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WASHINGTON, D.C. 20549
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).
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.
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).
The number of shares outstanding of the issuer’s common stock, $0.01 par value per share, was 25,161,736 at November 3, 2020.
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Information
This Quarterly Report on Form 10-Q may contain various forward-looking statements, which can be identified by the use of words such as “estimate,” “project,” “believe,” “intend,” “anticipate,” “plan,” “seek,” “expect” and similar expressions and verbs in the future tense. These forward-looking statements include, but are not limited to:
These forward-looking statements are based on current beliefs and expectations of our management and are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change.
The following factors, among others, could cause actual results to differ materially from the anticipated results or other expectations expressed in the forward-looking statements:
See also the factors referred to in reports filed by the Company with the Securities and Exchange Commission (particularly those under the caption “Risk Factors” in Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2019 and Quarterly Report on Form 10-Q for the quarter ended March 31, 2020).
The risks included here are not exhaustive. Other sections of this report may include additional factors which could adversely affect our business and financial performance. New risks emerge from time to time and it is not possible for management to predict all such risks, nor can it assess the impact of all such risks on our business or the extent to which any risk, or combination of risks, may cause actual results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results.
Overview
The following discussion and analysis is presented to assist the reader in understanding and evaluating the Company’s financial condition and results of operations. It is intended to complement the unaudited consolidated financial statements, footnotes, and supplemental financial data appearing elsewhere in this Quarterly Report on Form 10-Q and should be read in conjunction therewith. The detailed discussion in the sections below focuses on the results of operations for the three and nine months ended September 30, 2020 and 2019 and the financial condition as of September 30, 2020 compared to the financial condition as of December 31, 2019.
As described in the notes to the unaudited consolidated financial statements, we have two reportable segments: community banking and mortgage banking. The community banking segment provides consumer and business banking products and services to customers primarily within Southeastern Wisconsin along with a loan production office in Minneapolis, Minnesota. Consumer products include loan products, deposit products, and personal investment services. Business banking products include loans for working capital, inventory and general corporate use, commercial real estate construction loans, and deposit accounts. The mortgage banking segment, which is conducted by offices in 21 states through Waterstone Mortgage Corporation, consists of originating residential mortgage loans primarily for sale in the secondary market.
Our community banking segment generates the significant majority of our consolidated net interest income and requires the significant majority of our provision for loan losses. Our mortgage banking segment generates the significant majority of our noninterest income and a majority of our noninterest expenses. We have provided below a discussion of the material results of operations for each segment on a separate basis for the three and nine months ended September 30, 2020 and 2019, which focuses on noninterest income and noninterest expenses. We have also provided a discussion of the consolidated operations of the Company, which includes the consolidated operations of the Bank and Waterstone Mortgage Corporation, for the same periods.
Significant Items
Earnings comparisons for the three and nine months ended September 30, 2020 and 2019 were impacted by the Significant Items summarized below.
COVID-19 and the CARES Act
The COVID-19 pandemic has caused economic and social disruption on an unprecedented scale. While some industries have been impacted more severely than others, all businesses have been impacted to some degree. This disruption has resulted in the shuttering of businesses across the country, significant job loss, and aggressive measures by the federal government.
Congress, the President, and the Federal Reserve have taken several actions designed to cushion the economic fallout. Most notably, the Coronavirus Aid, Relief and Economic Security (“CARES”) Act was signed into law at the end of March 2020 as a $2 trillion legislative package. The goal of the CARES Act is to prevent a severe economic downturn through various measures, including direct financial aid to American families and economic stimulus to significantly impacted industry sectors. The package also includes extensive emergency funding for hospitals and providers. In addition to the general impact of COVID-19, certain provisions of the CARES Act as well as other recent legislative and regulatory relief efforts are expected to have a material impact on our operations. While it is not possible to know the full universe or extent of these impacts as of the date this filing, we are disclosing potentially material items of which we are aware.
Our fee income could be reduced due to COVID-19. In keeping with guidance from regulators, we are working with COVID-19 affected customers to waive fees from a variety of sources, such as, but not limited to, insufficient funds and overdraft fees, ATM fees, account maintenance fees, etc. These reductions in fees are thought, at this time, to be temporary in conjunction with the length of the expected COVID-19 related economic crisis. At this time, we are unable to project the materiality of such an impact, but recognize the breadth of the economic impact is likely to impact our fee income in future periods.
Our interest income could be reduced due to COVID-19. In keeping with guidance from regulators, we are actively working with COVID-19 affected borrowers to defer their payments, interest, and fees. While interest and fees will still accrue to income, through normal GAAP accounting, should eventual credit losses on these deferred payments emerge, interest income and fees accrued would need to be reversed. In such a scenario, interest income in future periods could be negatively impacted. At this time, we are unable to project the materiality of such an impact, but recognize the breadth of the economic impact may affect our borrowers’ ability to repay in future periods.
As of September 30, 2020, all of our capital ratios, and our subsidiary 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 COVID-19, our reported and regulatory capital ratios could be adversely impacted by further credit losses.
We maintain access to multiple sources of liquidity. Wholesale funding markets have remained open to us, but rates for short term funding have recently been volatile. If funding costs are elevated for an extended period of time, it could have an adverse effect on our net interest margin. If an extended recession caused large numbers of our deposit customers to withdraw their funds, we might become more reliant on volatile or more expensive sources of funding.
There were no Significant Items during the three and nine months ended September 30, 2019.
Comparison of Community Banking Segment Results of Operations for the Three Months Ended September 30, 2020 and 2019
Net income totaled $6.2 million for the three months ended September 30, 2020 compared to $6.7 million for the three months ended September 30, 2019. Net interest income decreased $424,000 to $13.5 million for the three months ended September 30, 2020 compared to $13.9 million for the three months ended September 30, 2019. Interest income on loans increased on volume offset by a decrease in interest earned in the other interest-earning asset categories. Interest expense decreased as funding rates decreased.
