Quarterly Report (10-q)

Date : 04/30/2019 @ 9:19PM
Source : Edgar (US Regulatory)
Stock : Southern First Bancshares Inc (SFST)
Quote : 39.45  0.31 (0.79%) @ 8:59PM
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Quarterly Report (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 March 31, 2019
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)

South Carolina       58-2459561
(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.)
     
100 Verdae Boulevard, Suite 100
Greenville, S.C. 29606
(Address of principal executive offices) (Zip Code)

864-679-9000
(Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address, and former fiscal year, if changed since last report)

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 and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§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. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

      Large accelerated filer             Accelerated filer      
  Non-accelerated filer     Smaller Reporting Company  
Emerging growth company

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the 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: 7,505,636 shares of common stock, par value $0.01 per share, were issued and outstanding as of April 26, 2019.


SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY
March 31, 2019 Form 10-Q

INDEX

PART I – CONSOLIDATED FINANCIAL INFORMATION       Page
     
Item 1.       Consolidated Financial Statements
 
Consolidated Balance Sheets 3
 
Consolidated Statements of Income 4
 
Consolidated Statements of Comprehensive Income 5
 
Consolidated Statements of Shareholders’ Equity 6
 
Consolidated Statements of Cash Flows 7
 
Notes to Unaudited Consolidated Financial Statements 8
 
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 24
 
Item 3. Quantitative and Qualitative Disclosures about Market Risk 38
 
Item 4. Controls and Procedures 38
 
PART II – OTHER INFORMATION
 
Item 1. Legal Proceedings 39
 
Item 1A. Risk Factors 39
 
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 39
 
Item 3. Defaults upon Senior Securities 39
 
Item 4. Mine Safety Disclosures 39
 
Item 5. Other Information 39
 
Item 6. Exhibits 39

2


PART I. CONSOLIDATED FINANCIAL INFORMATION
Item 1. CONSOLIDATED FINANCIAL STATEMENTS

SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS

 
March 31, December 31,
(dollars in thousands, except share data)       2019 2018
(Unaudited)       (Audited)
ASSETS
Cash and cash equivalents:
Cash and due from banks $      16,853 17,434
Federal funds sold 75,207 35,882
Interest-bearing deposits with banks 25,246 19,557
Total cash and cash equivalents 117,306 72,873
Investment securities:
Investment securities available for sale 73,300 74,905
Other investments 3,309 4,121
Total investment securities 76,609 79,026
Mortgage loans held for sale 9,393 9,241
Loans 1,733,964 1,677,332
Less allowance for loan losses (16,051 ) (15,762 )
Loans, net 1,717,913 1,661,570
Bank owned life insurance 34,226 34,010
Property and equipment, net 47,262 32,430
Deferred income taxes 3,877 4,020
Other assets 7,840 7,444
Total assets $ 2,014,426 1,900,614
LIABILITIES
Deposits $ 1,758,235 1,648,136
Federal Home Loan Bank advances and other borrowings 25,000 50,000
Junior subordinated debentures 13,403 13,403
Other liabilities 36,602 15,159
Total liabilities 1,833,240 1,726,698
SHAREHOLDERS’ EQUITY
Preferred stock, par value $.01 per share, 10,000,000 shares authorized - -
Common stock, par value $.01 per share, 10,000,000 shares authorized, 7,505,636 and 7,466,481 shares issued and outstanding at March 31, 2019 and December 31, 2018, respectively 75 75
Nonvested restricted stock (993 ) (741 )
Additional paid-in capital 103,600 102,625
Accumulated other comprehensive loss (379 ) (917 )
Retained earnings 78,883 72,874
Total shareholders’ equity 181,186 173,916
Total liabilities and shareholders’ equity $ 2,014,426 1,900,614

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

3


SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)

 
For the three months
ended March 31,
(dollars in thousands, except share data) 2019 2018
Interest income
Loans       $      20,889 16,563
Investment securities 549       368
Federal funds sold 174 247
Total interest income 21,612 17,178
Interest expense
Deposits 5,375 2,738
Borrowings 419 398
Total interest expense 5,794 3,136
Net interest income 15,818 14,042
Provision for loan losses 300 500
Net interest income after provision for loan losses 15,518 13,542
Noninterest income
Mortgage banking income 1,857 1,328
Service fees on deposit accounts 265 257
ATM and debit card income 380 334
Income from bank owned life insurance 216 220
Other income 276 281
Total noninterest income 2,994 2,420
Noninterest expenses
Compensation and benefits 6,783 5,843
Occupancy 1,339 1,137
Outside service and data processing costs 960 736
Insurance 318 313
Professional fees 439 476
Marketing 260 209
Other 549 491
Total noninterest expenses 10,648 9,205
Income before income tax expense 7,864 6,757
Income tax expense 1,855 1,543
Net income available to common shareholders $ 6,009 5,214
Earnings per common share
Basic $ 0.81 0.71
Diluted 0.78 0.67
Weighted average common shares outstanding
Basic 7,459,342 7,336,839
Diluted 7,741,860 7,726,885

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

4


SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)

       
For the three months
ended March 31,
(dollars in thousands)       2019       2018
Net income $      6,009 5,214
Other comprehensive income (loss):
Unrealized gain (loss) on securities available for sale:
Unrealized holding gain (loss) arising during the period, pretax

 

684 (919 )
Tax (expense) benefit (143 ) 192
Reclassification of realized (gain) loss (4 ) 1
Tax expense 1 -
Other comprehensive income (loss) 538 (726 )
Comprehensive income $ 6,547 4,488

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

5


SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
FOR THE THREE MONTHS ENDED MARCH 31, 2019 AND 2018
(Unaudited)

 
Accumulated
Nonvested Additional other
Common stock Preferred stock restricted paid-in comprehensive Retained
(dollars in thousands, except share data) Shares Amount Shares Amount stock capital loss earnings Total
December 31, 2017 7,347,851 73 - - (502 ) 99,986 (456 )    50,585    149,686
Net income    -    -    -    -    -    -    - 5,214 5,214
Proceeds from exercise of stock options 24,365 1 - - - 227 - - 228
Issuance of restricted stock 9,500 - - - (409 ) 409 - - -
Compensation expense related to restricted stock, net of tax - - - - 69 - - - 69
Compensation expense related to stock options, net of tax - - - - - 268 - - 268
Other comprehensive loss - - - - - - (726 ) - (726 )
 
