SOUTHERN FIRST BANCSHARES INC - Quarter Report: 2021 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2021

OR

☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period from    to

Commission file number 000-27719

 

Southern First Bancshares, Inc.

(Exact name of registrant as specified in its charter)

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

 

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

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

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

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 7,913,381 shares of common stock, par value $0.01 per share, were issued and outstanding as of October 21, 2021.

SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY

September 30, 2021 Form 10-Q

INDEX

PART I. CONSOLIDATED FINANCIAL INFORMATION

Item 1. CONSOLIDATED FINANCIAL STATEMENTS

SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

See notes to consolidated financial statements that are an integral part of these consolidated statements.

SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

See notes to consolidated financial statements that are an integral part of these consolidated statements.

SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

See notes to consolidated financial statements that are an integral part of these consolidated statements.

SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(Unaudited)

SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 – Nature of Business and Basis of Presentation

Business Activity

Southern First Bancshares, Inc. (the “Company”) is a South Carolina corporation that owns all of the capital stock of Southern First Bank (the “Bank”) and all of the stock of Greenville First Statutory Trusts I and II (collectively, the “Trusts”). The Trusts are special purpose non-consolidated entities organized for the sole purpose of issuing trust preferred securities. The Bank's primary federal regulator is the Federal Deposit Insurance Corporation (the “FDIC”). The Bank is also regulated and examined by the South Carolina Board of Financial Institutions. The Bank is primarily engaged in the business of accepting demand deposits and savings deposits insured by the FDIC, and providing commercial, consumer and mortgage loans to the general public.

Basis of Presentation

The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three- and nine-month period ended September 30, 2021 are not necessarily indicative of the results that may be expected for the year ending December 31, 2021. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2020 as filed with the U.S. Securities and Exchange Commission (“SEC”) on March 2, 2021. The consolidated financial statements include the accounts of the Company and the Bank. In accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 810, “Consolidation,” the financial statements related to the Trusts have not been consolidated.

Business Segments

In determining proper segment definition, the Company considers the materiality of a potential segment and components of the business about which financial information is available and regularly evaluated, relative to a resource allocation and performance assessment. The Company accounts for intersegment revenues and expenses as if the revenue/expense transactions were generated to third parties, that is, at current market prices. Please refer to “Note 10 – Reportable Segments” for further information on the reporting for the Company’s three business segments.

Use of Estimates

The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amount of income and expenses during the reporting periods. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, real estate acquired in the settlement of loans, fair value of financial instruments, evaluating other-than-temporary-impairment of investment securities and valuation of deferred tax assets.

Risks and Uncertainties

The unprecedented and rapid spread of COVID-19 and its variants and the associated impacts on trade (including supply chains and export levels), travel, employee productivity, unemployment, consumer spending, and other economic activities has resulted in less economic activity, lower equity market valuations and significant volatility and disruption in financial markets, and has had an adverse effect on the Company’s business, financial condition and results of operations. The ultimate extent of the impact of the COVID-19 pandemic on the Company’s business, financial condition and results of operations is currently uncertain and the timing and pace of recovery will depend on various developments and other factors, including, among others, the duration and scope of the pandemic, as well as governmental, regulatory and private sector initiatives, the effect of the continued rollout of vaccinations for the virus, whether such vaccinations will be effective against any resurgence of the virus, including any new strain of the virus, the ability for clients and businesses to return to, and remain in, their pre-pandemic routines, and the associated impacts on the economy, financial markets and our clients, employees and vendors.

The Company’s business, financial condition and results of operations generally rely upon the ability of the Bank’s borrowers to repay their loans, the value of collateral underlying the Bank’s secured loans, and demand for loans and other products and services the Bank offers, which are highly dependent on the business environment in the Bank’s primary markets where it operates and in the United States as a whole.

In addition, due to the COVID-19 pandemic, market interest rates declined significantly with the 10-year Treasury bond falling to a low of 0.52% in early August 2020 but increasing significantly since that time to near 1.50% at September 30, 2021. On March 3, 2020, the Federal Reserve reduced the target federal funds rate by 50 basis points, followed by an additional reduction of 100 basis points on March 16, 2020, making the target federal funds rate range 0% to 0.25%, and this low target rate was still in effect as of September 30, 2021. These reductions in interest rates and other effects of the COVID-19 pandemic have had, and are expected to continue to have, possibly materially, an adverse effect on Company’s business, financial condition and results of operations. For instance, the pandemic has had negative effects on the Bank’s interest income, provision for loan losses, and certain transaction-based line items of noninterest income. Other financial impacts could occur though such potential impact is unknown at this time.

As of September 30, 2021, the Company's and the Bank's capital ratios were in excess of all regulatory requirements. While management believes that we have sufficient capital to withstand an extended economic recession brought about by the COVID-19 pandemic, our reported and regulatory capital ratios could be adversely impacted by further credit losses.

The Company maintains access to multiple sources of liquidity, including a $15.0 million holding company line of credit with another bank which could be used to support capital ratios at the subsidiary bank. As of September 30, 2021, the $15.0 million line was unused.

Reclassifications

Certain amounts, previously reported, have been reclassified to state all periods on a comparable basis and had no effect on shareholders’ equity or net income.

Subsequent Events

Subsequent events are events or transactions that occur after the balance sheet date but before financial statements are issued. Recognized subsequent events are events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements. Non-recognized subsequent events are events that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date.

Newly Issued, But Not Yet Effective Accounting Standards

In June 2016, the FASB issued ASU 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments”. Among other things, ASU 2016-13 requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to form their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. In addition, ASU 2016-13 amends the accounting for credit losses on debt securities and purchased financial assets with credit deterioration. ASU 2016-13 was originally effective for all annual and interim periods beginning after December 31, 2019, with early adoption permitted for fiscal years beginning after December 15, 2018. In November 2019, the FASB issued guidance that addresses issues raised by stakeholders during the implementation of ASU 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments”. The amendments affect a variety of Topics in the Accounting Standards Codification. For public business entities that meet the definition of a smaller reporting company, such as the Company, the amendments are effective for fiscal years beginning after December 15, 2022 including interim periods within those fiscal years. Early adoption is permitted in any interim period as long as the Company has adopted to amendments in ASU 2016-13. Currently, the Company is evaluating the impact of adoption on its financial statements and is considering early adoption of the ASU as of January 1, 2022. Adoption will be applied through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective. The Company has established a team of individuals from credit, finance and risk management to evaluate the requirements of the new standard and the impact it will have on its processes.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on the consolidated financial statements upon adoption.

NOTE 2 – Investment Securities

The amortized costs and fair value of investment securities are as follows:

Contractual maturities and yields on the Company’s investment securities at September 30, 2021 and December 31, 2020 are shown in the following table. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

The tables below summarize gross unrealized losses on investment securities and the fair market value of the related securities at September 30, 2021 and December 31, 2020, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position.

At September 30, 2021 the Company had 43 individual investments with a fair market value of $53.9 million that were in an unrealized loss position for less than 12 months and 18 individual investments with a fair market value of $17.6 million that were in an unrealized loss position for 12 months or longer. The unrealized losses were primarily attributable to changes in interest rates, rather than deterioration in credit quality. The individual securities are each investment grade securities. The Company considers the length of time and extent to which the fair value of available-for-sale debt securities have been less than cost to conclude that such securities are not other-than-temporarily impaired. The Company also considers other factors such as the financial condition of the issuer including credit ratings and specific events affecting the operations of the issuer, volatility of the security, underlying assets that collateralize the debt security, and other industry and macroeconomic conditions.

As the Company has no intent to sell securities with unrealized losses and it is not more-likely-than-not that the Company will be required to sell these securities before recovery of amortized cost, the Company has concluded that these securities are not impaired on an other-than-temporary basis.

Other investments are comprised of the following and are recorded at cost which approximates fair value.

The Company has evaluated the Federal Home Loan Bank (“FHLB”) stock for impairment and determined that the investment in the FHLB stock is not other than temporarily impaired as of September 30, 2021 and that ultimate recoverability of the par value of this investment is probable. All of the FHLB stock is used to collateralize advances with the FHLB.

NOTE 3 – Mortgage Loans Held for Sale

Mortgage loans originated and intended for sale in the secondary market are reported as loans held for sale and carried at fair value under the fair value option with changes in fair value recognized in current period earnings. At the date of funding of the mortgage loan held for sale, the funded amount of the loan, the related derivative asset or liability of the associated interest rate lock commitment, less direct loan costs becomes the initial recorded investment in the loan held for sale. Such amount approximates the fair value of the loan. At September 30, 2021, mortgage loans held for sale totaled $31.6 million compared to $60.3 million at December 31, 2020.

Mortgage loans held for sale are considered de-recognized, or sold, when the Company surrenders control over the financial assets. Control is considered to have been surrendered when the transferred assets have been isolated from the Company, beyond the reach of the Company and its creditors; the purchaser obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets; and the Company does not maintain effective control over the transferred assets through an agreement that both entitles and obligates the Company to repurchase or redeem the transferred assets before their maturity or the ability to unilaterally cause the holder to return specific assets.

Gains and losses from the sale of mortgage loans are recognized based upon the difference between the sales proceeds and carrying value of the related loans upon sale and are recorded in mortgage banking income in the statement of income. Mortgage banking income also includes the unrealized gains and losses associated with the loans held for sale and the realized and unrealized gains and losses from derivatives.

Mortgage loans sold to investors by the Company, and which were believed to have met investor and agency underwriting guidelines at the time of sale, may be subject to repurchase or indemnification in the event of specific default by the borrower or subsequent discovery that underwriting standards were not met. The Company may, upon mutual agreement, agree to repurchase the loans or indemnify the investor against future losses on such loans. In such cases, the Company bears any subsequent credit loss on the loans. As appropriate, the Company establishes mortgage repurchase reserves related to various representations and warranties that reflect management’s estimate of losses.

NOTE 4 – Loans and Allowance for Loan Losses

The following table summarizes the composition of our loan portfolio. Total gross loans are recorded net of deferred loan fees and costs, which totaled $4.6 million as of September 30, 2021 and $3.9 million as of December 31, 2020.

Maturities and Sensitivity of Loans to Changes in Interest Rates

The information in the following tables summarizes the loan maturity distribution by type and related interest rate characteristics based on the contractual maturities of individual loans, including loans which may be subject to renewal at their contractual maturity. Renewal of such loans is subject to review and credit approval, as well as modification of terms upon maturity. Actual repayments of loans may differ from the maturities reflected below, because borrowers have the right to prepay obligations with or without prepayment penalties.

