Item 1. Business
General
MSB Financial Corp. (the "Company") is a Maryland-chartered corporation organized in 2014 to be the successor to MSB Financial Corp., a federal corporation ("Old MSB") upon completion of the second-step conversion of Millington Bank (the "Bank") from the two-tier mutual holding company structure to the stock holding company structure. MSB Financial, MHC (the "MHC") was the former mutual holding company for Old MSB prior to completion of the second-step conversion. In conjunction with the second-step conversion, each of the MHC and Old MSB ceased to exist. The second-step conversion was completed on July 16, 2015 at which time the Company sold 3,766,592 shares of its common stock (including 150,663 shares purchased by the Bank's employee stock ownership plan) at $10.00 per share for gross proceeds of approximately $37.7 million. Expenses related to the stock offering totaled $1.5 million and were netted against proceeds. As part of the second-step conversion, each of the outstanding shares of common stock of Old MSB held by persons other than the MHC were converted into 1.1397 shares of Company common stock with cash paid in lieu of fractional shares. As a result, a total of 2,187,242 shares were issued in exchange for Old MSB shares in the second-step conversion.
The Company's principal business is the ownership and operation of the Bank. The Bank is a New Jersey-chartered stock savings bank and its deposits are insured by the Federal Deposit Insurance Corporation. The primary business of the Bank is attracting retail deposits from the general public and using those deposits together with funds generated from operations, principal repayments on securities and loans and borrowed funds, for its lending and investing activities. The Bank's loan portfolio primarily consists of one-to-four family and home equity residential loans, commercial loans, and construction loans. It also invests in U.S. government obligations and mortgage-backed securities. The Bank is regulated by the New Jersey Department of Banking and Insurance and the Federal Deposit Insurance Corporation. The Board of Governors of the Federal Reserve System (the "Federal Reserve") regulates the Company as a bank holding company.
In accordance with the provisions of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), the Company is the successor issuer to Old MSB and all financial data included herein up through the completion of the second-step conversion is that of Old MSB.
Throughout this document, references to "we," "us," or "our" refer to the Bank or Company, or both, as the context indicates.
Change in Fiscal Year End
Effective November 17, 2014, the Company changed its fiscal year end from June 30 to December 31.
Competition
We operate in a market area with a high concentration of banking and other financial institutions, and we face substantial competition in attracting deposits and in originating loans. A number of our competitors are significantly larger institutions with greater financial and managerial resources and lending limits. Our ability to compete successfully is a significant factor affecting our growth potential and profitability.
Our competition for deposits and loans historically has come from other insured financial institutions such as local and regional commercial banks, savings institutions, and credit unions located in our primary market area. We also compete with mortgage banking and finance companies for real estate loans and with commercial banks and savings institutions for consumer loans, and we face competition for funds from investment products such as mutual funds, short-term money funds and corporate and government securities. There are large competitors operating throughout our total market area, and we also face strong competition from other community-based financial institutions.
Lending Activities
We have traditionally focused on the origination of one- to four-family loans and home equity loans and lines of credit, which together comprise a sizable portion of the total loan portfolio. During the past two years, we have significantly grown our commercial real estate portfolio, which includes multi-family dwellings/apartment buildings, service/retail and mixed-use properties, churches and non-profit properties, medical and dental facilities and other commercial real estate. Additionally, we originate residential and commercial construction loans and commercial and industrial loans. Our consumer loans are comprised of automobile loans, personal loans, account loans and overdraft lines of credit.
Loan Portfolio Composition. The following tables analyze the composition of the Company's loan portfolio by loan category at the dates indicated. Except as set forth below, there were no concentrations of loans exceeding 10% of total loans.
Loan Maturity Schedule. The following table sets forth the maturity of the Company's loan portfolio at December 31, 2018. Demand loans, loans having no stated maturity, and overdrafts are presented as due in one year or less. The construction loans presented in the table as of December 31, 2018 are net of $10.7 million of undistributed amounts. The table presents contractual maturities and does not reflect repricing or the effect of prepayments. Actual maturities may differ.
The following table sets forth the dollar amount of all loans due after December 31, 2019, which have fixed interest rates and which have floating or adjustable interest rates.
One- to Four-Family Real Estate Mortgages. Historically, the primary focus of our lending activity was the origination of one- to four-family first mortgage loans. We continue to offer fixed rate, conventional mortgage loans with terms from 5 to 30 years.
We also originate adjustable rate mortgages, or ARMs, with up to 30 year terms at rates based upon the U.S. Treasury One Year Constant Maturity as an index. Our ARMs currently reset on an annual basis, beginning with the first year, and have a 200 basis point annual increase cap and a 600 basis point lifetime adjustment cap. We do not originate "teaser" rate or negative amortization loans.
We are also offering a loan program whereby we offer an initial rate for a fixed period of time, normally 5 to 10 years, and thereafter there is one preset interest rate adjustment based on competitive rates.
Substantially all residential mortgages include "due on sale" clauses, which are provisions giving us the right to declare a loan immediately payable if the borrower sells or otherwise transfers an interest in the property to a third party. Property appraisals on real estate securing one-to four-family residential loans are made by state certified or licensed independent appraisers and are performed in accordance with applicable regulations and policies. We require title insurance policies on all first lien one-to four-family residential loans and all home equity loans over $250,000. Homeowners, liability, fire and, if applicable, flood insurance policies are also required.
We provide financing on residential investment properties with 5 to 30 year fixed duration mortgages. Our investment property lending product is available to individuals or proprietorships, partnerships, limited liability corporations, and corporations with personal guarantees. All investment property is underwritten on its ability substantially to carry itself, unless the property is a two-family residence with the mortgagor living in one of the units. Preference is given to those loans where rental income covers all operating expenditures, including but not limited to principal and interest, real estate taxes, hazard insurance, utilities, maintenance, and reserve. The cash coverage ratio to cover operating expenses must be at least 1.25 times. Any negative cash flow will be included in the borrower's total debt ratio. At December 31, 2018, investment property loans secured by one- to four-family homes totaled $35.9 million.
We generally originate one-to four-family first mortgage loans for primary residences and investment properties with loan-to-value ratios ranging from 65% to 80% depending on the collateral value.
Commercial and Multi-Family Real Estate Mortgages. Our commercial real estate lending includes multi-family dwellings/apartment buildings, service/retail and mixed-use properties, churches and non-profit properties, medical and dental facilities and other commercial real estate. Our commercial real estate mortgage loans are typically a 5 to 10 year balloon mortgage. Multi-family and commercial real estate loans can be amortized over 30 years with periodic rate resets or 15 year fixed duration mortgages. This type of lending is made available to proprietorships, partnerships, limited liability companies and corporations with personal guarantees and/or carve out guarantees. All commercial property loans are substantially underwritten on the ability of the underlying property to provide satisfactory cash flows. A cash flow and lease analysis is performed for each property. Preference is given to those loans where rental income covers all operating expenditures, including but not limited to principal and interest, real estate tax, hazard insurance, utilities, maintenance, and reserves. The cash coverage ratio to cover operating expenses must be at least 1.20 times for multi-family and 1.25 times for all other commercial loans. Any negative cash flow will be included in the limit on the borrower's total debt ratio. Cash from other assets of the borrower, who may own multiple properties and generate a surplus, can be made available to cover debt-service shortages of the financed property. Maximum loan-to-value ratios on commercial real estate loans range from 65% to 80%.
The management skills of the borrower are judged on the basis of his/her professional experience and must be documented to meet the Company's satisfaction in relation to the desired project. The assets of the borrower must indicate his/her ability to support the proposed investment, both in terms of liquidity and net worth, and tangible history of the borrower's capability and experience must be evident.
Unlike single-family residential mortgage loans, which generally are made on the basis of the borrower's ability to make repayment from his or her employment and other income, and which are secured by real property the value of which tends to be more easily ascertainable,
multi-family and commercial real estate loans typically are made on the basis of the borrower's ability to make repayment from the cash flow of the borrower's business or rental income. As a result, the availability of funds for the repayment of commercial real estate and multi-family loans may be substantially dependent on the success of the business itself, the tenants and the general economic environment. Commercial real estate and multi-family loans, therefore, have greater credit risk than one-to four-family residential mortgages or consumer loans. In addition, commercial real estate and multi-family loans generally result in larger balances to single borrowers, or related groups of borrowers and also generally require substantially greater evaluation and oversight efforts.
Construction Loans. We originate construction loans for an owner-occupied residence or to a builder with a valid contract of sale. We also provide financing for speculative residential or commercial construction and development with individual consideration given to builders based on their past performance, workmanship, and financial worth. Our construction lending includes loans for construction or major renovations or improvements of owner-occupied residences. The portfolio consists primarily of properties held by real estate developers.
Construction loans are mortgages up to 24 months in duration. Funds are disbursed periodically upon inspections made by our inspectors on the percentage of work completed, as per the approved budget. Funds disbursed may not exceed 60% of the loan-to-value of land and 80% of the loan-to-value of improvements any time during construction. The majority of our construction loans are variable rate loans with rates tied to the prime rate published in The Wall Street Journal, plus a premium. The Bank also has established a floor rate on all transactions. A minimum of interest-only payments on disbursed funds must be made on a monthly basis.
Construction lending is generally considered to involve a higher degree of credit risk than residential mortgage lending. If the estimate of construction cost proves to be inaccurate, we may be compelled to advance additional funds to complete the construction with repayment dependent, in part, on the success of the ultimate project rather than the ability of a borrower or guarantor to repay the loan. If we are forced to foreclose on a project prior to completion, there is no assurance that we will be able to recover the entire unpaid portion of the loan. In addition, we may be required to fund additional amounts to complete a project and may have to hold the property for an indeterminate period of time.
Consumer Loans. Our consumer lending products consist of new and used automobile loans, secured and unsecured personal loans, account loans and overdraft lines of credit. The maximum term for a loan on a new or used automobile is six years and four years, respectively. We will lend up to 80% of the retail value or dealer invoice on a car loan. We offer a reduction on the interest rate for car loans if payments are automatically deducted from a Millington Bank checking or statement savings account.
Our personal loans have terms of up to four years with a minimum and maximum balance of $1,000 and $5,000, respectively. A reduction to the interest rate is offered for loans with automatic debit repayment from a Millington Bank checking or statement savings account. Our account loans permit a depositor to borrow up to 90% of his or her funds on deposit with us in certificate of deposit accounts. The interest rate is the current rate paid to the depositor, plus a premium. A minimum payment of interest only is required. We also offer an overdraft line of credit with a minimum of $500 and up to a maximum of $5,000 and an interest rate tied to the prime rate published in The Wall Street Journal, plus a premium.
Consumer lending is generally considered to involve a higher degree of credit risk than residential mortgage lending. Consumer loan repayment is dependent on the borrower's continuing financial stability and can be adversely affected by job loss, divorce, illness, personal bankruptcy and other factors. The application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on consumer loans in the event of a default. Account loans are fully secured.
Home Equity Loans and Lines of Credit. We offer fixed rate home equity loans and variable rate home equity lines of credit with a minimum credit limit of $5,000. Collateral valuation is established through a variety of methods, including an on-line appraisal valuation estimator, drive-by appraisals, recent assessed tax value, purchase price or consideration value as evidenced by a deed or property search report or a report of comparable real estate properties from a licensed realtor. Loan requests over $50,000, however, require a drive-by appraisal and amounts over $100,000 require full appraisals. Loan requests over $500,000 require Loan Committee approval. Any policy exception requires approval from the Board of Directors. The loan-to-value limit on home equity lending varies depending on the collateral value and ranges from 65% up to 80%. The variable rate on home equity lines of credit is adjusted monthly and is currently set at prime for owner occupied properties and prime plus a premium for investment properties. The fixed rate loans on investment property are also higher than fixed rate owner occupied home equity loans. We generally provide home equity financing only for a first or second lien position.
Our fixed rate home equity loans have terms of 5 to 30 years. All new variable rate home equity lines of credit have terms of 10 years interest only draw period and a 15 year repayment period with a loan to value ranging from 65% to 80%. Our existing portfolio of home equity lines is also comprised of interest only home equity lines of credit based on a 10 year draw period and 15 year repayment period consisting of principal and interest repayments. The loan-to-value limit on interest only home equity financing is 80% on owner-occupied property and 70% on investment property. We also offer bridge loans with a variable rate and a 70% loan-to-value limit on owner-occupied property and 60% on investment property.
Commercial and Industrial Loans. We offer revolving lines of credit to businesses to finance short-term working capital needs like accounts receivable and inventory. These lines of credit may be unsecured or secured by liquid assets, accounts receivable and inventory or real estate. We generally provide such financing for no more than a 3 year term and with a variable rate. We also offer unsecured lines of credit to high net worth borrowers for short term working capital and/or business or investment purposes. These lines have a maximum term of two years with a variable interest rate.
We also originate commercial term loans to fund longer-term borrowing needs such as purchasing equipment, property improvements or other fixed asset needs. These loans are secured by new and used machinery, equipment, fixtures, furniture or other long-term fixed assets and have terms of 1 to 15 years. We originate commercial term loans for other general long-term business purposes, and these loans are secured by real estate. Principal and interest on commercial term loans is payable monthly.
The normal minimum amount for our commercial term loans and lines of credit is $5,000. The maximum amount is based on the loan to value limits set in our policy. We typically do not provide working capital loans to businesses outside our normal market area or to new businesses where repayment is dependent solely on future profitable operation of the business. We avoid originating loans for which the primary source of repayment could be liquidation of the collateral securing the loan in light of poor repayment prospects. We typically require personal and/or carve out guarantees on all commercial loans, regardless of other collateral securing the loan.
The loan-to-value limits on commercial loans vary according to the collateral. Loans secured by real estate may be originated for up to an 80% loan-to-value ratio. Other limits are typically: Savings accounts-90% of the deposit amount; new equipment-75% of purchase price; and used equipment-the lesser of 75% of the purchase price or current market value.
Loans to One Borrower. The Bank's regulatory limit on total loans to any borrower or attributed to any one borrower is 15% of unimpaired capital and surplus. Accordingly, as of December 31, 2018, our loans to one borrower legal limit was approximately $10.1 million.
The Bank's lending policies require that any transaction between $500,000 and the Bank's legal lending limit must be approved by the Senior Loan Committee. Any exceptions to policy requires prior Board approval.
At December 31, 2018, the Bank's largest lending relationship with a single borrower was a $9.0 million commercial loan to a non-depository financial institution.
Loan Originations, Purchases, Sales, Solicitation and Processing. Our customary sources of loan applications include repeat customers, referrals from realtors and other professionals, "walk-in" customers and business opportunities generated by our commercial lenders. Our residential loan originations are driven by the Bank's reputation, as opposed to being advertising driven.
Generally, it has been our policy to retain the loans we originate in our portfolio. We have not uniformly originated real estate mortgage loans to meet the documentation standards to sell loans in the secondary market. We may do so, however, in the future if we find it desirable in connection with interest rate risk management to sell longer term fixed rate mortgages into the secondary mortgage market. However, in 2018, we began to sell loans with servicing released into the secondary mortgage market. We sold eight residential mortgage loans through December 31, 2018, four residential mortgage loans through December 31, 2017, and did not sell any loans for the preceding three year period.
We purchased $7.1 million in whole commercial real estate loans during the year ended December 31, 2018. In addition, we participated out $30.5 million and sold $2.1 million in loans originated by us to other banks during 2018. The Company will continue to actively utilize purchases and participations to grow the portfolio.
Loan Approval Procedures and Authority. Lending policies and loan approval limits are approved and adopted by the Board of Directors. Lending authority is vested primarily in the Senior Loan Committee comprised of the Chief Executive Officer, Chief Operating Officer, Chief Lending Officer and the Chief Credit Officer who will review and approve loans over $500,000 and up to the Bank's legal lending limit. Each of the above individuals also has individual lending authority of up to $500,000. Certain other Bank employees also have limited lending authority. Prior Board approval is required for all loan products with any exceptions to loan policy, regardless of amount.
Asset Quality
Loan Delinquencies and Collection Procedures. The Company's procedures for delinquent loans are as follows:
15 days delinquent:
late charge added, first delinquent notice mailed
30 days delinquent:
second delinquent notice mailed
45 days delinquent:
additional late charge, third delinquent notice mailed, telephone contact made
60 days delinquent:
telephone contact made, separate letter mailed
90 days delinquent:
decision made to refer to attorney to send demand letter
120 days delinquent:
attorney to file complaint to begin legal action
When a loan is 90 days delinquent, the Senior Vice President and Chief Credit Officer or the President may determine to refer it to an attorney to send a demand letter. After 120 days, the attorney is able to start the foreclosure proceedings by filing a complaint with the court. All reasonable attempts are made to collect from borrowers prior to referral to an attorney for collection. In certain instances, we may modify the loan or grant a limited moratorium on loan payments to enable the borrower to reorganize his or her financial affairs, and we attempt to work with the borrower to establish a repayment schedule to cure the delinquency.
As to mortgage loans, if a foreclosure action is taken and the loan is not reinstated, paid in full or refinanced, the property is sold at judicial sale at which we may be the buyer if there are no adequate offers to satisfy the debt. Any property acquired as the result of foreclosure or by deed in lieu of foreclosure is classified as real estate owned until it is sold or otherwise disposed of. When real estate owned is acquired, it is recorded at its fair value less estimated selling costs. The initial write-down of the property is charged to the allowance for loan losses. Adjustments to the carrying value of the property that result from subsequent declines in value are charged to operations in the period in which the declines occur. At December 31, 2018, we had no other real estate owned.
As to commercial loans, the Company requests updated financial statements when the loan becomes 90 days delinquent. As to account loans, the outstanding balance is collected from the related account along with accrued interest when the loan is 180 days delinquent.
Loans are reviewed on a regular basis, and all delinquencies of 60 days or more are reported to the Board of Directors. Loans are placed on nonaccrual status when they are more than 90 days delinquent, except for such loans which are "well secured" and "in the process of collection." In addition a loan may be placed on nonaccrual status at any time if, in the opinion of management, the collection of the loan in full is doubtful. An asset is "well secured" if it is secured (1) by collateral in the form of liens on or pledges of real or personal property, including securities, that have a realizable value sufficient to discharge the debt (including accrued interest) in full, or (2) by the guarantee of a financially responsible party. An asset is "in process of collection" if collection of the asset is proceeding in due course either (1) through legal action, including judgment enforcement procedures, or (2) in appropriate circumstances, through collection efforts not involving legal action which are reasonably expected to result in repayment of the debt or its restoration to a current status in the near future.
