Bancorp 34, Inc. - Annual Report: 2019 (Form 10-K)

PART I

Forward Looking Statements

This Report contains certain “forward-looking statements” which may be identified by the use of words such as “believe,” “project,” “intend,” “plans,” “seek,” “will,” “would,” “may,” “expect,” “anticipate,” “should,” “planned,” “estimated” and “potential.” These forward-looking statements include, but are not limited to:

These forward-looking statements are based on current beliefs and expectations of our management and are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change.

The following factors, among others, could cause actual results to differ materially from the anticipated results or other expectations expressed in the forward-looking statements:

Because of these and other uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements.

Bancorp 34, Inc.

Bancorp 34, Inc. (the “Company”), a Maryland corporation that was organized in 2016, is a savings and loan holding company headquartered in Alamogordo, New Mexico. Bancorp 34, Inc.’s common stock is quoted on NASDAQ under the symbol “BCTF.” Bancorp 34, Inc. conducts its operations primarily through its wholly owned subsidiary, Bank 34, a federally chartered savings association. Bancorp 34, Inc. manages its operations as one unit, and thus does not have separate operating segments. At December 31, 2019, Bancorp 34, Inc. had total assets of $393.7 million, loans held for investment of $291.7 million, available-for-sale securities of $44.5 million, deposits of $303.9 million, and stockholders’ equity of $45.1 million.

The Company was formed to be the successor to Alamogordo Financial Corp. upon completion of the second step mutual-to-stock conversion (the “Conversion”) of AF Mutual Holding Company (the “MHC”), the top tier mutual holding company of Alamogordo Financial Corp. Alamogordo Financial Corp. was the former mid-tier holding company for Bank 34. Prior to completion of the Conversion, approximately 54.7% of the shares of common stock of Alamogordo Financial Corp. were owned by the MHC. In conjunction with the Conversion, the MHC and Alamogordo Financial Corp. merged into the Company. The Conversion was completed on October 11, 2016. The Company sold a total of 1,879,484 shares of common stock at $10.00 per share in the second-step offering. Concurrent with the completion of the stock offering, each share of Alamogordo Financial Corp. stock owned by public stockholders (stockholders other than the MHC) was exchanged for 2.0473 shares of Company common stock. The Conversion was accounted for as a capital raising transaction by entities under common control. The historical financial results of the MHC are immaterial to the results of the Company and therefore the net assets of the MHC have been reflected as an increase to stockholders’ equity.

As a result of the Conversion, all share and per share information for periods prior to October 11, 2016 has been revised to reflect the 2.0473-to-one exchange ratio. Such revised financial information presented in this Form 10-K is derived from the consolidated financial statements of Alamogordo Financial Corp. and its subsidiaries.

The executive offices of Bancorp 34, Inc. are located at 500 East 10th Street, Alamogordo, New Mexico 88310, and its telephone number is (575) 437-9334. Bancorp 34, Inc. is subject to comprehensive regulation and examination by the Board of Governors of the Federal Reserve System.

Bank 34

Bank 34 operates four full-service banking centers, one each in Otero and Dona Ana counties in New Mexico and two in Maricopa County, Arizona. Bank 34’s New Mexico offices include the main office and corporate headquarters located in Alamogordo and a branch office in Las Cruces. The Bank’s Arizona branch offices include the regional headquarters located in Scottsdale and a branch office in Peoria.

In May 2019, Bank 34 took steps to exit the Bank's operations with respect to originating residential mortgage loans for sale into the secondary market ("Mortgage Banking"). The Mortgage Banking operations that were disposed of, and that represent a strategic shift that will have a major effect on operations and financial results, are accounted for as discontinued operations. Additional information on discontinued operations can be found in The consolidated financial statements, Note 2 – Discontinued Operations.

Bank 34’s business model focuses on two primary areas. The commercial focus is on the credit, deposit and treasury management needs of small businesses and real estate professionals and investors. Bank 34 originates conventional, SBA and USDA loans within its primary market areas. Commercial loan types offered include: owner and non-owner occupied real estate (including construction loans), multi-family loans, and commercial and industrial loans. The consumer focus is on deposit, online banking and ancillary financial service needs of families and businesses served by Bank 34. While most of Bank 34’s real estate loans are secured by properties in the counties served by its branch offices, it does actively seek business in other areas of New Mexico, Arizona and the surrounding states.

Bank 34 originates deposits from its business and consumer customers predominantly from the areas where its branch offices are located. Bank 34’s emphasis is on generating business operating accounts and consumer checking and money market accounts.

Bank 34 is subject to comprehensive regulation and examination by the Office of the Comptroller of the Currency. Bank 34 is a member of the Federal Home Loan Bank system. Our website address is www.Bank 34.com. Information on our website is not considered a part of this report.

Business Strategy  

Our goal is to enhance long-term stockholder and franchise value by executing a safe and sound growth strategy that produces increasing earnings. We have sought to accomplish this objective by implementing a business strategy designed to grow our loan portfolio while maintaining a strong capital position and solid asset quality.

Our current business strategy consists of the following:

We grew commercial real estate loans and commercial and industrial loans 4.8% in 2019, 10.3% in 2018 and 10.4% in 2017. Commercial loans in our Arizona region represented 72%, 70% and 69% of our total commercial loans outstanding as of December 31, 2019, 2018 and 2017, respectively. Commercial real estate and commercial and industrial loans totaled 88.9% of our loan portfolio at December 31, 2019, compared to 87.4% of our loan portfolio at December 31, 2018 and 86.7% at December 31, 2017.

In addition, we continue to seek and originate Small Business Administration (“SBA”) credits and we are actively pursuing other government-sponsored loan programs, such as those offered through the U.S. Department of Agriculture, as a way to generate government-guaranteed loans with the opportunity to sell the guaranteed portion of the loan at a premium and retain the non- guaranteed portion as well as the servicing rights. We sold $2.0 million, $1.6 million and $11.7 million of SBA and USDA loans in the secondary market during the years ended December 31, 2019, 2018 and 2017, respectively, recognizing gains of $272,000, $129,000 and $1.0 million directly into income during those periods. We also intend to build on our experience of selectively pursuing construction lending to established builders with proven track records.

Competition

We face significant competition in originating loans and attracting deposits. Our primary market area and other areas in which we operate have a high concentration of financial institutions, many of which are significantly larger institutions that have greater financial resources than we have, and many of which are our competitors to varying degrees. Our competition for loans and leases comes principally from commercial banks, savings the U.S. Government, credit unions, leasing companies, insurance companies, real estate conduits and other companies that provide financial services to businesses and individuals. Our most direct competition for deposits has historically come from commercial banks, savings banks and credit unions. We face additional competition for deposits from online financial institutions and non-depository competitors such as the mutual fund industry, securities and brokerage firms and insurance companies.

We seek to meet this competition by emphasizing personalized service and efficient decision-making tailored to individual needs. In addition, we reward long-standing relationships with preferred rates and terms on deposit products based on existing and prospective lending business. We do not rely on any individual, group or entity for a material portion of our loans or deposits.

As of June 30, 2019 (the latest date for which information is available), Bank 34’s deposit market share was 13.12% of total deposits in Otero County, New Mexico, representing the third largest market share of nine institutions in Otero County; 2.05% of total deposits in Dona Ana County, New Mexico, representing the 13th largest market share of 18 institutions in Dona Ana County; and 0.15% of total deposits in Maricopa County, Arizona, representing the 36th largest market share of 62 institutions in Maricopa County.

Market Area 

Bank 34 operates four full-service banking centers, one each in Otero and Dona Ana counties in New Mexico and two in Maricopa County, Arizona.

Arizona. 2019 brought diverse employment growth as year-to–date job growth through October 2019 exceeded 73,000. The economy has diversified from a population-driven model and has attracted higher value-added industries since the end of the Great Recession. Arizona is currently the third fastest growing state for job growth with much of that growth centered in metropolitan Phoenix area. The combination of new residents and an aging Baby Boomer cohort is pushing demand for health care, construction, restaurants, and retailing. Based on data through October 2019, Arizona saw an increase in personal income of 5.9%, increase in population of 112,000 and a decrease in unemployment from 4.7% to 4.5%. Arizona’s home prices, in comparison to other western states, are still considered very affordable. It is anticipated that Arizona’s economy will continue with solid growth, driven by a mix of new and long established drivers. A consensus forecast for the metropolitan Phoenix area has employment increasing 2.8% and unemployment dropping below 4.0% by the end of 2020.

New Mexico. Las Cruces’ metropolitan statistical area (MSA) unemployment as of October 2019 was 5.6% while Otero county’s was 4.6% as compared to 5.7% and 5.0%, respectively, a year before. October 2019 state unemployment was at 4.8%. New Mexico’s total population has been consistently around or slightly below 2.1 million since crossing 2 million in 2008 followed by population decreases in 2014 and 2015. New Mexico gained a little over 2,000 residents between July 1, 2017 and July 1, 2018.  New Mexico is beginning to attract higher-wage employment with commitments from Facebook, Netflix, Safelite and Union Pacific. One of the main advantages that New Mexico has to offer is very affordable housing and; therefore, an overall affordable cost of living.

Lending Activities   

At December 31, 2019, our gross loans held for investment consisted of $242.7 million, or 82.1%, commercial real estate loans (including multi-family); $28.9 million, or 9.8%, one- to four-family residential real estate loans; $20.1 million, or 6.8%, commercial and industrial loans, and $3.9 million, or 1.3%, consumer and other loans. At December 31, 2019, commercial real estate and multi-family loans included construction loans of $16.1 million.

Commercial Real Estate Loans. At December 31, 2019, commercial real estate loans were $242.7 million, or 82.1%, of our total gross loans held for investment. This amount includes $37.8 million of multi-family residential real estate loans which are described below. Our commercial real estate loans are generally secured by properties used for business purposes such as office buildings, industrial and retail facilities. At December 31, 2019, $39.8 million of our commercial real estate portfolio was owner occupied commercial real estate, and $202.9 million was secured by income producing, or non-owner occupied commercial real estate. We currently target new commercial real estate loan originations to experienced, growing small- and mid-size owners and investors in our market area. The average outstanding loan in our commercial real estate portfolio was $678,000 as of December 31, 2019, although we originate commercial real estate loans with balances significantly larger than this average. At December 31, 2019, our ten largest commercial real estate loans had an average balance of $3.4 million.

We focus our commercial real estate lending on properties within our primary market areas, but we will originate commercial real estate loans on properties located outside this area based on an established relationship with a strong borrower. We intend to continue to grow our commercial real estate loan portfolio while maintaining prudent underwriting standards.