Paycheck Protection Program (“PPP”)

On March 27, 2020, President Trump signed the Coronavirus Aid, Relief, and Economic Security Act (the “CARES” Act or the “Act”) to provide emergency assistance and health care response for individuals, families, and businesses affected by the coronavirus pandemic. The Small Business Administration (“SBA”) received funding and authority through the Act to modify existing loan programs and establish a new loan program to assist small businesses nationwide adversely impacted by the COVID-19 emergency. The Act temporarily permits the SBA to guarantee 100% of certain loans under a new program titled the “Paycheck Protection Program” and also provides for forgiveness of up to the full principal amount of qualifying loans guaranteed under the PPP.

We became an approved SBA lender in March 2020 and processed 853 loans under the PPP for a total of $97.5 million during the second quarter of 2020. On June 26, 2020, we completed the sale of our PPP loan portfolio to The Loan Source Inc., together with its servicing partner, ACAP SME LLC, receiving net lender fees of $2.2 million during the three months ended June 30, 2020.

The SBA offered a second round of PPP loans through May 31, 2021; however, we did not originate any new PPP loans. We did, however, receive referral fees of approximately $268,000 during the three months ended June 30, 2021 from The Loan Source Inc. for PPP loans they originated to our clients.

Portfolio Segment Methodology

Commercial

Commercial loans are assessed for estimated losses by grading each loan using various risk factors identified through periodic reviews. The Company applies historic grade-specific loss factors to each loan class. In the development of statistically derived loan grade loss factors, the Company observes historical losses over 20 quarters for each loan grade. These loss estimates are adjusted as appropriate based on additional analysis of external loss data or other risks identified from current economic conditions and credit quality trends. The allowance also includes an amount for the estimated impairment on nonaccrual commercial loans and commercial loans modified in a troubled debt restructuring (“TDR”), whether on accrual or nonaccrual status.

Consumer

For consumer loans, the Company determines the allowance on a collective basis utilizing historical losses over 20 quarters to represent its best estimate of inherent loss. The Company pools loans, generally by loan class with similar risk characteristics. The allowance also includes an amount for the estimated impairment on nonaccrual consumer loans and consumer loans modified in a TDR, whether on accrual or nonaccrual status.

Credit Quality Indicators

Commercial

We manage a consistent process for assessing commercial loan credit quality by monitoring its loan grading trends and past due statistics. All loans are subject to individual risk assessment. Our risk categories include Pass, Special Mention, Substandard, and Doubtful, each of which is defined by our banking regulatory agencies. Delinquency statistics are also an important indicator of credit quality in the establishment of our allowance for loan losses.

We categorize our loans into risk categories based on relevant information about the ability of the borrower to service their debt such as current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. A description of the general characteristics of the risk grades is as follows:

•

Pass—These loans range from minimal credit risk to average credit risk; however, still have acceptable credit risk.  

•

Special mention—A special mention loan has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or the institution’s credit position at some future date.  

•

Substandard—A substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness, or weaknesses, that may jeopardize the liquidation of the debt. A substandard loan is characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.  

•

Doubtful—A doubtful loan has all of the weaknesses inherent in one classified as substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of the currently existing facts, conditions and values, highly questionable and improbable.  

The following tables provide past due information for outstanding commercial loans and include loans on nonaccrual status as well as accruing TDRs.

As of September 30, 2021 and December 31, 2020, loans 30 days or more past due represented 0.49% and 0.17% of the Company’s total loan portfolio, respectively. Commercial loans 30 days or more past due were 0.40% and 0.08% of the Company’s total loan portfolio as of September 30, 2021 and December 31, 2020, respectively.

The tables below provide a breakdown of outstanding commercial loans by risk category.

Consumer

The Company manages a consistent process for assessing consumer loan credit quality by monitoring its loan grading trends and past due statistics. All loans are subject to individual risk assessment. The Company’s categories include Pass, Special Mention, Substandard, and Doubtful, which are defined above. Delinquency statistics are also an important indicator of credit quality in the establishment of the allowance for loan losses.

The following tables provide past due information for outstanding consumer loans and include loans on nonaccrual status as well as accruing TDRs.

Consumer loans 30 days or more past due were 0.09% of total loans as of both September 30, 2021 and December 31, 2020.

The tables below provide a breakdown of outstanding consumer loans by risk category.

Nonperforming assets

The following table shows the nonperforming assets and the related percentage of nonperforming assets to total assets and gross loans. Generally, a loan is placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when the Company believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the contractual principal or interest on the loan is doubtful. A payment of interest on a loan that is classified as nonaccrual is recognized as a reduction in principal when received.

Following is a summary of our nonperforming assets, including nonaccruing TDRs.

Impaired Loans

The table below summarizes key information for impaired loans. The Company’s impaired loans include loans on nonaccrual status and loans modified in a TDR, whether on accrual or nonaccrual status. These impaired loans may have estimated impairment which is included in the allowance for loan losses. The Company’s commercial and consumer impaired loans are evaluated individually to determine the related allowance for loan losses.

The following table provides the average recorded investment in impaired loans and the amount of interest income recognized on impaired loans after impairment by portfolio segment and class.

Allowance for Loan Losses

The allowance for loan losses is management’s estimate of credit losses inherent in the loan portfolio. The allowance for loan losses is established as losses are estimated to have occurred through a 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 allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability 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 Company has an established process to determine the adequacy of the allowance for loan losses that assesses the losses inherent in the portfolio. While the Company attributes portions of the allowance to specific portfolio segments, the entire allowance is available to absorb credit losses inherent in the total loan portfolio. The Company’s process involves procedures to appropriately consider the unique risk characteristics of the commercial and consumer loan portfolio segments. For each portfolio segment, impairment is measured individually for each impaired loan. The Company’s allowance levels are influenced by loan volume, loan grade or delinquency status, historic loss experience and other economic conditions.

The following table summarizes the activity related to the allowance for loan losses by commercial and consumer portfolio segments:

The following table disaggregates the allowance for loan losses and recorded investment in loans by impairment methodology.

NOTE 5 – Troubled Debt Restructurings

At September 30, 2021, the Company had 13 loans totaling $6.8 million compared to 20 loans totaling $8.4 million at December 31, 2020, which were considered as TDRs. The Company considers a loan to be a TDR when the debtor experiences financial difficulties and the Company grants a concession to the debtor that it would not normally consider. Concessions can relate to the contractual interest rate, maturity date, or payment structure of the note. As part of the workout plan for individual loan relationships, the Company may restructure loan terms to assist borrowers facing financial challenges in the current economic environment.

A restructuring that results in only a delay in payments that is insignificant is not considered an economic concession. In accordance with the CARES Act, the Company implemented loan modification programs in response to the COVID-19 pandemic, and the Company elected the accounting policy in the CARES Act to not apply TDR accounting to loans modified for borrowers impacted by the COVID-19 pandemic.

The following table summarizes the concession at the time of modification and the recorded investment in the Company’s TDRs before and after their modification for the nine months ended September 30, 2020. There were no new TDRs for the three months ended September 30, 2021, and new TDRs for the three months ended September 30, 2020 were immaterial. The total TDRs for the nine months ended September 30, 2021 were not material.

As of September 30, 2021 and 2020, there were no loans modified as a TDR for which there was a payment default (60 days past due) within 12 months of the restructuring date.

NOTE 6 – Derivative Financial Instruments

The Company utilizes derivative financial instruments primarily to hedge its exposure to changes in interest rates. All derivative financial instruments are recognized as either assets or liabilities and measured at fair value. The Company accounts for all of its derivatives as free-standing derivatives and does not designate any of these instruments for hedge accounting. Therefore, the gain or loss resulting from the change in the fair value of the derivative is recognized in the Company’s statement of income during the period of change.

The Company enters into commitments to originate residential mortgage loans held for sale, at specified interest rates and within a specified period of time, with clients who have applied for a loan and meet certain credit and underwriting criteria (interest rate lock commitments). These interest rate lock commitments (“IRLCs”) meet the definition of a derivative financial instrument and are reflected in the balance sheet at fair value with changes in fair value recognized in current period earnings. Unrealized gains and losses on the IRLCs are recorded as derivative assets and derivative liabilities, respectively, and are measured based on the value of the underlying mortgage loan, quoted mortgage-backed securities (“MBS”) prices and an estimate of the probability that the mortgage loan will fund within the terms of the interest rate lock commitment, net of estimated commission expenses.

The Company manages the interest rate and price risk associated with its outstanding IRLCs and mortgage loans held for sale by entering into derivative instruments such as forward sales of MBS. Management expects these derivatives will experience changes in fair value opposite to changes in fair value of the IRLCs and mortgage loans held for sale, thereby reducing earnings volatility. The Company takes into account various factors and strategies in determining the portion of the mortgage pipeline (IRLCs and mortgage loans held for sale) it wants to economically hedge.

The following table summarizes the Company’s outstanding financial derivative instruments at September 30, 2021 and December 31, 2020.

NOTE 7 – Fair Value Accounting

FASB ASC 820, “Fair Value Measurement and Disclosures,” defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1 – Quoted market price in active markets

Quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities include certain debt and equity securities that are traded in an active exchange market.

Level 2 – Significant other observable inputs

Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include fixed income securities and mortgage-backed securities that are held in the Company’s available-for-sale portfolio and valued by a third-party pricing service, as well as certain impaired loans.

Level 3 – Significant unobservable inputs

Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. These methodologies may result in a significant portion of the fair value being derived from unobservable data.

The methods of determining the fair value of assets and liabilities presented in this note are consistent with our methodologies disclosed in Note 14 of the Company’s 2020 Annual Report on Form 10-K. The Company’s loan portfolio is initially fair valued using a segmented approach, using the eight categories of loans as disclosed in Note 4 – Loans and Allowance for Loan Losses. Loans are considered a Level 3 classification.

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

The tables below present the recorded amount of assets and liabilities measured at fair value on a recurring basis as of September 30, 2021 and December 31, 2020.

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

The tables below present the recorded amount of assets and liabilities measured at fair value on a nonrecurring basis as of September 30, 2021 and December 31, 2020.

The Company had no liabilities carried at fair value or measured at fair value on a nonrecurring basis.

Fair Value of Financial Instruments

Financial instruments require disclosure of fair value information, whether or not recognized in the consolidated balance sheets, when it is practical to estimate the fair value. A financial instrument is defined as cash, evidence of an ownership interest in an entity or a contractual obligation which requires the exchange of cash. Certain items are specifically excluded from the disclosure requirements, including the Company’s common stock, premises and equipment and other assets and liabilities.

