No

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark one)

For the quarterly period ended March 31, 2020

or

For the transition period from ______________ to _____________

Commission file number: 001-38589

COASTAL FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

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

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an “emerging growth company.”  See the definition of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act  ☒

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

As of May 6, 2020 there were 11,925,913 shares of the issuer’s common stock outstanding.  

 

 

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COASTAL FINANCIAL CORPORATION

 

Table of Contents

 

 

 

 

 

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Forward-Looking Statements

This report may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements reflect our current views with respect to, among other things, future events and our financial performance. Any statements about our management’s expectations, beliefs, plans, predictions, forecasts, objectives, assumptions or future events or performance are not historical facts and may be forward-looking. These statements are often, but not always, made through the use of words or phrases such as “anticipate,” “believes,” “can,” “could,” “may,” “predicts,” “potential,” “should,” “will,” “estimate,” “plans,” “projects,” “continuing,” “ongoing,” “expects,” “intends” and similar words or phrases. All forward-looking statements, expressed or implied, included herewith are expressly qualified in their entirety by the cautionary statements contained or referred to herein. The inclusion of forward-looking information in this report should not be regarded as a representation by us or any other person that the future plans, estimates or expectations contemplated by us will be achieved. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs.

Factors that may affect our results are disclosed in “Item 1A. Risk Factors” in Part II of this report and in the section titled “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019 (“Form 10-K”).  Some of the risks and uncertainties that may cause the Company’s actual results, performance or achievements to differ materially from those expressed include, but are not limited to, the following: the economic and uncertainties associated with the COVID-19 pandemic; our expected future financial results; the overall health of the local and national real estate market; the credit risk associated with our loan portfolio, and specifically with our commercial real estate loans; business and economic conditions generally and in the financial services industry, nationally and within our market area; our ability to maintain an adequate level of allowance for loan losses; our ability to successfully manage liquidity risk; our ability to implement our growth strategy and manage costs effectively; the composition of our senior leadership team and our ability to attract and retain key personnel; our ability to raise additional capital to implement our business plan; changes in market interest rates and impacts of such changes on our profits and business; the occurrence of fraudulent activity, breaches or failures of our information security controls or cybersecurity-related incidents; interruptions involving our information technology and telecommunications systems or third-party servicers; our ability to maintain our reputation; increased competition in the financial services industry; regulatory guidance on commercial lending concentrations; our partnership with broker-dealers and digital financial service providers; the effectiveness of our risk management framework; the costs and obligations associated with being a publicly traded company; the commencement and outcome of litigation and other legal proceedings and regulatory actions against us or to which we may become subject; the extensive regulatory framework that applies to us; the impact of recent and future legislative and regulatory changes; and other changes in banking, securities and tax laws and regulations, and their application by our regulators; the impact on the Company's operations due to epidemic illnesses and political developments that may disrupt or increase volatility in securities or otherwise affect economic conditions; the impact of benchmark interest rate reform in the U.S. and implementation of alternative reference rates, such as the Secured Overnight Funding Rate, to the London Interbank Offered Rate ("LIBOR"); fluctuations in the value of the securities held in our securities portfolio; governmental monetary and fiscal policies; material weaknesses in our internal control over financial reporting; and our success at managing the risks involved in the foregoing items.

The foregoing factors should not be construed as exhaustive and should be read together with the other cautionary statements included in this report. If one or more events related to these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may differ materially from what we anticipate. Furthermore, many of these risks and uncertainties are currently amplified by and may continue to be amplified by or may, in the future, be amplified by, the recent outbreak of the COVID-19 pandemic and the impact of varying governmental responses that affect our customers and the economies where they operate. You are cautioned not to place undue reliance on forward-looking statements. Further, any forward-looking statement speaks only as of the date on which it is made and we undertake no obligation to update or revise any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events, except as required by law.

 

 

 

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PART I.   FINANCIAL INFORMATION

Item 1. Financial Statements

COASTAL FINANCIAL CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

 

(dollars in thousands)

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

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COASTAL FINANCIAL CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

 

(dollars in thousands, except for per share data)

See accompanying Notes to Condensed Consolidated Financial Statements.

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COASTAL FINANCIAL CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)

 

(dollars in thousands)  

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

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COASTAL FINANCIAL CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (UNAUDITED)

 

(dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

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COASTAL FINANCIAL CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(dollars in thousands)  

See accompanying Notes to Condensed Consolidated Financial Statements. 

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COASTAL FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

Note 1 - Description of Business and Summary of Significant Accounting Policies

Nature of operations - Coastal Financial Corporation (“Corporation” or “Company”) is a registered bank holding company whose wholly owned subsidiary is Coastal Community Bank (“Bank”). The Company is a Washington state corporation that was organized in 2003. The Bank was incorporated and commenced operations in 1997 and is a Washington state-chartered commercial bank and Federal Reserve System (“Federal Reserve”) state member bank.

The Company provides a full range of banking services to small and medium-sized businesses, professionals, and individuals throughout the greater Puget Sound area through its 14 branches in Snohomish, Island, and King Counties, the Internet, and its mobile banking application. The Company plans to open its 15^th branch in Arlington, Washington in the second quarter 2020.  The Bank’s main branch and the headquarters of the Bank and Company are located in Everett, Washington. The Bank’s deposits are insured in whole or in part by the FDIC. The Bank’s loans and deposits are primarily within the greater Puget Sound area, and the Bank’s primary funding source is deposits from customers. The Bank is subject to regulation by the Federal Reserve and the Washington State Department of Financial Institutions Division of Banks. The Federal Reserve also has supervisory authority over the Company.

Financial statement presentation - The accompanying unaudited interim condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim reporting requirements and with instructions to Form 10-Q and Article 10 of Regulation S-X, and therefore do not include all the information and notes included in the annual consolidated financial statements in conformity with GAAP. These interim condensed consolidated financial statements and accompanying notes should be read in conjunction with the Company’s audited consolidated financial statements and accompanying notes included in the Company’s Annual report on Form 10-K as filed with the U.S. Securities and Exchange Commission (“SEC”) on March 12, 2020. Operating results for the three months ended March 31, 2020 are not necessarily indicative of the results that may be expected for future periods.

Amounts presented in the consolidated financial statements and footnote tables are rounded and presented in thousands of dollars except per-share amounts, which are presented in dollars. In the narrative footnote discussion, amounts are rounded to thousands and presented in dollars.

In management’s opinion, all accounting adjustments necessary to accurately reflect the financial position and results of operations on the accompanying consolidated financial statements have been made. These adjustments include normal and recurring accruals considered necessary for a fair and accurate presentation.

Principles of consolidation - The consolidated financial statements include the accounts of the Company and the Bank. All significant intercompany accounts have been eliminated in consolidation.

Business Segments - The Company is managed by legal entity and not by lines of business. The entity’s primary business is that of a traditional banking institution, gathering deposits and originating loans for portfolio in its market areas. The Bank offers a wide variety of deposit products to its customers. Lending activities include the origination of real estate, commercial and industrial, and consumer loans. Interest income on loans is the Company’s primary source of revenue, and is supplemented by interest income on deposits with other banks, interest income from investment securities, deposit service charges, and other service provided activities. The Company has determined that its current business and operations consist of a single reporting segment and, therefore, segment disclosures are not required.

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. Management believes that its critical accounting policies include determining the allowance for loan losses, the fair value of the Company’s investment securities, deferred tax assets, and financial instruments. Actual results could differ significantly from those estimates.

Subsequent Events - The Company has evaluated events and transactions subsequent to March 31, 2020 for potential recognition or disclosure.  To the extent any events and conditions exist, disclosures are made regarding the nature of events and the estimated financial effects for those events and conditions. The Company is not aware of any subsequent events which would require recognition or disclosure in the consolidated financial statements other than those listed below.

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The quarter ended March 31, 2020 closed amid an unprecedented global COVID-19 pandemic that is impacting the economic health of our community and nation.  The Company is working with the Small Business Administration (“SBA”) to offer assistance to small businesses as provided in the recently passed Coronavirus Aid, Relief and Economic Security Act (“CARES Act”).  As of May 6, 2020, the Company has funded SBA Paycheck Protection Program (“PPP”) loan requests for 1,874 borrowers and $393.4 million, impacting over 35,325 employees in our communities. As part of the Paycheck Protection Program Liquidity Facility, the Company pledged 327 of these loans, or $111.1 million as of May 6, 2020, which provides an additional source of funding for the PPP loans.  The Company is also in contact with borrowers with existing loans that have been impacted by COVID-19.  The Company expects to continue to restructure payments for existing loan customers during this uncertain time to help alleviate financial hardships and are deferring payments on over 215 loans representing $196.1 million in loans as of May 6, 2020.  In accordance with GAAP and interagency guidance issued on March 22, 2020, short-term modifications, made on a good faith basis in response to COVID-19 to borrowers that were current prior to any relief, are not classified as troubled debt restructurings.

On May 1, 2020 the Company entered into a Purchase and Sale agreement to purchase property in Freeland, WA, for a cash consideration of $875,000.  The Company currently leases and occupies the property, which is the location of their Freeland Branch.  The purchase is expected to be completed during the second quarter of 2020.

Accounting policies – Our complete accounting policies are described in Note 1, summary of significant accounting policies of the Company’s audited consolidated financial statements as of and for the years ended December 31, 2019 and 2018 included in the Company’s Annual Report Form 10-K filed with the SEC on March 12, 2020.

Reclassifications - Certain amounts reported in prior quarters' consolidated financial statements have been reclassified to conform to the current presentation with no effect on stockholders’ equity or net income.

Note 2 - Recent accounting standards

Recent Accounting Guidance

In March 2020, various regulatory agencies, including the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation, (the “agencies”) issued an interagency statement on loan modifications and reporting for financial institutions working with customers affected by the COVID-19. The interagency statement was effective immediately and impacted accounting for loan modifications. Under Accounting Standards Codification 310-40, Receivables – Troubled Debt Restructurings by Creditors, a restructuring of debt constitutes a troubled debt restructuring (“TDR”) if the creditor, for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider. The agencies confirmed with the staff of the Financial Accounting Standards Board (“FASB”) that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not to be considered TDRs. This includes short-term (e.g., six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. Borrowers considered current are those that are less than 30 days past due on their contractual payments at the time a modification program is implemented. This interagency guidance is not expected to have a material impact on the Company’s financial statements; however, this impact cannot be quantified at this time. See Note 4 of the Condensed Consolidated Financial Statements of this Report for disclosure of the impact to date.

Recent Accounting Guidance Not Yet Effective

 

In September 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The amendments replace 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 amendment is effective for annual periods beginning after December 15, 2019 and interim period within those annual periods. As a smaller reporting company our implementation will be effective January 1, 2023.  The Company is actively assessing the data and the model needs and are evaluating the impact of adopting the amendment. The Company expects to recognize a one-time cumulative effect adjustment to the allowance for loan losses as of the beginning of the first reporting period in which the new standard is effective, but cannot yet determine the magnitude of any such one-time adjustment or the overall impact of the new guidance on the consolidated financial statements.

 

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Note 3 - Investment Securities

The amortized cost and fair values of investment securities at the date indicated are as follows:

 

 

 

The amortized cost and fair value of debt securities at March 31, 2020, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because issuers or the underlying borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Mortgage-backed securities and collateralized mortgage obligations are shown separately, since they are not due at a single maturity date.