March 31, 2018 7,381,716 $     74 - $      - $     (842 ) $     100,890 $              (1,182 ) $     55,799 $      154,739
December 31, 2018 7,466,481 75 - - (741 ) 102,625 (917 ) 72,874 173,916
Net income - - - - - - - 6,009 6,009
Proceeds from exercise of stock options 28,455 - - - - 322 - - 322
Issuance of restricted stock 10,700 - - - (347 ) 347 - - -
Compensation expense related to restricted stock, net of tax - - - - 95 - - - 95
Compensation expense related to stock options, net of tax - - - - - 306 - - 306
Other comprehensive income - - - - - - 538 - 538
 
March 31, 2019 7,505,636 $ 75 - $ - $ (993 )   $ 103,600 $ (379 ) $ 78,883 $ 181,186

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

6


SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

 
For the three months ended
March 31,
(dollars in thousands) 2019 2018
Operating activities
Net income      $     6,009      5,214
Adjustments to reconcile net income to cash provided by (used for) operating activities:
Provision for loan losses 300 500
Depreciation and other amortization 453 401
Accretion and amortization of securities discounts and premium, net 83 116
(Gain) loss on sale of investment securities available for sale (4 ) 1
Gain on sale of fixed assets - (8 )
Operating lease payments 447 -
Compensation expense related to stock options and restricted stock grants 401 337
Gain on sale of loans held for sale (1,775 ) (941 )
Loans originated and held for sale (55,178 ) (49,194 )
Proceeds from sale of loans held for sale 56,801 51,040
Increase in cash surrender value of bank owned life insurance (216 ) (220 )
(Increase) decrease in deferred tax asset 1 (1 )
(Increase) decrease in other assets, net (396 ) 365
Increase (decrease) in other liabilities 5,978 (1,179 )
Net cash provided by operating activities 12,904 6,431
Investing activities
Increase (decrease) in cash realized from:
Increase in loans, net (56,643 ) (72,483 )
Purchase of property and equipment (266 ) (498 )
Purchase of investment securities:
Other investments - (2,595 )
Payments and maturities, calls and repayments of investment securities:
Available for sale 2,205 2,221
Other investments 812 4,001
Proceeds from sale of investment securities available for sale - 5,841
Net cash used for investing activities (53,892 ) (63,513 )
Financing activities
Increase (decrease) in cash realized from:
Increase in deposits, net 110,099 139,400
Decrease in Federal Home Loan Bank advances and other borrowings, net (25,000 ) (38,600 )
Proceeds from the exercise of stock options and warrants 322 228
Net cash provided by financing activities 85,421 101,028
Net increase in cash and cash equivalents 44,433 43,946
Cash and cash equivalents at beginning of the period 72,873 92,165
Cash and cash equivalents at end of the period $ 117,306 136,111
Supplemental information
Cash paid for
Interest $ 5,570 3,190
Income taxes - -
Schedule of non-cash transactions
Unrealized gain (loss) on securities, net of income taxes 538 (726 )
Right-of-use assets obtained in exchange for lease obligations:
Operating leases 15,395 -

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

7


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 Trust 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 month period ended March 31, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019. 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, 2018 as filed with the Securities and Exchange Commission (“SEC”) on February 28, 2019. 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 accounting principles generally accepted in the United States of America, or 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.

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. Management performed an evaluation to determine whether there have been any subsequent events since the balance sheet date and determined that no subsequent events occurred requiring accrual or disclosure.

8


Adoption of New Accounting Standards
In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842)” . The guidance in the update supersedes the requirements in ASC Topic 840, Leases. The guidance is intended to increase transparency and comparability among organizations by recognizing right-of-use assets and lease liabilities on the balance sheet. For public companies, this update was effective for interim and annual periods beginning after December 15, 2018. The Company adopted this guidance in the first quarter of 2019. Upon adoption, the Company elected a practical expedient which allows existing leases to retain their classification as operating leases. The Company has also elected to not recognize right-of-use assets and lease liabilities arising from short-term leases. Implementation of the guidance resulted in the recording of a right-of-use asset and lease liability on the balance sheet; however it does not have a material impact on the Company's other consolidated financial statements. See additional disclosures in Note 8.

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 is effective for all annual and interim periods beginning after December 31, 2019, with early adoption permitted for fiscal years beginning after December 15, 2018. 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 intends to adopt the guidance on January 1, 2020 and 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 our processes. Our implementation plan has progressed through the initial design, build, and testing phase and, in the first quarter of 2019, we began running parallel models. While we continue to evaluate the impact the new guidance will have on our financial position and results of operations, we currently expect the new guidance may result in an increase to our allowance for credit losses given the change to estimated losses over the contractual life of the loan portfolio. The amount of any change to our allowance is still under review and will depend, in part, upon the composition of our loan portfolio at the adoption date as well as economic conditions and loss forecasts at that date.

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.

9


NOTE 2 – Investment Securities

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

 
March 31, 2019
Amortized Gross Unrealized Fair
(dollars in thousands) Cost Gains Losses Value
Available for sale     
US government agencies $     8,970      1      75      8,896
SBA securities 3,441 - 52 3,389
State and political subdivisions 8,061 127 13 8,175
Asset-backed securities 9,504 - 78 9,426
Mortgage-backed securities
FHLMC 11,873 147 135 11,885
FNMA 27,777 45 364 27,458
GNMA 4,154 3 86 4,071
Total mortgage-backed securities 43,804 195 585 43,414
Total investment securities available for sale $ 73,780 323 803 73,300
 
December 31, 2018
Amortized Gross Unrealized Fair
Cost Gains Losses Value
Available for sale
US government agencies $ 8,975 1 194 8,782
SBA securities 3,628 - 103 3,525
State and political subdivisions 8,371 48 63 8,356
Asset-backed securities 9,595 12 49 9,558
Mortgage-backed securities
FHLMC 12,258 87 242 12,103
FNMA 29,068 25 551 28,542
GNMA 4,170 1 132 4,039
Total mortgage-backed securities 45,496 113 925 44,684
Total $ 76,065 174 1,334 74,905

Contractual maturities and yields on the Company’s investment securities at March 31, 2019 and December 31, 2018 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.