The estimated fair values of the Company’s financial instruments at September 30, 2021 and December 31, 2020 are as follows:

NOTE 8 – Leases

Effective January 1, 2019, the Company adopted ASU 2016-02, “Leases (Topic 842)”. As of September 30, 2021, we leased seven of our offices under various operating lease agreements. The lease agreements have maturity dates ranging from February 2022 to February 2032, some of which include options for multiple five-year extensions. The weighted average remaining life of the lease term for these leases was 7.54 years as of September 30, 2021.

The discount rate used in determining the lease liability for each individual lease was the FHLB fixed advance rate which corresponded with the remaining lease term as of January 1, 2019 for leases that existed at adoption and as of the lease commencement date for leases subsequently entered into. The weighted average discount rate for leases was 2.48% as of September 30, 2021.

The total operating lease costs were $711,000 and $616,000 for the three months ended September 30, 2021 and 2020, respectively, and $2.1 million and $1.8 million for the nine months ended September 30, 2021 and 2020, respectively. The right-of-use (ROU) asset, included in property and equipment, and lease liability, included in other liabilities, were $21.9 million and $23.0 million as of September 30, 2021, respectively, compared to $18.8 million and $19.5 million as of December 31, 2020, respectively. The ROU asset and lease liability are recognized at lease commencement by calculating the present value of lease payments over the lease term.

Maturities of lease liabilities as of September 30, 2021 were as follows:

NOTE 9 – Earnings Per Common Share

The following schedule reconciles the numerators and denominators of the basic and diluted earnings per share computations for the three and nine month periods ended September 30, 2021 and 2020. Dilutive common shares arise from the potentially dilutive effect of the Company’s stock options that were outstanding at September 30, 2021. The assumed conversion of stock options can create a difference between basic and dilutive net income per common share. At September 30, 2021 and 2020, there were 159,029 and 337,998 options, respectively, that were not considered in computing diluted earnings per common share because they were anti-dilutive.

NOTE 10 – Reportable Segments

The Company’s reportable segments represent the distinct product lines the Company offers and are viewed separately for strategic planning purposes by management. The three segments include Commercial and Retail Banking, Mortgage Banking, and Corporate. The following schedule presents financial information for each reportable segment.

Commercial and retail banking. The Company’s primary business is to provide traditional deposit and lending products and services to its commercial and retail banking clients.

Mortgage banking. The mortgage banking segment provides mortgage loan origination services for loans that will be sold in the secondary market to investors.

Corporate. Corporate is comprised primarily of compensation and benefits for certain members of management and interest on parent company debt.

Item 2. MANAGEMENT’S DISCUSSION AND Analysis of Financial Condition and Results of Operations.

 

The following discussion reviews our results of operations for the three and nine month periods ended September 30, 2021 as compared to the three and nine month periods ended September 30, 2020 and assesses our financial condition as of September 30, 2021 as compared to December 31, 2020. You should read the following discussion and analysis in conjunction with the accompanying consolidated financial statements and the related notes and the consolidated financial statements and the related notes for the year ended December 31, 2020 included in our Annual Report on Form 10-K for that period. Results for the three and nine month periods ended September 30, 2021 are not necessarily indicative of the results for the year ending December 31, 2021 or any future period.

 

Unless the context requires otherwise, references to the “Company,” “we,” “us,” “our,” or similar references mean Southern First Bancshares, Inc. and its consolidated subsidiary. References to the “Bank” refer to Southern First Bank.

 

Cautionary Warning Regarding forward-looking statements

 

This report contains statements which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). Forward-looking statements may relate to our financial condition, results of operations, plans, objectives, or future performance. These statements are based on many assumptions and estimates and are not guarantees of future performance. Our actual results may differ materially from those anticipated in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors which are beyond our control. The words “may,” “would,” “could,” “should,” “will,” “expect,” “anticipate,” “predict,” “project,” “potential,” “believe,” “continue,” “assume,” “intend,” “plan,” and “estimate,” as well as similar expressions, are meant to identify such forward-looking statements. Potential risks and uncertainties that could cause our actual results to differ from those anticipated in any forward-looking statements include, but are not limited to:

 

·

The continuing impact of COVID-19 and its variants on our business, including the impact of the actions taken by governmental authorities to try and contain the virus or address the impact of the virus on the United States economy (including, without limitation, the Coronavirus Aid, Relief and Economic Security Act, or the CARES Act), and the resulting effect of these items on our operations, liquidity and capital position, and on the financial condition of our borrowers and other customers;

·

Restrictions or conditions imposed by our regulators on our operations;

·

Increases in competitive pressure in the banking and financial services industries;

·

Changes in access to funding or increased regulatory requirements with regard to funding;

·

Changes in deposit flows;

·

Credit losses as a result of declining real estate values, increasing interest rates, increasing unemployment, changes in payment behavior or other factors;

·

Credit losses due to loan concentration;

·

Changes in the amount of our loan portfolio collateralized by real estate and weaknesses in the real estate market;

·

Our ability to successfully execute our business strategy;

·

Our ability to attract and retain key personnel;

·

The success and costs of our expansion into the Charlotte, North Carolina, Greensboro, North Carolina and Atlanta, Georgia markets and into potential new markets;

·

Changes in the interest rate environment which could reduce anticipated or actual margins;

·

Changes in political conditions or the legislative or regulatory environment, including governmental initiatives affecting the financial services industry, including as a result of the current presidential administration and Democratic control of Congress;

·

Changes in economic conditions resulting in, among other things, a deterioration in credit quality;

·

Changes occurring in business conditions and inflation;

·

Increased cybersecurity risk, including potential business disruptions or financial losses;

·

Changes in technology;

·

The adequacy of the level of our allowance for loan losses and the amount of loan loss provisions required in future periods;

·

Examinations by our regulatory authorities, including the possibility that the regulatory authorities may, among other things, require us to increase our allowance for loan losses or write-down assets;

·

Changes in monetary and tax policies;

·

The rate of delinquencies and amounts of loans charged-off;

·

The rate of loan growth in recent years and the lack of seasoning of a portion of our loan portfolio;

·

Our ability to maintain appropriate levels of capital and to comply with our capital ratio requirements;

·

Adverse changes in asset quality and resulting credit risk-related losses and expenses;

·

Changes in accounting policies and practices;

·

Risks associated with actual or potential litigation or investigations by customers, regulatory agencies or others;

·

Adverse effects of failures by our vendors to provide agreed upon services in the manner and at the cost agreed;

·

The potential effects of events beyond our control that may have a destabilizing effect on financial markets and the economy, such as epidemics and pandemics (including COVID-19), war or terrorist activities, disruptions in our customers’ supply chains, disruptions in transportation, essential utility outages or trade disputes and related tariffs; and

·

Other risks and uncertainties detailed in Part I, Item 1A, “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2020, in Part II, Item 1A, “Risk Factors” of our Quarterly Reports on Form 10-Q, and in our other filings with the SEC.

If any of these risks or uncertainties materialize, or if any of the assumptions underlying such forward-looking statements proves to be incorrect, our results could differ materially from those expressed in, implied or projected by, such forward-looking statements. We urge investors to consider all of these factors carefully in evaluating the forward-looking statements contained in this Quarterly Report on Form 10-Q. We make these forward-looking statements as of the date of this document and we do not intend, and assume no obligation, to update the forward-looking statements or to update the reasons why actual results could differ from those expressed in, or implied or projected by, the forward-looking statements, except as required by law.

 

OVERVIEW

 

Our business model continues to be client-focused, utilizing relationship teams to provide our clients with a specific banker contact and support team responsible for all of their banking needs. The purpose of this structure is to provide a consistent and superior level of professional service, and we believe it provides us with a distinct competitive advantage. We consider exceptional client service to be a critical part of our culture, which we refer to as "ClientFIRST."

 

At September 30, 2021, we had total assets of $2.78 billion, a 12.1% increase from total assets of $2.48 billion at December 31, 2020. The largest components of our total assets are loans which were $2.39 billion and $2.14 billion at September 30, 2021 and December 31, 2020, respectively. Our liabilities and shareholders’ equity at September 30, 2021 totaled $2.52 billion and $265.6 million, respectively, compared to liabilities of $2.25 billion and shareholders’ equity of $228.3 million at December 31, 2020. The principal component of our liabilities is deposits which were $2.43 billion and $2.14 billion at September 30, 2021 and December 31, 2020, respectively.

 

Like most community banks, we derive the majority of our income from interest received on our loans and investments. Our primary source of funds for making these loans and investments is our deposits, on which we pay interest. Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income on our interest-earning assets, such as loans and investments, and the expense on our interest-bearing liabilities, such as deposits and borrowings. Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities, which is called our net interest spread. In addition to earning interest on our loans and investments, we earn income through fees and other charges to our clients.

Our net income to common shareholders was $14.0 million and $2.2 million for the three months ended September 30, 2021 and 2020, respectively. Diluted earnings per share (“EPS”) was $1.75 for the third quarter of 2021 as compared to $0.28 for the same period in 2020. The increase in net income resulted primarily from a $17.1 million decrease in loan loss provision recorded in the third quarter of 2021 compared to the same period in 2020 and a $1.5 million increase in net interest income, partially offset by a $3.3 million decrease in noninterest income.

 

Our net income to common shareholders was $34.7 million and $9.7 million for the nine months ended September 30, 2021 and 2020, respectively. Diluted EPS was $4.36 for the nine months ended September 30, 2021 as compared to $1.24 for the same period in 2020. The increase in net income resulted primarily from a $35.5 million decrease in loan loss provision recorded in the first nine months of 2021 compared to the same period in 2020 and a $6.4 million increase in net interest income, partially offset by a $6.9 million decrease in noninterest income and a $2.5 million increase in noninterest expense.

 

Our mortgage banking segment reported pre-tax income of $1.1 million and $3.3 million for the three- and nine- month periods ended September 30, 2021, compared to $3.9 million and $8.7 million for the three- and nine- month periods ended September 30, 2020. Noninterest income, which consists mainly of realized and unrealized gains associated with the fair value of commitments and loans held for sale, was $2.8 million for the third quarter of 2021 as compared to $6.3 million for the third quarter of 2020. In addition, noninterest income for the first nine months of 2021 was $9.4 million as compared to $14.7 million for the first nine months of 2020. The $3.4 million and $5.3 million decreases during the 2021 periods were driven by a decline in sales activity combined with a decrease in the fair value of derivatives associated with mortgage loan commitments. Noninterest expense consists mainly of salaries, commissions and benefits of mortgage employees, professional fees and outside services and data processing costs. Noninterest expense was $2.0 million and $7.1 million for the third quarter and first nine months of 2021, respectively, as compared to $2.7 million and $6.8 million for the third quarter and first nine months of 2020, respectively. The $709,000 decrease during the third quarter of 2021 was driven by a decrease in salaries and benefits expense primarily related to commissions paid on sales activity. The $245,000 increase during the first nine months of 2021 relates primarily to an increase in salaries and benefits expense driven by an increase in fixed salaries and other benefits costs combined with an increase in professional fees.