 

 

Investment securities with carrying values of $13,809,000 and $16,843,000 at March 31, 2020 and December 31, 2019 respectively, were pledged to secure public deposits and for other purposes as required or permitted by law.

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There were no sales during the three months ended March 31, 2020 and 2019.

Information pertaining to securities with gross unrealized losses at the dates indicated, aggregated by investment category and length of time that individual securities have been in a continuous loss position, follows:

 

 

At March 31, 2020 and December 31, 2019, there were three and six securities in an unrealized loss position, respectively. Unrealized losses have not been recognized into income because management does not intend to sell and does not expect that it will be required to sell the investments. The decline is largely due to changes in market conditions and interest rates, rather than credit quality. The fair value is expected to recover as the underlying securities in the portfolio approach maturity date and market conditions improve. The Company does not consider these securities to be other than temporarily impaired at March 31, 2020 and December 31, 2019.

Note 4 - Loans and Allowance for Loan Losses

The composition of the loan portfolio is as follows as of the periods indicated:

 

 

Included in consumer and other loans are overdrafts of $19,000 and $26,000 at March 31, 2020 and December 31, 2019, respectively. The Company has pledged loans totaling $168,864,000 and $163,522,000 at March 31, 2020 and December 31, 2019, respectively, for borrowing lines at the FHLB and Federal Reserve Bank (“FRB”).

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The balance of SBA and United States Department of Agriculture (“USDA”) loans was $34,434,000 and $36,592,000 at March 31, 2020 and December 31, 2019, respectively.  Included in these totals is SBA and USDA loans serviced for others totaling $20,928,000 and $21,498,000 at March 31, 2020 and December 31, 2019, respectively.

The Company, at times, purchases individual loans at fair value as of the acquisition date. Purchased loans with remaining balances totaled $30,418,000 and $32,937,000 as of March 31, 2020 and December 31, 2019, respectively. Unamortized premiums totaled $484,000 and $527,000 as of March 31, 2020 and December 31, 2019, respectively, and are amortized into interest income over the life of the loans.

The Company has purchased participation loans with remaining balances totaling $32,876,000 and $31,352,000 as of March 31, 2020 and December 31, 2019, respectively.

The following is a summary of the Company’s loan portfolio segments:

Commercial and industrial loans - Commercial and industrial loans are secured by business assets including inventory, receivables and machinery and equipment of businesses located generally in our primary market area. Loan types include revolving lines of credit, term loans, and loans secured by liquid collateral such as cash deposits or marketable securities. The Company also issues letters of credit on behalf of its customers. Risk arises primarily due to the difference between expected and actual cash flows of the borrowers. In addition, the recoverability of the Company’s investment in these loans is also dependent on other factors primarily dictated by the type of collateral securing these loans. The fair value of the collateral securing these loans may fluctuate as market conditions change. In the case of loans secured by accounts receivable, the recovery of the Company’s investment is dependent upon the borrower’s ability to collect amounts due from its customers.

Construction, land and land development loans – The Company originates loans for the construction of 1-4 family, multifamily, and Commercial Real Estate (“CRE”) properties in our market area. Construction loans are considered to have higher risks due to construction completion and timing risk, the ultimate repayment being sensitive to interest rate changes, government regulation of real property and the availability of long-term financing. Additionally, economic conditions may impact the Company’s ability to recover its investment in construction loans, as adverse economic conditions may negatively impact the real estate market, which could affect the borrower’s ability to complete and sell the project. Additionally, the fair value of the underlying collateral may fluctuate as market conditions change. The Company occasionally originates land loans for the purpose of facilitating the ultimate construction of a home or commercial building. The primary risks include the borrower’s ability to pay and the inability of the Company to recover its investment due to a material decline in the fair value of the underlying collateral.

Residential real estate loans - Residential real estate loans include various types of loans for which the Company holds real property as collateral. Included in this segment are first lien single family loans, which are occasionally purchased to diversify the Company’s loan portfolio, and rental portfolios secured by one-to-four family homes. The primary risks of residential real estate loans include the borrower’s inability to pay, material decreases in the value of the collateral, and significant increases in interest rates which may make the loan unprofitable.

Commercial real estate (includes owner occupied and nonowner occupied) loans - Commercial real estate loans include various types of loans for which the Company holds real property as collateral. The primary risks of commercial real estate loans include the borrower’s inability to pay, material decreases in the value of the collateralized real estate and significant increases in interest rates, which may make the real estate loan unprofitable. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy.

Consumer and other loans – The Company originates a limited number of consumer loans, generally for banking customers only, which consist primarily of home equity lines of credit, saving account secured loans, and auto loans. This loan category also includes overdrafts. Repayment of these loans is dependent on the borrower’s ability to pay and the fair value of the underlying collateral.

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The following table illustrates an age analysis of past due loans as of the dates indicated:

 

 

 

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A summary of information pertaining to impaired loans as of the period indicated:

 

The following tables summarize our average recorded investment and interest income recognized on impaired loans by loan class for the three months ended March 31, 2020 and 2019:

 

 

The Company grants restructurings in response to borrower financial difficulty, and generally provides for a temporary modification of loan repayment terms. The restructured loans on accrual status represent the only impaired loans accruing interest. In order for a restructured loan to be considered for accrual status, the loan’s collateral coverage generally will be greater than or equal to 100% of the loan balance, the loan is current on payments, and the borrower must either prefund an interest reserve or demonstrate the ability to make payments from a verified source of cash flow for an extended period of time, usually at least six months in duration.

 

No loans were restructured in the three months ended March 31, 2020 and March 31, 2019 that qualified as TDRs. The Company has no commitments to loan additional funds to borrowers whose loans were classified as troubled debt restructurings at March 31, 2020, as there were no outstanding troubled debt restructurings at March 31, 2020.

The Company is in contact with borrowers with existing loans that have been impacted by COVID-19.  The Company is working on restructuring payments for loan customers during this uncertain time to help alleviate financial hardships, deferring payments on 52 loans, representing $37,862,000, as of March 31, 2020.  In accordance with GAAP and interagency guidance issued on March 22, 2020, these short-term modifications, made on a good faith basis in response to COVID-19 to borrowers that were current prior to any relief, are not considered troubled debt restructurings.  

When loans are placed on nonaccrual status, all accrued interest is reversed from current period earnings. Payments received on nonaccrual loans are generally applied as a reduction to the loan principal balance. If the likelihood of further loss is removed, the Company will recognize interest on a cash basis only. Loans may be returned to accruing status if the Company believes that all remaining principal and interest is fully collectible and there has been at least six months of sustained repayment performance since the loan was placed on nonaccrual.

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An analysis of nonaccrual loans by category consisted of the following at the periods indicated:

 

 

Credit Quality and Credit Risk

Federal regulations require that the Company periodically evaluate the risks inherent in its loan portfolio. In addition, the Company’s regulatory agencies have authority to identify problem loans and, if appropriate, require them to be reclassified. There are three classifications for problem loans: Substandard, Doubtful, and Loss. Substandard loans have one or more defined weaknesses and are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. Doubtful loans have the weaknesses of loans classified as Substandard, with additional characteristics that suggest the weaknesses make collection or recovery in full after liquidation of collateral questionable on the basis of currently existing facts, conditions, and values. There is a high possibility of loss in loans classified as Doubtful. A loan classified as Loss is considered uncollectible and of such little value that continued classification of the credit as a loan is not warranted. If a loan or a portion thereof is classified as Loss, it must be charged-off, meaning the amount of the loss is charged against the allowance for loan losses, thereby reducing that reserve. The Company also classifies some loans as Watch or Other Loans Especially Mentioned (“OLEM”). Loans classified as Watch are performing assets and classified as pass credits but have elements of risk that require more monitoring than other performing loans and are reported in the OLEM column in the following table. Loans classified as OLEM are assets that continue to perform but have shown deterioration in credit quality and require close monitoring.

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Loans by credit quality risk rating are as follows as of the periods indicated:

 

 

Allowance for Loan Losses

The Company’s allowance for loan losses (“ALLL”) covers estimated credit losses on individually evaluated loans that are determined to be impaired as well as estimated probable losses inherent in the remainder of the loan portfolio. The ALLL is prepared using the information provided by the Company’s credit review process together with economic information gathered from published sources.  Qualitative factors that are included in the analysis include industry data and data from peer institutions.

The loan portfolio is segmented into groups of loans with similar risk profiles. Each segment possesses varying degrees of risk based on the type of loan, the type of collateral, and the sensitivity of the borrower or industry to changes in external factors such as economic conditions. An estimated loss rate calculated the Company’s actual historical loss rates adjusted for current portfolio trends, economic conditions, and other relevant internal and external factors, is applied to each group’s aggregate loan balances.

The Company’s provision for credit losses of $1.6 million during the quarter ended March 31, 2020 is related to the growth in the loan portfolio along with an increase in qualitative factors primarily related to the uncertainties in the economic outlook from the COVID-19 pandemic. The Company is not required to implement the provisions of the Current Expected Credit Loss (“CECL”) accounting standard until January 1, 2023 and is continuing to account for the allowance for loan losses under the incurred loss model.

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The following tables summarize the allocation of the ALLL, as well as the activity in the ALLL attributed to various segments in the loan portfolio, as of and for the three months ended March 31, 2020:

 

 

The following tables summarize the allocation of the ALLL, as well as the activity in the ALLL attributed to various segments in the loan portfolio, as of and for the three months ended March 31, 2019:

 

 

The following table summarizes the allocation of the ALLL attributed to various segments in the loan portfolio as of December 31, 2019.

 

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Note 5 - Deposits

The composition of consolidated deposits consisted of the following at the periods indicated:

 

 

The following table presents the maturity distribution of time deposits as of March 31, 2020 (dollars in thousands):

 

 

Note 6 - Leases

The Company has committed to rent premises used in business operations under non-cancelable operating leases and determines if an arrangement meets the definition of a lease upon inception.

The Company adopted the provisions of ASU 2016-02 (Topic 842) on January 1, 2019. Operating lease right-of-use (“ROU”) assets represent a right to use an underlying asset for the contractual lease term. Operating lease liabilities represent an obligation to make lease payments arising from the lease.  Operating lease ROU assets and operating lease liabilities were recognized in our Unaudited Consolidated Balance Sheets for leases that existed at the adoption date, based on the present value of lease payments over the remaining lease term.  ROU assets were further adjusted for lease incentives.  Operating leases entered into after the adoption date were recognized as an operating lease ROU asset and operating lease liability at the commencement date of the new lease.

The Company’s leases do not provide an implicit interest rate, therefore the Company used its incremental collateralized borrowing rates commensurate with the underlying lease terms to determine the present value of operating lease liabilities. There were no new leases during the period.  

The Company’s operating lease agreements contain both lease and non-lease components, which are generally accounted for separately. The Company’s lease agreements do not contain any residual value guarantees.

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Operating leases with terms of 12 months or less are not included in ROU assets and operating lease liabilities recorded in our consolidated balance sheets. Operating lease terms include options to extend when it is reasonably certain that the Company will exercise such options, determined on a lease-by-lease basis.  As of March 31, 2020, the Company does not have any leases that have not yet commenced.  At March 31, 2020, lease expiration dates ranged from two to 26 years, with additional renewal options on certain leases typically ranging from 5 to 10 years. At March 31, 2020, the weighted average remaining lease term for the Company’s operating leases was 10.6 years.