The Company delayed adoption of ASC Topic 326 as permited under the CARES Act. The Company calculated the current quarter allowance using the incurred loss model. There was a provision for loan losses of $1.0 million for the three months ended September 30, 2020 compared to a negative provision of $150,000 for the three months ended September 30, 2019. During the three months ended September 30, 2020, we made adjustments to our qualitative factors, primarily to account for the significant increase in loans downgraded to our Watch caterogy.
Total noninterest income increased $1.7 million due primarily to gains as a result of two death benefits received on bank-owned life insurance policies in the current quarter. The loan fees increased primarily due to loan prepayment fees and fees earned on loan swaps. Cash surrender value of life insurance decreased as the balance decreased year over year as a result of the death benefits. Other income slightly increased primarily due to wealth management and rental income.
Compensation, payroll taxes, and other employee benefits expense increased $925,000 to $5.0 million due primarily to an increase in salaries expense, health insurance expense, and variable compensation. Occupancy, office furniture and equipment decreased due primarily to decreased computer and furniture and equipment expense. Advertising expense increased primarily due to deposit promotions during the three months ended September 30, 2020. Data processing fees decreased due to the digital conversion fees that began in 2019. Professional fees increased for the three months ended September 30, 2020 due to additional audit and legal fees in 2020. Other noninterest expense increased as a result of a credit for FDIC insurance received during the three months ended September 30, 2019 but not during the three months ended September 30, 2020.
Comparison of Mortgage Banking Segment Results of Operations for the Three Months Ended September 30, 2020 and 2019
Net income totaled $20.1 million for the three months ended September 30, 2020 compared to $4.1 million for the three months ended September 30, 2019. We originated $1.30 billion in mortgage loans held for sale (including sales to the community banking segment) during the three months ended September 30, 2020, which represents an increase of $445.4 million, or 52.3%, from the $851.3 million originated during the three months ended September 30, 2019. The increase in loan production volume was driven by a $286.8 million, or 160.4%, increase in refinance products as mortgage rates decreased. Mortgage purchase products increased $158.7 million, or 23.6% due to the high demand of single family homes. Total mortgage banking noninterest income increased $36.6 million, or 100.2%, to $73.1 million during the three months ended September 30, 2020 compared to $36.5 million during the three months ended September 30, 2019. The increase in mortgage banking noninterest income was related to a 52.3% increase in volume and a 26.5% increase in gross margin on loans originated and sold for the three months ended September 30, 2020 compared to September 30, 2019. Gross margin on loans originated and sold is the ratio of mortgage banking income (excluding the change in interest rate lock fair value) divided by total loan originations. The gross margin on loans originated and sold expansion reflects increased industry demand due to the current low rate environment. We sell loans on both a servicing-released and a servicing-retained basis. Waterstone Mortgage Corporation has contracted with a third party to service the loans for which we retain servicing.
Additionally, our overall margin can be affected by the mix of both loan type (conventional loans versus governmental) and loan purpose (purchase versus refinance). Conventional loans include loans that conform to Fannie Mae and Freddie Mac standards, whereas governmental loans are those loans guaranteed by the federal government, such as a Federal Housing Authority or U.S. Department of Agriculture loan. Loans originated for the purchase of a residential property, which generally yield a higher margin than loans originated for refinancing existing loans, comprised 64.1% of total originations during the three months ended September 30, 2020, compared to 79.0% of total originations during the three months ended September 30, 2019, respectively, as refinance demand accelerated from the low rate environment. The mix of loan type trended towards more conventional loans and less governmental loans; with conventional loans and governmental loans comprising 75.6% and 24.4% of all loan originations, respectively, during the three months ended September 30, 2020, compared to 70.1% and 29.9% of all loan originations, respectively, during the three months ended September 30, 2019.
Total compensation, payroll taxes and other employee benefits increased $10.9 million, or 46.3%, to $34.6 million for the three months ended September 30, 2020 compared to $23.6 million for the three months ended September 30, 2019. The increase in compensation expense was primarily a result of the increase in commission expense as fundings increased, bonus and incentives due to record originations. In addition, branch manager pay increased as branches were more profitable. Professional fees increased due to a tentative settlement agreement related to the Herrington litigation (see further discussion in Note 10 - Commitments, Off-Balance Sheet Arrangements, and Contingent Liabilities of the notes to unaudited consolidated financial statements for additional information). Occupancy, office furniture, and equipment decreased due to lower rent driven by a reduction in branches as underperforming branches closed over the past year. Advertising expense decreased as the low rate environment attracted customers. Loan processing expenses increased due primarily to increased application and funding volumes as interest rates remain low in 2020. Other noninterest expense increased primarily due to amortization of mortgage servicing rights as the value of the servicing portfolio has increased in 2020 compared to 2019.
Consolidated Waterstone Financial, Inc. Results of Operations
Net Interest Income
Average Balance Sheets, Interest and Yields/Costs
The following tables set forth average balance sheets, annualized average yields and costs, and certain other information for the periods indicated. Non-accrual loans are included in the computation of the average balances of loans receivable and held for sale. The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income or expense. Yields on interest-earning assets are computed on a fully tax-equivalent yield, where applicable.
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(1) Interest income includes net deferred loan fee amortization income of $349,000 and $136,000 for the three months ended September 30, 2020 and 2019, respectively.
(2) Average balance of mortgage related and debt securities are based on amortized historical cost.