 

recent events – covid-19 pandemic

The COVID-19 pandemic has had significant impact on our business, industry and clients. Twelve months ago, unemployment rates were at historical highs, our bank lobbies were closed to guests, and the majority of our team was working remotely. As of September 30, 2021, normalcy has begun to return as unemployment rates have continued to decrease to near pre-COVID levels, our bank lobbies have re-opened, and our team members have returned to the office. Our digital technology channels are also stronger and better utilized as a result of the pandemic.

Beginning in March 2020, we began granting loan modifications or deferrals to certain borrowers affected by the pandemic on a short-term basis of three to six months. As of September 30, 2021, all of these loans are under a normal payment structure.

We continue to monitor credit risk and our exposure to increased loan losses resulting from the impact of COVID-19 on our commercial clients. In doing so, we believe that the hospitality and tourism industry is still at risk for credit loss due to reduced business and recreational travel in our regions.

Hotel portfolio as of September 30, 2021:

	·	22 loans totaled $115.8 million
	·	0 loans remain under a deferral arrangement
	·	0% of hotel loans were 30 days or more past due
	·	0% of hotel loans were on nonaccrual
	·	Four hotel loans totaling $48.4 million were downgraded to special mention during the first quarter of 2021
	·	Seven hotel loans totaling $26.1 million were downgraded to substandard during the first quarter of 2021

As of September 30, 2021 our classified asset ratio (defined as classified assets divided by the sum of tier one capital plus the allowance for loan losses) was 14.90% compared to 8.18% at December 31, 2020 and 7.00% at September 30, 2020. The increase from the prior periods was driven by the $26.2 million of hotel loans we

downgraded to substandard during the first quarter of 2021. We will continue to closely monitor these loans as we believe they currently represent our most at-risk clients.

As of September 30, 2021, all of our capital ratios, and the Bank’s capital ratios, were in excess of all regulatory requirements. While we believe that we have sufficient capital to withstand an extended economic recession brought about by the COVID-19 pandemic, our regulatory capital ratios could be adversely impacted by further credit losses. We maintain access to multiple sources of liquidity, including a $15.0 million holding company line of credit with another bank which could be used to support capital ratios at the Bank.

results of operations

 

Net Interest Income and Margin

 

Our level of net interest income is determined by the level of earning assets and the management of our net interest margin. Our net interest income was $22.2 million for the third quarter of 2021, a 7.4% increase over net interest income of $20.6 million for the third quarter of the prior year, resulting primarily from lower deposit costs and growth in interest-earning assets, partially offset by lower yields on our interest-earning assets. In addition, our net interest margin, on a tax-equivalent basis (TE), was 3.38% for the third quarter of 2021 compared to 3.52% for the same period in 2020.

 

We have included a number of tables to assist in our description of various measures of our financial performance. For example, the “Average Balances, Income and Expenses, Yields and Rates” table reflects the average balance of each category of our assets and liabilities as well as the yield we earned or the rate we paid with respect to each category during the three- and nine- month periods ended September 30, 2021 and 2020. A review of this table shows that our loans typically provide higher interest yields than do other types of interest-earning assets, which is why we direct a substantial percentage of our earning assets into our loan portfolio. Similarly, the “Rate/Volume Analysis” table demonstrates the effect of changing interest rates and changing volume of assets and liabilities on our financial condition during the periods shown. We also track the sensitivity of our various categories of assets and liabilities to changes in interest rates, and we have included tables to illustrate our interest rate sensitivity with respect to interest-earning accounts and interest-bearing accounts.

 

The following tables entitled “Average Balances, Income and Expenses, Yield and Rates” sets forth information related to our average balance sheets, average yields on assets, and average costs of liabilities. We derived these yields by dividing income or expense by the average balance of the corresponding assets or liabilities. We derived average balances from the daily balances throughout the periods indicated. During the same periods, we had no securities purchased with agreements to resell. All investments owned have an original maturity of over one year. Nonaccrual loans are included in the following tables. Loan yields have been reduced to reflect the negative impact on our earnings of loans on nonaccrual status. The net of capitalized loan costs and fees are amortized into interest income on loans.

 

Average Balances, Income and Expenses, Yields and Rates

		For the Three Months Ended September 30,
		2021				2020
(dollars in thousands)		Average Balance	Income/ Expense	Yield/ Rate(1)		Average Balance	Income/ Expense	Yield/ Rate(1)
Interest-earning assets
Federal funds sold and interest-bearing deposits with banks		$  145,899	$     68	0.18%		$  162,092	$     63	0.15%
Investment securities, taxable		93,428	301	1.28%		77,365	261	1.34%
Investment securities, nontaxable(2)		10,974	70	2.54%		7,136	64	3.55%
Loans(3)		2,351,467	23,063	3.89%		2,088,746	23,042	4.39%
Total interest-earning assets		2,601,768	23,502	3.58%		2,335,339	23,430	3.99%
Noninterest-earning assets		132,929				104,065
Total assets		$2,734,697				$2,439,404
Interest-bearing liabilities
NOW accounts		$   316,775	48	0.06%		$   264,786	50	0.08%
Savings & money market		1,209,991	651	0.21%		1,021,850	1,176	0.46%
Time deposits		161,300	235	0.58%		296,186	1,167	1.57%
Total interest-bearing deposits		1,688,066	934	0.22%		1,582,822	2,393	0.60%
Subordinated debentures		36,062	380	4.18%		35,954	385	4.26%
Total interest-bearing liabilities		1,724,128	1,314	0.30%		1,618,776	2,778	0.68%
Noninterest-bearing liabilities		753,901				601,896
Shareholders’ equity		256,668				218,732
Total liabilities and shareholders’ equity		$2,734,697				$2,439,404
Net interest spread				3.28%				3.31%
Net interest income (tax equivalent) / margin			$22,188	3.38%			$20,652	3.52%
Less:  tax-equivalent adjustment(2)			(16)				15
Net interest income			$22,172				$20,637

(1)

Annualized for the three month period.

(2)

The tax-equivalent adjustment to net interest income adjusts the yield for assets earning tax-exempt income to a comparable yield on a taxable basis.

(3)

Includes mortgage loans held for sale.

 

Our net interest margin (TE) decreased 14 basis points to 3.38% during the third quarter of 2021, compared to the third quarter of 2020, primarily due to a reduction in yield on our interest-earning assets, partially offset by the decreased cost of our interest-bearing liabilities. Our average interest-earning assets grew by $266.4 million during the third quarter of 2021, while the average yield on these assets decreased by 41 basis points to 3.58% during the same period. In addition, our average interest-bearing liabilities grew by $105.4 million during the third quarter of 2021, while the rate on these liabilities decreased 38 basis points to 0.30%.

 

The increase in average interest-earning assets for the third quarter of 2021 related primarily to an increase of $262.7 million in our average loan balances, combined with a $19.9 million increase in investment securities, partially offset by a $16.2 million decrease in federal funds sold and interest-bearing deposits with banks. The decrease in yield on our interest earning assets was driven by a 50 basis point decrease in loan yield as our loan portfolio continues to show the impact of the Federal Reserve’s aggregate 225 basis point interest rate reduction since August 2019. These rate reductions resulted in the decreased loan yield, a decrease in yield on our federal funds sold and interest bearing-deposits with banks and a decrease in yield on our investment securities.

 

The increase in our average interest-bearing liabilities during the third quarter of 2021 resulted primarily from a $105.2 million increase in our interest-bearing deposits, while the 38 basis point decrease in rate on our interest-bearing liabilities resulted primarily from a 38 basis point decrease in deposit rates.

 

Our net interest spread was 3.28% for the third quarter of 2021 compared to 3.31% for the same period in 2020. The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities. The decrease in both the yield on our interest-earning assets and the rate on our interest-bearing liabilities resulted in a three basis point decrease in our net interest spread for the 2021 period. We anticipate continued pressure on our net interest spread and net interest margin in future periods as our loan yield continues to decline due to new and renewed loans pricing at rates lower than our current portfolio rate.

Average Balances, Income and Expenses, Yields and Rates

					For the Nine Months Ended September 30,
		2021					2020
(dollars in thousands)		Average Balance	Income/ Expense	Yield/ Rate(1)			Average Balance	Income/ Expense	Yield/ Rate(1)
Interest-earning assets
Federal funds sold and interest-bearing deposits with banks		$   118,417	$     167	0.19%			$    102,951	$      218	0.28%
Investment securities, taxable		87,981	759	1.15%			69,966	979	1.87%
Investment securities, nontaxable(2)		11,197	217	2.59%			6,854	144	2.81%
Loans(3)		2,267,611	67,938	4.01%			2,081,034	69,963	4.49%
Total interest-earning assets		2,485,206	69,081	3.72%			2,260,805	71,304	4.21%
Noninterest-earning assets		117,679					107,472
Total assets		$2,602,885					$2,368,277
Interest-bearing liabilities
NOW accounts		$   298,785	141	0.06%			$   248,373	309	0.17%
Savings & money market		1,142,409	1,817	0.21%			984,794	6,614	0.90%
Time deposits		183,239	1,051	0.77%			314,288	4,272	1.82%
Total interest-bearing deposits		1,624,433	3,009	0.25%			1,547,455	11,195	0.97%
FHLB advances and other borrowings		941	4	0.57%			41,305	335	1.08%
Junior subordinated debentures		36,035	1,143	4.24%			35,927	1,234	4.59%
Total interest-bearing liabilities		1,661,409	4,156	0.33%			1,624,687	12,764	1.05%
Noninterest-bearing liabilities		697,533					529,200
Shareholders’ equity		243,943					214,390
Total liabilities and shareholders’ equity		$2,602,885					$2,368,277
Net interest spread				3.39%					3.16%
Net interest income (tax equivalent) / margin			$64,925	3.49%				$58,540	3.46%
Less:  tax-equivalent adjustment(2)			(50)					33
Net interest income			$64,875					$58,507

(1)

Annualized for the nine month period.

(2)

The tax-equivalent adjustment to net interest income adjusts the yield for assets earning tax-exempt income to a comparable yield on a taxable basis.

(3)

Includes mortgage loans held for sale.

 

During the first nine months of 2021, our net interest margin (TE) improved by three basis points to 3.49%, compared to 3.46% for the first nine months of 2020, driven by the decrease in rate on our interest-bearing liabilities, partially offset by the lower yield on our interest-earning assets. Our average interest-earning assets grew by $224.4 million during the first nine months of 2021, with the average yield decreasing by 49 basis points. In addition, our average interest-bearing liabilities grew by $36.7 million during the 2021 period, while the rate on these liabilities decreased 72 basis points, resulting in the slight improvement in net interest margin.

