FIRST CAPITAL INC - Quarter Report: 2020 March (Form 10-Q)

1.

Presentation of Interim Information

 

First Capital, Inc. (“Company”) is the financial holding company for First Harrison Bank (“Bank”), an Indiana chartered commercial bank and wholly owned subsidiary. First Harrison Investments, Inc. and First Harrison Holdings, Inc. are wholly-owned Nevada corporate subsidiaries of the Bank that jointly own First Harrison, LLC, a Nevada limited liability corporation that holds and manages an investment portfolio. First Harrison REIT, Inc. (“REIT”) is a wholly-owned subsidiary of First Harrison Holdings, Inc. that holds a portion of the Bank’s real estate mortgage loan portfolio. FHB Risk Mitigation Services, Inc. (“Captive”) is a wholly-owned insurance subsidiary of the Company that provides property and casualty insurance coverage to the Company, the Bank and the Bank’s subsidiaries, and reinsurance to eight other third party insurance captives for which insurance may not be currently available or economically feasible in the insurance marketplace. Heritage Hill, LLC is a wholly-owned subsidiary of the Bank that holds and manages certain foreclosed real estate properties.

 

In the opinion of management, the unaudited consolidated financial statements include all adjustments considered necessary to present fairly the financial position as of March 31, 2020, and the results of operations for the three months ended March 31, 2020 and 2019 and the cash flows for the three months ended March 31, 2020 and 2019. All of these adjustments are of a normal, recurring nature. Such adjustments are the only adjustments included in the unaudited consolidated financial statements. Interim results are not necessarily indicative of results for a full year or any other period.

 

The accompanying unaudited consolidated financial statements and notes have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial statements and are presented as permitted by the instructions to Form 10-Q. Accordingly, they do not contain certain information included in the Company’s annual audited consolidated financial statements and related footnotes for the year ended December 31, 2019 included in the Company’s Annual Report on Form 10-K.

 

The unaudited consolidated financial statements include the accounts of the Company and its subsidiaries. All material intercompany balances and transactions have been eliminated in consolidation. Certain prior period amounts have been reclassified to conform with the current period presentation. The reclassifications had no effect on net income or stockholders’ equity.

 

COVID-19

 

On March 11, 2020, the World Health Organization declared the outbreak of the novel coronavirus (“COVID-19”) as a global pandemic, which continues to spread throughout the United States and around the world. The COVID-19 pandemic has adversely affected, and may continue to adversely affect economic activity globally, nationally and locally. COVID-19 and actions taken to mitigate the spread of it have had and are expected to continue to have an adverse impact on the economies and financial markets of many countries, including the geographical area in which the Company operates. Such events also may adversely affect business and consumer confidence, generally, and the Company and its customers, and their respective suppliers, vendors and processors, may be adversely affected.

 

 

FIRST CAPITAL, INC.

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Due to the COVID-19 pandemic market interest rates have declined significantly, as the Federal Open Market Committee reduced the targeted federal funds interest rate range by 150 basis points during the month of March 2020 to 0% to 0.25%. These reductions in interest rates and other effects of the COVID-19 pandemic may adversely affect the Company's financial condition and results of operations in future periods. It is unknown how long the adverse conditions associated with the COVID-19 pandemic will last and what the financial impact will be to the Company. It is reasonably possible that estimates made in the financial statements could be materially and adversely impacted in the near term as a result of these conditions, including expected credit losses on loans.

 

On March 22, 2020, the federal banking agencies issued an “Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus”. This guidance encourages financial institutions to work prudently with borrowers that may be unable to meet their contractual obligations because of the effects of COVID-19. The guidance goes on to explain that in consultation with the Financial Accounting Standards Board (“FASB”) staff that the federal banking agencies concluded that short-term modifications (e.g., six months) made on a good faith basis to borrowers who were current as of the implementation date of a relief program are not troubled debt restructurings (“TDRs”). The Coronavirus Aid, Relief and Economic Security (“CARES”) Act was passed by Congress on March 27, 2020. The CARES Act also addressed COVID-19 related modifications and specified that COVID-19 related modifications on loans that were current as of December 31, 2019 are not TDRs. The Bank has applied this guidance related to payment deferrals and other COVID-19 related loan modifications made through March 31, 2020, and additional modifications are expected in the second quarter of 2020.

