||||||
| Other operating expense | 73 | 192 | 119 | |||||||||
| Total noninterest expense | 563 | 498 | 458 | |||||||||
| Loss before income tax and equity in undistributed income of subsidiary | (828 | ) | (897 | ) | (506 | ) | ||||||
| Income tax benefit | (349 | ) | (305 | ) | (172 | ) | ||||||
| Loss before equity in undistributed income of subsidiary | (479 | ) | (592 | ) | (334 | ) | ||||||
| Equity in undistributed income of subsidiary | 7,679 | 5,895 | 1,476 | |||||||||
| Net income | $ | 7,200 | $ | 5,303 | $ | 1,142 | ||||||
| Preferred stock dividends | - | 166 | 126 | |||||||||
| Net income available to common shareholders | $ | 7,200 | $ | 5,137 | $ | 1,016 | ||||||
| 99 |
Statements of Cash Flows
| Year Ended December 31, | ||||||||||||
| (in thousands) | 2017 | 2016 | 2015 | |||||||||
| CASH FLOWS FROM OPERATING ACTIVITIES: | ||||||||||||
| Net income | $ | 7,200 | $ | 5,303 | $ | 1,142 | ||||||
| Adjustments to reconcile net income to net cash from operating activities: | ||||||||||||
| Deferred income taxes (benefits) | (115 | ) | (60 | ) | 519 | |||||||
| Share-based compensation | 695 | 399 | 436 | |||||||||
| Gain on sales of securities | - | (96 | ) | - | ||||||||
| Equity in undistributed income of subsidiary | (7,679 | ) | (5,895 | ) | (1,476 | ) | ||||||
| (Increase) decrease in other assets | 40 | 101 | (86 | ) | ||||||||
| Increase (decrease) in other liabilities | 84 | (2 | ) | (33 | ) | |||||||
| Net cash (used in) provided by operating activities | 225 | (250 | ) | 502 | ||||||||
| CASH FLOWS FROM INVESTING ACTIVITIES: | ||||||||||||
| Purchase of investment securities available-for-sale | - | - | (100 | ) | ||||||||
| Proceeds from sale of investment securities available-for-sale | - | 196 | - | |||||||||
| Cash and cash equivalents of acquisition | - | - | 10,064 | |||||||||
| Cash paid for acquisition | - | - | (2,015 | ) | ||||||||
| Investment in subsidiary | (23,000 | ) | - | (24,407 | ) | |||||||
| Net cash (used in) provided by investing activities | (23,000 | ) | 196 | (16,458 | ) | |||||||
| CASH FLOWS FROM FINANCING ACTIVITIES: | ||||||||||||
| Net (decrease) increase increase in short-term borrowings | (12,542 | ) | 12,468 | 16 | ||||||||
| Proceeds from issuance of long-tern debt | 82 | 82 | 3,371 | |||||||||
| Net proceeds from issuance of common stock, net of cost | 38,699 | 35 | 23,771 | |||||||||
| Redemption of preferred stock | - | (12,562 | ) | - | ||||||||
| Cash dividends on preferred stock | - | (166 | ) | (126 | ) | |||||||
| Net cash provided by (used in) financing activities | 26,239 | (143 | ) | 27,032 | ||||||||
| Net increase (decrease) in cash and cash equivalents | 3,464 | (197 | ) | 11,076 | ||||||||
| Cash and cash equivalents at beginning of period | 12,235 | 12,432 | 1,356 | |||||||||
| Cash and cash equivalents at end of period | $ | 15,699 | $ | 12,235 | $ | 12,432 | ||||||
| 100 |
Note 23: Quarterly Financial Results (unaudited)
The following table provides a summary of selected consolidated quarterly financial data for the years ended December 31, 2017 and December 31, 2016:
| 2017 | ||||||||||||||||
| Fourth | Third | Second | First | |||||||||||||
| (in thousands, except share data.) | Quarter | Quarter | Quarter | Quarter | ||||||||||||
| Interest income | $ | 11,338 | $ | 11,112 | $ | 10,708 | $ | 9,868 | ||||||||
| Interest expense | 1,482 | 1,357 | 1,211 | 1,117 | ||||||||||||
| Net interest income | 9,856 | 9,755 | 9,497 | 8,751 | ||||||||||||
| Provision for loan losses | 800 | 491 | 340 | 200 | ||||||||||||
| Noninterest income | 4,669 | 5,085 | 5,311 | 4,459 | ||||||||||||
| Noninterest expense | 11,848 | 11,618 | 11,234 | 10,500 | ||||||||||||
| Net income before income taxes | 1,877 | 2,731 | 3,234 | 2,510 | ||||||||||||
| Income (benefit) tax expenses | (6 | ) | 1,018 | 1,196 | 944 | |||||||||||
| Net income | 1,883 | 1,713 | 2,038 | 1,566 | ||||||||||||
| Preferred stock dividends | - | - | - | - | ||||||||||||
| Net income available to common shareholders | $ | 1,883 | $ | 1,713 | $ | 2,038 | $ | 1,566 | ||||||||
| Net income per common share, basic | $ | 0.19 | $ | 0.17 | $ | 0.21 | $ | 0.18 | ||||||||
| Net income per common share, diluted | $ | 0.19 | $ | 0.17 | $ | 0.21 | $ | 0.18 | ||||||||
| Average common shares outstanding | 9,815,228 | 9,808,542 | 9,779,772 | 8,806,404 | ||||||||||||
| Diluted average common shares outstanding | 9,858,809 | 9,854,822 | 9,822,165 | 8,856,763 | ||||||||||||
| 2016 | ||||||||||||||||
| Fourth | Third | Second | First | |||||||||||||
| (in thousands, except share data.) | Quarter | Quarter | Quarter | Quarter | ||||||||||||
| Interest income | $ | 9,752 | $ | 9,824 | $ | 9,553 | $ | 9,612 | ||||||||
| Interest expense | 1,239 | 1,176 | 1,178 | 969 | ||||||||||||
| Net interest income | 8,513 | 8,648 | 8,375 | 8,643 | ||||||||||||
| Provision for loan losses | 735 | 402 | 515 | 385 | ||||||||||||