 

The increase in average interest earning assets for the first nine months of 2021 related primarily to a $186.6 million increase in our average loan balances combined with a $22.4 million increase in our average investment securities. The decrease in yield on our interest-earning assets was driven by a 48 basis point decrease in our loan yield related to the interest rate reductions by the Federal Reserve.

 

In addition, our average interest-bearing liabilities increased by $36.7 million during the first nine months of 2021, driven by a $77.0 million increase in interest-bearing deposits, partially offset by a $40.4 million decrease in FHLB advances and other borrowings. The decrease in cost of our interest-bearing liabilities was driven by a 72 basis point decrease on our interest-bearing deposits.

 

Our net interest spread was 3.39% for the first nine months of 2021 compared to 3.16% for the same period of 2020. The 23 basis point increase in our net interest spread was a result of the 72 basis point decrease in cost on our interest-bearing liabilities, partially offset by the 49 basis point decrease in yield on our interest-earning assets.

Rate/Volume Analysis

Net interest income can be analyzed in terms of the impact of changing interest rates and changing volume. The following two tables set forth the effect which the varying levels of interest-earning assets and interest-bearing liabilities and the applicable rates have had on changes in net interest income for the periods presented.

 

	Three Months Ended
	September 30, 2021 vs. 2020					September 30, 2020 vs. 2019
	Increase (Decrease) Due to					Increase (Decrease) Due to
(dollars in thousands)	Volume	Rate	Rate/ Volume	Total		Volume	Rate	Rate/ Volume	Total
Interest income
Loans	$  2,898	(2,556)	(321)	21		$  3,078	(2,514)	(339)	225
Investment securities	73	(23)	(5)	45		(25)	(252)	11	(266)
Federal funds sold and interest-bearing deposits with banks	(6)	13	(2)	5		304	(620)	(284)	(600)
Total interest income	2,965	(2,566)	(328)	71		3,357	(3,386)	(612)	(641)
Interest expense
Deposits	276	(1,556)	(179)	(1,459)		893	(4,309)	(600)	(4,016)
FHLB advances and other borrowings	-	-	-	-		(218)	-	-	(218)
Subordinated debentures	1	(6)	-	(5)		245	(4)	(6)	235
Total interest expense	277	(1,562)	(179)	(1,464)		920	(4,313)	(606)	(3,999)
Net interest income	$  2,688	(1,004)	(149)	1,535		$  2,437	927	(6)	3,358

 

Net interest income, the largest component of our income, was $22.2 million for the third quarter of 2021 and $20.6 million for the third quarter of 2020, a $1.5 million, or 7.4%, increase. The increase during 2021 was driven by a $1.5 million decrease in interest expense primarily due to lower rates on our interest-bearing liabilities. In addition, interest income remained stable as the increase in loan volume offset the impact of a decrease in yield across all interest earning assets.

 

	Nine Months Ended
	September 30, 2021 vs. 2020					September 30, 2020 vs. 2019
	Increase (Decrease) Due to					Increase (Decrease) Due to
(dollars in thousands)	Volume	Rate	Rate/ Volume	Total		Volume	Rate	Rate/ Volume	Total
Interest income
Loans	$  4,994	(6,565)	(454)	(2,025)		$  11,246	(6,067)	(1,020)	4,159
Investment securities	281	(354)	(91)	(164)		(100)	(505)	31	(574)
Federal funds sold and interest-bearing deposits with banks	3	(53)	(1)	(51)		565	(1,136)	(499)	(1,070)
Total interest income	5,278	(6,972)	(546)	(2,240)		11,711	(7,708)	(1,488)	2,515
Interest expense
Deposits	966	(8,425)	(727)	(8,186)		2,672	(8,212)	(1,224)	(6,764)
FHLB advances and other borrowings	(324)	(220)	212	(332)		360	(470)	(245)	(355)
Subordinated debentures	3	(93)	-	(90)		783	(8)	(12)	763
Total interest expense	645	(8,738)	(515)	(8,608)		3,815	(8,690)	(1,481)	(6,356)
Net interest income	$  4,633	1,766	(31)	6,368		$  7,896	982	(7)	8,871

Net interest income for the first nine months of 2021 was $64.9 million compared to $58.5 million for 2020, a $6.4 million, or 10.9%, increase. The increase in net interest income during 2021 was driven by an $8.6 million decrease in interest expense related to reduced rates on our deposit balances. In contrast, the decrease in interest income was driven by lower rates on our loan portfolio which was partially offset by growth in loan balances compared to the 2020 period.

 

Provision for Loan Losses

We have established an allowance for loan losses through a provision for loan losses charged as an expense on our consolidated statements of income. We review our loan portfolio periodically to evaluate our outstanding loans and to measure both the performance of the portfolio and the adequacy of the allowance for loan losses. Please see the discussion included in Note 4 – Loans and Allowance for Loan Losses for a description of the factors we consider in determining the amount of the provision we expense each period to maintain this allowance.

For the three and nine months ended September 30, 2021, we recorded a reversal of provision for loan losses expense of $6.0 million and $8.2 million which resulted in an allowance for loan losses of $36.1 million, or 1.51% of gross loans. Comparatively, our provision for loan losses was $11.1 million and $27.3 million for the three and nine months ended September 30, 2020 which resulted in an allowance for loan losses of $42.2 million, or 2.03% of gross loans. The reversal of provision expense for the 2021 periods was driven by a reduction in qualitative adjustment factors related to the overall improvement in economic and business conditions such as unemployment and hotel occupancy rates as well as a reduction in the historical loss percentages of our various loan categories due to the low charge-off percentage during the year. In addition, we downgraded a significant portion of our hotel loan portfolio during the first quarter of 2021 as we believe the tourism and hospitality industry remains at risk of credit losses due to the pandemic, which partially offset the reduction in qualitative adjustments as an increased provision was required for these loans. Our nonperforming assets and loans 30 days or more past due increased during the third quarter of 2021 due to one client relationship which includes two commercial and one consumer real estate properties. We do not believe the increase in nonperforming and past due loans is systemic or indicative of the credit quality of our remaining portfolio.

Noninterest Income

The following table sets forth information related to our noninterest income.

 

	Three months ended September 30,			Nine months ended September 30,
(dollars in thousands)	2021	2020		2021	2020
Mortgage banking income	$   2,829	6,277		9,445	14,721
Service fees on deposit accounts	199	211		557	670
ATM and debit card income	542	465		1,532	1,258
Income from bank owned life insurance	321	270		919	810
Net lender and referral fees on PPP loans	-	-		268	2,247
Other income	348	361		1,043	1,002
Total noninterest income	$  4,239	7,584		13,764	20,708

 

Noninterest income decreased $3.3 million, or 44.1%, for the third quarter of 2021 as compared to the same period in 2020. The decrease in total noninterest income resulted primarily from the following:

 

·

Mortgage banking income decreased by $3.4 million, or 54.9%, driven by low inventory in the housing market, lower refinance volumes, and a decrease in margin on loan sales. We do not expect mortgage origination volume to continue at levels seen in the prior year which will reduce the amount of mortgage banking income recorded in future periods in comparison to prior periods.

 

Partially offsetting the above decrease was an increase in ATM and debit card income of $77,000, or 16.6%, due to an increase in debit card transactions. In addition, income from bank owned life insurance increased $51,000 as we purchased an additional $7.5 million in life insurance policies earlier in the year.

 

Noninterest income decreased $6.9 million, or 33.5%, during the first nine months of 2021 as compared to the same period of 2020. The decrease in total noninterest income resulted primarily from decreases in mortgage banking income, service fees on deposit accounts, and net lender and referral fees on PPP loans which declined $2.0 million as we originated and sold our PPP loans to a third party during the second quarter of 2020. Partially offsetting the above decreases was a $274,000 increase in ATM and debit card income.

Noninterest expenses

The following table sets forth information related to our noninterest expenses.

 

	Three months ended September 30,				Nine months ended September 30,
(dollars in thousands)	2021	2020			2021	2020
Compensation and benefits	$  7,468	6,666			20,974	19,450
Mortgage production costs	1,956	2,666			7,086	6,841
Occupancy	1,684	1,601			4,871	4,631
Real estate owned (income) expenses	(3)	673			385	673
Outside service and data processing costs	1,229	1,046			3,609	3,170
Insurance	244	377			807	995
Professional fees	561	395			1,479	1,270
Marketing	240	165			623	481
Other	660	594			1,861	1,687
Total noninterest expense	$14,039	14,183			41,695	39,198

Noninterest expense was $14.0 million for the third quarter of 2021, a $144,000, or 10.2%, decrease from noninterest expense of $14.2 million for the third quarter of 2020. The decrease in noninterest expenses was driven primarily by the following:

 

·

Mortgage production costs decreased by $710,000, or 26.7%, due primarily to less mortgage volume in the third quarter of 2021.

·

Real estate owned expenses decreased by $676,000, or 100.45%, due to a large write-down on one piece of property during the prior year.

 

Partially offsetting the above decreases were the following:

 

·

Compensation and benefits expense increased $801,000, or 12.0%, relating primarily to an increase in salaries and incentive compensation. We hired 24 new team members during the last 12 months, eight of which were hired in conjunction with the opening of our new Charlotte office.

·

Outside service and data processing costs increased $183,000, or 17.5%, primarily due to increased software licensing costs and ATM/debit card related expenses.

·

Professional fees increased $166,000, or 42.0%, driven by increases in director fees, legal fees, and other professional fees.

·

Other noninterest expense increased by $66,000, or 11.1%, driven by increased business meals and dues and subscriptions.

 

Noninterest expense was $41.7 million for the first nine months of 2021, a $2.5 million, or 6.4%, increase from the prior year. The increase in total noninterest expense resulted primarily from increases in compensation and benefits, mortgage production costs, occupancy, and outside service and data processing costs.

 

Our efficiency ratio was 53.2% for the third quarter of 2021 compared to 50.3% for the third quarter of 2020 and 53.0% for the first nine months of 2021 compared to 49.5% for the same period in 2020. The efficiency ratio represents the percentage of one dollar of expense required to be incurred to earn a full dollar of revenue and is computed by dividing noninterest expense by the sum of net interest income and noninterest income. The higher ratio during the third quarter of 2021, compared to the third quarter of 2020, relates primarily to the decrease in mortgage banking income, while the higher ratio for the first nine months of 2021, compared to the same period of 2020, relates to the decrease in mortgage banking income, combined with the increase in noninterest expenses.