Rental expense for operating leases is recognized on a straight-line basis over the lease term and amounted to $343,000 and $371,000, respectively, for the three months ended March 31, 2020 and 2019. Variable lease components, such as inflation adjustments, are expensed as incurred and not included in ROU assets and operating lease liabilities.

The following table presents the minimum annual lease payments under the terms of these leases, inclusive of renewal options that the Company is reasonably certain to renew, at March 31, 2020:

 

 

The following table presents the components of total lease expense and operating cash flows for the three months ended March 31, 2020:

 

 

Note 7 - Stock-Based Compensation

Stock Options and Restricted Stock

On April 30, 2018, the Company’s shareholders approved the Coastal Financial Corporation 2018 Omnibus Incentive Plan (“2018 Plan”). The 2018 Plan authorizes the Company to grant awards, including but not limited to, stock options restricted stock units, and restricted stock awards, to eligible employees, directors or individuals that provide service to the Company, up to an aggregate of 500,000 shares of common stock. The 2018 Plan replaces both the Company’s 2006 Stock Option and Equity Compensation Plan (“2006 Plan”) and its Directors’ Stock Bonus Plan.  Existing awards under the previous plans will vest under the terms granted and no further awards will be made under these plans. Shares available to be granted under the 2018 Plan totaled 276,407 at March 31, 2020.

Stock Option Awards

In January 2019, the Company granted 26,737 nonqualified stock options under the 2018 Plan to an employee, which vest ratably over 10 years. In January 2019, the Company also granted 99,100 qualified stock options under the 2018 Plan to employees, which vest ratably over 10 years. The Company has not granted any stock options in 2020.

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The fair value of each option award is estimated on the date of grant using the Black-Scholes option pricing model that uses the assumptions noted in the following table. Expected volatilities are based on historical volatility of the Company’s stock and other factors. The Company uses the vesting term and contractual life to determine the expected life. The risk-free interest rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. Compensation expense related to unvested stock option awards is reversed at date of forfeiture.

The following assumptions were used to estimate the value of options granted under the 2018 Plan as applicable in the period indicated:

 

 

A summary of stock option activity under the 2018 Plan and 2006 Plan during the three months ended March 31, 2020:

 

 

The total or aggregate intrinsic value (which is the amount by which the stock price exceeds the exercise price) of options exercised during the three months ended March 31, 2020 was $91,000 and was $69,000 for the three months ended March 31, 2019.

As of March 31, 2020, there was $2.2 million of total unrecognized compensation cost related to nonvested stock options granted under the 2018 Plan and 2006 Plan. Total unrecognized compensation costs are adjusted for unvested forfeitures. The Company expects to recognize that cost over a weighted-average period of approximately 7.3 years.   Compensation expense recorded related to stock options was $94,000 for the three months ended March 31, 2020, and $97,000 for the three months ended March 31, 2019.

Restricted Stock Units

In February 2020, the Company granted 78,756 restricted stock units under the 2018 Plan to employees, which vest ratably over 10 years.

The fair value of restricted stock units is equal to the fair value of the Company’s stock at the date of grant. Compensation expense is recognized over the vesting period that the awards are based. Restricted stock units are nonparticipating securities.

As of March 31, 2020, there was $1.4 million of total unrecognized compensation cost related to nonvested restricted stock units.  The Company expects to recognize that cost over the remaining weighted-average vesting period of approximately 9.8 years.  Compensation expense recorded related to restricted stock units was $23,000 for the three months ended March 31, 2020.  There were no restricted stock units and no compensation expense recorded related to restricted stock units for the three months ended March 31, 2019.

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A summary of the Company’s nonvested shares at March 31, 2020 and changes during the three-month period is presented below:

 

Restricted Stock Awards

Employees

In February 2020, there were 4,000 shares granted to an employee at an estimated fair value of $17.81 per share.

The fair value of restricted stock awards is equal to the fair value of the Company’s stock at the date of grant. Compensation expense is recognized over the vesting period that the awards are based. Restricted stock awards are participating securities.

As of March 31, 2020, there was $120,000 of total unrecognized compensation cost related to nonvested restricted stock awards.  The Company expects to recognize that cost over the remaining weighted-average vesting period of approximately 7.4 years.  Compensation expense recorded related to restricted stock awards was $3,000 for the three months ended March 31, 2020 and was $2,000 for the three months ended March 31, 2019.

 

Director’s Stock Bonus

The Company adopted and subsequently amended the Director’s Stock Bonus Plan (“Bonus Plan”). The Bonus Plan would have expired on May 31, 2018 but was replaced on April 30, 2018, when the shareholders approved the 2018 Plan.

Stock is granted to directors who attended at least 75% of the scheduled board meetings during the prior year. Grants cliff vest over two years from date awarded, contingent on the director still being a director of the Company. During the vesting period, the grants are considered participating securities. Grants also immediately vest when a director has to retire from the Board due to the age requirement.

Awards previously granted under the Bonus Plan will vest under the term granted.  Under the 2018 Plan, eligible directors are granted stock with a total market value of $5,000. Directors unable to receive stock will receive cash in lieu upon completion of the vesting period. Cash awards are recognized over the vesting period and recorded in other liabilities until paid.

In February 2020, there were 2,248 shares granted to eight directors at an estimated fair value of $17.81 per share. In January 2019, there were 2,352 shares granted to seven directors at an estimated fair value of $14.91 per share. Compensation expense recorded related to the 2018 Plan totaled $9,000 for the three months ended March 31, 2020 and $8,000 for the three months ended March 31, 2019.

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A summary of the Company’s nonvested shares at March 31, 2020 and changes during the three-month period is presented below:

 

 

Note 8 - Shareholders’ Equity  

 

The total authorized preferred stock is 25,000,000 shares.  There were no shares of preferred stock issued and outstanding at March 31, 2020 and December 31, 2019.

The total authorized common shares is 300,000,000 shares.  At March 31, 2020 and December 31, 2019, there were 11,929,413 and 11,913,885 common shares issued and outstanding.

At March 31, 2020 and December 31, 2019 there were no shares of Class B nonvoting common stock issued and outstanding.  

There were no shares of Class C nonvoting common stock issued and outstanding, at March 31, 2020 and December 31, 2019.     

 

Note 9 - Fair Value Measurements

The following tables present estimated fair values of the Company’s financial instruments as of the period indicated, whether or not recognized or recorded in the consolidated balance sheets at the period indicated:

 

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The Company measures and discloses certain assets and liabilities at fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (that is, not a forced liquidation or distressed sale). GAAP establishes a consistent framework for measuring fair value and disclosure requirements about fair value measurements. Among other things, the accounting standard requires the reporting entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s estimates for market assumptions. These two types of inputs create the following fair value hierarchy:

The estimated fair value amounts of financial instruments have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize at a future date. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. In addition, reasonable comparability between financial institutions may not be likely due to the wide range of permitted valuation techniques and numerous estimates that must be made given the absence of active secondary markets for certain financial instruments. This lack of uniform valuation methodologies also introduces a greater degree of subjectivity to these estimated fair values.

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Items measured at fair value on a recurring basis – The following fair value hierarchy table presents information about the Company’s assets that are measured at fair value on a recurring basis at the dates indicated:

 

 

The following methods were used to estimate the fair value of the class of financial instruments above:

Investment securities - The fair value of securities is based on quoted market prices, pricing models, quoted prices of similar securities, independent pricing sources, and discounted cash flows.

Limitations: The fair value estimates presented herein are based on pertinent information available to management as of March 31, 2020 and December 31, 2019. The factors used in the fair values estimates are subject to change subsequent to the dates the fair value estimates are completed, therefore, current estimates of fair value may differ significantly from the amounts presented herein.

Assets measured at fair value using significant unobservable inputs (Level 3)

The following table provides a description of the valuation technique, unobservable inputs, and qualitative information about the unobservable inputs for the Company’s assets and liabilities classified as Level 3 and measured at fair value on a nonrecurring basis at the dates indicated:

 

 

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Items measured at fair value on a nonrecurring basis – The following table presents financial assets and liabilities measured at fair value on a nonrecurring basis and the level within the fair value hierarchy of the fair value measurements for those assets at the dates indicated:

 

 

The amounts disclosed above represent the fair values at the time the nonrecurring fair value measurements were made, and not necessarily the fair value as of the dates reported on.

Impaired loans - A loan is considered impaired when it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement. Impairment is measured based on the fair value of the underlying collateral or the discounted cash expected future cash flows. Subsequent changes in the value of impaired loans are included within the provision for loan losses in the same manner in which impairment initially was recognized or as a reduction in the provision that would otherwise be reported. Impaired loans are evaluated quarterly to determine if valuation adjustments should be recorded. The need for valuation adjustments arises when observable market prices or current appraised values of collateral indicate a shortfall in collateral value compared to current carrying values of the related loan. If the Company determines that the value of the impaired loan is less than the carrying value of the loan, the Company either establishes an impairment reserve as a specific component of the allowance for loan losses or charges off the impairment amount. These valuation adjustments are considered nonrecurring fair value adjustments.

Note 10 - Earnings Per Common Share

The following is a computation of basic and diluted earnings per common share at the periods indicated:

 

 

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

We are a bank holding company that operates through our wholly owned subsidiary, Coastal Community Bank (the “Bank”). We are headquartered in Everett, Washington, which by population is the largest city in, and the county seat of, Snohomish County. We focus on providing a wide range of banking products and services to consumers and small to medium sized businesses in the broader Puget Sound region in the state of Washington. We currently operate 14 full-service banking locations, 11 of which are located in Snohomish County, where we are the largest community bank by deposit market share, and three of which are located in neighboring counties (one in King County and two in Island County). We plan to open our 15^th branch in Arlington, Washington during the second quarter 2020.  As of March 31, 2020, we had total assets of $1.18 billion, total gross loans of $1.01 billion, total deposits of $1.01 billion and total shareholders’ equity of $127.2 million.

The following discussion and analysis presents our financial condition and results of operations on a consolidated basis. However, because we conduct all of our material business operations through the Bank, the discussion and analysis relate to activities primarily conducted by the Bank.

As a bank holding company that operates through one segment, community banking, we generate most of our revenue from interest on loans and investments. Our primary source of funding for our loans is commercial and retail deposits. We place secondary reliance on wholesale funding, primarily borrowings from the Federal Home Loan Bank (“FHLB”). Less commonly used sources of funding include borrowings from the Federal Reserve System (“Federal Reserve”) discount window, draws on established federal funds lines from unaffiliated commercial banks, brokered funds, which allows us to obtain deposits from sources that do not have a relationship with the Bank and can be obtained through certificate of deposit listing services, via the internet or through other advertising methods, or a one-way buy through an insured cash sweep (“ICS”) account, which allows us to obtain funds from other institutions that have deposited funds through ICS. Our largest expenses are salaries and related employee benefits, occupancy, interest on deposits and borrowings, data processing, and provision for loan losses. Our principal lending products are commercial real estate loans, commercial and industrial loans, residential real estate loans, construction, land and land development loans, and to a lesser extent consumer loans.