(3) Interest income from tax-exempt securities is computed on a taxable equivalent basis using a tax rate of 21% for the three months ended September 30, 2020 and 2019. The yields on debt securities, federal funds sold and short-term investments before tax-equivalent adjustments were 1.75% and 2.53% for the three months ended September 30, 2020 and 2019, respectively.
(4) Net interest rate spread represents the difference between the yield on average interest-earning assets and the cost of average interest-bearing liabilities and is presented on a fully tax equivalent basis.
(5) Net interest-earning assets represent total interest-earning assets less total interest-bearing liabilities.
(6) Net interest margin represents net interest income divided by average total interest-earning assets.
Rate/Volume Analysis
The following table sets forth the effects of changing rates and volumes on our net interest income for the periods indicated. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The net column represents the sum of the prior columns. For purposes of this table, changes attributable to changes in both rate and volume that cannot be segregated have been allocated proportionately based on the changes due to rate and the changes due to volume.
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(1) Interest income includes net deferred loan fee amortization income of $349,000 and $136,000 for the three months ended September 30, 2020 and 2019, respectively.
(2) Non-accrual loans have been included in average loans receivable balance.
(3) Includes available for sale securities. Average balance of available for sale securities is based on amortized historical cost.
(4) Interest income from tax exempt securities is computed on a taxable equivalent basis using a tax rate of 21% for the three months ended September 30, 2020 and September 30, 2019.
Net interest income increased $255,000, or 1.9%, to $13.4 million during the three months ended September 30, 2020 compared to $13.2 million during the three months ended September 30, 2019.
Provision for Loan Losses
The Company delayed adoption of ASC Topic 326 as permited under the CARES Act. The Company calculated the current quarter allowance using the incurred loss model. The provision for loan losses was $1.0 million for the three months ended September 30, 2020 compared to $80,000 of negative provision for loan losses for the three months ended September 30, 2019 as there was an increase in loans downgraded to our Watch category. Additional qualitative risk factors were applied to each of the loan categories primarily to account for the downgrades. We had a provision for loan losses of $1.0 million at the community banking segment and $25,000 for the mortgage banking segment. Net recoveries were $85,000 for the three months ended September 30, 2020.
The provision is primarily a function of the Company's reserving methodology and assessments of certain quantitative and qualitative factors which are used to determine an appropriate allowance for loan losses for the period. See further discussion regarding the allowance for loan losses in the "Asset Quality" section for an analysis of charge-offs, nonperforming assets, specific reserves and additional provisions and the "Allowance for Loan Losses" section.
Noninterest Income
Total noninterest income increased $38.3 million, or 102.1%, to $75.8 million during the three months ended September 30, 2020 compared to $37.5 million during the three months ended September 30, 2019. The increase resulted primarily from an increase in mortgage banking income and other noninterest income.
Noninterest Expenses
Total noninterest expenses increased $16.8 million, or 46.3%, to $53.0 million during the three months ended September 30, 2020 compared to $36.2 million during the three months ended September 30, 2019.
Income Taxes
Income tax expense totaled $8.9 million for the three months ended September 30, 2020 compared to $3.6 million during the three months ended September 30, 2019. Income tax expense was recognized on the statement of income during the three months ended September 30, 2020 at an effective rate of 25.2% of pretax income compared to 24.6% during the three months ended September 30, 2019. The increase in rate is primarily due to higher pretax income. The Company recognized a benefit of $354,000 related to the proceeds received on the bank owned life insurance death benefit during the three months ended September 30, 2020.
Comparison of Community Banking Segment for the Nine Months Ended September 30, 2020 and 2019
Net income decreased $3.9 million for the nine months ended September 30, 2020 to $14.4 million compared to net income of $18.3 million for the nine months ended September 30, 2019. Net interest income decreased $477,000 to $40.1 million for the nine months ended September 30, 2020 compared to $40.5 million for the nine months ended September 30, 2019. Net interest income decreased primarily due to a decrease from mortgage-related securities and other interest-earning assets interest. Offsetting the decreases on net interest income, interest income on loans increased due to an increase in volume and interest expense on time deposits decreased as replacement rates were lower.
The Company delayed adoption of ASC Topic 326 as permited under the CARES Act. The Company calculated the current quarter allowance using the incurred loss model. Provision for loan losses was $6.1 million for the nine months ended September 30, 2020 compared to a negative provision of $850,000 for the nine months ended September 30, 2019 as economic conditions significantly worsened during the nine months ended September 30, 2020.
Total noninterest income increased $3.7 million due primarily to increases in loan fees and a gain from death benefits on bank owned life insurance. The loan fees increased primarily due to loan prepayment fees and fees earned on loan swaps. Cash surrender value of life insurance decreased as the balance decreased due to death benefit proceeds received on two bank owned life insurance policies. Other income increased primarily due to gain on death benefits, wealth management fees, and rental income.
Compensation, payroll taxes, and other employee benefits expense increased $1.6 million to $15.1 million due primarily to an increase in salaries expense, health insurance expense, and variable compensation. Occupancy, office furniture and equipment decreased due primarily to computer and snow plowing expense. Data processing and advertising expense increased primarily due to the rollout of a new ditigal banking platform and promotions for deposit customers during the nine months ended September 30, 2020. Communications expenese, professional fees, and other expenses, increased while real estate owned expenses decreased.