 

We incurred income tax expense of $4.4 million and $721,000 for the three months ended September 30, 2021 and 2020, respectively, and $10.4 million and $3.0 million for the nine months ended September 30, 2021 and 2020, respectively. Our effective tax rate was 23.1% and 23.5% for the nine months ended September 30, 2021 and 2020, respectively. The lower tax rate for the 2021 period relates to the favorable tax impact of certain equity compensation transactions.

Balance Sheet Review

 

Investment Securities

At September 30, 2021, the $116.6 million in our investment securities portfolio represented approximately 4.2% of our total assets. Our available for sale investment portfolio included U.S. treasury securities, U.S. government agency securities, SBA securities, state and political subdivisions, asset-backed securities and mortgage-backed securities with a fair value of $113.8 million and an amortized cost of $114.1 million, resulting in an unrealized loss of $314,000. At December 31, 2020, the $98.4 million in our investment securities portfolio represented approximately 4.0% of our total assets, including investment securities with a fair value of $94.7 million and an amortized cost of $93.4 million for an unrealized gain of $1.3 million.

 

Loans

Since loans typically provide higher interest yields than other types of interest earning assets, a substantial percentage of our earning assets are invested in our loan portfolio. Average loans, excluding mortgage loans held for sale, for the nine months ended September 30, 2021 and 2020 were $2.23 billion and $2.08 billion, respectively. Before the allowance for loan losses, total loans outstanding at September 30, 2021 and December 31, 2020 were $2.35 billion and $2.04 billion, respectively.

 

The principal component of our loan portfolio is loans secured by real estate mortgages. As of September 30, 2021, our loan portfolio included $2.05 billion, or 85.7%, of real estate loans, compared to $1.81 billion, or 84.6%, at December 31, 2020. Most of our real estate loans are secured by residential or commercial property. We obtain a security interest in real estate, in addition to any other available collateral, in order to increase the likelihood of the ultimate repayment of the loan. Generally, we limit the loan-to-value ratio on loans to coincide with the appropriate regulatory guidelines. We attempt to maintain a relatively diversified loan portfolio to help reduce the risk inherent in concentration in certain types of collateral and business types. Home equity lines of credit totaled $155.0 million as of September 30, 2021, of which approximately 50% were in a first lien position, while the remaining balance was second liens. At December 31, 2020, our home equity lines of credit totaled $157.0 million, of which approximately 45% were in first lien positions, while the remaining balance was in second liens. The average home equity loan had a balance of approximately $81,000 and a loan to value of 60% as of September 30, 2021, compared to an average loan balance of $83,000 and a loan to value of approximately 62% as of December 31, 2020. Further, 1.0% and 0.2% of our total home equity lines of credit were over 30 days past due as of September 30, 2021 and December 31, 2020, respectively. The increase in the past due percentage is related primarily to one loan.

 

Following is a summary of our loan composition at September 30, 2021 and December 31, 2020. During the first nine months of 2021, our loan portfolio increased by $246.2 million, or 11.5%, with a 18.4% increase in consumer loans while commercial loans increased by 7.7% during the period. The majority of the increase was in loans secured by real estate. Our consumer real estate portfolio includes high quality 1-4 family consumer real estate loans. Our average consumer real estate loan currently has a principal balance of $447,000, a term of 21 years, and an average rate of 3.51% as of September 30, 2021, compared to a principal balance of $429,000, a term of 19 years, and an average rate of 3.82% as of December 31, 2020.

	September 30, 2021			December 31, 2020
(dollars in thousands)	Amount	%  of Total		Amount	%  of Total
Commercial
Owner occupied RE	$    470,614	19.7%		$   433,320	20.2%
Non-owner occupied RE	628,521	26.3%		585,269	27.3%
Construction	87,892	3.7%		61,467	2.9%
Business	307,969	12.9%		307,599	14.4%
Total commercial loans	1,494,996	62.6%		1,387,655	64.8%
Consumer
Real estate	648,276	27.1%		536,311	25.0%
Home equity	155,049	6.5%		156,957	7.3%
Construction	57,419	2.4%		40,525	1.9%
Other	33,307	1.4%		21,419	1.0%
Total consumer loans	894,051	37.4%		755,212	35.2%
Total gross loans, net of deferred fees	2,389,047	100.0%		2,142,867	100.0%
Less—allowance for loan losses	(36,075)			(44,149)
Total loans, net	$ 2,352,972			$2,098,718

 

Nonperforming assets

Nonperforming assets include real estate acquired through foreclosure or deed taken in lieu of foreclosure and loans on nonaccrual status. Generally, a loan is placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when we believe, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the contractual principal or interest on the loan is doubtful. A payment of interest on a loan that is classified as nonaccrual is recognized as a reduction in principal when received. Our policy with respect to nonperforming loans requires the borrower to make a minimum of six consecutive payments in accordance with the loan terms and to show capacity to continue performing into the future before that loan can be placed back on accrual status. As of September 30, 2021 and December 31, 2020, we had no loans 90 days past due and still accruing.

 

Following is a summary of our nonperforming assets, including nonaccruing TDRs.

 

(dollars in thousands)		September 30, 2021		December 31, 2020
Commercial		$   8,869		1,477
Consumer		2,279		3,083
Nonaccruing troubled debt restructurings		2,730		3,509
Total nonaccrual loans		13,878		8,069
Other real estate owned		-		1,169
Total nonperforming assets		$ 13,878		9,238

 

At September 30, 2021, nonperforming assets were $13.9 million, or 0.50% of total assets and 0.58% of gross loans. Comparatively, nonperforming assets were $9.2 million, or 0.37% of total assets and 0.43% of gross loans at December 31, 2020. Nonaccrual loans increased $5.8 million during the first nine months of 2021 due primarily to $9.6 million in additions of loans on nonaccrual status, partially offset by $2.4 million of loans paid or charged off and $366,000 of loans moved to other real estate owned. The increase during the current period relates primarily to one client relationship which includes two commercial and one consumer real estate properties. On October 29, 2021 we sold the two commercial notes related to this relationship to a third-party at a discounted purchase price of $7.8 million which resulted in a combined charge-off of $812,000 on the two loans.

 

The amount of foregone interest income on the nonaccrual loans in the first nine months of 2021 was immaterial, while foregone interest income for the same period in 2020 was approximately $204,000. At September 30, 2021 and 2020, the allowance for loan losses represented 260.0% and 482.4% of the total amount of nonperforming loans, respectively. A significant portion, or approximately 95%, of nonperforming loans at September 30, 2021,

was secured by real estate. We have evaluated the underlying collateral on these loans and believe that the collateral on these loans is sufficient to minimize future losses.

 

As a general practice, most of our commercial loans and a portion of our consumer loans are originated with relatively short maturities of less than ten years. As a result, when a loan reaches its maturity we frequently renew the loan and thus extend its maturity using similar credit standards as those used when the loan was first originated. Due to these loan practices, we may, at times, renew loans which are classified as nonaccrual after evaluating the loan’s collateral value and financial strength of its guarantors. Nonaccrual loans are renewed at terms generally consistent with the ultimate source of repayment and rarely at reduced rates. In these cases, we will generally seek additional credit enhancements, such as additional collateral or additional guarantees to further protect the loan. When a loan is no longer performing in accordance with its stated terms, we will typically seek performance under the guarantee.

 

In addition, at September 30, 2021, 85.7% of our loans were collateralized by real estate and 95% of our impaired loans were secured by real estate. We utilize third party appraisers to determine the fair value of collateral dependent loans. Our current loan and appraisal policies require us to obtain updated appraisals on an annual basis, either through a new external appraisal or an appraisal evaluation. Impaired loans are individually reviewed on a quarterly basis to determine the level of impairment. As of September 30, 2021, we did not have any impaired real estate loans carried at a value in excess of the appraised value. We typically charge-off a portion or create a specific reserve for impaired loans when we do not expect repayment to occur as agreed upon under the original terms of the loan agreement.

 

At September 30, 2021, impaired loans totaled $17.9 million, for which $3.7 million of these loans had a reserve of approximately $1.2 million allocated in the allowance. During the first nine months of 2021, the average recorded investment in impaired loans was approximately $13.6 million. Comparatively, impaired loans totaled $13.0 million at December 31, 2020 for which $5.1 million of these loans had a reserve of approximately $1.7 million allocated in the allowance. During 2020, the average recorded investment in impaired loans was approximately $14.6 million.

 

We consider a loan to be a TDR when the debtor experiences financial difficulties and we provide concessions such that we will not collect all principal and interest in accordance with the original terms of the loan agreement. Concessions can relate to the contractual interest rate, maturity date, or payment structure of the note. As part of our workout plan for individual loan relationships, we may restructure loan terms to assist borrowers facing challenges in the current economic environment. As of September 30, 2021, we determined that we had loans totaling $6.8 million that we considered TDRs compared to $8.4 million as of December 31, 2020. The decrease during the first nine months of 2021 was driven by eight client relationships with loans totaling $1.4 million that were paid off or removed from TDR status during the period.

 

Allowance for Loan Losses

The allowance for loan losses was $36.1 million and $42.2 million at September 30, 2021 and 2020, respectively, or 1.51% of outstanding loans at September 30, 2021 and 2.03% of outstanding loans at September 30, 2020. At December 31, 2020, our allowance for loan losses was $44.1 million, or 2.06% of outstanding loans.

 

During the nine months ended September 30, 2021, we charged-off $658,000 of loans and recorded $784,000 of recoveries on loans previously charged-off, for net recoveries of $126,000. Comparatively, we charged-off $2.4 million of loans and recorded $690,000 of recoveries on loans previously charged-off, resulting in net charge-offs of $1.7 million for the first nine months of 2020. The $8.1 million decrease in the allowance for loan losses during the first nine months of 2021 was driven by a reduction in qualitative adjustment factors related to the improvement in economic conditions at both the national and regional levels at September 30, 2021 and lower historical loss percentages applied to the various loan categories driven by fewer charge-offs. Partially offsetting these decreases were downgrades in our hotel loan portfolio as we believe the tourism and hospitality industry remains at risk of credit losses due to the pandemic.

Following is a summary of the activity in the allowance for loan losses.

 

	Nine months ended September 30,			Year ended
(dollars in thousands)	2021	2020		December 31, 2020
Balance, beginning of period	$ 44,149	16,642		16,642
Provision for (reversal of) loan losses	(8,200)	27,300		29,600
Loan charge-offs	(658)	(2,413)		(3,414)
Loan recoveries	784	690		1,321
Net loan (charge-offs) recoveries	126	(1,723)		(2,093)
Balance, end of period	$ 36,075	42,219		44,149

 

Deposits and Other Interest-Bearing Liabilities

Our primary source of funds for loans and investments is our deposits and advances from the FHLB. In the past, we have chosen to obtain a portion of our certificates of deposits from areas outside of our market in order to obtain longer term deposits than are readily available in our local market. Our internal guidelines regarding the use of brokered CDs limit our brokered CDs to 20% of total deposits. In addition, we do not obtain time deposits of $100,000 or more through the Internet. These guidelines allow us to take advantage of the attractive terms that wholesale funding can offer while mitigating the related inherent risk.