The Company's Preparations and Responses to Pandemic

As part of its ongoing risk preparation and mitigation efforts, the Company had developed a detailed plan and action measures related to a possible pandemic scenario. This pandemic plan was implemented on March 12, 2020. Subsequently, the Company initiated a series of measures to limit operational disruptions, support customer needs and to ensure the continued safety of employees, customers and vendors. Management continues to monitor and, when appropriate, make changes to our planned response. To date we have:

Comparison of Operating Results for the Three Months Ended March 31, 2020 and March 31, 2019

 

The Company’s first quarter 2019 results were impacted by a temporary, atypically large balance held in a deposit account by a Banking as a Service (“BaaS”) client, which is not expected to occur again.  The deposits came through a BaaS relationship and not from the end customer so they are classified as brokered deposits in accordance with regulatory guidance.  

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The increase of BaaS-brokered deposits during the quarter ended March 31, 2019 most significantly affected the following balance sheet items: cash and cash equivalents, total assets, deposits, and total liabilities.  Cost of deposits, cost of funds, net interest margin, and net income were the most significantly impacted income statement items due to the temporary increase in BaaS-brokered deposits.  These BaaS-brokered deposits stabilized in the third quarter 2019 to a more normalized balance and remained that way through March of 2020.

Results of Operations

Net Income

Net income for the three months ended March 31, 2020, was $2.7 million, or $0.22 per diluted share, compared to $2.8 million, or $0.23 per diluted share, for the three months ended March 31, 2019. The decrease in net income over the comparable period in the prior year was attributable to a $1.0 million increase in the provision for loan losses, related to the growth in the loan portfolio along with an increase in qualitative factors related to the change in the economic outlook caused by the COVID-19 pandemic, and $1.4 million increase in noninterest expense, which includes $1.1 million more in salaries and employee benefits.   These are partially offset by $1.6 million increase in net interest income, primarily arising from increased interest earning assets from our loan growth initiatives, as well as increases in noninterest income of $420,000 in loan referral fees, and $133,000 in BaaS fees.  BaaS is a line of business that enable our broker dealer and digital financial service partners to offer their customers banking services.

Net Interest Income

Net interest income for the three months ended March 31, 2020, was $11.4 million, compared to $9.8 million for the three months ended March 31, 2019, an increase of $1.6 million, or 16.4%. The increase in net interest income consisted of a $1.7 million, or 15.1%, increase in interest income partially offset by a $129,000, or 7.9%, increase in interest expense.  The increase from prior quarter one year ago is related to increased interest income resulting from our loan growth, partially offset by increased interest expense due to growth in interest bearing deposits and a decrease in rates on existing loans that are tied to indexes, including, among others, Wall Street Journal Prime, FHLB term advance rates and LIBOR.

The growth in interest income was primarily attributable to a $184.2 million, or 23.6%, increase in average loans outstanding for the three months ended March 31, 2020, compared to the prior year period, partially offset by $30.1 million less in interest earning deposits and a 15 basis point decrease in average yield on loans.  The decrease in loan yields, as compared to the prior year period, was the result of the Federal Open Market Committee (“FOMC”) lowering rates five times since July 2019, resulting in lower rates on new and renewing loans as well as loans tied to indexes.  Contractual loan yields approximated 5.08% for the quarter ended March 31, 2020 compared to 5.22% for the quarter ended March 31, 2019.   Although we have rate floors in place for $347.7 million, or 34.5%, in existing loans, the rate reductions by the FOMC have had a corresponding impact on loan yields and subsequently the net interest margin in future periods. We have continued to focus on our loan growth initiatives, including the deepening of relationships with existing customers and developing new loan and deposit relationships with new customers. We have experienced a significant increase in commercial and industrial SBA 7(a) loans during the second quarter 2020, as small business owners apply for relief via the PPP as prescribed in the CARES Act. We primarily focus on organically growing loans through our existing lenders and by acquiring new lenders or teams to assist to grow our loan portfolio.

The increase in interest expense for the three months ended March 31, 2020 was primarily related to $57.0 million, or 10.0%, increase in average interest bearing deposits, compared to the prior year period.  The increase was partially offset by a six-basis point decrease in the cost of funds to 0.70% for the quarter ended March 31, 2020 compared to 0.76% for the quarter ended March 31, 2019.  The average rate paid on BaaS-brokered deposits decreased 1.29% compared to the prior year period, and NOW and money market accounts increased 28 basis points for the three months ended March 31, 2020.  The average rate paid on BaaS-brokered deposits was higher in the three months ended March 31, 2019 as a result of the temporary increase in BaaS-brokered deposits for that period.   The average rate paid on NOW and money market accounts in the quarter ended March 31, 2020 is the result of the recent decreased FOMC rates, compounded by continued market pressure for higher rates, which in turn resulted in lowered rates on these accounts; however, the impact of such rate decreases will be reflected in future periods, starting with second quarter 2020. The average balance of NOW and money market accounts grew $117.9 million, or 33.8%, in the three months ended March 31, 2020.  The average balance of BaaS-brokered deposits was $21.8 million for the three months ended March 31, 2020, which was down $52.3 million for the prior year period.  The average balance of savings accounts grew $1.5 million, or 2.8%, and the average balance of time deposits declined $10.1 million, or 10.7%, to $84.7 million in the three months ended March 31, 2020, in an intentional effort to focus on more on core deposit growth. We do not regularly advertise time deposit rates or money market rates, although we occasionally advertise promotional rates in targeted portions of our market area. Our branch managers, business development officers, and lenders collaborate to provide consistent and coordinated customer service and to seek deposits from new and existing customers.

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For the three months ended March 31, 2020, net interest margin (annualized net interest income divided by average total interest earning assets) and net interest spread (average yield on total interest earning assets minus average cost of total interest bearing liabilities) were 4.15% and 3.70%, respectively, compared to 4.13% and 3.69%, respectively, for the three months ended March 31, 2019.  

The following table presents an analysis of the average balances of net interest income, net interest spread and net interest margin for the periods indicated. Loan fees included in interest income totaled $429,000 and $350,000 for the three months ended March 31, 2020 and 2019, respectively. For the three months ended March 31, 2020 and 2019, the amount of interest income not recognized on nonaccrual loans was not material.

 

 

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The following table presents information regarding the dollar amount of changes in interest income and interest expense for the periods indicated for each major component of interest earning assets and interest bearing liabilities and distinguishes between the changes attributable to changes in volume and changes attributable to changes in interest rates. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been allocated to volume.  

 

Provision for Loan Losses

The provision for loan losses is an expense we incur to maintain an allowance for loan losses at a level that management deems appropriate to absorb inherent losses on existing loans. For a description of the factors taken into account by our management in determining the allowance for loan losses see “—Financial Condition—Allowance for Loan Losses.”

The provision for loan losses for the three months ended March 31, 2020 was $1.6 million, compared to $540,000 for the three months ended March 31, 2019. The allowance for loan losses as a percentage of loans was 1.29% at March 31, 2020, compared to 1.25% at March 31, 2019. The provision for loan losses was increased due to loan growth and along with an increase in qualitative factors related to the change in economic outlook caused by the COVID-19 pandemic.  We are not required to implement the provisions of the Current Expected Credit Loss (“CECL”) accounting standard until January 1, 2023, therefore we are continuing to account for the allowance for loan losses under the incurred loss model.  Credit quality has remained stable through March 31, 2020, as demonstrated by the low level of charge-offs and declining nonperforming loan balance.  Nonperforming assets to total assets was 0.06% at March 31, 2020 compared to 0.12% at March 31, 2019.

Net charge-offs for the three months ended March 31, 2020 totaled $123,000, or 0.05% (annualized) of total average loans, as compared to net recoveries of $32,000, or 0.02% (annualized) of total average loans, for the three months ended March 31, 2019. The immediate and long-term economic impact of the COVID-19 pandemic is unknown; however, we remain diligent in our efforts to communicate and work with borrowers to help mitigate potential credit deterioration.

Noninterest Income

Our primary sources of recurring noninterest income are loan referral fees, deposit service charges and fees, BaaS fees and mortgage broker fees. Noninterest income does not include loan origination fees to the extent they exceed the direct loan origination costs, which are generally recognized over the life of the related loan as an adjustment to yield using the interest or similiar method.

For the three months ended March 31, 2020, noninterest income totaled $2.7 million, an increase of $687,000, or 34.6%, compared to $2.0 million for the three months ended March 31, 2019.

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The following table presents, for the periods indicated, the major categories of noninterest income:

 

 

Loan Referral Fees. We earn loan referral fees when we originate a variable rate loan and the borrower enters into an interest rate swap agreement with a third party to fix the interest rate for an extended period, usually 20 or 25 years. We recognize the loan referral fee for arranging the interest rate swap. By facilitating interest rate swaps to our clients, we are able to provide them with a long-term, fixed interest rate without assuming the interest rate risk. We had $1.1 million in income from loan referral fees for the three months ended March 31, 2020, compared to $633,000 in the same period in the prior year. Interest rate volatility, swap rates, and the timing of loan closings all impact the demand for long-term fixed rate swaps. The recognition of loan referral fees fluctuates in response to these market conditions and as a result we may not recognize any loan referral fees in some periods.

 

Deposit Service Charges and Fees. Deposit service charges and fees include service charges on accounts, point-of-sale fees, merchant services fees and overdraft fees. Together they constitute one of the largest components of our noninterest income. Deposit service charges were $723,000 for the three months ended March 31, 2020, a decrease of $3,000, or 0.4%, from $726,000 over the same period in the prior year. The decrease in deposit service charges and fees was primarily the result of $29,000 less overdraft fee income in the quarter ended March 31, 2020 compared to the prior year period.

BaaS Fees. Our CCBX division provides BaaS offerings that enable our broker dealer and digital financial service partners to offer their customers banking services.  In exchange for providing these services, we earn fixed fees, volume-based fees and reimbursement of costs depending on the contract.  BaaS fee income for the three months ended March 31, 2020 was $579,000 compared to $446,000 for the three months ended March 31, 2019. The increase is the result of growth in the number of BaaS partnerships.  

Mortgage Broker Fees. We earn mortgage broker fees for residential real estate loans that we broker through mortgage lenders. Mortgage broker fees increased $77,000 in the three months ended March 31, 2020 to $162,000, compared to $85,000 in the same period in 2019 as a result of increased demand from lower interest rates on mortgages.

Other. This category includes a variety of other income-producing activities, annuity broker fees, and SBA and U.S. Department of Agriculture (“USDA”) servicing fees. Other noninterest income increased $40,000 in the three months ended March 31, 2020, compared to the same period in 2019 primarily as a result of higher SBA and USDA servicing fees.

Noninterest Expense

Generally, noninterest expense is composed of all employee expenses and costs associated with operating our facilities, obtaining and retaining customer relationships and providing bank services. The largest component of noninterest expense is salaries and employee benefits. Noninterest expense also includes operational expenses, such as occupancy expense, data processing expense, legal and professional fees, director and staff expense and software licenses, maintenance and subscriptions.

For the three months ended March 31, 2020, noninterest expense totaled $9.0 million, an increase of $1.4 million, or 17.7%, compared to $7.7 million for the three months ended March 31, 2019.

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The following table presents, for the periods indicated, the major categories of noninterest expense:

 

 

Salaries and Employee Benefits. Salaries and employee benefits are the largest component of noninterest expense and include payroll expense, incentive compensation costs, benefit plans, health insurance and payroll taxes. Salaries and employee benefits were $5.7 million for the three months ended March 31, 2020, an increase of $1.1 million, or 24.7%, compared to $4.6 million for the three months ended March 31, 2019. The increase was primarily due to hiring staff for our BaaS CCBX division and additional staff for our ongoing banking related growth initiatives. As our BaaS banking activities grow, we expect to continue to add employees to support this line of business.  As of March 31, 2020, we had 208 full-time equivalent employees, compared to 179 at March 31, 2019, a 16.2% increase.