Comparison of Mortgage Banking Segment Operations for the Nine Months Ended September 30, 2020 and 2019
Net income totaled $38.9 million for the nine months ended September 30, 2020 compared to $8.7 million for the nine months ended September 30, 2019. We originated $3.15 billion in mortgage loans held for sale (including sales to the community banking segment) during the nine months ended September 30, 2020, which represents an increase of $1.00 billion, or 46.7%, from the $2.15 billion originated during the nine months ended September 30, 2019. The increase in loan production volume was driven by a $870.9 million, or 265.7%, increase in refinance products as mortgage rates decreased. Mortgage purchase products increased $131.3 million, or 7.2% due to an increased housing demand. Total mortgage banking noninterest income increased $73.7 million, or 78.0%, to $168.2 million during the nine months ended September 30, 2020 compared to $94.5 million during the nine months ended September 30, 2019. The increase in mortgage banking noninterest income was related to a 46.7% increase in volume and an 17.8% increase in gross margin on loans originated and sold for the nine months ended September 30, 2020 compared to September 30, 2019. Gross margin on loans originated and sold is the ratio of mortgage banking income (excluding the change in interest rate lock fair value) divided by total loan originations. The increase in gross margin on loans originated and sold reflects industry demand due to the low rate environment resulting in higher volume. We sell loans on both a servicing-released and a servicing-retained basis. Waterstone Mortgage Corporation has contracted with a third party to service the loans for which we retain servicing.
Additionally, our overall margin can be affected by the mix of both loan type (conventional loans versus governmental) and loan purpose (purchase versus refinance). Conventional loans include loans that conform to Fannie Mae and Freddie Mac standards, whereas governmental loans are those loans guaranteed by the federal government, such as a Federal Housing Authority or U.S. Department of Agriculture loan. Our origination efforts continue to be focused on loans made for the purpose of residential purchases, as opposed to mortgage refinance. The percentage of origination volume related to purchase activity decreased to 61.9% from 84.7% of total originations for the nine months ended September 30, 2020 and 2019, respectively, as refinance demand accelerated from the low rate environment. The mix of loan type trended towards more conventional loans and less governmental loans; with conventional loans and governmental loans comprising 74.7% and 25.3% of all loan originations, respectively, during the nine months ended September 30, 2020, compared to 69.7% and 30.3% of all originations, respectively, during the nine months ended September 30, 2019.
Total compensation, payroll taxes and other employee benefits increased $23.8, or 38.3%, to $86.1 million for the nine months ended September 30, 2020 compared to $62.3 million for the nine months ended September 30, 2019. The increase in compensation expense was primarily a result of the increase in commission expense as fundings increased, bonus and incentives due to record originations. In addition, branch manager pay increased as branches were more profitable. Occupancy, office furniture, and equipment expense decreased due to lower rent expense as underperforming branches closed offset by an increase in computer expenses to accommodate remote work. Advertising expense decreased as the low rate environment attracted customers. Loan processing expenses increased for the nine months ended September 30, 2020 as loan costs increased due to loan application volume. Professional fees increased primarily due to a $4.25 million legal settlement (see further discussion in Note 10 - Commitments, Off-Balance Sheet Arrangements, and Contingent Liabilities of the notes to unaudited consolidated financial statements for additional information) along with ongoing litigation costs. Other noninterest expense increased primarily due to increased provision for loan sale losses as there was additional uncertainity regarding selling loans to third party investors from COVID-19 pandemic challenges and the amortization of mortgage servicing rights as the value of the servicing portfolio has increased in 2020 compared to 2019.
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Consolidated Waterstone Financial, Inc. Results of Operations
Net Interest Income
Average Balance Sheets, Interest and Yields/Costs
The following tables set forth average balance sheets, annualized average yields and costs, and certain other information for the periods indicated. Non-accrual loans are included in the computation of the average balances of loans receivable and held for sale. The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income or expense. Yields on interest-earning assets are computed on a fully tax-equivalent yield, where applicable.
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(1) Interest income includes net deferred loan fee amortization income of $948,000 and 458,000 for the nine months ended September 30, 2020 and 2019, respectively.
(2) Average balance of mortgage related and debt securities are based on amortized historical cost.
(3) Interest income from tax exempt securities is computed on a taxable equivalent basis using a tax rate of 21% for the nine months ended September 30, 2020 and 2019. The yields on debt securities, federal funds sold and short-term investments before tax-equivalent adjustments were 1.86% and 2.59% for the nine months ended September 30, 2020 and 2019, respectively.
(4) Net interest rate spread represents the difference between the yield on average interest-earning assets and the cost of average interest-bearing liabilities and is presented on a fully tax equivalent basis.
(5) Net interest-earning assets represent total interest-earning assets less total interest-bearing liabilities.
(6) Net interest margin represents net interest income divided by average total interest-earning assets.
Rate/Volume Analysis
The following table sets forth the effects of changing rates and volumes on our net interest income for the periods indicated. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The net column represents the sum of the prior columns. For purposes of this table, changes attributable to changes in both rate and volume that cannot be segregated have been allocated proportionately based on the changes due to rate and the changes due to volume.
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(2) Non-accrual loans have been included in average loans receivable balance.
(3) Includes available for sale securities. Average balance of available for sale securities is based on amortized historical cost.
(4) Interest income from tax exempt securities is computed on a taxable equivalent basis using a tax rate of 21% for the nine months ended September 30, 2020 and 2019.
Net interest income increased $113,000, or 0.3%, to $39.2 million during the nine months ended September 30, 2020 compared to $39.1 million during the nine months ended September 30, 2019.
Provision for Loan Losses
The Company delayed adoption of ASC Topic 326 as permited under the CARES Act. The Company calculated the current year allowance using the incurred loss model. The provision for loan losses was $6.3 million for the nine months ended September 30, 2020 compared to a negative provision for loan losses of $730,000 for the nine months ended September 30, 2019 as economic conditions worsened due to the COVID-19 pandemic along with an increase of loan downgrades to our Watch category. Additional qualitative risk factors were applied to each of the loan categories primarily to account for the significant increase in the unemployment rate and those downgrades. We had a provision for loan losses of $6.1 million at the community banking segment and $235,000 for the mortgage banking segment. Net recoveries were $147,000 for the nine months ended September 30, 2020.
The provision is primarily a function of the Company's reserving methodology and assessments of certain quantitative and qualitative factors which are used to determine an appropriate allowance for loan losses for the period. See further discussion regarding the allowance for loan losses in the "Asset Quality" section for an analysis of charge-offs, nonperforming assets, specific reserves and additional provisions and the "Allowance for Loan Losses" section.
Noninterest Income
Total noninterest income increased $77.2 million, or 79.6%, to $174.1 million during the nine months ended September 30, 2020 compared to $96.9 million during the nine months ended September 30, 2019. The increase resulted primarily from an increase in mortgage banking income along with increases in all noninterest income categories.
Noninterest Expenses
Total noninterest expenses increased $35.0 million, or 34.6%, to $135.9 million during the nine months ended September 30, 2020 compared to $100.9 million during the nine months ended September 30, 2019.
Income Taxes
Income tax expense totaled $17.8 million for the nine months ended September 30, 2020 compared to $8.7 million during the nine months ended September 30, 2019. Income tax expense was recognized on the statement of income during the nine months ended September 30, 2020 at an effective rate of 25.0% of pretax income compared to 24.3% during the nine months ended September 30, 2019. During the nine months ended September 30, 2020, the Company recognized a benefit of approximately $82,000 related to stock awards exercised compared to a benefit of $113,000 recognized during the nine months ended September 30, 2019. The Company recognized a benefit of $354,000 related to the proceeds received on the bank owned life insurance death benefit during the nine months ended September 30, 2020.
Comparison of Financial Condition at September 30, 2020 and December 31, 2019
Total Assets – Total assets increased by $224.5 million, or 11.2%, to $2.22 billion at September 30, 2020 from $2.00 billion at December 31, 2019. The increase in total assets primarily reflects an increase in loans held for sale, loans receivable and prepaid expenses and other assets due to an increase in the fair market value of the loan rate lock commitments partially offset by a decrease in securities available for sale. The total assets increase reflects liability increases in deposits, additional short-term debt, advance payments by borrowers for taxes, and other liabilities due to hedging liabilities.
Cash and Cash Equivalents – Cash and cash equivalents increased $12.3 million, or 16.5%, to $86.6 million at September 30, 2020, compared to $74.3 million at December 31, 2019. The increase in cash and cash equivalents primarily reflects the additional source of funds through an increase in deposits, short-term borrowings, and advance payments by borrowers for taxes.
Securities Available for Sale – Securities available for sale decreased $25.3 million to $153.2 million at September 30, 2020. The decrease was primarily due to paydowns in mortgage-related securities and maturities of debt securities exceeding security purchases for the year.
Loans Held for Sale - Loans held for sale increased $165.7 million to $385.8 million at September 30, 2020 due to the increase of refinancing activity resulting from the reduction in mortgage rates.
Loans Receivable - Loans receivable held for investment increased $46.1 million to $1.43 billion at September 30, 2020. The increase in total loans receivable was attributable to increases in commercial real estate, construction and land, multi-family, and commercial loan categories. The growth in the commercial loan category was driven by $30.1 million of PPP loans originated during the nine months ended September 30, 2020. Partially offsetting those increases, one- to four-family, home equity, and consumer loan categories decreased.
The following table shows loan originations during the periods indicated.
Allowance for Loan Losses - The allowance for loan losses increased $6.5 million to $18.8 million at September 30, 2020. The increase resulted from a provision due to increased economic uncertainity increasing the required allowance related to the loans collectively reviewed. The overall increase was primarily related to each of the one- to four-family, multi-family, home equity, construction and land, commercial real estate, consumer, and commercial categories. See Note 3 for further discussion on the allowance for loan losses.
Real Estate Owned – Total real estate owned increased $24,000 to $772,000 at September 30, 2020. During the nine months ended September 30, 2020, $369,000 of loans were transferred from loans receivable to real estate owned upon completion of foreclosure. During the same period, sales of real estate owned totaled $345,000. There were no writedowns during the nine months ended September 30, 2020.
Prepaid expenses and other assets – Total prepaid expenses and other assets increased $34.0 million to $54.8 million at September 30, 2020. The increase was primarily due to increases in loan rate lock commitments, funding receivables from investors, and receivables from back-to-back interest rate swaps.
Deposits – Total deposits increased $116.9 million to $1.18 billion at September 30, 2020. The increase was driven by an increase of $73.3 million in money market and savings deposits, $39.2 million in demand deposits, and $4.4 million in time deposits.
Borrowings – Total borrowings increased $68.6 million, or 14.2%, to $552.1 million at September 30, 2020. The community banking segment added $34.0 million in short-term FHLB borrowings. External short-term borrowings at the mortgage banking segment increased a total of $34.6 million at September 30, 2020 from December 31, 2019.
Advance Payments by Borrowers for Taxes - Advance payments by borrowers for taxes increased $21.8 million to $26.0 million at September 30, 2020. The increase was the result of payments received from borrowers for their real estate taxes and is seasonally normal, as balances increase during the course of the calendar year until real estate tax obligations are paid in the fourth quarter.
Other Liabilities - Other liabilities increased $11.5 million to $58.6 million at September 30, 2020 compared to December 31, 2019. Other liabilities increased primarily due to liabilies resulting from payables due on back-to-back swaps, accrued compensation, and forward commitments to sell loans at the mortgage banking segment. Offsetting the increase, other liabilities decreased related to a seasonal decrease in outstanding checks related to advance payments by borrowers for taxes. The Company receives payments from borrowers for their real estate taxes during the course of the calendar year until real estate tax obligations are paid in the fourth quarter. At the time at which the disbursements are made, the outstanding checks are classified as other liabilities in the statements of financial condition. These amounts remain classified as other liabilities until settled.