 

Our retail deposits represented $2.43 billion, or 100% of total deposits at September 30, 2021. At December 31, 2020, retail deposits represented $2.12 billion, or 99.0% of our total deposits, and brokered CDs were $22.0 million, representing 1.0% of our total deposits. Our loan-to-deposit ratio was 98% at September 30, 2021 and 100% at December 31, 2020.

 

The following is a detail of our deposit accounts:

 

	September 30,		December 31,
(dollars in thousands)	2021		2020
Non-interest bearing	$    720,444		$  576,610
Interest bearing:
NOW accounts	331,167		268,739
Money market accounts	1,188,666		1,042,745
Savings	34,018		27,254
Time, less than $100,000	28,469		36,454
Time and out-of-market deposits, $100,000 and over	130,254		190,956
Total deposits	$ 2,433,018		$2,142,758

 

During the past 12 months, we continued our focus on increasing core deposits, which exclude out-of-market deposits and time deposits of $250,000 or more, in order to provide a relatively stable funding source for our loan portfolio and other earning assets. Our core deposits were $2.37 billion and $2.01 billion at September 30, 2021, and December 31, 2020, respectively.

 

The following table shows the average balance amounts and the average rates paid on deposits.

 

	Nine months ended September 30,
	2021				2020
(dollars in thousands)	Amount	Rate			Amount	Rate
Noninterest-bearing demand deposits	$    648,930	-%			$    490,343	-%
Interest-bearing demand deposits	298,785	0.06%			248,373	0.17%
Money market accounts	1,110,579	0.22%			963,885	1.92%
Savings accounts	31,830	0.05%			20,909	0.05%
Time deposits less than $100,000	39,136	0.48%			42,649	1.49%
Time deposits greater than $100,000	144,103	0.87%			272,026	1.86%
Total deposits	$ 2,273,363	0.18%			$ 2,038,185	0.73%

During the first nine months of 2021, our average transaction account balances increased by $366.6 million, or 21.3%, from the prior year, while our average time deposit balances decreased by $131.4 million, or 41.87%.

 

All of our time deposits are certificates of deposits. The maturity distribution of our time deposits of $100,000 or more at September 30, 2021 was as follows:

 

(dollars in thousands)	September 30, 2021
Three months or less	$   38,735
Over three through six months	38,216
Over six  through twelve months	26,026
Over twelve months	27,277
Total	$ 130,254

 

Time deposits that meet or exceed the FDIC insurance limit of $250,000 at September 30, 2021 and December 31, 2020 were $86.5 million and $130.9 million, respectively.

 

Liquidity and Capital Resources

 

Liquidity represents the ability of a company to convert assets into cash or cash equivalents without significant loss, and the ability to raise additional funds by increasing liabilities. Liquidity management involves monitoring our sources and uses of funds in order to meet our day-to-day cash flow requirements while maximizing profits. Liquidity management is made more complicated because different balance sheet components are subject to varying degrees of management control. For example, the timing of maturities of our investment portfolio is fairly predictable and subject to a high degree of control at the time investment decisions are made. However, net deposit inflows and outflows are far less predictable and are not subject to the same degree of control. We have not experienced any unusual pressure on our deposit balances or our liquidity position as a result of the COVID-19 pandemic.

 

At September 30, 2021 and December 31, 2020 cash and cash equivalents totaled $128.5 million and $100.7 million, respectively, or 4.6% and 4.1% of total assets, respectively. Our investment securities at September 30, 2021 and December 31, 2020 amounted to $116.6 million and $98.4 million, respectively, or 4.2% and 4.0% of total assets, respectively. Investment securities traditionally provide a secondary source of liquidity since they can be converted into cash in a timely manner.

 

Our ability to maintain and expand our deposit base and borrowing capabilities serves as our primary source of liquidity. We plan to meet our future cash needs through the liquidation of temporary investments, the generation of deposits, loan payoffs, and from additional borrowings. In addition, we will receive cash upon the maturity and sale of loans and the maturity of investment securities. We maintain five federal funds purchased lines of credit with correspondent banks totaling $118.5 million for which there were no borrowings against the lines of credit at September 30, 2021.

 

We are also a member of the FHLB, from which applications for borrowings can be made. The FHLB requires that securities, qualifying mortgage loans, and stock of the FHLB owned by the Bank be pledged to secure any advances from the FHLB. The unused borrowing capacity currently available from the FHLB at September 30, 2021 was $552.1 million, based primarily on the Bank’s qualifying mortgages available to secure any future borrowings. However, we are able to pledge additional securities to the FHLB in order to increase our available borrowing capacity. In addition, at September 30, 2021 and December 31, 2020 we had $243.1 million and $206.2 million, respectively, of letters of credit outstanding with the FHLB to secure client deposits.

 

We also have a line of credit with another financial institution for $15.0 million, which was unused at September 30, 2021. The line of credit has an interest rate of LIBOR plus 3.50% and a maturity date of December 31, 2021.

 

We believe that our existing stable base of core deposits, federal funds purchased lines of credit with correspondent banks, and borrowings from the FHLB will enable us to successfully meet our long-term liquidity needs. However, as short-term liquidity needs arise, we have the ability to sell a portion of our investment securities portfolio to meet those needs.

Total shareholders’ equity was $265.6 million at September 30, 2021 and $228.3 million at December 31, 2020. The $37.3 million increase from December 31, 2020 is primarily related to net income of $34.7 million during the first nine months of 2021, stock option exercises and equity compensation expenses of $3.9 million, partially offset by a $1.3 million decrease in other comprehensive loss.

 

The following table shows the return on average assets (net income divided by average total assets), return on average equity (net income divided by average equity), equity to assets ratio (average equity divided by average assets), and tangible common equity ratio (total equity less preferred stock divided by total assets) annualized for the nine months ended September 30, 2021 and the year ended December 31, 2020. Since our inception, we have not paid cash dividends.

 

	September 30, 2021		December 31, 2020
Return on average assets	1.78 %		0.76 %
Return on average equity	19.02 %		8.49 %
Return on average common equity	19.02 %		8.49 %
Average equity to average assets ratio	9.37 %		9.01 %
Tangible common equity to assets ratio	9.54 %		9.20 %

 

Under the capital adequacy guidelines, regulatory capital is classified into two tiers. These guidelines require an institution to maintain a certain level of Tier 1 and Tier 2 capital to risk-weighted assets. Tier 1 capital consists of common shareholders’ equity, excluding the unrealized gain or loss on securities available for sale, minus certain intangible assets. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, are multiplied by a risk-weight factor of 0% to 100% based on the risks believed to be inherent in the type of asset. Tier 2 capital consists of Tier 1 capital plus the general reserve for loan losses, subject to certain limitations. We are also required to maintain capital at a minimum level based on total average assets, which is known as the Tier 1 leverage ratio.

 

Regulatory capital rules adopted in July 2013 and fully-phased in as of January 1, 2019, which we refer to Basel III, impose minimum capital requirements for bank holding companies and banks. The Basel III rules apply to all national and state banks and savings associations regardless of size and bank holding companies and savings and loan holding companies other than “small bank holding companies,” generally holding companies with consolidated assets of less than $3 billion (such as the Company). In order to avoid restrictions on capital distributions or discretionary bonus payments to executives, a covered banking organization must maintain a “capital conservation buffer” on top of our minimum risk-based capital requirements. This buffer must consist solely of common equity Tier 1, but the buffer applies to all three measurements (common equity Tier 1, Tier 1 capital and total capital). The capital conservation buffer consists of an additional amount of CET1 equal to 2.5% of risk-weighted assets.

 

To be considered “well-capitalized” for purposes of certain rules and prompt corrective action requirements, the Bank must maintain a minimum total risked-based capital ratio of at least 10%, a total Tier 1 capital ratio of at least 8%, a common equity Tier 1 capital ratio of at least 6.5%, and a leverage ratio of at least 5%. As of September 30, 2021, our capital ratios exceed these ratios and we remain “well capitalized.”

 

The following table summarizes the capital amounts and ratios of the Bank and the regulatory minimum requirements.

			September 30, 2021
	Actual		For capital adequacy purposes minimum plus the capital conservation buffer		To be well capitalized under prompt corrective action provisions minimum
(dollars in thousands)	Amount	Ratio	Amount	Ratio	Amount	Ratio
Total Capital (to risk weighted assets)	$ 317,659	14.34%	$ 232,567	10.50%	$ 221,492	10.00%
Tier 1 Capital (to risk weighted assets)	289,869	13.09%	188,268	8.50%	177,194	8.00%
Common Equity Tier 1 Capital (to risk weighted assets)	289,869	13.09%	155,044	7.00%	143,970	6.50%
Tier 1 Capital (to average assets)	289,869	10.60%	109,360	4.00%	136,700	5.00%

 

			December 31, 2020
	Actual		For capital adequacy purposes minimum plus the capital conservation buffer		To be well capitalized under prompt corrective action provisions minimum
(dollars in thousands)	Amount	Ratio	Amount	Ratio	Amount	Ratio
Total Capital (to risk weighted assets)	$ 279,414	13.92%	$ 160,554	8.00%	$ 200,693	10.00%
Tier 1 Capital (to risk weighted assets)	254,092	12.66%	120,416	6.00%	160,554	8.00%
Common Equity Tier 1 Capital (to risk weighted assets)	254,092	12.66%	90,312	4.50%	130,451	6.50%
Tier 1 Capital (to average assets)	254,092	10.26%	99,094	4.00%	123,867	5.00%

 

The following table summarizes the capital amounts and ratios of the Company and the minimum regulatory requirements.