We originate a variety of fixed and adjustable rate commercial real estate loans with terms and amortization periods generally up to 25 years, although our commercial real estate loans generally have balloon terms. Interest rates and payments on our adjustable rate loans generally adjust daily and generally are indexed to the prime rate as published in The Wall Street Journal, plus a margin. We generally include pre-payment penalties on commercial real estate loans we originate. Commercial real estate loan amounts generally do not exceed 75% to 80% of the property’s appraised value at the time the loan is originated., Aggregate debt service ratios, including the guarantor’s cash flow and the borrower’s other projects, have a guideline minimum income to debt service ratio of 1.30x. For commercial real estate loans in excess of $500,000, we require independent appraisals from an approved appraisers list. For such loans below $500,000, we require formal evaluations but do not require an independent appraisal. We require commercial real estate loan borrowers with loan relationships in excess of $100,000 to submit annual financial statements and/or rent rolls on the subject property. We may request such information for smaller loans on a case-by-case basis. Commercial real estate properties may also be subject to annual inspections with pictures as evidence appropriate maintenance is being performed by the owner/borrower. The loan and its borrowers and/or guarantors are subject to an annual loan review verifying the loan is properly risk rated based upon covenant compliance and other terms as provided for in the loan agreements. While this process does not prevent loans from becoming delinquent, it provides us with the opportunity to better identify problem loans in a timely manner and to work with the borrower.

Our three largest commercial real estate loans at December 31, 2019 included a $4.5 million school loan originated in May 2016 and increased in April 2017, a $3.7 million retail strip center and restaurant building loan originated in March 2017 and a $3.5 million apartment complex loan originated in July 2019. The collateral securing these loans is all located in our primary lending areas. At December 31, 2019, all of these loans were performing in accordance with their terms.

Multi-Family Real Estate Loans. At December 31, 2019, multi-family real estate loans were $37.8 million, or 12.8%, of our total loan portfolio. We originate individual multi-family real estate loans to experienced, growing small- and mid-size owners and investors in our market areas. Our multi-family real estate loans are generally secured by properties consisting of five to 40 rental units. The average outstanding loan size in our multi-family real estate portfolio was $858,000 as of December 31, 2019. We generally do not make multi-family real estate loans outside our primary market areas.

We originate a variety of fixed and adjustable rate multi-family real estate loans with balloon and amortization terms up to 30 years. Interest rates and payments on our adjustable rate loans generally adjust daily and generally are indexed to the prime rate as published in The Wall Street Journal, plus a margin. We generally include pre-payment penalties on loans we originate. Multi-family real estate loan amounts generally do not exceed 65% to 70% of the property’s appraised value at the time the loan is originated. Aggregate debt service ratios, including the guarantor’s cash flow and the borrower’s other projects, have a guideline minimum income to debt service ratio of 1.30x. We require multi-family real estate loan borrowers with loan relationships in excess of $100,000 to submit annual financial statements and/or rent rolls on the subject property. We may request such information for smaller loans on a case-by-case basis. These properties may also be subject to annual inspections with pictures as evidence appropriate maintenance is being performed.

Our largest multi-family real estate loan at December 31, 2019 totaled $3.5 million, was originated in July 2019 and is secured by a 47-unit apartment complex. At December 31, 2019, this loan was performing in accordance with its terms.

Commercial and Industrial Loans. We make commercial and industrial loans. primarily in our market area, to a variety of professionals, sole proprietorships and small businesses. These loans are generally secured by business assets, and we may support this collateral with junior liens on real property. At December 31, 2019, commercial and industrial loans were $20.1 million, or 6.8% of our total loan portfolio. As part of our relationship driven focus, we encourage our commercial borrowers to maintain their primary deposit accounts with us, which enhances our interest rate spread and profitability.

Commercial lending products include term loans and revolving lines of credit. Commercial loans and lines of credit are made with either adjustable or fixed rates of interest. Adjustable rates and fixed rates are based on the prime rate as published in The Wall Street Journal, plus a margin. We are focusing our efforts on experienced, growing small- to medium-sized, privately-held companies with solid historical and projected cash flow that operate in our market areas.

When making commercial and industrial loans, we consider the financial statements of the borrower, our lending history with the borrower, the debt service capabilities and global cash flows of the borrower and other guarantors, the projected cash flows of the business and the value of the collateral, accounts receivable, inventory and equipment. Depending on the collateral used to secure the loans, commercial and industrial loans are made in amounts of up to 80% of the value of the collateral securing the loan. All of these loans are secured by assets of the respective borrowers.

A portion of our commercial and industrial loans are guaranteed by the U.S. Small Business Administration (“SBA”) through the SBA 7(a) loan program. The SBA 7(a) loan program supports, through a U.S. Government guarantee, some portion of the traditional commercial loan underwriting that might not be fully covered absent the guarantee. A typical example would be a business acquiring another business, where the value purchased is an enterprise value (as opposed to tangible assets), which results in a collateral shortfall under traditional loan underwriting requirements. In addition, SBA 7(a) loans, through term loans, can provide a good source of permanent working capital for growing companies.

Our largest commercial and industrial loan at December 31, 2019 was a $1.9 million equipment loan originated in October 2019. This loan is to an equipment leasing company and is secured by 89 tractors and trailers, an assignment of leases, and all other business assets of the company.

Construction and Land Development Loans. At December 31, 2019, construction and land development loans were $22.3 million, or 7.6% of our total loan portfolio, consisting of $16.1 million of commercial and multi-family real estate loans, $5.1 million of residential land or development loans and $1.1 million of consumer one- to four-family residential loans, At December 31, 2019, none of our consumer one- to four-family residential construction loans and $15.7 million of our commercial and multi-family real estate construction loans are expected to convert to permanent loans upon completion of the construction phase. The majority of the balance of these loans is secured by properties located in our primary lending area.

We primarily make construction loans for commercial development projects, including hotels, small industrial, retail, office and apartment buildings. Most of our construction loans are interest-only loans that provide for the payment of interest during the construction phase, which is usually up to 12 to 24 months. At the end of the construction phase, the loan may convert to a permanent mortgage loan or the loan may be paid in full. Construction loans generally can be made with a maximum loan-to-value ratio of 80% of the estimated appraised market value upon completion of the project. Before making a commitment to fund a construction loan, we require an appraisal of the property by an independent licensed appraiser for loans in excess of $500,000. We also generally require inspections of the property before disbursements of funds during the term of the construction loan.

We also originate construction and land development loans to contractors and builders to finance the construction of single-family homes and subdivisions. While we may originate these loans whether or not the collateral property underlying the loan is under contract for sale, we consider each project carefully in light of current residential real estate market conditions. We actively monitor the number of unsold homes in our construction loan portfolio and local housing markets to attempt to maintain an appropriate balance between home sales and new loan originations.  We generally will limit the maximum number of speculative units (units that are not pre-sold) approved for each builder. We have attempted to diversify the risk associated with speculative construction lending by doing business with experienced small and mid-sized builders within our market area.

Our largest construction loan at December 31, 2019 totaled $2.3 million, was originated in November 2018 and is secured by 21 townhomes and an assisted living residence located in our primary market area. At December 31, 2019, this loan was performing in accordance with its terms.

One- to Four-Family Residential Real Estate Loans. Our one- to four-family residential real estate loan portfolio consists of mortgage loans that enable borrowers to purchase or refinance existing homes, most of which serve as the primary residence of the owner. At December 31, 2019, $28.9 million, or 9.8% of our loan portfolio, consisted of one- to four-family residential real estate loans, compared to $29.9 million, or 10.4% of total loans, at December 31, 2018.

Generally, one- to four-family residential real estate loans are originated in amounts up to 80% of the lesser of the appraised value or purchase price of the property, with private mortgage insurance required on loans with a loan-to-value ratio in excess of 80%. We will not make loans with a loan-to-value ratio in excess of 100% for loans secured by single family homes. Fixed rate one- to four-family residential real estate loans generally are originated for terms of 10 to 30 years. Generally, all fixed rate one- to four-family residential real estate loans are underwritten according to Freddie Mac, FHA, VA, USDA and Correspondent Investors policies and procedures.

In an effort to provide financing for moderate income home buyers, we offer Veterans Administration (VA), Federal Housing Administration (FHA) and bond loans specific to the states where we conduct business. These programs offer one- to four-family residential real estate loans to qualified individuals. These loans are offered with fixed rates of interest and terms of up to 30 years, and are secured by one- to four-family residential properties. All of these loans are originated using agency underwriting guidelines.

We also offer adjustable rate mortgage loans for one- to four-family properties, with an interest rate based on the one-year Constant Maturity Treasury Bill Index, which adjusts annually from the outset of the loan or which adjusts annually after a three-, five-, seven-, or ten-year initial fixed rate period. We originated $6.9 million of adjustable rate one-to four-family residential loans during the year ended December 31, 2019, all of which was sold in the secondary market. Our adjustable rate mortgage loans generally provide for maximum rate adjustments of 2% per adjustment, with a lifetime maximum adjustment up to 6% above the initial rate, regardless of the initial rate. Our adjustable rate one- to four-family residential real estate loans amortize over terms of up to 30 years.

Regulations limit the amount that an institution may lend relative to the appraised value of the real estate securing the loan, as determined by an appraisal of the property at the time the loan is originated. All borrowers are required to obtain title insurance. We also require homeowner’s insurance and fire and casualty insurance and, where circumstances warrant, flood insurance, on properties securing real estate loans. At December 31, 2019, our largest one- to four-family residential real estate loan had a principal balance of $593,000 and was secured by a residence located in Arizona. At December 31, 2019, this loan was performing in accordance with its original terms.

Consumer and Other Loans. We offer a limited range of consumer and other loans, principally to customers with other relationships residing in our primary market area with acceptable credit ratings. Our consumer and other loans generally consist of home equity loans or lines of credit, loans secured by deposit accounts, loans on new and used automobiles and unsecured personal loans. At December 31, 2019, consumer loans were $3.9 million, or 1.3% of total loans. The underwriting standards utilized for home equity lines of credit include a determination of the applicant’s credit history, an assessment of the applicant’s ability to meet existing obligations and payments on the proposed loan and the value of the collateral securing the loan. The loan-to-value ratio for a home equity line of credit is generally limited to 75%. The procedures for underwriting other consumer loans include an assessment of the applicant’s payment history on other debts and ability to meet existing obligations plus payments on the proposed loan.