Occupancy Expenses. Occupancy expenses were $927,000 for the three months ended March 31, 2020, compared to $994,000 for the three months ended March 31, 2019. This category includes building, leasehold, furniture, fixtures and equipment depreciation totaling $309,000 and $304,000 for the three months ended March 31, 2020 and 2019, respectively. The decrease of 6.7% in occupancy expenses for the three months ended March 31, 2020, compared to the same period in the prior year, was largely due to a decrease in maintenance and repair costs and lower utilities expense.

Data Processing. Data processing costs were $551,000 for the three months ended March 31, 2020, compared to $529,000 for the three months ended March 31, 2019. Data processing costs include all of our customer transaction processing and data storage, computer processing, and network costs.  Data processing costs grow as we add new products, customers and branches.  

Legal and Professional Fees. Legal and professional costs were $323,000 for the quarter ended March 31, 2020 compared to $409,000 for the quarter ended March 31, 2019.  Legal and professional costs fluctuate with the development of contracts for CCBX customers and are also impacted by our reporting cycle and timing of legal services.  

Director and Staff Expenses. Director and staff expenses includes compensation for director service, continuing education for employees and other director and staff related expenses.   Director and staff expenses were $270,000 for the three months ended March 31, 2020 compared to $240,000 for the three months ended March 31, 2019, an increase of $30,000 or 12.5%.  Increased expenses related to staff training combined with the addition of one director to the Board of Directors of the Company in May of 2019 contributed to the increase in the quarter ended March 31, 2020 compared to quarter ended March 31, 2019.  

Software Licenses, Maintenance and Subscriptions. Software licenses, maintenance and subscriptions includes expenses related to obtaining and maintaining software required for various functions throughout the Company.   Software licenses, maintenance and subscriptions were $241,000 for the quarter ended March 31, 2020, compared to $86,000 for the prior year period.  Late in 2019, we changed how we were expensing these costs, consolidating all related expenses to one category, which contributed to the increase over the prior year period.  Software related expenses is expected to continue to increase as we grow product lines and expand our CCBX division.     

Excise Taxes. Excise taxes were $203,000 for the three months ended March 31, 2020 compared to $165,000 for the three months ended March 31, 2019.  Excise taxes are based on gross income of $15.8 million and $13.4 million for the three months ended March 31, 2020 and 2019, respectively.  Gross income is reduced by certain allowed deductions to arrive at the taxable base; however, as gross income increases, so does the excise tax expense.  

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Business Development. Business development costs were $125,000 for the three months ended March 31, 2020 compared to $102,000 for the three months ended March 31, 2019.  Business development costs include sponsorships and other activities to cultivate business and community development.  As expected, these expenses increase as the Bank grows.

Other. This category includes dues and memberships, office supplies, mail services, telephone, examination fees, internal loan expenses, services charges from banks, operational losses, directors and officer’s insurance, donations, provision for unfunded commitments, and miscellaneous other expenses. Other noninterest expense was $514,000 for the three months ended March 31, 2020, compared to $410,000 for the three months ended March 31, 2019. The increase was largely due to a $49,000 increase in bank examination fees and overall growth for the three months ended March 31, 2020 as compared to the same period last year.

Income Tax Expense

The amount of income tax expense we incur is impacted by the amounts of our pre-tax income, tax-exempt income and other nondeductible expenses. Deferred tax assets and liabilities are reflected at current income tax rates in effect for the period in which the deferred tax assets and liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Valuation allowances are established when necessary to reduce our deferred tax assets to the amount expected to be realized. For the three months ended March 31, 2020, income tax expense totaled $714,000, compared to $741,000 for the three months ended March 31, 2019. Our effective tax rates for the three months ended March 31, 2020 and 2019, were 20.8% and 20.9%, respectively.

 

Financial Condition

The Company’s total assets increased $55.5 million, or 4.9%, to $1.18 billion at March 31, 2020 from $1.13 billion at December 31, 2019.  The increase is primarily the result of $66.1 million in gross loan growth during the three months ended March 31, 2020.  This increase was partially offset by a decrease of $13.0 million in investment securities resulting from maturities and principal paydowns.

Loan Portfolio

The quarter ended March 31, 2020 closed amid an unprecedented global COVID-19 pandemic that is impacting the economic health of our community and nation.  The provision for loan losses allowances was $1.6 million during the quarter ended March 31, 2020, as a result of loan growth and an increase in qualitative factors related to the economic outlook.  As a preferred SBA lender, we are working diligently with the SBA to offer assistance to small businesses as provided in the recently passed Coronavirus Aid, Relief and Economic Security Act (“CARES Act”).  These SBA loans are discussed further under the Commercial and Industrial loans section below.  We are also in contact with borrowers with existing loans that have been impacted by COVID-19.  We expect to continue to restructure payments for our loan customers during this uncertain time to help alleviate financial hardships and are deferring payments on over 215 loans as of May 6, 2020.  These loans include 87 commercial real estate loans representing $132.1 million; 72 commercial and industrial loans representing $22.1 million; 11 construction, land and land development loans representing $23.5 million; and 43 residential real estate loans representing $18.4 million.   In accordance with GAAP and interagency guidance issued on March 22, 2020, short-term modifications, made on a good faith basis in response to COVID-19 to borrowers that were current prior to any relief, are not classified as troubled debt restructurings.  As part of the stay at home order issued by the Governor of Washington in March 2020, non-essential construction projects have been temporarily halted which will likely have an impact on future draws on unfunded commitments.  The Bank is working with our contractors and extending the construction period as appropriate to compensate for the work shutdown.

Our primary source of income is derived through interest earned on loans. A substantial portion of our loan portfolio consists of commercial real estate loans and commercial and industrial loans in the Puget Sound region. Our loan portfolio represents the highest yielding component of our earning assets.

As of March 31, 2020, gross loans totaled $1.01 billion, an increase of $66.1 million, or 7.0%, compared to December 31, 2019. The increase was primarily due to our efforts to increase income by building a diversified loan portfolio while maintaining strong credit quality.

Loans as a percentage of deposits were 100.0% as of March 31, 2020, compared to 97.0% as of December 31, 2019.  We are focused on serving our communities and markets by growing loans and funding those loans with customer deposits.

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The following table summarizes our loan portfolio by type of loan as of the dates indicated:

 

 

Commercial and Industrial Loans. Commercial and industrial loans increased $11.3 million, or 10.1%, to $122.7 million as of March 31, 2020, from $111.4 million as of December 31, 2019. Commercial and industrial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and effectively. These loans are primarily made based on the borrower’s ability to service the debt from income. Most commercial and industrial loans are secured by the assets being financed or other business assets, such as accounts receivable, inventory or equipment, and we generally obtain personal guarantees on these loans.

 

We are working with the SBA to help small businesses as provided in the recently passed CARES Act.  We expect to see an increase in commercial and industrial SBA 7(a) loans in the second quarter 2020, as small business owners apply for financial relief under the PPP.  This program allows business owners that are impacted by the COVID-19 pandemic to apply for and receive financial relief to help pay for employee wages and certain other expenses.  These short-term loans bear a 1% interest rate and may be forgiven by the government if certain criteria are met.  As of May 6, 2020, we have successfully funded 1,874 loan applications representing $393.4 million in resources to businesses in our community through PPP loans.  All PPP activity has occurred subsequent to March 31, 2020.

Commercial Real Estate Loans. Commercial real estate loans increased $30.1 million, or 4.9%, to $643.5 million as of March 31, 2020, from $613.4 million as of December 31, 2019. Included in this increase is $11.5 million in capital call lines resulting from relationships with our BaaS clients.  We make commercial mortgage loans collateralized by owner-occupied and non-owner-occupied real estate, as well as multi-family residential loans. The real estate securing our existing commercial real estate loans includes a wide variety of property types, such as manufacturing and processing facilities, business parks, warehouses, retail centers, convenience stores, hotels and motels, office buildings, mixed-use residential and commercial, and other properties. We originate both fixed- and adjustable-rate loans with terms up to 20 years. Fixed-rate loans typically amortize over a 10-to-25 year period with balloon payments at the end of five to ten years. Adjustable-rate loans are generally based on the prime rate and adjust with the prime rate or are based on term equivalent FHLB rates. At March 31, 2020, approximately 37.9% of the commercial real estate loan portfolio consisted of fixed rate loans. Commercial real estate loans represented 63.9% of our loan portfolio at March 31, 2020 and are our largest source of revenue. The Bank actively seeks commercial real estate loans in our markets and our lenders are experienced in originating and competing for these loans.  Our credit administration team has substantial experience in underwriting, managing, monitoring and working out commercial real estate loans.  

Construction, Land and Land Development Loans. Construction, land and land development loans increased $22.6 million, or 23.3%, to $119.7 million as of March 31, 2020, from $97.0 million as of December 31, 2019. We saw favorable economic conditions for building in our market area in the first quarter of 2020.  We have a number of construction loans that have been approved, primarily for commercial projects, where the contractor/developer has not requested the funds, resulting in our unfunded construction and development commitments increasing to $72.9 million at March 31, 2020, from $63.7 million at December 31, 2019.

Although we have seen a strong commercial and residential real estate market in the Puget Sound region thus far in 2020, the immediate and long-term effects of the COVID-19 pandemic remain to be seen.  As part of the stay at home order issued by the Governor of Washington in March 2020, non-essential construction projects have been temporarily halted which will likely have an impact on future draws on unfunded commitments.  The Bank is working with our contractors and extending the construction period as appropriate to compensate for the work shutdown.

Residential Real Estate Loans.  Our residential loans increased $2.8 million, or 2.4%, from $115.0 million at December 31, 2019 to $117.8 million at March 31, 2020. We originate one-to-four adjustable-rate mortgage (“ARM”), loans for our portfolio and operate as a mortgage broker for mortgage lenders we have agreements with for customers who want a 15-year to 30-year, fixed-rate mortgage loan. As of March 31, 2020, the balance of our ARM portfolio loans was $14.0 million, compared to $11.7 million at December 31,

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2019.  Our ARM loans typically do not meet the guidelines for sale in the secondary market due to characteristics of the property, the loan terms or exceptions from agency underwriting guidelines, which enables us to earn a higher interest rate. We also purchase residential mortgages originated by other financial institutions to hold for investment with the intent to diversify our residential mortgage loan portfolio, meet certain regulatory requirements and increase our interest income.  As of March 31, 2020, we held $26.6 million in purchased residential real estate mortgage loans, compared to $28.6 million at December 31, 2019.  These loans purchased typically have a fixed rate with a term of 15 to 30 years and are collateralized by one-to-four family residential real estate. We have a defined set of credit guidelines that we use when evaluating these loans. Although purchased loans were originated and underwritten by another institution, our mortgage, credit, and compliance departments conduct an independent review of each underlying loan that includes re-underwriting each of these loans to our credit and compliance standards. We also make one-to-four family loans to investors to finance their rental properties and to business owners to secure their business loans.  As of March 31, 2020, residential real estate loans made to investors and business owners totaled $63.2 million.