 

			September 30, 2021
	Actual		For capital adequacy purposes minimum plus the capital conservation buffer (1)		To be well capitalized under prompt corrective action provisions minimum
(dollars in thousands)	Amount	Ratio	Amount	Ratio	Amount	Ratio
Total Capital (to risk weighted assets)	$ 329,667	14.88%	$ 232,556	10.50%	N/A	N/A
Tier 1 Capital (to risk weighted assets)	278,877	12.59%	188,515	8.50%	N/A	N/A
Common Equity Tier 1 Capital (to risk weighted assets)	265,877	12.00%	155,037	7.00%	N/A	N/A
Tier 1 Capital (to average assets)	278,877	10.20%	109,381	4.00%	N/A	N/A

 

				December 31, 2020
	Actual			For capital adequacy purposes minimum plus the capital conservation buffer (1)		To be well capitalized under prompt corrective action provisions minimum
(dollars in thousands)	Amount		Ratio	Amount	Ratio	Amount	Ratio
Total Capital (to risk weighted assets)	$ 288,593		14.38%	$ 160,554	8.00%	N/A	N/A
Tier 1 Capital (to risk weighted assets)	240,271		11.97%	120,416	6.00%	N/A	N/A
Common Equity Tier 1 Capital (to risk weighted assets)	227,271		11.32%	90,312	4.50%	N/A	N/A
Tier 1 Capital (to average assets)	240,271		9.70%	99,094	4.00%	N/A	N/A

(1)

Under the Federal Reserve’s Small Bank Holding Company Policy Statement, the Company is not subject to the minimum capital adequacy and capital conservation buffer capital requirements at the holding company level, unless otherwise advised by the Federal Reserve (such capital requirements are applicable only at the Bank level). Although the minimum regulatory capital requirements are not applicable to the Company, we calculate these ratios for our own planning and monitoring purposes.

The ability of the Company to pay cash dividends is dependent upon receiving cash in the form of dividends from the Bank. The dividends that may be paid by the Bank to the Company are subject to legal limitations and regulatory capital requirements. Since our inception, we have not paid cash dividends.

Effect of Inflation and Changing Prices

 

The effect of relative purchasing power over time due to inflation has not been taken into account in our consolidated financial statements. Rather, our financial statements have been prepared on an historical cost basis in accordance with generally accepted accounting principles.

 

Unlike most industrial companies, our assets and liabilities are primarily monetary in nature. Therefore, the effect of changes in interest rates will have a more significant impact on our performance than will the effect of changing prices and inflation in general. In addition, interest rates may generally increase as the rate of inflation increases, although not necessarily in the same magnitude. As discussed previously, we seek to manage the relationships between interest sensitive assets and liabilities in order to protect against wide rate fluctuations, including those resulting from inflation.

 

Off-Balance Sheet Risk

 

Commitments to extend credit are agreements to lend money to a client as long as the client has not violated any material condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee. At September 30, 2021, unfunded commitments to extend credit were $574.7 million, of which $182.8 million were at fixed rates and $391.9 million were at variable rates. At December 31, 2020, unfunded commitments to extend credit were $480.1 million, of which approximately $114.6 million were at fixed rates and $365.5 million were at variable rates. A significant portion of the unfunded commitments related to consumer home equity lines of credit. We evaluate each client’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by us upon extension of credit, is based on our credit evaluation of the borrower. The type of collateral varies but may include accounts receivable, inventory, property, plant and equipment, and commercial and residential real estate.

 

At September 30, 2021 and December 31, 2020, there were commitments under letters of credit for $10.1 million and $8.7 million, respectively. The credit risk and collateral involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Since most of the letters of credit are expected to expire without being drawn upon, they do not necessarily represent future cash requirements.

 

At September 30, 2021, there were commitments of $35.4 million related to the construction of a new headquarters building of which $18.4 million had been paid through the end of the third quarter of 2021.

 

Except as disclosed in this report, we are not involved in off-balance sheet contractual relationships, unconsolidated related entities that have off-balance sheet arrangements or transactions that could result in liquidity needs or other commitments that significantly impact earnings.

 

Market Risk and Interest Rate Sensitivity

 

Market risk is the risk of loss from adverse changes in market prices and rates, which principally arises from interest rate risk inherent in our lending, investing, deposit gathering, and borrowing activities. Other types of market risks, such as foreign currency exchange rate risk and commodity price risk, do not generally arise in the normal course of our business.

 

We actively monitor and manage our interest rate risk exposure in order to control the mix and maturities of our assets and liabilities utilizing a process we call asset/liability management. The essential purposes of asset/liability management are to seek to ensure adequate liquidity and to maintain an appropriate balance between interest sensitive assets and liabilities in order to minimize potentially adverse impacts on earnings from changes in market interest rates. Our asset/liability management committee (“ALCO”) monitors and considers methods of managing exposure to interest rate risk. We have both an internal ALCO consisting of senior management that meets at various times during each month and a board ALCO that meets monthly. The ALCOs are responsible for maintaining the level of interest rate sensitivity of our interest sensitive assets and liabilities within board-approved limits.

 

As of September 30, 2021, the following table summarizes the forecasted impact on net interest income using a base case scenario given upward and downward movements in interest rates of 100, 200, and 300 basis points

based on forecasted assumptions of prepayment speeds, nominal interest rates and loan and deposit repricing rates. Estimates are based on current economic conditions, historical interest rate cycles and other factors deemed to be relevant. However, underlying assumptions may be impacted in future periods which were not known to management at the time of the issuance of the Consolidated Financial Statements. Therefore, management’s assumptions may or may not prove valid. No assurance can be given that changing economic conditions and other relevant factors impacting our net interest income will not cause actual occurrences to differ from underlying assumptions. In addition, this analysis does not consider any strategic changes to our balance sheet which management may consider as a result of changes in market conditions.

 

 

Interest rate scenario		Change in net interest income from base
Up 300 basis points		17.55%
Up 200 basis points		11.88%
Up 100 basis points		6.01%
Base		-
Down 100 basis points		(2.09)%
Down 200 basis points		(3.18)%
Down 300 basis points		(3.84)%

 

Critical Accounting Policies

 

We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States and with general practices within the banking industry in the preparation of our financial statements. Our significant accounting policies are described in the footnotes to our audited consolidated financial statements as of December 31, 2020, as filed in our Annual Report on Form 10-K.

 

Certain accounting policies involve significant judgments and assumptions by us that have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgment and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Our Critical Accounting Policies are the allowance for loan losses, fair value of financial instruments and income taxes. Because of the nature of the judgment and assumptions we make, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of our assets and liabilities and our results of operations. A brief discussion of each of these areas appears in our 2020 Annual Report on Form 10-K. During the first three months of 2021, we did not significantly alter the manner in which we applied our Critical Accounting Policies or developed related assumptions and estimates.

 

Accounting, Reporting, and Regulatory Matters

 

See Note 1 – Nature of Business and Basis of Presentation in the accompanying condensed notes to consolidated financial statements included elsewhere in this report for details of recently issued accounting pronouncements and their expected impact on our consolidated financial statements.

 

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on the consolidated financial statements upon adoption.

 

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

As a "smaller reporting company" as defined by Item 10 of Regulation S-K, the Company is not required to provide information required by this Item.

Item 4. CONTROLS AND PROCEDURES.

 

Evaluation of Disclosure Controls and Procedures

 

Management, including our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports we file and submit under the Exchange Act is (i) recorded, processed, summarized and reported as and when required and (ii) accumulated and communicated to our management, including our Chief Executive Officer and the Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

 

Changes in Internal Control over Financial Reporting

 

There has been no change in the Company’s internal control over financial reporting during the three months ended September 30, 2021, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

PART II. OTHER INFORMATION

 

Item 1. LEGAL PROCEEDINGS.

We are a party to claims and lawsuits arising in the course of normal business activities. Management is not aware of any material pending legal proceedings against the Company which, if determined adversely, would have a material adverse impact on the company’s financial position, results of operations or cash flows.

 

Item 1A. RISK FACTORS.

Investing in shares of our common stock involves certain risks, including those identified and described in Item 1A. of our Annual Report on Form 10-K for the fiscal year ended December 31, 2020, as well as cautionary statements contained in this Quarterly Report on Form 10-Q, including those under the caption “Cautionary Warning Regarding Forward-Looking Statements” set forth in Part I, Item 2 of this Form 10-Q, risks and matters described elsewhere in this Form 10-Q, and in our other filings with the SEC.

 

There have been no material changes to the risk factors disclosed in Item 1A. of Part I in our Annual Report on Form 10-K for the year ended December 31, 2020.

 

Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

(a)

Not applicable.

(b)

Not applicable.

(c)

Issuer Purchases of Registered Equity Securities

 

The following table reflects share repurchase activity during the third quarter of 2021:

 

									(d) Maximum
							(c) Total		Number (or
							Number of		Approximate
							Shares (or		Dollar Value) of
							Units)		Shares (or
		(a) Total					Purchased as		Units) that May
		Number of					Part of Publicly		Yet Be
		Shares (or		(b) Average			Announced		Purchased
		Units)		Price Paid per			Plans or		Under the Plans
Period		Purchased		Share (or Unit)			Programs		or Programs
July 1 – July 31		-		$	-		-		388,612
August 1 – August 31		-			-		-		388,612
September 1 – September 30		-			-		-		388,612
Total		-			-		-		388,612*

*On March 9, 2021, the Company announced a share repurchase plan allowing us to repurchase up to 388,612 shares of our common stock (the “Repurchase Plan”). As of September 30, 2021, we have not repurchased any of the shares authorized for repurchase under the Repurchase Plan. The Company is not obligated to purchase any such shares under the Repurchase Plan, and the Repurchase Plan may be discontinued, suspended or restarted at any time; however, repurchases under the Repurchase Plan after December 31, 2021 would require additional approval of our Board of Directors and the Federal Reserve.

 

Item 3. DEFAULTS UPON SENIOR SECURITIES.

None.

 

Item 4. MINE SAFETY DISCLOSURES.

Not applicable.

 

Item 5. OTHER INFORMATION.

None.

 

Item 6. EXHIBITS.

The exhibits required to be filed as part of this Quarterly Report on Form 10-Q are listed in the Index to Exhibits attached hereto and are incorporated herein by reference.

INDEX TO EXHIBITS

Exhibit Number		Description
31.1		Rule 13a-14(a) Certification of the Principal Executive Officer.
31.2		Rule 13a-14(a) Certification of the Principal Financial Officer.
32		Section 1350 Certifications.
101		The following materials from the Quarterly Report on Form 10-Q of Southern First Bancshares, Inc. for the quarter ended September 30, 2021, formatted in iXBRL (Inline eXtensible Business Reporting Language): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Income, (iii) Consolidated Statements of Comprehensive Income, (iv) Consolidated Statement of Changes in Shareholders’ Equity, (v) Consolidated Statements of Cash Flows and (vi) Notes to Unaudited Consolidated Financial Statements.
104		Cover Page Interactive Data File (embedded within the Inline XBRL document)
______		________________________________________________

 

SIGNATURES

 

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

  

 

		SOUTHERN FIRST BANCSHARES, INC.
		Registrant
Date: November 2, 2021		/s/ R. Arthur Seaver, Jr.
		R. Arthur Seaver, Jr.
		Chief Executive Officer (Principal Executive Officer)
Date: November 2, 2021		/s/ Michael D. Dowling
		Michael D. Dowling
		Chief Financial Officer (Principal Financial and Accounting Officer)