When loans with interest accrued and unpaid are placed on nonaccrual status, the accrued interest is reversed and charged against interest income. Subsequent payments are either applied to the outstanding principal balance or recorded as interest income, depending on the assessment of the ultimate collectability of the loan. At December 31, 2018, we had approximately $4.1 million of loans that were held on a nonaccrual basis and classified as impaired with only $341,000 subject to specific loss allowance reserves totaling $30,000. The remaining nonaccrual impaired loans did not require specific loss allowances.
Non-Performing Assets. The following table provides information regarding our non-performing loans and other non-performing assets as of the dates indicated.
_______________
(1)
Includes $915,000, $1.7 million, $2.2 million, and $4.1 million in troubled debt restructurings ("TDRs") at December 31, 2018, 2017, 2016, and 2015, respectively.
(2)
Total non-performing assets consist of total non-performing loans and other real estate owned of $-, $-, $-, and $1.3 million at December 31, 2018, 2017 ,2016 and 2015.
At December 31, 2018, there were no loans not disclosed in the table above where known information about possible credit problems of borrowers causes management to have serious doubts as to the ability of such borrowers to comply with present loan repayment terms and which may result in disclosure of such loans in the future.
During the year ended December 31, 2018, gross interest income of $211,000 would have been recorded on loans accounted for on a nonaccrual basis and an additional $59,000 would have been recorded on TDRs if those loans had been current in accordance with their original terms. Interest collected on such loans totaling $543,000 was included in interest income during the period.
Classified Assets. The Company in compliance with the Uniform Credit Classification and Account Management Policy adopted by the Federal Deposit Insurance Corporation, and the Company has an internal loan review program, whereby non-performing loans are classified as special mention, substandard, doubtful or loss. It is our policy to review the commercial real estate, construction, and commercial loan portfolios, in accordance with regulatory classification procedures, on at least a quarterly basis. When a loan is classified as substandard or doubtful, management is required to evaluate the loan for impairment. When management classifies a portion of a loan as loss, a reserve equal to 100% of the loss amount is required to be established or the loan is to be charged-off, if a conforming loss event has occurred.
An asset that does not currently expose the Company to a sufficient degree of risk to warrant an adverse classification, but which possesses credit deficiencies or potential weaknesses that deserve management's close attention is classified as "special mention."
An asset classified as "substandard" is inadequately protected by the current net worth and paying capacity of the obligor or the collateral pledged, if any. Assets so classified have well-defined weaknesses and are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.
An asset classified as "doubtful" has all the weaknesses inherent in a "substandard" asset with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. The possibility of a loss on a doubtful asset is high.
That portion of an asset classified as "loss" is considered uncollectible and of such little value that its continuance as an asset, without charge-off, is not warranted. This classification does not necessarily mean that an asset has absolutely no recovery or salvage value; but rather, it is not practical or desirable to defer writing off a basically worthless asset even though partial recovery may be affected in the future.
Management's classification of assets is reviewed by the Board on a regular basis and by the regulatory agencies as part of their examination process.
The following table discloses the Company's classification of loans as of December 31, 2018.
At December 31, 2018, 7 out of the 14 loans adversely classified, totaling $1.2 million, are included as non-performing loans in the non-performing assets table.
Management further monitors the performance and credit quality of the retail portfolio by analyzing the age of the portfolio as determined by the length of time a recorded payment is past due. These credit quality indicators are assessed in the aggregate in these relatively homogeneous portfolios. Loans greater than 90 days past due are generally considered nonperforming and placed on nonaccrual status.
Allowance for Credit Losses. The allowance for credit losses consists of the allowance for loan losses and the reserve for unfunded credit commitments. The allowance for loan losses represents management's estimate of probable incurred losses in the loan portfolio as of the Statement of Financial Condition date and is recorded as a reduction to loans. The reserve for unfunded credit commitments represents management's estimate of losses inherent in its unfunded loan commitments and is recorded in other liabilities on the consolidated Statement of Financial Condition. No additional provisions are recorded in the event the unallocated portion of the allowance for credit losses exceeds the calculated reserve for unfunded credit commitments. The allowance for credit losses is increased by the provision for loan losses, and decreased by charge-offs, net of recoveries. All, or part, of the principal balance of loans receivable that are deemed uncollectible are charged against the allowance when management determines that the repayment of that amount is highly unlikely. Any subsequent recoveries are credited to the allowance. Non-residential consumer loans are generally charged off no later than 120 days past due on a contractual basis, earlier in the event of bankruptcy, or if there is an amount deemed uncollectible.
Management, in determining the allowance for loan losses, considers the Company's past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant revision as more information becomes available. The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as impaired. For loans that are classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price of the impaired loan) is lower than the carrying value of that loan. The general component covers pools of loans by loan class. These pools of loans are evaluated for loss exposure based upon historical loss rates for each of these classes of loans, adjusted for qualitative factors. Each factor is assigned a value to reflect improving, stable or declining conditions based on management's best judgment using relevant information available at the time of the evaluation. The unallocated component is maintained to cover uncertainties that could affect management's estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
The allowance calculation methodology includes segregation of the total loan portfolio into segments. The Company's loans receivable portfolio is comprised of the following segments: residential mortgage, commercial real estate, construction, consumer and commercial and industrial. Some segments of the Company's loan receivable portfolio are further disaggregated into classes which allows management to better monitor risk and performance.
The residential mortgage loan segment is disaggregated into two classes: one-to four-family loans, which are primarily first liens, and home equity loans, which consist of first and second liens. The commercial real estate loan segment consists of both owner and non-owner occupied loans and is further disaggregated into owner-occupied loans and investor properties, which have medium risk due to historical activity on these type loans. The construction loan segment is further disaggregated into two classes: one-to four-family owner occupied, which includes land loans, whereby the owner is known and there is less risk, and other, whereby the property is generally under development and tends to have more risk than the one-to four-family owner occupied loans. The commercial and industrial loan segment consists of loans made for the purpose of financing the activities of commercial customers. The commercial and industrial loans consist of a mix of loans secured by real estate and unsecured lines of credit some of which are for high net worth individuals. The consumer loan segment consists primarily of installment loans and overdraft lines of credit connected with customer deposit accounts.
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record and the amount of the shortfall in relation to the principal and interest owed.
Loans whose terms are modified are classified as TDRs if the Company grants such borrowers concessions and it is deemed that those borrowers are experiencing financial difficulty. Concessions granted under a TDR generally involve a reduction in interest rate, a below market interest rate based on risk, or an extension of a loan's stated maturity date. Nonaccrual troubled debt restructuring are restored to accrual status if principal and interest payments, under the modified terms, are current for six consecutive months after modification. Loans classified as TDRs are designated as impaired.
The evaluation of the need and amount of the allowance for impaired loans and whether a loan can be removed from impairment status is made on a quarterly basis. The Company's policy for recognizing interest income on impaired loans does not differ from its overall policy for interest recognition.
In addition, the New Jersey Department of Banking and Insurance and the Federal Deposit Insurance Corporation, as an integral part of their examination processes, periodically review our loan and real estate owned portfolios and the related allowance for loan losses and valuation allowance for real estate owned. They may require the allowance for loan losses or the valuation allowance for real estate owned to be increased based on their review of information available at the time of the examination, which would negatively affect our earnings.
The following table sets forth information with respect to the Company's allowance for loan losses for the periods indicated:
Allocation of Allowance for Loan Losses. The following table sets forth the allocation of the Company's allowance for loan losses by loan category and the percent of loans in each category to total loans receivable at the dates indicated. The portion of the loan loss allowance allocated to each loan category does not represent the total available for future losses that may occur within the loan category since the total loan loss allowance is a valuation allocation applicable to the entire loan portfolio.
Securities Portfolio
Our investment policy is designed to manage cash flows and foster earnings within prudent interest rate risk and credit risk guidelines. The portfolio mix is governed by our short term and long term liquidity needs. Rate-of-return, cash flow, rating and guarantor-backing are also considered when making investment decisions. The purchase of principal only and stripped coupon interest only security instruments is specifically not authorized by our investment policy. Furthermore, other than government related securities which may not be rated, we only purchase securities with a rating of AAA or AA. We invest primarily in mortgage-backed securities, U.S. Government obligations, U.S. Government agency issued securities, state and political subdivision general obligations and to a lesser extent in Corporate Bonds and Certificates of Deposits.
Mortgage-backed securities represent a participation interest in a pool of mortgages issued by U.S. government agencies or government-sponsored enterprises, such as Federal Home Loan Mortgage Corporation ("Freddie Mac"), the Government National Mortgage Association ("Ginnie Mae"), and the Federal National Mortgage Association ("Fannie Mae"), as well as non-government, private corporate issuers. Mortgage-backed securities are pass-through securities and generally yield less than the mortgage loans underlying the securities. The characteristics of the underlying pool of mortgages, i.e., fixed-rate or adjustable-rate, as well as prepayment risk, are passed on to the certificate holder.
Mortgage-backed securities issued or sponsored by U.S. government agencies and government-sponsored entities are guaranteed as to the payment of principal and interest to investors.
Corporate bonds often pay higher rates than government or municipal bonds, because they tend to be riskier. The bond holder receives interest payments (yield) and principal and is repaid on a fixed maturity date. Corporate bonds can mature anywhere between 1 to 30 years and changes in interest rates are generally reflected in the bond prices. Corporate bonds carry no claims to ownership and do not pay a dividend, but are considered to be less risky than stocks, since the company has to pay off all of its debts (including bonds) before it handles its obligations to stockholders. Corporate bonds have a wide range of ratings and yields because the financial health of the issuers can vary widely,
Accounting standards require that securities be categorized as "held to maturity," "trading securities" or "available for sale," based on management's intent as to the ultimate disposition of each security. These standards allow debt securities to be classified as "held to maturity" and reported in financial statements at amortized cost if the reporting entity has the positive intent and ability to hold these securities to maturity. Securities that might be sold in response to changes in market interest rates, changes in the security's prepayment risk, increases in loan demand, or other similar factors cannot be classified as "held to maturity."
At December 31, 2018, our entire securities portfolio was classified as held to maturity. All securities were purchased with the intent to hold each security until maturity. Securities not classified as "held to maturity" or as "trading securities" are classified as "available for sale" and are reported at fair value with unrealized gains and losses on the securities impacting equity. The Company held no available for sale or trading securities during the years ended December 31, 2018 and 2017.
Individual securities are considered impaired when their fair values are less than their amortized cost. Management evaluates all securities with unrealized losses quarterly to determine if such impairments are "temporary" or "other-than-temporary" in accordance with applicable accounting guidance. Accordingly, the Company accounts for temporary impairments based upon security classification as either trading, available for sale or held to maturity. Temporary impairments on "available for sale" securities would be recognized, on a tax-effected basis, through other comprehensive income with offsetting entries adjusting the carrying value of the security and the balance of deferred taxes. Temporary impairments of held to maturity securities are not recognized in the consolidated financial statements; however, information concerning the amount and duration of impairments on held to maturity securities is disclosed in the notes to the consolidated financial statements. The carrying value of securities held in a trading portfolio would be adjusted to fair value through earnings on a quarterly basis.
Other-than-temporary impairments on securities that the Company has decided to sell or will more likely than not be required to sell prior to the full recovery of their fair value to a level equal to or exceeding amortized cost are recognized in earnings. Otherwise, the other-than-temporary impairment is bifurcated into credit-related and noncredit-related components. The credit-related impairment generally represents the amount by which the present value of the cash flows expected to be collected on a debt security falls below its amortized cost. The noncredit-related component represents the remaining portion of the impairment not otherwise designated as credit-related. Credit-related other-than-temporary impairments are recognized in earnings while noncredit-related other-than-temporary impairments are recognized, net of deferred taxes, in other comprehensive income.
At December 31, 2018, our securities portfolio did not contain securities of any issuer, other than the U.S. Government agencies and government-sponsored enterprises, having an aggregate book value in excess of 10% of stockholders' equity. We do not currently participate in hedging programs, interest rate caps, floors or swaps, or other activities involving the use of off-balance sheet derivative financial instruments, however, we may in the future utilize such instruments if we believe it would be beneficial for managing our interest rate risk.
The following table sets forth certain information regarding the carrying values, weighted average yields and maturities of our held to maturity securities portfolio at December 31, 2018. Our held to maturity securities portfolio is carried at amortized cost. This table shows contractual maturities and does not reflect repricing or the effect of prepayments. Actual maturities of the securities held by us may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without prepayment penalties. Callable securities pose reinvestment risk because we may not be able to reinvest the proceeds from called securities at an equivalent or higher interest rate.
The following table sets forth the carrying value of our held to maturity securities portfolio at the dates indicated. All securities are classified as held to maturity and, therefore, are shown at amortized cost.
Sources of Funds
General. Deposits are our major source of funds for lending and other investment purposes. To the extent that our loan originations may exceed the funding available from deposits, we have borrowed funds from the Federal Home Loan Bank ("FHLB") to supplement the amount of funds for lending and funding daily operations.
In addition, we derive funds from loan and mortgage-backed securities principal repayments, interest, and proceeds from the maturity and call of investment securities. Loan and securities payments are a relatively stable source of funds, while deposit inflows and outflows are significantly influenced by pricing strategies and money market conditions .
Deposits. Our current deposit products include checking and savings accounts, certificates of deposit and fixed or variable rate individual retirement accounts (IRAs). Deposit account terms vary, primarily as to the required minimum balance amount, the amount of time, if any, that the funds must remain on deposit and the applicable interest rate. Our savings account menu includes regular passbook, statement, money market and club accounts. We also offer a six-level tiered savings account. Our certificates of deposit currently range in terms from 6 months to 10 years. Our IRAs are available with the same maturities as certificates of deposit accounts, with the exception of the 30 month term. We offer a two year certificate of deposit that permits the depositor to increase the interest rate to the current two year rate once during the term.
Deposits are obtained primarily from within New Jersey. The Bank may utilize brokered deposits and a listing service as funding sources. As of December 31, 2018 the Bank had $26.5 million in listing service deposits. Premiums or incentives for opening accounts are sometimes offered. Periodically we select particular certificate of deposit maturities for promotion in connection with asset/liability management and interest rate risk concerns.
The determination of deposit and certificate interest rates is based upon a number of factors, including: (1) need for funds based on loan demand, current maturities of deposits and other cash flow needs; (2) a current survey of a selected group of competitors' rates for similar products; (3) economic conditions; and (4) business plan projections.
A large percentage of our deposits are in certificates of deposit. The inflow of certificates of deposit and the retention of such deposits upon maturity are significantly influenced by general interest rates and money market conditions, making certificates of deposit traditionally a more volatile source of funding than core deposits. Our liquidity could be reduced if a significant amount of certificates of deposit maturing within a short period of time were not renewed. To the extent that such deposits do not remain with us, they may need to be replaced with borrowings which could increase our cost of funds and negatively impact our net interest rate spread and our financial condition.
The following table sets forth the distribution of average deposits for the periods indicated and the weighted average nominal interest rates for each period on each category of deposits presented.
The following table sets forth certificates of deposit classified by interest rate categories as of the dates indicated.
The following table sets forth the amount and maturities of certificates of deposit at December 31, 2018.
The following table shows the amount of the Company's certificates of deposit of $100,000 or more by time remaining until maturity as of December 31, 2018.
Borrowings. To supplement our deposits as a source of funds for lending or investment, we have borrowed funds in the form of advances from the FHLB of New York ("FHLB of NY"). At December 31, 2018, our collateralized borrowing limit with the FHLB of NY was $149.9 million and our outstanding borrowings with the FHLB of NY totaled $94.3 million. Information regarding our total borrowings as of December 31, 2018 is set forth in the following table.
A summary of short-term borrowings for 2018, 2017 and 2016 is set forth in the following table.
Advances from the FHLB of NY are typically secured by the FHLB stock and a portion of our residential mortgage loans and by other assets, mainly securities which are obligations of or guaranteed by the U.S. government. Additional information regarding our borrowings is included under Note 8 to our consolidated financial statements beginning on page .
Subsidiary Activity
The Company has no direct subsidiaries other than the Bank. The Bank has one wholly owned subsidiary, Millington Savings Service Corp., formed in 1984. The service corporation is currently inactive.
Regulation and Supervision
The Bank and the Company operate in a highly regulated industry. This regulation establishes a comprehensive framework of activities in which they may engage and is intended primarily for the protection of the Deposit Insurance Fund and depositors. Set forth below is a brief description of certain laws that relate to the regulation of the Bank and the Company. The description does not purport to be complete and is qualified in its entirety by reference to applicable laws and regulations.
Regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the imposition of restrictions on operations, the classification of assets and the adequacy of the allowance for loan losses. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, or legislation, including changes in the regulations governing mutual holding companies, could have a material adverse impact on the Company and the Bank. The adoption of regulations or the enactment of laws that restrict the operations of the Bank and/or the Company or impose burdensome requirements upon one or both of them could reduce their profitability and could impair the value of the Bank's franchise, resulting in negative effects on the trading price of the Company's common stock.
On May 24, 2018, the Economic Growth, Regulatory Relief and Consumer Protection Act (“EGRRCPA”) was enacted. EGRRCPA provided targeted regulatory relief to institutions of all sizes. For community banks and their holding companies, the most significant provisions include (i) an increase in the limit for applicability of the Small Bank Holding Company Policy Statement from $1 billion to $3 billion in total
assets; (ii) an extension of the period between examinations from 12 months to 18 months for well managed institutions; (iii) the end of the Volcker Rule for most community banks; (iv) the establishment of a Community Bank Leverage Ratio, which, if satisfied, would satisfy all applicable capital requirements; (v) Home Mortgage Disclosure Act (“HMDA”) relief for institutions originating fewer than 500 closed-end or 500 open-end in each of the preceding two calendar years provided the institutions also have a CRA rating of satisfactory or better; (vi) changes to the definition of a “brokered deposit” under the FDIC regulations; (vii) the creation of a safe harbor under the “ability to pay” rules and definition of “qualified mortgage” and (viii) various other regulatory relief provisions. EGRRCPA also made significant changes affecting larger institutions including an immediate increase in the threshold for being deemed a systemically important financial institution (“SIFI”) from $50 billion in total assets to $100 billion with the threshold to be further increased to $250 billion in total assets 18 months after enactment of EGRRCPA. While certain of the provisions were immediately effective, others require rulemaking with such rules in various stages of being finalized.