| Noninterest income | 2,976 | 4,384 | 4,570 | 2,852 | ||||||||||||
| Noninterest expense | 9,268 | 9,880 | 9,861 | 9,676 | ||||||||||||
| Net income before income taxes | 1,486 | 2,750 | 2,569 | 1,434 | ||||||||||||
| Income tax expenses | 532 | 1,002 | 928 | 474 | ||||||||||||
| Net income | 954 | 1,748 | 1,641 | 960 | ||||||||||||
| Preferred stock dividends | - | - | 109 | 57 | ||||||||||||
| Net income available to common shareholders | $ | 954 | $ | 1,748 | $ | 1,532 | $ | 903 | ||||||||
| Net income per common share, basic | $ | 0.14 | $ | 0.25 | $ | 0.22 | $ | 0.13 | ||||||||
| Net income per common share, diluted | $ | 0.14 | $ | 0.25 | $ | 0.22 | $ | 0.13 | ||||||||
| Average common shares outstanding | 6,990,390 | 6,985,559 | 6,970,876 | 6,955,462 | ||||||||||||
| Diluted average common shares outstanding | 7,020,733 | 7,077,420 | 7,061,867 | 7,047,987 | ||||||||||||
| 101 |
Note 24: Subsequent Events
On March 1, 2018, we completed our acquisition of First Mariner through the merger of First Mariner with and into the Bank pursuant to the Agreement and Plan of Reorganization dated as August 14, 2017, as amended, by and between Bancorp, the Bank and First Mariner. As a result of the merger, each outstanding share of common stock of First Mariner was converted into the right to receive 1.6624 shares of Bancorp common stock, provided that cash was paid in lieu of any fractional shares. The aggregate merger consideration of $173.8 million included $9.2 million of cash and 9,143,230 shares of our common stock, which was valued at approximately $164.6 million based on Bancorp’s closing stock price of $18.00 on February 28, 2018.
The merger is being accounted for under the acquisition method in accordance with FASB ASC Topic 805, “Business Combinations,” with the Company treated as the acquirer. Under the acquisition method, the assets and liabilities of First Mariner, as of February 28, 2018, will be recorded at their fair value, and excess of the merger consideration over the fair value of First Mariner’s net assets will be allocated to goodwill.
The calculations to determine fair values were not complete at the time of filing the 2017 Annual Report on Form 10-K. Until the determination of the fair values are complete, it is impractical to include disclosures related to the fair value of the assets acquired and liabilities assumed as required by the accounting guidance.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
None
Item 9A. Controls and Procedures
As required by SEC rules, the Company’s Chief Executive Officer and Chief Financial Officer evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) as of the end of the period covered by this annual report on Form 10-K. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective as of December 31, 2017. Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
There were no changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) during the quarter ended December 31, 2017, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Management’s Report On Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) for the Company. The Company’s internal control over financial reporting is a process designed to provide reasonable assurance to management and the Board of Directors regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America, as well as provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements. Management evaluates the effectiveness of internal control over financial reporting and tests for reliability through an internal audit process with actions taken to correct potential deficiencies as they are identified. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management evaluated the effectiveness of the Company’s internal control over financial reporting as of December 31, 2017 using the framework set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control – Integrated Framework (2013). Based on that evaluation, management concluded that, as of December 31, 2017, the Company’s internal control over financial reporting is effective. Dixon Hughes Goodman LLP, the registered public accounting firm that audited the Company’s financial statements included in this report as of December 31, 2017 and 2016 and for the two-year period ended December 31, 2017, has issued an attestation report on the Company’s internal control over financial reporting as of December 31, 2017 that is included elsewhere in this report.
| 102 |
None
Item 10. Directors, Executive Officers and Corporate Governance
The Company has adopted a code of ethics (conduct) that applies to all of its employees and a separate code of ethics (conduct) that applies to its non-employee directors. These codes of conduct are available on the Company’s Internet Web site at www.howardbank.com. There have been no material changes in the procedures previously disclosed by which stockholders may recommend nominees to the Company's Board of Directors.