Shareholders’ Equity – Shareholders' equity increased $5.7 million to $399.4 million at September 30, 2020 from December 31, 2019. Shareholders' equity increased primarily due to net income, additional paid-in capital as stock options were exercised and equity awards vested, an increase in fair value of the security portfolio, and unearned ESOP shares vesting. Partially offsetting the increases, there were decreases due to the declaration of regular and special dividends and the repurchase of stock.
ASSET QUALITY
NONPERFORMING ASSETS
All loans that are 90 days or more past due with respect to principal and interest are recognized as non-accrual. Troubled debt restructurings that are non-accrual either due to being past due greater than 90 days or which have not yet performed under the modified terms for a reasonable period of time, are included in the table above. In addition, loans that are past due less than 90 days are evaluated to determine the likelihood of collectability given other credit risk factors such as early stage delinquency, the nature of the collateral or the results of a borrower review. When the collection of all contractual principal and interest is determined to be unlikely, the loan is moved to non-accrual status and an updated appraisal of the underlying collateral is ordered. This process generally takes place when a loan is contractually past due between 60 and 89 days. Upon determining the updated estimated value of the collateral, a loan loss provision is recorded to establish a specific reserve to the extent that the outstanding principal balance exceeds the updated estimated net realizable value of the collateral. When a loan is determined to be uncollectible, typically coinciding with the initiation of foreclosure action, the specific reserve is reviewed for adequacy, adjusted if necessary, and charged-off.
The following table sets forth activity in our non-accrual loans for the periods indicated.
Total non-accrual loans decreased by $984,000, or 14.0%, to $6.0 million as of September 30, 2020 compared to $7.0 million as of December 31, 2019. The ratio of non-accrual loans to total loans receivable was 0.42% at September 30, 2020 compared to 0.51% at December 31, 2019. During the nine months ended September 30, 2020, $2.3 million in loans were placed on non-accrual status. Offsetting this activity, $1.6 million returned to accrual status, $1.4 million in principal payments were received, and $369,000 transferred to real estate owned during the nine months ended September 30, 2020.
Of the $6.0 million in total non-accrual loans as of September 30, 2020, $4.9 million in loans have been specifically reviewed to assess whether a specific valuation allowance is necessary. A specific valuation allowance is established for an amount equal to the impairment when the carrying value of the loan exceeds the present value of expected future cash flows, discounted at the loan's original effective interest rate or the fair value of the underlying collateral with an adjustment made for costs to dispose of the asset. Based upon these specific reviews, a total of $1.2 million in cumulative partial net charge-offs have been recorded over the life of these loans as of September 30, 2020. Partially charged-off loans measured for impairment based upon net realizable collateral value are maintained in a "non-performing" status and are disclosed as impaired loans. In addition, specific reserves totaling $24,000 have been recorded as of September 30, 2020. The remaining $1.2 million of non-accrual loans were reviewed on an aggregate basis and $237,000 in general valuation allowance was deemed appropriate related to those loans as of September 30, 2020. The $237,000 in valuation allowance is based upon a migration analysis performed with respect to similar non-accrual loans in prior periods.
The outstanding principal balance of our five largest non-accrual loans as of September 30, 2020 totaled $2.1 million, which represents 34.5% of total non-accrual loans as of that date. These five loans have not had any cumulative life-to-date net charge-offs and $24,000 in specific valuation allowance was deemed necessary based on net realizable collateral value with respect to these five loans as of September 30, 2020.
For the nine months ended September 30, 2020, gross interest income that would have been recorded had our non-accruing loans been current in accordance with their original terms was $311,000. We received $320,000 of interest payments on such loans during the nine months ended September 30, 2020. Interest payments received are treated as interest income on a cash basis as long as the remaining book value of the loan (i.e., after charge-off of all identified losses) is deemed to be fully collectible. If the remaining book value is not deemed to be fully collectible, all payments received are applied to unpaid principal. Determination as to the ultimate collectability of the remaining book value is supported by an updated credit department evaluation of the borrower's financial condition and prospects for repayment, including consideration of the borrower's sustained historical repayment performance and other relevant factors.
There were no accruing loans past due 90 days or more at September 30, 2020 or December 31, 2019.
TROUBLED DEBT RESTRUCTURINGS
The following table summarizes information with respect to the accrual status of our troubled debt restructurings:
All troubled debt restructurings are considered to be impaired, are risk rated as either substandard or watch and are included in the internal risk rating tables disclosed in the notes to the unaudited consolidated financial statements. Specific reserves have been established to the extent that collateral-based impairment analyses indicate that a collateral shortfall exists.
We do not participate in government-sponsored troubled debt restructuring programs. Our troubled debt restructurings are short-term modifications. Typical initial restructured terms include six to twelve months of principal forbearance, a reduction in interest rate or both. Restructured terms do not include a reduction of the outstanding principal balance unless mandated by a bankruptcy court. Troubled debt restructuring terms may be renewed or further modified at the end of the initial term for an additional period if performance has been acceptable and the short-term borrower difficulty persists.
If a restructured loan is current in all respects and a minimum of six consecutive restructured payments have been received, it can be considered for return to accrual status. After a restructured loan that is current in all respects reverts to contractual/market terms, if a credit department review indicates no evidence of elevated market risk, the loan is removed from the troubled debt restructuring classification.