Holding Company Regulation
General. The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956 (the "BHC Act"), and is regulated by the Board of Governors of the Federal Reserve System (the "Federal Reserve"). The Federal Reserve has enforcement authority over the Company and the Company's non-bank subsidiaries which also permits the Federal Reserve to restrict or prohibit activities that are determined to be a serious risk to the subsidiary bank. This regulation and oversight is intended primarily for the protection of the depositors of the Bank and not for shareholders of the Company.
As a bank holding company, the Company is required to file with the Federal Reserve an annual report and any additional information as the Federal Reserve may require under the BHC Act. The Federal Reserve will also examine the Company and its subsidiaries.
Under the BHC Act, the Company must obtain the prior approval of the Federal Reserve before it may acquire control of another bank or bank holding company, merge or consolidate with another bank holding company, acquire all or substantially all of the assets of another bank or bank holding company, or acquire direct or indirect control of any voting shares of any bank or bank holding company if, after such acquisition, the Company would directly or indirectly own or control more than 5% of such shares.
Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the BHC Act on extensions of credit to the bank holding company or any of its subsidiaries, on investments in the stock or other securities of the bank holding company or its subsidiaries, and on the taking of such stock or securities as collateral for loans to any borrower. Furthermore, under amendments to the BHC Act and regulations of the Federal Reserve, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or provision of credit or providing any property or services. Generally, this provision provides that a bank may not extend credit, lease or sell property, or furnish any service to a customer on the condition that the customer provide additional credit or service to the bank, to the bank holding company, or to any other subsidiary of the bank holding company or on the condition that the customer not obtain other credit or service from a competitor of the bank, the bank holding company, or any subsidiary of the bank.
Extensions of credit by the Bank to executive officers, directors, and principal shareholders of the Bank or any affiliate thereof, including the Company, are subject to Section 22(h) of the Federal Reserve Act, which among other things, generally prohibits loans to any such individual where the aggregate amount exceeds an amount equal to 15% of a bank's unimpaired capital and surplus, plus an additional 10% of unimpaired capital and surplus in the case of loans that are fully secured by readily marketable collateral.
Source of Strength Doctrine. A bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, it is the policy of the Federal Reserve that a bank holding company should stand ready to use available resources to provide adequate capital to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company's failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve to be an unsafe and unsound banking practice or a violation of the Federal Reserve regulations, or both.
Non-Banking Activities. The business activities of the Company, as a bank holding company, are restricted by the BHC Act. Under the BHC Act and the Federal Reserve's bank holding company regulations, the Company may only engage in, or acquire or control voting securities or assets of a company engaged in, (1) banking or managing or controlling banks and other subsidiaries authorized under the BHC Act and (2) any BHC Act activity the Federal Reserve has determined to be so closely related to banking or managing or controlling banks to be a proper incident thereto. These include any incidental activities necessary to carry on those activities, as well as a lengthy list of activities that the Federal Reserve has determined to be so closely related to the business of banking as to be a proper incident thereto.
Financial Modernization. The Gramm-Leach-Bliley Act permits greater affiliation among banks, securities firms, insurance companies, and other companies under a new type of financial services company known as a "financial holding company." A financial holding company essentially is a bank holding company with significantly expanded powers. Financial holding companies are authorized by statute to engage in a number of financial activities previously impermissible for bank holding companies, including securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency; and merchant banking activities. The Act also permits the Federal Reserve and the Treasury Department to authorize additional activities for financial holding companies if they are "financial in nature" or "incidental" to financial activities. A bank holding company may become a financial holding company if it and each of its subsidiary banks is well capitalized and well managed, and each of its subsidiary banks has at least a "satisfactory" CRA rating. A financial holding company must provide notice to the Federal Reserve within 30 days after commencing activities previously determined by statute or
by the Federal Reserve and Department of the Treasury to be permissible. The Company has not submitted notice to the Federal Reserve of its intent to be deemed a financial holding company.
Regulatory Capital Requirements. The Federal Reserve has adopted capital adequacy guidelines pursuant to which it assesses the adequacy of capital in examining and supervising a bank holding company and in analyzing applications to it under the BHC Act. The Federal Reserve's capital adequacy guidelines are similar to those imposed on the Bank by the FDIC. See "Regulation of the Bank -Regulatory Capital Requirements." The Federal Reserve, however, has adopted a policy statement that exempts bank holding companies with less than $3.0 billion in consolidated assets that are not engaged in significant non-banking or off-balance sheet activities and that do not have a material amount of debt or equity securities registered with the SEC from its regulatory capital requirements as long as their bank subsidiaries are well capitalized, such bank holding companies need only maintain a pro forma debt to equity ratio of less than 1.0 in order to pay dividends and repurchase stock and to be eligible for expedited treatment on applications.
Federal Securities Law. The Company's common stock is registered under Section 12(b) of the Exchange Act, and the Company is subject to the periodic reporting and other requirements of Section 12(b) of the Exchange Act.
Acquisition of Control. Under the Change in Bank Control Act, a notice must be submitted to the Federal Reserve if any person (including a company), or group acting in concert, seeks to acquire "control" of a bank company. An acquisition of "control" can occur upon the acquisition of 10% or more of the voting stock of a bank holding company or as otherwise defined by the Federal Reserve. Under the Change in Bank Control Act, the Federal Reserve has 60 days from the filing of a complete notice to act, taking into consideration certain factors, including the financial and managerial resources of the acquirer and the anti-trust effects of the acquisition. Any company that so acquires control is then subject to regulation as a bank holding company.
Regulation of the Bank
General. As a New Jersey chartered, FDIC-insured bank, the Bank is regulated by the New Jersey Department of Banking and Insurance and the FDIC. The Bank's operations are subject to extensive regulation, including restrictions or requirements with respect to loans to one borrower, the percentage of non-mortgage loans or investments to total assets, capital distributions, permissible investments and lending activities, liquidity, transactions with affiliates and community reinvestment. The Bank must file regulatory reports concerning its activities and financial condition, and must obtain regulatory approvals prior to entering into certain transactions, such as mergers with or acquisitions of other financial institutions. The New Jersey Department of Banking and Insurance and the FDIC regularly examine the Bank and prepare reports to the Bank's Board of Directors on deficiencies, if any, found in its operations. The regulatory authorities have substantial discretion to impose enforcement action on an institution that fails to comply with applicable regulatory requirements, particularly with respect to its capital requirements.
Federal Deposit Insurance. The Bank's deposits are insured to applicable limits by the FDIC. Under the Dodd-Frank Act, the maximum deposit insurance amount has been permanently increased from $100,000 to $250,000.
The FDIC has adopted a risk-based premium system that provides for quarterly assessments based on an insured institution's ranking in one of four risk categories based on their examination ratings and capital ratios. The assessment base is the institution's average consolidated assets less average tangible equity. Insured banks with more than $1.0 billion in assets must calculate quarterly average assets based on daily balances while smaller banks and newly chartered banks may use weekly averages. In the case of a merger, the average assets of the surviving bank for the quarter must include the average assets of the merged institution for the period in the quarter prior to the merger. Average assets are reduced by goodwill and other intangibles. Average tangible equity equals Tier 1 capital. For institutions with more than $1.0 billion in assets, average tangible equity is calculated on a weekly basis while smaller institutions may use the quarter-end balance.
Effective July 1, 2016, the FDIC amended its assessment regulations for established banks (generally, an institution that has been federally insured for at least five years as of the last day of any quarter for which it is being assessed) with less than $10 billion in assets to replace the previous risk categories with updated financial ratios that are designed to better predict the risk of failure of insured institutions. The amended rules became effective during the first quarter after the designated reserve ratio of the Deposit Insurance Fund reached 1.15% and will remain in effect until the designated reserve ratio reaches 2.0%. The amended regulations set a maximum rate that banks rated CAMELS 1 or 2 may be charged and a minimum rate that CAMELS 3, 4 and 5 banks may be charged. Under the amended rules, the FDIC uses a bank's weighted average CAMELS component ratings and the following financial measures to determine assessments: Tier 1 leverage ratio; ratio of net income before taxes to total assets; ratio of non-performing loans to gross assets; and ratio of other real estate owned to gross assets. In addition, assessments take into consideration core deposits to total assets, one-year asset growth and a loan mix index. The loan mix index measures the extent to which a bank's total assets include higher risk loans. To calculate the loan mix index, each category of loan in the bank's portfolio (other than credit card loans) is divided by the bank's total assets to determine the percentage of assets represented by that loan category. Each percentage is then multiplied by that loan category's historical weighted average industry-wide charge-off rate. The sum of these numbers determines the loan mix index value for that bank. The amended regulations are intended to be revenue neutral to the FDIC but to shift premium payments to higher risk institutions. A companion regulation assessed banks over $10 billion in assets at higher rates for two years in accordance with the requirements of the Dodd-Frank Act.
In addition, all FDIC-insured institutions are required to pay assessments to the FDIC to fund interest payments on bonds issued by the Financing Corporation ("FICO"), an agency of the Federal government established to recapitalize the Federal Savings and Loan Insurance
Corporation. The FICO assessment rates, which are determined quarterly, averaged 0.385% of insured deposits on an annualized basis in 2018. These assessments will continue until the FICO bonds mature in 2019.
Regulatory Capital Requirements. The FDIC has promulgated capital adequacy requirements for state-chartered banks that, like the Bank, are not members of the Federal Reserve System. Effective January 1, 2015, the capital adequacy requirements were substantially revised to conform them to the international regulatory standards agreed to by the Basel Committee on Banking Supervision in the accord often referred to as "Basel III". The final rule applies to all depository institutions as well as to all top-tier bank and savings and loan holding companies that are not subject to the Federal Reserve's Small Bank Holding Company Policy Statement.
Under the FDIC's revised capital adequacy regulations, the Bank is required to meet four minimum capital standards: (1) "Tier 1" or "core" capital leverage ratio equal to at least 4% of total adjusted assets, (2) a common equity Tier 1 capital ratio equal to 4.5% of risk-weighted assets, (3) a Tier 1 risk-based ratio equal to 6% of risk-weighted assets, and (4) a total capital ratio equal to 8% of total risk-weighted assets. Common equity Tier 1 capital is defined as common stock instruments, retained earnings, any common equity Tier 1 minority interest and, unless the bank has made an "opt-out" election, accumulated other comprehensive income, net of goodwill and certain other intangible assets. Tier 1 or core capital is defined as common equity Tier 1 capital plus certain qualifying subordinated interests and grandfathered capital instruments. Total capital consists of Tier 1 capital plus Tier 2 or supplementary capital items, which include allowances for loan losses in an amount of up to 1.25% of risk-weighted assets, qualifying subordinated instruments and certain grandfathered capital instruments. An institution's risk-based capital requirements are measured against risk-weighted assets, which equal the sum of each on-balance-sheet asset and the credit-equivalent amount of each off-balance-sheet item after being multiplied by an assigned risk weight. Risk weightings range from 0% for cash to 100% for property acquired through foreclosure, commercial loans, and certain other assets to 150% for exposures that are more than 90 days past due or are on nonaccrual status and certain commercial real estate facilities that finance the acquisition, development or construction of real property. Pursuant to EGRRCPA, the federal banking agencies may only apply a heightened risk weight to a higher volatility commercial real estate exposure that constitutes a higher volatility commercial real estate acquisition, development or construction loan as defined in EGRRCPA and which was originated on or after January 1, 2015.
In addition to higher capital requirements, the capital rules require banks to maintain and covered financial institution holding companies to maintain a capital conservation buffer of at least 2.5% of risk-weighted assets over and above the minimum risk-based capital requirements. Institutions that do not maintain the required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital buffer requirement is being phased in over four years beginning January 1, 2016. The fully phased-in capital buffer requirement will effectively raise the minimum required risk-based capital ratios to 7% for Common Equity Tier 1 Capital, 8.5% for Tier 1 Capital and 10.5% for Total Capital on a fully phased-in basis.
In assessing an institution's capital adequacy, the FDIC takes into consideration not only these numeric factors but also qualitative factors, and has the authority to establish higher capital requirements for individual institutions where necessary.
EGRRCPA directs the federal banking agencies to develop a community bank leverage ratio of tangible capital to average total consolidated assets of between 8% and 10% as an alternative to the current leverage and risk-based capital rules for qualifying community banks and satisfying any other leverage or capital requirements to which they are subject. Qualifying community banks meeting the community bank leverage ratio would also be deemed well-capitalized for purposes of the prompt corrective action rules. A qualifying community bank is a depository institution or holding company with total consolidated assets of less than $10 billion that is not excluded from qualification by the federal banking regulators based on the institution’s risk profile. Under regulations proposed by the federal banking agencies, a qualifying community bank may opt in to the community bank leverage ratio framework if its community bank leverage ratio exceeds 9%. The proposed regulations would define tangible equity as total bank equity capital less: (i) accumulated other comprehensive income; (ii) intangible assets (other than mortgage servicing assets); and (iii) deferred tax assets (net of related valuation allowances) arising from net operating loss and tax credit carryforwards. Under the proposal, a qualifying community bank must have total off-balance sheet exposures (excluding derivatives other than credit derivatives and unconditionally cancellable commitments) of 25% of less of total consolidated assets, total trading assets and liabilities of 5% or less of total consolidated assets, mortgage servicing assets of 25% or less of tangible equity and temporary difference deferred tax assets of less than 25% of tangible equity.
Prompt Corrective Regulatory Action. Under applicable federal statutes, the federal bank regulatory agencies are required to take "prompt corrective action" with respect to institutions that do not meet specified minimum capital requirements. For these purposes, the law establishes five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. Under the FDIC's prompt corrective action regulations, an institution is deemed to be "well capitalized" if it has a Total Risk-Based Capital Ratio of 10.0% or greater, a Tier 1 Risk-Based Capital Ratio of 8.0% or greater, a Common Equity Tier 1 risk-based capital ratio of 6.5% or better and a leverage ratio of 5.0% or greater. An institution is "adequately capitalized" if it has a Total Risk-Based Capital Ratio of 8.0% or greater, a Tier 1 Risk-Based Capital Ratio of 6.0% or greater, a Common Equity Tier 1 Capital Ratio of 4.5% or better and a Leverage Ratio of 4.0% or greater. An institution is "undercapitalized" if it has a Total Risk-Based Capital Ratio of less than 8.0%, a Tier 1 Risk-Based Capital ratio of less than 6.0%, a Common Equity Tier 1 ratio of less than 4.5% or a Leverage Ratio of less than 4.0%. An institution is deemed to be "significantly undercapitalized" if it has a Total Risk-Based Capital Ratio of less than 6.0%, a Tier 1 Risk-Based Capital Ratio of less than 4.0%, a Common Equity Tier 1 ratio of less than 3.0% or a Leverage Ratio of less than 3.0%. An institution is considered to be "critically undercapitalized" if it has a ratio of tangible equity to total assets that is equal to or less than 2.0%
The prompt corrective action regulations provide for the imposition of a variety of requirements and limitations on institutions that fail to meet the above capital requirements. In particular, the FDIC may require any non-member bank that is not "adequately capitalized" to take certain action to increase its capital ratios. If the non-member bank's capital is significantly below the minimum required levels of capital or if it is unsuccessful in increasing its capital ratios, the bank's activities may be restricted.
Under the proposed community bank leverage ratio regulations, a qualifying community bank would be deemed: well capitalized if it has a community bank leverage ratio greater than 9%; adequately capitalized if its community bank leverage ratio is 7.5% or greater; undercapitalized if its community bank leverage ratio is less than 7.5% and significantly undercapitalized if its community bank leverage ratio is less than 6%. A qualifying community bank will continue to be treated as critically undercapitalized if it has a ratio of tangible equity to total assets of 2% or less.
At December 31, 2018, the Bank qualified as "well capitalized" under the prompt corrective action rules.
Community Reinvestment Act. Under the Community Reinvestment Act, every insured depository institution, including the Bank, has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The Community Reinvestment Act does not establish specific lending requirements or programs for financial institutions nor does it limit an institution's discretion to develop the types of products and services that it believes are best suited to its particular community. The Community Reinvestment Act requires the depository institution's record of meeting the credit needs of its community to be assessed and taken into account in the evaluation of certain applications by such institution, such as a merger or the establishment of a branch office by the Bank. An unsatisfactory Community Reinvestment Act examination rating may be used as the basis for the denial of an application. The Bank received a "satisfactory" rating in its most recent Community Reinvestment Act examination.
Federal Home Loan Bank System. The Bank is a member of the FHLB of NY, which is one of twelve regional federal home loan banks. Each FHLB serves as a reserve or central bank for its members within its assigned region. It is funded primarily from funds deposited by financial institutions and proceeds derived from the sale of consolidated obligations of the FHLB System. It makes loans to members pursuant to policies and procedures established by its board of directors.
As a member, the Bank is required to purchase and maintain stock in the FHLB of NY in an amount equal to the greater of 1% of its aggregate unpaid residential mortgage loans, home purchase contracts or similar obligations at the beginning of each year or 5% of its outstanding FHLB advances. The FHLB imposes various limitations on advances such as limiting the amount of certain types of real estate related collateral to 30% of a member's capital and limiting total advances to a member.
The FHLB is required to provide funds for the resolution of troubled savings institutions and to contribute to affordable housing programs through direct loans or interest subsidies on advances targeted for community investment and low- and moderate-income housing projects. These contributions have adversely affected the level of FHLB dividends paid and could continue to do so in the future. In addition, these requirements could result in the FHLB imposing a higher rate of interest on advances to their members.
Item 1A.
Item 1A. Risk Factors
Not applicable as the Company is a "smaller reporting company."
Item 1B.
Item 1B. Unresolved Staff Comments
Not applicable.
Item 2.
Item 2. Properties
At December 31, 2018, our investment in property and equipment, net of depreciation and amortization, totaled $8.2 million, including leasehold improvements and construction in progress. The following table lists our offices.