Like our commercial real estate loans, our residential real estate loans are secured by real estate, the value of which may fluctuate significantly over a short period of time as a result of market conditions in the area in which the real estate is located. Adverse developments affecting real estate values in our market areas could therefore increase the credit risk associated with these loans, impair the value of property pledged as collateral on loans, and affect our ability to sell the collateral upon foreclosure without a loss or additional losses.

Consumer and Other Loans. Consumer and other loans totaled $3.7 million as of March 31, 2020, decreasing $519,000 from $4.2 million at December 31, 2019. Our consumer and other loans are comprised of personal lines of credit, automobile, boat, and recreational vehicle loans, and secured term loans.

Industry Exposure and Categories of Loans

We have a diversified loan portfolio, representing a wide variety of industries.  The three largest categories of loans are commercial real estate, commercial and industrial, and construction, land and land development loans.  Together they represent $885.8 million in outstanding loan balances or 88.0% of total gross loans outstanding.  When combined with $159.1 million in unused commitments the total of these three categories is $1.05 billion or 88.1% of total outstanding loans and loan commitments.

Commercial Real Estate Loans. Commercial real estate represents the largest segment of our loans, comprising 63.9% of our total balance of outstanding loans as of March 31, 2020.  Unused commitments to extend credit represents an additional $11.3 million, the combined total exposure in commercial real estate loans represents $654.7 million or 55.2% of our total outstanding loans and loan commitments.

The following table summarizes our concentration by industry for our commercial real estate loan portfolio as of March 31, 2020:

 

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Commercial and Industrial Loans. Commercial and industrial loans comprise 12.2% of our total balance of outstanding loans as of March 31, 2020.  Unused commitments to extend credit represents an additional $74.9 million, the combined total exposure in commercial and industrial loans represents $197.6 million or 16.7% of our total outstanding loans and loan commitments.

The following table summarizes our concentration by industry for our commercial and industrial loan portfolio as of March 31, 2020:

 

Construction, Land and Land Development Loans. Construction, land and land development loans comprise 11.9% of our total balance of outstanding loans as of March 31, 2020.  Unused commitments to extend credit represents an additional $72.9 million, the combined total exposure in construction, land and land development loans represents $192.5 million or 16.2% of our total outstanding loans and loan commitments.

The following table details our concentration for our construction, land and land development loan portfolio as of March 31, 2020:

 

Nonperforming Assets

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on nonaccrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by applicable regulations. Loans may be placed on nonaccrual status regardless of whether or not such loans are considered past due. In general, we place loans on nonaccrual status when they become 90 days past due. We also place loans on nonaccrual status if they are less than 90 days past due if the collection of principal or interest is in doubt. We are not required to report as nonperforming a loan for which we have allowed the borrower to defer payment on a short term basis because of financial pressure related to COVID-19. When loans are placed on nonaccrual status, all unpaid accrued interest is reversed from income and all interest accruals are stopped. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal balance. Loans are returned to accrual status if we believe that all remaining principal and interest is fully collectible and there has been at least six months of sustained repayment performance since the loan was placed on nonaccrual status.  We define nonperforming loans as loans on nonaccrual status and accruing loans 90 days or more past due.  Nonperforming assets also include other real estate owned and repossessed assets.  

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We believe our lending practices and active approach to managing nonperforming assets has resulted in sound asset quality and timely resolution of problem assets. We have procedures in place to assist us in maintaining the overall credit quality of our loan portfolio. We have established underwriting guidelines, concentration limits and we also monitor our delinquency levels for any negative or adverse trends. We actively manage problem assets to reduce our risk for loss.

We had $763,000 in nonperforming assets, as of March 31, 2020, compared to $1.0 million as of December 31, 2019. There were no loans more than 90 days past due and still accruing interest as of March 31, 2020 and December 31, 2019.  

Credit quality has remained stable in 2020 thus far as demonstrated by the low level of charge-offs and declining nonperforming loan balance.  The immediate and long-term economic impact of the COVID-19 pandemic is unknown; however, we remain diligent in our efforts to communicate and work with borrowers to help mitigate potential credit deterioration. Credit administration is closely analyzing higher risk segments within the loan portfolio, monitoring and tracking loan payment deferrals and customer liquidity, and providing timely reporting to management and the board of directors.

The following table presents information regarding nonperforming assets at the dates indicated:

 

 

Allowance for Loan Losses

We maintain an allowance for loan losses that represents management’s best estimate of the loan losses and risks inherent in our loan portfolio. The amount of the allowance for loan losses should not be interpreted as an indication that charge-offs in future periods will necessarily occur in those amounts. In determining the allowance for loan losses, we estimate losses on specific loans, or groups of loans, where the probable loss can be identified and reasonably determined. The balance of the allowance for loan losses is based on internally assigned risk classifications of loans, historical loan loss rates, changes in the nature of our loan portfolio, overall portfolio quality, industry concentrations, delinquency trends, and current economic factors.

In connection with our allowance for loan loss review, we consider risk elements applicable to particular loan types or categories in assessing the quality of individual loans. Some of the risk elements we consider include:

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As of March 31, 2020, the allowance for loan losses totaled $12.9 million, or 1.29% of total loans. As of December 31, 2019, the allowance for loan losses totaled $11.5 million, or 1.22% of total loans. Our allowance for loan losses as of March 31, 2020, increased by $1.5 million, or 12.7%, compared to December 31, 2019, due to growth in our loan portfolio along with an increase in our qualitative factors primarily related to uncertainties in the economic outlook from the COVID-19 pandemic on our loan portfolio.

The following table presents, as of and for the periods indicated, an analysis of the allowance for loan losses and other related data:

 

 

(1)Ratios for the three months ended March 31, 2020 and 2019, are annualized.

Although we believe that we have established our allowance for loan losses in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”) and that the allowance for loan losses was adequate to provide for known and inherent losses in the portfolio at all times shown above, future provisions for loan losses will be subject to ongoing evaluations of the risks in our loan portfolio.  In anticipation of the potential economic effects of the COVID-19 pandemic on our loan portfolio, we increased our provision during the quarter ended March 31, 2020.  If Washington State remains under a stay at home order for a long period of time, preventing businesses and consumers from conducting business, the state and Puget Sound region may experience an economic downturn, and our asset quality could deteriorate, which may require material additional provisions for loan losses.  We remain focused on working with the communities we serve, offering payment deferrals and other resources available under the CARES Act to provide financial assistance to businesses and consumers until they are able to re-open and recover from this uncertain and trying time.  

Securities

We use our securities portfolio primarily as a source of liquidity and collateral that can be readily sold or pledged for public deposits or other business purposes. At March 31, 2020, 76.2% of our investment portfolio consisted of U.S. Treasury securities. The remainder of our securities portfolio was invested in U.S. Government agency securities, U.S. Agency collateralized mortgage obligations and U.S. Agency residential mortgage-backed securities, and municipal bonds. Because we target a loan-to-deposit ratio in the range of 90% to 100%, we prioritize liquidity over the earnings of our securities portfolio. At March 31, 2020, our loan-to-deposit ratio was 100.0%.   Our securities portfolio represented less than 2% of assets. To the extent our securities represent more than 5% of assets, absent an immediate need for liquidity, we anticipate investing excess funds to provide a higher return.

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As of March 31, 2020, the carrying amount of our investment securities totaled $19.8 million, a decrease of $13.0 million, or 39.6%, compared to $32.7 million as of December 31, 2019. The decrease in the securities portfolio was due to maturities and principal paydowns.  We do not expect to purchase securities to replace these decreases, except as needed for pledging purposes.

Our investment portfolio consists of securities classified as available for sale and, to a lesser amount, held to maturity. The carrying values of our investment securities classified as available for sale are adjusted for unrealized gain or loss, and any gain or loss is reported on an after-tax basis as a component of other comprehensive income in shareholders’ equity.

The following table summarizes the amortized cost and estimated fair value of our investment securities as of the dates shown:

 

Deposits

We offer a variety of deposit products that have a wide range of interest rates and terms, including demand, savings, money market and time accounts as well as BaaS-brokered deposits. In addition, we recently added reciprocal deposits to our product offering. This enables us to extend Federal Deposit Insurance Corporation (“FDIC”) insurance to customers that have balances in excess of the FDIC insurance limit.  This service trades our customer’s funds as CDs in increments under the FDIC insured amount to other participating financial institutions and in exchange we receive CD investments from participating financial institutions in a reciprocal agreement.  We rely primarily on competitive pricing policies, convenient locations, electronic delivery channels (Internet and mobile), and personalized service to attract new deposits and retain existing deposits.

Total deposits as of March 31, 2020 were $1.01 billion, an increase of $37.1 million, or 3.8%, compared to $968.0 million as of December 31, 2019. The increase was largely in core deposits, which increased $29.9 million to $892.4 million from $862.5 million at December 31, 2019.  We define core deposits as all deposits except time deposits and BaaS-brokered deposits. We focus on growing core deposits and our branch managers, business development officers, treasury service personnel and lenders work together to grow deposits from existing and new customers.

Noninterest bearing deposits as of March 31, 2020 were $345.5 million, a decrease of $25.7 million, or 6.9%, compared to $371.2 million as of December 31, 2019. The $25.7 million decrease partially resulted from a $10.2 million estate distribution and a $8.5 million reclassification to interest bearing deposits from a BaaS customer which we expect to eventually transfer back to noninterest bearing.  These deposits represent 34.4% and 38.4% of total deposits for March 31, 2020 and December 31, 2019, respectively.

Total interest bearing account balances, excluding time deposits, as of March 31, 2020 were $570.8 million, an increase of $55.9 million, or 10.9%, from $514.9 million as of December 31, 2019. Included in interest bearing account balances is $23.9 million in BaaS-brokered deposits, an increase of $318,000 from December 31, 2019. Also included in interest bearing deposits is $638,000 in reciprocal deposits.  In 2019 we introduced reciprocal deposits as a product available for time deposit customers and beginning this year we are offering an interest bearing demand reciprocal deposit product.

Total time deposit balances as of March 31, 2020 were $88.8 million, an increase of $6.9 million, or 8.4%, from $81.9 million as of December 31, 2019. The increase is the result of $10.9 million in reciprocal deposits, which are included in time deposits.  We have

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seen competitors continue to offer higher rates on time deposits, and we have not globally matched their rates in response as we have been able to grow and retain less costly core deposits.

The following table sets forth deposit balances at the dates indicated.

 

 

The following table sets forth the Company’s time deposits of $100,000 or more by time remaining until maturity as of the dates indicated:

 

 

Average deposits for the three months ended March 31, 2020 were $981.0 million, compared to $859.1 million for the three months ended March 31, 2019. The increase in average deposits was primarily due to an increase in core deposits, both in noninterest bearing deposits and in interest bearing deposits.  Continued growth in our primary market areas and the increase in commercial lending relationships for which we also seek deposit balances and the results of business development efforts by our business development officers, branch managers and lenders continue to contribute to deposit growth.

The average rate paid on total deposits was 0.64% and 0.68%, respectively, for the three months ended March 31, 2020 and March 31, 2019, respectively.  The average rate paid on BaaS-brokered deposits decreased 1.29% for the three months ended March 31, 2020, compared to the prior year period, and NOW and money market accounts increased 28 basis points.  The average rate paid on NOW and money market accounts in the quarter ended March 31, 2020 is the result of the recent decreased FOMC rates, compounded by continued market pressure for higher rates, which in turn resulted in lowered rates on these accounts; however, the impact of such rate decreases will be reflected in future periods, starting with second quarter 2020. Any further changes to the fed funds rate along with competition are expected to continue to impact future cost of deposits and our pricing strategies.

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The following table presents the average balances and average rates paid on deposits for the periods indicated:

 

 

The ratio of average noninterest bearing deposits to average total deposits for the three months ended March 31, 2020 was 36.0%, compared to 33.5% for the three months ended March 31, 2019.

Borrowings

We have the ability to utilize short-term to long-term borrowings to supplement deposits to fund our lending and investment activities, each of which is discussed below.

Federal Reserve Bank Line of Credit. The Federal Reserve allows us to borrow against our line of credit through a borrower in custody agreement utilizing the discount window, which is collateralized by certain loans. As of March 31, 2020 and December 31, 2019, total borrowing capacity of $21.4 million was available under this arrangement.  As of March 31, 2020 and December 31, 2019, Federal Reserve advances totaled zero.

Federal Home Loan Bank Advances. The FHLB allows us to borrow against our line of credit, which is collateralized by certain loans. As of March 31, 2020 and December 31, 2019, we had borrowing capacity of $88.1 million and $84.9 million, respectively, under this arrangement. On March 4, 2020 we borrowed a total of $25.0 million in FHLB long term advances.  This includes $10.0 million for a three-year term and $15.0 million for a five-year term.  FHLB advances totaled $25.0 million as of March 31, 2020 and $10.0 million as of December 31, 2019.  There was $63.1 million and $74.9 million borrowing capacity remaining as of March 31, 2020, and December 31, 2019, respectively.

The table below provides details on FHLB short term borrowings for the periods indicated:

 

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The table below provides details on the FHLB long term borrowings for the periods indicated:

 

Junior Subordinated Debentures. In 2004, we issued $3.6 million in junior subordinated debentures to Coastal (WA) Statutory Trust I (the “Trust”), of which we own all of the outstanding common securities. The Trust used the proceeds from the issuance of its underlying common securities and preferred securities to purchase the debentures issued by the Company. These debentures are the Trust’s only assets and the interest payments from the debentures finance the distributions paid on the preferred securities. The debentures bear interest at a rate per annum equal to the 3-month LIBOR plus 2.10%. The effective rate as of March 31, 2020, and December 31, 2019, was 2.84% and 3.99%, respectively. We generally have the right to defer payment of interest on the debentures at any time or from time to time for a period not exceeding five years provided that no extension period may extend beyond the stated maturity of the debentures. During any such extension period, distributions on the Trust’s preferred securities will also be deferred, and our ability to pay dividends on our common stock will be restricted. The Trust’s preferred securities are mandatorily redeemable upon maturity of the debentures, or upon earlier redemption as provided in the indenture, subject to Federal Reserve approval. If the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest. We unconditionally guarantee payment of accrued and unpaid distributions required to be paid on the Trust securities subject to certain exceptions, the redemption price with respect to any Trust securities called for redemption and amounts due if the Trust is liquidated or terminated.

Subordinated Debt. In 2016, the Company issued a subordinated note to a commercial bank in the amount of $10.0 million. The note matures on August 1, 2026, and bears interest at the rate of 5.65% per year for five years and, thereafter, at a rate equal to The Wall Street Journal prime rate plus 2.50%. Principal payments of $500,000 per quarter commence November 1, 2021. We may redeem the subordinated note, in whole or in part, without premium or penalty after July 29, 2021, subject to any required regulatory approvals.

 

Liquidity and Capital Resources

Liquidity Management

Liquidity refers to our capacity to meet our cash obligations at a reasonable cost. Our cash obligations require us to have cash flow that is adequate to fund loan growth and maintain on-balance sheet liquidity while meeting present and future obligations of deposit withdrawals, borrowing maturities and other contractual cash obligations. In managing our cash flows, management regularly confronts situations that can give rise to increased liquidity risk. These include funding mismatches, market constraints in accessing sources of funds and the ability to convert assets into cash. Changes in economic conditions or exposure to credit, market, and operational, legal and reputational risks also could affect the Bank’s liquidity risk profile and are considered in the assessment of liquidity management.

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We continually monitor our liquidity position to ensure that our assets and liabilities are managed in a manner to meet all reasonably foreseeable short-term, long-term and strategic liquidity demands. Management has established a comprehensive process for identifying, measuring, monitoring and controlling liquidity risk. Because of its critical importance to the viability of the Bank, liquidity risk management is fully integrated into our risk management processes. Critical elements of our liquidity risk management include: effective corporate governance consisting of oversight by the board of directors and active involvement by management; appropriate strategies, policies, procedures, and limits used to manage and mitigate liquidity risk; comprehensive liquidity risk measurement and monitoring systems that are commensurate with the complexity of our business activities; active management of intraday liquidity and collateral; an appropriately diverse mix of existing and potential future funding sources; adequate levels of highly liquid marketable securities free of legal, regulatory, or operational impediments, that can be used to meet liquidity needs in stressful situations; contingency funding policies and plans that sufficiently address potential adverse liquidity events and emergency cash flow requirements; and internal controls and internal audit processes sufficient to determine the adequacy of the Bank’s liquidity risk management process.

Our liquidity position is supported by management of our liquid assets and liabilities and access to alternative sources of funds. Our liquidity requirements are met primarily through our deposits, FHLB advances and the principal and interest payments we receive on loans and investment securities. Cash on hand, cash at third-party banks, investments available-for-sale and maturing or prepaying balances in our investment and loan portfolios are our most liquid assets. Other sources of liquidity that are routinely available to us include funds from retail, commercial, and BaaS deposits, advances from the FHLB and proceeds from the sale of loans. Less commonly used sources of funding include borrowings from the Federal Reserve discount window, draws on established federal funds lines from unaffiliated commercial banks, brokered funds, a one-way buy through an ICS account, and the issuance of debt or equity securities. We are also participating in the PPPLF, which provides an additional source of funding for the PPP loans.  We have pledged 327 of these loans, or $111.1 million as of May 6, 2020.  We believe we have ample liquidity resources to fund future growth and meet other cash needs as necessary and are closely monitoring liquidity in this uncertain economic environment.

The Company is a corporation separate and apart from our Bank and, therefore, must provide for its own liquidity, including liquidity required to meet its debt service requirements on its subordinated note and junior subordinated debentures. The Company’s main source of cash flow has been through equity and debt offerings. The Company has consistently retained a portion of the funds from equity and debt offerings so that is has sufficient funds for its operating and debt costs for the next few years. The Company down-streamed $7.5 million in capital to the Bank during the first quarter of 2020, bringing the Company’s cash holding to $6.1 million at March 31, 2020.  The Company uses approximately $1.3 million for debt servicing and operating purposes each year, leaving about $3.5 million for other purposes after deducting $2.6 million to cover operating purposes for the next two years.  In addition, the Bank can declare and pay dividends to the Company to meet the Company’s debt and operating expenses. There are statutory and regulatory limitations that affect the ability of the Bank to pay dividends to the Company. We believe that these limitations will not impact the ability of the Bank to pay dividends to the Company to meet ongoing operating needs. For contingency purposes, the Company maintains a minimum level of cash to fund one year’s projected operating cash flow needs and the Bank established a minimum liquidity ratio of 5% of assets. Both of these minimum liquidity levels are on-balance sheet sources. Per policy and the Bank’s liquidity contingency plan, in event of a liquidity emergency the Bank can utilize wholesale funds in an amount up to 30% of assets. Since the Bank uses only a small portion of its borrowing or wholesale funding capacity, the Bank has access to funds if needed in a liquidity emergency.

Capital Adequacy

Capital management consists of providing equity and other instruments that qualify as regulatory capital to support current and future operations. Banking regulators view capital levels as important indicators of an institution’s financial soundness. As a general matter, FDIC-insured depository institutions and their holding companies are required to maintain minimum capital levels relative to the amount and types of assets they hold. We are subject to regulatory capital requirements at the bank level. The Company will become subject to regulatory capital requirements once its consolidated assets exceed $3.0 billion. Currently, the Federal Reserve assesses the capital position of the Company by reviewing its debt-to-equity ratio and assessing the Company's capacity to serve as a source of strength to the Bank.

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As of March 31, 2020 and December 31, 2019, the Bank was in compliance with all applicable regulatory capital requirements, and the Bank was classified as “well capitalized” for purposes of the Federal Reserve’s prompt corrective action regulations. As we deploy our capital and continue to grow our operations, our regulatory capital levels may decrease depending on our level of earnings. However, we expect to monitor and control our growth in order to remain in compliance with all regulatory capital standards applicable to us.

The following table presents the Company’s and the Bank’s regulatory capital ratios as of the dates presented, as well as the regulatory capital ratios that are required by Federal Reserve regulations to maintain “well-capitalized” status:

 

 

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Contractual Obligations

The following table summarizes contractual obligations and other commitments to make future payments (other than non-time deposit obligations), which consist of future cash payments associated with our contractual obligations, as of March 31, 2020.

 

 

For a discussion of our borrowings, see “—Financial Condition—Borrowings” in this section.

We believe that we will be able to meet our contractual obligations as they come due. Adequate cash levels are expected through profitability, repayments from loans and securities, deposit gathering activity, access to borrowing sources and periodic loan sales.

Off-Balance Sheet Items

In the normal course of business, we enter into various transactions, which, in accordance with GAAP, are not included in our consolidated balance sheets. We enter into these transactions to meet the financing needs of our customers. These transactions include commitments to extend credit and standby and commercial letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in our consolidated balance sheets.

Our commitments associated with outstanding commitments to extend credit and standby and commercial letters of credit are summarized below. Since commitments associated with commitments to extend credit and letters of credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements.

 

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being fully drawn upon, the total commitment amounts disclosed above do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if considered necessary by us, upon extension of credit, is based on management’s credit evaluation of the customer.

Standby and commercial letters of credit are conditional commitments issued by us to guarantee the performance of a customer to a third party. In the event of nonperformance by the customer, we have rights to the underlying collateral, which can include commercial real estate, physical plant and property, inventory, receivables, cash and/or marketable securities. Our credit risk associated with issuing letters of credit is essentially the same as the risk involved in extending loan facilities to our customers.

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Critical Accounting Policies

Our accounting policies are integral to understanding our results of operations. Our accounting policies are described in greater detail in “Note 1 - Description of Business and Summary of Significant Accounting Policies and Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies” of our Form 10-K. We have procedures and processes in place to facilitate making these judgments. Actual results in these areas could differ from management’s estimates. There have been no significant changes concerning our critical accounting policies as described in our Form 10-K.

Selected Financial Data

The following table shows the Company’s key performance ratios for the periods indicated.  The table also includes ratios that were adjusted by removing the impact of the BaaS-brokered deposits to the quarters ended June 30, 2019 and March 31, 2019.  The BaaS-brokered deposits normalized at the end of the second quarter of 2019, therefore no adjustment was made to the loans receivable to deposits ratio as of June 30, 2019 and  no adjustments were made to the performance ratios that are calculated using an average balance since the quarter ended June 30, 2019. These adjusted ratios are non-GAAP measures.  For more information about non-GAAP financial measures see “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures” section that follows.

 

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GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures

Some of the financial measures included in this report are not measures of financial performance recognized by GAAP. Our management uses the non-GAAP financial measures set forth below in its analysis of our performance.