 
    March 31, 2019
Less than one year One to five years Five to ten years Over ten years Total
(dollars in thousands) Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield
Available for sale                              
US government agencies $     - - 3,418 2.06% 5,478 2.90% - - 8,896 2.58%
SBA securities - - - - - - 3,389 2.78% 3,389 2.78%
State and political subdivisions - - 1,130 2.96% 4,145 6.74% 2,900 2.87% 8,175 4.84%
Asset-backed securities - - - - 1,776 3.21% 7,651 3.26% 9,426 3.25%
Mortgage-backed securities - - 4,864 1.92% 9,396 2.22% 29,153 2.78% 43,414 2.61%
Total $ - - 9,412 2.10% 20,795 3.11% 43,093 2.92% 73,300 2.94%
 
December 31, 2018
Less than one year One to five years Five to ten years Over ten years Total
(dollars in thousands) Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield
Available for sale
US government agencies $ - - 2,665 2.12% 6,117 2.77% - - 8,782 2.57%
SBA securities - - - - - - 3,525 2.72% 3,525 2.72%
State and political subdivisions - - 819 2.60% 4,637 3.04% 2,900 2.88% 8,356 2.94%
Asset-backed securities - - - - 1,862 3.22% 7,696 3.29% 9,558 3.27%
Mortgage-backed securities - - 5,094 1.89% 9,763 2.22% 29,827 2.70% 44,684 2.50%
Total $ - - 8,578 2.03% 22,379 2.62% 43,948 2.81% 74,905 2.67%

10


The tables below summarize gross unrealized losses on investment securities and the fair market value of the related securities at March 31, 2019 and December 31, 2018, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position.

     
March 31, 2019
Less than 12 months 12 months or longer Total
Fair Unrealized Fair Unrealized Fair Unrealized
(dollars in thousands) # value losses # value losses # value losses
Available for sale
US government agencies    1    $      499    $      1    8    $      7,147    $      74    9    $      7,646    $      75
SBA securities - - - 2 3,389 52 2 3,389 52
State and political subdivisions - - - 4 1,561 13 4 1,561 13
Asset-backed securities 5 7,651 70 1 1,775 8 6 9,426 78
Mortgage-backed securities
FHLMC - - - 10 7,218 135 10 7,218 135
FNMA 1 887 7 22 20,143 357 23 21,030 364
GNMA - - - 3 2,947 86 3 2,947 86
Total 7 $ 9,037 $ 78 50 $ 44,180 $ 725 57 $ 53,217 $ 803
 
December 31, 2018
Less than 12 months 12 months or longer Total
Fair Unrealized Fair Unrealized Fair Unrealized
(dollars in thousands) # value losses # value losses # value losses
Available for sale
US government agencies    1     $ 1,246    $ 3    8    $ 7,035    $ 191    9    $ 8,281    $ 194
SBA securities - - - 2 3,525 103 2 3,525 103
State and political subdivisions - - - 7 2,829 63 7 2,829 63
Asset-backed securities 4 6,707 49 - - - 4 6,707 49
Mortgage-backed securities
FHLMC - - - 10 7,402 242 10 7,402 242
FNMA 2 2,689 6 23 22,814 545 25 25,503 551
GNMA 1 1,104 6 3 2,919 126 4 4,023 132
Total 8 $ 11,746 $ 64 53 $ 46,524 $ 1,270 61 $ 58,270 $ 1,334

At March 31, 2019, the Company had seven individual investments with a fair market value of $9.0 million that were in an unrealized loss position for less than 12 months and 50 individual investments with a fair market value of $44.2 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.

         
(dollars in thousands) March 31, 2019 December 31, 2018
Federal Home Loan Bank stock       $      2,774       3,587
Other investments 132 131
Investment in Trust Preferred securities 403 403
Total other investments $ 3,309 4,121

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 March 31, 2019 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.

11


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 March 31, 2019, mortgage loans held for sale totaled $9.4 million compared to $9.2 million at December 31, 2018.

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 by the Company to investors 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.

The Company establishes mortgage repurchase reserves related to various representations and warranties that reflect management’s estimate of losses based on a combination of factors. The Company establishes a reserve at the time loans are sold and updates the reserve estimate on a quarterly basis during the estimated life of the loan.

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 $2.9 million as of March 31, 2019 and $2.8 million as of December 31, 2018.

         
March 31, 2019 December 31, 2018
(dollars in thousands) Amount % of Total Amount % of Total
Commercial
Owner occupied RE       $      386,256       22.3%       $      367,018       21.9%
Non-owner occupied RE 423,953 24.4% 404,296 24.1%
Construction 80,561 4.7% 84,411 5.0%
Business 281,502 16.2% 272,980 16.3%
Total commercial loans 1,172,272 67.6% 1,128,705 67.3%
Consumer
Real estate 330,538 19.1% 320,943 19.1%
Home equity 167,146 9.6% 165,937 9.9%
Construction 39,838 2.3% 37,925 2.3%
Other 24,170 1.4% 23,822 1.4%
Total consumer loans 561,692 32.4% 548,627 32.7%
Total gross loans, net of deferred fees 1,733,964 100.0% 1,677,332 100.0%
Less—allowance for loan losses (16,051 ) (15,762 )
Total loans, net $ 1,717,913 $ 1,661,570

12


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.

     
March 31, 2019
After one
One year but within After five
(dollars in thousands) or less five years years Total
Commercial
Owner occupied RE       $      21,648       165,318       199,290       386,256
Non-owner occupied RE 41,795 244,292 137,866 423,953
Construction 18,526 35,798 26,237 80,561
Business 80,049 141,048 60,405 281,502
Total commercial loans 162,018 586,456 423,798 1,172,272
Consumer
Real estate 24,754 73,030 232,754 330,538
Home equity 8,127 26,423 132,596 167,146
Construction 15,122 877 23,839 39,838
Other 7,473 12,121 4,576 24,170
Total consumer loans 55,476 112,451 393,765 561,692
Total gross loans, net of deferred fees $ 217,494 698,907 817,563 1,733,964
Loans maturing after one year with:
Fixed interest rates $      1,155,862
Floating interest rates 360,608
 
December 31, 2018
After one
One year but within After five
(dollars in thousands) or less five years years Total
Commercial
Owner occupied RE       $      20,839       165,436       180,743       367,018
Non-owner occupied RE 43,000 227,454 133,842 404,296
Construction 22,941 33,045 28,425 84,411
Business 80,672 128,911 63,397 272,980
Total commercial loans 167,452 554,846 406,407 1,128,705
Consumer
Real estate 29,301 70,467 221,175 320,943
Home equity 8,867 24,618 132,452 165,937
Construction 16,006 1,646 20,273 37,925
Other 7,681 11,253 4,888 23,822
Total consumer 61,855 107,984 378,788 548,627
Total gross loan, net of deferred fees $ 229,307 662,830 785,195 1,677,332
Loans maturing after one year with :
Fixed interest rates $      1,100,854
Floating interest rates 347,171

13


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

     
March 31, 2019
Owner Non-owner
(dollars in thousands) occupied RE occupied RE Construction Business Total
Pass       $      382,553       415,897       80,494       275,450       1,154,394
Special mention 1,495 4,261 67 1,967 7,790
Substandard 2,208 3,795 - 4,085 10,088
Doubtful - - - - -
$ 386,256 423,953 80,561 281,502 1,172,272
 