__________________
(1)
The Bank's main office opened in 1911 in Millington, New Jersey. The Bank moved into its current main office in 1994.
(2)
The Bank's first branch office opened in 1998 in Liberty Corner, New Jersey. This office was relocated in 2005.
Item 3.
Item 3. Legal Proceedings
The Bank, from time to time, is a party to routine litigation which arises in the normal course of business, such as claims to enforce liens, condemnation proceedings on properties in which we hold security interests, claims involving the making and servicing of real property loans, and other issues incident to our business. There were no lawsuits pending or known to be contemplated against the Company or the Bank at December 31, 2018 that would have a material effect on operations or income.
Item 4.
Item 4. Mine Safety Disclosures
Not applicable
PART II
Item 5.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
(a) Market Information. The Company's common stock trades on the NASDAQ Stock Market under the symbol "MSBF". The table below shows the reported high and low closing prices of common stock reported by NASDAQ and dividends declared during the periods indicated.
Dividends. Declarations of dividends by the Board of Directors depend on a number of factors, including investment opportunities, growth objectives, financial condition, profitability, tax considerations, minimum capital requirements, regulatory limitations, and general economic as well as stock market conditions. The timing, frequency and amount of dividends are determined by the Board of Directors.
Stockholders. As of March 15, 2019, there were approximately 454 shareholders of record of the Company's common stock. This number does not include brokerage firms, banks and registered clearing agents acting as nominees for an indeterminate number of beneficial ("street name") owners.
(b) Use of Proceeds.
Not applicable
(c) Issuer Purchases of Equity Securities.
On December 17, 2018, the Company announced that is has approved a stock repurchase plan to purchase up to 273,150 shares of the Company's common stock. In connection with the repurchase plan, the Company entered into a Rule 10b5-1 plan with Keefe, Bruyette & Wood, a Stifel Company. The following table shows shares repurchased during the quarter ended December 31, 2018.
Item 6.
Item 6. Selected Financial Data
Not applicable as the Company is a smaller reporting company.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
This discussion and analysis reflects the Company's consolidated financial statements and other relevant statistical data and is intended to enhance your understanding of our financial condition and results of operations. You should read the information in this section in conjunction with the Company's consolidated financial statements and accompanying notes thereto beginning on page following Item 16 of this Form 10-K.
Critical Accounting Policies
Our accounting policies are integral to understanding the results reported and are described in Note 2 to our consolidated financial statements beginning on page. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the consolidated statements of financial condition and revenues and expenses for the periods then ended. Actual results could differ significantly from those estimates. A material estimate that is particularly susceptible to significant change relates to the determination of the allowance for loan losses.
The allowance for loan losses is established through provisions for loan losses charged against income. Loans deemed to be uncollectible are charged against the allowance for loan losses, and subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses is maintained at a level by management which represents the evaluation of known and probable incurred losses in the loan portfolio at the consolidated balance sheet date that are reasonable to estimate. Management's periodic evaluation of the adequacy of the allowance is based on the Company's past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, the composition of the loan portfolio, current economic conditions, and other relevant factors. This evaluation is inherently subjective, as it requires material estimates that may be susceptible to significant change, including the amounts and timing of future cash flows expected to be received on impaired loans.
In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance for loan losses based on their judgments about information available to them at the time of their examinations.
The Company's loan portfolio is comprised of the following segments: residential mortgage, commercial real estate, construction, commercial and industrial and consumer. Some segments of the Company's loan receivable portfolio are further disaggregated into classes which allow management to more accurately monitor risk and performance. Accordingly, the methodology and allowance calculation includes the segmentation of the total loan portfolio.
The residential mortgage loan segment is disaggregated into two classes: one-to-four family loans, which are primarily first liens, and home equity loans, which consist of first and second liens. The commercial real estate loan segment includes owner and non-owner occupied loans which have medium risk based on historical experience with these types of loans. The construction loan segment is further disaggregated into two classes: one-to-four family owner-occupied, which includes land loans, whereby the owner is known and there is less risk, and other, whereby the property is generally under development and tends to have more risk than the one-to-four family owner-occupied loans. The commercial and industrial loan segment consists of loans made for the purpose of financing the activities of commercial customers. The commercial and industrial loans carry a mix of loans secured by real estate and unsecured lines of credit some of which are for high net worth individuals. The consumer loan segment consists primarily of installment loans and overdraft lines of credit connected with customer deposit accounts.
The allowance consists of specific, general and unallocated components. The specific component is related to loans that are classified as impaired. For loans classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers pools of loans by loan class and is based on historical loss experience adjusted for qualitative factors. These qualitative risk factors include:
1.
Lending policies and procedures, including underwriting standards and collection, charge-off, and recovery practices.
2.
National, regional, and local economic and business conditions as well as the condition of various market segments, including the value of underlying collateral for collateral dependent loans.
3.
Nature and volume of the portfolio and terms of loans.
4.
Experience, ability, and depth of lending management and staff.
5.
Volume and severity of past due, classified and nonaccrual loans as well as and other loan modifications.
6.
Quality of the Company's loan review system, and the degree of oversight by the Company's Board of Directors.
7.
Existence and effect of any concentrations of credit and changes in the level of such concentrations.
8.
Effect of external factors, such as competition and legal and regulatory requirements.
Each factor is assigned a value to reflect improving, stable or declining conditions based on management's best judgment using relevant information available at the time of the evaluation.
The unallocated component is maintained to cover uncertainties that could affect management's estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record and the amount of the shortfall in relation to the principal and interest owed.
Loans the terms of which are modified are classified as TDRs if, in connection with the modification, the Company grants such borrowers concessions and it is deemed that those borrowers are experiencing financial difficulty. Concessions granted under a TDR generally involve a reduction in interest rate below market rate given the associated credit risk, or an extension of a loan's stated maturity date. Nonaccrual TDRs are restored to accrual status if principal and interest payments, under the modified terms, are current for six consecutive months after modification. Loans classified as TDRs are designated as impaired until they are ultimately repaid in full or foreclosed and sold.
Once the determination has been made that a loan is impaired, impairment is measured by comparing the recorded investment in the loan to one of the following:(a) the present value of expected cash flows (discounted at the loan's effective interest rate), (b) the loan's observable market price or (c) the fair value of collateral adjusted for expected selling costs. The method is selected on a loan by loan basis with management primarily utilizing the fair value of collateral method.
The estimated fair values of the real estate collateral are determined primarily through third-party appraisals. When a real estate secured loan becomes impaired, a decision is made regarding whether an updated certified appraisal of the real estate is necessary. This decision is based on various considerations, including the age of the most recent appraisal, the loan-to-value ratio based on the original appraisal and the condition of the property. Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property.
The estimated fair values of non-real estate collateral, such as accounts receivable, inventory and equipment, are determined based on the borrower's financial statements, inventory reports, accounts receivable agings or equipment appraisals or invoices. Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets.
The evaluation of the need and amount of the allowance for impaired loans and whether a loan can be removed from impairment status is made on a quarterly basis. The Company's policy for recognizing interest income on impaired loans does not differ from its overall policy for interest recognition.
Overview
Our primary business is attracting deposits from the general public and using those deposits, together with funds generated from operations, principal repayments on securities and loans and borrowed funds, for our lending and investing activities. Our loan portfolio consists of one-to-four-family residential real estate mortgages, commercial real estate mortgages, construction loans, commercial and industrial loans, home equity loans and lines of credit, and other consumer loans. We also invest in U.S. Government obligations and mortgage-backed securities and, to a lesser extent, corporate bonds.
We reported net income of $4.8 million for the year ended December 31, 2018 as compared to a net income of $2.7 million for 2017. Net income for 2017 was affected by the $678,000 charge we took in connection with the revaluation of our deferred tax assets. As a result of the enactment of the Tax Cuts and Jobs Act effective December 22, 2017, corporate tax rates were reduced thereby resulting in a reduction in the in the value of our deferred tax assets. This charge was taken as part of the provision for income taxes.
Net interest income for 2018 was up approximately $1.9 million, or 11.93%, as compared to 2017. For the year ended December 31, 2018, interest income increased by $3.9 million, or 19.84%, while interest expense increased by $2.0 million, or 56.65%, as compared to 2017. Non-interest expense increased by $680,000, or 6.08%, while non-interest income decreased by $22,000, or 2.68%, for the same comparative period. The net interest rate spread decreased in 2018 to 3.08%, compared to 3.15% for 2017, mainly as a result of increased competition for deposits forced an increase in deposit rates paid.
Total assets were $584.5 million at December 31, 2018, a 3.81% increase compared to $563.0 million at December 31, 2017. The increase in assets occurred primarily as the result of a $28.9 million increase in loans receivable, net, an increase of $2.6 million in FHLB stock, and an increase of $1.0 million in securities held to maturity. Deposits were $420.6 million at December 31, 2018, compared to $448.9 million at December 31, 2017. FHLB advances were $94.3 million at December 31, 2018 compared to $37.7 million at December 31, 2017.
Stockholders' equity at December 31, 2018 was $66.6 million compared to our stockholders' equity at December 31, 2017 of $73.0 million. The Company had net income of $4.8 million for the year ended December 31, 2018. The decline in shareholders' equity was primarily due to the repurchase of 373,948 shares of common stock at a total cost of $6.7 million and by $5.0 million used to pay two special dividends to shareholders. Our return on average equity for the year ended December 31, 2018 was 6.88% compared to 3.67% for the year ended December 31, 2017.
Comparison of Financial Condition at December 31, 2018 and 2017
General. Total assets at December 31, 2018 were $584.5 million versus $563.0 million at December 31, 2017 with the increase attributable mainly to continued loan growth. During the year ended December 31, 2018, the Company experienced growth of $28.9 million, or 6.10%, in loans receivable, net and a $2.6 million, or 123.18%, increase in FHLB of New York stock. Securities held to maturity increased $994,000 primarily as a result of the purchase of $9.0 million in securities offset by maturities and principal repayments. Other assets decreased $422,000 primarily due to the decrease in deferred tax assets. Deposits decreased by $28.3 million while FHLB advances increased by $56.6 million.
The ratio of average interest-earning assets to average-interest bearing liabilities was 120.21% for the year ended December 31, 2018 as compared to 124.73% for the year ended December 31, 2017.
Loans. Loans receivable, net, increased $28.9 million, or 6.10%, from $473.4 million at December 31, 2017 to $502.3 million at December 31, 2018. The Bank's commercial and multi-family real estate loan portfolio grew by $15.9 million, or 8.10%, since December 31, 2017. The commercial and industrial portfolio increased by $35.1 million, or 47.83%, on continued strong loan demand, while the construction loan portfolio decreased approximately $14.1 million due to the completion of projects. The residential mortgage portfolio, consisting of one-to-four family residential loans and home equity loans, decreased $16.9 million to $167.8 million from $184.7 million as of year-end 2017. All remaining portfolios were consistent with prior year-end levels.
Securities. The securities held to maturity portfolio totaled $39.5 million at December 31, 2018 compared to $38.5 million at December 31, 2017. Maturities, calls and principal repayments during 2018 totaled $7.9 million and $9.0 million in securities were purchased compared to $6.7 million of maturities, calls and principal repayments and $1.2 million in purchases during 2017.
Deposits. Total deposits at December 31, 2018 decreased to $420.6 million from $448.9 million at December 31, 2017. Overall, deposits decreased by $28.3 million with non-interest bearing balances increasing by $9.8 million and interest-bearing deposits decreasing $38.1 million since December 31, 2017 as the Company focused on deposit pricing and the development of deeper commercial and small business relationships.
Borrowings. Total borrowings were $94.3 million at December 31, 2018 compared to $37.7 million at December 31, 2017. During the year, we had a maturity of a $10.0 million advance at a rate of 3.46%. Overnight advances with the FHLB of New York at December 31, 2018 were $66.6 million compared to none at December 31, 2017.
Equity. Stockholders' equity was $66.6 million at December 31, 2018 compared to $73.0 million at December 31, 2017, a decrease of $6.4 million or 8.74%. The decrease in shareholders' equity was primarily due to the repurchase of 373,948 shares of common stock at a total cost of $6.7 million and the payment of two special dividends to shareholders for an aggregate amount of $5.0 million. This reduction was partially offset by a $4.8 million increase in retained earnings related to net income.
Comparison of Operating Results for the Years Ended December 31, 2018 and 2017
General. Our results of operations depend primarily on our net interest income. Net interest income is the difference between the interest income we earn on our interest-earning assets and the interest we pay on our interest-bearing liabilities. It is a function of the average balances of loans and investments versus deposits and borrowed funds outstanding in any one period and the yields earned on those loans and investments and the cost of those deposits and borrowed funds. Our results of operations are also affected by our provision for loan losses, non-interest income and non-interest expense. Non-interest income includes service fees and charges, and income on bank owned life insurance. Non-interest expense includes salaries and employee benefits, occupancy and equipment expense and other general and administrative expenses such as service bureau fees and advertising costs.
The Company reported net income of $4.8 million for December 31, 2018 compared to net income of $2.7 million for the year ended December 31, 2017, representing an increase of $2.1 million or 77.63%. This increase was largely driven by a $1.9 million increase in net interest income and a decrease in the provision for loan losses of $945,000. Offsetting this was an increase in non-interest expense of $680,000, and a decrease of $22,000 in non-interest income. Income tax expense increased $43,000 for the year ended December 31, 2018 versus 2017 due to the increase in pre-tax income offset by a decrease in the corporate tax rate as a result of the passage of the Tax Cuts and Jobs Act on December 22, 2017 which significantly reduced corporate tax rates.
Net Interest Income. Net interest income for the year ended December 31, 2018 totaled $17.9 million compared to $16.0 million for the year ended December 31, 2017. Interest income for the year ended December 31, 2018 was $23.3 million compared to $19.5 million for the year end December 31, 2017, while interest expense increased by $2.0 million to $5.4 million from the same period a year earlier.
Average earning assets increased $64.3 million, or 13.33%, to $546.5 million year over year while the average yield on interest earning assets increased by 0.23% to 4.27% for the year ended December 31, 2018. The result of those variances was an increase in interest income of $3.9 million for the year ended December 31, 2018 compared to the year ended December 31, 2017. Interest income for the year ended December 31, 2018 was $23.3 million compared to $19.5 million for the year end December 31, 2017. Interest income on loans receivable grew by $3.7 million to $22.0 million mainly due to an increase in loan volume. Average loans were $495.7 million and $429.8 million for the years ended December 31, 2018 and 2017, respectively. The average yield on loans increased by .18% which also contributed to the increase in interest income from loans. Average securities held to maturity declined by $1.7 million to $39.9 million from $41.6 million. The average rate earned on the portfolio increased 0.24% to 2.67% from 2.43% for the prior year. Overall, the decreased volume combined with the increased rate resulted in an increase of $54,000 in interest income from securities. Other interest-earning assets, consisting of our Federal Reserve account,
FHLB stock and other interest-bearing deposits with other financial institutions, increased by $166,000 on average, to $10.9 million for the year ended December 31, 2018 compared with $10.7 million for the year ended December 31, 2017. Partnered with this increase was an increase in the average yield from 1.78% to 2.94%. This increase in rate was largely attributed to larger balances held at the Federal Reserve Bank earning an average rate of 1.26%. The combined impact was an increase in interest income on other interest-earning assets of $129,000.
Total interest expense increase by $2.0 million to $5.4 million for the year ended December 31, 2018 as a result of increased volumes, and higher rates. Overall, average interest-bearing liabilities increased $68.0 million, or 17.6%, to $454.6 million for the year ended December 31, 2018 as compared to $386.6 million for the year ended December 31, 2017. Interest expense on certificates of deposit increased $382,000 as average balances were approximately $5.0 million higher for the year ended 2018 period totaling $124.6 million compared to $119.6 million for the year ended December 31, 2017. The average cost of certificates of deposit increased by 0.25%. Savings accounts averaged $105.6 million for the year ended December 31, 2018 versus $105.4 million for the year ended December 31, 2017. The 0.26% increase in the average rate was the primary reason for the $271,000 increase in interest expense for these accounts in 2018 as compared to the same period in 2017. Interest demand and money market accounts on average grew $34.3 million to $153.4 million which resulted in an increase in interest expense of $731,000 for the year ended December 31, 2018. The average interest rate paid on these accounts rose 0.38% to 0.82% from 0.44% as a result of a mixture of larger balance accounts earning a higher rate of interest and the volume of deposits. Interest expense on FHLB advances rose by $568,000 to $1.6 million from $996,000 a year earlier. The average cost of advances decreased by 0.15% to 2.20% from 2.35% as a result of one long-term borrowing maturing during the year costing 3.46%. Average FHLB advances were $71.1 million for the year ended December 31, 2018 versus $42.4 million for the year ended December 31, 2017 which was the cause of the increase in interest expense.
The Company's net interest spread and margin declined over the periods and were 3.08% and 3.28%, respectively for the year ended December 31, 2018 compared to 3.15% and 3.33%, respectively for the year ended December 31, 2017.
Provision for Loan Losses . The loan loss provision for the year ended December 31, 2018 was $240,000 compared to $1.2 million for the year ended December 31, 2017. The Company's management reviews the level of the allowance for loan losses on a quarterly basis based on a variety of factors including, but not limited to, (1) the risk characteristics of the loan portfolio, (2) current economic conditions, (3) actual losses previously experienced, (4) the Company's level of loan growth and (5) the existing level of reserves for loan losses that are probable and estimable. This analysis resulted in a lower provision for loan loss being required for the period ended December 31, 2018. The decrease in the level of provision for loan loss primarily reflects lower loan growth year-over-year in addition to other credit metrics generally improving year over year. There was a stabilization of the quantitative and qualitative factors during the year ended December 31, 2018 and December 31, 2017. The Company had $8,000 in charge-offs and $9,000 in recoveries for the year ended December 31, 2018 compared to $255,000 in charge-offs and $8,000 in recoveries for the year ended December 31, 2017. The Company had $4.1 million in non-performing loans as of December 31, 2018, compared to $4.1 million at December 31, 2017. The allowance for loan losses as a percentage of total loans was 1.09% and 1.08% at December 31, 2018 and December 31, 2017, respectively, while the allowance for loan losses as a percentage of non-performing loans increased to 136.83% at December 31, 2018 from 130.99% at December 31, 2017. Non-performing loans to total loans were 0.80% at December 31, 2018 compared to 0.83% at December 31, 2017. Net charge-offs to average loans outstanding ratios were 0.00% for the year ended December 31, 2018 compared to 0.06% for the year ended December 31, 2017. While management believes the allowance for loan losses is adequate for the risk in the loan portfolio, there can be no assurance that future increases may not be necessary.