 

The CARES Act also included an allocation of $349 billion for loans to be issued by financial institutions through the Small Business Administration (“SBA”). This program is known as the Paycheck Protection Program (“PPP”). PPP loans are forgivable, in whole or in part, if the proceeds are used for eligible payroll costs and other permitted purposes in accordance with the requirements of the PPP. These loans carry a fixed rate of 1.00% and a term of two years, if not forgiven in whole or in part. Payments are deferred for the first six months of the loan and the loans are 100% guaranteed by the SBA. The SBA pays the originating bank a processing fee ranging from 1% to 5%, based on the size of the loan. The SBA began accepting submissions for these PPP loans on April 3, 2020 and the initial allocation of funds was exhausted on April 16, 2020. An additional $310 billion was allocated to the PPP on April 27, 2020. Through May 6, 2020, the Bank had received SBA authorizations for PPP loans totaling approximately $44.6 million. Participation in the PPP will likely have a positive impact on the Company’s financial position and results of operations as this fee income is recognized over the term of the PPP loans.

 

2.

Investment Securities

 

Investment securities have been classified in the consolidated balance sheets according to management’s intent. Investment securities at March 31, 2020 and December 31, 2019 are summarized as follows:

 

 

Agency notes and bonds, agency mortgage-backed securities and agency collateralized mortgage obligations (“CMO”) include securities issued by the Government National Mortgage Association (“GNMA”), a U.S. government agency, and the Federal National Mortgage Association (“FNMA”), the Federal Home Loan Mortgage Corporation (“FHLMC”) and the Federal Home Loan Bank (“FHLB”), which are government-sponsored enterprises.

 

 

 

FIRST CAPITAL, INC.

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The amortized cost and fair value of debt securities as of March 31, 2020, by contractual maturity, are shown below. Expected maturities of mortgage-backed securities and CMO may differ from contractual maturities because the mortgages underlying the obligations may be prepaid without penalty.

 

 

Information pertaining to investment securities with gross unrealized losses at March 31, 2020, aggregated by investment category and the length of time that individual investment securities have been in a continuous position, follows.

 

 

 

FIRST CAPITAL, INC.

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Information pertaining to investment securities with gross unrealized losses at December 31, 2019, aggregated by investment category and the length of time that individual investment securities have been in a continuous position, follows.

 

 

Management evaluates securities for other-than-temporary impairment at least quarterly, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to (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) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recover in fair value.

 

At March 31, 2020, the U.S. government agency debt securities, including agency notes and bonds, mortgage-backed securities and CMO, and municipal obligations in a loss position had depreciated approximately 1.0% from the amortized cost basis. All of the U.S. government agency securities and municipal obligations are issued by U.S. government agencies, government-sponsored enterprises and municipal governments, or are secured by first mortgage loans and municipal project revenues. These unrealized losses related principally to current interest rates for similar types of securities. In analyzing an issuer’s financial condition, management considers whether the securities are issued by the federal government, its agencies or other governments, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition. As the Company has the ability to hold the debt securities until maturity, or the foreseeable future if classified as available for sale, no declines are deemed to be other-than-temporary.

 

While management does not anticipate any credit-related impairment losses at March 31, 2020, additional deterioration in market and economic conditions may have an adverse impact on credit quality in the future.

 

 

FIRST CAPITAL, INC.

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During the three months ended March 31, 2019, the Company realized gross losses of $86,000 on sales of available for sale securities and gross losses of $11,000 on sales of time deposits. During the three months ended March 31, 2020, the Company sold no securities or time deposits.

 

Certain available for sale debt securities were pledged to secure public fund deposits at March 31, 2020 and December 31, 2019.

 

Equity Securities

 

In September 2018, the Company acquired 90,000 shares of common stock in another bank holding company, representing approximately 5% of the outstanding common stock of the entity, for a total investment of $1.9 million. During the three months ended March 31, 2020, the Company recognized an unrealized loss of $394,000 on this equity investment. During the three months ended March 31, 2019, the Company recognized an unrealized gain of $131,000 on this equity investment. At March 31, 2020 and December 31, 2019, the equity investment had a fair value of $1.4 million and $1.7 million, respectively, and is included in other assets on the consolidated balance sheet.

 

3.