December 31, 2018
Owner Non-owner
(dollars in thousands) occupied RE occupied RE Construction Business Total
Pass $ 363,621 400,266 84,411 266,898 1,115,196
Special mention 296 118 - 2,971 3,385
Substandard 3,101 3,912 - 3,111 10,124
Doubtful - - - - -
$ 367,018 404,296 84,411 272,980 1,128,705

14


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

     
March 31, 2019
Owner Non-owner
(dollars in thousands) occupied RE occupied RE Construction Business Total
Current       $      386,146       423,953       80,561       281,430       1,172,090
30-59 days past due 110 - - - 110
60-89 days past due - - - - -
Greater than 90 Days - - - 72 72
$ 386,256 423,953 80,561 281,502 1,172,272
 
December 31, 2018
Owner Non-owner
occupied RE occupied RE Construction Business Total
Current $ 367,018 404,179 84,411 272,864 1,128,472
30-59 days past due - 117 - 36 153
60-89 days past due - - - - -
Greater than 90 Days - - - 80 80
$ 367,018 404,296 84,411 272,980 1,128,705

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

     
March 31, 2019
(dollars in thousands) Real estate Home equity Construction Other Total
Pass       $      324,421       163,989       39,838       24,007       552,255
Special mention 2,428 415 - 127 2,970
Substandard 3,689 2,742 - 36 6,467
Doubtful - - - - -
$ 330,538 167,146 39,838 24,170 561,692
 
December 31, 2018
(dollars in thousands) Real estate Home equity Construction Other Total
Pass $ 314,586 162,626 37,925 23,586 538,723
Special mention 1,792 864 - 139 2,795
Substandard 4,565 2,447 - 97 7,109
Doubtful - - - - -
$ 320,943 165,937 37,925 23,822 548,627

15


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

     
March 31, 2019
(dollars in thousands)       Real estate       Home equity       Construction       Other       Total
Current $      328,378 166,632 39,838 24,140 558,988
30-59 days past due 656 246 - 30 932
60-89 days past due 862 - - - 862
Greater than 90 Days 642 268 - - 910
$ 330,538 167,146 39,838 24,170 561,692
 
December 31, 2018
(dollars in thousands) Real estate Home equity Construction Other Total
Current $ 317,267 165,727 37,925 23,603 544,522
30-59 days past due 2,555 30 - 106 2,691
60-89 days past due 923 - - 113 1,036
Greater than 90 Days 198 180 - - 378
$ 320,943 165,937 37,925 23,822 548,627

As of March 31, 2019 and December 31, 2018, loans 30 days or more past due represented 0.17% and 0.26% of the Company’s total loan portfolio, respectively. Commercial loans 30 days or more past due were 0.01% of the Company’s total loan portfolio as of March 31, 2019 and December 31, 2018, while consumer loans 30 days or more past due were 0.16% and 0.25% of total loans as of March 31, 2019 and December 31, 2018, respectively.

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.

 
(dollars in thousands)       March 31, 2019       December 31, 2018
Commercial
Owner occupied RE $         - -
Non-owner occupied RE 403 210
Construction - -
Business 72 81
Consumer
Real estate 1,840 1,980
Home equity 1,249 1,006
Construction - -
Other - 12
Nonaccruing troubled debt restructurings 2,485 2,541
Total nonaccrual loans, including nonaccruing TDRs 6,049 5,830
Other real estate owned - -
Total nonperforming assets $ 6,049 5,830
Nonperforming assets as a percentage of:
Total assets 0.30% 0.31%
Gross loans 0.35% 0.35%
Total loans over 90 days past due 982 458
Loans over 90 days past due and still accruing - -
Accruing troubled debt restructurings $ 6,839 6,742

16


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.

 
          March 31, 2019
Recorded investment
Impaired loans
Unpaid with related Related
Principal Impaired allowance for allowance for
(dollars in thousands)       Balance       loans       loan losses       loan losses
Commercial
Owner occupied RE $      2,816 2,751 449 75
Non-owner occupied RE 2,977 2,953 1,773 546
Construction - - - -
Business 3,242 2,615 1,998 946
Total commercial 9,035 8,319 4,220 1,567
Consumer
Real estate 2,755 2,748 1,264 414
Home equity 1,704 1,665 268 95
Construction - - - -
Other 156 156 156 18
Total consumer 4,615 4,569 1,688 527
Total $ 13,650 12,888            5,908           2,094
 
          December 31, 2018
Recorded investment
Impaired loans
Unpaid with related Related
Principal Impaired allowance for allowance for
(dollars in thousands) Balance loans loan losses loan losses
Commercial
Owner occupied RE $ 2,827 2,762 451 75
Non-owner occupied RE 3,321 2,807 2,204 558
Construction - - - -
Business 3,745 2,520 2,005 895
Total commercial 9,893 8,089 4,660 1,528
Consumer
Real estate 2,993 2,892 1,398 456
Home equity 1,935 1,421 - -
Construction - - - -
Other 170 170 170 30
Total consumer 5,098 4,483 1,568 486
Total $ 14,991 12,572 6,228 2,014

17


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.

 
Three months ended Three months ended Year ended
March 31, 2019 March 31, 2018 December 31, 2018
    Average   Recognized   Average   Recognized   Average   Recognized
recorded interest recorded interest recorded interest
(dollars in thousands)       investment       income       investment       income       investment       income
Commercial
Owner occupied RE $      2,757 30 2,231 17 2,784 142
Non-owner occupied RE 2,977 49 3,758 50 2,860 174
Construction - - - - - -
Business 2,567 40 1,886 21 2,883 162
Total commercial 8,301 119 7,875 88 8,527 478
Consumer
Real estate 2,761 25 2,814 41 2,930 151
Home equity 1,677 30 2,203 28 1,453 99
Construction - - - - - -
Other 157 1 168 1 174 5
Total consumer 4,595 56 5,185 70 4,557 255
Total $ 12,896 175 13,060 158 13,084 733

Allowance for Loan Losses

The allowance for loan loss 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:

 
Three months ended March 31, 2019
Commercial Consumer
Owner   Non-owner
occupied occupied Real Home
(dollars in thousands)     RE     RE     Construction     Business     Estate     equity     Construction     Other     Total
Balance, beginning of period $      2,726 3,811               615 3,616 3,081 1,348 275    290 15,762
Provision for loan losses 57 74 (43 ) 171 (56 ) 61 7 29 300
Loan charge-offs - - - - - - - (41 ) (41 )
Loan recoveries - 1 - 9 16 1 - 3 30
Net loan charge-offs - 1 - 9 16 1 - (38 ) (11 )
Balance, end of period $ 2,783 3,886 572 3,796 3,041 1,410 282 281 16,051
Net charge-offs to average loans (annualized) 0.00%
Allowance for loan losses to gross loans 0.93%
Allowance for loan losses to nonperforming loans 265.35%

18



 
Three months ended March 31, 2018
Commercial Consumer
Owner   Non-owner
occupied occupied Real Home
(dollars in thousands)     RE     RE     Construction     Business     Estate     equity     Construction     Other     Total
Balance, beginning of period $ 2,534 3,230 325       3,848 3,495 1,600 210 281 15,523
Provision for loan losses 146 135 90 (294 ) (105 ) 451 46 31 500
Loan charge-offs - - - (119 ) - (140 ) - (34 ) (293 )
Loan recoveries - 1 - 118 1 - - 2 122
Net loan charge-offs - 1 - (1 ) 1 (140 ) -    (32 ) (171 )
Balance, end of period $      2,680 3,366 415 3,553 3,391 1,911 256 280 15,852
Net charge-offs to average loans (annualized) 0.05%
Allowance for loan losses to gross loans 1.09%
Allowance for loan losses to nonperforming loans 217.92%

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

 
March 31, 2019
Allowance for loan losses Recorded investment in loans
(dollars in thousands)       Commercial       Consumer       Total       Commercial       Consumer       Total
Individually evaluated $ 1,567 527 2,094 8,319 4,569 12,888
Collectively evaluated 9,470 4,487 13,957 1,163,953 557,123 1,721,076
Total $ 11,037 5,014 16,051 1,172,272 561,692 1,733,964
 
December 31, 2018
Allowance for loan losses Recorded investment in loans
(dollars in thousands) Commercial Consumer Total Commercial Consumer Total
Individually evaluated $      1,528 486 2,014 8,089 4,483 12,572
Collectively evaluated 9,240 4,508 13,748 1,120,616 544,144 1,664,760
Total $ 10,768 4,994 15,762 1,128,705 548,627 1,677,332

NOTE 5 – Troubled Debt Restructurings

At March 31, 2019 and December 31, 2018, the Company had 26 loans totaling $9.3 million 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. To date, the Company has restored three commercial loans previously classified as TDRs to accrual status.

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. There were no new loans classified as TDRs during the three months ended March 31, 2019.

 
For the three months ended March 31, 2018
Pre- Post-
modification modification
Renewals Reduced Converted Maturity Total outstanding outstanding
deemed a or deferred to interest date Number recorded recorded
(dollars in thousands)       concession       payments       only       extensions       of loans       investment       investment
Consumer
Real estate 2 - - - 2 $       549 $       669
Total loans 2 - - - 2 $ 549 $ 669

19


As of March 31, 2019 and 2018, 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 March 31, 2019 and December 31, 2018.

 
March 31, 2019
Fair Value
(dollars in thousands)       Notional       Balance Sheet Location       Asset/(Liability)
Mortgage loan interest rate lock commitments $ 42,620 Other assets $                589
MBS forward sales commitments 26,000 Other liabilities (107 )
Total derivative financial instruments $ 68,620 $ 482
 
December 31, 2018
Fair Value
(dollars in thousands) Notional Balance Sheet Location Asset/(Liability)
Mortgage loan interest rate lock commitments $      20,552 Other assets $ 345
MBS forward sales commitments 11,750 Other liabilities   (121 )
Total derivative financial instruments $ 32,302 $ 224

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.

20


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 13 of the Company’s 2018 Form 10-K. The Company’s loan portfolio is initially fair valued using a segmented approach, using the eight categories 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 March 31, 2019 and December 31, 2018.

     
March 31, 2019
(dollars in thousands) Level 1 Level 2 Level 3 Total
Assets                        
Securities available for sale
US government agencies $ - 8,896 - 8,896
SBA securities - 3,389 - 3,389
State and political subdivisions - 8,175 - 8,175
Asset-backed securities - 9,426 - 9,426
Mortgage-backed securities - 43,414 - 43,414
Mortgage loans held for sale - 9,393 - 9,393
Mortgage loan interest rate lock commitments - 589 - 589
Total assets measured at fair value on a recurring basis $ - 83,282 - 83,282
 
Liabilities
MBS forward sales commitments $ - 107 - 107
Total liabilities measured at fair value on a recurring basis $ - 107 - 107
                   
  December 31, 2018
(dollars in thousands) Level 1 Level 2 Level 3 Total
Assets
Securities available for sale:
US government agencies $ - 8,782 - 8,782
SBA securities - 3,525 - 3,525
State and political subdivisions - 8,356 - 8,356
Asset-backed securities - 9,558 - 9,558
Mortgage-backed securities - 44,684 - 44,684
Mortgage loans held for sale - 9,241 - 9,241
Mortgage loan interest rate lock commitments - 345 - 345
Total assets measured at fair value on a recurring basis $ - 84,491 - 84,491
 
Liabilities
MBS forward sales commitments $ - 121 - 121
Total liabilities measured at fair value on a recurring basis $ - 121 - 121

21


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 March 31, 2019 and December 31, 2018.

     
As of March 31, 2019
(dollars in thousands) Level 1 Level 2 Level 3 Total
Assets                        
Impaired loans $      - 2,386 8,408 10,794
Total assets measured at fair value on a nonrecurring basis $ - 2,386 8,408 10,794
     
  As of December 31, 2018
(dollars in thousands) Level 1 Level 2 Level 3 Total
Assets
Impaired loans $ - 2,190 8,368 10,558
Total assets measured at fair value on a nonrecurring basis $ - 2,190 8,368 10,558

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 March 31, 2019 and December 31, 2018 are as follows:

     
March 31, 2019
Carrying Fair
(dollars in thousands) Amount Value Level 1 Level 2 Level 3
Financial Assets:                              
Other investments, at cost $      3,309 3,309 - - 3,309
Loans 1 1,705,025 1,675,800 - - 1,675,800
Financial Liabilities:
Deposits 1,758,235 1,646,234 - 1,646,234 -
FHLB and other borrowings 25,000 25,689 - 25,689 -
Junior subordinated debentures 13,403 14,528 - 14,528 -

December 31, 2018
Carrying Fair
(dollars in thousands) Amount Value Level 1 Level 2 Level 3
Financial Assets:                              
Other investments, at cost $      4,121 4,121 - - 4,121
Loans 1 1,648,998 1,618,618 - - 1,618,618
Financial Liabilities:
Deposits 1,648,136 1,515,123 - 1,515,123 -
FHLB and other borrowings 50,000 50,147 - 50,147 -
Junior subordinated debentures 13,403 14,807 - 14,807 -

1 Carrying amount is net of the allowance for loan losses and previously presented impaired loans.

22


NOTE 8 – Leases

Effective January 1, 2019, the Company adopted ASU 2016-02, “Leases (Topic 842)”. As of March 31, 2019, the Company leases five of our offices under various operating lease agreements. The lease agreements have maturity dates ranging from February 2022 to August 2028, some of which include options for multiple five-year extensions. The weighted average remaining life of the lease term for these leases was 7.83 years as of March 31, 2019.