 

We believe that these non-GAAP financial measures provide information that is important to investors and that is useful in understanding our results of operations. The following non-GAAP measures are presented to illustrate the impact of provision for loan losses and provision for income taxes on net income and return on average assets. However, these non-GAAP financial measures are supplemental and are not a substitute for an analysis based on GAAP measures. As other companies may use different calculations for these measures, this presentation may not be comparable to other similarly titled measures by other companies.

 

“Pre-tax, pre-provision net income” is a non-GAAP measure that excludes the impact of provision for loan losses and provision for income taxes from net income.  The most directly comparable GAAP measure is net income.

 

“Pre-tax, pre-provision return on average assets” is a non-GAAP measure that excludes the impact of provision for loan losses and provision for income taxes from return on average assets.  The most directly comparable GAAP measure is return on average assets.

 

Reconciliations of the GAAP and non-GAAP measures are presented below.

 

 

We believe that these non-GAAP financial measures provide information that is important to investors and that is useful in understanding our results of operations. The following non-GAAP financial measures are presented to illustrate and identify the impact of temporary high rate BaaS deposits on the balance sheet.  By removing these temporary deposits to show what the results would have been without them we are providing the investors with the information to better compare results with periods that did not have these temporary deposits.  However, these non-GAAP financial measures are supplemental and are not a substitute for an analysis based on GAAP measures. As other companies may use different calculations for these measures, this presentation may not be comparable to other similarly titled measures by other companies. These measures include the following:

“Adjusted return on average assets” is a non-GAAP measure that excludes the temporary impact of holding high rate BaaS-brokered deposits on the balance sheet. The most directly comparable GAAP measure is return on average assets.

“Adjusted cost of funds” is a non-GAAP measure that excludes the temporary impact of holding high rate BaaS-brokered deposits on the balance sheet. The most directly comparable GAAP measure is cost of funds.

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“Adjusted cost of deposits” is a non-GAAP measure that excludes the temporary impact of holding high rate BaaS-brokered deposits on the balance sheet. The most directly comparable GAAP measure is cost of deposits.

“Adjusted net interest margin” is a non-GAAP measure that excludes the temporary impact of holding high rate BaaS-brokered deposits on the balance sheet. The most directly comparable GAAP measure is net interest margin.

“Adjusted noninterest expense to average assets” is a non-GAAP measure that excludes the temporary impact of holding high rate BaaS-brokered deposits on the balance sheet. The most directly comparable GAAP measure is noninterest expense to average assets.

“Adjusted loans receivable to deposits” is a non-GAAP measure that excludes BaaS-brokered deposits on the balance sheet. The most directly comparable GAAP measure is loans receivable to deposits.

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The Company also presented comparable earnings and financial information using GAAP financial measures.  Reconciliations of the GAAP and non-GAAP measures are presented in the following table:

 

 

 

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Item 3.  Quantitative and Qualitative Disclosure about Market Risk

Quantitative and Qualitative Disclosures about Market Risk

As a financial institution, our primary component of market risk is interest rate volatility. Our asset liability and funds management policy provides management with the guidelines for effective funds management, and we have established a measurement system for monitoring our net interest rate sensitivity position. We have historically managed our sensitivity position within our established guidelines.

Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on most of our assets and liabilities, and the market value of all interest earning assets and interest bearing liabilities, other than those which have a short term to maturity. Interest rate risk is the potential for economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a decrease in current fair market values. Our objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income.

We manage our exposure to interest rates by structuring our balance sheet in the ordinary course of business. We do not enter into instruments such as leveraged derivatives, financial options, financial future contracts or forward delivery contracts for the purpose of reducing interest rate risk. Based upon the nature of our operations, we are not subject to foreign exchange or commodity price risk. We do not own any trading assets.

Our exposure to interest rate risk is managed by the Asset Liability Committee (ALCO), of the Bank and reviewed by the Asset Liability and Investment Committee of our board of directors in accordance with policies approved by our board of directors. ALCO formulates strategies based on appropriate levels of interest rate risk. In determining the appropriate level of interest rate risk, ALCO considers the impact on earnings and capital on the current outlook on interest rates, potential changes in interest rates, regional economies, liquidity, business strategies and other factors. ALCO meets regularly to review, among other things, the sensitivity of assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, purchase and sale activities, commitments to originate loans and the maturities of investments and borrowings. Additionally, ALCO reviews liquidity, cash flows, maturities of deposits and consumer and commercial deposit activity. Management employs various methodologies to manage interest rate risk including an analysis of relationships between interest earning assets and interest bearing liabilities and interest rate simulations using a model. The Asset Liability and Investment Committee of our board of directors meets quarterly to review the Bank’s interest rate risk profile, liquidity position, including contingent liquidity, and investment portfolio.

We use interest rate risk simulation models to test interest rate sensitivity of net interest income and fair value of equity, and the impact of changes in interest rates on other financial metrics. Contractual maturities and re-pricing opportunities of loans are incorporated in the model, as are prepayment assumptions, maturity data and call options within the investment portfolio. Average life of non-maturity deposit accounts are based on historical decay rates and assumptions and are incorporated into the model. The assumptions used are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various management strategies.

On a quarterly basis, we run multiple simulations under two different premises of which one is a static balance sheet and the other is a dynamic growth balance sheet. The static balance sheet approach produces results that show the interest risk currently inherent in our balance sheet at that point in time. The dynamic balance sheet includes our projected growth levels going forward and produces results that shows how net income, net interest income, and interest risk change based on our projected growth. These simulations test the impact on net interest income and fair value of equity from changes in market interest rates under various scenarios. Under the static and dynamic approaches, rates are shocked instantaneously and ramped over a 12-month horizon assuming parallel yield curve shifts. Parallel shock scenarios assume instantaneous parallel movements in the yield curve compared to a flat yield curve scenario. Non-parallel simulations are also conducted and involve analysis of interest income and expense under various changes in the shape of the yield curve including a forward curve, flat curve, steepening curve, and an inverted curve. Our internal policy regarding internal rate risk simulations currently specifies that for instantaneous parallel shifts of the yield curve, estimated net income at risk for the subsequent one- and two-year period should not decline by more than 10% for a 100 basis point shift, 15% for a 200 basis point shift, 20% for a 300 basis point shift, and 25% for a 400 basis point shift.

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The following tables summarize the simulated change in net interest income over a 12-month horizon as of the dates indicated:

 

 

The results illustrate that the Bank is asset sensitive and generally performs better in an increasing interest rate environment. The results are primarily due to behavior of demand, money market and savings deposits during such rate fluctuations. We have found that, historically, interest rates on these deposits change more slowly than changes in the discount and federal funds rates. This assumption is incorporated into the simulation model. The assumptions incorporated into the model are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions, the shape of the interest yield curve, and the application and timing of various strategies.

Impact of Inflation

Our consolidated financial statements and related notes to those financial statements included elsewhere in this report have been prepared in accordance with GAAP. GAAP requires the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative value of money over time due to inflation or recession.

Unlike many industrial companies, substantially all of our assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on our performance than the effects of general levels of inflation. Interest rates may not necessarily move in the same direction or in the same magnitude as the prices of goods and services. However, other operating expenses do reflect general levels of inflation.

Item 4.  Controls and Procedures

Disclosure Controls and Procedures. An evaluation was performed under the supervision and with the participation of the Company's management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”)). Based on that evaluation, the Company's Chief Executive Officer and the Chief Financial Officer concluded that, as of the end of the period covered by this report, the Company's disclosure controls and procedures were effective for the purpose of ensuring that the information required to be disclosed in the reports that the Company files or submits under the Exchange Act with the Securities and Exchange Commission (the “SEC”) (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.  

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Change in Internal Control over Financial Reporting. There were no changes in the Company’s internal control over financial reporting occurred during the three months ended March 31, 2020, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II.  OTHER INFORMATION

Item 1.  Legal Proceedings

From time to time, we are a party to various litigation matters incidental to the conduct of our business. We do not believe that any currently pending legal proceedings will have a material adverse effect on our business, financial condition or earnings.

Item 1A.  Risk Factors

For information regarding the Company’s risk factors, see “Risk Factors” in the Company’s Annual Report on Form 10-K, which are incorporated by reference herein. As of March 31, 2020, the risk factors of the Company have not changed materially from those disclosed in the Form 10-K, other than those noted below.

The effects of COVID-19, and the impact of actions to mitigate it, could adversely affect our business, financial condition and results of operations.

COVID-19 has led to federal, state and local governments enacting various restrictions in an attempt to limit the spread of the virus, including the declaration of a federal National Emergency; multiple cities’ and states’ declarations of states of emergency; school and business closings; limitations on social or public gatherings and other social distancing measures, such as working remotely, travel restrictions, quarantines and shelter in place orders. Such measures have significantly contributed to rising unemployment and reductions in consumer and business spending. In response to the economic and financial effects of COVID-19, the Federal Reserve has sharply reduced interest rates and instituted quantitative easing measures as well as domestic and global capital market support programs. In addition, the Trump Administration, Congress, various federal agencies and state governments have taken measures to address the economic and social consequences of the pandemic, including the passage of the CARES Act. The CARES Act, among other things, provides certain measures to support individuals and businesses in maintaining solvency through monetary relief, including in the form of financing, loan forgiveness and automatic forbearance. Since the end of March 2020, we began processing loan applications under the PPP created under the CARES Act, and we expect to see a continued increase in such loans, during time that they are available. Other banking regulatory agencies have encouraged lenders to extend additional loans, and the federal government is considering additional stimulus and support legislation focused on providing aid to various sectors, including small businesses.  Further, we expect to continue to restructure certain payments and/or defer payments for our loan customers during this uncertain time to help alleviate financial hardships. The full impact on our business activities as a result of new government and regulatory policies, programs and guidelines, as well as regulators’ reactions to such activities, remains uncertain.

The economic effects of the COVID-19 outbreak have had a destabilizing effect on financial markets, key market indices and overall economic activity. The uncertainty regarding the duration of the pandemic and the resulting economic disruption has caused increased market volatility and may lead to an economic recession and/or a significant decrease in consumer confidence and business generally. The continuation of these conditions caused by the outbreak, including the impacts of the CARES Act and other federal and state measures, specifically with respect to loan forbearances, can be expected to adversely impact our businesses and results of operations and the operations of our borrowers, customers and business partners. In particular, these events can be expected to, among other things:

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Prolonged measures by health or other governmental authorities encouraging or requiring significant restrictions on travel, assembly or other core business practices could further harm our business and those of our customers, in particular our small to medium sized business customers. Although we have business continuity plans and other safeguards in place, there is no assurance that they will be effective.

The ultimate impact of these factors is highly uncertain at this time and we do not yet know the full extent of the impacts on our business, our operations or the global economy as a whole. However, the decline in economic conditions generally and a prolonged negative impact on small to medium sized businesses, in particular, due to COVID-19 may result in a material adverse effect to our business, financial condition and results of operations and may heighten many of our known risks described in the “Risk Factors” section of our Form 10-K.

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds

There were no unregistered sales of the Company’s equity securities during the three months ended March 31, 2020.

The Company did not repurchase any of its equity securities during the three months ended March 31, 2020 and does not have any authorized share repurchase programs.

Item 3.  Defaults Upon Senior Securities

None.

Item 4.  Mine Safety Disclosures

Not applicable.

Item 5.  Other Information

None.

Item 6.  Exhibits

 

 

+ Management contract or compensatory plan, contract or arrangement.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

 

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