Loans and Allowance for Loan Losses

 

The Company’s loan and allowance for loan loss policies are as follows:

 

Loans are stated at unpaid principal balances, less net deferred loan fees and the allowance for loan losses. The Company originates real estate mortgage, commercial business and consumer loans. A substantial portion of the loan portfolio is represented by mortgage loans to customers in the Louisville, Kentucky metropolitan statistical area (MSA). The ability of the Company’s customers to honor their loan agreements is largely dependent upon the real estate and general economic conditions in this area.

 

Loan origination and commitment fees, as well as certain direct costs of underwriting and closing loans, are deferred and amortized as a yield adjustment to interest income over the lives of the related loans using the interest method. Amortization of net deferred loan fees is discontinued when a loan is placed on nonaccrual status.

 

The recognition of income on a loan is discontinued and previously accrued interest is reversed, when interest or principal payments become 90 days past due unless, in the opinion of management, the outstanding interest remains collectible. Past due status is determined based on contractual terms. Generally, by applying the cash receipts method, interest income is subsequently recognized only as received until the loan is returned to accrual status. The cash receipts method is used when the likelihood of further loss on the loan is remote. Otherwise, the Company applies the cost recovery method and applies all payments as a reduction of the unpaid principal balance until the loan qualifies for return to accrual status. Interest income on impaired loans is recognized using the cost recovery method, unless the likelihood of further loss on the loan is remote.

 

A loan is restored to accrual status when all principal and interest payments are brought current and the borrower has demonstrated the ability to make future payments of principal and interest as scheduled, which generally requires that the borrower demonstrate a period of performance of at least six consecutive months.

 

 

FIRST CAPITAL, INC.

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For portfolio segments other than consumer loans, the Company’s practice is to charge-off any loan or portion of a loan when the loan is determined by management to be uncollectible due to the borrower’s failure to meet repayment terms, the borrower’s deteriorating or deteriorated financial condition, the depreciation of the underlying collateral, the loan’s classification as a loss by regulatory examiners, or for other reasons. A partial charge-off is recorded on a loan when the uncollectibility of a portion of the loan has been confirmed, such as when a loan is discharged in bankruptcy, the collateral is liquidated, a loan is restructured at a reduced principal balance, or other identifiable events that lead management to determine the full principal balance of the loan will not be repaid. A specific reserve is recognized as a component of the allowance for estimated losses on loans individually evaluated for impairment. Partial charge-offs on nonperforming and impaired loans are included in the Company’s historical loss experience used to estimate the general component of the allowance for loan losses as discussed below. Specific reserves are not considered charge-offs in management’s analysis of the allowance for loan losses because they are estimates and the outcome of the loan relationship is undetermined.

 

Consumer loans not secured by real estate are typically charged off at 90 days past due, or earlier if deemed uncollectible, unless the loans are in the process of collection. Overdrafts are charged off after 45 days past due. Charge-offs are typically recorded on loans secured by real estate when the property is foreclosed upon.

 

The allowance for loan losses reflects management’s judgment of probable loan losses inherent in the loan portfolio at the balance sheet date. Additions to the allowance for loan losses are made by the provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

 

The Company uses a disciplined process and methodology to evaluate the allowance for loan losses on at least a quarterly basis that is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

 

The allowance consists of specific and general components. The specific component relates to loans that are individually evaluated for impairment or loans otherwise classified as doubtful, substandard, or special mention. For such loans that are also classified as impaired, an allowance is established when the underlying discounted collateral value (or present value of estimated future cash flows) of the impaired loan is lower than the carrying value of that loan.

 

 

FIRST CAPITAL, INC.

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The general component covers loans not considered to be impaired. Such loans are pooled by segment and losses are modeled using annualized historical loss experience adjusted for qualitative factors. The historical loss experience is determined by portfolio segment and is based on the actual loss history experienced by the Company over the prior five years. The Company’s historical loss experience is then adjusted for qualitative factors that are reviewed on a quarterly basis based on the risks present for each portfolio segment. Management considers changes and trends in the following qualitative loss factors: underwriting standards, economic conditions, changes and trends in past due and classified loans, collateral valuations, loan concentrations and other internal and external factors.

 

Management also applies additional loss factor multiples to loans classified as watch, special mention and substandard that are not individually evaluated for impairment. The loss factor multiples for classified loans are based on management’s assessment of historical trends regarding losses experienced on classified loans in prior periods. See below for additional discussion of the qualitative factors utilized in management’s allowance for loan loss methodology at March 31, 2020 and December 31, 2019.