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 in to. The weighted average discount rate for leases was 3.13% as of March 31, 2019.

The total operating lease costs were $528,000 for the three months ended March 31, 2019. The right-of-use asset, included in property and equipment, and lease liabilities, included in other liabilities, were $15.0 million and $15.5 million as of March 31, 2019, respectively. The right-of-use 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 March 31, 2019 were as follows:

   
Operating
(dollars in thousands) Leases
2019 $      1,367
2020 1,862
2021 1,907
2022 1,151
2023 1,020
Thereafter 12,331
Total undiscounted lease payments 19,639
Discount effect of cash flows 4,174
Total lease liability $ 15,465

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-month periods ended March 31, 2019 and 2018. Dilutive common shares arise from the potentially dilutive effect of the Company’s stock options that were outstanding at March 31, 2019. The assumed conversion of stock options can create a difference between basic and dilutive net income per common share. At March 31, 2019 and 2018, there were 271,034 and 166,172 options, respectively, that were not considered in computing diluted earnings per common share because they were anti-dilutive.

     
Three months ended
March 31,
(dollars in thousands, except share data) 2019 2018
Numerator:            
Net income available to common shareholders $      6,009 5,214
Denominator:
Weighted-average common shares outstanding – basic 7,459,342 7,336,839
Common stock equivalents 282,518 390,046
Weighted-average common shares outstanding – diluted 7,741,860 7,726,885
Earnings per common share:
Basic $ 0.81 0.71
Diluted $ 0.78 0.67

23


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.

                                       
Three months ended Three months ended
March 31, 2019 March 31, 2018
Commercial Commercial
and Retail Mortgage Elimin- Consol- and Retail   Mortgage Elimin- Consol-
(dollars in thousands) Banking Banking Corporate ations idated    Banking    Banking    Corporate    ations    idated
Interest income    $      21,519    93    3    (3 )    21,612 17,078 100 2 (2 ) 17,178
Interest expense 5,631 - 166 (3 ) 5,794 3,019 - 119 (2 ) 3,136
Net interest income (loss) 15,888 93 (163 ) - 15,818 14,059 100 (117 ) - 14,042
Provision for loan losses 300 - - - 300 500 - - - 500
Noninterest income 1,137 1,857 - - 2,994 1,092 1,328 - - 2,420
Noninterest expense 9,465 1,123 60 - 10,648 8,181 964 60 - 9,205
Net income (loss) before taxes 7,260 827 (223 ) - 7,864 6,470 464 (177 ) - 6,757
Income tax provision (benefit) 1,728 174 (47 ) - 1,855 1,483 97 (37 ) - 1,543
Net income (loss) $ 5,532 653 (176 ) - 6,009 4,987 367 (140 ) - 5,214
Total assets $  2,002,957 11,003  194,671   (194,205 ) 2,014,426 1,720,017 8,814   168,137 (167,669 ) 1,729,299

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 month period ended March 31, 2019 as compared to the three month period ended March 31, 2018 and assesses our financial condition as of March 31, 2019 as compared to December 31, 2018. 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, 2018 included in our Annual Report on Form 10-K for that period. Results for the three month period ended March 31, 2019 are not necessarily indicative of the results for the year ending December 31, 2019 or any future period.

C AUTIONARY W ARNING R EGARDING FORWARD - LOOKING STATEMENTS

This report, including information included or incorporated by reference in 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, those described under Item 1A. Risk Factors of our Annual Report on Form 10-K for the year ended December 31, 2018, as well as the following:

Restrictions or conditions imposed by our regulators on our operations;

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

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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 Greensboro, North Carolina, Raleigh, North Carolina and Atlanta, Georgia 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;

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; and

Other risks and uncertainties detailed in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2018, in Part II, Item 1A of this Quarterly Report on Form 10-Q, and from time to time 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. For information with respect to factors that could cause actual results to differ from the expectations stated in the forward-looking statements, see “Risk Factors” under Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2018 and “Risk Factors” under Part II, Item 1A of this Quarterly Report on Form 10-Q. 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.

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."

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At March 31, 2019, we had total assets of $2.01 billion, a 6.0% increase from total assets of $1.90 billion at December 31, 2018. The largest components of our total assets are loans, cash and cash equivalents and securities which were $1.73 billion, $117.3 million and $76.6 million, respectively, at March 31, 2019. Comparatively, our loans, cash and cash equivalents and securities totaled $1.68 billion, $72.9 million and $79.0 million, respectively, at December 31, 2018. Our liabilities and shareholders’ equity at March 31, 2019 totaled $1.83 billion and $181.2 million, respectively, compared to liabilities of $1.73 billion and shareholders’ equity of $173.9 million at December 31, 2018. The principal component of our liabilities is deposits which were $1.76 billion and $1.65 billion at March 31, 2019 and December 31, 2018, 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 $6.0 million and $5.2 million for the three months ended March 31, 2019 and 2018, respectively, an increase of $795,000, or 15.3%. Diluted earnings per share (“EPS”) was $0.78 for the first quarter of 2019 as compared to $0.67 for the same period in 2018. The increase in net income resulted primarily from increases in net interest income and noninterest income, which were partially offset due to an increase in noninterest expense.

Economic conditions, competition, and the monetary and fiscal policies of the Federal government significantly affect most financial institutions, including the Bank. Lending and deposit activities and fee income generation are influenced by levels of business spending and investment, consumer income, consumer spending and savings, capital market activities, and competition among financial institutions, as well as customer preferences, interest rate conditions and prevailing market rates on competing products in our market areas.

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 $15.8 million for the three month period ended March 31, 2019, a 12.7% increase over net interest income of $14.0 million for the same period in 2018. In addition, our average earning assets increased 16.1%, or $252.4 million, during the first quarter of 2019 compared to the first quarter of 2018, while our interest-bearing liabilities increased by $184.5 million, or 15.4%, during the same period. The increase in average earning assets was primarily related to an increase in average loans partially offset by a decrease in federal funds sold, while the increase in average interest-bearing liabilities was primarily a result of an increase in interest-bearing deposits.