The remainder of the information required by this Item is incorporated by reference to the information included under the captions “Election of Directors,” “Committees and Meetings of the Board of Directors; Corporate Governance,” “Executive Officers who are not Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s definitive proxy statement for its Annual Meeting of Stockholders to be held on May 23, 2018 (the “Proxy Statement”).
Item 11. Executive Compensation
The information required by this Item is incorporated by reference to the information included under the captions “Director Compensation” and “Executive Compensation” in the Proxy Statement.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this Item is incorporated by reference to the information included under the captions “Securities Authorized for Issuance Under Equity Compensation Plans” and “Security Ownership of Directors, Officers and Certain Beneficial Owners” in the Proxy Statement.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information required by this Item is incorporated by reference to the information included under the captions “Election of Directors” and “Certain Relationships and Related Transactions” in the Proxy Statement.
Item 14. Principal Accounting Fees and Services
The information required by this Item is incorporated by reference to the information included under the captions “Fees to Independent Registered Public Accounting Firm” and “Policy on Audit Committee Pre-Approval of Audit and Non-Audit Services of Independent Registered Public Accounting Firm” in the Proxy Statement.
Item 15. Exhibits, Financial Statement Schedules
The following financial statements are included in this report
Consolidated Balance Sheets at December 31, 2017 and 2016
Consolidated Statements of Operations for the years ended December 31, 2017, 2016 and 2015
Consolidated Statements of Comprehensive Income for the years ended December 31, 2017, 2016 and 2015
Consolidated Statements of Changes in Stockholders' Equity for the years ended December 31, 2017, 2016 and 2015
Consolidated Statements of Cash Flows for the years ended December 31, 2017, 2016 and 2015
Notes to the Consolidated Financial Statements
Reports of Independent Registered Public Accounting Firms
All financial statement schedules have been omitted as the required information is either inapplicable or included in the consolidated financial statements or related notes.
| 103 |
| 104 |
| Exhibit No. | Description | Filed herewith: | ||
| 21 | Subsidiaries of the Registrant | |||
| 23.1 | Consent of Stegman & Company | |||
| 23.2 | Consent of Dixon Hughes Goodman LLP | |||
| 31(a) | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Exchange Act pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |||
| 31(b) | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Exchange Act pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |||
| 32 | Certifications pursuant to 18 U.S.C. Section 1350, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | |||
| 101 | Extensible Business Reporting Language (“XBRL”) | |||
| 101.INS XBRL Instance File | ||||
| 101.SCH XBRL Schema File | ||||
| 101.CAL XBRL Calculation File | ||||
| 101.DEF XBRL Definition File | ||||
| 101.LAB XBRL Label File | ||||
| 101.PRE XBRL Presentation File |
* Management compensatory plan, contract or arrangement
None.
| 105 |
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
| Howard Bancorp, Inc. | ||
| Date: March 15, 2018 | By: | /s/ Mary Ann Scully |
| Mary Ann Scully | ||
| President, Chairman and Chief Executive Officer |
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and dates indicated.
| Name | Capacities | Date | |||
| /s/ Mary Ann Scully | President, Chief Executive | March 15, 2018 | |||
| Mary Ann Scully | Officer, Chairman | ||||
| (Principal Executive Officer) | |||||
| /s/ George C. Coffman | Chief Financial Officer | March 15, 2018 | |||
| George C. Coffman | (Principal Accounting and | ||||
| Financial Officer) | |||||
| /s/ Richard G. Arnold | Director | March 15, 2018 | |||
| Richard G. Arnold | |||||
| /s/ W. Gary Dorsch | Director | March 15, 2018 | |||
| W. Gary Dorsch | |||||
| /s/ James T. Dresher, Jr. | Director | March 15, 2018 | |||
| James T, Dresher, Jr. | |||||
| /s/ Howard P. Feinglass | Director | March 15, 2018 | |||
| Howard P. Feinglass | |||||
| /s/ Michael B. High | Director | March 15, 2018 | |||
| Michael B. High | |||||
| /s/ John J. Keenan | Director | March 15, 2018 | |||
| John J. Keenan | |||||
| /s/ Robert D. Kunisch, Jr. | Director | March 15, 2018 | |||
| Robert D. Kunisch, Jr. | |||||
| /s/ Paul I. Latta, Jr. | Director | March 15, 2018 | |||
| Paul I. Latta, Jr. | |||||
| /s/ Kenneth C. Lundeen | Director | March 15, 2018 | |||
| Kenneth C. Lundeen | |||||
| /s/ Thomas P. O’Neill | Director | March 15, 2018 | |||
| Thomas P. O’Neill | |||||
| /s/ Robert W. Smith, Jr. | Director | March 15, 2018 | |||
| Robert W. Smith, Jr. | |||||
| /s/ Donna Hill Staton | Director | March 15, 2018 | |||
| Donna Hill Staton | |||||
| /s/ Jack E. Steil | Director | March 15, 2018 | |||
| Jack E. Steil |
| 106 |