Non-Interest Income. This category includes fees derived from checking accounts, ATM transactions, debit card use and other fees. It also includes increases in the cash-surrender value of our bank owned life insurance. Overall, non-interest income was $800,000 for the year ended December 31, 2018 compared to $822,000 for the year ended December 31, 2017, a decrease of $22,000 or 2.68%.
Income from fees and service charges totaled $334,000 for the year ended December 31, 2018 compared to $342,000 for the year ended December 31, 2017, a decrease of $8,000 or 2.34%. The decrease was attributable to lower volume in services fees charged during the year.
Income on bank owned life insurance was $388,000 and $413,000 for the years ended December 31, 2018 and 2017, while other non-interest income was $78,000 and $67,000 for the years ended December 31, 2018 and 2017, respectively.
Non-Interest Expenses. Total non-interest expenses increased by $680,000, or 6.08%, during the year ended December 31, 2018 and totaled $11.9 million as compared to $11.2 million for the year ended December 31, 2017.
Salaries and employee benefits expense increased by $433,000, or 6.94%, to $6.7 million for the year ended December 31, 2018 compared to $6.2 million for the year ended December 31, 2017. Salary and benefits increased due to an increase in incentive compensation as well as normal increases in salaries and benefits expenses and additions to staff.
Directors' compensation expense totaled $490,000 for the year ended December 31, 2018 compared to $743,000 for the year ended December 31, 2017, representing a decrease of $253,000 or 34.05%. The decrease was primarily due to the expense recorded in the 2017 period for the termination of the director retirement plan as described in Note 12.
Professional services increased $383,000 totaling $1.7 million for the year ended December 31, 2018 compared with $1.3 million for the year ended December 31, 2017. The increase is primarily attributable to costs associated with our Sarbanes-Oxley implementation.
Occupancy and equipment expense decreased by $56,000, or 3.46%, to $1.6 million for the year ended December 31, 2018 compared to $1.6 million for the same period a year earlier.
Service bureau fees increased by $118,000, or 51.53%, to $347,000 for the year ended December 31, 2018 compared to $229,000 for the year ended December 31, 2017 as a result of a reduction in the Company's relationship credit that declines every year.
Other non-interest expense totaled $813,000 for the year ended December 31, 2018, compared to $794,000 for the year earlier, reflecting an increase of $19,000, or 2.39%, due to various expense category increases.
Income Taxes. The income tax expense for the year ended December 31, 2018 was $1.8 million, or 27.2% of income before taxes as compared to income tax expense of $1.8 million, or 39.4%, of the reported income before income taxes, for the year ended December 31, 2017. The increase in income tax expense and the decrease in the effective tax rate was attributable to a larger proportion of pre-tax income being taxable and the revaluation of the Company's deferred tax asset as a result of the passage of the Tax Cuts and Jobs Act on December 22, 2017 which significantly reduced corporate tax rates. As a result, the Company recorded an additional tax provision of $678,000 for the revaluation for the year ended December 31, 2017.
In addition, certain directors, executive officers and directors emeriti executed options to purchase 212,468 shares of common stock at a per share exercise price of $9.4323. In lieu of issuing shares of common stock upon the exercise of such options, the Company made a cash payment to such optionees equal to the excess of the closing price of the common stock on the Nasdaq Stock Market on August 4, 2017 of $17.30 over the per share exercise price of such options of $9.4323 multiplied by the number of options being exercised. An aggregate of $1.7 million was paid to the optionees. The transaction resulted in a $406,000 tax benefit to the Company for the year ended December 31, 2017.
Average Balance Sheet. The following tables set forth certain information for the year ended December 31, 2018 and 2017. The average yields and costs are derived by dividing interest income and expense by the average daily balance of assets and liabilities, respectively, for the periods presented.
________________
(1)
Non-accruing loans have been included, and the effect of such inclusion was not material. The allowance for loan losses is excluded, while construction loans in process and deferred fees are included.
(2)
Includes FHLB of New York stock at cost and term deposits with other financial institutions.
(3)
Net interest rate spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.
(4)
Net interest margin represents net interest income as a percentage of average interest-earning assets.
Rate/Volume Analysis. The following table reflects the sensitivity of our interest income and interest expense to changes in volume and in prevailing interest rates during the periods indicated. Each category reflects the: (1) changes in volume (changes in volume multiplied by past rate); (2) changes in rate (changes in rate multiplied by past volume); and (3) net change. The net change attributable to the combined impact of volume and rate has been allocated proportionally to the absolute dollar amounts of change in each.
Liquidity, Commitments and Capital Resources
The Bank must be capable of meeting its customer obligations at all times. Potential liquidity demands include funding loan commitments, cash withdrawals from deposit accounts and other funding needs as they present themselves. Accordingly, liquidity is measured by our ability to have sufficient cash reserves on hand, at a reasonable cost and/or with minimum losses.
Senior management is responsible for managing our overall liquidity position and risk and is responsible for ensuring that our liquidity needs are being met on both a daily and long-term basis. The Financial Review Committee, comprised of senior management and chaired by the President and Chief Executive Officer is responsible for establishing and reviewing our liquidity procedures, guidelines, and strategy on a periodic basis.
Our approach to managing day-to-day liquidity is measured through our daily calculation of investable funds and/or borrowing needs to ensure adequate liquidity. In addition, senior management constantly evaluates our short-term and long-term liquidity risk and strategy based on current market conditions, outside investment and/or borrowing opportunities, short and long-term economic trends, and anticipated short and long-term liquidity requirements. The Bank's loan and deposit rates may be adjusted as another means of managing short and long-term liquidity needs. We do not at present participate in derivatives or other types of hedging instruments to meet liquidity demands, as we take a conservative approach in managing liquidity.
At December 31, 2018, the Bank had outstanding commitments to originate loans of $14.2 million, unused lines of credit of $74.1 million (including $14.5 million for home equity lines of credit and $59.3 million for commercial lines of credit), and standby letters of credit of $159,000. Certificates of deposit scheduled to mature in one year or less at December 31, 2018, totaled $39.8 million.
The Bank had contractual obligations related to the long-term operating leases for the two branch and one operations center location that it leases (Loan Production Office, RiverWalk and Martinsville). For additional information regarding the Bank's lease commitments as of December 31, 2018, see Note 10 to our consolidated financial statements beginning on page.
The Bank has access to cash through borrowings from the FHLB, as needed, to meet its day-to-day funding obligations. At December 31, 2018, its total loans to deposits ratio was 119.43%. At December 31, 2018, the Bank's collateralized borrowing limit with the FHLB was $149.9 million, of which $94.3 million was outstanding. As of December 31, 2018, the Bank also had a $13.0 million line of credit with a financial institution for an unsecured line of credit (which is a form of borrowing) that it could access if necessary.
Consistent with its goals to operate a sound and profitable financial organization, the Bank actively seeks to maintain its status as a well-capitalized institution in accordance with regulatory standards. As of December 31, 2018, the Company and the Bank exceeded all applicable
regulatory capital requirements. See Note 9 to our consolidated financial statements beginning at page for more information about the Company and the Bank's regulatory capital compliance.
Off-Balance Sheet Arrangements
We are a party to financial instruments with off-balance-sheet risk in the normal course of our business of investing in loans and securities as well as in the normal course of maintaining and improving the Bank facilities. These financial instruments include significant purchase commitments such as commitments to purchase investment securities or mortgage-backed securities and commitments to extend credit to meet the financing needs of our customers. At December 31, 2018, our significant off-balance sheet commitments consisted of commitments to originate loans of $14.2 million, unused lines of credit of $74.1 million (including $14.5 million for home equity lines of credit and $59.3 million for commercial lines of credit) and standby letters of credit of $159,000.
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. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. We use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments. Since a number of commitments typically expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. For additional information regarding our outstanding lending commitments at December 31, 2018, see Note 13 to our consolidated financial statements beginning on page.
Impact of Inflation
The Company's financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. These principles require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of money over time due to inflation.
Our primary assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on our performance than the effects of general levels of inflation. Interest rates, however, do not necessarily move in the same direction or with the same magnitude as the price of goods and services, since such prices are affected by inflation. In a period of rapidly rising interest rates, the liquidity and maturities of our assets and liabilities are critical to the maintenance of acceptable performance levels.
The principal effect of inflation on earnings, as distinct from levels of interest rates, is in the area of non-interest expense. Expense items such as employee compensation, employee benefits and occupancy and equipment costs may be subject to increases as a result of inflation. An additional effect of inflation is the possible increase in the dollar value of the collateral securing loans that we have made. We are unable to determine the extent, if any, to which properties securing our loans have appreciated in dollar value due to inflation.
Recent Accounting Pronouncements
Note 2 to the consolidated financial statements is incorporated herein by reference.
Quarterly Results of Operations
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Management of Interest Rate Risk and Market Risk
Qualitative Analysis. Because the majority of our assets and liabilities are sensitive to changes in interest rates, a significant form of market risk for us is interest rate risk, or changes in interest rates.
We derive our income mainly from the difference or "spread" between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits, borrowings and other interest-bearing liabilities. In general, the larger the spread, the more we earn. When market rates of interest change, the interest we receive on our assets and the interest we pay on our liabilities will fluctuate. This can cause decreases in our spread and can adversely affect our income.
Quantitative Analysis. The following table presents the Bank's economic value of equity ("EVE") as of December 31, 2018. The Bank outsources its interest rate risk modeling and the EVE values in this table were calculated by an outside consultant, based on information provided by the Bank. This analysis shows:
________________
(1) The -200bp scenario was not disclosed due to the low prevailing interest rate environment
Future interest rates or their effect on EVE or net interest income are not predictable. Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, prepayments, and deposit run-offs, and should not be relied upon as indicative of actual results. Certain shortcomings are inherent in this type of computation. Although certain assets and liabilities may have similar maturity or periods of repricing, they may react at different times and in different degrees to changes in the market interest rates. The interest rate on certain types of assets and liabilities, such as demand deposits and savings accounts, may fluctuate in advance of changes in market interest rates, while rates on other types of assets and liabilities may lag behind changes in market interest rates. Certain assets, such as adjustable rate mortgages, generally have features that restrict changes in interest rates on a short-term basis and over the life of the asset. In the event of a change in interest rates, prepayments and early withdrawal levels could deviate significantly from those assumed in making calculations set forth above. Additionally, an increased credit risk may result as the ability of many borrowers to service their debt may decrease in the event of an interest rate increase.
Notwithstanding the discussion above, the quantitative interest rate analysis presented above indicates that a rapid increase or decrease in interest rates would adversely affect our net interest margin and earnings.
Item 8.
Item 8. Financial Statements and Supplementary Data
The Company's consolidated financial statements are contained in this Annual Report on Form 10-K immediately following Item 15.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
(a)
Disclosure Controls and Procedures
An evaluation was performed under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures (as defined in Rule l3a-l5(e) promulgated under the Securities Exchange Act of 1934, as amended) as of December 31, 2018. Based on such evaluation, the Company's Chief Executive Officer and Chief Financial Officer have concluded that the Company's disclosure controls and procedures as of December 31, 2018 were not effective because of the material weaknesses described below.
Notwithstanding the material weaknesses described below, the Company’s management, including the Chief Executive Officer and Chief Financial Officer, believes that the audited consolidated financial statements contained in this Annual Report on Form 10-K fairly present, in all material respects, the Company’s financial condition, results of operations and cash flows for the fiscal years presented in conformity with GAAP. In addition, the material weaknesses described below did not result in the restatements of any of our audited or unaudited consolidated financial statements or disclosures for any previously reported periods.
(b)
Internal Control Over Financial Reporting
1. Management's Annual Report on Internal Control Over Financial Reporting.
Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a- 15(f). The Company's internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorization of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company's assets that could have a material effect on the financial statements.
Internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements prepared for external purposes in accordance with generally accepted accounting principles. Because of inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of the changes in conditions, or that the degree of compliance with the policies and procedures may deteriorate.
Our management under the direction of the audit committee conducted an assessment of the effectiveness of the system of internal control over financial reporting as of December 31, 2018 using the criteria set forth in the report of the Treadway Commission’s Committee on Sponsoring Organizations (“COSO”) - Internal Control - Integrated Framework (2013). Based on that assessment, our management believes that, as of December 31, 2018, the Company’s internal control over financial reporting was not effective based on the COSO criteria because management identified certain material weaknesses in the system of internal control over financial reporting. A material weakness is a control deficiency, or combination of control deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis.
Management identified the following material weaknesses:
A material weakness in internal controls related to the design, implementation, and effectiveness of certain information technology general controls. In the fourth quarter of 2018, management identified an issue in internal control related to the design, implementation and effectiveness of certain information technology general controls (“ITGCs”) in the area of user access as some employees had access to systems that, based on their job functions, they should not. Management also identified that there was a formal process in place to periodically review user access to the various information technology systems and to document the granting, revoking or modifying user access however additional levels of precision are required to make this an effective process. In addition, management was not formally documenting its review of security logs for financially significant systems. These deficiencies in aggregate constitute a material weakness. The Company believes that these deficiencies were largely a result of system access that enabled certain employees to serve in multiple capacities to best serve customers. While no material misstatements to the financial statements have been identified as a result of this material weakness, this material weakness is being addressed as described below.
A material weakness in internal controls over the processing and approving of department level journal entries. In the fourth quarter of 2018, management identified a material weakness in the processing and approving of journal entries to the general ledger and online transaction entries due to improper user provisioning and system design. Specifically, certain employees had authority to post entries to the general ledger and customer accounts without a system in place to review all such entries. In addition, employees with access to a secondary system used to prepare financial statements and facilitate the Company’s electronic filings with the SEC had the ability to alter data imported to the reporting application from the core system without a system in place to review such changes. While the Company had in place a system of dual review for financial statements and footnotes, there was not a formal process in place to validate the completed financial statements to the core system rather than the system used to prepare the statements.
A material weakness in internal controls over loan data within the loan accounting system. In the fourth quarter of 2018, management determined that while it had in place controls for a review of loans posted to the loan accounting system by an individual independent of the recording function to ensure the loans exist and are accurately recorded, the controls did not require the post-closing review be to a system-generated loan report to ensure all loans were subject to the control. With respect to changes made to a loan after it has been closed, management determined that there was not a formal review of the changes.
A material weakness in internal controls over deposit data within the deposit accounting system. In the fourth quarter of 2018, management determined a material weakness with respect to its internal controls over deposit data within the deposit accounting system. While the Company had in place a documented checklist of items to be completed when a new account was opened, it did not have in place a system of dual review of such documentation nor did it have a system of dual review of subsequent changes to deposit accounts.
A material weakness in internal controls over the allowance for loan loss calculation. In the third quarter of 2018, the Bank implemented a dual review procedure for the allowance for loan loss calculation. While these reviews are being performed, the reviewer failed to document that the review had been traced back to the original source documents to ensure proper loan classifications and other factors that could affect the calculation of the allowance for loan losses. In addition, for three quarters in 2018, management had improperly pooled TDR impaired loans for purposes of allowance for loan losses calculation rather than applying an expected cash flow or collateral method, which has been determined to not be material to the current and prior year financial results.
The aggregation of material weaknesses described above resulted in an entity level material weakness in the design and monitoring of internal controls over financial reporting as of December 31, 2018. These material weaknesses did not result in any changes to the Company’s financial results for the year ended December 31, 2018.
This annual report contains an audit report of our independent registered public accounting firm regarding internal control over financial reporting pursuant to the rules of the SEC.
Remediation Efforts
Management, with the oversight of the audit committee, has taken the following steps starting in 2018, and will continue to take steps that management and the audit committee believe will remediate the material weaknesses. As part of these steps:
•
Management reviewed the material weaknesses with our audit committee and the appropriate levels of management.
•
Management enhanced and implemented systemic controls over information technology processing including the periodic, precise review of user access rights and a formalized precise process for granting and revoking user access.
•
Management has added staff and redefined roles to address segregation of duties issues. Specifically an IT Manager joined the firm in March 2019 and duties and abilities within Loan and Deposit Operations were adjusted to account for segregation of duties. Management requires and documents dual control over journal entries and implements a process to ensure that all transactions are subject to this control.
•
Management implemented a formal review process over loan and deposit data maintenance and requires that such reviews be made utilizing core system generated reports and other core system tools available to the Company.
•
Management will implement a checklist to further support and augment review processes such as the allowance for loan losses and other significant estimates
Management believes that these changes have and will contribute significantly to the remediation of the material weaknesses in internal control over financial reporting that were in existence as of December 31, 2018. Additional changes may be implemented if determined necessary.
Although the Company’s remediation efforts are well underway and are expected to be completed in the near future, the Company’s material weaknesses will not be considered remediated until new internal controls are operational for a period of time and are tested, and management concludes that these controls are operating effectively.
/s/ Michael A. Shriner
/s/ John S. Kaufman
Michael A. Shriner
John S. Kaufman
President and Chief Executive Officer
First Vice President and Chief Financial Officer
2.
Report of Independent Registered Public Accounting Firm
The effectiveness of the Company's internal control over financial reporting at December 31, 2018 has been audited by Crowe LLP, an independent registered public accounting firm as stated in its report filed as part of the financial statements included within beginning on pages. Such report is incorporated herein by reference.
3.
Changes in Internal Control over Financial Reporting
Except as noted above, no change in the Company's internal controls over financial reporting (as defined in Rule l3a-l5(f) promulgated under the Securities Exchange Act of 1934, as amended) occurred during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
The information in the sections captioned "Proposal I - Election of Directors," "Section 16(a) Beneficial Ownership Compliance" and "Corporate Governance" in the Company's Proxy Statement for its 2018 Annual Meeting of Stockholders (the "Proxy Statement") is incorporated herein by reference.