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 month periods ended March 31, 2019 and 2018. 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.

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The following table 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 March 31,
2019 2018
(dollars in thousands) Average
Balance
Income/
Expense
Yield/
Rate
(1)
Average
Balance
Income/
Expense
Yield/
Rate
(1)
Interest-earning assets                        
Federal funds sold $ 30,656 $ 174 2.30 % $ 61,743 $ 247 1.62 %
Investment securities, taxable 71,876 508 2.87 % 58,029 312 2.18 %
Investment securities, nontaxable (2) 5,427 53 3.98 % 7,046 73 4.19 %
Loans (3) 1,715,570 20,889 4.94 % 1,444,343 16,563 4.65 %
Total interest-earning assets 1,823,529 21,624 4.81 % 1,571,161 17,195 4.44 %
Noninterest-earning assets 86,431 74,685
Total assets $ 1,909,960 $ 1,645,846
Interest-bearing liabilities
NOW accounts $ 186,070 86 0.19 % $ 238,690 91 0.15 %
Savings & money market 780,115 3,300 1.72 % 595,374 1,577 1.07 %
Time deposits 371,694 1,989 2.17 % 315,344 1,070 1.38 %
Total interest-bearing deposits 1,337,879 5,375 1.63 % 1,149,408 2,738 0.97 %
FHLB advances and other borrowings 31,302 256 3.32 % 35,287 283 3.25 %
Junior subordinated debentures 13,403 163 4.93 % 13,403 115 3.48 %
Total interest-bearing liabilities 1,382,584 5,794 1.70 % 1,198,098 3,136 1.06 %
Noninterest-bearing liabilities 349,988 295,374
Shareholders’ equity 177,388 152,374
Total liabilities and shareholders’ equity $      1,909,960 $      1,645,846
Net interest spread 3.11 % 3.38 %
Net interest income (tax equivalent) / margin $ 15,830 3.52 % $      14,059 3.63 %
Less: tax-equivalent adjustment (2) 12 17
Net interest income $       15,818 $ 14,042
(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, on a tax-equivalent basis, was 3.52% for the three months ended March 31, 2019 compared to 3.63% for the first quarter of 2018. The 11 basis point decrease in net interest margin was driven by the increase in rate on our interest-bearing liabilities, partially offset by the increased rate on our interest-earning assets as compared to the prior year period. Our average interest-earning assets grew by $252.4 million during the first three months of 2019 as compared to the same period in 2018, while the average yield on these assets increased by 37 basis points. In addition, our average interest-bearing liabilities grew by $184.5 million during the 2019 period while the rate on these liabilities increased 64 basis points to 1.70% for the three months ended March 31, 2019.

The increase in average interest-earning assets for the three months ended March 31, 2019 as compared to the same period in 2018 primarily related to a $271.2 million increase in our average loan balances. The 37 basis point increase in yield on these assets was driven by a 29 basis point increase in our loan yield. The higher yield on our loan portfolio was due to loans being originated or renewed at market rates which are higher than those in the past.

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In addition, the increase in our interest-bearing liabilities resulted primarily from a $188.5 million increase in our interest-bearing deposits at an average rate of 1.63%, a 66 basis point increase from the average rate in the first quarter of 2018. This increase was partially offset by a $4.0 million decrease in FHLB advances and other borrowings at an average rate of 3.32%, a seven basis point increase from the first quarter of 2018.

Our net interest spread was 3.11% for the three months ended March 31, 2019 compared to 3.38% for the same period in 2018. 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 37 basis point increase in yield on our interest-earning assets and the 64 basis point increase in rate on our interest-bearing liabilities, resulted in a 27 basis point decrease in our net interest spread for the 2019 period. We anticipate continued pressure on our net interest spread and net interest margin in future periods based on the competitive rate environment around our deposits.

Rate/Volume Analysis
Net interest income can be analyzed in terms of the impact of changing interest rates and changing volume. The following table sets 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
March 31, 2019 vs. 2018 March 31, 2018 vs. 2017
Increase (Decrease) Due to Increase (Decrease) Due to
Rate/ Rate/
(dollars in thousands)       Volume       Rate       Volume       Total       Volume       Rate       Volume       Total
Interest income
Loans $ 3,110 1,024 192 4,326 $ 2,582 382 73 3,037
Investment securities 69 94 18 181 (25 ) 18 (1 ) (8 )
Federal funds sold (124 ) 103 (52 ) (73 ) 62 61 67 190
Total interest income 3,055 1,221 158 4,434 2,619 461 139 3,219
Interest expense
Deposits 439 1,894 304 2,637 404 820 265 1,489
FHLB advances and other borrowings (32 ) 6 (1 ) (27 ) (714 ) (9 ) 7 (716 )
Junior subordinated debt - 48 - 48 - 11 - 11
Total interest expense 407 1,948 303 2,658 (310 ) 822 272 784
Net interest income $ 2,648 (727 )       (145 ) 1,776 $      2,929 (361 )       (133 ) 2,435

Net interest income, the largest component of our income, was $15.8 million for the three months ended March 31, 2019 and $14.0 million for the three months ended March 31, 2018, a $1.8 million, or 12.7%, increase during the first quarter of 2019. The increase in net interest income is due to a $4.4 million increase in interest income, partially offset by a $2.7 million increase in interest expense. During the first quarter of 2019, our average interest-earning assets increased $252.4 million as compared to the same period in 2018, resulting in $3.1 million of additional interest income, while higher rates on our interest-earning assets also increased interest income by $1.2 million from the prior year period. Overall, our average interest-bearing deposits increased by $188.5 million. While the growth in interest-bearing deposits resulted in additional interest expense, the reduction in FHLB advances and other borrowings partially offset the increase, resulting in a net increase in interest expense of $407,000. However, higher rates on our interest-bearing deposits, junior subordinated debt, as well as FHLB advances and other borrowings, resulted in an increase in interest expense of $1.9 million from the prior year 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 Footnote 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.

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For the three months ended March 31, 2019, we incurred a noncash expense related to the provision for loan losses of $300,000, which resulted in an allowance for loan losses of $16.1 million, or 0.93% of gross loans. For the three months ended March 31, 2018, our provision for loan losses of $500,000 resulted in an allowance for loan losses of $15.9 million, or 1.09% of gross loans. During the past 12 months, our loan balances increased by $274.6 million, while the percentage of our nonperforming loans and classified loans have declined. Factors such as these are also considered in determining the amount of loan loss provision necessary to maintain our allowance for loan losses at an adequate level.