We modified loans for borrowers that were not considered troubled debt under the CARES Act. Loans less than 30 days past due as of December 31, 2019 were allowed for modifications if the borrower experienced a COVID-19 hardship. As of September 30, 2020, the Company has modified $3.2 million of loans consisting of the deferral of principal and interest or deferral of interest. In accordance with the CARES Act, these short term deferrals are not considered troubled debt restructurings.
The following table summarizes information with respect to the loans modified under the CARES Act as of September 30, 2020.
LOAN DELINQUENCY
The following table summarizes loan delinquency in total dollars and as a percentage of the total loan portfolio:
Past due loans decreased by $910,000, or 14.1%, to $5.6 million at September 30, 2020 from $6.5 million at December 31, 2019. Loans past due less than 90 days increased by $670,000, or 36.6%, primarily in the one- to four-family loan category. Loans past due 90 days or more decreased by $1.6 million, or 34.1%, primarily in the one- to four-family during the nine months ended September 30, 2020.
REAL ESTATE OWNED
Total real estate owned increased by $24,000, or 3.2%, to $772,000 at September 30, 2020, compared to $748,000 at December 31, 2019. During the nine months ended September 30, 2020, $369,000 of loans were transferred to real estate owned upon completion of foreclosure. During the same period, sales of real estate owned totaled $345,000. There were no write downs during the nine months ended September 30, 2020. New appraisals received on real estate owned and collateral dependent impaired loans are based upon an “as is value” assumption. During the period of time in which we are awaiting receipt of an updated appraisal, loans evaluated for impairment based upon collateral value are measured by the following:
Virtually all habitable real estate owned (both residential and commercial properties) is managed with the intent of attracting a lessee to generate revenue. Foreclosed properties are recorded at the lower of carrying value or fair value, less costs to sell, with charge-offs, if any, charged to the allowance for loan losses upon transfer to real estate owned within 90 days of being transferred. Subsequent write-downs to reflect current fair market value, as well as gains and losses upon disposition and revenue and expenses incurred in maintaining such properties, are treated as period costs and included in real estate owned in the consolidated statements of income. The fair value is primarily based upon updated appraisals in addition to an analysis of current real estate market conditions.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses increased $6.5 million to $18.8 million at September 30, 2020, compared to $12.4 million at December 31, 2019. The increase in allowance for loan losses reflects the $6.3 million provision. The provision recorded during the current year reflects an increased allocation related to the economic condition qualatitive factor as a result of the COVID-19 pandemic in each of the loan categories. Additionally, there were increased qualatitive factors to account for an increase of loan downgrades to our Watch category.
We had net recoveries of $147,000, or 0.01% of average loans annualized, for the nine months ended September 30, 2020, compared to net recoveries of $28,000, or less than 0.01% of average loans annualized, for the nine months ended September 30, 2019. Of the $147,000 in recoveries during the nine months ended September 30, 2020, the majority of the activity related to loans secured by one- to four-family residential loans.
Our underwriting policies and procedures emphasize that credit decisions must rely on both the credit quality of the borrower and the estimated value of the underlying collateral. Credit quality is assured only when the estimated value of the collateral is objectively determined and is not subject to significant fluctuation.
The allowance for loan losses has been determined in accordance with GAAP. We are responsible for the timely and periodic determination of the amount of the allowance required. Any future provisions for loan losses will continue to be based upon our assessment of the overall loan portfolio and the underlying collateral, trends in non-performing loans, current economic conditions and other relevant factors. To the best of management’s knowledge, all probable losses have been provided for in the allowance for loan losses.
The establishment of the amount of the loan loss allowance inherently involves judgments by management as to the appropriateness of the allowance, which ultimately may or may not be correct. Higher than anticipated rates of loan default would likely result in a need to increase provisions in future years.
Liquidity and Capital Resources
We maintain liquid assets at levels we consider adequate to meet our liquidity needs. We adjust our liquidity levels to fund loan commitments, repay our borrowings, fund deposit outflows and pay real estate taxes on mortgage loans. We also adjust liquidity as appropriate to meet asset and liability management objectives. The level of our liquidity position at any point in time is dependent upon the judgment of the senior management as supported by the Asset/Liability Committee. Liquidity is monitored on a daily, weekly and monthly basis using a variety of measurement tools and indicators.
Our primary sources of liquidity are deposits, amortization and repayment of loans, sales of loans held for sale, maturities of investment securities and other short-term investments, and earnings and funds provided from operations. While scheduled principal repayments on loans are a relatively predictable source of funds, deposit flows and loan repayments are greatly influenced by market interest rates, economic conditions, and rates offered by our competitors. We set the interest rates on our deposits to maintain a desired level of total deposits. In addition, we invest excess funds in short-term, interest-earning assets, which provide liquidity to meet lending requirements. Additional sources of liquidity used for the purpose of managing long- and short-term cash flows include advances from the FHLB.
During the nine months ended September 30, 2020, primary uses of cash and cash equivalents included: $3.06 billion in funding loans held for sale, $46.3 million for funding of loans receivable, $32.7 million in purchases of our common stock, $21.7 million for cash dividends paid, $5.6 million for purchases of FHLB stock, $4.5 million for purchases of mortgage related securities, and $5.0 million for purchases of debt securities.
During the nine months ended September 30, 2020, primary sources of cash and cash equivalents included: $3.07 billion in proceeds from the sale of loans held for sale, $34.0 million in proceeds from short-term FHLB borrowings, $34.6 million in proceeds from additional short-term borrowings, $116.9 million from an increase in deposits, $33.6 million in principal repayments on mortgage related securities, $3.8 million in maturities of debt securities, $53.3 million in net income, $9.6 million in proceeds from death benefits on bank owned life insurance, and a $9.9 million increase in advance payments by borrowers for taxes.
During the nine months ended September 30, 2019, primary uses of cash and cash equivalents included: $2.09 billion in funding loans held for sale, $22.9 million for cash dividends paid, $12.1 million for purchases of mortgage related securities, and $22.7 million in purchases of our common stock.
During the nine months ended September 30, 2019, primary sources of cash and cash equivalents included: $2.09 billion in proceeds from the sale of loans held for sale, $40.0 million in additional proceeds from long-term borrowings, $1.1 million from an increase in deposits, $40.7 million in additional proceeds from short-term borrowings, $21.9 million in principal repayments on mortgage related securities, $7.7 million from a decrease in loans receivable, and $27.1 million in net income.
A portion of our liquidity consists of cash and cash equivalents, which are a product of our operating, investing and financing activities. At September 30, 2020 and 2019, respectively, $86.6 million and $66.2 million of our assets were invested in cash and cash equivalents. At September 30, 2020, cash and cash equivalents were comprised of the following: $54.7 million in cash held at the Federal Reserve Bank and other depository institutions and $31.9 million in federal funds sold and short-term investments. Our primary sources of cash are principal repayments on loans, proceeds from the calls and maturities of debt and mortgage-related securities, increases in deposit accounts, advances from the FHLB, and repurchase agreements from other institutions.
Liquidity management is both a daily and longer-term function of business management. If we require funds beyond our ability to generate them internally, borrowing agreements exist with the FHLB which provide an additional source of funds. At September 30, 2020, we had $470.0 million in long-term advances from the FHLB with contractual maturity dates in 2027, 2028, and 2029. The 2028 advance maturities have single call options in March 2021 and May 2021, along with two advances that have quarterly call options. Two advances are currently callable quarterly. The 2029 advance maturities have quarterly call option currently available and the other options beginning November 2020, August 2021, and May 2022. We had $34.0 million in short-term advances with the FHLB and contractual maturities in October 2020 and May 2021. As an additional source of funds, the mortgage banking segment has a repurchase agreement. At September 30, 2020, we had $48.1 million outstanding under the repurchase agreement with a total outstanding commitment of $55.0 million.
At September 30, 2020, we had outstanding commitments to originate loans receivable of $16.8 million. In addition, at September 30, 2020, we had unfunded commitments under construction loans of $76.2 million, unfunded commitments under business lines of credit of $22.8 million and unfunded commitments under home equity lines of credit and standby letters of credit of $14.4 million. At September 30, 2020, certificates of deposit scheduled to mature in one year or less totaled $701.2 million. Based on prior experience, management believes that, subject to the Bank’s funding needs, a significant portion of such deposits will remain with us, although there can be no assurance that this will be the case. In the event a significant portion of our deposits is not retained by us, we will have to utilize other funding sources, such as FHLB advances, in order to maintain our level of assets. However, we cannot assure that such borrowings would be available on attractive terms, or at all, if and when needed. Alternatively, we could reduce our level of liquid assets, such as our cash and cash equivalents and securities available-for-sale in order to meet funding needs. In addition, the cost of such deposits may be significantly higher if market interest rates are higher or there is an increased amount of competition for deposits in our market area at the time of renewal.
Waterstone Financial, Inc. is a separate legal entity from WaterStone Bank and must provide for its own liquidity to pay dividends to its shareholders, repurchase shares of its common stock, and for other corporate purposes. The primary source of liquidity for Waterstone Financial, Inc. is dividend payments from WaterStone Bank. The ability of WaterStone Bank to pay dividends is subject to regulatory restrictions. At September 30, 2020, Waterstone Financial, Inc. (on an unconsolidated basis) had liquid assets totaling $26.9 million.
Capital
Shareholders' equity increased $5.7 million to $399.4 million at September 30, 2020 from December 31, 2019. Shareholders' equity increased primarily due to net income, additional paid-in capital as stock options were exercised, equity awards vesting, the fair value of the security portfolio, and unearned ESOP shares vesting. Partially offsetting the increases, there were decreases due to the declaration of regular and special dividends and the repurchase of stock.
The Company's Board of Directors authorized a stock repurchase program in the third quarter of 2020. As of September 30, 2020, the Company had repurchased 10.5 million shares at an average price of $14.34 under previously approved stock repurchase plans.
WaterStone Bank is subject to various regulatory capital requirements, including a risk-based capital measure. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk-weighted assets by assigning assets and off-balance sheet items to broad risk categories. At September 30, 2020, WaterStone Bank exceeded all regulatory capital requirements and is considered “well capitalized” under regulatory guidelines. See “Notes to Unaudited Consolidated Financial Statements - Note 8 - Regulatory Capital.”
Contractual Obligations, Commitments, Contingent Liabilities, and Off-balance Sheet Arrangements
The following tables present information indicating various contractual obligations and commitments of the Company as of September 30, 2020 and the respective maturity dates.
(1) Secured under a blanket security agreement on qualifying assets, principally, mortgage loans. Excludes interest which will accrue on the advances. See call provisions in Note 7 - Borrowings.
(2) Represents non-cancelable operating leases for offices and equipment.
(3) Excludes interest.
See Note 10 - Commitments, Off-Balance Sheet Arrangements, and Contingent Liabilities of the notes to unaudited consolidated financial statements for additional information.
Off-Balance Sheet Commitments
The following table details the amounts and expected maturities of significant off-balance sheet commitments as of September 30, 2020.
General: Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract and generally have fixed expiration dates or other termination clauses.
(1) Commitments for loans are extended to customers for up to 90 days after which they expire.
(2) Unused portions of home equity loans are available to the borrower for up to 10 years.
(3) Unused portions of construction loans are available to the borrower for up to one year.