The Company has adopted a Code of Ethics that applies to its principal executive officer, principal financial officer, principal accounting officer or controller or persons performing similar functions. The Code of Ethics has been posted on the Company's website and may be found at www.millingtonbank.com/about-us/investor-relations.
There have been no material changes in the procedures by which security holders may recommend nominees to the Company's Board of Directors since the date of the Company's last proxy statement mailed to its stockholders.
Item 11.
Item 11. Executive Compensation
The information contained in the sections captioned "Executive Compensation" and "Director Compensation" in the Proxy Statement is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
(a)
Security Ownership of Certain Beneficial Owners.
The information contained in the section captioned "Principal Holders of our Common Stock" in the Proxy Statement is incorporated herein by reference.
(b)
Security Ownership of Management.
The information contained in the sections captioned "Principal Holders of our Common Stock" and "Proposal I - Election of Directors" in the Proxy Statement is incorporated herein by reference.
(c)Changes in Control. Management of the Company knows of no arrangements, including any pledge by any person of securities of the Company, the operation of which may at a subsequent date result in a change in control of the Company.
(d)Securities Authorized for Issuance Under Equity Compensation Plans. Set forth below is information as of December 31, 2018 with respect to compensation plans under which equity securities of the Registrant are authorized for issuance.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information contained in the sections captioned "Related Party Transactions" and "Corporate Governance" in the Proxy Statement is incorporated herein by reference.
Item 14.
Item 14. Principal Accounting Fees and Services
The information contained in the section captioned "Proposal II - Ratification of the Appointment of the Independent Registered Public Accounting Firm" in the Proxy Statement is incorporated herein by reference.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules
(1)
The following financial statements and the reports of independent registered public accounting firms appear in this Annual Report on Form 10-K immediately after this Item 15:
(2)
All schedules are omitted because they are not required or applicable, or the required information is shown in the consolidated financial statements or the notes thereto.
(3)
The following exhibits are filed as part of this report:
(Footnotes on following page)
________________
Item 16. Summary
Not applicable
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized as of March 29, 2019.
MSB FINANCIAL CORP.
By:
/s/ Michael A. Shriner
Michael A. Shriner
President and Chief Executive Officer
(Duly Authorized Representative)
Pursuant to the requirement of the Securities Exchange Act of 1934, this report has been signed below on March 29, 2019 by the following persons on behalf of the registrant and in the capacities indicated.
/s/ Michael A. Shriner
/s/ W. Scott Gallaway
Michael A. Shriner
President, Chief Executive Officer and Director
W. Scott Gallaway
Chairman of the Board and Director
/s/ Gary T. Jolliffe
Anthony Bruno
Director
Gary T. Jolliffe
Director
/s/ H. Gary Gabriel
/s/ Lawrence B. Seidman
H. Gary Gabriel
Director
Lawrence B. Seidman
Director
/s/ Milena Schaefer
/s/ Raymond J. Vanaria
Milena Schaefer
Director
Raymond J. Vanaria
Director
/s/ Robert D. Andersen
/s/ Robert D. Vollers
Robert D. Andersen
Director
Robert D. Vollers
Director
/s/ John S. Kaufman
John S. Kaufman
First Vice President & Chief Financial Officer
(Principal Financial and Accounting Officer)
Report of Independent Registered Public Accounting Firm
Shareholders and the Board of Directors
MSB Financial Corp. and Subsidiaries
Millington, New Jersey
Opinion on the Financial Statements
We have audited the accompanying consolidated statement of financial condition of MSB Financial Corp. and Subsidiaries (the "Company") as of December 31, 2018, the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for year ended December 31, 2018, and the related notes (collectively referred to as the "financial statements"). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2018, and the results of their operations and their cash flows for year ended December 31, 2018, in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company’s internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework: (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 29, 2019 expressed an adverse opinion.
Basis for Opinion
These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audit included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audit also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audit provides a reasonable basis for our opinion.
/s/ Crowe LLP
We have served as the Company's auditor since 2018.
New York, New York
March 29, 2019
Report of Independent Registered Public Accounting Firm
Shareholders and the Board of Directors
MSB Financial Corp. and Subsidiaries
Millington, New Jersey
Opinion on Internal Control over Financial Reporting
We have audited MSB Financial Corp. and Subsidiaries (the “Company”) internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework: (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). In our opinion, because of the effects of the material weakness discussed in the following paragraph, the Company has not maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework: (2013) issued by COSO.
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis. The following material weaknesses have been identified and included in management's report:
•
Material weakness in internal controls related to the design, implementation, and effectiveness of certain information technology general controls.
•
Material weakness in internal controls over the processing and approving of department level journal entries.
•
Material weakness in internal controls over loan data within the loan accounting system.
•
Material weakness in internal controls over deposit data within the deposit accounting system.
•
Material weakness in internal controls over the allowance for loan loss calculation.
•
Material weakness at the entity level in the design and monitoring of internal controls over financial reporting.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated statements of financial condition of the Company as of December 31, 2018, the related consolidated statements of income, comprehensive income, changes in stockholders’ equity and cash flows for each of the year ended December 31, 2018, and the related notes (collectively referred to as the "financial statements") and our report dated March 29, 2019 expressed an unqualified opinion. We considered the material weakness identified above in determining the nature, timing, and extent of audit procedures applied in our audit of the 2018 financial statements, and this report on Internal Control over Financial Reporting does not affect such report on the financial statements.
Basis for Opinion
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
Definition and Limitations of Internal Control Over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ Crowe LLP
New York, New York
March 29, 2019
Report of Independent Registered Public Accounting Firms
Stockholders and Board of Directors
MSB Financial Corp.
Millington, New Jersey
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated statement of financial condition of MSB Financial Corp. (the “Company”) and Subsidiaries as of December 31, 2017, and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for the year then ended. In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company and subsidiaries at December 31, 2017, and the results of their operations and their cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.
Basis for Opinion
These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audit. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company was not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audit we were required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.
Our audit included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audit also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audit provides a reasonable basis for our opinion.
/s/ BDO USA, LLP
We served as the Company's auditor from 2013 to 2018.
Woodbridge, New Jersey
March 2, 2018
Note A: The gross amount of prior service cost amortization is recorded in Directors' Compensation. The related tax impact is recorded in income tax expense.
Note B: The gross amount of actuarial (gain) loss amortization is recorded in Directors' Compensation, $0 and $203, respectively. The related tax expense is recorded in income tax expense.
See notes to consolidated financial statements.
Note 1 - Organization and Business
MSB Financial Corp. (the "Company") is a Maryland-chartered corporation organized in 2014 to be the successor to MSB Financial Corp., a federal corporation ("Old MSB") upon completion of the second-step conversion of Millington Bank (the "Bank") from the two-tier mutual holding company structure to the stock holding company structure. MSB Financial, MHC (the "MHC") was the former mutual holding company for Old MSB prior to completion of the second-step conversion. In conjunction with the second-step conversion, each of the MHC and Old MSB ceased to exist. The second-step conversion was completed on July 16, 2015 at which time the Company sold 3,766,592 shares of its common stock (including 150,663 shares purchased by the Bank's employee stock ownership plan) at $10.00 per share for gross proceeds of approximately $37.7 million. Expenses related to the stock offering totaled $1.5 million and were netted against proceeds. As part of the second-step conversion, each of the outstanding shares of common stock of Old MSB held by persons other than the MHC were converted into 1.1397 shares of Company common stock with cash paid in lieu of fractional shares. As a result, a total of 2,187,242 additional shares were issued in the second-step conversion. As a result of the second-step conversion, all share and per share information has subsequently been revised to reflect the 1.1397 exchange ratio unless otherwise noted.
The Company's principal business is the ownership and operation of the Bank. The Bank is a New Jersey-chartered stock savings bank and its deposits are insured by the Federal Deposit Insurance Corporation. The primary business of the Bank is attracting retail deposits from the general public and using those deposits together with funds generated from operations, principal repayments on securities and loans and borrowed funds, for its lending and investing activities. The Bank's loan portfolio primarily consists of one-to-four family and home equity residential loans, commercial real estate loans, commercial loans, and construction loans. It also invests in U.S. government obligations and mortgage-backed securities. The Bank is regulated by the New Jersey Department of Banking and Insurance and the Federal Deposit Insurance Corporation. The Board of Governors of the Federal Reserve System (the "Federal Reserve") regulates the Company as a bank holding company.
The primary business of Millington Savings Service Corp (the "Service Corp"), the Bank's wholly-owned subsidiary, was the ownership and operation of a single commercial rental property. This property was sold during the year ended June 30, 2007. Currently the Service Corp is inactive.
Note 2 - Summary of Significant Accounting Policies
Basis of Consolidated Financial Statement Presentation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, the Bank and the Bank's wholly owned subsidiary, the Service Corp. All significant intercompany accounts and transactions have been eliminated in consolidation.
The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America ("GAAP"). In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the consolidated statements of financial condition and revenues and expenses for the periods then ended. Actual results could differ significantly from those estimates.
Cash and Cash Equivalents
Cash and cash equivalents include cash and amounts due from depository institutions and interest-bearing deposits with banks with original maturities of six months or less.
Securities
Investments in debt securities that the Company has the positive intent and ability to hold to maturity are classified as held to maturity securities and reported at amortized cost. Debt securities that are bought and held principally for the purpose of being sold in the near term are classified as trading securities and reported at fair value, with unrealized holding gains and losses included in earnings. Debt securities not classified as trading securities or as held to maturity securities are classified as available for sale securities and reported at fair value, with unrealized holding gains or losses, net of applicable income taxes, reported in a separate component of stockholders' equity. The Company had no trading or available for sale securities as of December 31, 2018 and 2017.
Beginning in 2018, equity investments are measured at fair value with changes in fair value recognized in net income. The Company had no equity investments with changes in fair value recorded in net income at December 31, 2018.
Individual securities are considered impaired when their fair value is less than amortized cost. Management evaluates all securities with unrealized losses quarterly to determine if such impairments are "temporary" or "other-than-temporary" in accordance with applicable accounting guidance. Accordingly, the Company accounts for temporary impairments based upon a security's classification as trading, available for sale or held to maturity. Temporary impairments on available for sale securities are recognized, on a tax-effected basis, through other comprehensive income (loss) with offsetting entries adjusting the carrying value of the security and the balance of deferred taxes. Temporary impairments of held to maturity securities are not recognized in the consolidated financial statements; however, information concerning the amount and duration of impairments on held to maturity securities is disclosed in the notes to the consolidated financial statements. The carrying value of securities held in the trading portfolio is adjusted to fair value through earnings on a monthly basis.
Note 2 - Summary of Significant Accounting Policies (Continued)
Other-than-temporary impairments on securities that the Company has decided to sell or will more likely than not be required to sell prior to the full recovery of their fair value to a level equal to or exceeding amortized cost are recognized in earnings. Otherwise, the other-than-temporary impairment is bifurcated into credit-related and noncredit-related components. The credit-related impairment generally represents the amount by which the present value of the cash flows expected to be collected on the debt security falls below its amortized cost. The noncredit-related component represents the remaining portion of the impairment not otherwise designated as credit-related. Credit-related other-than-temporary impairments are recognized in earnings while noncredit-related other-than-temporary impairments are recognized, net of deferred taxes, in other comprehensive income (loss).
The Company reviews its investment portfolio on a quarterly basis for indications of impairment. This review includes analyzing the length of time and the extent to which the fair value of a security has been lower than the cost, and the financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer. The Company also assesses its intent with regard to selling or holding each security as well as any conditions which may require the sale of security prior to the recovery of fair value to a level which equals or exceeds amortized cost.
Discounts and premiums on securities are accreted/amortized to maturity by use of the level-yield method. Gain or loss on sales of securities is based on the specific identification method.
Concentration of Risk
The Bank's lending activities are concentrated in loans secured by real estate located in the State of New Jersey.
Loans Receivable
Loans are stated at their outstanding unpaid principal balances, net of an allowance for loan losses and any deferred fees or costs. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct loan origination costs, are deferred and recognized as an adjustment of the yield (interest income) of the related loans. The Company is generally amortizing these amounts based on the effective interest method.
Allowance for Credit Losses
The allowance for credit losses consists of the allowance for loan losses and the reserve for unfunded lending commitments. The allowance for loan losses represents management's estimate of probable incurred losses in the loan portfolio as of the statement of financial condition date and is recorded as a reduction to loans. The reserve for unfunded lending commitments represents management's estimate of probable incurred losses in its unfunded loan commitments and is recorded in other liabilities, when required, on the consolidated statement of financial condition. The allowance for credit losses is increased by the provision for loan losses, and decreased by charge-offs, net of recoveries. All, or part, of the principal balance of loans receivable that are deemed uncollectible are charged against the allowance for loan losses when management determines that the repayment of that amount is highly unlikely. Any subsequent recoveries are credited to the allowance for loan losses. Non-residential consumer loans are generally charged off no later than 120 days past due on a contractual basis, earlier in the event of bankruptcy, or if there is an amount deemed uncollectible.
The allowance for loan losses is maintained at a level considered adequate to provide for losses that can be reasonably anticipated. Management performs a quarterly evaluation of the adequacy of the allowance. The allowance is based on the Company's three year loan loss experience, known and probable incurred losses in the portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, the composition of the loan portfolio, current economic conditions and other relevant factors.
This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant revision as more information becomes available.
For additional detail regarding the allowance for loan losses, see Note 4 to the Consolidated Financial Statements.
Other Real Estate Owned ("OREO")
Other real estate owned represents real estate acquired through formal foreclosure or by taking possession of the real estate and is initially recorded at the lower of cost or fair value, less estimated selling costs establishing a new cost basis. Write-downs required at the time of acquisition are charged to the allowance for loan losses. Thereafter, the Company maintains an allowance for decreases in the property's estimated fair value, through charges to earnings. Such charges are included in other non-interest expense along with any additional property maintenance. There was no OREO at December 31, 2018 and 2017. We may obtain physical possession of residential and commercial real estate collateralizing consumer and commercial mortgage loans via foreclosure or in-substance repossession. As of December 31, 2018, we had consumer loans with a carrying value of $708,000 collateralized by residential real estate property for which formal foreclosure proceedings were in process.
Premises and Equipment
Note 2 - Summary of Significant Accounting Policies (Continued)
Premises and equipment are comprised of land, at cost, and buildings, building improvements, furnishings and equipment and leasehold improvements, at cost, less accumulated depreciation and amortization. Depreciation and amortization charges are computed on the straight-line method over the following estimated useful lives:
Years
Building and improvements
5 - 50
Furnishings and equipment
3 - 7
Leasehold improvements
Shorter of useful life
or term of lease
Significant renewals and betterments are capitalized to the premises and equipment account. Maintenance and repairs are charged to operations in the year incurred. Rental income is netted against occupancy costs in the consolidated statements of income.
Federal Home Loan Bank Stock
Federal law requires a member institution of the Federal Home Loan Bank ("FHLB") system to hold restricted stock of its district's FHLB according to a predetermined formula based on advances available and outstanding. The restricted stock is carried at cost. Management's determination of whether these shares are impaired is based on an assessment of the ultimate recoverability of its cost rather than by recognizing temporary declines in value. The determination of whether a decline affects the ultimate recoverability of cost is influenced by criteria such as (1) the significance of the decline in net assets of the FHLB as compared to the capital stock amount for the FHLB and the length of time this situation has persisted, (2) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLB, and (3) the impact of legislative and regulatory changes on institutions and, accordingly, on the customer base of the FHLB.
Management believes no impairment charge was necessary related to the FHLB restricted stock during the years ended December 31, 2018 and 2017.
Bank Owned Life Insurance
Bank owned life insurance is carried at net cash surrender value. The change in the net cash surrender value is recorded as a component of non-interest income.
Defined Benefit Plans
In accordance with applicable guidance prescribed in Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 715, "Compensation - Retirement Benefits", the Company recognizes the over-funded or under-funded status of a defined benefit postretirement plan as an asset or liability in the consolidated statement of financial condition, with changes in the funded status recorded through other comprehensive income (loss) in the year in which those changes occur. The funded status of the plan is calculated using actuarial concepts which involve making assumptions regarding discount rate, mortality, expected rate of compensation increases and others.
Stock-based Compensation Plans
In accordance with FASB ASC 718, "Compensation - Stock Compensation", the Company recognizes compensation expense for the total of the fair value of all share-based compensation awards granted over the requisite service periods. In addition, ASC 718 requires that cash flow activity be reported on a financing rather than an operating cash flow basis for the benefits, if any, of realized tax deductions in excess of previously recognized tax benefits on compensation expense.
Advertising
The Company expenses advertising and marketing costs as incurred.
Income Tax Expense
The Company and its subsidiaries file a consolidated federal income tax return. Federal income taxes are allocated based on the contribution of their respective income or loss to the consolidated income tax return. Separate state income tax returns are filed.
Federal and state income taxes have been provided for these consolidated financial statements on the basis of reported income. The amounts reflected on the income tax returns differ from these provisions due principally to temporary differences in the reporting of certain items
Note 2 - Summary of Significant Accounting Policies (Continued)
of income and expense for financial reporting and income tax reporting purposes. Deferred income taxes are recorded to recognize such temporary differences.
The Company follows the provisions of FASB ASC 740, "Income Taxes", formerly FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes ("FIN48"). ASC 740 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and also provides guidance on derecognizing, classification, interest and penalties, accounting in interim periods, disclosure and transition. As a result of the Company's evaluation under ASC 740, no significant income tax uncertainties have been identified. Therefore, the Company recognized no adjustment for unrecognized income tax benefits for the years ended December 31, 2018 and 2017. The Company's policy is to recognize interest and penalties on unrecognized tax benefits in income tax expense in the consolidated statement of income. The Company did not recognize any interest and penalties for the years ended December 31, 2018 and 2017. The tax years subject to examination by the taxing authorities are the years ended December 31, 2018, 2017, 2016 and 2015.
Off-Balance Sheet Credit-Related Financial Instruments
In the ordinary course of business, the Company enters into commitments to extend credit, including commitments under lines of credit. Such financial instruments are recorded when they are funded.
Earnings per Share
Basic earnings per share is computed by dividing net income by the weighted average number of common shares outstanding, exclusive of the Employee Stock Ownership Plan ("ESOP") shares not yet committed to be released. Diluted earnings per share is calculated by adjusting the weighted average number of shares of common stock outstanding to include the effect of contracts or securities exercisable (such as stock options) or which could be converted into common stock, if dilutive, using the treasury stock method.
The following table shows the computation of basic and diluted earnings per share:
Other Comprehensive Income
Other comprehensive income includes benefit plan's amounts recognized under ASC 715, "Compensation-Retirement Benefits". This item of other comprehensive income reflects, net of tax, prior service costs and unrealized net losses that had not been recognized in the consolidated financial statements prior to the implementation of ASC 715 along with actuarial losses arising during the current period.
Recent Accounting Pronouncements
In May 2014, the FASB issued Accounting Standards Update (ASU) No. 2014-9, "Revenue from Contracts with Customers (ASU 2014-9)", which supersedes nearly all existing revenue recognition guidance under GAAP. The core principle of ASU 2014-9 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-9 defines a five-step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing GAAP. The FASB also subsequently issued ASUs Nos. 2016-8, 2016-10, 2016-12, 2016-20 and 2017-5 to augment, amend and clarify the original pronouncement. The Company evaluated all of its revenue streams and determined that the majority of its revenue is derived from financial instruments that are scoped out. In addition, non-interest revenue streams were evaluated, including deposit and service charges and interchange fees. The Company adopted ASU 2014-9 on January 1, 2018 and it did not materially change the timing of recognition of our current revenue sources. Accordingly, no cumulative effect adjustment was recorded under the modified retrospective transition method.
Note 2 - Summary of Significant Accounting Policies (Continued)
In January 2016, the FASB issued ASU No. 2016-1, "Financial Instruments - Overall." The guidance in this ASU among other things, (1) requires equity investments with certain exceptions, to be measured at fair value with changes in fair value recognized in net income, (2) simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment, (3) eliminates the requirement for public businesses entities to disclose the methods and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet, (4) requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes, (5) requires an entity to present separately in other comprehensive income the portion of the change in fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments, (6) requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements and (7) clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities. The guidance in this ASU is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The adoption of this guidance effective January 1, 2018, did not have a material impact on our consolidated financial statements, but did change the disclosure requirements in Note 15 - Fair Value Measurements.
In February 2016, the FASB issued ASU No. 2016-2, "Leases" (Topic 842). This ASU revises the accounting related to lessee accounting. Under the new guidance, lessees will be required to recognize a right-of-use asset and a lease liability for all leases. The new lease guidance also simplified the accounting for sale and leaseback transactions primarily due to the recognition of lease assets and lease liabilities. ASU 2016-2 is effective for the first interim period within annual periods beginning after December 15, 2018, with early adoption permitted. The standard is required to be adopted using the modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The adoption of ASC 842 will result in the recognition of a right-of-use (ROU) asset of $1.3 million and a lease liability of $1.3 million on our Consolidated Statements of Financial Condition. We will provide additional detail to our leases disclosures on a prospective basis, beginning in the first quarter of 2019.
In June 2016, the FASB issued ASU No. 2016-13, "Measurement of Credit Losses on Financial Instruments." This ASU requires credit losses on most financial assets measured at amortized cost and certain other instruments to be measured using an expected credit loss model. Under this model, entities will estimate credit losses over the entire contractual term of the instrument. The standard is effective for public companies in annual and interim periods in fiscal years beginning after December 15, 2019. Early adoption is permitted, including adoption in the interim or annual period provided that the entire standard is adopted. We are currently evaluating the impact of ASU 2016-13 on our consolidated financial statements. We have taken steps to begin preparations for implementation, such as evaluating changes to our current loss recognition model and evaluating the potential use of outside professionals for an updated model.
Note 3 - Securities Held to Maturity
The amortized cost of securities held to maturity and their fair values are summarized as follows:
Note 3 - Securities Held to Maturity (Continued)
All mortgage-backed securities at December 31, 2018 and 2017 have been issued by FNMA, FHLMC or GNMA and are secured by 1-4 family residential real estate.
The amortized cost and fair value of securities held to maturity at December 31, 2018, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
There were no sales of securities held to maturity during the years ended December 31, 2018 and 2017. At December 31, 2018 and 2017, securities held to maturity with a fair value of approximately $2 million and $1 million, respectively, were pledged to secure public funds on deposit.
The following table provides the gross unrealized losses and fair value of securities in an unrealized loss position, by the length of time that such securities have been in a continuous unrealized loss position:
Note 3 - Securities Held to Maturity (Continued)
At December 31, 2018, management concluded that the unrealized losses above (which related to two U.S. Government agency bonds, twenty mortgage-backed securities, five corporate bonds and six state and political subdivision bonds, compared to five U.S. Government agency bonds, sixteen mortgage-backed securities, three corporate bonds, four state and political subdivision bonds, and one certificate of deposit, at December 31, 2017, were temporary in nature since they were not related to the underlying credit quality of the issuer. The Company does not intend to sell these securities and it is not more-likely-than-not that the Company would be required to sell these securities prior to the full recovery of fair value to a level which equals or exceeds amortized cost. The losses above are primarily related to market interest rate conditions and are considered noncredit related and temporary.
Note 4 - Loans Receivable and Allowance for Loan Losses
The composition of total loans receivable at December 31, 2018 and 2017 was as follows:
Note 4 - Loans Receivable and Allowance for Loan Losses (Continued)
The commercial and industrial category is further segregated into secured of $60,426 and unsecured (high net worth) of $48,176 as of December 31, 2018.
Allowance for Loan Losses
The Company's loan portfolio is comprised of the following segments: residential mortgage, commercial real estate, construction, commercial and industrial and consumer. Some segments of the Company's loan receivable portfolio are further disaggregated into classes which allow management to more accurately monitor risk and performance. Accordingly, the methodology and allowance calculation includes the segmentation of the total loan portfolio.
The residential mortgage loan segment is disaggregated into two classes: one-to-four family loans, which are primarily first liens, and home equity loans, which consist of first and second liens. The commercial real estate loan segment includes owner and non-owner occupied loans which have medium risk based on historical experience with these types of loans. The construction loan segment is further disaggregated into two classes: one-to-four family owner-occupied, which includes land loans, whereby the owner is known and there is less risk, and other, whereby the property is generally under development and tends to have more risk than the one-to-four family owner-occupied loans. The commercial and industrial loan segment consists of loans made for the purpose of financing the activities of commercial customers. The commercial and industrial loans carry a mix of loans secured by real estate and unsecured lines of credit some of which are for high net worth individuals. The consumer loan segment consists primarily of installment loans and overdraft lines of credit connected with customer deposit accounts.
The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as impaired. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments or principal or interest when due according to the contractual terms of the loan agreement. For loans that are classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers pools of loans by loan class. These pools of loans are evaluated for loss exposure based upon historical loss rates for each of these classes of loans, adjusted for qualitative factors. These qualitative risk factors include:
1.
Lending policies and procedures, including underwriting standards and collection, charge-off, and recovery practices.
2.
National, regional, and local economic and business conditions as well as the condition of various market segments, including the value of underlying collateral for collateral dependent loans.
3.
Nature and volume of the portfolio and terms of loans.
4.
Experience, ability, and depth of lending management and staff.
5.
Volume and severity of past due, classified and nonaccrual loans as well as other loan modifications.
6.
Quality of the Company's loan review system, and the degree of oversight by the Company's Board of Directors.
7.
Existence and effect of any concentrations of credit and changes in the level of such concentrations.
8.
Effect of external factors, such as competition and legal and regulatory requirements.
Each factor is assigned a value to reflect improving, stable or declining conditions based on management's best judgment using relevant information available at the time of the evaluation.
Although management seeks to avoid intentionally creating an unallocated component, one will exist at times due to the dynamic interplay of balances, qualitative factors and other items that could impact management's estimate of probable losses. The unallocated component of the allowances reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
The following tables provide an analysis of the allowance for loan losses and the loan receivable balances, by the portfolio segment segregated into the amount required for loans individually evaluated for impairment and the amount required for loans collectively evaluated for impairment as of December 31, 2018 and 2017:
Note 4 - Loans Receivable and Allowance for Loan Losses (Continued)
Nonaccrual and Past Due Loans
For all classes of loans receivable, the accrual of interest is discontinued when the contractual payment of principal or interest has become 90 days past due or when management has serious doubts about further collectability of principal or interest, even though the loan is currently performing. Certain loans may remain on accrual status if they are in the process of collection and are either guaranteed or well secured. When a loan is placed on nonaccrual status, unpaid interest credited to income in the current year is reversed. Interest received on nonaccrual loans, including impaired loans, generally is either applied against principal or reported as interest income, according to management's judgment as to the collectability of principal. Generally, loans are restored to accrual status when the obligation is brought current, has performed in accordance with the contractual terms for a reasonable period of time (generally six months) and the ultimate collectability of the total contractual principal and interest is no longer in doubt. The past due status of all classes of loans receivable is determined based on contractual due dates for loan payments.
The following table represents the classes of the loans receivable portfolio summarized by aging categories of performing loans and nonaccrual loans as of December 31, 2018 and 2017:
Note 4 - Loans Receivable and Allowance for Loan Losses (Continued)
(1)
Nonaccrual loans at December 31, 2018, included $2.2 million that were 90 days or more delinquent, $123,000 that were 60-89 days delinquent, $556,000 that were 30-59 days delinquent, and $1.2 million that were current or less than 30 days delinquent.
(1)
Nonaccrual loans at December 31, 2017, included $1.7 million that were 90 days or more delinquent, $341,000 that were 60-89 days delinquent, $631,000 that were 30-59 days delinquent, and $1.3 million that were current or less than 30 days delinquent.
Impaired Loans
Management evaluates individual loans in all of the loan segments (including loans in the residential mortgage and consumer segments) for possible impairment if the loan is either on nonaccrual status or is risk rated Substandard or worse or has been modified in a troubled debt restructuring ("TDR"). A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record and the amount of the shortfall in relation to the principal and interest owed.
Once the determination has been made that a loan is impaired, impairment is measured by comparing the recorded investment in the loan to one of the following: (a) the present value of expected cash flows (discounted at the loan's effective interest rate), (b) the loan's observable market price or (c) the fair value of collateral adjusted for expected selling costs. The method is selected on a loan by loan basis with management primarily utilizing the fair value of collateral method.
The estimated fair values of the real estate collateral are determined primarily through third-party appraisals. When a real estate secured loan becomes impaired, a decision is made regarding whether an updated certified appraisal of the real estate is necessary. This decision is based on various considerations, including the age of the most recent appraisal, the loan-to-value ratio based on the original appraisal and the condition of the property. Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property.
Note 4 - Loans Receivable and Allowance for Loan Losses (Continued)
The estimated fair values of non-real estate collateral, such as accounts receivable, inventory and equipment, are determined based on the borrower's financial statements, inventory reports, accounts receivable aging schedules or equipment appraisals or invoices. Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets.
The evaluation of the need and amount of the allowance for impaired loans and whether a loan can be removed from impairment status is made on a quarterly basis. The Company's policy for recognizing interest income on impaired loans does not differ from its overall policy for interest recognition.
The following tables provide an analysis of the impaired loans at December 31, 2018 and 2017 and the average balances of such loans for the years then ended:
As of December 31, 2018 and 2017, impaired loans listed above include $11.4 million, of loans previously modified in TDRs and as such are considered impaired under GAAP. As of December 31, 2018 and 2017, $10.5 million and $9.7 million, respectively, of these loans have been performing in accordance with their modified terms for an extended period of time and as such were removed from nonaccrual status and considered performing. As of December 31, 2018, interest income of $543,000 was recorded on impaired loans related to accruing TDRs.
Credit Quality Indicators
Management uses a nine point internal risk rating system to monitor the credit quality of the loans in the Company's commercial real estate, construction and commercial and industrial loan segments. The borrower's overall financial condition, repayment sources, guarantors and value of collateral, if appropriate, are evaluated annually or when credit deficiencies, such as delinquent loan payments, arise. The criticized rating categories utilized by management generally follow bank regulatory definitions.
The Bank's rating categories are as follows:
1 - 5: The first five risk rating categories are considered not criticized, and are aggregated as "Pass" rated.
Note 4 - Loans Receivable and Allowance for Loan Losses (Continued)
6: "Special Mention" category includes assets that are currently protected, but are potentially weak, resulting in increased credit risk and deserving management's close attention. If uncorrected, the potential weaknesses may result in deterioration of the repayment prospects.
7: "Substandard" loans have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt and have a distinct possibility that some loss will be sustained if the weaknesses are not corrected. This includes loans that are inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any.
8: "Doubtful" loans have all the weaknesses inherent in loans classified "Substandard" with the added characteristic that collection or liquidation in full, on the basis of current conditions and facts, is highly improbable.
9: "Loss" loans are considered uncollectible and subsequently charged off.
The following table presents the classes of the loans receivable portfolio summarized by the aggregate "Pass" and the criticized categories of "Special Mention", "Substandard", "Doubtful" and "Loss" within the internal risk rating system as of December 31, 2018 and 2017:
Management further monitors the performance and credit quality of the retail portfolio by analyzing the age of the portfolio as determined by the length of time a recorded payment is past due. These credit quality indicators are assessed in the aggregate in these relatively homogeneous portfolios. Loans greater than 90 days past due are generally considered nonperforming and placed on nonaccrual status.
Troubled Debt Restructurings
Loans whose terms are modified are classified as a TDR if, in connection with the modification, the Company grants such borrowers concessions and it is deemed that those borrowers are experiencing financial difficulty. Concessions granted under a TDR generally involve a reduction in interest rate below market rates given the associated credit risk, or an extension of a loan's stated maturity date or capitalization of interest and/or escrow. Nonaccrual TDRs are restored to accrual status if principal and interest payments, under the modified terms, are current for six consecutive months after modification. Loans classified as TDRs are designated as impaired until they are ultimately repaid in full or foreclosed and sold. The nature and extent of impairment of TDRs, including those which experienced a subsequent default, is considered in the determination of an appropriate level of allowance for loan losses.
Note 4 - Loans Receivable and Allowance for Loan Losses (Continued)
The recorded investment balance of TDRs totaled $11.4 million at December 31, 2018 and December 31, 2017. The majority of the Company's TDRs are on accrual status and totaled $10.5 million at December 31, 2018 versus $9.7 million at December 31, 2017. The total of TDRs on nonaccrual status was $915,000 at December 31, 2018 and $1.7 million at December 31, 2017.
For the year ended December 31, 2018, one loan was modified into a TDR. The Company refinanced a multi-family & commercial loan that was restructured to extend the maturity date and capitalize the interest. For the year ended December 31, 2017, the terms of thirteen loans were modified into six TDRs. The Company refinanced and consolidated a one-to-four family and one home equity mortgage loan which was restructured to an adjustable interest rate from a fixed interest rate. In addition, the Company restructured a one-to-four family loan, a home equity loan and a commercial line of credit. These loans were consolidated into one one-to-four family TDR with an extended maturity date. The Company restructured a commercial loan and a multi-family real estate loan into one TDR and extended the maturity date. The Company refinanced and consolidated a one-to-four family loan and three commercial loans into a multi-family and commercial loan with an adjustable interest rate from a fixed interest rate. In addition, the Company refinanced a one-to-four family loan and capitalized the interest. The Company restructured one commercial loan and extended the maturity date.
The following tables summarize by class loans modified into TDRs during the year ended December 31, 2018 and 2017:
A loan is considered to be in payment default once it is 90 days contractually past due under the modified terms. There were no loans modified in TDRs during the previous 12 months and for which there was a subsequent payment default for the years ended December 31, 2018 and 2017.
Note 5 - Premises and Equipment
The components of premises and equipment at December 31, 2018 and 2017 were as follows:
Note 6 - Accrued Interest Receivable
The components of interest receivable at December 31, 2018 and 2017 were as follows:
Note 7 - Deposits
Deposits at December 31, 2018 and 2017 consisted of the following classifications:
A summary of certificates of deposit by maturity at December 31, 2018 and 2017 is as follows:
The aggregate amount of certificates of deposit with a minimum denomination of $250,000 was approximately $18.1 million and $17.4 million at December 31, 2018 and 2017, respectively. Generally, deposits in excess of $250,000 are not insured by the FDIC.
A summary of interest expense on deposits for the years ended December 31, 2018 and 2017 is as follows:
Note 8 - Borrowings
The Company participates in the FHLB of New York Overnight Advance Program. Advances under this program allow the Company to borrow up to the balance of its qualifying mortgage loans that have been pledged as collateral, less any related outstanding indebtedness. As of December 31, 2018 and 2017, the Company had $149.9 million and $77.6 million, respectively, available for borrowing under this agreement.
Term advances due to the FHLB of NY at December 31, 2018 and 2017 consisted of the following:
The advances are secured by a blanket assignment of unpledged and qualifying mortgage and commercial real estate loans.
The Company had $66.6 million in overnight advances with the FHLB of NY at a rate of 2.60% as of December 31, 2018 and none as of December 31, 2017.
As of December 31, 2018 and 2017, the Company had a $13.0 million unsecured line of credit with another financial institution. There were no amounts outstanding on the line as of December 31, 2018 and 2017.
Note 9 - Stockholders' Equity
Regulatory Capital
The Bank is subject to various regulatory capital requirements administered by Federal and State banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weighting, and other factors.
The Federal Reserve Board approved final rules on Basel III in July 2013 establishing a new comprehensive capital framework for U.S. banks. Basel III substantially revised the risk-based capital requirements applicable to bank holding companies and depository institutions. The minimum regulatory capital requirements became effective for the Company and the Bank on January 1, 2015 and include a minimum common equity Tier 1 capital ratio of 4.50% of risk-weighted assets and raised the Tier 1 capital ratio from 4.00% to 6.00% of risk-weighted assets. The rules also require a minimum Total capital ratio of 8.00% of risk-weighted assets and a minimum Tier 1 leverage capital ratio of 4.00% of average assets. The final rule also established a new capital conservation buffer, comprised of common equity Tier 1 capital, above the regulatory minimum capital requirements. The phase-in of the capital conservation buffer began on January 1, 2016 at 0.625% of risk-weighted assets and increases each subsequent year by an additional 0.625% until reaching its final level of 2.5% on January 1, 2019. For 2018, the capital conservation buffer was 1.875%.
Pursuant to the Federal Reserve’s Small Bank Holding Company Policy Statement, a bank holding company such as the Company with consolidated assets under $3 billion is exempt from regulatory capital requirements provided that: (i) it is not engaged in significant non-banking or off-balance sheet activities; (ii) it does not have a material amount of debt or equity securities registered with the SEC; and (iii) its bank subsidiary is well capitalized. As a result, the minimum capital requirements are not applicable to MSB Financial Corp. as of December 31, 2018.
As of December 31, 2018, the most recent notification from the regulators categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the institution's category.
The following table presents a reconciliation of GAAP capital and regulatory capital and information as to the Bank's capital levels at the dates presented:
(1)
Amounts and ratios do not include the capital conservation buffer.
(1)
Amounts and ratios do not include the capital conservation buffer.
Common Stock Repurchase Plan
The Company announced that on June 2, 2016 it had received the non-objection of the Federal Reserve Bank of New York to purchase up to 112,600 shares of the Company's common stock in order to fund future awards of restricted stock that may be made under the Company's 2016 Equity Incentive Plan that was approved by stockholders at the Annual Meeting of Stockholders held on April 22, 2016. On August 4, 2016, the Company announced that it had approved a stock repurchase plan to purchase up to 595,342 shares of the Company's common stock. On December 17, 2018, the Company announced that it had approved a stock repurchase plan to repurchase up to 273,150 shares, approximately 5% of the outstanding shares of the Company's common stock.
During the year ended December 31, 2017, the Company did not repurchase any additional shares under any previously-announced plans. During the year ended December 31, 2018, the Company repurchased 373,948 shares of Company's common stock with an average price of $17.95.
Note 10 - Lease Commitments and Total Rental Expense
The Company leases two branches and one loan office location under long-term operating leases. Future minimum lease payments by year and in the aggregate, under non-cancellable operating leases with initial or remaining terms of one year or more, consisted of the following at December 31, 2018:
The total rental expense for all leases was approximately $510,000 and $478,000 for the years ended December 31, 2018 and 2017.
Note 11 - Income Taxes
The total tax expense consisted of the following for the years ended December 31, 2018 and 2017:
A reconciliation of the statutory federal income tax at a rate of 21% and 34%, respectively, to the income tax expense included in the statements of income for the year ended December 31, 2018 and 2017 is as follows:
During the year ended December 31, 2017, certain directors, executive officers and directors emeriti executed options to purchase 212,468 shares of common stock at a per share exercise price of $9.4323. In lieu of issuing shares of common stock upon the exercise of such options, the Company made a cash payment to such optionees equal to the excess of the closing price of the common stock on the Nasdaq Stock Market on August 4, 2017 of $17.30 over the per share exercise price of such options of $9.4323 multiplied by the number of options being exercised. An aggregate of $1.7 million was paid to the optionees. In addition, the change in tax rate included a permanent tax deduction for the year ended December 31, 2017 period due to restricted stock that vested.
The impact of the corporate tax rate change on the net deferred tax assets was attributable to the revaluation of the Company's deferred tax asset as a result of the passage of the Tax Cuts and Jobs Act on December 22, 2017 which significantly reduced corporate tax rates. As a result, the Company recorded an additional tax provision of $678,000 for the revaluation for the year ended December 31, 2017.
The components of the net deferred tax asset at December 31, 2018 and 2017 were as follows:
At December 31, 2018, the Company had state net operating loss carryforwards of $1.5 million which begin to expire in 2030. Realization of deferred tax assets associated with net operating loss carryforwards is dependent upon generating sufficient taxable income prior to their expiration. A valuation allowance to reflect management’s estimate of the temporary deductible differences that may expire prior to their utilization has been recorded at December 31, 2018. The deferred tax asset and valuation allowance related to state net operating losses was $105,000 as of December 31, 2018.
Retained earnings included $1.5 million at December 31, 2018 and 2017 for which no provision for income tax has been made. These amounts represent deductions for bad debt reserves for tax purposes which were only allowed to savings institutions which met certain definitional tests prescribed by the Internal Revenue Code of 1986, as amended (the "Code"). The Small Business Job Protection Act of 1996 (the "Act") eliminated the special bad debt deduction granted solely to thrifts. Under the terms of the Act, there would be no recapture of the pre-1988 (base year) reserves. However, these pre-1988 reserves would be subject to recapture under the rules of the Code if the Bank itself pays a cash dividend in excess of earnings and profits, or liquidates. The Act also provides for the recapture of deductions arising from the "applicable excess reserve" defined as the total amount of reserve over the base year reserve. The Bank's total reserve exceeds the base year reserve and deferred taxes have been provided for this excess.
Note 12 - Benefit Plans
Directors' Retirement Plan
The Bank had a Directors' Retirement Plan, which provided that certain directors meeting specified age and service requirements may retire and continue to be paid. This plan was unfunded. Effective September 1, 2016, the Company terminated its Directors' Retirement Plan. The Company had between 12 and 24 months from the time the plan was terminated to distribute all funds to the plan's participants. The Company distributed the remaining Directors' Retirement Plan funds of $1.4 million during the month of January 2018.
The following table sets forth the accumulated benefit obligation, the changes in the plan's projected benefit obligation and the plan's funded status as of and for each period presented.
Note 12 - Benefit Plans (Continued)
Net periodic pension cost included the following:
401(k) Savings Plan
The Bank sponsors a savings and profit sharing plan, pursuant to Section 401(k) of the Code, for all eligible employees. Employees may elect to defer up to 80% of their compensation, subject to Code limitations. The Bank will match 50% of the first 6% of the employee's salary deferral up to a maximum of 3% of each employee's compensation. The Plan expense amounted to approximately $88,000 and $75,000 for the years ended December 31, 2018 and 2017, respectively.
Employee Stock Ownership Plan
Effective upon completion of Old MSB's initial public stock offering in 2007, the Bank established the ESOP for all eligible employees who complete a twelve-month period of employment with the Bank, have attained the age of 21 and have completed at least 1,000 hours of service in a plan year. The ESOP used $2.0 million in proceeds from a term loan obtained from Old MSB to purchase 202,342 shares of Old MSB common stock. The term loan principal was payable over 48 equal quarterly installments through December 31, 2018. The interest rate on the term loan was 8.25%.
Note 12 - Benefit Plans (Continued)
On July 16, 2015, the Company completed a second-step stock conversion that included the purchase of 150,663 shares by the ESOP and the conversion of 202,342 shares of Old MSB's common stock at a conversion rate of 1.1397 to 230,609 shares of Company common stock bringing the total shares to 381,272. The old term loan was refinanced into a new term loan in the amount of $2.3 million which included additional funds of $1.5 million to cover the cost of the newly purchased shares. The term loan principal is payable over 80 equal quarterly installments through June 30, 2035. The interest rate on the term loan is 3.25%.
Each quarter, the Bank intends to make discretionary contributions to the ESOP, which will be equal to principal and interest payments required on the term loan. The ESOP may further pay down the loan with dividends paid, if any, on the Company common stock owned by the ESOP. Shares purchased with the loan proceeds provide collateral for the term loan and are held in a suspense account for future allocations among participants. Base compensation is the basis for allocation to participants of contributions to the ESOP and shares released from the suspense account, as described by the ESOP, in the year of allocation.
ESOP shares pledged as collateral were initially recorded as unallocated ESOP shares in the consolidated statement of financial condition. On a monthly basis, 910 shares are allocated and compensation expense is recorded equal to the number of allocated shares multiplied by the monthly average market price of the Company's common stock and the allocated shares become outstanding for basic earnings per common share computations. The difference between the fair value of shares and the cost of the shares allocated by the ESOP is recorded as an adjustment to paid-in capital. ESOP compensation expense was approximately $210,000 and $265,000 for the years ended December 31, 2018 and 2017, respectively.
ESOP shares at December 31, 2018 and 2017 are summarized as follows:
Stock-Based Compensation
After shareholder approval in 2016, the MSB Financial Corp. 2016 Equity Incentive Plan (the “2016 Plan”) became effective. In addition, the Company also has the MSB Financial Corp. 2008 Stock Compensation and Incentive Plan (the “2008 Plan”). No future awards are being granted under the 2008 Plan. The 2016 Plan will terminate on the tenth anniversary of its effective date, after which no awards may be granted. Collectively, the 2008 Plan and the 2016 Plan are referred to as Stock Option Plans. Under the 2016 Plan, the Company may grant options to purchase up to 281,499 shares of Company's common stock and issue up to 112,600 shares of restricted stock. At December 31, 2018, there were 85,985 shares remaining for future option grants and 13,597 shares remaining for future restricted share grants under the plan.
On July 16, 2015, the Company completed a second-step stock conversion that included the conversion of the stock options issued and outstanding under the 2008 Plan at a conversion rate of 1.1397. As a result, the number of options outstanding was increased by the conversion factor and the exercise price per share was converted to $9.4323.
On August 4, 2017, certain directors, executive officers and directors emeriti executed options to purchase 212,468 shares of common stock at a per share exercise price of $9.4323. In lieu of issuing shares of common stock upon the exercise of such options, the Company made a cash payment to such optionees equal to the excess of the closing price of the common stock on the Nasdaq Stock Market on August 4, 2017 of $17.30 over the per share exercise price of such options of $9.4323 multiplied by the number of options being exercised. An aggregate of $1.7 million was paid to the optionees.
During 2018, options to purchase 10,556 shares of common stock at $17.65 per share were awarded and will expire no later than ten years following the grant date. The options granted vest over a five-year service period, with 20% of the awards vesting on each anniversary of the date of grant. The fair value of the options granted, as computed using the Black-Scholes option-pricing model, was determined to be $4.24 per option based upon the following underlying assumptions: a risk-free interest rate, expected option life, expected stock price volatility, and dividend yield of 2.49%, 6.5 years, 16.53%, and 0.00% respectively.
During 2017, options to purchase 10,556 shares of common stock at $17.30 per share were awarded and will expire no later than ten years following the grant date. The options granted vest over a five-year service period, with 20% of the awards vesting on each anniversary of the date of grant. The fair value of the options granted, as computed using the Black-Sholes option-pricing model, was determined to be $3.71 per option based upon the following underlying assumptions: a risk-free interest rate, expected option life, expected stock price volatility, and dividend yield of 1.98%, 6.5 years, 15.41%, and 0.00%, respectively.
Note 12 - Benefit Plans (Continued)
The risk-free interest rate was based on the U.S. Treasury yield at the option grant date for securities with a term matching the expected life of the options granted. The expected life was calculated using the "simplified" method provided for under Staff Accounting Bulletin No. 110. Expected volatility was calculated based upon the actual price history of the Company's common stock up until the date of the option grants. The dividend yield was not used in the calculation since no dividends were declared since the Company completed the full stock conversion.
A summary of stock options at December 31, 2018 and 2017 was as follows:
The total amount of compensation cost remaining to be recognized relating to unvested option grants as of December 31, 2018 was $233,000. The weighted-average period over which the expense is expected to be recognized is 2.5 years. At December 31, 2018, the intrinsic value of options exercisable and all options outstanding was approximately $322,000 and $472,000, respectively.
The total amount of compensation cost remaining to be recognized relating to unvested option grants as of December 31, 2017 was $322,000. The weighted-average period over which the expense is expected to be recognized is 3.5 years. At December 31, 2017, the intrinsic value of options exercisable and all options outstanding was approximately $205,000 and $954,000, respectively.
The Company awarded 107,403 shares of restricted stock that vest over a five year period during the year ended December 31, 2016. The fair value of the restricted stock is equal to the fair value of the Company's common stock on the date of grant. For the year ended December 31, 2018, there were 55,443 restricted shares that were unvested and outstanding with a fair value of $13.04. The total amount of compensation cost to be recognized relating to non-vested restricted stock as of December 31, 2018, was $586,000. The weighted-average period over which the expense is expected to be recognized is 2.5 years.
During the year ended December 31, 2018 and December 31, 2017, stock-based compensation expense recorded in regard to the options and the restricted stock grants totaled $328,000 and $391,000, respectively.
Note 13 - Transactions with Officers and Directors
The Bank has had, and may be expected to have in the future, banking transactions in the ordinary course of business with its officers, directors, their immediate families, and affiliated companies (commonly referred to as related parties). These persons were indebted to the Bank for loans totaling $8.2 million and $7.9 million at December 31, 2018 and 2017, respectively. During the year ended December 31, 2018, $1.7 million of new loans and $1.4 million of repayments were made. During the year ended December 31, 2017, the Bank had $4.2 million in loans related to a director that retired who no longer qualifies as related party. Total deposits from related parties at December 31, 2018 were $43.5 million.
Note 14 - Commitments
The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and letters of credit. Such commitments involve, to varying degrees, elements of credit, and interest rate risk in excess of the amount recognized in the statements of financial condition.
The Bank's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
At December 31, 2018 and 2017, the following financial instruments were outstanding whose contract amounts represent credit risk:
At December 31, 2018, commitments to grant loans included $281,000 one-to-four family mortgage loans, $4.8 million of construction loans, $6.9 million of commercial and multi-family estate loans and $2.2 million of commercial and industrial loans. Of the unfunded commitments under lines of credit at December 31, 2018, $14.5 million was available under the Bank's home equity lending program, $414,000 was available under the overdraft protection lending program and $59.3 million was available under commercial lines of credit.
At December 31, 2017, commitments to grant loans included $95,000 of one-to-four family mortgage loans, $4.5 million of construction loans, $8.6 million of commercial and multi-family real estate loans and $12.0 million of commercial and industrial loans. Of the unfunded commitments under lines of credit at December 31, 2017, $14.9 million was available under the Bank's home equity lending program, $428,000 was available under the overdraft protection lending program and $50.2 million was available under the commercial lines of credit.
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. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation. Collateral held varies but primarily includes residential and income-producing commercial real estate properties.
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending other loan commitments. The Bank requires collateral supporting these letters of credit when deemed necessary. Management believes that the proceeds obtained through a liquidation of such collateral would be sufficient to cover the maximum potential amount of future payments required under the corresponding guarantees. The fair values of these obligations were immaterial as of December 31, 2018 and 2017.
Note 15 - Fair Value Measurements
The Company uses fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures.
FASB ASC Topic 820, Fair Market Value Disclosures ("ASC 820"), defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction. Market participants are buyers and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact and (iv) willing to transact.
ASC 820 requires the use of valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets and liabilities. The income approach uses valuation techniques to convert future amounts, such as cash flows or earnings, to a single present amount on a discounted basis. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (replacement cost). Valuation techniques should be consistently applied. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from independent sources, or unobservable, meaning those that reflect the reporting entity's own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. In that regard, ASC 820 establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:
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Level 1 Inputs - Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.
Note 15 - Fair Value Measurements (Continued)
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Level 2 Inputs - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means.
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Level 3 Inputs - Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity's own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.
A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below. An asset's or liability's level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.
In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company's valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future values. While management believes the Company's valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.
Assets and Liabilities Measured at Fair Value on a Recurring Basis
The Bank did not have any financial assets measured at fair value on a recurring basis as of December 31, 2018 and 2017.
Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis
Certain financial and non-financial assets are measured at fair value on a non-recurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment).
The following tables summarize those assets measured at fair value on a non-recurring basis as of December 31, 2018 and 2017:
For Level 3 input assets measured at fair value on non-recurring basis as of December 31, 2018 and 2017, the significant unobservable inputs used in fair value measurements were as follows:
Note 15 - Fair Value Measurements (Continued)
An impaired loan is measured for impairment at the time the loan is identified as impaired. Loans are considered impaired when based on current information and events it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement. The Company's impaired loans are generally collateral dependent and, as such, are carried at the lower of cost or estimated fair value less estimated selling costs. Fair values are estimated through current appraisals and adjusted as necessary to reflect current market conditions and as such are classified as Level 3.
Disclosure about Fair Value of Financial Instruments
The fair value of a financial instrument is defined above. Significant estimates were used for the purposes of disclosing fair values. Estimated fair values have been determined using the best available data and estimation methodology suitable for each category of financial instruments. However, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Company could have realized in a sale transaction on the dates indicated. The estimated fair value amounts have been measured as of their respective reporting dates, and have not been reevaluated or updated for purposes of these consolidated financial statements subsequent to those respective dates. As such, the estimated fair values of these financial instruments subsequent to the respective reporting dates may be different than the amounts reported.
The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of the Company's assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Company's disclosures and those of other companies may not be meaningful.
The following presents the carrying amount, fair value and placement in the fair value hierarchy as of December 31, 2018 and 2017, of the Company's financial instruments which are carried on the consolidated statement of financial condition at cost and are not measured or recorded at fair value on a recurring basis.
(1)
Includes impaired loans measured at fair value on a non-recurring basis as discussed above.
Note 15 - Fair Value Measurements (Continued)
Management used exit prices to estimate the fair values in the table above as of December 31, 2018. Methods and assumptions used to estimate fair values of financial assets and liabilities as of December 31, 2017 are as follows:
Cash and Cash Equivalents
For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value.
Securities Held to Maturity
The fair value for securities held to maturity is based on quoted market prices, where available. If quoted market prices are not available, fair value is estimated using quoted market prices for similar securities.
Loans Receivable
The fair value of loans is based upon a multitude of sources, including assumed current market rates by category and the Bank's current offering rates. Both fixed and variable rate loan fair values are derived at using a discounted cash flow methodology. For variable rate loans, repricing terms, including next reprice date, reprice frequency and reprice rate are factored into the discounted cash flow formula.
Deposits
Fair values for demand deposits, savings accounts and club accounts are, by definition, equal to the amount payable on demand at the reporting date. Fair values of fixed-maturity certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on similar instruments with similar maturities.
Advances from Federal Home Loan Bank of New York
Fair values of advances are estimated using discounted cash flow analyses, based on rates currently available to the Company for advances from the FHLB of New York with similar terms and remaining maturities.
Off-Balance Sheet Financial Instruments
Fair values of commitments to extend credit are estimated using the fees currently charged to enter into similar agreement, into account market interest rates, the remaining terms, and the present credit worthiness of the counterparties. As of December 31, 2018 and 2017, the fair value of the commitments to extend credit was not considered to be material.
Note 16 - Parent Only Financial Statements