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

   
Three months ended
March 31,
(dollars in thousands) 2019       2018
Mortgage banking income $      1,857 1,328
Service fees on deposit accounts 265 257
ATM and debit card income 380 334
Income from bank owned life insurance 216 220
Other income 276 281
Total noninterest income $      2,994 2,420

Noninterest income increased $574,000, or 23.7%, for the first quarter of 2019 as compared to the same period in 2018. The increase in total noninterest income during the 2019 period resulted primarily from the following:

Mortgage banking income increased by $529,000, or 39.8%, driven by higher mortgage origination volume during the first quarter of 2019 due in part to the favorable interest rate environment for mortgage loans.
ATM and debit card income increased by $46,000, or 13.8%, driven by an increase in transaction volume.

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

   
Three months ended
March 31,
(dollars in thousands) 2019       2018
Compensation and benefits $ 6,783 5,843
Occupancy 1,339 1,137
Outside service and data processing costs 960 736
Insurance 318 313
Professional fees 439 476
Marketing 260 209
Other 549 491
Total noninterest expense $      10,648 9,205

Noninterest expense was $10.6 million for the three months ended March 31, 2019, a $1.4 million, or 15.7%, increase from noninterest expense of $9.2 million for the three months ended March 31, 2018. The increase in noninterest expenses during the 2019 period was driven by the following:

Compensation and benefits expense increased $940,000, or 16.1%, relating primarily to increases in base compensation, incentive compensation and benefits expenses. Base compensation increased by $756,000 driven by the cost of 14 additional employees, five of which were hired in conjunction with the opening of our new office in Atlanta, Georgia; five of which were hired as additional team leaders or mortgage executives in our existing markets; and the remainder being hired to support loan, deposit and corporate growth. Incentive compensation increased by $90,000 and benefits expense increased by $97,000 during the 2019 period. The increase in incentive compensation related to the additional number of employees at March 31, 2019 while the increase in benefits expenses was driven by an increase in payroll taxes and partially offset by a decrease in group insurance costs for the 2019 period.

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Occupancy expenses increased by $202,000, or 17.8%, primarily driven by our new office in Atlanta, Georgia as well as additional rent expense recognized due to the implementation of the new lease accounting standard.
Outside service and data processing fees increased by $224,000, or 30.4%, primarily due to increased electronic banking and software licensing costs.

Our efficiency ratio was 56.6% for the first quarter of 2019 compared to 55.9% for the same period in 2018. 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 2019 period relates primarily to the increase in noninterest expenses as a percentage of net interest and noninterest income compared to the prior year.

We incurred income tax expense of $1.9 million and $1.5 million for the three months ended March 31, 2019 and 2018, respectively. Our effective tax rate was 23.6% and 22.8% for the three months ended March 31, 2019 and 2018, respectively. The higher tax rate for the 2019 period relates to the lesser impact of our tax exempt income on our taxable income.

Balance Sheet Review

Investment Securities
At March 31, 2019, the $76.6 million in our investment securities portfolio represented approximately 3.8% of our total assets. Our available for sale investment portfolio included U.S. government agency securities, SBA securities, state and political subdivisions, and mortgage-backed securities with a fair value of $73.3 million and an amortized cost of $73.8 million, resulting in an unrealized loss of $480,000. At December 31, 2018, the $79.0 million in our investment securities portfolio represented approximately 4.2% of our total assets. At December 31, 2018, we held investment securities available for sale with a fair value of $74.9 million and an amortized cost of $76.1 million for an unrealized loss of $1.2 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 for the three months ended March 31, 2019 and 2018 were $1.72 billion and $1.44 billion, respectively. Before the allowance for loan losses, total loans outstanding at March 31, 2019 and December 31, 2018 were $1.73 billion and $1.68 billion, respectively.

The principal component of our loan portfolio is loans secured by real estate mortgages. As of March 31, 2019, our loan portfolio included $1.4 billion, or 82.4%, of real estate loans. As of December 31, 2018, real estate loans made up 82.3% of our loan portfolio and totaled $1.4 billion. 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. This collateral is taken 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. We do not generally originate traditional long term residential mortgages to hold in our loan portfolio, but we do issue traditional second mortgage residential real estate loans and home equity lines of credit. Home equity lines of credit totaled $167.1 million as of March 31, 2019, of which approximately 60% were in a first lien position, while the remaining balance was second liens, compared to $165.9 million as of December 31, 2018, with approximately 56% in first lien positions and the remaining balance in second liens. The average loan had a balance of approximately $88,000 and a loan to value of 69% as of March 31, 2019, compared to an average loan balance of $88,000 and a loan to value of approximately 70% as of December 31, 2018. Further, 0.3% and 0.1% of our total home equity lines of credit were over 30 days past due as of March 31, 2019 and December 31, 2018, respectively.

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Following is a summary of our loan composition at March 31, 2019 and December 31, 2018. During the first three months of 2019, our loan portfolio increased by $56.6 million, or 3.4%. Our commercial and consumer loan portfolios each experienced growth during the three months ended March 31, 2019 with a 3.9% increase in commercial loans and a 2.4% increase in consumer loans during the period. Of the $56.6 million in loan growth during the first three months of 2019, $47.8 million of the increase was in loans secured by real estate, $8.5 million in commercial business loans, and $348,000 in other consumer loans. 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 $377,000, a term of eleven years, and an average rate of 4.52% as of March 31, 2019, compared to a principal balance of $377,000, a term of eleven years, and an average rate of 4.47% as of December 31, 2018.

  
March 31, 2019 December 31, 2018
(dollars in thousands)       Amount       % of Total       Amount       % of Total
Commercial
Owner occupied RE $ 386,256 22.3 % $ 367,018 21.9 %
Non-owner occupied RE 423,953 24.4 % 404,296 24.1 %
Construction 80,561 4.7 % 84,411 5.0 %
Business 281,502 16.2 % 272,980 16.3 %
Total commercial loans 1,172,272 67.6 % 1,128,705 67.3 %
   
Consumer
Real estate 330,538 19.1 % 320,943 19.1 %
Home equity 167,146 9.6 % 165,937 9.9 %
Construction 39,838 2.3 % 37,925 2.3 %
Other 24,170 1.4 % 23,822 1.4 %
Total consumer loans 561,692 32.4 % 548,627 32.7 %
Total gross loans, net of deferred fees 1,733,964      100.0 % 1,677,332      100.0 %
Less—allowance for loan losses (16,051 ) (15,762 )
Total loans, net $