Loan Underwriting Risks

Commercial and Multi-Family Real Estate Loans. Loans secured by commercial and multi-family real estate generally have larger balances and involve a greater degree of risk than one- to four-family residential real estate loans. Of primary concern in commercial and multi-family real estate lending is the borrower’s creditworthiness and the feasibility and cash flow potential of the project. Payments on loans secured by income properties often depend on successful operation and management of the properties. As a result, repayment of such loans may be subject to a greater extent than residential real estate loans, to adverse conditions in the real estate market or the economy. To monitor cash flows on income properties, we require borrowers and loan guarantors to provide annual financial statements on commercial and multi-family real estate loans. In reaching a decision on whether to make a commercial or multi-family real estate loan, we consider and review a global cash flow analysis of the borrower and consider the net operating income of the property, the borrower’s expertise, credit history and profitability and the value of the underlying property. We have generally required that the properties securing these real estate loans have an aggregate debt service ratio, including the guarantor’s cash flow and the borrower’s other projects, of at least 1.30x. An environmental phase one report is obtained when the possibility exists that hazardous materials may have existed on the site, or the site may have been impacted by adjoining properties that handled hazardous materials.

If we foreclose on a commercial real estate or multi-family loan, the marketing and liquidation period to convert the real estate asset to cash can be lengthy with substantial holding costs. In addition, vacancies, deferred maintenance, repairs and market stigma can result in prospective buyers expecting sale price concessions to offset their real or perceived economic losses for the time it takes them to return the property to profitability. Depending on the individual circumstances, initial charge-offs and subsequent losses on commercial real estate loans can be unpredictable and substantial.

Construction and Land Development Loans. Our construction loans are based upon estimates of costs and values associated with the completed project. Underwriting is focused on the borrowers’ financial strength, credit history and demonstrated ability to produce a quality product and effectively market and manage their operations.  

Construction lending involves additional risks when compared with permanent lending because funds are advanced upon the security of the project, which is of uncertain value prior to its completion. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation of real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the related loan-to-value ratio. In addition, generally during the term of a construction loan, interest may be funded by the borrower or disbursed from an interest reserve set aside from the construction loan budget. These loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project and the ability of the borrower to sell or lease the property or obtain permanent take-out financing, rather than the ability of the borrower or guarantor to repay principal and interest. If the appraised value of a completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project and may incur a loss.

Commercial and Industrial Loans. Unlike residential real estate loans, which generally are made on the basis of the borrower’s ability to make repayment from his or her employment or other income, and which are secured by real property whose value tends to be more easily ascertainable, commercial and industrial loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business and the collateral securing these loans may fluctuate in value. Our commercial and industrial loans are originated primarily based on the identified cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. Most often, this collateral consists of real estate, accounts receivable, inventory or equipment. Credit support provided by the borrower for most of these loans and the probability of repayment is based on the liquidation of the pledged collateral and enforcement of a personal guarantee, if any. As a result, the availability of funds for the repayment of commercial and industrial loans may depend substantially on the success of the business itself. Further, any collateral securing such loans may depreciate over time, may be difficult to appraise and may fluctuate in value.

Adjustable Rate Loans. While we anticipate that adjustable rate loans will better offset the adverse effects of an increase in interest rates as compared to fixed-rate loans, an increased monthly payment required of adjustable rate loan borrowers in a rising interest rate environment could cause an increase in delinquencies and defaults. In a high interest rate environment, the marketability of the underlying collateral may be adversely affected as the value of the underlying collateral decreases. For our adjustable rate one- to four-family real estate loans, upward adjustment of the contractual interest rate is also limited by the maximum periodic and lifetime interest rate adjustments permitted by our loan documents and, therefore, the effectiveness of adjustable rate real estate loans may be limited during periods of rapidly rising interest rates.

Consumer and Other Loans. Consumer loans may entail greater risk than residential real estate loans, particularly in the case of consumer loans that are unsecured or secured by assets that depreciate rapidly, such as motor vehicles. Repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan and a small remaining deficiency often does not warrant further substantial collection efforts against the borrower. Consumer loan collections depend on the borrower’s continuing financial stability, and therefore are likely to be adversely affected by various factors, including job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount that can be recovered on such loans.

Loan Originations, Purchases and Sales

Lending activities are conducted primarily by our loan personnel operating at our four full-service banking offices. All loans originated by us are underwritten pursuant to our policies and procedures. We originate both adjustable-rate and fixed-rate loans. Our ability to originate fixed or adjustable-rate loans is dependent upon competition for such loans and the relative customer demand for such loans, which is affected by current and expected future levels of market interest rates.

We participate out interests in commercial real estate loans to other financial institutions, including the guaranteed portions of SBA or USDA loans, the portion of other loans exceeding our borrowing limits and periodically other loans when portfolio growth surges and the balances exceeds target portfolio loan levels. At December 31, 2019, we were servicing $33.2 million of commercial real estate loans where we had participated out an interest to other financial institutions. For the years ended December 31, 2019 and 2018, we participated out loan participations of $8.6 million and $9.2 million, respectively.

Loan Approval Procedures and Authority

Our lending activities follow written, non-discriminatory, underwriting standards and loan origination procedures established by management and approved by the Board of Directors. The Board of Directors has granted loan approval authority to certain officers up to prescribed limits, depending on the officer’s experience, the type of loan and whether the loan is secured or unsecured. Loans to relationships of $2.0 million and below require approval by members of senior management. Loans to relationships greater than $2.0 million require approval by the Director’s Loan Committee. Loans that involve exceptions to loan policy must be authorized by senior management. Loan policy exceptions are fully disclosed to the approving authority, either an individual officer or the appropriate management or Director’s Loan Committee prior to commitment. Exceptions are reported to the Board of Directors monthly.

Loans-to-One Borrower Limit

The maximum amount that we may lend to one borrower and the borrower’s related entities is generally limited, by regulation, to 15% of our unimpaired capital and surplus. At December 31, 2019, our regulatory limit on loans-to-one borrower was $6.4 million. At that date, the largest aggregate amount loaned to one borrower was $5.6 million, consisting of a 28-unit apartment complex and 39 condominium units. The loans comprising this lending relationship were performing in accordance with their original repayment terms at December 31, 2019.

Investment Activities

Bank 34 has an Asset/Liability Committee which is responsible, among other duties, for implementing the Bank’s Investment Policy. The Investment Policy is reviewed annually and any changes to the policy are recommended to, and subject to the approval of, our board of directors. While general investment strategies are developed and authorized by the Asset/Liability Committee, the execution of specific actions rests with the Chief Financial Officer, who is Bank 34’s designated Investment Officer. In the absence of the Chief Financial Officer, the Chief Executive Officer will be the designated Investment Officer. The Investment Officer is responsible for ensuring that the guidelines and requirements included in the Investment Policy are followed and that all securities are considered prudent for investment. The Investment Officer is authorized to execute investment transactions (purchases and sales) without the prior approval of the Asset/Liability Committee and within the scope of the established investment policy; however, all transactions shall be reviewed and ratified by the Asset/Liability Committee and Board of Directors.

Bank 34 utilizes the services of an independent investment advisor to assist in managing the investment portfolio. The investment advisor is responsible for maintaining current information regarding securities dealers with whom they are conducting business on our behalf. A list of appropriate dealers is provided annually to the board of directors for approval and authorization prior to execution of trades. The investment advisor, through its assigned portfolio manager, must contact our designated Investment Officer to review all investment recommendations and transactions and receive approval from the designated Investment Officer prior to execution of any transaction that might be executed on our behalf. Upon receipt of approval, the investment advisor, or its assigned portfolio manager, is authorized to conduct all investment business on our behalf.

We have legal authority to invest in various types of investment securities and liquid assets, including U.S. Treasury obligations, securities of various government-sponsored enterprises, residential mortgage-backed securities and municipal governments, deposits at the Federal Home Loan Bank of Dallas, certificates of deposit of federally insured institutions, investment grade corporate bonds and investment grade marketable equity securities, including common stock and money market mutual funds. Our equity securities generally pay dividends. We also are required to maintain an investment in Federal Home Loan Bank of Dallas stock, which investment is based on the level of our Federal Home Loan Bank borrowings. We have the authority under applicable law to invest in derivative securities. At December 31, 2019, due to our exit from mortgage banking operations in June 2019, the Company had no mortgage interest rate lock commitment ("IRLC") assets and no liabilities to national investment brokers. At December 31, 2018, the Company had $381,000 in fair value of mortgage IRLC assets and $154,000 in liabilities to national investment brokers representing the net fair value of forward trade commitments utilized to hedge loans in our mortgage banking pipeline with a notional value of $21.5 million. Our investment objectives are to provide and maintain liquidity, to establish an acceptable level of interest rate and credit risk, to provide a use of funds when demand for loans is weak and to generate a favorable return.

At December 31, 2019 our investment security portfolio had a fair value of $44.5 million, and consisted primarily of mortgage-backed securities, taxable municipal bonds and securities of U.S. Government Agencies. All investment securities as of December 31, 2019 were classified as available-for-sale. Bonds secured by adjustable rate loans were 3.0% of the total portfolio.

Each reporting period, we evaluate all securities with a decline in fair value below the amortized cost to determine whether or not the impairment is deemed to be other than temporary. Other than temporary impairment is required to be recognized if (1) we intend to sell the security; (2) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis; or (3) for debt securities, the present value of expected cash flows is not sufficient to recover the entire amortized cost basis. At December 31, 2019 our investment securities had a fair value of $44.5 million and a net unrealized gain of $412,000. The Bank does not have the intent to sell these securities before maturity and it is unlikely that it will be required to sell them before their maturity. No other-than-temporary impairment was recognized for any periods from 2012 through 2019.

Mortgage-Backed Securities. We purchase mortgage-backed securities insured or guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. We invest in mortgage-backed securities to achieve positive interest rate spreads with minimal administrative expense, and lower our credit risk as a result of the guarantees provided by Freddie Mac, Fannie Mae and Ginnie Mae.

Mortgage-backed securities are created by the pooling of mortgages and the issuance of a security with an interest rate that is less than the interest rates on the underlying mortgages. Mortgage-backed securities typically represent a participation interest in a pool of single-family or multi-family mortgages, although we focus our investments on mortgage-backed securities backed by one- to four-family mortgages. The issuers of such securities (generally U.S. government agencies and government-sponsored enterprises, including Fannie Mae, Freddie Mac and Ginnie Mae) pool and resell the participation interests in the form of securities to investors such as Putnam Bank, and guarantee the payment of principal and interest to investors. Mortgage-backed securities generally yield less than the loans that underlie such securities because of the cost of payment guarantees and credit enhancements. However, mortgage-backed securities are usually more liquid than individual mortgage loans and may be used to collateralize our specific liabilities and obligations.

At December 31, 2019 mortgage-backed securities totaled $31.0 million, or 69.7% of total securities, of which 4.4% were backed by adjustable rate mortgage loans and 95.6% were backed by fixed rate mortgage loans. The mortgage-backed securities portfolio had a weighted average yield of 2.60% at December 31, 2019.

Investments in mortgage-backed securities involve a risk that actual prepayments may differ from estimated prepayments over the life of the security, which may require adjustments to the amortization of any premium or accretion of any discount relating to such instruments thereby changing the net yield on such securities. There is also reinvestment risk associated with the cash flows from such securities or if such securities are redeemed by the issuer. In addition, the market value of such securities may be adversely affected by changes in interest rates.

U.S. Government and Government-Sponsored Securities. At December 31, 2019, our U.S. Government and government-sponsored securities portfolio totaled $1.1 million, or 2.4% of total securities. While U.S. Government and government-sponsored securities generally provide lower yields than other investments in our securities investment portfolio, we maintain these investments, to the extent appropriate, for liquidity purposes, as collateral for borrowings and prepayment protection.

Municipal Obligations. At December 31, 2019 our investment in municipal obligations totaled $12.4 million or 27.9% of total securities and 3.2% of total assets. The Bank’s investment in municipal bonds may not exceed 5% of total assets. Municipal obligations generally carry a higher interest rate than U.S. Government obligations but also carry a higher credit risk.

Deposit Activities 

Our deposit accounts consist principally of certificates of deposit, savings accounts, checking accounts and money market accounts. We provide commercial checking accounts and related services, such as online cash management. We also provide low-cost checking account services.

Our deposits are generated mainly from residents and businesses within our primary deposit market area. Deposit account terms vary, with the principal differences being the minimum balance required, the amount of time the funds must remain on deposit and the interest rate.

Interest rates, maturity terms, service fees and withdrawal penalties are established on a periodic basis, supported by third party reporting of competitive deposit rates by market. Deposit rates and terms are based primarily on current operating strategies and market rates, liquidity requirements, rates paid by competitors and growth goals. Personalized customer service and long-standing relationships with customers are relied upon to attract and retain deposits.

The flow of deposits is influenced significantly by general economic conditions, changes in money market and other prevailing interest rates and competition. The variety of deposit accounts offered allows us to be competitive in obtaining funds and responding to changes in consumer demand. Based on experience, we believe that our deposits are relatively stable. However, the ability to attract and maintain deposits and the rates paid on these deposits, has been and will continue to be significantly affected by market conditions.

At December 31, 2019, our deposits totaled $303.9 million. Interest-bearing deposits totaled $247.5 million and noninterest-bearing deposits totaled $56.4 million. Savings, money market and checking deposits totaled $166.1 million, and certificates of deposit totaled $81.4 million, of which $55.6 million had maturities of one year or less.

Subsidiary Activities

Bancorp 34, Inc. has no subsidiaries other than Bank 34.

Personnel

At December 31, 2019, Bank 34 had 54 full-time employees and 3 part-time employees, none of whom was party to a collective bargaining agreement. Bank 34 believes it has a good working relationship with its employees.

TAXATION

Bancorp 34 and Bank 34 are subject to federal and state income taxation in the same general manner as other corporations, with some exceptions discussed below. The following discussion of federal and state taxation is intended only to summarize certain pertinent tax matters and is not a comprehensive description of the tax rules applicable to Bancorp 34 or Bank 34.

Our federal and state tax returns have not been audited for the past five years.

Federal Taxation

Method of Accounting. For federal income tax purposes, Bancorp 34 and Bank 34 currently report their income and expenses on the accrual method of accounting and use a tax year ending December 31 for filing their federal income tax returns.

Taxable Distributions and Recapture. Prior to the 1996 Act, bad debt reserves created prior to January 1, 1988 were subject to recapture into taxable income if Bank 34 failed to meet certain thrift asset and definitional tests. Federal legislation has eliminated these thrift-related recapture rules. At December 31, 2019, our total federal pre-1988 base year reserve was approximately $2.7 million, or $680,000 tax-effected. However, under current law, pre-1988 base year reserves remain subject to recapture if Bank 34 makes certain non-dividend distributions, repurchases any of its stock, pays dividends in excess of tax earnings and profits, or ceases to maintain a bank charter.

Alternative Minimum Tax. Prior to January 1, 2018, the Internal Revenue Code imposes an alternative minimum tax (“AMT”) at a rate of 20% on a base of regular taxable income plus certain tax preferences, which we refer to as “alternative minimum taxable income.” The AMT is payable to the extent such alternative minimum taxable income is in excess of an exemption amount and the AMT exceeds the regular income tax. Net operating losses can offset no more than 90% of alternative minimum taxable income. Certain AMT payments may be used as credits against regular tax liabilities in future years Effective January 1, 2018, the corporate AMT is repealed. At December 31, 2019, the Company had no AMT credit carryforwards.

Net Operating Loss Carryovers. Prior to January 1, 2018, subject to certain limitations, a company may carry back net operating losses to the preceding two taxable years and forward to the succeeding 20 taxable years. For net operating losses generated beginning January 1, 2018, there are no carry backs allowed and an unlimited carry forward period. At December 31, 2019, Bancorp 34 had $3.8 million in net operating loss carry forwards for federal income tax purposes.

Corporate Dividends-Received Deduction. Bancorp 34 may exclude from its income 100% of dividends received from Bank 34 as a member of the same affiliated group of corporations. Through December 31, 2017, the corporate dividends-received deduction is 80% in the case of dividends received from a corporation in which a corporate recipient owns at least 20% of its stock, and corporations that own less than 20% of the stock of a corporation distributing a dividend may deduct only 70% of dividends received or accrued on their behalf. Effective January 1, 2018, the dividends received deduction decreases from 80% to 65% and 70% to 50% for corporate recipients owning at least 20% or less than 20%, respectively, of a corporation’s stock.

State Taxation

Bank 34’s full service branches and loan production offices in New Mexico and Arizona subject Bank 34 to taxation in those states. During 2019, Bank 34 closed loan production offices in Oregon, Texas, and Washington. Bank 34 regularly assesses where it is doing business and has state income tax nexus. As a Maryland business corporation, Bancorp 34 is required to file an annual report with and pay franchise taxes to the state of Maryland.

SUPERVISION AND REGULATION

General

As a federal savings association, Bank 34 is subject to examination and regulation by the Office of the Comptroller of the Currency, and is also subject to examination by the Federal Deposit Insurance Corporation (FDIC). The federal system of regulation and supervision establishes a comprehensive framework of activities in which Bank 34 may engage and is intended primarily for the protection of depositors and the Federal Deposit Insurance Corporation’s Deposit Insurance Fund. This regulation and supervision establishes a comprehensive framework of activities in which an institution may engage and is intended primarily for the protection of the Federal Deposit Insurance Corporation’s deposit insurance fund and depositors, and not for the protection of security holders. Bank 34 also is a member of and owns stock in the Federal Home Loan Bank of Dallas, which is one of the 11 regional banks in the Federal Home Loan Bank System.

Under this system of regulation, the regulatory authorities have extensive discretion in connection with their supervisory, enforcement, rulemaking and examination activities and policies, including rules or policies that: establish minimum capital levels; restrict the timing and amount of dividend payments; govern the classification of assets; determine the adequacy of loan loss reserves for regulatory purposes; and establish the timing and amounts of assessments and fees. Moreover, as part of their examination authority, the banking regulators assign numerical ratings to banks and savings institutions relating to capital, asset quality, management, liquidity, earnings and other factors. These ratings are inherently subjective and the receipt of a less than satisfactory rating in one or more categories may result in enforcement action by the banking regulators against a financial institution. A less than satisfactory rating may also prevent a financial institution, such as Bank 34 or its holding company, from obtaining necessary regulatory approvals to access the capital markets, pay dividends, acquire other financial institutions or establish new branches.

In addition, we must comply with significant anti-money laundering and anti-terrorism laws and regulations, Community Reinvestment Act laws and regulations, and fair lending laws and regulations. Government agencies have the authority to impose monetary penalties and other sanctions on institutions that fail to comply with these laws and regulations, which could significantly affect our business activities, including our ability to acquire other financial institutions or expand our branch network.

As a savings and loan holding company, Bancorp 34 is required to comply with the rules and regulations of the Federal Reserve Board. It is required to file certain reports with the Federal Reserve Board and is subject to examination by and the enforcement authority of the Federal Reserve Board. Bancorp 34 is also subject to the rules and regulations of the Securities and Exchange Commission under the federal securities laws.

Any change in applicable laws or regulations, whether by the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Federal Reserve Board, the Securities and Exchange Commission or Congress, could have a material adverse impact on the operations and financial performance of Bancorp 34 and Bank 34.

Set forth below is a brief description of material regulatory requirements that are or will be applicable to Bank 34 and Bancorp 34. The description is limited to certain material aspects of the statutes and regulations addressed, and is not intended to be a complete description of such statutes and regulations and their effects on Bank 34 and Bancorp 34.

Federal Banking Regulation

Business Activities. A federal savings association derives its lending and investment powers from the Home Owners’ Loan Act, as amended, and applicable federal regulations. Under these laws and regulations, Bank 34 may invest in mortgage loans secured by residential and commercial real estate, commercial business and consumer loans, certain types of debt securities and certain other assets, subject to applicable limits. Bank 34 may also establish subsidiaries that may engage in certain activities not otherwise permissible for Bank 34, including real estate investment and securities and insurance brokerage.

Capital Requirements. Federal regulations require federally insured depository institutions to meet several minimum capital standards: a common equity Tier 1 capital to risk-based assets ratio of 4.5%, a Tier 1 capital to risk-based assets ratio of 6.0%, a total capital to risk-based assets ratio of 8.0%, and a 4.0% Tier 1 capital to total assets leverage ratio.

In determining the amount of risk-weighted assets for purposes of calculating risk-based capital ratios, all assets, including certain off-balance sheet assets (e.g., recourse obligations, direct credit substitutes, residual interests) are multiplied by a risk weight factor assigned by the regulations based on the risks believed inherent in the type of asset. Higher levels of capital are required for asset categories believed to present greater risk. Common equity Tier 1 capital is generally defined as common stockholders’ equity and retained earnings. Tier 1 capital is generally defined as common equity Tier 1 and additional Tier 1 capital. Additional Tier 1 capital includes certain noncumulative perpetual preferred stock and related surplus and minority interests in equity accounts of consolidated subsidiaries. Total capital includes Tier 1 capital (common equity Tier 1 capital plus additional Tier 1 capital) and Tier 2 capital. Tier 2 capital is comprised of capital instruments and related surplus, meeting specified requirements, and may include cumulative preferred stock and long-term perpetual preferred stock, mandatory convertible securities, intermediate preferred stock and subordinated debt. Also included in Tier 2 capital is the allowance for loan and lease losses limited to a maximum of 1.25% of risk-weighted assets and, for institutions that made such an election regarding the treatment of Accumulated Other Comprehensive Income, up to 45% of net unrealized gains on available-for-sale equity securities with readily determinable fair values. Calculation of all types of regulatory capital is subject to deductions and adjustments specified in the regulations. In assessing an institution’s capital adequacy, the Office of the Comptroller of the Currency takes into consideration not only these numeric factors, but qualitative factors as well, and has the authority to establish higher capital requirements for individual institutions where deemed necessary.

In addition to establishing the minimum regulatory capital requirements, the regulations limit capital distributions and certain discretionary bonus payments to management if the institution does not hold a “capital conservation buffer” consisting of 2.5% of common equity Tier 1 capital to risk-weighted asset above the amount necessary to meet its minimum risk-based capital requirements. The capital conservation buffer requirement was phased in beginning January 1, 2016 at 0.625% of risk-weighted assets and increased each year until fully implemented at 2.5% of risk-weighted assets on January 1, 2019.

At December 31, 2019, Bank 34’s capital exceeded all applicable requirements.

Legislation enacted in May 2018 required the federal banking agencies, including the Office of the Comptroller of the Currency, to establish a “community bank leverage ratio” of between 8% to 10% of average total consolidated assets for qualifying institutions with assets of less than $10 billion of assets. Institutions with capital meeting the specified requirement and electing to follow the alternative framework would be deemed to comply with the applicable regulatory capital requirements, including the risk-based requirements. The federal regulators have adopted a final rule that set the ratio at 9%, Tier 1 capital to average total consolidated assets, effective January 1, 2020.

Loans-to-One Borrower. Generally, a federal savings association may not make a loan or extend credit to a single or related group of borrowers in excess of 15% of unimpaired capital and surplus. An additional amount may be loaned, equal to 10% of unimpaired capital and surplus, if the loan is secured by readily marketable collateral, which generally does not include real estate. As of December 31, 2019, Bank 34 was in compliance with the loans-to-one borrower limitations.

Qualified Thrift Lender Test. As a federal savings association, Bank 34 must satisfy the qualified thrift lender, or “QTL,” test. Under the QTL test, Bank 34 must maintain at least 65% of its “portfolio assets” in “qualified thrift investments” (primarily residential mortgages and related investments, including mortgage-backed securities) in at least nine months of every 12-month period. “Portfolio assets” generally means total assets of a savings association, less the sum of specified liquid assets up to 20% of total assets, goodwill and other intangible assets, and the value of property used in the conduct of the savings association’s business.

Bank 34 also may satisfy the QTL test by qualifying as a “domestic building and loan association” as defined in the Internal Revenue Code of 1986, as amended. This test generally requires a savings association to have at least 75% of its deposits held by the public and earn at least 25% of its income from loans and U.S. government obligations. Alternatively, a savings association can satisfy this test by maintaining at least 60% of its assets in cash, real estate loans and U.S. Government or state obligations.

A savings association that fails the qualified thrift lender test must operate under specified restrictions set forth in the Home Owners’ Loan Act. The Dodd-Frank Act made noncompliance with the QTL test subject to agency enforcement action for a violation of law. At December 31, 2019, Bank 34 satisfied the QTL test.

Capital Distributions. Federal regulations govern capital distributions by a federal savings association, which include cash dividends, stock repurchases and other transactions charged to the savings association’s capital account. A federal savings association must file an application with the Office of the Comptroller of the Currency for approval of a capital distribution if:

Even if an application is not otherwise required, every savings association that is a subsidiary of a savings and loan holding company, such as Bank 34, must still file a notice with the Federal Reserve Board at least 30 days before the board of directors declares a dividend or approves a capital distribution.

A notice or application related to a capital distribution may be disapproved if:

In addition, the Federal Deposit Insurance Act provides that an insured depository institution may not make any capital distribution if, after making such distribution, the institution would fail to meet any applicable regulatory capital requirement. A federal savings association also may not make a capital distribution that would reduce its regulatory capital below the amount required for the liquidation account established in connection with its conversion to stock form.

Community Reinvestment Act and Fair Lending Laws. All Federal Deposit Insurance Corporation-insured institutions have a responsibility under the Community Reinvestment Act and related regulations to help meet the credit needs of their communities, including low- and moderate-income borrowers. In connection with its examination of a federal savings association, the Office of the Comptroller of the Currency is required to assess the federal savings association’s record of compliance with the Community Reinvestment Act. A savings association’s failure to comply with the provisions of the Community Reinvestment Act could, at a minimum, result in denial of certain corporate applications such as branches or mergers, or in restrictions on its activities. In addition, the Equal Credit Opportunity Act and the Fair Housing Act prohibit lenders from discriminating in their lending practices on the basis of characteristics specified in those statutes. The failure to comply with the Equal Credit Opportunity Act and the Fair Housing Act could result in enforcement actions by the Office of the Comptroller of the Currency, as well as other federal regulatory agencies and the Department of Justice.

The Community Reinvestment Act requires all institutions insured by the Federal Deposit Insurance Corporation to publicly disclose their rating. Bank 34 received a “satisfactory” Community Reinvestment Act rating in its most recent federal examination.

Transactions with Related Parties. A federal savings association’s authority to engage in transactions with its affiliates is limited by Sections 23A and 23B of the Federal Reserve Act and federal regulation. An affiliate is generally a company that controls, or is under common control with, an insured depository institution such as Bank 34. Bancorp 34 is an affiliate of Bank 34 because of its control of Bank 34. In general, transactions between an insured depository institution and its affiliates are subject to certain quantitative limits and collateral requirements. In addition, federal regulations prohibit a savings association from lending to any of its affiliates that are engaged in activities that are not permissible for bank holding companies and from purchasing the securities of any affiliate, other than a subsidiary. Finally, transactions with affiliates must be consistent with safe and sound banking practices, not involve the purchase of low-quality assets and be on terms that are as favorable to the institution as comparable transactions with non-affiliates.

Bank 34’s authority to extend credit to its directors, executive officers and 10% stockholders, as well as to entities controlled by such persons, is currently governed by the requirements of Sections 22(g) and 22(h) of the Federal Reserve Act and Regulation O of the Federal Reserve Board. Among other things, these provisions generally require that extensions of credit to insiders:

In addition, extensions of credit in excess of certain limits must be approved by Bank 34’s board of directors. Extensions of credit to executive officers are subject to additional limits based on the type of extension involved.

Enforcement. The Office of the Comptroller of the Currency has primary enforcement responsibility over federal savings associations and has authority to bring enforcement action against all “institution-affiliated parties,” including directors, officers, stockholders, attorneys, appraisers and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on a federal savings association. Formal enforcement action by the Office of the Comptroller of the Currency may range from the issuance of a capital directive or cease and desist order to removal of officers and/or directors of the institution and the appointment of a receiver or conservator. Civil penalties cover a wide range of violations and actions, and range up to $50,000 per day (as adjusted for inflation), unless a finding of reckless disregard is made, in which case penalties may be as high as $2 million per day. The Federal Deposit Insurance Corporation also has the authority to terminate deposit insurance or recommend to the Office of the Comptroller of the Currency that enforcement action be taken with respect to a particular savings association. If such action is not taken, the Federal Deposit Insurance Corporation has authority to take the action under specified circumstances.

Standards for Safety and Soundness. Federal law requires each federal banking agency to prescribe certain standards for all insured depository institutions. These standards relate to, among other things, internal controls, information systems and audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, compensation and other operational and managerial standards as the agency deems appropriate. Interagency guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. If the appropriate federal banking agency determines that an institution fails to meet any standard prescribed by the guidelines, the agency may require the institution to submit to the agency an acceptable plan to achieve compliance with the standard. If an institution fails to meet these standards, the appropriate federal banking agency may require the institution to implement an acceptable compliance plan. Failure to implement such a plan can result in further enforcement action, including the issuance of a cease and desist order or the imposition of civil money penalties.

Interstate Banking and Branching. Federal law permits well capitalized and well managed holding companies to acquire banks in any state, subject to Federal Reserve Board approval, certain concentration limits and other specified conditions. Interstate mergers of banks are also authorized, subject to regulatory approval and other specified conditions. In addition, among other things, recent amendments made by the Dodd-Frank Act permit banks to establish de novo branches on an interstate basis provided that branching is authorized by the law of the host state for the banks chartered by that state.

Prompt Corrective Action. Federal law requires, among other things, that federal bank regulators take “prompt corrective action” with respect to institutions that do not meet minimum capital requirements. For this purpose, the law establishes five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. Under applicable regulations, an institution is deemed to be “well capitalized” if it has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 8.0% or greater, a leverage ratio of 5.0% or greater and a common equity Tier 1 ratio of 6.5% or greater. An institution is “adequately capitalized” if it has a total risk-based capital ratio of 8.0% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, a leverage ratio of 4.0% or greater and a common equity Tier 1 ratio of 4.5% or greater. An institution is “undercapitalized” if it has a total risk-based capital ratio of less than 8.0%, a Tier 1 risk-based capital ratio of less than 6.0%, a leverage ratio of less than 4.0% or a common equity Tier 1 ratio of less than 4.5%. An institution is deemed to be “significantly undercapitalized” if it has a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 4.0%, a leverage ratio of less than 3.0% or a common equity Tier 1 ratio of less than 3.0%. An institution is considered to be “critically undercapitalized” if it has a ratio of tangible equity (as defined in the regulations) to total assets that is equal to or less than 2.0%.

At each successive lower capital category, an insured depository institution is subject to more restrictions and prohibitions, including restrictions on growth, restrictions on interest rates paid on deposits, restrictions or prohibitions on payment of dividends, and restrictions on the acceptance of brokered deposits. Furthermore, if an insured depository institution is classified in one of the undercapitalized categories, it is required to submit a capital restoration plan to the appropriate federal banking agency, and the holding company must guarantee the performance of that plan. Based upon its capital levels, a bank that is classified as well-capitalized, adequately capitalized, or undercapitalized may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, determines that an unsafe or unsound condition, or an unsafe or unsound practice, warrants such treatment. An undercapitalized bank’s compliance with a capital restoration plan is required to be guaranteed by any company that controls the undercapitalized institution in an amount equal to the lesser of 5.0% of the institution’s total assets when deemed undercapitalized or the amount necessary to achieve the status of adequately capitalized. If an “undercapitalized” bank fails to submit an acceptable plan, it is treated as if it is “significantly undercapitalized.” “Significantly undercapitalized” banks must comply with one or more of a number of additional restrictions, including but not limited to a regulatory order to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets, ceasing receipt of deposits from correspondent banks, dismissal of directors or officers, and restrictions on interest rates paid on deposits, compensation of executive officers and capital distributions by the parent holding company. “Critically undercapitalized” institutions are subject to additional measures including, subject to a narrow exception, the appointment of a receiver or conservator within 270 days after it obtains such status.

At December 31, 2019, Bank 34 met the criteria for being considered “well capitalized.”

The previously referenced final rule establishing an elective “community bank leverage ratio” regulatory capital requirement provides that a qualifying institution whose capital exceeds the community bank leverage ratio and opts to use that framework will be considered “well-capitalized” for purposes of prompt corrective action.

Insurance of Deposit Accounts. The Deposit Insurance Fund of the Federal Deposit Insurance Corporation insures deposits at Federal Deposit Insurance Corporation insured financial institutions such as Bank 34. Deposit accounts in Bank 34 are insured by the Federal Deposit Insurance Corporation generally up to a maximum of $250,000 per separately insured depositor. The Federal Deposit Insurance Corporation charges insured depository institutions premiums to maintain the Deposit Insurance Fund.

Under the Federal Deposit Insurance Corporation’s risk-based assessment system, insured institutions were assigned to one of four risk categories based on supervisory evaluations, regulatory capital levels and certain other risk factors. Rates were based on each institution’s risk category and certain specified risk adjustments. Institutions deemed to be less risky paid lower rates while institutions deemed riskier pay higher rates. Assessment rates (inclusive of possible adjustments) ranged from 2 ¹/2 to 45 basis points of each institution’s total assets less tangible capital.

Effective in 2016, the Federal Deposit Insurance Corporation adopted changes that eliminated the risk categories. Assessments for most institutions are now based on financial measures and supervisory ratings derived from statistical modeling estimating the probability of failure within three years. The assessment range (inclusive of possible adjustments) for most banks and savings associations is currently 1.5 basis points to 30 basis points.

The Dodd-Frank Act increased the minimum target Deposit Insurance Fund ratio from 1.15% of estimated insured deposits to 1.35% of estimated insured deposits. The Federal Deposit Insurance Corporation was required to seek to achieve the 1.35% ratio by September 30, 2020. The Federal Deposit Insurance Corporation indicated that the 1.35% ratio was exceeded in 2018. Insured institutions of less than $10 billion of assets received credits for the portion of their assessments that contributed to the reserve ratio between 1.15% and 1.35%. The Dodd-Frank Act eliminated the 1.5% maximum fund ratio, instead leaving it to the discretion of the Federal Deposit Insurance Corporation, and the Federal Deposit Insurance Corporation has exercised that discretion by establishing a long-range fund ratio of 2%.

The Federal Deposit Insurance Corporation has authority to increase insurance assessments. Any significant increases would have an adverse effect on the operating expenses and results of operations of Bank 34. We cannot predict what assessment rates will be in the future.

Insurance of deposits may be terminated by the Federal Deposit Insurance Corporation upon a finding that an institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the Federal Deposit Insurance Corporation. We do not know of any practice, condition or violation that may lead to termination of our deposit insurance.

Privacy Regulations. Federal regulations generally require that Bank 34 disclose its privacy policy, including identifying with whom it shares a customer’s “non-public personal information,” to customers at the time of establishing the customer relationship and annually thereafter. In addition, Bank 34 is required to provide its customers with the ability to “opt-out” of having their personal information shared with unaffiliated third parties and not to disclose account numbers or access codes to non-affiliated third parties for marketing purposes. Bank 34 currently has a privacy protection policy in place and believes that such policy is in compliance with the regulations.

USA PATRIOT Act. Bank 34 is subject to the USA PATRIOT Act, which gives federal agencies additional powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. The USA PATRIOT Act contains provisions intended to encourage information sharing among bank regulatory agencies and law enforcement bodies and imposes affirmative obligations on financial institutions, such as enhanced recordkeeping and customer identification requirements.

Prohibitions Against Tying Arrangements. Federal savings associations are prohibited, subject to some exceptions, from extending credit to or offering any other service, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or its affiliates or not obtain services of a competitor of the institution.

Other Regulations

Interest and other charges collected or contracted for by Bank 34 are subject to state usury laws and federal laws concerning interest rates. Loan operations are also subject to state and federal laws applicable to credit transactions, such as the:

The deposit operations of Bank 34 also are subject to, among others, the:

Federal Reserve System

The Federal Reserve Board regulations require depository institutions to maintain noninterest-earning reserves against their transaction accounts (primarily NOW and regular checking accounts). For 2019, the Federal Reserve Board regulations generally require that reserves be maintained against aggregate transaction accounts as follows: for that portion of transaction accounts aggregating $124.2 million or less (which may be adjusted by the Federal Reserve Board) the reserve requirement is 3.0% and the amounts greater than $124.2 million require a 10.0% reserve (which may be adjusted annually by the Federal Reserve Board between 8.0% and 14.0%). The first $16.3 million of otherwise reservable balances (which may be adjusted by the Federal Reserve Board) are exempted from the reserve requirements. Bank 34 was in compliance with these requirements at December 31, 2019.

Federal Home Loan Bank System

Bank 34 is a member of the Federal Home Loan Bank System, which consists of 11 regional Federal Home Loan Banks. The Federal Home Loan Bank provides a central credit facility primarily for member institutions. Members of the Federal Home Loan Bank are required to acquire and hold shares of capital stock in the Federal Home Loan Bank. Bank 34 was in compliance with this requirement at December 31, 2019. Based on redemption provisions of the Federal Home Loan Bank of Dallas, the stock has no quoted market value and is carried at cost. Bank 34 reviews for impairment, based on the ultimate recoverability, the cost basis of the Federal Home Loan Bank of Dallas stock. As of December 31, 2019, no impairment had been recognized.

Final Federal Regulation

Effective July 1, 2019, the Office of the Comptroller of the Currency issued a final rule implementing a section of the Economic Growth, Relief and Consumer Protection Act that permits an eligible federal savings association with total consolidated assets of $20 billion or less as of December 31, 2017, to elect to operate with national bank powers without converting to a national bank charter. An eligible savings association is a federal savings association that: (1) is well capitalized; (2) has a CAMELs composite rating of 1 or 2; (3) has a consumer compliance rating of 1 or 2; (4) has a Community Reinvestment Act rating of “outstanding” or “satisfactory,” if applicable; and (5) is not subject to an enforcement action.

Holding Company Regulation

Bancorp 34 is a unitary savings and loan holding company subject to regulation and supervision by the Federal Reserve Board. The Federal Reserve Board has enforcement authority over Bancorp 34 and its non-savings institution subsidiaries. Among other things, this authority permits the Federal Reserve Board to restrict or prohibit activities that are determined to be a risk to Bank 34.

As a savings and loan holding company, Bancorp 34’s activities are limited to those activities permissible by law for financial holding companies (if Bancorp 34 makes an election to be treated as a financial holding company and meets the other requirements to be a financial holding company) or multiple savings and loan holding companies. A financial holding company may engage in activities that are financial in nature, incidental to financial activities or complementary to a financial activity. Such activities include lending and other activities permitted for bank holding companies under Section 4(c) (8) of the Bank Holding Company Act, insurance and underwriting equity securities. Multiple savings and loan holding companies are authorized to engage in activities specified by federal regulation, including activities permitted for bank holding companies under Section 4(c)(8) of the Bank Holding Company Act.

Federal law prohibits a savings and loan holding company, directly or indirectly, or through one or more subsidiaries, from acquiring more than 5% of another savings institution or savings and loan holding company without prior written approval of the Federal Reserve Board, and from acquiring or retaining control of any depository institution not insured by the Federal Deposit Insurance Corporation. In evaluating applications by holding companies to acquire savings institutions, the Federal Reserve Board must consider such things as the financial and managerial resources and future prospects of the company and institution involved, the effect of the acquisition on and the risk to the federal deposit insurance fund, the convenience and needs of the community and competitive factors. A savings and loan holding company may not acquire a savings institution in another state and hold the target institution as a separate subsidiary unless it is a supervisory acquisition or the law of the state in which the target is located authorizes such acquisitions by out-of-state companies.

Savings and loan holding companies historically have not been subject to consolidated regulatory capital requirements. The Dodd-Frank Act required the Federal Reserve Board to establish minimum consolidated capital requirements for all depository institution holding companies that were as stringent as those required for the insured depository subsidiaries. However, pursuant to federal legislation, the Federal Reserve Board maintains a “small holding company” exception to the applicability of consolidated holding company capital requirements. That exception generally applies to holding companies with less than $3 billion of consolidated assets, such as Bancorp 34. Such holding companies are not subject to the requirements unless otherwise advised by the Federal Reserve Board.

The Dodd-Frank Act extended the “source of strength” doctrine to savings and loan holding companies. The Federal Reserve Board has promulgated regulations implementing the “source of strength” doctrine that require holding companies to act as a source of strength to their subsidiary depository institutions by providing capital, liquidity and other support in times of financial stress.

The Federal Reserve Board has issued a policy statement regarding the payment of dividends and the repurchase of shares of common stock by bank holding companies and savings and loan holding companies. In general, the policy provides that dividends should be paid only out of current earnings and only if the prospective rate of earnings retention by the holding company appears consistent with the organization’s capital needs, asset quality and overall financial condition. Regulatory guidance provides for prior regulatory consultation with respect to capital distributions in certain circumstances such as where the company’s net income for the past four quarters, net of capital distributions previously paid over that period, is insufficient to fully fund the dividend or the company’s overall rate of earnings retention is inconsistent with the company’s capital needs and overall financial condition. The ability of a holding company to pay dividends may be restricted if a subsidiary bank becomes undercapitalized. The policy statement also states that a holding company should inform the Federal Reserve Board supervisory staff prior to redeeming or repurchasing common stock or perpetual preferred stock if the holding company is experiencing financial weaknesses or if the repurchase or redemption would result in a net reduction, as of the end of a quarter, in the amount of such equity instruments outstanding compared with the beginning of the quarter in which the redemption or repurchase occurred. These regulatory policies may affect the ability of Bancorp 34 to pay dividends, repurchase shares of common stock or otherwise engage in capital distributions.

Federal Securities Laws

Bancorp 34 common stock is registered with the Securities and Exchange Commission. Bancorp 34 is subject to the information, proxy solicitation, insider trading restrictions and other requirements under the Securities Exchange Act of 1934.

The registration under the Securities Act of 1933 of shares of common stock issued in Bancorp 34’s public offering does not cover the resale of those shares. Shares of common stock purchased by persons who are not affiliates of Bancorp 34 may be resold without registration. Shares purchased by an affiliate of Bancorp 34 are subject to the resale restrictions of Rule 144 under the Securities Act of 1933. If Bancorp 34 meets the current public information requirements of Rule 144 under the Securities Act of 1933, each affiliate of Bancorp 34 that complies with the other conditions of Rule 144, including those that require the affiliate’s sale to be aggregated with those of other persons, would be able to sell in the public market, without registration, a number of shares not to exceed, in any three-month period, the greater of 1% of the outstanding shares of Bancorp 34, or the average weekly volume of trading in the shares during the preceding four calendar weeks. In the future, Bancorp 34 may permit affiliates to have their shares registered for sale under the Securities Act of 1933.

Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002 is intended to improve corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. We have policies, procedures and systems designed to comply with these regulations, and we review and document such policies, procedures and systems to ensure continued compliance with these regulations.

Change in Control Regulations

Under the Change in Bank Control Act, no person may acquire control of a savings and loan holding company, such as Bancorp 34, unless the Federal Reserve Board has been given 60 days’ prior written notice and has not issued a notice disapproving the proposed acquisition, taking into consideration certain factors, including the financial and managerial resources of the acquirer and the competitive effects of the acquisition. Control, as defined under federal law, means ownership, control of or holding irrevocable proxies representing more than 25% of any class of voting stock, control in any manner of the election of a majority of the institution’s directors, or a determination by the regulator that the acquirer has the power, directly or indirectly, to exercise a controlling influence over the management or policies of the institution. Acquisition of more than 10% of any class of a savings and loan holding company’s voting stock constitutes a rebuttable determination of control under the regulations under certain circumstances including where, as is the case with Bancorp 34, the issuer has registered securities under Section 12 of the Securities Exchange Act of 1934.

In addition, federal regulations provide that no company may acquire control of a savings and loan holding company without the prior approval of the Federal Reserve Board. Any company that acquires such control becomes a “savings and loan holding company” subject to registration, examination and regulation by the Federal Reserve Board.

Emerging Growth Company Status

Bancorp 34 was an emerging growth company under the JOBS Act. The Company lost its status as an emerging growth company at the end of 2019.

Bancorp 34 elected to use the extended transition period to delay adoption of new or revised accounting pronouncements applicable to public companies until such pronouncements were made applicable to private companies. Accordingly, these financial statements may not be comparable to the financial statements of public companies that comply with such new or revised accounting standards.

Not applicable, as Bancorp 34, Inc. is a “Smaller Reporting Company.”

None.

We conduct business through our main office in Alamogordo, New Mexico and three branch offices located in Las Cruces, New Mexico and Peoria and Scottsdale, Arizona. At December 31, 2019, the total net book value of our premises, land and equipment was $9.0 million.

Periodically, we are involved in claims and lawsuits, such as claims to enforce liens, condemnation proceedings on properties in which we hold security interests, claims involving the making and servicing of real property loans and other issues incident to our business. We are not a party to any pending legal proceedings that we believe would have a material adverse effect on our financial condition, results of operations or cash flows.

Not applicable.

PART II

Our common stock is listed on the NASDAQ Capital Market under the symbol “BCTF.” As of February 12, 2020, we had 364 stockholders of record (excluding the number of persons or entities holding stock in street name through various brokerage firms), and 3,168,574 shares of common stock outstanding.

There were no sales of unregistered securities during the quarter ended December 31, 2019.

On October 24, 2017, the Company adopted its initial stock repurchase program under which it would repurchase up to 171,910 shares of its common stock, or approximately 5.0% of the Company’s outstanding shares. This repurchase program was completed in February 2019. On May 24, 2019, the Company adopted a second repurchase program under which it was authorized to repurchase up to 167,747 shares of its common stock, or approximately 5.0% of the Company’s outstanding shares. 157,042 shares were repurchased under this program through December 31, 2019. The Company did not repurchase common stock in the three months ended December 31, 2019.

You should read the following summary financial information in connection with our historical financial information, which appears elsewhere in this annual report. The selected historical financial data at December 31, 2019 and 2018 and for the years ended December 31, 2019 and 2018 is derived in part from the audited consolidated financial statements that appear in this report. The information at December 31, 2017, 2016 and 2015 is derived in part from audited consolidated financial statements that do not appear in this report.

The following summary financial tables comprise of total operations, including continuing and discontinued.

The following selected financial data for the years ended December 31, 2019 and 2018 consists of continuing operations only.

This discussion and analysis reflects our consolidated financial statements and other relevant statistical data, and is intended to enhance your understanding of our financial condition and results of operations. The information in this section as of and for the year ended December 31, 2019 and 2018, has been derived from the consolidated financial statements that appear elsewhere in this annual report. You should read the information in this section in conjunction with the business and financial information regarding Bancorp 34, Inc. and the financial statements provided in Part II, Item 8 of this annual report.

Critical Accounting Policies

Critical accounting policies are those that involve significant judgments and assumptions by management and that have, or could have, a material impact on our income or the carrying value of our assets. Our critical accounting policies are those related to our allowance for loan losses, the evaluation of other-than-temporary impairment of securities, the valuation of and our ability to realize deferred tax assets and the measurement of fair values of financial instruments.

Allowance for Loan Losses. The allowance for loan losses is calculated with the objective of maintaining an allowance necessary to absorb probable credit losses inherent in the loan portfolio. Management’s determination of the adequacy of the allowance is based on periodic evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective, as it requires an estimate of the losses for each risk rating and for each impaired loan, an estimate of the amounts and timing of expected future cash flows, and an estimate of the value of collateral.

We have established a systematic method of periodically reviewing the credit quality of the loan portfolio in order to establish an allowance for loan losses. The allowance for loan losses is based on our current judgments about the credit quality of individual loans and segments of the loan portfolio. The allowance for loan losses is established through a provision for loan losses based on our evaluation of the probable losses inherent in the loan portfolio, and considers all known internal and external factors that affect loan collectability as of the reporting date. Our evaluation, which includes a review of loans on which full collectability may not be reasonably assured, considers among other matters, the estimated net realizable value or the fair value of the underlying collateral, economic conditions, historical loan loss experience, our knowledge of inherent losses in the portfolio that are probable and reasonably estimable and other factors that warrant recognition in providing an appropriate loan loss allowance. Management believes this is a critical accounting policy because this evaluation involves a high degree of complexity and requires us to make subjective judgments that often require assumptions or estimates about various matters.

The allowance for loan losses consists primarily of specific allocations and general allocations. Specific allocations are made for loans that are determined to be impaired. Impairment is measured by determining the present value of expected future cash flows or, for collateral-dependent loans, the fair value of the collateral, including adjustments for market conditions and selling expenses. The general allocation is determined by segregating the remaining loans by type of loan, risk weighting and payment history. We also analyze delinquency trends, general economic conditions, trends in historical loss experience and geographic and industry concentrations. This analysis establishes factors that are applied to the loan groups to determine the amount of the general allowance. The principal assumption used in calculating the allowance for loan losses is the estimate of loss for each risk rating. Actual loan losses may be significantly more than the allowance we have established, which could have a material negative effect on our financial results.

Other-Than-Temporary Impairment. Securities are evaluated on at least a quarterly basis, to determine whether a decline in their value is other-than-temporary. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) whether or not we intend to sell or expect that it is more likely than not that we will be required to sell the investment security prior to an anticipated recovery in fair value. Once a decline in value for a debt security is determined to be other than temporary, the other-than-temporary impairment is separated in (a) the amount of total other-than-temporary impairment related to a decrease in cash flows expected to be collected from the debt security (the credit loss) and (b) the amount of other-than-temporary impairment related to all other factors. The amount of the total other-than-temporary impairment related to credit loss is recognized in operations. The amount of other-than-temporary impairment related to other factors is recognized in other comprehensive loss.

Valuation of Deferred Tax Assets. As a result of the reduction in the Federal corporate tax rate effective in 2018 under the Tax Cuts and Jobs Act signed into law in December 2017, income tax expense for 2017 includes a $1.2 million deferred tax asset re-measurement adjustment. Effective December 31, 2016, we reversed 100% of our net deferred tax asset valuation allowances and recognized an income tax benefit based upon our assessment of net deferred tax assets that are more-likely-than-not to be realized. The net deferred tax asset had been offset by an equal valuation allowance from June 2012 through November 2016. In evaluating our ability to realize deferred tax assets, management considers all positive and negative information, including our past operating results and our forecast of future taxable income. In determining future taxable income, management utilizes a budget process that makes business assumptions and the implementation of feasible and prudent tax planning strategies, if any. These assumptions require us to make judgments about our future taxable income that are consistent with the plans and estimates we use to manage our business. Any change in estimated future taxable income or effective tax rates may result in changes to the carrying balance of our net deferred tax assets which would result in an income tax benefit or expense in the same period.

Fair Value Measurements. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs.  A three-level of fair value hierarchy prioritizes the inputs used to measure fair value:

The asset or liability’s fair value measurement level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. 

Average Balance Sheet

The following table sets forth average balances, average yields and costs, and certain other information for the years indicated. Tax-equivalent yield adjustments have not been made for tax-exempt securities, as the effect thereof was not material. All average balances are daily average balances. Nonaccrual loans were included in the computation of average balances, but have been reflected in the table as loans carrying a zero yield. The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income. 

Rate/Volume Analysis

The following table presents the effects of changing rates and volumes on our net interest income for the years indicated. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately based on the changes due to rate and the changes due to volume.

Comparison of Financial Condition at December 31, 2019 and December 31, 2018

Cash and cash equivalents were $29.5 million at December 31, 2019 and $11.8 million at December 31, 2018. Daily cash and cash equivalent balances vary around our target levels of $5.0 to $10.0 million primarily due to the timing of commercial loan fundings and payoffs and changes in deposit balances and FHLB advances. Cash and cash equivalents were above normal target level at December 31, 2019 due to the reduction in mortgage loans held for sale during the year ended December 31, 2019.

Available-for-sale securities increased $11.1 million, or 33.2%, during the year ended December 31, 2019 to $44.5 million. There were no sales of available-for-sale securities and we purchased $16.2 million of securities in the year ended December 31, 2019.

There were no loans held for sale at December 31, 2019. Until June 30, 2019 we sold a significant majority of our residential mortgage loans in the secondary market. At December 31, 2018, loans held for sale totaled $26.9 million and all were residential mortgage loans. As discussed in The consolidated financial statements, Note 2 – Discontinued Operations, the Company discontinued originating mortgage loans held for sale in its name in June 2019 due to the mortgage banking business exit.

Loans held for investment increased $9.0 million, or 3.1%, to $294.7 million at December 31, 2019 from $285.7 million at December 31, 2018, due to organic growth. In the year ended December 31, 2019, commercial real estate loans increased $9.6 million to $242.7 million and represented 82.1% of the gross loan portfolio at December 31, 2019, compared to 81.3% at December 31, 2018.

The core deposit intangible recorded in connection with the acquisition of Bank 1440 decreased $39,000 to $133,000 at December 31, 2019 from $172,000 at December 31, 2018, reflecting normal amortization.

Total deposits increased $38.7 million, or 14.6%, to $303.9 million at December 31, 2019 from $265.2 million at December 31, 2018. The increase included an $23.8 million, or 16.7%, increase in savings and NOW deposits, a $3.8 million, or 5.0%, increase in time deposits and a $11.1 million, or 24.4%, increase in demand deposits.

Federal Home Loan Bank advances were down $27.0 million, or 40.3%, to $40.0 million at December 31, 2019 compared to $67.0 million at December 31, 2018. The reduction was due to a $26.9 million decrease in residential mortgage loans held for sale. We utilize short-term borrowings to fund loans held for sale, and long-term borrowings and some short-term borrowings to fund net growth in loans held for investment.

Accrued interest and other liabilities increased $267,000, or 6.3%, to $4.5 million at December 31, 2019 compared to $4.2 million at December 31, 2018.

Total stockholders’ equity decreased $1.3 million to $45.1 million at December 31, 2019 from $46.4 million at December 31, 2018. The largest changes in stockholders’ equity were a $2.7 million reduction due to common stock repurchases and a $703,000 increase due to available-for-sale securities fair value appreciation.

Comparison of Operating Results for the Years Ended December 31, 2019 and December 31, 2018

General. We had net income of $710,000 for the year ended December 31, 2019, which was $363,000 less than net income of $1.1 million for the year ended December 31, 2018. This includes net income from continuing operations of $2.0 million and net loss from discontinued operations of $1.3 million for the year ended December 31, 2019, and net income from continuing operations of $1.9 million and net loss from discontinued operations of $802,000 for the year ended December 31, 2018. The comparison of operating results is discussed in more detail between continuing operations and discontinued operations.

We had net income from continuing operations of $2.0 million for the year ended December 31, 2019, which was $91,000 more than net income from continuing operations of $1.9 million for the year ended December 31, 2018. The increase was primarily caused by a $437,000, or 3.2%, increase in net interest income, a $296,000, or 92.9%, smaller provision for loan losses, and a $265,000, or 35.2% increase in noninterest income, partially offset by a $916,000, or 7.9%, increase in noninterest expense.

We had a net loss from discontinued operations, as discussed in The consolidated financial statements, Note 2 – Discontinued Operations, of $1.3 million for the year ended December 31, 2019, which was $454,000 more than the net loss from discontinued operations of $802,000 for the year ended December 31, 2018. The increased net loss from discontinued operations was primarily caused by a $9.5 million, or 66.3%, decrease in noninterest income, partially offset by a $9.0 million, or 57.5%, decrease in noninterest expense. Noninterest expense for the year ended December 31, 2019 included an $845,000 loss on disposal of discontinued operations.

Interest Income. Interest income from continuing operations increased $2.1 million, or 12.4%, to $18.9 million for the year ended December 31, 2019 from $16.9 million for the year ended December 31, 2018. The increase was due to a $33.5 million, or 10.5%, increase in average interest-earning assets and a nine basis point increase in average yields. Loans, which are our highest yielding asset, decreased to 83.7% of average interest-earning assets from 85.6% of average interest-earning assets. The increase in yield on average interest earning assets included yield increases on loans, securities and other interest earning assets of 12 basis points, 36 basis points and 24 basis points, respectively. Interest income on loans increased due to a $21.9 million, or 8.0%, increase in average loan balances due to organic growth and a 12 basis point increase in yield to 5.91% for the year ended December 31, 2019 from 5.79% for the year ended December 31, 2018. Interest on securities increased $319,000, or 48.8%, for the year ended December 31, 2019 compared to the year ended December 31, 2018 due primarily to an $8.1 million, or 28.5%, increase in average securities balances due to second, third and fourth quarter 2019 purchases and a 36 basis point increase in yield due to favorable market rate increases.

Interest Expense. Interest expense from continuing operations increased $1.6 million, or 51.9%, to $4.8 million for the year ended December 31, 2019 from $3.2 million for the year ended December 31, 2018. The increase was the result of increases of $1.4 million, or 56.4%, in interest expense on deposits and $277,000, or 37.3%, in interest expense on borrowings.

Interest paid on checking, money market and savings accounts increased $836,000, or 63.1%, to $2.2 million for the year ended December 31, 2019 from $1.3 million for the year ended December 31, 2018. The average rate we paid on such deposit accounts increased 39 basis points to 1.39% for the year ended December 31, 2019 from 1.00% for the year ended December 31, 2018 due to the increase in market interest rates. The average balance increased $22.5 million, or 17.0%, to $154.8 million for the year ended December 31, 2019 from $132.3 million for the year ended December 31, 2018.

Interest on certificates of deposit increased $534,000, or 48.3%, to $1.6 million for the year ended December 31, 2019 from $1.1 million for the year ended December 31, 2018. The average rate paid on certificates of deposit increased 49 basis points, or 31.4%, to 2.06% for the year ended December 31, 2019 compared to 1.57% for the year ended December 31, 2018 due to the increase in market interest rates. The average balance of certificates of deposit increased $9.1 million, or 12.9%, to $79.4 million for the year ended December 31, 2019 from $70.4 million for the year ended December 31, 2018.

The average balance of borrowings decreased $9.7 million, or 16.1%, from the year ended December 31, 2018 to the year ended December 31, 2019 and the average rate paid increased 79 basis points to 2.02% for the year ended December 31, 2019 from 1.23% for the year ended December 31, 2018.

Net Interest Income. Net interest income from continuing operations increased $437,000, or 3.2%, to $14.1 million for the year ended December 31, 2019 from $13.7 million for the year ended December 31, 2018, primarily due to a 10.5% increase in average interest earning assets, mostly offset by a 39 basis point decrease in net interest rate spread to 3.67% for the year ended December 31, 2019 from 4.06% for the year ended December 31, 2018. Average interest bearing liability rates for continuing operations increased 48 basis points compared to a nine basis point increase in the average interest earning assets yield for continuing operations. Our average net interest-earning assets increased by $3.8 million, or 5.2%, to $77.1 million for the year ended December 31, 2019 from $73.3 million for the year ended December 31, 2018 due primarily to organic growth.

Net interest income from discontinued operations decreased $156,000, or 47.7%, to $171,000 for the year ended December 31, 2019 from $326,000 for the year ended December 31, 2018, primarily due to an 48.1% decrease in average mortgage loans held for sale to $8.4 million for the year ended December 31, 2019 from $16.2 million for the year ended December 31, 2018.

Provision for Loan Losses. We recorded a provision for loan losses of $23,000 for the year ended December 31, 2019, compared to $318,000 for the year ended December 31, 2018. In the year ended December 31, 2019, the allowance for loan losses increased $21,000, or 0.7%, including an $23,000 increase from provisions, partially offset by $2,000 in net charge-offs.

Noninterest Income. Noninterest income from continuing operations increased $118,000, or 13.1%, to $1.0 million for the year ended December 31, 2019 from $901,000 for the year ended December 31, 2018 due primarily to an $143,000, or 110.7%, increase in loan sales gains.

The gain on sale of loans from continuing operations increased $143,000, or 110.7%, to $272,000 for the year ended December 31, 2019 from $129,000 for the year ended December 31, 2018. We sold $3.4 million of SBA and USDA loans during the year ended December 31, 2019 and recognized $272,000 of sales gains directly into income, compared to $1.6 million of SBA and USDA loan sales in the year ended December 31, 2018 with gains of $129,000.

Noninterest income from discontinued operations, represented by loan sales gains, decreased $9.5 million, or 66.3%, to $4.8 million for the year ended December 31, 2019 from $14.3 million for the year ended December 31, 2018. The gain on sale of loans from discontinued operations decreased due primarily to the mortgage banking business exit in the second quarter of 2019.

During the year ended December 31, 2019, we sold $146.3 million of mortgage loans for a gain of $4.8 million, compared to $305.8 million of mortgage loan sales during the year ended December 31, 2018 for a gain of $14.3 million. We realized a 4.2% average premium (gain on sale/sold loans) on the sales of mortgage loans for the year ended December 31, 2019 and 4.25% for the year ended December 31, 2018. Premiums vary from period to period based upon the mix of government Federal Housing Administration (FHA) and Veterans Administration (VA) loans to conventional loans, geographic markets and market interest rates, specifically 10-year U.S. Treasury rates.

Noninterest Expense. Noninterest expense from continuing operations increased $769,000, or 6.6%, to $12.5 million for the year ended December 31, 2019 from $11.7 million for the year ended December 31, 2018. The increase was primarily related to higher salaries and benefits and data processing fees, partially offset by a decrease in professional fees, and by $84,000 in FDIC credits recognized in 2019 which reduced expense. Average assets from continuing operations for the year ended December 31, 2019 were 9.7% larger than for the year ended December 31, 2018.

Noninterest expense from discontinued operations decreased $9.0 million, or 57.5%, to $6.7 million for the year ended December 31, 2019 from $15.7 million for the year ended December 31, 2018. The decrease was primarily related to the mortgage banking business exit in the second quarter of 2019, partially offset by the net loss on disposal for the quarter ended June 30, 2019.

Provision for Income Tax. Provision for income tax expense from continuing operations was $666,000 for the year ended December 31, 2019, representing an effective tax rate of 25.3% on pre-tax income from continuing operations. There are numerous differences between pre-tax income and actual taxable income that have an effect on the effective income tax rate for any given period. We recognized an income tax expense from continuing operations of $675,000 for the year ended December 31, 2018 representing 26.5% of the $2.5 million income from continuing operations before income taxes.

Benefit for income taxes from discontinued operations was $428,000 for the year ended December 31, 2019, representing an effective tax rate of 25.4% on pre-tax loss from discontinued operations. We recognized a benefit for income taxes from discontinued operations of $259,000 for the year ended December 31, 2018 representing 24.4% of the $1.1 million loss before benefit for income taxes.

Loans Held for Investment

We originate residential real estate loans, as well as commercial real estate loans, including multi-family residential real estate loans, construction loans, commercial and industrial loans and consumer and other loans. The following tables set forth the composition of our loans held for investment by type at the dates indicated.

The following table sets forth the contractual maturities of our loans held for investment at December 31, 2019. Demand loans, loans having no stated repayment schedule or maturity, and overdraft loans are reported as being due in one year or less. The table presents contractual maturities and does not reflect repricing or the effect of prepayments. Actual maturities may differ.

The following table sets forth our fixed and adjustable-rate loans at December 31, 2019 that are contractually due after December 31, 2020.

Asset Quality

We review loans on a regular basis, and place loans on nonaccrual status when either principal or interest is 90 days or more past due, or earlier if we do not expect to receive full payment of interest or principal. Interest accrued and unpaid at the time a loan is placed on nonaccrual status is reversed from interest income. Once a loan is placed on nonaccrual status, the borrower must generally demonstrate at least six months of payment performance before the loan is eligible to return to accrual status.

Nonperforming Assets. The following table sets forth information regarding our nonperforming assets.