 

Management exercises significant judgment in evaluating the relevant historical loss experience and the qualitative factors. Management also monitors the differences between estimated and actual incurred loan losses for loans considered impaired in order to evaluate the effectiveness of the estimation process and make any changes in the methodology as necessary.

 

Management utilizes the following portfolio segments in its analysis of the allowance for loan losses: residential real estate, land, construction, commercial real estate, commercial business, home equity and second mortgage, and other consumer loans. Additional discussion of the portfolio segments and the risks associated with each segment can be found in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019.

 

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

 

 

FIRST CAPITAL, INC.

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Values for collateral dependent loans are generally based on appraisals obtained from independent licensed real estate appraisers, with adjustments applied for estimated costs to sell the property, costs to complete unfinished or repair damaged property and other factors. New appraisals are generally obtained for all significant properties when a loan is identified as impaired, and a property is considered significant if the value of the property is estimated to exceed $200,000. Subsequent appraisals are obtained as needed or if management believes there has been a significant change in the market value of the property. In instances where it is not deemed necessary to obtain a new appraisal, management bases its impairment and allowance for loan loss analysis on the original appraisal with adjustments for current conditions based on management’s assessment of market factors and management’s inspection of the property.

 

At March 31, 2020, the Company held no foreclosed real estate. At December 31, 2019, the balance of foreclosed real estate includes $170,000 of residential real estate properties where physical possession had been obtained. At March 31, 2020 and December 31, 2019, the recorded investment in loans secured by residential real estate properties for which formal foreclosure proceedings are in process was $289,000 and $319,000, respectively.

 

Loans at March 31, 2020 and December 31, 2019 consisted of the following:

 

 

 

FIRST CAPITAL, INC.

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The following table provides the components of the Company’s recorded investment in loans at March 31, 2020:

 

 

 

 

FIRST CAPITAL, INC.

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The following table provides the components of the Company’s recorded investment in loans at December 31, 2019:

 

 

 

 

FIRST CAPITAL, INC.

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An analysis of the allowance for loan losses as of March 31, 2020 is as follows:

 

 

An analysis of the allowance for loan losses as of December 31, 2019 is as follows:

 

 

 

 

FIRST CAPITAL, INC.

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An analysis of the changes in the allowance for loan losses for the three months ended March 31, 2020 is as follows:

 

 

An analysis of the changes in the allowance for loan losses for the three months ended March 31, 2019 is as follows:

 

 

 

 

FIRST CAPITAL, INC.

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At March 31, 2020 and December 31, 2019, the estimated allowance for loan losses related to qualitative factor adjustments to various portfolio segments totaled approximately $4.1 million and $3.8 million, respectively. These changes were made to reflect management’s estimates of inherent losses in these portfolio segments at March 31, 2020 and December 31, 2019. The increases to qualitative factors at March 31, 2020 were largely related to economic uncertainties surrounding COVID-19.

 

Management also adjusts the historical loss factors for loans classified as watch, special mention and substandard that are not individually evaluated for impairment. The adjustments consider the increased likelihood of loss on classified loans based on the Company’s separate historical experience for classified loans. The effect of the adjustments for classified loans was to increase the estimated allowance for loan losses by $407,000 and $386,000 at March 31, 2020 and December 31, 2019, respectively. These factors were not adjusted during the period from December 31, 2019 to March 31, 2020.

 

 

 

 

 

FIRST CAPITAL, INC.

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The following table summarizes the Company’s impaired loans as of March 31, 2020 and for the three months ended March 31, 2020 and 2019. The Company did not recognize any interest income on impaired loans using the cash receipts method of accounting for the three month periods ended March 31, 2020 and 2019:

 

 

 

 

FIRST CAPITAL, INC.

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The following table summarizes the Company’s impaired loans as of December 31, 2019:

 

 

 

 

FIRST CAPITAL, INC.

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Nonperforming loans consists of nonaccrual loans and loans over 90 days past due and still accruing interest. The following table presents the recorded investment in nonperforming loans at March 31, 2020 and December 31, 2019:

 

 

The following table presents the aging of the recorded investment in loans at March 31, 2020:

 

 

 

 

FIRST CAPITAL, INC.

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The following table presents the aging of the recorded investment in loans at December 31, 2019:

 

 

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, public information, historical payment experience, credit documentation, and current economic trends, among other factors. The Company classifies loans based on credit risk at least quarterly. The Company uses the following regulatory definitions for risk ratings:

 

Special Mention: Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date.

 

Substandard: Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

 

Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

 

Loss: Loans classified as loss are considered uncollectible and of such little value that their continuance on the institution’s books as an asset is not warranted.

 

Loans not meeting the criteria above that are analyzed individually as part of the described process are considered to be pass rated loans.

 

 

FIRST CAPITAL, INC.

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The following table presents the recorded investment in loans by risk category as of the date indicated:

 

 

 

 

FIRST CAPITAL, INC.

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The following table summarizes the Company’s TDRs by accrual status as of March 31, 2020 and December 31, 2019:

 

 

At March 31, 2020 and December 31, 2019, there were no commitments to lend additional funds to debtors whose loan terms have been modified in a TDR.

 

The Company restructured one commercial real estate loan and one residential mortgage loan during the three months ended March 31, 2020, with a pre-modification and post-modification outstanding balance of $265,000. The terms of the modifications included the deferral of contractual principal payments and a maturity extension to lower the payment. There were no TDRs that were restructured during the three months ended March 31, 2019.

 

There were no principal charge-offs recorded as a result of TDRs and there was no specific allowance for loan losses related to TDRs modified during the three months ended March 31, 2020 or 2019.

 

 

FIRST CAPITAL, INC.

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There were no TDRs modified within the previous 12 months for which there was a subsequent payment default (defined as the loan becoming more than 90 days past due, being moved to nonaccrual status, or the collateral being foreclosed upon) during the three months ended March 31, 2020 and 2019. In the event that a TDR subsequently defaults, the Company evaluates the restructuring for possible impairment. As a result, the related allowance for loan losses may be increased or charge-offs may be taken to reduce the carrying amount of the loan.

 

As discussed in Note 1, the federal banking agencies issued guidance in March 2020 that short-term modifications (e.g., six months) made to a borrower affected by the COVID-19 pandemic does not need to be identified as a TDR if the loan was current at the time of the modification. The CARES Act also addressed COVID-19 related modifications and specified that such modifications made on loans that were current as of December 31, 2019 are not TDRs. As of May 6, 2020, the Bank had approved payment extensions using this guidance on approximately 11.7% of balances in the loan portfolio, primarily related to commercial real estate lending relationships. These payment extensions are generally for periods of one to three months, but may extend for up to six months.

 

Purchased Credit Impaired (PCI) Loans

 

Purchased loans acquired in a business combination are recorded at estimated fair value on their purchase date with no carryover of the related allowance for loan and lease losses. Such loans are accounted for individually or aggregated into pools of loans based on common risk characteristics such as credit score, loan type and date of origination. In determining the estimated fair value of purchased loans or pools, management considers a number of factors including the remaining life, estimated prepayments, estimated loss ratios, estimated value of the underlying collateral, and net present value of cash flows expected to be received, among others. Purchased loans that have evidence of credit deterioration since origination for which it is deemed probable at the date of acquisition that the acquirer will not collect all contractually required principal and interest payments are accounted for in accordance with FASB Accounting Standards Codification (“ASC”) 310-30. The difference between contractually required payments and the cash flows expected to be collected at acquisition is referred to as the nonaccretable difference. The difference between the expected cash flows and the fair value at acquisition is recorded as interest income over the remaining life of the loan or pool of loans and is referred to as the accretable yield. Subsequent decreases to the expected cash flows will generally result in a provision for loan losses. Subsequent increases in expected cash flows will result in a reversal of the provision for loan losses to the extent of prior charges and then an adjustment to accretable yield, which is recognized as future interest income.

 

The following table presents the carrying amount of PCI loans accounted for under ASC 310-30 at March 31, 2020 and December 31, 2019:

 

 

 

 

FIRST CAPITAL, INC.

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The outstanding balance of PCI loans accounted for under ASC 310-30, including contractual principal, interest, fees and penalties was $452,000 and $466,000 at March 31, 2020 and December 31, 2019, respectively.

 

There was a $23,000 allowance for loan losses related to PCI loans at March 31, 2020 and a $12,000 allowance for loan losses related to PCI loans at December 31, 2019. There was a $11,000 provision for loan losses related to PCI loans for the three-month period ended March 31, 2020. There were no net provisions for loan losses related to PCI loans for the three-month period ended March 31, 2019.

 

Accretable yield, or income expected to be collected, is as follows for the three month periods ended March 31, 2020 and 2019: