ITEM 1A - Risk Factors
Our operations and financial results are subject to various risks and uncertainties, including, but not limited to, the material risks described below. Many of these risks are beyond our control although efforts are made to manage those risks while simultaneously optimizing operational and financial results. The occurrence of any of the following risks, as well as risks of which we are currently unaware or currently deem immaterial, could materially and adversely affect our assets, business, cash flows, condition (financial or otherwise), liquidity, prospects, results of operations and the trading price of our common stock. It is impossible to predict or identify all such factors and, as a result, you should not consider the following factors to be a complete discussion of the risks, uncertainties and assumptions that could materially and adversely affect our assets, business, cash flows, condition (financial or otherwise), liquidity, prospects, results of operations and the trading price of our common stock.
In addition, certain statements in the following risk factors constitute forward-looking statements. Please refer to the section entitled “Cautionary note regarding forward-looking statements” beginning on page 2 of this Annual Report.
Risks related to our business
Difficult or volatile conditions in the national financial markets, the U.S. economy generally, or the state of Tennessee in particular may adversely affect our lending activity or other businesses, as well as our financial condition.
Our business and financial performance are vulnerable to weak economic conditions in the financial markets and economic conditions generally or specifically in the state of Tennessee, the principal market in which we conduct business. A deterioration in economic conditions in our primary market areas could result in the following consequences, any of which could materially and adversely affect our business: increased loan delinquencies; problem assets and foreclosures; significant write-downs of asset values; lower demand for our products and services; reduced low cost or noninterest-bearing deposits; intangible asset impairment; and collateral for loans made by us, especially real estate, may decline in value, in turn reducing our customers' ability to repay outstanding loans, and reducing the value of assets and collateral associated with our existing loans. Additional issues surrounding weakening economic conditions and volatile markets that could adversely impact us include:
•
Increased regulation of our industry, and resulting increased costs associated with regulatory compliance and potential limits on our ability to pursue business opportunities;
•
Our ability to assess the creditworthiness of our customers may be impaired if the models and approaches we use to select, manage, and underwrite our customers become less predictive of future performance;
•
The process we use to estimate losses inherent in our loan portfolio requires difficult, subjective, and complex judgments, including forecasts of economic conditions and how these economic predictions might impair the ability of our borrowers to repay their loans, which process may no longer be capable of accurate estimation and may, in turn, impact its reliability;
•
Downward pressure on our stock price.
Additionally, we conduct our banking operations primarily in Tennessee. As of December 31, 2018, approximately 77% of our loans and approximately 87% of our deposits were made to borrowers or received from depositors who live and/or primarily conduct business in Tennessee. Therefore, our success will depend in large part upon the general economic
conditions in this area. This geographic concentration imposes risks from lack of geographic diversification, as adverse economic developments in Tennessee (including the Nashville MSA, our largest market), among other things, could affect the volume of loan originations, increase the level of nonperforming assets, increase the rate of foreclosure losses on loans, reduce the value of our loans and loan servicing portfolio, reduce the value of the collateral securing our loans and reduce the amount of our deposits.
Any regional or local economic downturn that affects Tennessee or existing or prospective borrowers, depositors or property values in this area may affect us and our profitability more significantly and more adversely than our competitors whose operations are less geographically concentrated.
We face strong competition from financial services companies and other companies that offer banking services.
We conduct our banking operations primarily in Tennessee, with our largest market being the Nashville MSA, which is a highly competitive banking market. Many of our competitors offer the same, or a wider variety of, banking services within our market areas, and we compete with them for the same customers. These competitors include banks with nationwide operations, regional banks and community banks. In many instances these national and regional banks have greater resources than we do, and the smaller community banks may have stronger ties in local markets than we do, which may put us at a competitive disadvantage. We also face competition from many other types of financial institutions, including thrift institutions, finance companies, brokerage firms, insurance companies, credit unions, mortgage banks and other internet-based companies offering financial services which enjoy fewer regulatory constraints and some may have lower cost structures. In addition, a number of out-of-state financial institutions have opened offices and solicit deposits in our market areas. Increased competition in our markets may result in reduced loans and deposits, as well as reduced net interest margin and profitability. If we are unable to attract and retain banking customers, we may be unable to continue to grow our loan and deposit portfolios, and our business, financial condition or results of operations may be adversely affected.
Further, a number of larger banks have recently entered the Nashville MSA, and we believe this trend will continue as banks look to gain a foothold in this growing market. This trend will likely result in greater competition in, and may impair our ability to grow our share of our largest market.
If we do not effectively manage our asset quality and credit risk, we could experience loan losses.
Making any loan involves various risks, including risks inherent in dealing with individual borrowers, risks of nonpayment, risks resulting from uncertainties as to the future value of collateral and cash flows available to service debt, and risks resulting from changes in economic and market conditions. Our credit risk approval and monitoring procedures may fail to identify or reduce these credit risks, and they cannot completely eliminate all credit risks related to our loan portfolio. If the overall economic climate, including employment rates, real estate markets, interest rates and general economic growth, in the United States, generally, or Tennessee (particularly the Nashville MSA), specifically, experiences material disruption, our borrowers may experience difficulties in repaying their loans, the collateral we hold may decrease in value or become illiquid, and the levels of nonperforming loans, charge-offs and delinquencies could rise and require additional provisions for loan losses, which would cause our net income and return on equity to decrease.
Our provision and allowance for credit losses may not be adequate to cover actual credit losses.
We make various assumptions and judgments about the collectability of our loan and lease portfolio and utilize these assumptions and judgments when determining the provision and allowance for credit losses. The determination of the appropriate level of the provision for credit losses inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in the amount reserved in the allowance for credit losses. In addition, bank regulatory agencies periodically review our provision and the total allowance for credit losses and may require an increase in the allowance for credit losses or future provisions for credit losses, based on judgments different than those of management. Any increases in the provision or allowance for credit losses will result in a decrease in our net income and, potentially, capital, and may have a material adverse effect on our financial condition or results of operations.
The Company may be required to increase its allowance for credit losses as a result of a recently issued accounting standard.
In June 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update 2016-13 (“ASU 2016-13”), Financial Instruments - Credit Losses. This accounting standard replaces the current incurred loss accounting model with a current expected credit loss approach (“CECL”) for financial instruments measured at amortized cost and other commitments to extend credit. The amendments made by ASU 2016-13 require entities to consider all available relevant information when estimating current expected credit losses, including details about past events, current conditions, and reasonable and supportable forecasts. The resulting allowance for credit losses is to reflect the portion of the amortized cost basis that the entity does not expect to collect. The amendments also eliminate the current accounting model for purchased
credit impaired loans and debt securities. While the CECL model does not apply to available for sale debt securities, ASU 2016-13 does require entities to record an allowance when recognizing credit losses for available-for-sale securities, rather than reduce the amortized cost of the securities by direct write-offs.
The amendments in ASU 2016-13 will be effective for fiscal years beginning after December 15, 2019. For most debt securities, the transition approach requires a cumulative-effect adjustment to the statement of financial position as of the beginning of the first reporting period the guidance is effective. For other-than-temporarily impaired debt securities, the guidance will be applied prospectively. The Company will record a one-time adjustment to its credit loss allowance, as of the beginning of the first quarter of 2020, equal to the difference between the amounts of its credit loss allowance under the incurred loss methodology and CECL. Moreover, the new accounting standard is likely, as a result of its requirement to estimate and recognize expected credit losses on new assets, to introduce greater volatility in our provision for credit loans and allowance for loan losses. The Company is currently evaluating the magnitude of the one-time cumulative adjustment to its allowance and of the ongoing impact of the CECL model on its loan loss allowance and results of operations.
Because a significant portion of our loan portfolio is comprised of real estate loans, negative changes in the economy affecting real estate values and liquidity could impair the value of collateral securing our real estate loans and result in loan and other losses.
As of December 31, 2018, approximately 71% of our loan portfolio was comprised of loans with real estate as a primary or secondary component of collateral. This includes collateral consisting of income producing and residential construction properties, which properties tend to be more sensitive to general economic conditions and downturns in real estate markets. As a result, adverse developments affecting real estate values in our market areas could increase the credit risk associated with our real estate loan portfolio. Adverse changes affecting real estate values and the liquidity of real estate in one or more of our markets could increase the credit risk associated with our loan portfolio and could result in losses that would adversely affect credit quality and our financial condition or results of operations. These adverse changes could significantly impair the value of property pledged as collateral to secure the loans and affect our ability to sell the collateral upon foreclosure without a loss or additional losses. If real estate values decline, it is also more likely that we would be required to increase our allowance for loan losses. Thus, declines in the value of real estate collateral could adversely affect our financial condition, results of operations or cash flows.
We are exposed to higher credit risk from commercial real estate, commercial and industrial, and construction based lending.
Commercial real estate, commercial and industrial, and construction based lending usually involves higher credit risks than 1-4 family residential real estate lending. As of December 31, 2018, the following loan types accounted for the stated percentages of our loan portfolio: commercial real estate (both owner-occupied and non-owner occupied) - 32%; commercial and industrial - 24%; and construction - 15%. These loans expose us to greater credit risk than loans secured by other types of collateral because the collateral securing these loans is typically more difficult to liquidate. Additionally, these types of loans also often involve larger loan balances to a single borrower or groups of related borrowers. These higher credit risks are further heightened when the loans are concentrated in a small number of larger borrowers leading to relationship exposure.
Non-owner occupied commercial real estate loans may be affected to a greater extent than residential loans by adverse conditions in real estate markets or the economy because commercial real estate borrowers’ ability to repay their loans depends on successful development of their properties. These loans also involve greater risk because they generally are not fully amortizing over the loan period, and therefore have a balloon payment due at maturity. A borrower’s ability to make a balloon payment typically will depend on being able to either refinance the loan or sell the underlying property in a timely manner. In addition, banking regulators have been giving commercial real estate lending greater scrutiny, and may require banks with higher levels of commercial real estate loans to implement improved underwriting, internal controls, risk management policies and portfolio stress testing, as well as possibly higher levels of allowances for losses and capital levels as a result of commercial real estate lending growth and exposures.
Commercial and industrial loans and owner-occupied commercial real estate loans are typically based on the borrowers’ ability to repay the loans from the cash flow of their businesses. These loans may involve greater risk because the availability of funds to repay each loan depends substantially on the success of the business itself. In addition, the assets securing the loans depreciate over time, are difficult to appraise and liquidate, and fluctuate in value based on the success of the business.
Risk of loss on a construction loan depends largely upon whether our initial estimate of the property’s value at completion of construction or development equals or exceeds the cost of the property construction or development (including interest), the availability of permanent take-out financing and the builder’s ability to sell the property. During the construction or development phase, a number of factors can result in delays and cost overruns. If estimates of value are inaccurate or if actual construction costs exceed estimates, the value of the property securing the loan may be insufficient to ensure full repayment when completed through a permanent loan or by foreclosure on collateral.
Commercial real estate loans, commercial and industrial loans, and construction loans are more susceptible to a risk of loss during a downturn in the business cycle due to the vulnerability of these sectors during a downturn. Our underwriting, review and monitoring cannot eliminate all of the risks related to these loans.
We also make both secured and unsecured loans to our commercial customers. Unsecured loans generally involve a higher degree of risk of loss than secured loans because, without collateral, repayment is wholly dependent upon the success of the borrowers’ businesses. Because of this lack of collateral, we are limited in our ability to collect on defaulted unsecured loans. Further, the collateral that secures our secured commercial and industrial loans typically includes inventory, accounts receivable and equipment, which usually have a value that is insufficient to satisfy the loan without a loss if the business does not succeed.
Our loan concentration in these sectors and their higher credit risk could lead to increased losses on these loans, which could have a material adverse effect on our financial condition, results of operations or cash flows.
We are exposed to higher credit risk due to relationship exposure with a number of large borrowers.
As of December 31, 2018, we had 38 borrowing relationships in excess of $10 million but less than $15 million and 27 relationships greater than $15 million which accounted for approximately 12% and 15% of our loan portfolio, respectively. While we are not overly dependent on any one of these relationships and while these credit relationships have not had a significant impact on the allowance for loan losses in the past, a deterioration of any of these large credits could require us to increase our allowance for loan losses or result in significant losses to us, which could have a material adverse effect on our financial condition, results of operations or cash flows.
Our deposit portfolio includes significant concentrations and a large percentage of our deposits are attributable to a relatively small number of clients.
As a commercial bank, we provide services to a number of clients whose deposit levels may vary considerably and have seasonality based on their nature. At December 31, 2018, five commercial and individual clients, maintained balances (aggregating all related accounts, including multiple business entities and personal funds of business owners) in excess of $25.0 million, which amounted to $412.0 million in total deposits at December 31, 2018. These clients are not concentrated in any particular industry or business but include certain related parties of the Company. In addition, mortgage escrow deposits that our third-party servicing provider, Cenlar, transfer to the Bank totaled $53.5 million at December 31, 2018. Further, our deposits from municipal and governmental entities (i.e., “public deposits”) totaled $448.2 million at December 31, 2018. Of these public deposits, two public entities maintained balances in excess of $25.0 million at December 31, 2018 totaling $155.1 million. These deposits can and do fluctuate substantially. The loss of any combination of these depositors, or a significant decline in the deposit balances due to unexpected fluctuations related to these customers’ businesses, would adversely affect our liquidity and may require us to raise deposit rates to quickly attract new customer deposits, purchase brokered deposits, purchase federal funds or borrow funds on a short-term basis to replace such deposits. Depending on the interest rate environment and competitive factors, lower cost deposits may need to be replaced with higher cost funding, resulting in a decrease in net interest income and net income. While these events could have a material impact on the Bank’s results, the Bank expects, in the ordinary course of business, that these deposits will fluctuate and believes it is capable of mitigating this risk, as well as the risk of losing one of these depositors, through additional liquidity, and business generation in the future. However, should a significant number of these customers leave the Bank, it could have a material adverse impact on the Bank.
We make loans to small-to-medium sized businesses that may not have the resources to weather a downturn in the economy.
We make loans to privately-owned businesses, many of which are considered to be small to medium-sized businesses. Small to medium-sized businesses frequently have smaller market share than their competition, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience significant volatility in operating results. Any one or more of these factors may impair the borrower’s ability to repay a loan. In addition, the success of a small to medium-sized business often depends on the management talents and efforts of one or two persons or a small group of persons, and the death, disability or resignation of one or more of these persons could have a material adverse impact on the business and its ability to repay a loan. Economic downturns, a sustained decline in commodity prices and other events that negatively impact small businesses in our market areas could cause us to incur substantial credit losses that could negatively affect our results of operations or financial condition.
We may be materially and adversely affected by the creditworthiness and liquidity of other financial institutions.
Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks and other institutional customers. Many of these transactions expose us to credit risk in the event of a default by, or questions or concerns about the creditworthiness of, a counterparty or client, or concerns about the financial services industry generally. In addition, our credit
risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due to us. Any such losses could have a material adverse effect on us.
A lack of liquidity could adversely affect our operations and jeopardize our business, financial condition or results of operations.
We rely on our ability to generate deposits and effectively manage the repayment and maturity schedules of our loans and investment securities to ensure that we have adequate liquidity to fund our operations. In addition to our traditional funding sources, we also may borrow funds from third-party lenders or issue equity or debt securities to investors. Our access to funding sources in amounts adequate to finance or capitalize our activities, or on terms that are acceptable to us, could be impaired by factors that affect us directly or the financial services industry or economy in general, such as disruptions in the financial markets or negative views and expectations about the prospects for the financial services industry. Any decline in available funding could adversely impact our ability to originate loans, invest in securities, meet our expenses, pay dividends to our shareholders, or to fulfill obligations such as repaying our borrowings or meeting deposit withdrawal demands, any of which could have a material adverse impact on our liquidity, business, financial condition or results of operations.
We may not be able to meet our unfunded credit commitments, or adequately reserve for losses associated with our unfunded credit commitments.
A commitment to extend credit is a formal agreement to lend funds to a client as long as there is no violation of any condition established under the agreement. The actual borrowing needs of our customers under these credit commitments have historically been lower than the contractual amount of the commitments. A significant portion of these commitments expire without being drawn upon. Because of the credit profile of our customers, we typically have a substantial amount of total unfunded credit commitments, which is not reflected on our balance sheet. Actual borrowing needs of our customers may exceed our expected funding requirements, especially during a challenging economic environment when our client companies may be more dependent on our credit commitments due to the lack of available credit elsewhere, the increasing costs of credit, or the limited availability of financings from other sources. Any failure to meet our unfunded credit commitments in accordance with the actual borrowing needs of our customers may have a material adverse effect on our business, financial condition, results of operations or reputation.
Changes in interest rates could have an adverse impact on our results of operations and financial condition.
Our earnings and financial condition are dependent to a large degree upon net interest income, which is the difference, or spread, between interest earned on loans, securities and other interest-earning assets and interest paid on deposits, borrowings and other interest-bearing liabilities. When market rates of interest change, the interest we receive on our assets and the interest we pay on our liabilities may fluctuate. This may cause decreases in our spread and may adversely affect our earnings and financial condition.
Interest rates are highly sensitive to many factors including, without limitation:
•
The rate of inflation;
•
Economic conditions;
•
Federal monetary policies; and
•
Stability of domestic and foreign markets
Although we have implemented procedures we believe will reduce the potential effects of changes in interest rates on our net interest income, these procedures may not always be successful. Accordingly, changes in levels of market interest rates could materially and adversely affect our net interest income and our net interest margin, asset quality, loan and lease origination volume, liquidity or overall profitability. Additionally, changes in interest rates can adversely impact the origination of mortgage loans held for sale and resulting mortgage banking revenues.
A transition away from LIBOR as a reference rate for financial contracts could negatively affect our income and expenses and the value of various financial contracts.
LIBOR is used extensively in the United States and globally as a benchmark for various commercial and financial contracts, including adjustable rate mortgages, corporate debt, interest rate swaps and other derivatives. LIBOR is set based on interest rate information reported by certain banks, which may stop reporting such information after 2021. It is uncertain at this time whether LIBOR will change or cease to exist or the extent to which those entering into financial contracts will transition to any other particular benchmark. Other benchmarks may perform differently than LIBOR or alternative benchmarks have performed in the past or have other consequences that cannot currently be anticipated. It is also uncertain what will happen with instruments that rely on LIBOR for future interest rate adjustments and which remain outstanding if LIBOR ceases to exist.
We have a significant number of loans, derivative contracts, borrowings and other financial instruments with attributes that are either directly or indirectly dependent on LIBOR. The transition from LIBOR could create considerable costs and additional
risk. Since proposed alternative rates are calculated differently, payments under contracts referencing new rates will differ from those referencing LIBOR. The transition will change our market risk profiles, requiring changes to risk and pricing models, valuation tools, product design and hedging strategies. Furthermore, failure to adequately manage this transition process with our customers could adversely impact our reputation. Although we are currently unable to assess what the ultimate impact of the transition from LIBOR will be, failure to adequately manage the transition could have a material adverse effect on our business, financial condition and results of operations.
If we are unable to grow our noninterest income, our growth prospects will be impaired.
Taking advantage of opportunities to develop new, and expand existing, streams of noninterest income, including our mortgage business, cash management services, investment services and interchange fees, is a part of our long-term growth strategy. If we are unsuccessful in our attempts to grow our noninterest income, especially in light of the expected continued competitive pressure on mortgage revenues from the interest rate environment, our long-term growth will be impaired. Further, focusing on these noninterest income streams may divert management’s attention and resources away from our core banking business, which could impair our core business, financial condition and operating results. We also derive a meaningful amount of our noninterest income from non-sufficient funds and overdraft fees, and such fees are subject to increased regulatory scrutiny, which could result in an erosion of such fees, and as a result, materially impair our future noninterest income.
Our recent results may not be indicative of our future results.
We may not be able to grow our business at the same rate of growth achieved in recent years or even grow our business at all. In the future, we may not have the benefit of several factors that have been favorable to the growth of our business in past years, such as an interest rate environment where changes in rates occur at a relatively orderly and modest pace and the ability to find suitable expansion opportunities and acquisition targets. Numerous factors, such as weakening or deteriorating economic conditions, regulatory and legislative considerations, and competition may impede or restrict our ability to expand our market presence and build our franchise. Even if we are able to grow our business, we may fail to build the infrastructure sufficient to support such growth, suffer loan losses in excess of reserves for such losses or experience other risks associated with growth.
Our future success is largely dependent upon our ability to successfully execute our business strategy.
Our future success, including our ability to achieve our growth and profitability goals, is dependent on the ability of our management team to execute on our long-term business strategy, which requires them to, among other things:
•
maintain and enhance our reputation;
•
attract and retain experienced and talented bankers in each of our markets;
•
maintain adequate funding sources, including by continuing to attract stable, ow-cost deposits;
•
enhance our market penetration in our metropolitan markets and maintain our leadership position in our community markets;
•
improve our operating efficiency;
•
implement new technologies to enhance the client experience and keep pace with our competitors;
•
identify attractive acquisition targets, close on such acquisitions on favorable terms and successfully integrate acquired businesses;
•
attract and maintain business banking relationships with well-qualified businesses, real estate developers and investors with proven track records in our market areas;
•
attract sufficient loans that meet prudent credit standards;
•
originate conforming residential mortgage loans for resale into secondary markets to provide mortgage banking income;
•
maintain adequate liquidity and regulatory capital and comply with applicable federal and state banking laws and regulations;
•
manage our credit, interest rate and liquidity risk;
•
develop new, and grow our existing streams of noninterest income;
•
oversee the performance of third-party vendors that provide material services to our business; and
•
control expenses in line with their current projections.
Failure of management to execute our business strategy could negatively impact our business, growth prospects, financial condition or results of operations. Further, if we do not manage our growth effectively, our business, financial condition, results of operations and future prospects could be negatively affected, and we may not be able to continue to implement our business strategy and successfully conduct our operations.
We may not be able to complete future financial institution acquisitions.
From time to time, we evaluate and engage in the acquisition of other banking organizations. We must satisfy a number of meaningful conditions before we can complete an acquisition of another bank or bank holding company, including federal and state bank regulatory approvals. The process for obtaining required regulatory approvals can be time-consuming and
unpredictable and is subject to numerous regulatory and policy factors, a number of which are beyond our control. We may fail to pursue or to complete strategic and competitively significant acquisition opportunities as a result of the perceived difficulty or impossibility of obtaining required regulatory approvals in a timely manner or at all.
Our strategy of pursuing acquisitions exposes us to financial, execution, compliance and operational risks that could have a material adverse effect on our business, financial condition, results of operations and growth prospects.
We intend to continue pursuing a strategy that includes acquisitions. An acquisition strategy involves significant risks, including the following:
•
finding suitable candidates for acquisition;
•
attracting funding to support additional growth within acceptable risk tolerances;
•
maintaining asset quality;
•
retaining customers and key personnel, including bankers;
•
obtaining necessary regulatory approvals, which we may have difficulty obtaining or be unable to obtain;
•
conducting adequate due diligence and managing known and unknown risks and uncertainties;
•
integrating acquired businesses; and
•
maintaining adequate regulatory capital
The market for acquisition targets is highly competitive, which may adversely affect our ability to find acquisition candidates that fit our strategy and standards. We face significant competition in pursuing acquisition targets from other banks and financial institutions, many of which possess greater financial, human, technical and other resources than we do. Our ability to compete in acquiring target institutions will depend on our available financial resources to fund the acquisitions, including the amount of cash and cash equivalents we have and the liquidity and market price of our common stock. In addition, increased competition may also drive up the acquisition consideration that we will be required to pay in order to successfully capitalize on attractive acquisition opportunities. To the extent that we are unable to find suitable acquisition targets, an important component of our growth strategy may not be realized.
Acquisitions of financial institutions also involve operational risks and uncertainties, such as unknown or contingent liabilities with no available manner of recourse, exposure to unexpected problems such as asset quality, the retention of key employees and customers, and other issues that could negatively affect our business. We may not be able to complete future acquisitions or, if completed, we may not be able to successfully integrate the operations, technology platforms, management, products and services of the entities that we acquire or to realize our attempts to eliminate redundancies. The integration process may also require significant time and attention from our management that would otherwise be directed toward servicing existing business and developing new business. Failure to successfully integrate the entities we acquire into our existing operations in a timely manner may increase our operating costs significantly and adversely affect our business, financial condition and results of operations. Further, acquisitions typically involve the payment of a premium over book and market values and, therefore, some dilution of our tangible book value and net income per common share may occur in connection with any future acquisition, and the carrying amount of any goodwill that we currently maintain or may acquire may be subject to impairment in future periods.
If we continue to grow, we will face risks arising from our increased size. If we do not manage such growth effectively, we may be unable to realize the benefit from the investments in technology, infrastructure and personnel that we have made to support our expansion. In addition, we may incur higher costs and realize less revenue growth than we expect, which would reduce our earnings and diminish our future prospects, and we may not be able to continue to implement our business strategy and successfully conduct our operations. Risks associated with failing to maintain effective financial and operational controls as we grow, such as maintaining appropriate loan underwriting procedures, information technology systems, determining adequate allowances for loan losses and complying with regulatory accounting requirements, including increased loan losses, reduced earnings and potential regulatory penalties and restrictions on growth, all could have a negative effect on our business, financial condition and results of operations.
Acquisitions may disrupt our business and dilute stockholder value, and integrating acquired companies may be more difficult, costly, or time-consuming than we expect.
Our pursuit of acquisitions may disrupt our business, and any equity that we issue as merger consideration may have the effect of diluting the value of your investment. In addition, we may fail to realize some or all of the anticipated benefits of completed acquisitions. We anticipate that the integration of businesses that we may acquire in the future will be a time-consuming and expensive process, even if the integration process is effectively planned and implemented.
In addition, our acquisition activities could be material to our business and involve a number of significant risks, including the following:
•
incurring time and expense associated with identifying and evaluating potential acquisitions and negotiating potential transactions, resulting in our attention being diverted from the operating of our existing business;
•
using inaccurate estimates and judgments to evaluate credit, operations, management, and market risks with respect to the target company or the assets and liabilities that we seek to acquire;
•
exposure to potential asset quality issues of the target company;
•
intense competition from other banking organizations and other potential acquirers, many of which have substantially greater resources than we do;
•
potential exposure to unknown or contingent liabilities of banks and businesses we acquire, including, without limitation, liabilities for regulatory and compliance issues;
•
inability to realize the expected revenue increases, cost savings, increases in geographic or product presence, an other projected benefits of the acquisition;
•
incurring time and expense required to integrate the operations and personnel of the combined businesses;
•
inconsistencies in standards, procedures, and policies that would adversely affect our ability to maintain relationships with customers and employees;
•
experiencing higher operating expenses relative to operating income from the new operations;
•
creating an adverse short-term effect on our results of operations;
•
losing key employees and customers;
•
significant problems related to the conversion of the financial and customer data of the entity;
•
integration of acquired customers into our financial and customer product systems;
•
potential changes in banking or tax laws or regulations that may affect the target company; or
•
risks of impairment to goodwill.
If difficulties arise with respect to the integration process, the economic benefits expected to result from acquisitions might not occur. As with any merger of financial institutions, there also may be business disruptions that cause us to lose customers or cause customers to move their business to other financial institutions. Failure to successfully integrate businesses that we acquire could have an adverse effect on our profitability, return on equity, return on assets, or our ability to implement our strategy, any of which in turn could have a material adverse effect on our business, financial condition, and results of operations.
The value of our Mortgage servicing rights asset is subjective by nature and may be vulnerable to inaccuracies or other events outside our control.
The value of our mortgage servicing rights asset can fluctuate. Particularly, the asset could decrease in value if prepay speeds, delinquency rates, or the cost to service increases or overall values decrease causing a lack of liquidity of MSRs in the market. Similarly, the value may decrease if interest rates decrease or change in a non-parallel manner or are otherwise volatile. All of which are mostly out of FirstBank’s control. We must use estimates, assumptions and judgments when valuing this asset. An inaccurate valuation, or changes to the valuation due to factors outside of our control, could negatively impact our ability to realize the full value of this asset. As a result, our balance sheet may not precisely represent the fair market value of this and other financial assets.
We follow a relationship-based operating model, and our ability to maintain our reputation is critical to the success of our business.
We are a community bank, and our reputation is one of the most valuable components of our business. As such, we strive to conduct our business in a manner that enhances our reputation. This is done, in part, by recruiting, hiring and retaining bankers and other associates who share our core values of being an integral part of the communities we serve, delivering superior service to our customers and caring about our customers and associates. Further, maintaining our reputation also depends on our ability to protect our brand and associated intellectual property. If our reputation is negatively affected by the actions of our associates or otherwise, our business and, therefore, our operating results may be materially and adversely affected.
We depend on our executive officers and other key individuals to continue the implementation of our long-term business strategy and could be harmed by the loss of their services and our inability to make up for such loss with qualified replacements.
We believe that our continued growth and future success will depend in large part on the skills of our senior management team and our ability to motivate and retain these individuals and other key individuals. The loss of any member of our senior management team could reduce our ability to successfully implement our long-term business strategy, our business could suffer and the value of our common stock could be materially and adversely affected.
The success of our operating model is largely dependent on our ability to attract and retain talented bankers in each of our markets.
We strive to attract and retain talented bankers in each of our markets by fostering an entrepreneurial environment, empowering them with local decision making authority and providing them with sufficient infrastructure and resources to support their growth while also providing management with appropriate oversight. However, the competition for bankers in each of our markets is intense. We compete for talent with both smaller banks that may be able to offer bankers more
responsibility, autonomy and local relationships and larger banks that may be able to offer bankers higher compensation, resources and support. As a result, we may not be able to effectively compete for talent across our markets. Further, our bankers may leave us to work for our competitors and, in some instances, may take important banking relationships with them. If we are unable to attract and retain talented bankers in our markets, our business, growth prospects or financial results could be materially and adversely affected.
We may fail to realize all of the anticipated benefits from previously acquired financial institutions or institutions that we may acquire in the future, or those benefits may take longer to realize than expected. We may also encounter significant difficulties in integrating financial institutions that we acquire.
Our ability to realize the anticipated benefits of any acquisition of other financial institutions, bank branches and/or mortgage operations in target markets will depend, to a large extent, on our ability to successfully integrate the acquired businesses. Such an acquisition strategy will involve significant risks, including the following:
•
finding suitable markets for expansion;
•
finding suitable candidates for acquisition;
•
finding suitable financing sources to fund acquisitions;
•
attracting and retaining qualified management;
•
maintaining adequate regulatory approvals; and
•
closing on suitable acquisitions on terms that are favorable to us.
The integration and combination of the acquired businesses is a complex, costly and time-consuming process. As a result, we may be required to devote significant management attention and resources to integrating business practices and operations. The integration process may disrupt our business and the business of the acquired bank and, if implemented ineffectively, would restrict the full realization of the anticipated benefits of the acquisition. The failure to meet the challenges involved in integrating acquired businesses and to fully realize the anticipated benefits of acquisitions could adversely impact our business, financial condition or results of operations. Further, we cannot assure you that we will be successful in completing any future acquisitions or integrations, or that we will not incur disruptions or unexpected expenses in negotiating or consummating such acquisitions or integrations. Additionally, in attempting to make such acquisitions, we anticipate competing with other financial institutions, some of which have greater financial and operational resources.
Our lending limit may restrict our growth and prevent us from effectively implementing our business strategy.
We are limited by law in the amount we can loan in the aggregate to a single borrower or related borrowers by the amount of our capital. Tennessee’s legal lending limit is intended to prevent one person or a relatively small and economically related group of persons from borrowing an unduly large amount of a bank’s funds. It is also intended to safeguard a bank’s depositors by diversifying the risk of loan losses among a relatively large number of creditworthy borrowers engaged in various types of businesses. Based upon our capitalization at December 31, 2018, our legal lending limits were approximately $80 million (15% of capital and surplus) and $133 million (25% of capital and surplus). Therefore, based upon our current capital levels, the amount we may lend may be significantly less than that of many of our larger competitors and may discourage potential borrowers who have credit needs in excess of our lending limit from doing business with us. We may accommodate larger loans by selling participations in those loans to other financial institutions, but this strategy may not always be available. In addition to these legally imposed lending limits, we also employ appropriate limits on our overall loan portfolio and requirements with respect to certain types of lending and individual lending relationships. If we are unable to compete effectively for loans from our target customers, we may not be able to effectively implement our business strategy, which could have a material adverse effect on our business, financial condition, results of operations or prospects.
Our funding sources may prove insufficient to support our future growth.
Deposits, cash flows from operations (including from our mortgage business) and investment securities for sale are the primary sources of funds for our lending activities and general business purposes. However, from time to time we also obtain advances from the Federal Home Loan Bank, purchase federal funds, engage in overnight borrowing from the Federal Reserve and correspondent banks and sell loans. While we believe our current funding sources to be adequate, our future growth may be severely constrained if we are unable to maintain our access to funding or if adequate financing is not available on acceptable terms to accommodate future growth, which could have a material adverse effect on our financial condition, results of operations or cash flows.
The performance of our investment securities portfolio is subject to fluctuation due to changes in interest rates and market conditions, including credit deterioration of the issuers of individual securities.
Changes in interest rates may negatively affect both the returns on and fair value of our investment securities. Interest rate volatility can reduce unrealized gains or increase unrealized losses in our portfolio. Interest rates are highly sensitive to many factors including monetary policies, domestic and international economic and political issues, and other factors beyond our control. Additionally, actual investment income and cash flows from investment securities that carry prepayment risk, such as mortgage-backed securities and callable securities, may materially differ from those anticipated at the time of investment
or subsequently as a result of changes in interest rates and market conditions. These occurrences could have a material adverse effect on our net interest income or our results of operations.
Decreased residential mortgage origination volume and pricing decisions of competitors may adversely affect our profitability.
Our mortgage operation originates, sells and services residential mortgage loans and provides third-party origination services to other community banks and mortgage companies. Changes in interest rates, housing prices, applicable government regulations and pricing decisions by our loan competitors may adversely affect demand for our residential mortgage loan products, the revenue realized on the sale of loans, the revenues received from servicing such loans for others and, ultimately, reduce our net income. New regulations, increased regulatory reviews, and/or changes in the structure of the secondary mortgage markets which we utilize to sell mortgage loans may increase costs and make it more difficult to operate a residential mortgage origination business. Our revenue from the mortgage banking business was $100.7 million in 2018. This revenue could significantly decline in future periods if interest rates were to continue rising and the other risks highlighted in this paragraph were realized, which may adversely affect our profitability.
Our mortgage banking profitability could significantly decline if we are not able to originate and resell a high volume of mortgage loans and securities.
Mortgage production, especially refinancing activity, declines in rising interest rate environments. Our mortgage origination volume could be materially and adversely affected by rising interest rates. Moreover, when interest rates increase further, there can be no assurance that our mortgage production will continue at current levels. Further, nearly a third of our mortgage volume is through our consumer direct internet delivery channel, which targets national customers. As a result, loan originations through this channel are particularly susceptible to the interest rate environment and the national housing market. Because we sell a substantial portion of the mortgage loans we originate, the profitability of our mortgage banking business also depends in large part on our ability to aggregate a high volume of loans and sell them in the secondary market at a gain. In fact, as rates rise, we expect increasing industry-wide competitive pressures related to changing market conditions to reduce our pricing margins and mortgage revenues generally. If our level of mortgage production declines, our continued profitability will depend upon our ability to reduce our costs commensurate with the reduction of revenue from our mortgage operations. If we are unable to do so, our continued profitability may be materially and adversely affected.
We may incur costs, liabilities, fines and other sanctions if we fail to satisfy our mortgage loan servicing obligations.
We act as servicer for approximately $6.0 billion of mortgage loans owned by third parties as of December 31, 2018. As a servicer for those loans, we have certain contractual obligations to third parties. If we commit a material breach of our obligations as servicer, we may be subject to termination if the breach is not cured within a specified period of time following notice, causing us to lose servicing income. For certain investors and/or transactions, we may be contractually obligated to repurchase a mortgage loan or reimburse the investor for credit losses incurred on the loan as a remedy for origination errors with respect to the loan. If we have increased repurchase obligations because of claims that we did not satisfy our obligations as a servicer, or if we have increased loss severity on such repurchases, we may have a significant reduction to net servicing income within our mortgage banking noninterest income. In addition, we may be subject to fines and other sanctions imposed by federal or state regulators as a result of actual or perceived deficiencies in our foreclosure practices. Any of these actions may harm our reputation or negatively affect our residential lending or servicing business and, as a result, our profitability.
We may be required to repurchase mortgage loans or indemnify buyers against losses in some circumstances.
In 2018, we sold nearly all of the $6.15 billion of mortgage loans held for sale that we originated and purchased. When mortgage loans are sold, whether as whole loans or pursuant to a securitization, we are required to make customary representations and warranties to purchasers, guarantors and insurers about the mortgage loans and the manner in which they were originated. We may be required to repurchase or substitute mortgage loans, or indemnify buyers against losses, in the event we breach certain representations or warranties in connection with the sale of such loans. If repurchase and indemnity demands increase, such demands are valid claims and are in excess of our provision for potential losses, our liquidity, results of operations or financial condition may be materially and adversely affected.
We depend on third-party service providers in the operation of our business.
We depend on a third-party service providers in the operation of our business. In particular, we have engaged one such third party, Cenlar, to provide servicing of our mortgage loan business. In the event that this service provider, or any other third-party service provider that we may use in the future, fails to perform its servicing duties or performs those duties inadequately, we could experience a temporary interruption in collecting principal and interest on mortgage loans, sustain credit losses on our loans or incur additional costs to obtain a replacement servicer. There can be no assurance that a replacement servicer could be retained in a timely manner or at similar rates. Further, our servicing rights could be terminated or we may be required to repurchase mortgage loans or reimburse investors as a result of such failures of our third-party service providers, any of which could adversely affect our reputation, results of operations or financial condition.
We also receive core systems processing, essential web hosting and other Internet systems, deposit processing and other processing services from third-party service providers. If these third-party service providers experience difficulties, or terminate their services, and we are unable to replace them with other service providers, particularly on a timely basis, our operations could be interrupted. If an interruption were to continue for a significant period of time, our business, financial condition or results of operations could be adversely affected, perhaps materially. Even if we are able to replace third-party service providers, it may be at a higher cost to us, which could adversely affect our business, financial condition or results of operations.
Failure to timely and accurately implement changes to mortgage laws and regulations into our compliance processes could adversely affect our ability to mitigate certain risks and losses.
FirstBank must routinely implement changes to mortgage industry law and regulation into our mortgage business practices. Since the CFPB was created in 2011, even more drastic and frequent changes have occurred. In 2015, the CFPB enacted rules known as the TILA-RESPA Integrated Disclosure. This new set of rules consolidated and combined certain mortgage origination rules previously established separately under the Truth-in-Lending Act (TILA) and Real Estate Settlement Procedures Act (RESPA). Additionally, Congress amended the Home Mortgage Disclosure Act (HMDA) in 2010 and the CFPB finalized a rule implementing changes to HMDA in 2015. The rule’s provisions require that certain mortgage origination data be collected and reported on an accurate and timely basis. These new CFPB rules, among others, require personnel training, technological enhancements, and revisions to policies and procedures. In addition to these past and future CFPB regulations, FirstBank is subject to additional regulations and rules promulgated by other federal and local governing authorities and agencies including, HUD, FDIC, GNMA, Fannie Mae, and Freddie Mac, among others. We must also comply with many ever-changing federal and local consumer protection laws including in part, the Dodd-Frank Act, the Fair Credit Reporting Act, the Homeowner’s Protection Act, the Gramm-Leach-Bliley Act, the Servicemembers Civil Relief Act, the Fair Debt Collection Practices Act, the Telephone Consumer Protection Act, and the Equal Credit Opportunity Act. FirstBank’s response to and implementation of these laws and regulation that are already enacted and those to be enacted in the future, could materially increase our compliance expenses causing weakness to our overall financial condition.
Our risk management framework may not be effective in mitigating risks and/or losses to us.
Our risk management framework is comprised of various processes, systems and strategies, and is designed to manage the types of risk to which we are subject, including, among others, credit, market, liquidity, interest rate and compliance risks. Our framework also includes financial or other modeling methodologies that involve management assumptions and judgment. Our risk management framework may not be effective under all circumstances and may not adequately mitigate any risk or loss to us. If our framework is not effective, we could suffer unexpected losses and our business, financial condition, results of operations or prospects could be materially and adversely affected.
System failure or breaches of our network security, including as a result of cyber-attacks or data security breaches, could subject us to increased operating costs as well as litigation and other liabilities.
The computer systems and network infrastructure we use may be vulnerable to physical theft, fire, power loss, telecommunications failure or a similar catastrophic event, as well as security breaches, denial of service attacks, viruses, worms and other disruptive problems caused by hackers. Any damage or failure that causes breakdowns or disruptions in our client relationship management, general ledger, deposit, loan and other systems could damage our reputation, result in a loss of client business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on us.
Computer break-ins, phishing and other disruptions could also jeopardize the security of information stored in and transmitted through our computer systems and network infrastructure. Information security risks have generally increased in recent years in part because of the proliferation of new technologies, the use of the internet and telecommunications technologies to conduct financial transactions, and the increased sophistication and activities of organized crime, hackers, terrorists, and other external parties. Our operations rely on the secure processing, transmission and storage of confidential information in our computer systems and networks. Although we believe we have robust information security procedures and controls, our technologies, systems, networks, and our customers’ devices may become the target of cyber-attacks or information security breaches that could result in the unauthorized release, gathering, monitoring, misuse, loss or destruction of our or our customers’ confidential, proprietary and other information, or otherwise disrupt our or our customers’ business operations. As cyber threats continue to evolve, we may be required to expend significant additional resources to continue to modify or enhance our protective measures or to investigate and remediate any information security vulnerabilities.
We are under continuous threat of loss due to hacking and cyber-attacks especially as we continue to expand client capabilities to utilize internet and other remote channels to transact business. While we are not aware of any successful hacking or cyber-attacks into our computer or information technology systems, there can be no assurance that we will not be the victim of successful hacking or cyber-attacks in the future that could cause us to suffer material losses. The occurrence of any cyber-attack or information security breach could result in significant potential liabilities to customers and other third parties, reputational damage, the disruption of our operations and regulatory concerns, all of which could materially and adversely affect our business, financial condition or results of operations.
The financial services industry is undergoing rapid technological changes and, we may not have the resources to implement new technology to stay current with these changes.
The financial services industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services. In addition to better serving customers, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Our future success will depend in part upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy client demands for convenience as well as to provide secure electronic environments as we continue to grow and expand our market area. Many of our larger competitors have substantially greater resources to invest, and have invested significantly more than us, in technological improvements. As a result, they may be able to offer additional or more convenient products compared to those that we will be able to provide, which would put us at a competitive disadvantage. Accordingly, we may not be able to effectively implement new technology-driven products and services or be successful in marketing such products and services to our customers, which could impair our growth and profitability.
We are subject to certain operational risks, including, but not limited to, client or employee fraud.
Employee errors and employee and client misconduct could subject us to financial losses or regulatory sanctions and seriously harm our reputation. Misconduct by our employees could include hiding unauthorized activities from us, improper or unauthorized activities on behalf of our customers or improper use of confidential information. It is not always possible to prevent employee errors and misconduct, and the precautions we take to prevent and detect this activity may not be effective in all cases. Employee errors could also subject us to financial claims for negligence. We maintain a system of internal controls and insurance coverage to mitigate against these operational risks. If our internal controls fail to prevent or detect an occurrence, or if any resulting loss is not insured or exceeds applicable insurance limits, it could have a material adverse effect on our business, financial condition or results of operations.
In addition, we rely heavily upon information supplied by third parties, including the information contained in credit applications, property appraisals, title information, equipment pricing and valuation and employment and income documentation, in deciding which loans we will originate, as well as the terms of those loans. If any of the information upon which we rely is misrepresented, either fraudulently or inadvertently, and the misrepresentation is not detected prior to asset funding, the value of the asset may be significantly lower than expected, or we may fund a loan that we would not have funded or on terms we would not have extended.
Catastrophic events and disasters could negatively affect our local economies or disrupt our operations or result in other consequences which could have an adverse impact on our financial results or condition.
A significant portion of our business is located in the Southeast and includes areas which are susceptible to weather-related events such as tornadoes, floods, droughts, and fires. Such events can disrupt our operations, cause damage to our properties, and negatively affect the local economies in which we operate. The severity and impact of future natural disasters such as earthquakes, fires, hurricanes, tornadoes, droughts, floods, and other weather-related events are difficult to predict. While we maintain insurance covering many of these weather-related events, there is no insurance against the disruption that such a catastrophic event could cause in the markets that we serve, the resulting adverse impact on our borrowers’ ability to timely repay their loans, and/or the value of any collateral held by us.
In addition, geopolitical matters, including international trade disputes, political unrest, and slow growth in the global economy, as well as acts of terrorism, war, and other violence could result in disruptions in the financial markets or the markets that we serve. These negative events could have a material adverse effect on our results of operations or financial condition and may affect our ability to access capital.
We may need to raise additional capital in the future.
We are required to meet certain regulatory capital requirements and maintain sufficient liquidity. We may need to raise additional capital in the future to provide us with sufficient capital resources and liquidity to meet our commitments and business needs, which could include the possibility of financing acquisitions. Our ability to raise additional capital depends on conditions in the capital markets, economic conditions and a number of other factors, including investor perceptions regarding the banking industry, market conditions, governmental activities, and our financial condition and performance. Accordingly, we may be unable to raise additional capital if needed or on terms acceptable to us. Further, such additional capital could result in dilution to our existing shareholders. If we fail to maintain capital to meet regulatory requirements, our financial condition, liquidity, results of operations, as well as our ability to maintain compliance with regulatory capital requirements, would be materially and adversely affected.
Our FDIC deposit insurance premiums and assessments may increase.
Our deposits are insured by the FDIC up to legal limits and, accordingly, subjects us to the payment of FDIC deposit insurance premiums and assessments. High levels of bank failures since the financial crisis and increases in the statutory deposit insurance limits have increased resolution costs to the FDIC and put significant pressure on the Deposit Insurance Fund. In
order to maintain a strong funding position and restore the reserve ratios of the Deposit Insurance Fund following the financial crisis, the FDIC increased deposit insurance assessment rates and charged special assessments to all FDIC-insured financial institutions. Further increases in assessment rates or special assessments may occur in the future, especially if there are significant additional failures of financial institutions. Any future special assessments, increases in assessment rates or required prepayments in FDIC insurance premiums could reduce our profitability or limit our ability to pursue certain business opportunities, which could have a material adverse effect on our assets, business, cash flow, condition (financial or otherwise), liquidity, prospects or results of operations.
Our financial condition may be affected negatively by the costs of litigation.
We may be involved from time to time in a variety of litigation, investigations or similar matters arising out of our business. From time to time, and particularly during periods of economic stress, customers may make claims or otherwise take legal action pertaining to performance of our responsibilities. These claims are often referred to as “lender liability” claims. Whether customer claims and legal action related to the performance of our responsibilities are founded or unfounded, if such claims and legal actions are not resolved in a favorable manner, they may result in significant financial liability and/or adversely affect our market perception, products and services, as well as potentially affecting customer demand for those products and services. In many cases, we may seek reimbursement from our insurance carriers to cover such costs and expenses. Our insurance may not cover all claims that may be asserted against us, and any claims asserted against us, regardless of merit or eventual outcome, may harm our reputation. Should the ultimate judgments or settlements in any litigation or investigation significantly exceed our insurance coverage, they could have a material adverse effect on our business, financial condition or results of operations.
Prior to our initial public offering, we were treated as an S-corporation, and claims of taxing authorities or our former sole shareholder related to our prior status as an S-corporation, could harm us.
Prior to our initial public offering, we were an S-corporation for U.S. federal income tax purposes. While we were an S-corporation, Mr. Ayers, our sole shareholder at the time, was taxed on our income. Following our initial public offering in 2016, our status as an S-corporation was terminated and we became a “C-corporation” under the provisions of the Internal Revenue Code. If the unaudited, open tax years in which we were an S-corporation are audited by the Internal Revenue Service (the “IRS”) and we are determined not to have qualified for, or to have violated, our S-corporation status, we will be obligated to pay back tax, interest and penalties. The amounts that we would be obligated to pay could include tax on all of our taxable income while we were an S-corporation. Any such claims could result in additional costs to us and could have a material adverse effect on our results of operations or financial condition.
In addition, in the event of an adjustment to our reported taxable income for periods prior to termination of our S-corporation status, it is possible that Mr. Ayers would be liable for additional income taxes for those prior periods. Therefore, we entered into a tax sharing agreement with Mr. Ayers. Pursuant to this agreement, upon our filing any tax return (amended or otherwise), in the event of any restatement of our taxable income or pursuant to a determination by, or a settlement with, a taxing authority, for any period during which we were an S-corporation, we may be required to make a payment to Mr. Ayers in an amount equal to Mr. Ayers’ incremental tax liability. In addition, we have agreed to indemnify Mr. Ayers with respect to unpaid income tax liabilities to the extent that such unpaid income tax liabilities are attributable to an adjustment to our taxable income for any period after our S-corporation status terminates. In both cases the amount of the payment will be based on the assumption that Mr. Ayers is taxed at the highest rate applicable to individuals for the relevant periods. We will also indemnify Mr. Ayers for any interest, penalties, losses, costs or expenses arising out of any claim under the agreement. Any such payments to or on behalf of Mr. Ayers would result in additional costs to us and could have a material adverse effect on our results of operations or financial condition.
We could be subject to environmental risks and associated costs on our other real estate owned assets.
A significant portion of our loan portfolio is comprised of loans collateralized by real estate. There is a risk that hazardous or toxic waste could be discovered on the properties that secure our loans. If we acquire such properties as a result of foreclosure, we could be held responsible for the cost of cleaning up or removing this waste, and this cost could exceed the value of the underlying properties and materially and adversely affect us.
We could be required to write down goodwill and other intangible assets.
At December 31, 2018, our goodwill and other identifiable intangible assets were $148.8 million. Under current accounting standards, if we determine goodwill or intangible assets are impaired because, for example, the acquired business does not meet projected revenue targets or certain key employees leave, we are required to write down the carrying value of these assets. We conduct a review at least annually to determine whether goodwill is impaired. Our goodwill impairment evaluation indicated no impairment of goodwill for our reporting segments. We cannot provide assurance, however, that we will not be required to take an impairment charge in the future. Any impairment charge would have an adverse effect on our shareholders' equity and financial results and could cause a decline in our stock price.
Risks related to our regulatory environment
The Dodd-Frank Act and related rules and regulations may adversely affect our business, financial condition or results of operations.
The Dodd-Frank Act contains a variety of far-reaching changes and reforms for the financial services industry and directs federal regulatory agencies to study the effects of, and issue implementing regulations for, these reforms. Many of the provisions of the Dodd-Frank Act could have a direct effect on our performance and, in some cases, impact our ability to conduct business. Examples of these provisions include, but are not limited to:
•
Increased capital requirements and changes to the quality of capital required to be held by banking organizations;
•
Changes to deposit insurance assessments;
•
Regulation of proprietary trading;
•
Repeal of the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts;
•
Establishment of the Consumer Financial Protection Bureau (the "CFPB") with broad authority to implement new consumer protection regulations and, for banks with $10 billion or more in assets, to examine and enforce compliance with federal consumer laws;
•
Implementation of risk retention rules for loans (excluding qualified residential mortgages) that are sold by a bank;
•
Regulation of debit-card interchange fees; and
•
Regulation of lending and the requirements for "qualified mortgages", "qualified residential mortgages" and the assessment of "ability to repay" requirements.
Many of these provisions have already been the subject of proposed and final rules by regulatory authorities. Many other provisions, however, remain subject to regulatory rulemaking and implementation, the effects of which are not yet known. The provisions of the Dodd-Frank Act and any rules adopted to implement those provisions as well as any additional legislative or regulatory changes may impact the profitability of our business, require that we change certain of our business practices, materially affect our business model or affect retention of key personnel, require us to raise additional capital and expose us to additional costs (including increased compliance costs). These and other changes may also require us to invest significant management attention and resources to make any necessary changes and may adversely affect our ability to conduct our business as previously conducted or our financial condition or results of operations.
Monetary policies and economic factors may limit our ability to attract deposits or make loans.
The monetary policies of federal regulatory authorities, particularly the Federal Reserve, and economic conditions in our service area and the United States generally, affect our ability to attract deposits and extend loans. We cannot predict either the nature or timing of any changes in these monetary policies and economic conditions, including the Federal Reserve’s interest rate policies, or their impact on our financial performance. Adverse conditions in the economic environment could also lead to a potential decline in deposits and demand for loans, which could have a material and adverse effect on our financial condition, results of operations or cash flows.
As the parent company of FirstBank, the Federal Reserve may require us to commit capital resources to support the Bank.
The Federal Reserve requires us to act as a source of strength to the Bank and to commit capital and financial resources to support the Bank. This support may be required at times when we might otherwise determine not to provide it. In addition, if we commit to a federal bank regulator that we will maintain the capital of the Bank, whether in response to the Federal Reserve’s invoking its source-of-strength authority or in response to other regulatory measures, that commitment will be assumed by a bankruptcy trustee and, as a result, the Bank will be entitled to priority payment in respect of that commitment, ahead of our other creditors. Thus, any borrowing that must be done by us in order to support the Bank may adversely impact our cash flow, financial condition, results of operations or prospects.
Federal and state regulators periodically examine our business and may require us to remediate adverse examination findings or may take enforcement action against us.
The Federal Reserve, the FDIC and the TDFI periodically examine our business, including our compliance with laws and regulations. If, as a result of an examination, the Federal Reserve or the TDFI were to determine that our financial condition, capital resources, asset quality, earnings prospects, management, liquidity or other aspects of any of our operations had become unsatisfactory, or that we were in violation of any law or regulation, they may take a number of different remedial actions as they deem appropriate. These actions may include the power to require us to remediate any such adverse examination findings.
In addition, these agencies have the power to take enforcement action against us to enjoin “unsafe or unsound” practices, to require affirmative action to correct any conditions resulting from any violation of law or regulation or unsafe or unsound practice, to issue an administrative order that can be judicially enforced, to direct an increase in our capital, to direct the sale of subsidiaries or other assets, to limit dividends and distributions, to restrict our growth, to assess civil monetary penalties against us or our officers or directors, to remove officers and directors or, if it is concluded that such conditions cannot be corrected or there is an imminent risk of loss to depositors, to terminate our deposit insurance and place us into receivership or conservatorship. Any regulatory enforcement action against us could have a material adverse effect on our assets, business, cash flow, condition (financial or otherwise), liquidity, prospects or results of operations.
Federal, state and local consumer lending laws may restrict our ability to originate certain mortgage loans or increase our risk of liability with respect to such loans and could increase our cost of doing business.
Federal, state and local laws and regulations have been adopted that are intended to eliminate certain lending practices considered “predatory.” The origination of loans with certain terms and conditions and that otherwise meet the definition of a “qualified mortgage” may protect us from liability to a borrower for failing to make the necessary determinations. In either case, we may find it necessary to tighten our mortgage loan underwriting standards in response to applicable regulations, which may constrain our ability to make loans consistent with our business strategies. It is our policy not to make predatory loans and to determine borrowers’ ability to repay, but the law and related rules create the potential for increased liability with respect to our lending and loan investment activities. They increase our cost of doing business and, ultimately, may prevent us from making certain loans and cause us to reduce the average percentage rate or the points and fees on loans that we do make, which in turn could have a material adverse effect on our business, cash flow, condition (financial or otherwise), liquidity, prospects or results of operations.
We are subject to numerous fair lending laws designed to protect consumers and failure to comply with these laws could lead to a wide variety of sanctions.
The Equal Credit Opportunity Act, the Fair Housing Act and other fair lending laws and regulations prohibit discriminatory lending practices by financial institutions. The U.S. Department of Justice, federal banking agencies and other federal agencies are responsible for enforcing these laws and regulations. A successful regulatory challenge to an institution’s compliance with fair lending laws and regulations could result in a wide variety of sanctions, including damages and civil money penalties, injunctive relief, restrictions on mergers and acquisitions, restrictions on expansion and restrictions on entering new lines of business. Private parties may also have the ability to challenge an institution’s performance under
fair lending laws in private class action litigation. Such actions could have a material adverse effect on our assets, business, cash flow, condition (financial or otherwise), liquidity, prospects or results of operations.
We could face a risk of noncompliance and enforcement action with the Bank Secrecy Act of 1970 (the “Bank Secrecy Act”) and other anti-money laundering statutes and regulations.
The Bank Secrecy Act, the USA PATRIOT Act and other laws and regulations require financial institutions, among other duties, to institute and maintain effective anti-money laundering programs and file suspicious activity and currency transaction reports as appropriate. The Financial Crimes Enforcement Network, established by the U.S. Department of the Treasury to administer the Bank Secrecy Act, is authorized to impose significant civil money penalties for violations of those requirements and engages in coordinated enforcement efforts with the individual federal banking regulators, as well as the U.S. Department of Justice, Drug Enforcement Administration and IRS. There is also increased scrutiny of compliance with the rules enforced by the Office of Foreign Assets Control related to U.S. sanctions regimes. If our policies, procedures and systems are deemed deficient or the policies, procedures and systems of the financial institutions that we have already acquired or may acquire in the future are deficient, we would be subject to liability, including fines and regulatory actions such as restrictions on our ability to pay dividends and the necessity to obtain regulatory approvals to proceed with certain aspects of our business plan, including our acquisition plans, which would negatively impact our business, financial condition or results of operations. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us, which could in turn have a material adverse effect on our business.
Risks related to our common stock
We have a shareholder who owns a significant portion of our stock and that shareholders' interests in our business may be different than our other shareholders.
Mr. Ayers, our Executive Chairman, currently owns approximately 44% of our common stock. Further, Mr. Ayers has the right under the shareholder's agreement, by and between the Company and Mr. Ayers and entered into in connection with the Company's initial public offering, to designate up to 40% of our directors and at least one member of the nominating and compensation committees of our board of directors for so long as permitted under applicable law. So long as Mr. Ayers continues to own a significant portion of our common stock, he will have the ability to significantly influence the vote in any election of directors and will have the ability to significantly influence a vote regarding a transaction that requires shareholder
approval regardless of whether others believe the transaction is in our best interests. In any of these matters, the interests of Mr. Ayers may differ from or conflict with the interests of our other shareholders. Moreover, this concentration of stock ownership may also adversely affect the trading price of our common stock to the extent investors perceive disadvantages in owning stock of a company with a significant shareholder.
Our corporate organization documents contain certain provisions that could have an anti-takeover effect and may delay, make more difficult or prevent an attempted acquisition of us that our shareholders may favor.
Our governing documents and certain agreements to which we are a party contain provisions that make a change-in-control difficult to accomplish, and may discourage a potential acquirer. These include a provision that directors cannot be removed except for cause and a provision that requires the affirmative vote of eighty percent (80%) of the shares outstanding to amend certain provisions of our charter. These anti-takeover provisions may have an adverse effect on the market for our common stock.
We have the ability to incur debt and pledge our assets, including our stock in the Bank, to secure that debt.
Absent special and unusual circumstances, a holder of any indebtedness for borrowed money has rights that are superior to those of holders of any common stock. For example, interest must be paid to the lender before dividends can be paid to any shareholders, and loans must be paid off before any assets can be distributed to any shareholders if we were to liquidate. Further, we would have to make principal and interest payments on our indebtedness, which could reduce our profitability or result in net losses on a consolidated basis even if the Bank were profitable.
The price of our common stock could be volatile.
The market price of our common stock may be volatile and could be subject to wide fluctuations in price in response to various factors, some of which are beyond our control. In addition, if the market for stocks in our industry, or the stock market in general, experiences a loss of investor confidence, the trading price of our common stock could decline for reasons unrelated to our business, financial condition or results of operations. If any of the foregoing occurs, it could cause our stock price to fall and may expose us to lawsuits that, even if unsuccessful, could be costly to defend and a distraction to management which could materially adversely affect our business, financial condition or results of operations.
Future sales of our common stock or securities convertible into our common stock may dilute our shareholders’ ownership in us and may adversely affect us or the market price of our common stock.
We are generally not restricted from issuing additional shares of our common stock up to the authorized number of shares set forth in our charter. We may issue additional shares of our common stock or securities convertible into our common stock in the future pursuant to current or future employee stock option plans, employee stock grants, upon exercise of warrants or in connection with future acquisitions or financings. In addition, Mr. Ayers has registration rights that allow him to sell additional shares of common stock in subsequent offerings. We cannot predict the size of any such future issuances or the effect, if any, that any such future issuances will have on the trading price of our common stock. Any such future issuances of shares of our common stock or securities convertible into common stock may have a dilutive effect on the holders of our common stock and could have a material negative effect on the trading price of our common stock.
Future sales of our common stock in the public market could lower our share price, and any additional capital raised by us through the sale of equity or convertible debt securities may dilute our shareholders ownership in us and may adversely affect us or the market price of our common stock.
We or Mr. Ayers, may sell additional shares of common stock in subsequent public offerings. We may also issue additional shares of common stock or convertible securities to finance future acquisitions. We cannot predict the size of future issuances of our common stock or the effect, if any, that future issuances and sales of our common stock will have on the market price of our common stock. Sales of substantial amounts of our common stock (including sales that may occur pursuant to registration rights and shares that may be issued in connection with acquisitions), or the perception that such sales could occur, may adversely affect prevailing market prices for our common stock.
Applicable laws and regulations restrict both the ability of the Bank to pay dividends to us and our ability to pay dividends to our shareholders.
We and the Bank are subject to various regulatory restrictions relating to the payment of dividends. In addition, the Federal Reserve has the authority to prohibit bank holding companies from engaging in unsafe or unsound practices in conducting their business. These federal and state laws, regulations and policies are described in greater detail in “Business: Supervision and regulation: Bank regulation: Bank dividends” and “Business: Supervision and regulation: Holding company regulation: Restriction on bank holding company dividends,” and generally consider previous results and net income, capital needs, asset quality, existence of enforcement or remediation proceedings, and overall financial condition in determining whether a dividend payment is appropriate. For the foreseeable future, the majority, if not all, of our revenue will be from any dividends paid to us by the Bank. Accordingly, our ability to pay dividends also depends on the ability of the Bank to pay dividends to us. Further, the present and future dividend policy of the Bank is subject to the discretion of its board of directors. We cannot
guarantee that we or the Bank will be permitted by financial condition or applicable regulatory restrictions to pay dividends, that the board of directors of the Bank will elect to pay dividends to us, or the timing or amount of any dividend actually paid. See “Dividend policy.” If we do not pay dividends, market perceptions of our common stock may be adversely affected, which could in turn create downward pressure on our stock price.
We are an emerging growth company, and we cannot be certain if the reduced disclosure requirements applicable to emerging growth companies will make our common stock less attractive to investors.
We are an “emerging growth company,” as defined in the JOBS Act, and we intend to take advantage of certain exemptions from various regulatory and reporting requirements that are applicable to public companies that are emerging growth companies, including, but not limited to, exemptions from being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved. In addition, even if we comply with the greater obligations of public companies that are not emerging growth companies, we may avail ourselves of the reduced requirements applicable to emerging growth companies from time to time in the future, so long as we are an emerging growth company. We will remain an emerging growth company for up to five years, though we will cease to be an emerging growth company earlier if we have more than $1 billion in annual gross revenues, have more than $700 million in market value of our common stock held by non-affiliates, or issue more than $1 billion of non-convertible debt in a three-year period. Investors and securities analysts may find it more difficult to evaluate our common
stock because we will rely on one or more of these exemptions and, as a result, investor confidence or the market price of our common stock may be materially and adversely affected.
Securities that we issue, including our common stock, are not FDIC insured.
Securities that we issue, including our common stock, are not savings or deposit accounts or other obligations of any bank, insured by the FDIC, any other governmental agency or instrumentality, or any private insurer, and are subject to investment risk, including the possible loss of our shareholders’ investments.
ITEM 1B
ITEM 1B - Unresolved Staff Comments
None.
ITEM 2
ITEM 2 - Properties
Our principal executive offices and FirstBank’s main office are located at 211 Commerce Street, Suite 300, Nashville, Tennessee 37201. We currently operate 56 full-service bank branches and 9 other banking locations throughout our geographic market areas as well as 19 mortgage offices throughout the southeastern United States. We have banking locations in the metropolitan markets of Nashville, Chattanooga, Knoxville, Memphis, Jackson, Tennessee and Huntsville, Alabama in addition to 12 community markets. See “ITEM 1. Business - Our Markets” for more detail. We own 44 of these banking locations and lease our other banking locations, nearly all of our mortgage offices and our principal executive office. We believe that our offices and banking locations are in good condition, are suitable to our needs and, for the most part, are relatively new or refurbished.
ITEM 3
ITEM 3 - Legal Proceedings
Various legal proceedings to which FB Financial Corporation or a subsidiary of FB Financial Corporation is party arise from time to time in the normal course of business. As of the date hereof, there are no material pending legal proceedings to which FB Financial Corporation or any of its subsidiaries is a party or of which any of its or its subsidiaries' assets or properties are subject.
ITEM 4
ITEM 4 - Mine Safety Disclosures
Not applicable.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
PART II
ITEM 5.
ITEM 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Market Information and Holders of Record
FB Financial Corporation's common stock is traded on the New York Stock Exchange under the symbol "FBK" and has traded on that market since September 16, 2016.
The Company had approximately 739 stockholders of record as of March 5, 2019. A substantially greater number of holders of FBK common stock are "street name" or beneficial holders, whose shares of record are held by banks, brokers, and other financial institutions.
Stock Performance Graph
The performance graph and table below compares the cumulative total stockholder return on the common stock of the Company with the cumulative total return on the equity securities included in the Standard & Poor’s 500 Index (S&P 500), which reflects overall stock market performance and the S&P 500 Bank Industry Group, which is a GICS Level 2 industry group consisting of 19 regional and national publicly traded banks. The graph assumes an initial $100 investment on December 29, 2017 through December 31, 2018. Data for the S&P 500 and S&P 500 Bank Industry Group assumes reinvestment of dividends. Returns are shown on a total return basis. The performance graph represents past performance and should not be considered to be an indication of future performance. The information in this paragraph and the following stock performance graph shall not be deemed to be “soliciting material” or to be “filed” with the SEC or subject to Regulation 14A or 14C, other than as provided in Item 201 of Regulation S-K, or to the liabilities of Section 18 of the Exchange Act, except to the extent that we specifically request that such information be treated as soliciting material or specifically incorporate it by reference into a filing under the Securities Act or the Exchange Act.
Source: S&P Global Market Intelligence
Dividends
Prior to our initial public offering, we were an S corporation for U.S. federal income tax purposes. As an S Corporation, we historically made distributions to our sole shareholder to provide him with funds to pay U.S. federal income tax on our taxable income that was “passed through” to him. We also historically paid additional dividends to our shareholder as a return on his investment from time to time. Following our initial public offering and after our conversion to a C corporation, our dividend policy and practice changed, and we elected to retain earnings to fund the development and growth of our business. As such, no dividends were paid to holders of our common stock through the first quarter of 2018. During the second quarter of 2018, our board of directors declared a dividend on our common stock for the first time as a public company and each subsequent quarter in 2018. Our dividend declarations have also been applicable to outstanding restricted stock units and related cash distributions are made when the underlying units vest. Additionally, subsequent to December 31, 2018, our board of directors declared a dividend of $0.08 per share to shareholders of record as of February 1, 2019 payable February 15, 2019.
Any future determination or policy changes relating to our dividend policy will be made by our board of directors and will depend on a number of factors, including general and economic conditions, industry standards, our financial condition and operating results, our available cash and current and anticipated cash needs, capital requirements, banking regulations, contractual, legal, tax and regulatory restrictions and implications on the payment of dividends by us to our shareholders or by the Bank to us, and such other factors as our board of directors may deem relevant.
The following table shows the dividends that have been declared on our common stock with respect to the periods indicated below. Per share amounts are presented to the nearest cent.
As a bank holding company, any dividends paid by us are subject to various federal and state regulatory limitations and also may be subject to the ability of the Bank to make distributions or pay dividends to us. The Bank is also subject to various legal, regulatory and other restrictions on its ability to pay dividends and make other distributions and payments to us. Our ability to pay dividends is limited by minimum capital and other requirements prescribed by law and regulation. Furthermore, we are generally prohibited under Tennessee corporate law from making a distribution to a shareholder to the extent that, at the time of the distribution, after giving effect to the distribution, we would not be able to pay our debts as they become due in the usual course of business or our total assets would be less than the sum of its total liabilities plus (unless the charter permits otherwise) the amount that would be needed, if we were to be dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution of any shareholders who may have preferential rights superior to those receiving the distribution. In addition, financing arrangements that we may enter into in the future may include restrictive covenants that may limit our ability to pay dividends.
Stock Repurchase Program
On October 22, 2018, the Company announced that its board of directors authorized a stock repurchase program pursuant to which the Company may purchase up to $50.0 million in shares of the Company's issued and outstanding common stock (the "Program"). The Program will terminate either on the date on which the maximum dollar amount is repurchased under the Program or October 22, 2019, whichever date occurs earlier. The Program will be conducted pursuant to a written plan and is intended to comply with Rule 10b-18 promulgated under the Exchange Act. As of December 31, 2018, the Company has yet to repurchase any shares under the program.
Sale of Equity Securities and Use of Proceeds
Initial Public Offering
On September 15, 2016, our registration statement on Form S-1 (Registration No. 333-213210) was declared effective by the SEC for our underwritten initial public offering in which we sold a total of 6,764,704 shares of our common stock at a price to the public of $19.00 per share. J.P. Morgan Securities LLC, UBS Securities LLC, and Keefe, Bruyette & Woods, Inc., acted as the joint book-running managers for the offering, and Raymond James & Associates, Inc., Sandler O’Neill & Partners, L.P., and Stephens Inc. acted as co-managers.
The offering commenced on September 15, 2016 and closed on September 21, 2016. All of the shares registered pursuant to the registration statement were sold at an aggregate offering price of $128.5 million. We received net proceeds of approximately $115.5 million after deducting underwriting discounts and commissions of $9.0 million and other offering expenses of $4.0 million. No payments with respect to expenses were made by us to directors, officers or persons owning ten percent or more of either class of our common stock or to their associates, or to our affiliates. However, $55.0 million of the net proceeds from the offering were used to fund a cash distribution to James W. Ayers, our former majority shareholder and executive chairman, which was intended to be non-taxable to Mr. Ayers, and $10.1 million of the net proceeds from the offering were used to fund the repayment of all amounts outstanding under our subordinated notes held by Mr. Ayers. During the third quarter of 2017, a portion was used to fund the merger with the Clayton Banks and to fund cash dividends paid to shareholders during the year ended December 31, 2018. Remaining proceeds may be used to fund additional future dividends or acquisitions or for general business purposes.
Private Placement
As previously reported in our Current Report on Form 8-K that was filed with the SEC on May 26, 2017, we sold 4,806,710 shares of our common stock (the “Private Placement Shares”) to accredited investors in a private placement that closed on June 1, 2017. We received net proceeds of approximately $152.7 million from the sale of the Private Placement Shares after deducting placement agent fees of approximately $5.5 million and other offering expenses of approximately $0.4 million. The net proceeds were used to fund a portion of the payment of approximately $184.2 million cash consideration to Clayton HC, Inc. in connection with our acquisition of Clayton Bank and Trust and American City Bank, which closed on July 31, 2017. The Private Placement Shares were originally issued in reliance on the exemption from registration in Section 4(a)(2) of the Securities Act and Regulation D promulgated under the Securities Act.
ITEM 6
ITEM 6 - Selected Financial Data
The following selected historical consolidated financial data of the Company should be read in conjunction with, and are qualified by reference to, “Management’s discussion and analysis of financial condition and results of operations” and the consolidated financial statements and notes thereto included elsewhere herein. Our historical results for any prior period are not necessarily indicative of results to be expected in any future period.
(1)
Book value per share equals our total shareholders’ equity as of the date presented divided by the number of shares of our common stock outstanding as of the date presented. The number of shares of our common stock outstanding was 30,724,532, 30,535,517 and 24,107,660 as of December 31, 2018, 2017, and 2016 respectively, and 17,180,000 as of December 31, 2015 and 2014.
(2)
We have calculated our return on average assets and return on average equity for a period by dividing net income for that period by our average assets and average equity, as the case may be, for that period. We have calculated our pro forma return on average assets and pro forma return on average equity for a period by calculating our pro forma net income for that period as described in footnote 4 below and dividing that by our average assets and average equity, as the case be, for that period. We calculate our average assets and average equity for a period by dividing the sum of our total asset balance or total stockholder’s equity balance, as the case may be, as of the close of business on each day in the relevant period and dividing by the number of days in the period.
(3)
We calculate our risk-weighted assets using the standardized method of the Basel III Framework as of December 31, 2018, 2017, 2016 and 2015 and the Basel II Framework for all previous periods, as implemented by the Federal Reserve and the FDIC.
(4)
We have calculated our pro forma net income, pro forma net income per share, pro forma returns on average assets and pro forma return on average equity for each period shown by calculating a pro forma provision for federal income tax using a combined effective income tax rate of 36.75%, 35.08% and 35.63% for the years ended December 31, 2016, 2015 and 2014, respectively, and adjusting our historical net income for each period to give effect to the pro forma provision for U.S. federal income tax for such period.
(5)
These measures are not measures recognized under generally accepted accounting principles (United States) (“GAAP”), and are therefore considered to be non-GAAP financial measures. See “GAAP reconciliation and management explanation of non-GAAP financial measures” for a reconciliation of these measures to their most comparable GAAP measures.
GAAP reconciliation and management explanation of non-GAAP financial measures
We identify certain financial measures discussed in this Report as being "non-GAAP financial measures." The non-GAAP financial measures presented in this Report are adjusted efficiency ratio (tax equivalent basis), tangible book value per common share, tangible common equity to tangible assets and return on average tangible equity.
In accordance with the SEC's rules, we classify a financial measure as being a non-GAAP financial measure if that financial measure excludes or includes amounts, or is subject to adjustments that have the effect of excluding or including amounts, that are included or excluded, as the case may be, in the most directly comparable measure calculated and presented in accordance with GAAP as in effect from time to time in the United States in our statements of income, balance sheets or statements of cash flows.
The non-GAAP financial measures that we discuss in this Report should not be considered in isolation or as a substitute for the most directly comparable or other financial measures calculated in accordance with GAAP. Moreover, the manner in which we calculate the non-GAAP financial measures that we discuss in our selected historical consolidated financial data may differ from that of other companies reporting measures with similar names. You should understand how such other banking organizations calculate their financial measures similar or with names similar to the non-GAAP financial measures we have discussed in our selected historical consolidated financial data when comparing such non-GAAP financial measures. The following reconciliation tables provide a more detailed analysis of these, and reconciliation for, each of non-GAAP financial measures.
Adjusted efficiency ratio (tax equivalent basis)
The adjusted efficiency ratio (tax equivalent basis) is a non-GAAP measure that excludes certain gains (losses), merger and offering-related expenses and other selected items. Our management uses this measure in its analysis of our performance. Our management believes this measure provides a greater understanding of ongoing operations and enhances comparability
of results with prior periods, as well as demonstrates the effects of significant gains and charges. The most directly comparable financial measure calculated in accordance with GAAP is the efficiency ratio.
The following table presents, as of the dates set forth below, a reconciliation of our adjusted efficiency ratio (tax-equivalent basis) to our efficiency ratio:
Tangible book value per common share and tangible common equity to tangible assets
Tangible book value per common share and tangible common equity to tangible assets are non-GAAP measures that exclude the impact of goodwill and other intangibles used by the Company’s management to evaluate capital adequacy. Because intangible assets such as goodwill and other intangibles vary extensively from company to company, we believe that the presentation of this information allows investors to more easily compare the Company’s capital position to other companies. The most directly comparable financial measure calculated in accordance with GAAP is book value per common share and our total shareholders’ equity to total assets.
The following table presents, as of the dates set forth below, tangible common equity compared with total shareholders’ equity, tangible book value per common share compared with our book value per common share and common equity to tangible assets compared to total shareholders’ equity to total assets:
Return on average tangible common equity
Return on average tangible common equity is a non-GAAP measure that uses average shareholders' equity and excludes the impact of goodwill and other intangibles. This measurement is also used by the Company's management to evaluate capital adequacy. The following table presents, as of the dates set forth below, reconciliations of total average tangible common equity to average shareholders' equity and return on average tangible common equity to return on average
shareholders equity:
ITEM 7
ITEM 7 - Management’s discussion and analysis of financial condition and results of operations
The following is a discussion of our financial condition at December 31, 2018 and 2017 and our results of operations for each of the three years in the three year period ended December 31, 2018, and should be read in conjunction with our audited consolidated financial statements included elsewhere herein. This discussion and analysis contains forward-looking statements that are subject to certain risks and uncertainties and are based on certain assumptions that we believe are reasonable but may prove to be inaccurate. Certain risks, uncertainties and other factors, including those set forth in the “Cautionary note regarding forward-looking statements” and “Risk Factors” sections of this Annual Report, may cause actual results to differ materially from those projected results discussed in the forward-looking statements appearing in this discussion and analysis. We assume no obligation to update any of these forward-looking statements.
Critical accounting policies
Our financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and general practices within the banking industry. Within our financial statements, certain financial information contain approximate measurements of financial effects of transactions and impacts at the consolidated balance sheet dates and our results of operations for the reporting periods. We monitor the status of proposed and newly issued accounting standards to evaluate the impact on our financial condition and results of operations. Our accounting policies, including the impact of newly issued accounting standards, are discussed in further detail in Note 1, “Summary of Significant Accounting Policies,” in the notes to our consolidated financial statements. The following discussion presents some of the more significant judgments and estimates used in preparing our financial statements.
Allowance for loan losses
The allowance for loan losses is established through a provision for loan losses charged to expense. Management periodically reviews the allowance for loan losses. Loans are charged against the allowance for loan losses when management believes that the collectability of principal is unlikely. Recoveries of amounts previously charged off are credited to the allowance. In the event management concludes that the allowance for loan losses is more than adequate to absorb potential loan losses, a reverse provision may be recorded whereby a credit is made to the expense account.
The allowance for loan losses is maintained at a level that management considers adequate to absorb probable incurred credit losses on outstanding loans. Factors considered in management’s evaluation of the adequacy of the allowance are current and anticipated economic conditions, previous loan loss experience, changes in the nature, volume and composition of the loan portfolio, industry or other concentrations of credit, review of specific problem loans, the level of classified and nonperforming loans, the results of regulatory examinations, the estimated fair value of underlying collateral and overall quality of the loan portfolio. The allowance consists of specific and general components. The specific component relates to loans that are classified as impaired. For such loans, an allowance is established when the discounted cash flows or the collateral value, less estimated selling costs, of the impaired loan is lower than the carrying value of that loan. The general component covers non-impaired loans and is based on historical loss experience with the overall level, adjusted for qualitative, economic and other factors impacting the future collectability of the loan portfolio.
Certain loans acquired in acquisitions or mergers are accounted for under ASC 310-30 “Loans and Debt Securities Acquired with Deteriorated Credit Quality,” which prohibits the carryover of an allowance for loan losses for loans acquired in which the acquirer concludes that it will not collect the contractual amount. As a result, these loans are carried at values which represent management’s estimate of the future cash flows of these loans. Increases in expected cash flows to be collected from the contractual cash flows are required to be recognized as an adjustment to the loan’s yield over its remaining life, while decreases in expected cash flows are required to be recognized as impairment charges to the provision for loan losses.
Fair Value Measurements
A hierarchical disclosure framework associated with the level of pricing observability is utilized in measuring financial instruments at fair value. See Note 17 "Fair Value" in the consolidated financial statements herein for additional disclosures regarding the fair value of our assets and liabilities, including a description of the fair value hierarchy.
Impaired loans and other real estate owned
Impaired loans and foreclosed assets may be measured and carried at fair value, the determination of which requires management to make assumptions, estimates and judgments. When a loan is considered individually impaired, the loan is carried on a net basis at the present value of estimated future cash flow using the loan's existing rate or at the fair value of the collateral if repayment is expected from the collateral through either a specific valuation allowance or a charge-off. Additionally, other real estate owned (“OREO”) includes real estate acquired through, or in lieu of, loan foreclosure and excess
land and facilities held for sale. OREO is initially recorded at fair value less the estimated cost to sell at the date of foreclosure which may establish a new cost basis. After foreclosure, valuations are periodically performed by management and the asset is carried at the lower of carrying amount or fair value less costs to sell. Revenue and expenses from operations are included in other noninterest income and noninterest expenses. Losses due to the valuation of the property are included in loss on sales or write-downs of other real estate owned.
Investment securities
Debt securities are classified as held to maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity. Debt securities are classified as available-for-sale when they might be sold before maturity. Securities available-for-sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income (loss), net of applicable taxes. Gains and losses on sales are recorded on the trade date and determined using the specific identification method as no ready market exists for this stock and it has no quoted market value.
In periods prior to 2018, equity securities were classified as available-for-sale. As such, equity securities were carried at fair value, with unrealized holding gains and losses reported in other comprehensive income (loss), net of applicable taxes.
As of January 1, 2018, the Company adopted ASU 2016-01, "Recognition and Measurement of Financial Assets and Liabilities" requiring that equity securities with readily determinable fair values be carried at fair value on the balance sheet with any periodic changes in value adjusted through the income statement. The change in accounting policy resulted in a one-time adjustment to retained earnings for the after-tax decrease in fair value below book value at January 1, 2018 and a reclassification of certain investments that did not meet the definition of equity securities with readily determinable fair values to other assets. These other investments are carried at cost less any identified impairment.
Interest income includes the amortization and accretion of purchase premium and discount. Premiums and discounts on securities are amortized on the level-yield method anticipating prepayments based upon the prior three month average monthly prepayments when available.
We evaluate available-for-sale securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. For securities in an unrealized loss position, consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and our intent and ability to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. In analyzing an issuer’s financial condition, we consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition.
When OTTI is determined to have occurred, the amount of the OTTI recognized in earnings depends on whether we intend to sell the security or it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss. If we intend to sell the security or it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss, the OTTI recognized in earnings is equal to the entire difference between its amortized cost basis and its fair value at the balance sheet date. If we do not intend to sell the security and it is not more likely than not that we will be required to sell the security before recovery of its amortized cost basis less any current-period loss, the OTTI is separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized as a charge to earnings. The amount of the OTTI related to other factors is recognized in other comprehensive income (loss), net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the investment.
Loans held for sale
Loans originated and intended for sale in the secondary market, primarily mortgage loans, are carried at fair value as permitted under the guidance in ASC 825, “Financial Instruments.” Gains and losses are recognized in income at the time the loan is closed. These gains and losses are classified under the line item “Mortgage banking income” in our consolidated financial statements. Pass through origination costs and related loan fees are also included in “Mortgage banking income.” Other expenses are classified in the appropriate noninterest expense accounts.
Mortgage servicing rights
We began retaining the right to service certain mortgage loans in 2014 that we sell to secondary market investors.
In periods prior to 2017, mortgage servicing rights were amortized in proportion to and over the period of estimated net servicing income. These servicing rights were carried at amortized cost less any impairment. Impairment losses on mortgage servicing rights were recognized to the extent by which the unamortized cost exceeded fair value.
As of January 1, 2017, the Company elected to account for its mortgage servicing rights under the fair value option as permitted under ASC 860-50-35, "Transfers and Servicing." The change in accounting policy resulted in a one-time adjustment
to retained earnings for the after-tax increase in fair value above book value at the time of adoption. Subsequent changes in fair value are recorded in earnings in Mortgage banking income.
Retained mortgage servicing rights are measured at fair value as of the date of the related loan sale. We use quoted market prices when available. Subsequent fair value measurements are determined using a discounted cash flow model. In order to determine the fair value of the MSR, the present value of expected net future cash flows is estimated. Assumptions used include market discount rates, anticipated prepayment speeds, delinquency and foreclosure rates, and ancillary fee income net of servicing costs. This model is periodically validated by an independent model validation group. The model assumptions and the MSR fair value estimates are also compared to observable trades of similar portfolios as well as to MSR broker valuations and industry surveys, as available.
Derivative financial instruments
We enter into cash flow hedges to mitigate the exposure to variability in expected future cash flows or other types of forecasted transactions. Changes in the fair value of the cash flow hedges, to the extent that the hedging relationship is effective, are recorded as other comprehensive income and are subsequently recognized in earnings at the same time that the hedged item is recognized in earnings. The ineffective portions of the changes in fair value of the hedging instruments are immediately recognized in earnings. The assessment of the effectiveness of the hedging relationship is evaluated under the hypothetical derivative method.
We utilize derivative instruments that are not designated as hedging instruments. The Company enters into swaps, interest rate cap and/or floor agreements with its customers and then enters into an offsetting derivative contract position with other financial institutions to mitigate the interest rate risk associated with these customer contracts. Because these derivative instruments are not designated as hedging instruments, changes in the fair value of the derivative instruments are recognized currently in earnings.
We enter into commitments to originate and purchase loans whereby the interest rate on the loan is determined prior to funding (rate-lock commitments). Rate-lock commitments on mortgage loans that are intended to be sold are considered to be derivatives. Accordingly, such commitments, along with any related fees received from potential borrowers, are recorded at fair value in other assets or liabilities, with changes in fair value recorded in mortgage banking income. Fair value is based on fees currently charged to enter into similar agreements, and for fixed-rate commitments, the difference between current levels of interest rates and the committed rates is also considered.
We utilize forward loan sale contracts to mitigate the interest rate risk inherent in our mortgage loan pipeline and held-for-sale portfolio. Forward loan sale contracts are contracts for delayed delivery of mortgage loans. We agree to deliver on a specified future date, a specified instrument, at a specified price or yield. However, the contract may allow for cash settlement. The credit risk inherent to us arises from the potential inability of counterparties to meet the terms of their contracts. In the event of non-acceptance by the counterparty, we would be subject to the credit and inherent (or market) risk of the loans retained. Such contracts are accounted for as derivatives and, along with related fees paid to investor are recorded at fair value in derivative assets or liabilities, with changes in fair value recorded in mortgage banking income. Fair value is based on the estimated amounts that we would receive or pay to terminate the commitment at the reporting date.
We utilize two methods to deliver mortgage loans sold to an investor. Under a “best efforts” sales agreement, the Company enters into a sales agreement with an investor in the secondary market to sell the loan when an interest rate-lock commitment is entered into with a customer, as described above. Under a “best efforts” sales agreement, the Company is obligated to sell the mortgage loan to the investor only if the loan is closed and funded. Thus, the Company will not incur any liability to an investor if the mortgage loan commitment in the pipeline fails to close. The Company also utilizes “mandatory delivery” sales agreements. Under a mandatory delivery sales agreement, the Company commits to deliver a certain principal amount of mortgage loans to an investor at a specified price and delivery date. Penalties are paid to the investor should the Company fail to satisfy the contract. Mandatory commitments are recorded at fair value in the Company’s Consolidated Balance Sheets. Gains and losses arising from changes in the valuation of these commitments are recognized currently in earnings and are reflected under the line item “Other noninterest income” on the Consolidated Statements of Income.
Goodwill and other intangible assets
Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. Goodwill impairment testing is performed annually or more frequently if events or circumstances indicate possible impairment. Goodwill is assigned to the Company’s reporting units, which are determined based on geography and may include one or more individual branches. Fair values of reporting units are determined using either discounted cash flow analyses based on internal financial forecasts or, if available, market-based valuation multiples for comparable businesses. If the estimated implied fair value of goodwill is less than the carrying amount, an impairment loss would be recognized as noninterest expense to reduce the carrying amount to the estimated implied fair value which could be material to our operating results for any particular reporting period.
Other intangible assets consist of core deposit intangible assets arising from whole bank and branch acquisitions in addition to an operating lease intangible, customer base trust intangible and a loan servicing intangible related to a manufactured housing recorded in conjunction with the merger with the Clayton Banks completed on July 31, 2017. All intangible assets are initially measured at fair value and then amortized over their estimated useful lives.
Business combinations and accounting for acquired loans with credit deterioration
Business combinations are accounted for by applying the acquisition method in accordance with ASC 805, “Business Combinations” (“ASC 805”). Under the acquisition method, identifiable assets acquired and liabilities assumed and any non-controlling interest in the acquiree at the acquisition date are measured at their fair values as of that date. Any excess of the purchase price over fair value of net assets acquired is recorded as goodwill. To the extent the fair value of net assets acquired, including any other identifiable intangible assets, exceed the purchase price, a bargain purchase gain is recognized. Results of operations of acquired entities are included in the Consolidated Statements of Income from the date of acquisition.
Loans acquired in business combinations with evidence of credit deterioration since origination and for which it is probable that all contractually required payments will not be collected are considered to be credit-impaired. Purchased credit impaired loans (“PCI” loans) are accounted for under the accounting guidance for loans and debt securities acquired with deteriorated credit quality, in accordance with ASC 310-30, “Loans and Debt Securities Acquired with Deteriorated Credit Quality” (“ASC 310-30”), and initially measured at fair value, which includes estimated future credit losses expected to be incurred over the life of the loans. We evaluate on a quarterly basis, the present value of the acquired loans determining the effective interest rates. Increases in expected cash flows to be collected on these loans are recognized as an adjustment of the loan’s yield over its remaining life, while decreases in expected cash flows are recognized as an impairment. As a result, related discounts are recognized subsequently through accretion based on the expected cash flow of the acquired loans or through adjustment to the allowance for loan loss for any impairment identified subsequent to acquisitions.
Overview
We are a bank holding company headquartered in Nashville, Tennessee. We operate primarily through our wholly-owned bank subsidiary, FirstBank, the third largest bank headquartered in Tennessee, based on total assets. FirstBank provides a comprehensive suite of commercial and consumer banking services to clients in select markets in Tennessee, North Alabama, and North Georgia. Our footprint includes 56 full-service bank branches and several other banking locations serving the following MSAs Nashville, Chattanooga (including North Georgia), Knoxville, Memphis, Jackson, and Huntsville (AL) and 12 community markets throughout Tennessee. FirstBank also provides mortgage banking services utilizing its bank branch network and mortgage banking offices strategically located throughout the southeastern United States and a national internet delivery channel.
We operate through two segments, Banking and Mortgage. We generate most of our revenue in our Banking segment from interest on loans and investments, loan-related fees, mortgage originations in our banking footprint, investment services and deposit-related fees and, in our Mortgage segment, from origination fees and gains on sales in the secondary market of mortgage loans that we originate outside our Banking footprint or through our internet delivery channels and from servicing. Our primary source of funding for our loans is customer deposits, and to a lesser extent brokered and internet deposits, Federal Home Loan Bank advances and other borrowings.
Mergers and acquisitions
Atlantic Capital Bank, N.A. Branches
On November 14, 2018, the Bank entered into a Purchase and Assumption Agreement to purchase 11 Tennessee and three Georgia branch locations (the "Branches") from Atlantic Capital Bank, N.A., a national banking association and a wholly-owned subsidiary of Atlantic Capital Bancshares, Inc., a Georgia corporation (collectively, “Atlantic Capital”), further increasing market share in existing markets and expanding the Bank's footprint into new locations. See Note 2, “Mergers and acquisitions” in the notes to the consolidated financial statements for further details regarding the terms and conditions of these acquisitions.
Clayton Bank and Trust and American City Bank
Effective July 31, 2017, FirstBank merged with Clayton Bank and Trust (“CBT”) and American City Bank (“ACB” and together with CBT, the “Clayton Bank”), pursuant to the Stock Purchase Agreement dated February 8, 2017, as amended on May 26, 2017, by and among the Company, FirstBank, the Clayton Banks, Clayton HC, Inc., a Tennessee corporation and its majority shareholder, James L. Clayton. The Company issued 1,521,200 share of common stock and paid approximately $184.2 million to purchase all of the outstanding shares of the Clayton Banks. At closing, the Clayton Banks merged with and into FirstBank, with FirstBank continuing as the surviving banking corporation. After finalizing purchase accounting adjustments, the Clayton Banks merger added approximately $1,215.8 million in total assets, $1,059.7 million in loans, and $979.5 million in deposits. Operating results for 2017 include the operating results of the acquired assets and assumed liabilities of the
Clayton Banks subsequent to the acquisition date. Substantially all of the operations of the Clayton Banks are included in the Banking segment.
Key factors affecting our business
Economic conditions
Our business and financial performance are affected by economic conditions generally in the United States and more directly in the markets where we primarily operate. The significant economic factors that are most relevant to our business and our financial performance include the general economic conditions in the U.S. and in our markets, unemployment rates, real estate markets and interest rates.
The United States economy expanded by 2.6% annualized in the fourth quarter of 2018, due primarily to increases in business investment. This expansion follows the growth experienced in 2014 through 2017, which followed modest growth in 2013. Unemployment rates decreased slightly, following a pattern of continuous decline. According to the U.S. Bureau of Labor Statistics, the seasonally adjusted unemployment rate at December 31, 2018 was 4.0% compared to 4.1% at December 31, 2017 and 4.7% at December 31, 2016. The Federal Reserve Board increased its federal funds target range by 25 basis points in December 2018 to 225-250 basis points, the seventh increase to its target range since December 2016. Interest rates remain low by historical standards, and general economic conditions are supportive of growth.
Existing home sales in the United States, as indicated by the National Association of Realtors, fell to a seasonally adjusted annual rate of 4.94 million units in December 2018, compared to 5.56 million units in December 2017 and 5.51 million units in December 2016. New home sales showed slightly lower growth, falling to a seasonally adjusted annual rate of 600 thousand units in December 2018, down from 643 thousand units in December 2017, and 535 thousand units in December 2016. Home values, as indicated by the seasonally adjusted S&P CoreLogic Case-Shiller 20-City Composite Home Price Index, showed an increase of 4.18% from December 31, 2017 to December 31, 2018. Bankruptcy filings, per the U.S. Court Statistics, also improved with total filings down 2.0% for the year ended December 31, 2018, compared to the same period in 2017.
According to the Beige Book published by the Federal Reserve Board in January 2018, overall economic activity in the Sixth Federal Reserve District (which includes Florida, Georgia, Alabama and parts of Tennessee, Mississippi and Louisiana) remained largely positive with a majority of business contacts noting that economic activity grew at a moderate pace in 2018. Most business contacts expect steady growth in the near-term; however, several cited increased levels of uncertainty going into 2019, including concerns over politics and trade. As labor markets remained tight, many firms noted increasing retention efforts. On balance, wages increased since the previous report, with pressure growing particularly among low-skill, hourly positions. Reports from the hospitality sector were positive, reflecting strong advance bookings. Housing activity slowed on a year over year basis, with existing home sales either moderating or declining. New home construction continued to lag behind demand, with most new home starts concentrated in higher price points. Commercial real estate leasing and sales activity remained steady, with vacancy rates in most markets continuing a modest downward trend. Manufacturers indicated that business conditions softened slightly, however expectations for future productions levels increased.
The economy in the state of Tennessee continued to see moderate improvements as well, according to the U.S. Bureau of Economic Analysis. The unemployment rate, as indicated by the U.S. Bureau of Labor Statistics, rose to 3.6% as of December 31, 2018, up slightly from 3.3% of December 31, 2017. Nashville achieved a historically low unemployment rate of 2.3% as of December 31, 2018, down from 2.4% as of December 31, 2017.
Interest rates
Net interest income is the largest contributor to our net income and is the difference between the interest and fees earned on interest-earning assets (primarily loans and investment securities) and the interest expense incurred in connection with interest-bearing liabilities (primarily deposits and borrowings). The level of net interest income is primarily a function of the average balance of interest-earning assets, the average balance of interest-bearing liabilities and the spread between the contractual yield on such assets and the contractual cost of such liabilities. These factors are influenced by both the pricing and mix of interest-earning assets and interest-bearing liabilities which, in turn, are impacted by external factors such as local economic conditions, competition for loans and deposits, the monetary policy of the Federal Reserve Board and market interest rates.
The cost of our deposits and short-term wholesale borrowings is largely based on short-term interest rates, which are primarily driven by the Federal Reserve Board’s actions. The yields generated by our loans and securities are typically driven by short-term and long-term interest rates, which are set by the market and are, at times, heavily influenced by the Federal Reserve Board’s actions. The level of net interest income is therefore influenced by movements in such interest rates and the pace at which such movements occur. Since December of 2016, the Federal Open Market Committee has raised the Fed Funds Target rate eight times, which has caused other short term yields such as 1-month and 3-month LIBOR to rise. Although short-term interest rates have risen, the Federal Reserve now maintains a neutral monetary policy, and we expect interest rates to increase nominally or remain flat throughout 2019. Subsequent declines in the yield curve or a
decline in longer-term yields relative to short-term yields (a flatter yield curve) would have an adverse impact on our net interest margin and net interest income. Continued rate increases may have the effect of decreasing our mortgage origination and our general mortgage banking profitability. For additional information regarding our interest rate risks factors and management, see “Business: Risk management: Liquidity and interest rate risk management” and “Risk factors: Risks related to our business.”
Credit trends
We focus on originating quality loans and have established loan approval policies and procedures to assist us in upholding the overall credit quality of our loan portfolio. However, credit trends in the markets in which we operate and in our loan portfolio can materially impact our financial condition and performance and are primarily driven by the economic conditions in our markets.
Underlying credit quality declined marginally during 2018 compared to 2017, which is consistent with the shifts in macro-economic factors discussed above. Our percentage of total nonperforming loans to loans held for investment increased to 0.46% as of December 31, 2018, from 0.32% at December 31, 2017. Our loans classified as substandard increased to 1.81% of loans held for investment for the year ended December 31, 2018, compared to 1.75% for 2017. Our nonperforming assets for the year ended December 31, 2018 were $31.4 million, or 0.61% of assets, decreasing from $72.3 million, or 1.53% of assets for the year ended December 31, 2017. Excluding $43.0 million of rebooked GNMA loans, our adjusted nonperforming assets represented 0.62% of assets for the year ended December 31, 2017.
Although, overall we have experienced favorable credit trends in 2018 and 2017, we are sensitive to credit quality risks in our commercial real estate, commercial and industrial, and construction loan portfolios due to our concentration of loans in these categories. For additional information regarding credit quality risk factors for our Company, see “Business: Risk management: Credit risk management” and “Risk factors: Risks related to our business.”
Competition
Our profitability and growth are affected by the highly competitive nature of the financial services industry. We compete with commercial banks, savings banks, credit unions, non-bank financial services companies, online mortgage providers, internet banks and other financial institutions operating within the areas we serve, particularly with national and regional banks that often have more resources than we do to invest in growth and technology and community banks with strong local ties, all of which target the same clients we do. Recently, we have seen increased competitive pressures on loan rates and terms and increased competition for deposits. Continued loan pricing pressure may continue to affect our financial results in the future.
For additional information, see “Business: Our markets,” “Business: Competition” and “Risk factors: Risks related to our business.”
Regulatory trends and changes in laws
We are subject to extensive regulation and supervision, which continue to evolve as the legal and regulatory framework governing our operations continues to change. The current operating environment also has heightened supervisory expectations in areas such as consumer compliance, the Bank Secrecy Act and anti-money laundering compliance, risk management and internal audit. As a result of these heightened expectations, we expect to incur additional costs for additional compliance, risk management and audit personnel or professional fees associated with advisors and consultants.
As described further under “Business: Supervision and regulation,” we are subject to a variety of laws and regulations, including the Dodd-Frank Act. The Dodd-Frank Act is complex, and many aspects of it are subject to final rulemaking that continues to emerge. Implementation of the Dodd-Frank Act will continue to impact our earnings through higher compliance costs and imposition of new restrictions on our business. The Dodd-Frank Act may also continue to have a material adverse impact on the value of certain assets and liabilities held on our balance sheet. The ultimate impact of the Dodd-Frank Act on our business will depend on regulatory interpretation and rulemaking as well as the success of any of our actions to mitigate the negative impacts of certain provisions. Key parts of the Dodd-Frank Act that will specifically impact our business include the repeal of a previous prohibition against payment of interest on demand deposits, the implementation of the Basel III capital adequacy standards, a change in the basis for FDIC deposit insurance assessments, substantial revisions to the regulatory regime applicable to the mortgage market, and enhanced emphasis on consumer protection generally.
See also “Risk factors: Risks related to our regulatory environment.”
Factors affecting comparability of financial results
S Corporation status
From our formation in 2001 through September 16, 2016, we elected to be taxed for federal income tax purposes as a “Subchapter S corporation” under the provisions of Section 1361 through 1379 of the Internal Revenue Code of 1986, as amended (the “Code”). As a result, our net income was not subject to, and we have not paid, U.S. federal income taxes, and we have not been required to make any provision or recognize any liability for federal income tax in our financial statements for the periods ending on or prior to September 16, 2016. We terminated our status as a “Subchapter S” corporation in connection with our initial public offering as of September 16, 2016. We commenced paying federal income taxes on our taxable income, and our net income for each fiscal year and each interim period commencing on or after September 16, 2016 will reflect a provision for federal income taxes. As a result of that change in our status under the federal income tax laws during 2016, the net income and earnings per share data presented in our historical financial statements set forth elsewhere in this report, which do not include any provision for federal income taxes, will not be comparable with our 2018 and 2017 results or future net income and earnings per share in periods in which we are taxed as a C corporation, which will be calculated by including a provision for federal income taxes. Unaudited pro forma amounts for income tax expense and basic and diluted earnings per share are presented in the consolidated statements of income assuming the Company’s pro forma tax rates of 36.75% for the year ended December 31, 2016 as if it had been a C corporation during the full year. The unaudited pro forma results for the year ended December 31, 2016 excludes the effect of recognition of the increase in the deferred tax liability of $13.2 million attributable to the conversion in our taxable status as discussed in Note 13 in the notes to our consolidated financial statements.
Although we have not historically paid federal income tax, in the past, we have made periodic cash distributions to our majority (and formerly sole) shareholder in amounts estimated to be necessary for him to pay his estimated individual U.S. federal income tax liabilities related to our taxable income that was “passed through” to him. However, these distributions have not been consistent, as sometimes the distributions have been lower than or in excess of the shareholder’s estimated individual U.S. federal income tax rates which may differ from the rates imposed on the income of C Corporations. Our historical cash flows and financial condition have been affected by such cash distributions.
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of the change in tax rates resulting from becoming a C Corporation was recognized in income in the third quarter of 2016 in which such change took place. On September 16, 2016, the Company recorded an additional net deferred tax liability of $13.2 million to recognize the difference between the financial statement carrying amounts of assets and liabilities and their respective tax bases as of the date that the Company became a taxable corporate entity. In recording the impact of the conversion to a C Corporation, the Company recorded a deferred income tax expense of $3.0 million related to the unrealized gain on available for sale securities through the income statement; therefore, the amount shown in other comprehensive income has not been reduced by the above expense. This difference will remain in OCI until the underlying securities are sold or mature.
Public company costs
On August 19, 2016, we filed a Registration Statement on Form S-1 with the SEC. That Registration Statement was declared effective by the SEC on September 15, 2016. We sold and issued 6,764,704 shares of common stock at $19 per share pursuant to that Registration Statement. Total proceeds received, net of offering costs, were approximately $115.5 million. The proceeds were used to fund a $55.0 million distribution to the majority shareholder representing undistributed earnings previously taxed to him under subchapter S, and used to repay all $10.1 million aggregate principal amount of subordinated notes held by the majority shareholder, plus any accrued and unpaid interest thereon. We qualify as an “emerging growth company” as defined by the Jumpstart Our Business Startups Act (JOBS Act).
There are additional costs associated with operating as a public company, hiring additional personnel, enhancing technology and expanding additional operational and administrative capabilities. We expect that these costs will include legal, regulatory, accounting, investor relations and other expenses that we did not incur as a private company. Sarbanes-Oxley, as well as rules adopted by the U.S. Securities and Exchange Commission, or SEC, the FDIC and national securities exchanges also requires public companies to implement specified corporate governance practices. In addition, due to regulatory changes in the banking industry and the implementation of new laws, rules and regulations, we are now subject to higher regulatory compliance costs. These additional rules and regulations also increase our legal, regulatory, accounting and financial compliance costs and make some activities more time-consuming.
Tax legislation changes
On December 22, 2017, the Tax Cuts and Jobs Act (the “Tax Reform Act”) was enacted into law. The Tax Reform Act provides for significant changes to the U.S. tax code that impact businesses. Effective January 1, 2018, the Tax Reform Act reduces the U.S. federal tax rate for corporations from 35% to 21% for U.S. taxable income and requires a one-time remeasurement of deferred taxes to reflect their value at a lower tax rate of 21%. The Tax Reform Act includes other changes, including, but
not limited to, immediate deductions for certain new investments instead of deductions for depreciation expense over time, additional limitations on the deductibility of executive compensation and limitations on the deductibility of interest. For more information regarding the impact of the Tax Reform Act on the Company, see Note 13, “Income Taxes” in the notes to our consolidated financial statements.
Overview of recent financial performance
Results of operation
Our financial performance over the last three years primarily reflects the success of our growth strategies and the continued favorable economic conditions in our markets, as described above. As a result, we have improved our pre-tax and pro forma net income and profitability over each of the last three years. Our net income increased by 53.1% in 2018 to $80.2 million from $52.4 million in 2017. Pre-tax net income increased by $32.4 million, or 44.0%, from $73.5 million for the year ended December 31, 2017 to $105.9 million for the year ended December 31, 2018. Diluted earnings per common share was $2.55 and $1.86 for the years ended December 31, 2018 and 2017, respectively, compared to unaudited pro forma diluted earnings per common share of $2.04 for the year ended December 31, 2016. Our net income for the year ended 2017 was $52.4 million, up by $13.0 million, compared to the unaudited pro forma net income for the year ended December 31, 2016. Pre-tax net income and unaudited pro forma net income for the year ended December 31, 2016 were $62.3 million and $39.4 million, respectively. Our net income represented a return on average assets, or ROAA, of 1.7%, 1.4% and 1.4% in 2018, 2017 and 2016, respectively, and a return on average shareholders’ equity, or ROAE, of 12.7%, 11.2% and 14.7% in 2018, 2017 and 2016, respectively. Our ratio of return on average tangible common equity ("ROATE") for the years ended December 31, 2018, 2017 and 2016 was 16.7%, 14.0% and 17.6%, respectively. Our ratio of average shareholders’ equity to average assets in 2018, 2017 and 2016 was 13.0%, 12.2% and 9.2% respectively.
During the year ended December 31, 2018, net interest income before provision for loan losses increased to $204.1 million compared to $153.3 million and $111.0 for the years ended December 31, 2017 and 2016, respectively, which was attributable to an increase in interest income and expense, primarily driven by loan and deposit growth the full year results from the Clayton Banks merger in addition to increased overall interest rates. Our net interest margin, on a tax-equivalent basis, increased to 4.66% for the year ended December 31, 2018 as compared to 4.46% and 4.10% for the years ended December 31, 2017 and 2016, respectively, due to loan and deposit growth, including the full year impact of the product mix acquired from the Clayton Banks, in addition to an increase in contractual loan yield during the period offset by elevated costs of funds.
Noninterest income for the year ended December 31, 2018 decreased by $10.9 million to $130.6 million from $141.6 million in the same period in the previous year. The decrease in noninterest income was largely a result of a decrease in mortgage banking income. This followed a $3.1 million decrease in noninterest income in 2017 from noninterest income of $144.7 million in 2016 primarily due to a decrease in gain on sale of securities of approximately $4.1 million during the period.
Noninterest expense increased to $223.5 million for the year ended December 31, 2018 compared to $222.3 million and $194.8 million for the years ended December 31, 2017 and 2016, respectively. The current year increase was largely a result of costs associated with our overall growth and added operational costs resulting from the merger with the Clayton Banks offset by the decrease in merger and conversion costs resulting from the Clayton Banks merger completed in 2017. Increased merger and conversion expenses of $15.8 million in 2017 was the primary driver of the increase in noninterest expense compared to the year ended December 31, 2016.
Financial condition
Our total assets grew by 8.7% in 2018 to $5.14 billion at December 31, 2018 as compared to $4.73 billion at December 31, 2017. The increase was driven by strong growth in our loans held for investment during the year of 15.8% to $3.67 billion at December 31, 2018 from $3.17 billion at December 31, 2017.
In 2018, we grew total deposits by 13.8% to $4.17 billion and noninterest-bearing deposits by 6.9% to $949.1 million at December 31, 2018 from $3.66 billion and $888.2 million, respectively, at December 31, 2017. Most of the increase came from customer time deposits which increased from $602.6 million at December 31, 2017 to $1.02 billion at December 31, 2018, representing an increase of 68.7%.
Business segment highlights
We operate our business in two business segments: Banking and Mortgage. See Note 19, “Segment Reporting,” in the notes to our consolidated financial statements for a description of these business segments.
Banking
Income before taxes increased by $44.3 million, or 73.4% in the year ended December 31, 2018 to $104.7 million as compared to $60.4 million in the year ended December 31, 2017. The increase reflects an improvement of $51.5 million in net interest
income due to an increase of $957.9 million in average loan balances driven by our merger with the Clayton Banks in addition to strong organic loan growth combined with increased interest rates and a continuing strong credit environment. Noninterest income increased $4.1 million to $55.4 million in the year ended December 31, 2018 as compared to $51.4 million in the year ended December 31, 2017. Noninterest expense increased $4.9 million or 3.4%, primarily due to increases in salaries and other costs associated with our growth offset by a decrease in merger and conversion costs related to merger with the Clayton Banks in 2017. Results of our Banking Segment also include mortgage retail footprint pre-tax net contribution of $3.8 million in the year ended December 31, 2018 compared to $5.0 million for the year ended December 31, 2017.
Income before taxes increased by $4.7 million, or 8.4% in the year ended December 31, 2017 to $60.4 million compared to $55.7 million in the year ended December 31, 2016. The increase reflects an improvement of $40.7 million in net interest income due to an increase of $667.5 million in average loan balances driven by our merger with the Clayton Banks in addition to strong organic loan growth combined with favorable interest rates and an improved credit environment. Noninterest income decreased $1.1 million to $51.4 million in the year ended December 31, 2017 as compared to $52.5 million in the year ended December 31, 2016. Noninterest expense increased $34.4 million, primarily due to increase merger and conversion costs of $15.8 million attributed to our merger with the Clayton Banks in addition to increase in salaries and other costs associated with our growth. Results of our Banking Segment also include mortgage retail footprint pre-tax net contribution of $5.0 million in the year ended December 31, 2017 compared to $9.4 million for the year ended December 31, 2016.
Mortgage
Income before taxes from the Mortgage segment decreased 91.0% to $1.2 million in the year ended December 31, 2018 as compared to $13.1 million in the year ended December 31, 2017 primarily due to a decrease in noninterest income. Noninterest income decreased $15.0 million to $75.2 million for the year ended December 31, 2018 as compared to $90.2 million for the year ended December 31, 2017, driven by decreased interest rate lock commitment volume as well as compressing margins experienced across the market. Interest rate lock commitment volume decreased $449.1 million, or 5.9%, during the year ended December 31, 2018 compared to the year ended December 31, 2017 due to higher interest rates and competitive pricing pressures. The change in fair value on MSRs and related hedging activities included in mortgage banking income amounted to a loss of $8.7 million mainly due to decay during the year ended December 31, 2018. Decay exists regardless of MSR hedging activity and is due to the natural aging and paydown of the mortgage servicing portfolio with the payments from customers more than offsetting the decay, resulting in positive gross servicing income of $11.9 million. This compares to a decline in fair value on MSRs and related hedging activities of $3.4 million and gross servicing income of $9.7 million, respectively for the year ended December 31, 2017. Interest rate lock commitments in the pipeline at December 31, 2018 were $318.7 million compared with $504.2 million at December 31, 2017. During the year ended December 31, 2018 and 2017, we sold $39.4 million and $11.7 million, respectively, of mortgage servicing rights. No material gain or loss was recognized in connection with this sale in the year ended December 31, 2018 while a loss of $0.2 was recognized in the year ended December 31, 2017. During the fourth quarter of 2018, the Company entered into a letter of intent for the sale of certain mortgage servicing rights on approximately $2,061.2 million of serviced mortgage loans. The transaction closed subsequent to the year ended December 31, 2018 during the first quarter of 2019, resulting in the reduction of $29.4 million in mortgage servicing rights. The Company will continue to service the loans until they can be transferred to the purchaser in 2019. No significant gain or loss was recognized related to this transaction.
Income before taxes from the mortgage segment increased $6.5 million in the year ended December 31, 2017 to $13.1 million as compared to $6.6 million in the year ended December 31, 2016. This increase is primarily attributable to increased interest rate lock commitments. Interest rate lock commitment volume increased $1,604.7 million for the year ended December 31, 2017 to $7,570.4 million as compared to $5,965.7 million for the year ended December 31, 2016. The increase in interest rate lock commitment volume is primarily due to increased activity in our correspondent delivery channel, which was established in the second quarter of 2016. Noninterest income decreased $2.0 million to $90.2 million for the year ended December 31, 2017 as compared to $92.2 for the year ended December 31, 2016, driven by the change in delivery channel mix of interest rate lock commitment volume during the year. Additionally, on January 1, 2017, fair value accounting was elected on MSRs; the change in fair value is now included in mortgage banking income and amounted to a $3.4 million charge including related hedging impact during the year ended December 31, 2017. Previous to this change, amortization and impairment of MSRs was included in noninterest expense and amounted to $13.0 million for the year ended December 31, 2016. This decline in amortization and impairment was partially offset by an increase in other mortgage noninterest expense of $6.2 million related to the correspondent channel and overall increased production. Interest rate lock commitments in the pipeline at December 31, 2017 were $504.2 million compared with $532.9 million at December 31, 2016.
Results of operation
Throughout the following discussion of our operating results, we present our net interest income, net interest margin and efficiency ratio on a fully tax-equivalent basis. The fully tax-equivalent basis adjusts for the tax-favored status of net interest income from certain loans and investments. We believe this measure to be the preferred industry measurement of net interest income, which enhances comparability of net interest income arising from taxable and tax-exempt sources. The adjustment
to convert certain income to a tax-equivalent basis consists of dividing tax exempt income by one minus the combined federal and blended state statutory income tax rate of 26.06% and 39.23% for the year ended December 31, 2018 and 2017, respectively.
Net interest income
Our net interest income is primarily affected by the interest rate environment and by the volume and the composition of our interest-earning assets and interest-bearing liabilities. We utilize net interest margin (“NIM”) which represents net interest income, on a tax-equivalent basis, divided by average interest-earning assets, to track the performance of our investing and lending activities. We earn interest income from interest, dividends and fees earned on interest-earning assets, as well as from amortization and accretion of discounts on acquired loans. Our interest-earning assets include loans, time deposits in other financial institutions and securities available for sale. We incur interest expense on interest-bearing liabilities, including interest-bearing deposits, borrowings and other forms of indebtedness as well as from amortization of premiums on purchased deposits. Our interest-bearing liabilities include deposits, advances from the FHLB, repurchase agreements and subordinated debt.
Year ended December 31, 2018 compared to year ended December 31, 2017
Net interest income increased 33.1% to $204.1 million in the year ended December 31, 2018 compared to $153.3 million in the year ended December 31, 2017. On a tax-equivalent basis, net interest income increased $49.6 million to $205.7 million in the year ended December 31, 2018 as compared to $156.1 million in the year ended December 31, 2017. The increase in tax-equivalent net interest income in the year ended December 31, 2018 was primarily driven by increased volume on loans held for investment, offset by increased rates on deposits.
Interest income, on a tax-equivalent basis, was $241.2 million for the year ended December 31, 2018, compared to $172.4 million for the year ended December 31, 2017, an increase of $68.7 million. The two largest components of interest income are loan income and investment income. Loan income consists primarily of interest earned on our loans held for investment portfolio in addition to loans held for sale. Investment income consists primarily of interest earned on our investment portfolio made up of both taxable and tax-exempt securities. Interest income on loans held for investment, on a tax-equivalent basis, increased $68.6 million to $205.5 million from $137.0 million for the year ended December 31, 2018 and 2017, respectively, primarily due to volume driven by increased average loan balances of $957.9 million. A secondary driver of the increase in interest income on loans held for investment were increased rates. The tax-equivalent yield on loans held for investment was 6.09%, up 43 basis points from the year ended December 31, 2017. The increase in yield was primarily due to increases in contractual interest rates and loan fees which yielded 5.42% and 0.39%, respectively, in the year ended December 31, 2018 compared with 4.95% and 0.32% during the year ended December 31, 2017, respectively. Slightly offsetting this increase was a decrease in nonaccrual interest collections of 10 basis points and syndicated fee income of 2 basis points during the year ended December 31, 2018 compared to the same period in the previous year. Also included in the loan yield is the purchase accounting contribution of accretion, which amounted to $7.6 million and $5.4 million and contributed 23 and 22 basis points for the the years ended December 31, 2018 and 2017, respectively.
The components of our loan yield, a key driver to our NIM for the December 31, 2018, 2017 and 2016 were as follows:
(1)
Includes tax equivalent adjustment
Our NIM, on a tax-equivalent basis, increased to 4.66% during the year ended December 31, 2018 from 4.46% in the year ended December 31, 2017, primarily a result of loan growth and increases in contractual loan yields partly offset by increased cost of funds. Accretion on purchased loans contributed 17 and 15 basis points to the NIM for the year ended December 31, 2018 and 2017, respectively. Additionally, nonaccrual interest collections and syndicated loan fees contributed 3 and 1 basis points, respectively, to the NIM for the year ended December 31, 2018 compared to 9 and 3 basis points, respectively, to the NIM for the year ended December 31, 2017.
For the year ended December 31, 2018, interest income on loans held for sale decreased $1.6 million to $15.6 million compared to $17.3 million for the year ended December 31, 2017 due to a decrease in volume contributing a decline of $3.0 million offset by increased rates contributing additional income of $1.3 million. The average balance of loans held for sale decreased $66.9 million to $352.4 million for the year ended December 31, 2018 compared to $419.3 million for the year ended December 31, 2017.
For the year ended December 31, 2018 investment income, on a tax-equivalent basis, increased to $17.9 million from $16.7 million for the year ended December 31, 2017 due primarily to increased volume and rates on taxable securities available-for-sale. The average balance in the investment portfolio for the year ended December 31, 2018 was $597.3 million compared to $558.0 million for the year ended December 31, 2017.
Interest expense was $35.5 million for the year ended December 31, 2018, an increase of $19.2 million as compared to the year ended December 31, 2017. The primary driver for the increase in total interest expense is the increase in interest expense on deposits of $16.5 million to $29.5 million for the year ended December 31, 2018, compared to $13.0 million for the year ended December 31, 2017. The increase was largely attributed to money market and time deposits which each increased to $10.9 million, and $11.9 million, respectively, for the year ended December 31, 2018 from $5.4 million and $3.8 million, respectively, for the year ended December 31, 2017. The $5.5 million increase in money market interest expense during the year ended December 31, 2018 was attributed to increased rates with a secondary driver of increased volume. The average rate on money markets rose to 1.06%, up 45 basis points from the year ended December 31, 2017. Average money market balances increased $138.8 million to $1,027.0 million during the year ended December 31, 2018 from $888.3 million for the same period in the previous year. The $8.1 million increase in time deposit interest expense during the year ended December 31, 2018 was primarily attributed to increased volume and rates in customer time deposits. Average customer time deposits increased $277.3 million from $467.5 during the year ended December 31, 2017 to $744.8 during the year ended December 31, 2018. Yield on customer time deposits increased 74 basis points from 0.66% for the year ended December 31, 2017 to 1.40% for the year ended December 31, 2018. This aggressive growth and increased yield was the result of a time deposit campaign implemented during the second half of 2018 as well as the merger with the Clayton Banks, which was completed on July 31, 2017. A secondary driver of the increase in time deposit interest expense was the increase in volume of brokered and internet time deposits. Average brokered and internet time deposits increased $37.9 million from $44.2 during the year ended December 31, 2017 to $82.1 during the year ended December 31, 2018. This increased volume in brokered and internet time deposits is due to the purchase of $53.9 million of brokered deposits during the third quarter of 2018 to lower funding costs by swapping FHLB borrowings with lower cost brokered time deposits. The result was an overall increase in time deposit interest expense of 71 basis points to 1.44% during the year ended December 31, 2018. The overall growth of our deposits came with a higher cost of total deposits of 0.76% for the year ended December 31, 2018 compared to 0.42% for the year ended December 31, 2017.
A secondary driver of the increase in total interest expense was interest expense on total borrowings, which increased $2.7 million to $6.0 million during the year ended December 31, 2018 compared to $3.3 million during the year ended December 31, 2017. This increase was primarily driven by increased volume related to FHLB advances. The cost of total borrowings increased to 2.24% for the year ended December 31, 2018 from 2.09% for the year ended December 31, 2017. Average FHLB advances increased $105.2 million to $216.0 million for the year ended December 31, 2018 compared to $110.8 million for the year ended December 31, 2017. This increase in average FHLB advances was primarily due to the funding strategy implemented with the merger of the Clayton banks. For more information about our borrowings, refer to the discussion in this section under the heading “Financial condition: Borrowed funds.”
Year ended December 31, 2017 compared to year ended December 31, 2016
Net interest income increased 38.1% to $153.3 million in the year ended December 31, 2017 compared to $111.0 million in the year ended December 31, 2016. On a tax-equivalent basis, net interest income increased $42.8 million to $156.1 million in the year ended December 31, 2017 as compared to $113.3 million in the year ended December 31, 2016. The increase in tax-equivalent net interest income in the year ended December 31, 2017 was primarily driven by increased volume on loans held for investment, due to the success of our growth initiatives including the merger with the Clayton Banks.
Interest income, on a tax-equivalent basis, was $172.4 million for the year ended December 31, 2017, compared to $122.9 million for the year ended December 31, 2016, an increase of $49.6 million. The two largest components of interest income are loan income and investment income. Loan income consists primarily of interest earned on our loans held for investment portfolio in addition to loans held for sale. Investment income consists primarily of interest earned on our investment portfolio made up of both taxable and tax-exempt securities. Interest income on loans held for investment, on a tax-equivalent basis, increased $42.2 million to $137.0 million from $94.8 million for the year ended December 31, 2017 and 2016, respectively, primarily due to volume driven by increased average loan balances of $667.5 million attributed to strong loan growth in addition to our merger with the Clayton Banks. A secondary driver of the increase in interest income on loans held for investment were increased rates. The tax-equivalent yield on loans held for investment was 5.66%, up 25 basis points from the year ended December 31, 2016. The increase in yield was primarily due to increases in contractual interest rates and
nonaccrual interest collections which yielded 4.95% and 0.14%, respectively, in the year ended December 31, 2017 compared with 4.69% and 0.06% during the year ended December 31, 2016, respectively. Slightly offsetting this increase was a decrease in loan fees and syndicated fee income of 9 and 2 basis points, respectively during the year ended December 31, 2017 compared to the same period in the previous year. Also included in the loan yield is the purchase accounting contribution of accretion which amounted to $5.4 million and $3.5 million and contributed 22 and 20 basis points for the years ended December 31, 2018 and 2017, respectively.
Our NIM, on a tax-equivalent basis, increased to 4.46% during the year ended December 31, 2017 from 4.10% in the year ended December 31, 2016, primarily a result of loan growth and increases to contractual loan yields. Accretion on purchased loans contributed 15 and 13 basis points to the NIM for the year ended December 31, 2017 and 2016, respectively. Additionally, nonaccrual interest collections and syndicated loan fees contributed 9 and 3 basis points, respectively, to the NIM for the year ended December 31, 2018 compared to 4 and 3 basis points, respectively, to the NIM for the year ended December 31, 2016.
For the year ended December 31, 2017, interest income on loans held for sale increased $6.0 million to $17.3 million compared to $11.3 million for the year ended December 31, 2016 due to an increase in volume and rates, resulting in increases of $2.3 million and $3.7 million, respectively, in interest income. The average balance of loans held for sale increased $56.8 million to $419.3 million for the year ended December 31, 2017 compared to $362.5 million for the year ended December 31, 2016.
For the year ended December 31, 2017 investment income, on a tax-equivalent basis, increased to $16.7 million from $16.2 million for the year ended December 31, 2016. The average balance in the investment portfolio in the year ended December 31, 2017 was $558.0 million compared to $576.9 million in the year ended December 31, 2016.
Interest expense was $16.3 million for the year ended December 31, 2017, an increase of $6.8 million as compared to the year ended December 31, 2016. The primary driver for the increase in total interest expense is the increase in interest expense on deposits of $5.7 million to $13.0 million for the year ended December 31, 2017, compared to $7.3 million for the year ended December 31, 2016. The increase was largely attributed to money market and time deposits which each increased to $5.4 million and $3.8 million, respectively, for the year ended December 31, 2017 from $2.3 million and $1.9 million, respectively, for the year ended December 31, 2016. The $3.1 million increase in money market interest expense during the year ended December 31, 2017 was attributed to both increased volume and rates. Average money market balances increased $273.5 million to $888.3 million during the year ended December 31, 2017 from $614.8 million for the same period in the previous year. The interest rates on money markets rose to 0.61%, up 24 basis points from the year ended December 31, 2016. Time deposit interest expense increased $1.8 million to $3.8 million from the year ended December 31, 2016, driven by an increases in both rates and balances. The rate on time deposits was 0.73%, up 25 basis points from the year ended December 31, 2016 due to the higher renewal rate of maturing accounts and increase in brokered and internet time deposits during the period. Average time deposit balances increased $110.3 million to $511.7 million from $401.5 million during the year ended December 31, 2017. The increase in balances included a change in product mix attributable to our merger with the Clayton Banks, which increased average brokered and internet time deposits by $42.0 million for the year ended December 31, 2017 compared to the same period in 2016. The rate on broker and internet time deposits carried an inherently higher rate at 1.54% for the year ended December 31, 2017 than traditional customer time deposits, which carried a rate of 0.66% for the year ended December 31, 2017 compared to 0.48% for the year ended December 31, 2016, reflecting rate increases.
A secondary driver of the increase in total interest expense was interest expense on total borrowings, which increased $1.1 million to $3.3 million during the year ended December 31, 2017 compared to $2.2 million during the year ended December 31, 2016. This increase was primarily driven by increased volume related to FHLB advances during the year ended December 31, 2017. The cost of total borrowing increased to 2.09% for the year ended December 31, 2017 from 1.49% for the year ended December 31, 2016. Average FHLB advances increased $46.5 million to $110.8 million for the year ended December 31, 2017 compared to $64.3 million for the year ended December 31, 2016. This increase in average FHLB advances was primarily due to the funding strategy implemented with the merger of the Clayton banks. For more information about our borrowings, refer to the discussion in this section under the heading “Financial condition: Borrowed funds.”
Average balance sheet amounts, interest earned and yield analysis
The table below shows the average balances, income and expense and yield rates of each of our interesting-earning assets and interest-bearing liabilities on a tax-equivalent basis, if applicable, for the periods indicated.
(1)
Calculated using daily averages.
(2)
Average balances of nonaccrual loans are included in average loan balances. Loan fees of $13.1 million, $7.6 million and $7.2 million, accretion of $7.6 million, $5.4 million and $3.5 million, nonaccrual interest collections of $1.4 million, $3.3 million and $1.1 million, and syndicated loan fees of $0.4 million, $1.0 million and $0.8 million are included in interest income in the years ended December 31, 2018, 2017 and 2016, respectively.
(3)
Includes investments in premises and equipment, other real estate owned, interest receivable, MSRs, core deposit and other intangibles, goodwill and other miscellaneous assets.
(4)
Interest income includes the effects of taxable-equivalent adjustments using a U.S. federal income tax rate and, where applicable, state income tax to increase tax-exempt interest income to a tax-equivalent basis. The net taxable-equivalent adjustment amounts included in the above table were $1.6 million, $2.8 million and $2.4 million for the years ended December 31, 2018, 2017 and 2016, respectively.
(5)
The NIM is calculated by dividing annualized net interest income, on a tax-equivalent basis, by average total earning assets.
Rate/volume analysis
The tables below present the components of the changes in net interest income for the year ended December 31, 2018 and 2017. For each major category of interest-earning assets and interest-bearing liabilities, information is provided with respect to changes due to average volumes and changes due to rates, with the changes in both volumes and rates allocated to these two categories based on the proportionate absolute changes in each category.
Year ended December 31, 2018 compared to year ended December 31, 2017
(1)
Average loans are gross, including nonaccrual loans and overdrafts (before deduction of allowance for loan losses). Loan fees of $13.1 million and $7.6 million and accretion of $7.6 million and $5.4 million, nonaccrual interest collections of $1.4 million and $3.3 million, and syndicated loan fee income of $0.4 million and $1.0 million are included in interest income for the years ended December 31, 2018 and 2017, respectively.
(2)
Interest income includes the effects of the tax-equivalent adjustments to increase tax-exempt interest income to a tax-equivalent basis.
As discussed above, the $68.6 million increase in loans held for investment tax-equivalent interest income during year ended December 31, 2018 compared to year ended December 31, 2017 was the primary driver of the $49.6 million increase in net interest income. The increase in loan interest income was primarily driven by an increase in average loans held for investment of $957.9 million, or 39.6%, to $3.38 billion for the year ended December 31, 2018, as compared to $2.42 billion for the year ended December 31, 2017, which was largely attributable to strong loan growth, including the impact of our merger with the Clayton Banks. The increase in loan income was partially offset by an increase in interest expense of $19.2 million due to increases in rates and volume of interest-bearing deposits and to a lesser extent, volume of FHLB advances.
Year Ended December 31, 2017 compared to Year Ended December 31, 2016
(1)
Average loans are gross, including nonaccrual loans and overdrafts (before deduction of allowance for loan losses). Loan fees of $7.6 million and $7.2 million accretion of $5.4 million and $3.5 million, nonaccrual interest collections of $3.3 million and $1.1 million, and syndicated loan fee income of $1.0 million and $0.8 million are included in interest income for the years ended December 31, 2017 and 2016, respectively.
(2)
Interest income includes the effects of the tax-equivalent adjustments to increase tax-exempt interest income to a tax-equivalent basis.
As discussed above, the $42.2 million increase in loans held for investment tax-equivalent interest income during year ended December 31, 2017 compared to year ended December 31, 2016 was the primary driver of the $42.8 million increase in net interest income. The increase in loan interest income was primarily driven by an increase in average loans held for investment of $667.5 million, or 38.1%, to $2.42 billion for the year ended December 31, 2017, as compared to $1.75 billion for the year ended December 31, 2016, which was largely attributable to our merger with the Clayton Banks in addition to loan growth in our metropolitan markets. The increase in loan income was partially offset by an increase in interest expense of $6.8 million due to increases in rates and volume of interest-bearing deposits and to a
lesser extent, volume of FHLB advances.
Provision for loan losses
The provision for loan losses charged to operating expense is an amount which, in the judgment of management, is necessary to maintain the allowance for loan losses at a level that is believed to be adequate to meet the inherent risks of losses in our loan portfolio. Factors considered by management in determining the amount of the provision for loan losses include the internal risk rating of individual credits, historical and current trends in net charge-offs, trends in nonperforming loans, trends in past due loans, trends in the market values of underlying collateral securing loans and the current economic conditions in the markets in which we operate. The determination of the amount is complex and involves a high degree of judgment and subjectivity.
Year ended December 31, 2018 compared to year ended December 31, 2017
Our provision for loan losses for the year ended December 31, 2018 was $5.4 million as compared to a reversal of $1.0 million for the year ended December 31, 2017. The increase is primarily attributable to our loan growth and also includes $0.9 million of subsequent deterioration on PCI loans during the year ended December 31, 2018. Net charge offs for the year ended December 31, 2018 were $0.2 million compared with net recoveries in the previous year of $3.2 million.
Year ended December 31, 2017 compared to year ended December 31, 2016
Our reversal of the provision for loan losses for the year ended December 31, 2017 was $1.0 million as compared $1.5 million for the year ended December 31, 2016, reflecting continued improving credit quality throughout the year. Net recoveries for the year ended December 31, 2017 were of $3.2 million compared to net charge-offs of $1.2 million in the previous year.
Noninterest income
Our noninterest income includes gains on sales of mortgage loans, fees on mortgage loan originations, loan servicing fees, hedging results, fees generated from deposit services, investment services and trust income, gains and losses on securities, other real estate owned and other assets and other miscellaneous noninterest income.
The following table sets forth the components of noninterest income for the periods indicated:
Year ended December 31, 2018 compared to year ended December 31, 2017
Noninterest income was $130.6 million for the year ended December 31, 2018, a decrease of $10.9 million, or 7.7%, as compared to $141.6 million for the year ended December 31, 2017. Noninterest income to average assets (excluding any gains or losses from sale of securities) was 2.7% in the year ended December 31, 2018 as compared to 3.7% in the year ended December 31, 2017.
Mortgage banking income primarily includes origination fees on mortgage loans including fees and realized gains and losses on the sale of mortgage loans, unrealized change in fair value of mortgage loans and derivatives, and mortgage servicing fees. Mortgage banking income is initially driven by the recognition of interest rate lock commitments (IRLCs) at fair value at inception of the IRLCs. This is subsequently adjusted for changes in the overall interest rate environment offset by derivative contracts entered into to offset the interest rate exposure. Upon sale of the loan, the net fair value gain is reclassified as a realized gain on sale. Mortgage banking income was $100.7 million and $116.9 million for the year ended December 31, 2018 and 2017, respectively.
During the year ended December 31, 2018, the Bank’s mortgage operations had sales of $6,154.8 million which generated a sales margin of 1.59%. This compares to $6,349.7 million and 1.63% for the year ended December 31, 2017. Mortgage banking income from gains on sale and related fair value changes amount to $88.7 million during the year ended December 31, 2018 compared to $107.2 million for the same period in the previous year. This activity was driven by a decrease in interest rate lock volume of $449.1 million, or 5.9%, to $7,121.3 million for the year ended December 31, 2018 due to overcapacity and slow-down of the mortgage market and overall compressing margins. Changes in market conditions have also shifted the mix of interest rate lock commitments by purpose to 65.7% purchase for the year ended December 31, 2018 from 57.6% for the same period in the prior year. Income from mortgage servicing was $20.6 and $13.2 million for the years ended December 31, 2018 and 2017, respectively, offset by a decline in fair value on MSRs and related hedging activity of $8.7 million and $3.4 million in the years ended December 31, 2018 and 2017, respectively.
The components of mortgage banking income for the December 31, 2018, 2017 and 2016 were as follows:
Mortgage banking income attributable to our Banking segment from retail operations within the Bank footprint was $25.5 million and $26.7 million for the years ended December 31, 2018 and 2017, respectively, and mortgage banking income attributable to our Mortgage segment was $75.2 million and $90.2 million for the years ended December 31, 2018 and 2017, respectively.
Service charges on deposit accounts include analysis and maintenance fees on accounts, per item charges, non-sufficient funds and overdraft fees. Service charges on deposit accounts were $8.5 million, a increase of $1.1 million, or 14.5%, for the year ended December 31, 2018, compared to $7.4 million for the year ended December 31, 2017. This increase is attributable to our 24.3% growth in average deposits, including contributed deposits of the Clayton Banks.
ATM and interchange fees include debit card interchange, ATM and other consumer fees. These fees increased $1.2 million to $10.0 million during the year ended December 31, 2018 as compared to $8.8 million for the year ended December 31, 2017. This increase is attributable to our growth in deposits, including contributed deposits of the Clayton Banks.
Investment services and trust income increased $1.2 million during the year ended December 31, 2018 to $5.2 million compared to $3.9 million for the year ended December 31, 2017. This increase is primarily related to increased trust operations connected with our merger with the Clayton Banks, which increased $0.7 million during the year ended December 31, 2018 as compared to the five months of activity reflected in 2017.
Loss on securities for the year ended December 31, 2018 was $0.1 million compared to a gain on securities for the year ended December 31, 2017 of $0.3 million. Activity is typically driven by sales activity within our available-for-sale securities portfolio in addition to change in fair value of equity securities with readily determinable market values. Sales activity is attributable to management taking advantage of portfolio structuring opportunities to maintain comparable interest rates and maturities and to fund current loan growth in addition to overall asset liability management. The loss in the year ended December 31, 2018 is related to the sale of approximately $2.7 million in available-for-sale debt securities and also includes a net loss of $81 thousand related to changes in fair value of equity securities with readily determinable fair values. The gain for the year ended 2017 is resulted from the sale of approximately $94.7 million in securities. Also included in gain from securities is a charge for impairment of $0.9 million during the year ended December 31, 2017 related to one of our equity securities without a readily determinable fair value which we did not intend to hold long-term.
Net loss on sales or write-downs of other real estate owned for the year ended December 31, 2018 was $0.1 million compared to a net gain of $0.8 million for the year ended December 31, 2017. This change was the result of specific sales and valuation transactions of other real estate.
Net gain on other assets for the year ended December 31, 2018 was $0.3 million compared to a net loss of $0.7 million for the year ended December 31, 2017. The gain during the year ended December 31, 2018 was attributable to the sale of restricted marketable securities received in satisfaction of a previously charged-off loan and resulting in a gain of $0.3 million.
These securities had previously been written down, contributing $0.8 million to the loss reported for the same period in the previous year.
Other noninterest income for the year ended December 31, 2018 increased $2.1 million to $6.2 million as compared to other noninterest income of $4.1 million for the year ended December 31, 2017, reflecting the contribution from the Clayton Banks during the full year of 2018.
Year ended December 31, 2017 compared to year ended December 31, 2016
Noninterest income was $141.6 million for the year ended December 31, 2017, a decrease of $3.1 million, or 2.1%, as compared to $144.7 million for the year ended December 31, 2016. Noninterest income to average assets (excluding any gains or losses from sale of securities) was 3.7% in the year ended December 31, 2017 as compared to 4.7% in the year ended December 31, 2016.
Mortgage banking income was $116.9 million and $117.8 million for the years ended December 31, 2017 and 2016, respectively. During the year ended December 31, 2017, the Bank's mortgage operations had sales of $6,349.7 million which generated a sales margin of 1.63%. This compares to $4,434.7 million and 2.13% for the year ended December 31, 2016. Mortgage banking income from gains on sale and related fair value changes amounted to $107.2 million during the year ended December 31, 2017 compared to $105.7 million during the year ended December 31, 2016. During the fourth quarter of 2016, mortgage rates increased above prevailing rates experienced during the first three quarters of 2016. This increase in rates caused the level of interest rate lock commitments in the pipeline to decline to $504.2 million at December 31, 2017 from its height of $850.5 million at September 30, 2016 and $532.9 million at December 31, 2016. The increase in gains on sale were driven by an increase in interest rate lock volume of $1,604.7 million, or 26.9%, to $7,570.4 million for the year ended December 31, 2017, due to growth in the correspondent delivery channel, which was established during the second quarter of 2016, offset by declining interest rate lock volume in the consumer direct delivery channel. An increase in rates and change in mix of sales volume, including a lower contribution margin from the newly established correspondent delivery channel, contributed to a decline in mortgage sales margins from the year ended December 31, 2016. Income from mortgage servicing was $13.2 million and $12.1 million for the years ended December 31, 2017 and 2016, respectively. This increase was offset by a decline in fair value on MSRs and related hedging activity of $3.4 million for the year ended December 31, 2017. The fair value adjustment during the year ended December 31, 2017 was the result of our change in accounting policy to elect fair value on MSRs as of January 1, 2017. As such, there is no such fair value adjustment reflected in mortgage banking income for the year ended December 31, 2016.
Mortgage banking income attributable to our Banking segment was $26.7 million and $25.5 million for the years ended December 31, 2017 and 2016, respectively, and mortgage banking income attributable to our Mortgage segment was $90.2 million and $92.2 million for the years ended December 31, 2017 and 2016, respectively.
Service charges on deposit accounts include analysis and maintenance fees on accounts, per item charges, non-sufficient funds and overdraft fees. Service charges on deposit accounts were $7.4 million, a decrease of $0.3 million, or 3.8%, for the year ended December 31, 2017, compared to $7.7 million for the year ended December 31, 2016.
ATM and interchange fees include debit card interchange, ATM and other consumer fees. These fees increased 12.7% to $8.8 million during the year ended December 31, 2017 as compared to $7.8 million for the year ended December 31, 2016 as a result of increased debit card fees from continued growth in client usage of debit cards experienced by most financial institutions in addition to our merger with the Clayton Banks.
Investment services and trust income increased 18.3% during the year ended December 31, 2017 to $3.9 million compared to $3.3 million for the year ended December 31, 2016 due to the merger with the Clayton Banks, which added revenue from trust operations for the last five months of 2017.
Gains on securities for the year ended December 31, 2017 were $0.3 million, resulting from the sale of approximately $94.7 million in securities, compared to gains on sales of securities of $4.4 million, resulting from the sale of approximately $271.1 million for the year ended December 31, 2016. Also included in gain from securities is a charge for impairment of $0.9 million during the year ended December 31, 2017 related to one of the equity securities held which we do not intend to hold long-term. The gains are attributable to management taking advantage of portfolio structuring opportunities to lock in current gains while maintaining comparable interest rates and maturities and to fund current loan growth in addition to overall asset liability management.
Net gain on sales or write-downs of other real estate owned for the year ended December 31, 2017 was $0.8 million compared to a net loss of $1.3 million for the year ended December 31, 2016. This change was the result of specific sales and valuation transactions of other real estate.
Net loss on other assets for the year ended December 31, 2017 was $0.7 million compared to a net loss of $0.1 million for the year ended December 31, 2016. The loss during the year ended December 31, 2017 was attributable to the write down of restricted marketable securities received in satisfaction of a previously charged off loan.
Other noninterest income for the year ended December 31, 2017 increased $1.6 million to $4.1 million as compared to $2.5 million for the year ended December 31, 2016, reflecting the contribution from the Clayton Banks during the last five months of 2017.
Noninterest expense
Our noninterest expense includes primarily salaries and employee benefits expense, occupancy expense, legal and professional fees, data processing expense, regulatory fees and deposit insurance assessments, advertising and promotion and other real estate owned expense, among others. We monitor the ratio of noninterest expense to the sum of net interest income plus noninterest income, which is commonly known as the efficiency ratio.
The following table sets forth the components of noninterest expense for the periods indicated:
Year ended December 31, 2018 compared to year ended December 31, 2017
Noninterest expense increased by $1.1 million during the year ended December 31, 2018 to $223.5 million as compared to $222.3 million in the year ended December 31, 2017. This increase resulted primarily from the $6.9 million increase in salaries and employee benefits expense and overall increases associated with our growth, including the impact of our merger with the Clayton Banks offset by a decline in merger and conversion expenses.
Salaries and employee benefits expense was the largest component of noninterest expenses representing 61.3% and 58.5% of total noninterest expense in the year ended December 31, 2018 and 2017, respectively. During the year ended December 31, 2018, salaries and employee benefits expense increased $6.9 million, or 5.3%, to $136.9 million as compared to $130.0 million for the year ended December 31, 2017. The increase was primarily due to increased costs associated with our growth, including the addition of several revenue producers during the second half of 2018 across our community and metropolitan markets. The average employee headcount increased from 1,267 employees in 2017 to 1,397 employees in 2018. However, our headcount at period end decreased 2.2% to 1,356 employees at December 31, 2018 from 1,386 employees at December 31, 2017 due to a reduction of mortgage operations personnel.
Salaries and employee benefits expense also reflects $7.4 million and $8.2 million accrued for equity compensation grants during the year ended December 31, 2018 and 2017, respectively. These grants comprise restricted stock units that were granted in conjunction with our 2016 IPO to all full-time associates and extended to new associates each year, in addition to an accrual related to annual stock-based performance grants. The grant to new employees hired in 2018 amounted to approximately $0.2 million compared with $0.8 million granted in the previous year, which included retained associates from the merger with the Clayton Banks, the majority of which were immediately vested.
Occupancy and fixed asset expense in the year ended December 31, 2018 was $14.0 million, an increase of $1.0 million, compared to $13.0 million for the year ended December 31, 2017, reflecting the impact of the Clayton Banks.
Legal and professional fees were $7.9 million for the year ended December 31, 2018 as compared to $5.7 million for the year ended December 31, 2017. The increase in legal and professional fees is attributable to our growth and volume of business.
Data processing costs increased $2.6 million, or 40.3%, to $9.1 million for the year ended December 31, 2018 from $6.5 million for the year ended December 31, 2017. The increase for the year ended December 31, 2018 was attributable to our growth and volume of transaction processing, partially attributable to our merger with the Clayton Banks.
Merger and conversion costs amounted to $1.6 million for the year ended December 31, 2018 compared to $19.0 million for the year ended December 31, 2017. Merger and conversion costs during the year ended December 31, 2018 include due diligence costs associated with our ACBI branch acquisition to be completed during the second quarter of 2019. Merger and conversion expenses for the year ended December 31, 2017 related to the merger with the Clayton Banks that closed on July 31, 2017 included a $10 million charitable contribution to a foundation established to invest in the communities across the markets of the Clayton Banks.
Amortization of core deposit and other intangible assets totaled $3.2 million for the year ended December 31, 2018 compared to $2.0 million for the year ended December 31, 2017. The increase is due to the additional core deposit intangible and other intangibles recognized in our merger with the Clayton Banks.
Regulatory fees and deposit insurance assessments increased $0.7 million during the year ended December 31, 2018 to $2.7 million from $2.0 for the year ended December 31, 2017. This increase is attributable to our continued overall growth and volume of business, including the impact of the merger with Clayton Banks.
During the year ended December 31, 2018, the Company sold $39.4 million of mortgage servicing rights on $3,181.5 million of serviced mortgage loans. No material gain or loss was recognized in connection with this transaction. During the year ended December 31, 2017, the Company sold $11.7 million of mortgage servicing rights on $1,086.5 million serviced mortgage loans and recognized a loss of $0.2 million in connection with the transaction. During the fourth quarter of 2018, the Company entered into a letter of intent for the sale of certain mortgage servicing rights on $2,061.2 million of serviced mortgage loans. The transaction closed subsequent to the year ended December 31, 2018 during the first quarter of 2019, resulting in the reduction of $29.4 million in mortgage servicing rights. The Company will continue to service a portion of the loans until they can be transferred to the purchaser in 2019. No significant gain or loss was recognized related to this transaction.
Software license and maintenance fees for the year ended December 31, 2018 were $2.4 million compared to $2.8 million for the year ended December 31, 2017.
Advertising costs for the year ended December 31, 2018 were relatively stable, amounting to $13.1 million, compared to $13.0 million for the year ended December 31, 2017.
Other noninterest expense for the year ended December 31, 2018 was $32.6 million, an increase of $4.5 million from the year ended December 31, 2017. This increase includes $0.7 million in expenses related to the completion of a $151.8 million follow-on secondary offering competed during the second quarter of 2018 in addition to costs associated with our continued overall growth, including the impact of the merger with the Clayton Banks. Additionally, this increase includes $1.0 million increase in other real estate owned expense. Legal costs related to specific sales of other real estate owned were the primary driver of the increase in OREO related expenses during the years ended December 31, 2018 and 2017, respectively.
Year Ended December 31, 2017 compared to year ended December 31, 2016
Noninterest expense increased by $27.5 million during the year ended December 31, 2017 to $222.3 million as compared to $194.8 million in the year ended December 31, 2016. This increase resulted primarily from the $15.8 million increase in merger and conversion expenses during the year ended December 31, 2017 in addition to increased costs associated with our growth and merger with the Clayton Banks, including higher salaries and employee benefits expenses.
Salaries and employee benefits expense was the largest component of noninterest expenses representing 58.5% and 58.3% of total noninterest expense in year ended December 31, 2017 and 2016, respectively. During the year ended December 31, 2017, salaries and employee benefits expense increased $16.5 million, or 14.6%, to $130.0 million as compared to $113.5 million for the year ended December 31, 2016. The increase was primarily due to increased costs associated with our growth and merger with the Clayton Banks and the $7.8 million increase in mortgage banking salaries and benefits resulting from the increase in mortgage loan interest rate lock commitment volume and expansion in our correspondent delivery channel.
Salaries and employee benefits expense also reflects $8.2 million accrued for equity compensation grants during the year ended December 31, 2017. This compares to $4.3 million in stock-related grant expense during the year ended December 31, 2016 related to grants made in conjunction with our initial public offering to all full-time employees. During the year ended December 31, 2017, additional restricted stock units with a total value of $0.8 million were granted to employees of the Clayton Banks and other legacy bank employees that joined the Company during the year. Additionally, salaries and benefits expense includes amounts accrued under our three management incentive plans (prior to the IPO) that were based on our total assets, tangible book value of consolidated equity and contractually-defined after-tax earnings. As of September 16, 2016, the date of the initial public offering, participants in these plans were given the option to convert their equity based incentive plan units to shares of restricted stock units at the IPO price of $19 per share. Aggregate salaries and employee benefits expense recognized under these incentive plans totaled $3.5 million and $5.4 million for the year ended December 31, 2017 and 2016, respectively.
Occupancy and equipment expense in the year ended December 31, 2017 was $13.0 million, an increase of $0.7 million, compared to $12.3 million for the year ended December 31, 2016, reflecting the impact of the Clayton Banks.
Legal and professional fees were $5.7 million for the year ended December 31, 2017 as compared to $3.5 million for the year ended December 31, 2016. The increase in legal and professional fees is attributable to additional professional services related to being a publicly traded company in addition to our growth and volume of business.
Data processing costs increased $2.3 million, or 55.2%, to $6.5 million for the year ended December 31, 2017 from $4.2 million for the year ended December 31, 2016. The increase for the year ended December 31, 2017 was attributable to our growth and volume of transaction processing, partially attributable to our merger with the Clayton Banks.
Merger and conversion expenses related to the merger with the Clayton Banks that closed on July 31, 2017 were $19.0 million for the year ended December 31, 2017 as compared to $3.3 million related to the acquisition of NWGB for the year ended December 31, 2016. Also included in merger and conversion expenses for the year ended December 31, 2017 is a $10 million charitable contribution to a foundation established to invest in the communities across the markets of the Clayton Banks. We completed the core conversion of the Clayton Banks onto our core system and consolidated five branch locations on December 1, 2017.
Amortization of core deposit and other intangible assets totaled $2.0 million for the year ended December 31, 2017 compared to $2.1 million for the year ended December 31, 2016. This amortization relates to the core deposit intangible recognized in connection with the merger with the Clayton Banks and the acquisition of NWGB and the leasehold intangible, customer base trust intangible and manufactured housing servicing intangible recognized in the merger with the Clayton Banks. These intangibles are being amortized over their useful lives (see Note 8 in the notes to Consolidated Financial Statements).
MSRs are recognized as a separate asset on the date the corresponding mortgage loan is sold. Prior to January 1, 2017, MSRs were amortized in proportion to and over the period of estimated net servicing income. The amortization of MSRs was determined using the level yield method based on the expected life of the loan and these servicing rights were carried at the lower of amortized cost or fair value. As of January 1, 2017, we elected to transition our accounting policy to carry MSRs at fair value as permitted under ASC-860-50-35, Transfers and Servicing, which positions us to hedge our MSR portfolio. Fair value is determined using an income approach with various assumptions including expected cash flows, prepayment speeds, market discount rates, servicing costs and other factors. MSRs were carried at fair value at December 31, 2017 and amortized cost less impairment at December 31, 2016. Therefore, there was no amortization expense or impairment losses for the year ended December 31, 2017 as fair value changes under fair value accounting are included in noninterest income as mortgage banking income. Amortization expense amounted to $8.3 million for the year ended December 31, 2016. Impairment losses on MSRs are recognized to the extent by which the unamortized cost exceeds fair value. Impairment losses on MSRs of $4.7 million were recognized in earnings in the year ended December 31, 2016.
During the year ended December 31, 2017, the Company sold $11.7 million of mortgage servicing rights on $1,086.5 million serviced mortgage loans and recognized a loss of $0.2 million in connection with the transaction. During the year ended December 31, 2016, the Company sold $34.1 million of mortgage servicing rights on $3,370.4 million of serviced mortgage loans and recognized a net loss of $4.4 million.
Regulatory fees and deposit insurance assessments were relatively flat, amounting to $2.0 million for the year ended December 31, 2017.
Software license and maintenance fees for the year ended December 31, 2017 were $2.8 million, a decrease of $0.6 million compared to $3.4 million for the year ended December 31, 2016. This decrease is due to costs associated with the conversion of our core system to Jack Henry Silverlake during the second quarter of 2016.
Advertising costs for the year ended December 31, 2017 were $13.0 million, an increase of $2.3 million, compared to $10.6 million for the year ended December 31, 2016. This increase was largely driven by the mortgage segment and expansion in the correspondent channel established in the second quarter of 2016 along with the addition of the Clayton Banks.
Other noninterest expense for year ended December 31, 2017 was $28.0 million, an increase of $5.5 million from the year ended December 31, 2016, reflecting an increase of various expenses associated with our overall growth, including the impact of the merger with the Clayton Banks in addition to increases in mortgage banking activities.
Efficiency ratio
The efficiency ratio is one measure of productivity in the banking industry. This ratio is calculated to measure the cost of generating one dollar of revenue. That is, the ratio is designed to reflect the percentage of one dollar which must be expended to generate that dollar of revenue. We calculate this ratio by dividing noninterest expense by the sum of net interest income and noninterest income. For an adjusted efficiency ratio, we exclude certain gains, losses and expenses we do not consider core to our business.
Our efficiency ratio was 66.8%, 75.4% and 76.2% for the years ended December 31, 2018, 2017 and 2016, respectively. Our adjusted efficiency ratio, on a tax-equivalent basis, was 64.1%, 67.3% and 70.6% for the years ended December 31,
2018, 2017 and 2016, respectively. See “GAAP reconciliation and management explanation of non-GAAP financial measures” in this Report for a discussion of the adjusted efficiency ratio.
Return on equity and assets
The following table sets forth our ROAA, ROAE, dividend payout ratio and average shareholders’ equity to average assets ratio for the periods indicated:
Income tax
Income tax expense was $25.6 million, $21.1 million and $21.7 million for the years ended December 31, 2018, 2017 and 2016, respectively. This reflects the federal rate change enacted by the Tax Reform Act on December 22, 2017, which resulted in a $5.9 million adjustment to reduce our deferred tax liability as of December 31, 2017. As such, our effective tax rates were 24.2%, 28.7% and 34.9% for the years ended December 31, 2018, 2017 and 2016, respectively. The primary differences from the enacted rates are applicable state income taxes reduced for non-taxable income and additional deductions for equity-based compensation upon the distribution of RSUs in addition to nondeductible stock offering costs related to the follow-on secondary offering completed during the second quarter of 2018.
Income tax expense for the year ended December 31, 2016 includes the $13.2 million increase in deferred tax liability associated with our conversion to a C corporation. From our formation in 2001 through September 16, 2016, we elected to be taxed for federal income tax purposes as a “Subchapter S corporation” under the provisions of Section 1361 through 1379 of the Internal Revenue Code. As a result, our net income was not subject to, and we did not pay, U.S. federal income taxes and we were not required to make any provision or recognize any liability for federal income tax in our financial statements for the periods ending on or prior to June 30, 2016. We terminated our status as an S Corporation in connection with our initial public offering as of September 16, 2016. We commenced paying federal income taxes on our pre-tax net income in the third quarter of 2016 and our net income for each fiscal year and each interim period commencing on or after September 16, 2016 and each such period reflect a provision for federal income taxes. See “Pro forma income tax expense and net income” below for a discussion on what our income tax expense and net income would have been had we been taxed as a C Corporation for the full period.
Pro forma income tax expense and net income
We have determined that had we been taxed as a C Corporation and paid U.S. federal income tax for the year ended December 31, 2016, our combined effective income tax rate would have been 36.75%. This pro forma effective rate reflects a U.S. federal income statutory tax rate of 35.00% on corporate income and the fact that a portion of our net income in this period was derived from nontaxable investment income and other nondeductible expenses. Our net income for the years ended December 31, 2016 was $40.6 million and our tax-equivalent net interest income for the same period was $113.3 million. Had we been subject to U.S. federal income tax during these periods, on a pro forma basis, our provision for combined federal and state income tax would have been $22.9 million for the year ended December 31, 2016. The increase in such pro forma provision for U.S. federal income tax would have resulted primarily from the increase in our net income for the period. As a result of the foregoing factors, our unaudited pro forma net income (after U.S. federal income tax) for the year ended December 31, 2016 would have been $39.4 million.
Financial condition
The following discussion of our financial condition compares the year ended December 31, 2018 with the year ended December 31, 2017.
Total assets
Our total assets were $5.14 billion at December 31, 2018. This compares to total assets of $4.73 billion as of December 31, 2017. This increase was largely attributable to an increase of $500.6 million in loans held for investment driven by strong demand for our loan products in our markets and the success of our growth initiatives. The growth was partially offset by a $247.4 million decrease in loans held for sale, reflecting the decline in the mortgage market and derecognition of rebooked GNMA delinquent loans, which made up $43.0 million of total loans held for sale as of December 31, 2017.
Loan portfolio
Our loan portfolio is our most significant earning asset, comprising 71.4% and 67.0% of our total assets as of December 31, 2018 and 2017, respectively. Our strategy is to grow our loan portfolio by originating quality commercial and consumer loans that comply with our credit policies and that produce revenues consistent with our financial objectives. Our overall lending approach is primarily focused on providing credit to our customers directly rather than purchasing loan syndications and loan participations from other banks (collectively, “Participated loans”). At December 31, 2018 and 2017, loans held for investment included approximately $88.8 million and $62.9 million, respectively, related to participated loans. Currently, our loan portfolio is diversified relative to industry concentrations across the various loan portfolio categories. At December 31, 2018 and 2017, our outstanding loans to the broader healthcare industry made up less than 5% of our total outstanding loans and are spread across nursing homes, assisted living facilities, outpatient mental health and substance abuse centers, home health care services, and medical practices within our geographic markets. We believe our loan portfolio is well-balanced, which provides us with the opportunity to grow while monitoring our loan concentrations.
Loans
Loans increased $500.6 million, or 15.8%, to $3.67 billion as of December 31, 2018 as compared to $3.17 billion as of December 31, 2017. Our loan growth during the year ended December 31, 2018 has been composed of increases of $152.0 million, or 21.3%, in commercial and industrial loans, $107.7 million, or 24.0%, in construction loans, $148.7 million, or 27.0%, in non-owner occupied commercial real estate loans, $83.4 million, or 11.3%, in residential real estate loans and $11.2 million, or 5.1%, in consumer and other loans, respectively. These increases were slightly offset by a $2.3 million, or 0.5%, decrease in owner occupied commercial real estate loans. The increase in loans during the year ended December 31, 2018 is attributable to continued strong demand in our metropolitan markets, building customer relationships and continued favorable economic conditions throughout much of our geographic footprint.
Loans by type
The following table sets forth the balance and associated percentage of each major category in our loan portfolio of loans as of the dates indicated:
Loan concentrations are considered to exist when there are amounts loaned to a number of borrowers engaged in similar activities which would cause them to be similarly impacted by economic or other conditions. At December 31, 2018 and 2017, there were no concentrations of loans exceeding 10% of loans other than the categories of loans disclosed in the table above.
Banking regulators have established thresholds of less than 100% for concentrations in construction lending and less than 300% for concentrations in commercial real estate lending that management monitors as part of the risk management process. The construction concentration ratio is a percentage of the outstanding construction and land development loans to total risk-based capital. The commercial real estate concentration ratio is a percentage of the outstanding balance of non-owner occupied commercial real estate, multifamily, and construction and land development loans to total risk-based capital. Management strives to operate within the thresholds set forth above. When a company's ratios are in excess of one or both of these guidelines, banking regulators generally require an increased level of monitoring in these lending areas by management. The table below shows concentration ratios for the Bank and Company as of December 31, 2018 and 2017, which both were within the stated thresholds.
Loan categories
The principal categories of our loans held for investment portfolio are discussed below and in the “Business: Products and Services: Lending Strategy” section of this Annual Report.
Commercial and industrial loans. We provide a mix of variable and fixed rate commercial and industrial loans. Our commercial and industrial loans are typically made to small and medium-sized manufacturing, wholesale, retail and service businesses for working capital and operating needs and business expansions, including the purchase of capital equipment and loans made to farmers relating to their operations. This category also includes loans secured by manufactured housing receivables. Commercial and industrial loans generally include lines of credit and loans with maturities of five years or less. The loans are generally made with operating cash flows as the primary source of repayment, but may also include collateralization by inventory, accounts receivable, equipment and personal guarantees. We plan to continue to make commercial and industrial loans an area of emphasis in our lending operations in the future. As of December 31, 2018, our commercial and industrial loans comprised of $867.1 million, or 24% of loans, compared to $715.1 million, or 23% of loans, as of December 31, 2017.
Commercial real estate owner-occupied loans. Our commercial real estate owner-occupied loans include loans to finance commercial real estate owner occupied properties for various purposes including use as offices, warehouses, production facilities, health care facilities, retail centers, restaurants, churches and agricultural based facilities. Commercial real estate owner-occupied loans are typically repaid through the ongoing business operations of the borrower, and hence are dependent on the success of the underlying business for repayment and are more exposed to general economic conditions. As of December 31, 2018, our owner occupied commercial real estate loans comprised $493.5 million, or 13% of loans, compared to $495.9 million, or 16%, of loans, as of December 31, 2017.
Commercial real estate non-owner occupied loans. Our commercial real estate non-owner occupied loans include loans to finance commercial real estate non-owner occupied investment properties for various purposes including use as offices, warehouses, health care facilities, hotels, mixed-use residential/commercial, manufactured housing communities, retail centers, multifamily properties, assisted living facilities and agricultural based facilities. Commercial real estate non-owner occupied loans are typically repaid with the funds received from the sale of the completed property or rental proceeds from such property, and are therefore more sensitive to adverse conditions in the real estate market, which can also be affected by general economic conditions. As of December 31, 2018, our non-owner occupied commercial real estate loans comprised $700.2 million, or 19%, of loans, compared to $551.6 million, or 17% of loans, as of December 31, 2017.
Residential real estate 1-4 family mortgage loans. Our residential real estate 1-4 family mortgage loans are primarily made with respect to and secured by single family homes, including manufactured homes with real estate, which are both owner-occupied and investor owned. We intend to continue to make residential 1-4 family housing loans at a similar pace, so long as housing values in our markets do not deteriorate from current prevailing levels and we are able to make such loans consistent with our current credit and underwriting standards. First lien residential 1-4 family mortgages may be affected by unemployment or underemployment and deteriorating market values of real estate. As of December 31, 2018, our residential real estate mortgage loans comprised $555.8 million, or 16% of loans, compared to $481.0 million, or 15%, of loans as of December 31, 2017.
Residential line of credit loans. Our residential line of credit loans are primarily revolving, open-end lines of credit secured by 1-4 family residential properties. We intend to continue to make residential line of credit loans if housing values in our markets do not deteriorate from current prevailing levels and we are able to make such loans consistent with our current credit and underwriting standards. Residential line of credit loans may be affected by unemployment or underemployment and deteriorating market values of real estate. Our home equity loans as of December 31, 2018 comprised $190.5 million or 5% of loans compared to $195.0 million, or 6%, of loans as of December 31, 2017.
Multi-family residential loans. Our multi-family residential loans are primarily secured by multi-family properties, such as apartments and condominium buildings. These loans may be affected by unemployment or underemployment and deteriorating market values of real estate. Our multifamily loans as of December 31, 2018 comprised $75.5 million, or 2% of loans, compared to $62.4 million, or 2%, of loans as of December 31, 2017.
Construction loans. Our construction loans include commercial construction, land acquisition and land development loans and single-family interim construction loans to small- and medium-sized businesses and individuals. These loans are generally secured by the land or the real property being built and are made based on our assessment of the value of the property on an as-completed basis. We expect to continue to make construction loans at a similar pace so long as demand continues and the market for and values of such properties remain stable or continue to improve in our markets. These loans can carry risk of repayment when projects incur cost overruns, have an increase in the price of building materials, encounter zoning and environmental issues, or encounter other factors that may affect the completion of a project on time and on budget. Additionally, repayment risk may be negatively impacted when the market experiences a deterioration in the value of real estate. As of December 31, 2018, our construction loans comprised $556.1 million, or 15% of loans compared to $448.3 million, or 14% of loans as of December 31, 2017.
Consumer and other loans. Consumer and other loans include consumer loans made to individuals for personal, family and household purposes, including car, boat and other recreational vehicle loans and personal lines of credit. Consumer loans are generally secured by vehicles and other household goods. The collateral securing consumer loans may depreciate over time. The company seeks to minimize these risks through its underwriting standards. Other loans also include loans to states and political subdivisions in the U.S. These loans are generally subject to the risk that the borrowing municipality or political subdivision may lose a significant portion of its tax base or that the project for which the loan was made may produce inadequate revenue. None of these categories of loans represents a significant portion of our loan portfolio. As of December 31, 2018, our consumer and other loans comprised $228.9 million, or 6% of loans, compared to $217.7 million, or 7% of loans as of December 31, 2017.
Loan maturity and sensitivities
The following tables present the contractual maturities of our loan portfolio as of December 31, 2018 and 2017. Loans with scheduled maturities are reported in the maturity category in which the payment is due. Demand loans with no stated maturity and overdrafts are reported in the “due in 1 year or less” category. Loans that have adjustable rates are shown as amortizing to final maturity rather than when the interest rates are next subject to change. The tables do not include prepayment or scheduled repayments.
For loans due after one year or more, the following tables present the sensitivities to changes in interest rates as of December 31, 2018 and 2017:
(1) Included in fixed interest rates are loans totaling $78.5 million at December 31, 2018, in which the Company has entered into variable rate swap contracts.
(1) Included in fixed interest rates are loans totaling $29.6 million at December 31, 2017, in which the Company has entered into variable rate swap contracts.
The following table presents the contractual maturities of our loan portfolio segregated into fixed and floating interest rate loans as of December 31, 2018 and 2017:
(1) Included in fixed interest rates are loans totaling $78.5 million at December 31, 2018, in which the Company has entered into variable interest rate swap contracts.
(1) Included in fixed interest rates are loans totaling $29.6 million at December 31, 2017, in which the Company has entered into variable interest rate swap contracts.
Of the loans shown above with floating interest rates totaling $1,611.5 million as of December 31, 2018, many of such have interest rate floors as follows:
Asset quality
In order to operate with a sound risk profile, we focus on originating loans that we believe to be of high quality. We have established loan approval policies and procedures to assist us in maintaining the overall quality of our loan portfolio. When delinquencies in our loans exist, we rigorously monitor the levels of such delinquencies for any negative or adverse trends. From time to time, we may modify loans to extend the term or make other concessions, including extensions or interest rate modifications, to help a borrower with a deteriorating financial condition stay current on their loan and to avoid foreclosure. Furthermore, we are committed to collecting on all of our loans and which can result in us carrying higher nonperforming assets. We believe this practice leads to higher recoveries in the long-term.
Nonperforming assets
Our nonperforming assets consist of nonperforming loans, other real estate owned and other miscellaneous non-earning assets. Nonperforming loans are those on which the accrual of interest has stopped, as well as loans that are contractually 90 days past due on which interest continues to accrue. Generally, the accrual of interest is discontinued when the full collection of principal or interest is in doubt or when the payment of principal or interest has been contractually 90 days past due, unless the obligation is both well secured and in the process of collection. In our loan review process, we seek to identify and proactively address nonperforming loans.
Purchased credit impaired (“PCI”) loans are considered past due or delinquent when the contractual principal or interest due in accordance with the terms of the loan agreement remains unpaid after the due date of the scheduled payment. However, these loans are considered to be performing, even though they may be contractually past due, as any non-payment of contractual principal or interest is considered in the periodic re-estimation of expected cash flows and is included in the resulting recognition of current period covered loan loss provision or future period yield adjustments. The accrual of interest is discontinued on PCI loans if management can no longer reliably estimate future cash flows on the loan. No PCI loans were classified as nonaccrual at December 31, 2018 or December 31, 2017 as the carrying value of the respective loan or pool of loans cash flows were considered estimable and probable of collection. Therefore, interest revenue, through accretion of the difference between the carrying value of the loans and the expected cash flows, is being recognized on all PCI loans.
As of December 31, 2018 and 2017, we had $31.4 million and $72.3 million, respectively, in nonperforming assets. As of December 31, 2018 and 2017, other real estate owned included $5.4 million and $5.9 million, respectively, of excess land and facilities resulting from the merger with the Clayton Banks that is held for sale. Other nonperforming assets, including other repossessed non-real estate, as of December 31, 2018 and December 31, 2017 included $1.6 million and $2.4 million, respectively, in other repossessed assets. During 2018, we sold restricted marketable equity securities received in satisfaction of a previously charged off loan that represented $0.7 million of other nonperforming assets at December 31, 2017.
As of December 31, 2017, the amount of loans held for sale that are 90 days or more past due includes government guaranteed GNMA mortgage loans that the Bank, as the original transferor and servicer, has the right, but not obligation, to repurchase totaling $43.0 million at December 31, 2017 with an offsetting liability in the same amount. This option was not exercised and the rebooked GNMA loans were derecognized in 2018. At December 31, 2018, there were $67.4 million of delinquent GNMA loans that had previously been sold; however, we determined there not to be a more-than-trivial benefit of rebooking based on an analysis of interest rates and an assessment of potential reputational risk associated with these loans. As such,
we did not rebook any delinquent GNMA loans as of December 31, 2018; however, we continue to assess on a quarterly basis.
If our nonperforming assets would have been current during the year ended December 31, 2018 and 2017, we would have recorded an additional income of $0.6 million and $0.5 million, respectively. We had net interest recoveries of $1.4 million and $3.3 million for the year ended December 31, 2018 and 2017, respectively, recognized on loans that had previously been charged off or classified as nonperforming in previous periods.
The following table provides details of our nonperforming assets, the ratio of such loans and other real estate owned to total assets as of the dates presented, and certain other related information:
(1) Amount for December 31, 2017, includes $43.0 million in rebooked GNMA loans which the Company is under no obligation to repurchase. See the previous discussion of serviced GNMA loans eligible for repurchase and the impact of our repurchases of delinquent mortgage loans under the GNMA optional repurchase program. See Note 1, “Basis of presentation” in the notes to the consolidated financial statements for additional detail on rebooked GNMA loans.
Total nonperforming loans as a percentage of loans were 0.46% as of December 31, 2018 as compared to 0.32% as of December 31, 2017. Our coverage ratio, or our allowance for loan losses as a percentage of our nonperforming loans, was 173.0% as of December 31, 2018 as compared to 238.1% as of December 31, 2017.
Management has evaluated the aforementioned loans and other loans classified as nonperforming and believes that all nonperforming loans have been adequately reserved for in the allowance for loan losses at December 31, 2018. Management also continually monitors past due loans for potential credit quality deterioration. Loans 30-89 days past due were $9.2 million at December 31, 2018, as compared to $15.1 million at December 31, 2017.
Under acquisition accounting rules, acquired loans were recorded at their estimated fair value at acquisition. We recorded the loan portfolio acquired from the Clayton Banks at fair value as of the July 31, 2017 acquisition date, which resulted in a discount to the loan portfolio’s previous carrying value. Neither the credit portion nor any other portion of the fair value mark is reflected in the reported allowance for loan and lease losses; however, as of December 31, 2018, the allowance included $0.9 million in reserves related to subsequent deterioration since the acquisition date.
Other real estate owned consists of properties acquired through foreclosure or acceptance of a deed in lieu of foreclosure in addition to excess facilities held for sale. These properties are carried at the lower of cost or fair market value based on appraised value less estimated selling costs. Losses arising at the time of foreclosure of properties are charged against the allowance for loan losses. Reductions in the carrying value subsequent to acquisition are charged to earnings and are included in “(Loss) gain on sales or write-downs of other real estate owned” in the accompanying consolidated statements of income. Other real estate owned with a cost basis of $5.8 million were sold as of year ended December 31, 2018, resulting in a net loss of $0.1 million. Other real estate owned with a cost basis of $5.7 million were sold during the year ended December 31, 2017, resulting in a net gain of $0.8 million.
Classified loans
Accounting standards require us to identify loans, where full repayment of principal and interest is doubtful, as impaired loans. These standards require that impaired loans be valued at the present value of expected future cash flows, discounted at the loan’s effective interest rate, or using one of the following methods: the observable market price of the loan or the fair value of the underlying collateral if the loan is collateral dependent. We have implemented these standards in our quarterly review of the adequacy of the allowance for loan losses and identify and value impaired loans in accordance with guidance on these standards. As part of the review process, we also identify loans classified as watch, which have a potential weakness that deserves management’s close attention.
Loans totaling $66.5 million and $55.5 million were classified as substandard under our policy at December 31, 2018 and 2017, respectively. As of December 31, 2018 and 2017, $22.3 million and $32.0 million of substandard loans were purchased credit impaired in connection with our mergers and acquisitions. The following table sets forth information related to the credit quality of our loan portfolio at December 31, 2018 and 2017.
Allowance for loan losses
The allowance for loan losses is the amount that, based on our judgment, is required to absorb probable credit losses inherent in our loan portfolio and that, in management’s judgment, is appropriate under GAAP. The determination of the amount of the allowance is complex and involves a high degree of judgment and subjectivity. Among the material estimates required to establish the allowance are loss exposure at default, the amount and timing of future cash flows on impacted loans, value of collateral and determination of the loss factors to be applied to the various elements of the portfolio.
Our methodology for assessing the adequacy of the allowance for loan losses includes a general allowance for performing loans, which are grouped based on similar characteristics, and an allocated allowance for individual impaired loans. Actual credit losses or recoveries are charged or credited directly to the allowance.
The appropriate level of the allowance is established on a quarterly basis after input from management and our loan review staff and is based on an ongoing analysis of the credit risk of our loan portfolio. In making our evaluation of the credit risk of the loan portfolio, we consider factors such as the volume, growth and composition of our loan portfolio, the diversification by industry of our commercial loan portfolio, the effect of changes in the local real estate market on collateral values, trends in past dues, our experience as a lender, changes in lending policies, the effects on our loan portfolio of current economic indicators and their probable impact on borrowers, historical loan loss experience, industry loan loss experience, the amount of nonperforming loans and related collateral and the evaluation of our loan portfolio by our loan review function.
In addition, on a regular basis, management and the Company’s Board of Directors review loan ratios. These ratios include the allowance for loan losses as a percentage of loans, net charge-offs as a percentage of average loans, the provision for loan losses as a percentage of average loans, nonperforming loans as a percentage of loans and the allowance coverage on nonperforming loans. Also, management reviews past due ratios by relationship manager, individual markets and the Bank as a whole. The allowance for loan losses was $28.9 million and $24.0 million and represented 0.79% and 0.76% of loans held for investment at December 31, 2018 and 2017, respectively.
The following table presents the allocation of the allowance for loan losses by loan category as of the periods indicated:
The following table summarizes activity in our allowance for loan losses during the periods indicated:
(1) See Note 1. Basis of Presentation for discussion regarding this adjustment.
Mortgage loans held for sale
Mortgage loans held for sale were $278.8 million at December 31, 2018 compared to $526.2 million at December 31, 2017. Interest rate lock volume for the year ended December 31, 2018 and 2017 totaled $7,121.3 million and $7,570.4 million, respectively. Generally, mortgage volume increases in lower interest rate environments and robust housing markets and decreases in rising interest rate environments and slower housing markets. Rising interest rates during the year ended December 31, 2018 resulted in slow down of interest rate lock volume and resulted in a reduction of interest rate lock commitments in the pipeline at the end of 2018 compared with the end of the previous year. Interest rate lock commitments in the pipeline at December 31, 2018 and 2017 were $318.7 million and $504.2 million, respectively.
Mortgage loans to be sold are sold either on a “best efforts” basis or under a mandatory delivery sales agreement. Under a “best efforts” sales agreement, residential real estate originations are locked in at a contractual rate with third party private investors or directly with government sponsored agencies, and we are obligated to sell the mortgages to such investors only if the mortgages are closed and funded. The risk we assume is conditioned upon loan underwriting and market conditions in the national mortgage market. Under a mandatory delivery sales agreement, we commit to deliver a certain principal amount of mortgage loans to an investor at a specified price and delivery date. Penalties are paid to the investor if we fail to satisfy the contract. Gains and losses are realized at the time consideration is received and all other criteria for sales treatment have been met. These loans are typically sold within thirty days after the loan is funded. Although loan fees and some interest income are derived from mortgage loans held for sale, the main source of income is gains from the sale of these loans in the secondary market.
Deposits
Deposits represent the Bank’s primary source of funds. We continue to focus on growing core deposits through our relationship driven banking philosophy, community-focused marketing programs, and initiatives such as the development of our treasury management services.
Total deposits were $4.17 billion and $3.66 billion as of December 31, 2018 and 2017, respectively. Noninterest-bearing deposits at December 31, 2018 and 2017 were $949.1 million and $888.2 million, respectively, while interest-bearing deposits were $3.22 billion and $2.78 billion at December 31, 2018 and 2017, respectively. The 13.8% increase in total deposits is attributed to a continued focus on deposit growth, other movements in customer activity including additional deposits from certain large depositors, and the purchase of $53.9 million brokered deposits at the end of the third quarter of 2018.
Brokered and internet time deposits at December 31, 2018 and 2017 was $103.1 million and $85.7 million, respectively. The increase of $17.4 million was due to expected run-off of brokered and internet time deposits acquired through the merger with the Clayton Banks offset by a purchase of $53.9 million brokered deposits during the third quarter of 2018. The larger purchase of brokered deposits was an opportunity to lower our funding costs by swapping short-term FHLB borrowing with brokered time deposits due to lower rates available in the market. This decision does not reflect a change in philosophy of growing customer loans funded by core customer deposits.
Included in noninterest-bearing deposits are certain mortgage escrow deposits that our third-party servicing provider, Cenlar, transfers to the Bank which totaled $53.5 million and $53.7 million at December 31, 2018 and 2017, respectively.
Additionally, our deposits from municipal and governmental entities (i.e. "public deposits") totaled $448.2 million at December 31, 2018 compared to $368.5 million at December 31, 2017. The increase in public deposits is mainly attributed to notable increase concentrated in a few large customers.
In connection with the merger of the Clayton Banks, a significant amount of the $184.2 million cash portion of the purchase price together with pre-acquisition dividends were deposited in interest-bearing accounts with our Bank. Since that time, as expected, these deposit balances have declined and should continue to decline throughout 2019.
Our deposit base also includes certain commercial and high net worth individuals that periodically place deposits with the Bank for short periods of time and can from period to period cause fluctuations in the overall level of customer deposits outstanding. These fluctuations may include certain deposits from related parties as disclosed in Note 23 to the consolidate financial statements included in this Annual Report. The mix between noninterest-bearing and interest-bearing as of December 31, 2018 shifted slightly due to rising rates of interest-bearing deposits when compared to December 31, 2017. Management continues to focus on strategic pricing to grow noninterest-bearing deposits while allowing more costly funding sources, including brokered deposit and internet time deposits acquired through the merger with the Clayton Banks, to mature.
Average deposit balances by type, together with the average rates per periods are reflected in the average balance sheet amounts, interest earned and yield analysis tables included above under the discussion of net interest income.
The following table sets forth the distribution by type of our deposit accounts for the dates indicated:
The following table sets forth our time deposits segmented by months to maturity and deposit amount as of December 31, 2018 and 2017:
Investment portfolio
Our investment portfolio provides liquidity and certain investment securities in our portfolio serve as collateral for certain deposits and other types of borrowings. Our investment strategy aims to maximize earnings while maintaining liquidity in
securities with minimal credit risk. The types and maturities of securities purchased are primarily based on our current and projected liquidity and interest rate sensitivity positions.
The following table shows the carrying value of our total securities available for sale by investment type and the relative percentage of each investment type for the dates indicated:
The balance of our available-for-sale debt securities portfolio at December 31, 2018 was $655.7 million compared to $536.3 million at December 31, 2017. During the years ended December 31, 2018, 2017 and 2016, we purchased $203.8 million, $81.4 million and $316.4 million in investment securities, respectively. Mortgage-backed securities and collateralized mortgage obligations, or CMOs, in the aggregate, comprised 81.4%, 73.4% and 83.0% of these purchases, respectively. CMOs are included in the “Mortgage-backed securities” line item in the above table. The mortgage-backed securities and CMOs held in our investment portfolio are primarily issued by government sponsored entities. U.S. Government agency securities and municipal securities accounted for 18.6%, 26.6% and 17.0%, respectively of total securities purchased in the years ended December 31, 2018, 2017 and 2016, respectively. The carrying value of securities sold during the years ended December 31, 2018, 2017 and 2016 totaled $2.7 million, $94.7 million and $271.1 million, respectively. Maturities and calls of securities during the years ended December 31, 2018, 2017 and 2016, totaled $73.1 million, $83.3 million and $104.4 million, respectively. As of December 31, 2018 and 2017, net unrealized losses of $12.3 million and $4.8 million, respectively, were recorded on available-for-sale debt securities.
As of December 31, 2018 and December 31, 2017, the Company had $3.1 million and $7.7 million, respectively, in equity securities recorded at fair value. Net losses of $81 thousand were recognized due to the changes in fair value of these equity securities during the year ended December 31, 2018. As of January 1, 2018, the Company adopted ASU 2016-01 and reclassified $3.6 million of other securities without readily determinable market values to other assets. The provisions of this update require that equity securities be carried at fair value on the balance sheet with any periodic changes in value as adjustments to the income statement.
The following table sets forth the fair value, scheduled maturities and weighted average yields for our investment portfolio as of December 31, 2018 and 2017:
(1)
Yields on a tax-equivalent basis.
The following table summarizes the amortized cost of debt securities classified as available-for-sale and their approximate fair values as of the dates shown:
Borrowed funds
Deposits and investment securities available for sale are the primary source of funds for our lending activities and general business purposes. However, we may also obtain advances from the FHLB, purchase federal funds and engage in overnight borrowing from the Federal Reserve, correspondent banks, or enter into client purchase agreements. We also use these sources of funds as part of our asset liability management process to control our long-term interest rate risk exposure, even if it may increase our short-term cost of funds. This may include match funding of fixed-rate loans. Our level of short-term
borrowing can fluctuate on a daily basis depending on funding needs and the source of funds to satisfy the needs in addition to the overall interest rate environment and cost of public funds. Borrowings include securities sold under agreements to repurchase, lines of credit, advances from the FHLB, federal funds and subordinated debt.
The following table sets forth our total borrowings segmented by years to maturity as of December 31, 2018:
Securities sold under agreements to repurchase and federal funds purchased
We enter into agreements with certain customers to sell certain securities under agreements to repurchase the security the following day. These agreements are made to provide customers with comprehensive treasury management programs a short-term return for their excess funds. Securities sold under agreements to repurchase totaled $15.1 million and $14.3 million at December 31, 2018 and 2017, respectively.
The Bank maintains lines with certain correspondent banks that provide borrowing capacity in the form of federal funds purchased in the aggregate amount of $240.0 million and $165.0 million as of December 31, 2018 and 2017, respectively. There were no borrowings against the line at December 31, 2018 or 2017.
Federal Home Loan Bank advances
As a member of the FHLB Cincinnati, the Bank receives advances from the FHLB pursuant to the terms of various agreements that assist in funding its mortgage and loan portfolio balance sheet. Under the agreements, we pledge qualifying residential mortgages of $619.0 million and qualifying commercial mortgages of $608.7 million as collateral securing a line of credit with a total borrowing capacity of $737.0 million as of December 31, 2018. As of December 31, 2017, we pledged qualifying residential mortgages of $761.2 million and qualifying commercial mortgages of $207.4 million as collateral securing a line of credit with a total borrowing capacity of $671.5 million.
Borrowings against our line totaled $181.8 million and $302.4 million as of December 31, 2018 and 2017, respectively. Total borrowings comprised $1.8 million and $12.4 million in long-term advances as of December 31, 2018 and 2017, respectively, and $80.0 million and $190.0 million in overnight cash management advances (CMAs) as of December 31, 2018 and 2017, respectively. In addition, a letter of credit with the FHLB of $100.0 million was pledged at December 31, 2018 to secure public funds that required collateral. Overnight borrowings include $100.0 million in variable rate advances borrowed during the third quarter of 2017 as part of the funding strategy for the Clayton Banks merger. These advances have 90 day fixed rate repricing terms. An additional line of $800.0 million has been secured with the FHLB for overnight borrowing; however, additional collateral may be needed to draw on the line. The maximum amount of FHLB borrowing outstanding at any month end was $388.1 million and $302.4 million for the years ended December 31, 2018 and 2017, respectively. The weighted average interest rate on FHLB borrowings was 1.93% and 1.61% for the year ended December 31, 2018 and 2017.
Additionally, the Bank maintained a line with the Federal Reserve Bank through the Borrower-in-Custody program in 2018 and 2017. As of December 31, 2018 and 2017, $1,336.1 million and $737.9 million of qualifying loans and $8.6 million and $13.5 million of investment securities were pledged to the Federal Reserve Bank, securing a line of credit of $934.7 million and $529.5 million.
Subordinated Debt
We have two wholly-owned subsidiaries that are statutory business trusts (“Trusts”). The Trusts were created for the sole purpose of issuing 30-year capital trust preferred securities to fund the purchase of junior subordinated debentures issued by the Company. As of December 31, 2018 and 2017, our $0.9 million investment in the Trusts was included in other assets in the accompanying consolidated balance sheets, and our $30.0 million obligation is reflected as junior subordinated debt, respectively. The junior subordinated debt bears interest at floating interest rates based on a spread over 3-month LIBOR plus 315 basis points (5.97% and 4.82% at December 31, 2018 and 2017, respectively) for the $21.7 million debenture and 3-month LIBOR plus 325 basis points (5.65% and 4.59% at December 31, 2018 and 2017, respectively) for the remaining $9.3 million. The $9.3 million debenture may be redeemed prior to the 2033 maturity date upon the occurrence of a special event, and the $21.7 million debenture may be redeemed prior to 2033 at our option.
Liquidity and capital resources
Bank liquidity management
We are expected to maintain adequate liquidity at the Bank to meet the cash flow requirements of clients who may be either depositors wishing to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. Our Liquidity and Interest Rate Risk Policy is intended to cause the Bank to maintain adequate liquidity and, therefore, enhance our ability to raise funds to support asset growth, meet deposit withdrawals and lending needs, maintain reserve requirements and otherwise sustain our operations. We accomplish this through management of the maturities of our interest-earning assets and interest-bearing liabilities. We believe that our present position is adequate to meet our current and future liquidity needs.
We continuously monitor our liquidity position to ensure that assets and liabilities are managed in a manner that will meet all of our short-term and long-term cash requirements. We manage our liquidity position to meet the daily cash flow needs of clients, while maintaining an appropriate balance between assets and liabilities to meet the return on investment objectives of our shareholder. We also monitor our liquidity requirements in light of interest rate trends, changes in the economy and the scheduled maturity and interest rate sensitivity of the investment and loan portfolios and deposits.
As part of our liquidity management strategy, we are also focused on minimizing our costs of liquidity and attempt to decrease these costs by growing our noninterest-bearing and other low-cost deposits and replacing higher cost funding including time deposits and borrowed funds. While we do not control the types of deposit instruments our clients choose, we do influence those choices with the rates and the deposit specials we offer. As a result of these strategies, we have been able to maintain a relatively low cost of funds in an increasing rate environment.
Our investment portfolio is another alternative for meeting liquidity needs. These assets generally have readily available markets that offer conversions to cash as needed. Securities within our investment portfolio are also used to secure certain deposit types and short-term borrowings. At December 31, 2018 and 2017, securities with a carrying value of $326.2 million and $337.6 million, respectively, were pledged to secure government, public, trust and other deposits and as collateral for short- term borrowings, letters of credit and derivative instruments.
Additional sources of liquidity include federal funds purchased and lines of credit. Interest is charged at the prevailing market rate on federal funds purchased and FHLB advances. Funds and advances obtained from the FHLB are used primarily to match-fund fixed rate loans in order to minimize interest rate risk and also used to meet day to day liquidity needs, particularly when the cost of such borrowing compares favorably to the rates that we would be required to pay to attract deposits. The balance of outstanding overnight CMAs at December 31, 2018 and 2017 were $80.0 million and $190.0 million, respectively. During the third quarter of 2017, $100.0 million of 90 day fixed-rate advances were borrowed as part of the funding strategy of merger with the Clayton Banks as described in management’s discussion and analysis on lines of credit and other borrowings. At December 31, 2018 and 2017, the balance of our outstanding additional long-term advances with the FHLB were $1.8 million and $12.4 million, respectively. The remaining balance available with the FHLB was $455.2 million and $369.1 million at December 31, 2018 and 2017. We also maintain lines of credit with other commercial banks totaling $240.0 million and $165.0 million as of December 31, 2018 and 2017. These are unsecured, uncommitted lines of credit typically maturing at various times within the next twelve months. There were no borrowings against the lines at December 31, 2018 or 2017.
See discussion of deposit composition and seasonality in management's discussion and analysis of deposits.
Holding company liquidity management
The Company is a corporation separate and apart from the Bank and, therefore, it must provide for its own liquidity. The Company’s main source of funding is dividends declared and paid to it by the Bank. Statutory and regulatory limitations exist that affect the ability of the Bank to pay dividends to the Company. Management believes that these limitations will not impact the Company’s ability to meet its ongoing short-term cash obligations. For additional information regarding dividend restrictions, see the “Item 1. Business - Supervision and regulation,” "Item 1A. Risk Factors - Risks related to our business" and " Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities - Dividend Policy," sections in this Annual Report.
Due to state banking laws, the Bank may not declare dividends in any calendar year in an amount exceeding the total of its net income for that year combined with its retained net income of the preceding two years, without the prior approval of the Tennessee Department of Financial Institutions ("TDFI"). Based upon this regulation, as of December 31, 2018 and 2017, $164.9 million and $105.5 million of the Bank’s retained earnings were available for the payment of dividends without such prior approval. In addition, dividends paid by the Bank to the Company would be prohibited if the effect thereof would cause the Bank’s capital to be reduced below applicable minimum capital requirements.
During the year ended December 31, 2018, the Company declared dividends of $0.20 per share, or $6.4 million. Subsequent to December 31, 2018, the Company declared its fourth quarter dividend in the amount of $0.08 per share, or $2.5 million payable to stockholders of record as of February 1, 2019 on February 15, 2019.
Additionally, at December 31, 2018 and 2017, the Company had cash balances on deposit with the Bank totaling $17.4 million and $25.8 million, respectively, for ongoing corporate needs.
The Company is party to a registration rights agreement with its former majority shareholder entered into in connection with the 2016 IPO, under which the Company is responsible for payment of expenses (other than underwriting discounts and commissions) relating to sales to the public by the shareholder of shares of the Company's common stock beneficially owned by him. Such expenses include registration fees, legal and accounting fees, and printing costs payable by the Company and expensed when incurred. During the year ended December 31, 2018, the Company paid expenses totaling $0.7 million related to the completion of a follow-on secondary offering whereby the former majority shareholder was the seller. No such expenses were incurred during the year ended December 31, 2017. We believe that our present position is adequate to meet our current and future liquidity needs.
Capital management and regulatory capital requirements
Our capital management consists of providing adequate equity to support our current and future operations. We are subject to various regulatory capital requirements administered by state and federal banking agencies, including the TDFI, Federal Reserve and the FDIC. Failure to meet minimum capital requirements may prompt certain actions by regulators that, if undertaken, could have a direct material adverse effect on our financial condition and results of operations. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. Our capital amounts and classification are also subject to qualitative judgments by the regulators about components of capital, risk weightings and other factors.
As a result of recent developments such as the Dodd-Frank Act and Basel III, we have become subject to increasingly stringent regulatory capital requirements beginning in 2015. For further discussion of the changing regulatory framework in which we operate, see "Item 1. Business - Supervision and regulation" in this Annual Report.
The Federal Reserve, the FDIC and the Office of the Comptroller of the Currency have issued guidelines governing the levels of capital that banks must maintain. Those guidelines specify capital tiers, which include the classifications set forth in the following table. As of December 31, 2018 and 2017, we exceeded all capital ratio requirements under prompt corrective action and other regulatory requirements, as detailed in the table below:
We also have outstanding junior subordinated debentures with a carrying value of $30.9 million at December 31, 2018 and 2017, of which $30.0 million are included in our Tier 1 capital. The Federal Reserve Board issued rules in March 2005 providing stricter quantitative limits on the amount of securities that, similar to our junior subordinated debentures, are includable in Tier 1 capital. This guidance, which became fully effective in March 2009, did not impact the amount of debentures we include in Tier 1 capital. While our existing junior subordinated debentures are unaffected and are included in our Tier 1 capital, the Dodd-Frank Act specifies that any such securities issued after May 19, 2010 may not be included in Tier 1 capital.
In July 2013, the Federal Reserve, the FDIC and the Office of the Comptroller of the Currency approved the implementation of the Basel III regulatory capital reforms and issued rules affecting certain changes required by the Dodd-Frank Act, which we refer to as the Basel III Rules, that call for broad and comprehensive revision of regulatory capital standards for U.S. banking organizations. The Basel III Rules implement a new common equity Tier 1 minimum capital requirement, a higher minimum Tier 1 capital requirement and other items that will affect the calculation of the numerator of a banking organization’s risk-based capital ratios. Additionally, the Basel III Rules apply limits to a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a specified amount of common equity Tier 1 capital in addition to the amount necessary to meet its minimum risk-based capital requirements.
When fully implemented, the common equity Tier 1 capital ratio includes common equity as defined under GAAP and does not include any other type of non-common equity under GAAP. When the Basel III Rules are fully effective in 2019, banks will be required to have common equity Tier 1 capital of 4.5% of average assets, Tier 1 capital of 6% of average assets, as compared to the current 4%, and total capital of 8% of risk-weighted assets to be categorized as adequately capitalized.
The Basel III Rules do not require the phase-out of trust preferred securities as Tier 1 capital of bank holding companies whose asset size is under $15 billion.
Further, the Basel III Rules changed the agencies’ general risk-based capital requirements for determining risk-weighted assets, which will affect the calculation of the denominator of a banking organization’s risk-based capital ratios. The Basel III Rules have revised the agencies’ rules for calculating risk-weighted assets to enhance risk sensitivity and incorporate certain international capital standards of the Basel Committee on Banking Supervision set forth in the standardized approach of the “International Convergence of Capital Measurement and Capital Standards: A Revised Framework”.
The calculation of risk-weighted assets in the denominator of the Basel III capital ratios are adjusted to reflect the higher risk nature of certain types of loans. Specifically, as applicable to the Company and the Bank:
•
Commercial mortgages: Replaces the current 100% risk weight with a 150% risk weight for certain high volatility commercial real estate acquisition, development and construction loans.
•
Nonperforming loans: Replaces the current 100% risk weight with a 150% risk weight for loans, other than residential mortgages, that are 90 days past due or on nonaccrual status.
•
Securities pledged to overnight repurchase agreements: Replaced the current 0% risk weight with a 20% risk weight for repurchase agreements secured by mortgage back securities.
•
Unfunded lines of credit: Replaced the current 0% risk weight with 20% or higher based on risk category of collateral or guarantee for unfunded lines of credit maturing in one year or less.
Certain calculations under the rules related to deductions from capital have phase-in periods through 2018. Specifically, the capital treatment of MSRs is phased in through the transition periods. Under the prior rules, the Bank deducted 10% of the value of MSRs (net of deferred tax) from Tier 1 capital ratios. However, under Basel III, the Bank and the Company must deduct a much larger portion of the value of MSRs from Tier 1 capital.
•
MSRs (net of deferred tax in excess of 10% of Tier 1 capital before threshold based deductions must be deducted from common equity. The disallowable portion of MSRs will be phased in incrementally (40% in 2015; 60% in 2016; 80% in 2017 and beyond).
•
In addition, the combined balance of MSRs and deferred tax assets is limited to approximately 15% of the Bank's and the Company's common equity Tier 1 capital. These combined assets must be deducted from common equity to the extent that they exceed the 15% threshold.
•
Any portion of the Bank's and the Company's MSRs that are not deducted from the calculation of common equity Tier 1 is subject to a 100% risk weight.
On November 21, 2017, the federal banking regulators finalized a halt in the phase-in of certain provisions of the Rule for certain banks, including FirstBank. The final rules had provided for a number of adjustments to deductions from Tier 1 capital. Deductions included, for example, the requirement that MSRs, certain deferred tax assets not dependent upon future taxable income and significant investments in non-consolidated financial entities be deducted from Tier 1 Capital to the extent that any one such category exceeds 10% of Tier 1 capital or all such categories in the aggregate exceed 15% of Tier 1 capital.
Effective on January 1, 2018, the 2017 rule paused the full transition to the Basel III treatment, allowing the MSR disallowance to remain at 80%.
As of December 31, 2018 and 2017, the Bank and Company met all capital adequacy requirements to which it is subject. Also, as of June 30, 2017, the date of the most recent notification from the FDIC, the Bank was 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 Bank’s category. As part of our ongoing balance sheet and capital management during the quarter, the Company sold $39.4 million of mortgage servicing rights on $3.18 billion of serviced mortgages. There was not a material gain or loss recognized in this transaction; however, the sale provided approximately $20.0 million in regulatory capital relief to support continued growth in the Banking segment of our business.
On December 21, 2018, federal banking agencies issued a joint final rule to revise their regulatory capital rules to (i) address the upcoming implementation of the “current expected credit losses” (“CECL”) accounting standard under GAAP; (ii) provide an optional three-year phase-in period for the day-one adverse regulatory capital effects that banking organizations are expected to experience upon adopting CECL; and (iii) require the use of CECL in stress tests beginning with the 2020 capital planning and stress testing cycle for certain banking organizations. The Company is currently evaluating the impact of this change in accounting standard.
On November 21, 2018, the federal banking agencies jointly issued a proposed rule to simplify the regulatory capital requirements for eligible banks and holding companies with less than $10 billion in consolidated assets that opt into the Community Bank Leverage Ratio (“CBLR”) framework, as required by Section 201 of the Economic Growth, Relief and Consumer Protection Act (the “Regulatory Relief Act”). The Regulatory Relief Act mandates that the banking agencies develop a CBLR of not less than 8% and not more than 10% for qualifying community banking organizations. A qualifying community banking organization that exceeds the CBLR threshold would be exempt from the agencies’ current capital framework, including the risk-based capital requirements and capital conservation buffer described above, and would be deemed well-capitalized under the agencies’ prompt corrective action regulations. The Regulatory Relief Act defines a “qualifying community banking organization” as a depository institution or depository institution holding company with total consolidated assets of less than $10 billion. Under the proposed rule, if a qualifying community banking organization elects to use the CBLR framework, it will be considered “well-capitalized” so long as its CBLR is greater than 9%. The Company is currently evaluating the impact of this proposed rule.
On November 14, 2018, the Company entered into a purchase agreement to purchase eleven Tennessee and three Georgia branch locations from Atlantic Capital Bank, N.A. The result of the transaction is expected to decrease capital ratios upon consummation of the acquisition.
Capital Expenditures
Currently, we have not entered into any capital commitments exceeding $1 million over the next twelve months; however, over the next twelve months we plan on investing approximately $9.6 million in branch improvements and expansion across our markets.
Shareholders’ equity
Our total shareholders’ equity was $671.9 million at December 31, 2018 and $596.7 million, at December 31, 2017. Book value per share was $21.87 at December 31, 2018 and $19.54 at December 31, 2017. The growth in shareholders’ equity was attributable to earnings retention offset by declared dividends, changes in accumulated other comprehensive income and activity related to equity-based compensation.
Off-balance sheet arrangements
We enter into loan commitments and standby letters of credit in the normal course of our business. Loan commitments are made to accommodate the financial needs of our clients. Standby letters of credit commit us to make payments on behalf of clients when certain specified future events occur. Both arrangements have credit risk essentially the same as that involved in extending loans to clients and are subject to our normal credit policies. Collateral (e.g., securities, receivables, inventory, equipment, etc.) is obtained based on management’s credit assessment of the client.
Loan commitments and standby letters of credit do not necessarily represent our future cash requirements because while the borrower has the ability to draw upon these commitments at any time, these commitments often expire without being drawn upon. Our unfunded loan commitments and standby letters of credit outstanding at the dates indicated were as
follows:
We closely monitor the amount of our remaining future commitments to borrowers in light of prevailing economic conditions and adjust these commitments as necessary. We will continue this process as new commitments are entered into or existing commitments are renewed.
For more information about our off-balance sheet arrangements, see "Part I. Financial Information - Notes to Consolidated Financial Statements - Note (15) - Commitments and contingencies" in this Annual Report.
Risk Management
There have been no significant changes in our Risk Management practices as described in "Item 1. Business - Risk Management" in our Annual Report.
Credit risk
There have been no significant changes in our Credit Risk Management practices as described in our "Item 1. Business - Risk Management - Credit risk management" in our Annual Report.
Contractual obligations
The following tables present, as of December 31, 2018, our significant fixed and determinable contractual obligations to third parties by payment date. For more information about our contractual obligations, see "Part I. Financial Information - Notes to Consolidated Financial Statements - Note (15) - Commitments and contingencies" in this Annual Report.
(1)
Excludes Interest
ITEM 7A
ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest rate sensitivity
Our market risk arises primarily from interest rate risk inherent in the normal course of lending and deposit-taking activities. Management believes that our ability to successfully respond to changes in interest rates will have a significant impact on our financial results. To that end, management actively monitors and manages our interest rate risk exposure.
The Asset Liability Management Committee (“ALCO”), which is authorized by our board of directors, monitors our interest rate sensitivity and makes decisions relating to that process. The ALCO’s goal is to structure our asset/liability composition to maximize net interest income while managing interest rate risk so as to minimize the adverse impact of changes in interest rates on net interest income and capital in either a rising or declining interest rate environment. Profitability is affected by fluctuations in interest rates. A sudden and substantial change in interest rates may adversely impact our earnings because the interest rates borne by assets and liabilities do not change at the same speed, to the same extent or on the same basis.
We monitor the impact of changes in interest rates on our net interest income and economic value of equity (“EVE”) using rate shock analysis. Net interest income simulations measure the short-term earnings exposure from changes in market rates of interest in a rigorous and explicit fashion. Our current financial position is combined with assumptions regarding future business to calculate net interest income under varying hypothetical rate scenarios. EVE measures our long-term earnings exposure from changes in market rates of interest. EVE is defined as the present value of assets minus the present value of liabilities at a point in time. A decrease in EVE due to a specified rate change indicates a decline in the long-term earnings capacity of the balance sheet assuming that the rate change remains in affect over the life of the current balance sheet.
The following analysis depicts the estimated impact on net interest income and EVE of immediate changes in interest rates at the specified levels for the periods presented:
(1)
The percentage change represents the projected net interest income for 12 months and 24 months on a flat balance sheet in a stable interest rate environment versus the projected net income in the various rate scenarios.
(2)
The percentage change in this column represents our EVE in a stable interest rate environment versus EVE in the various rate scenarios.
The results for the net interest income simulations for December 31, 2018 and 2017 resulted in an asset sensitive position. The primary influence of our asset sensitivity is the variability in our loans held for sale and time deposit balances. As our mortgage loans held for sale increase, we become more asset sensitive. Conversely, as mortgage rates continue to rise, we expect our mortgage originations and mortgage loans held for sale to decline, which contribute to decreased asset sensitivity. As of December 31, 2018 the decrease in mortgage loans held for sale was offset by the increase in time deposits, which resulted in an overall asset sensitive position. Beta assumptions on loans and deposits were consistent for both time periods. The ALCO also reviewed beta assumptions for time deposits and loans with industry standards and revised them accordingly.
The preceding measures assume no change in the size or asset/liability compositions of the balance sheet. Thus, the measures do not reflect the actions the ALCO may undertake in response to such changes in interest rates. The scenarios assume instantaneous movements in interest rates in increments of 100, 200, 300 and 400 basis points. With the present position of the target federal funds rate, the declining rate scenarios seem improbable. Furthermore, it has been the Federal Reserve’s policy to adjust the target federal funds rate incrementally over time. As interest rates are adjusted over a period of time, it is our strategy to proactively change the volume and mix of our balance sheet in order to mitigate our interest rate risk. The computation of the prospective effects of hypothetical interest rate changes requires numerous assumptions regarding characteristics of new business and the behavior of existing positions. These business assumptions are based upon our experience, business plans and published industry experience. Key assumptions employed in the model include asset prepayment speeds, competitive factors, the relative price sensitivity of certain assets and liabilities and the expected life of non-maturity deposits. Because these assumptions are inherently uncertain, actual results may differ from simulated results.
We utilize derivative financial instruments as part of an ongoing effort to mitigate interest rate risk exposure to interest rate fluctuations and facilitate the needs of our customers.
The Company enters into derivative instruments that are not designated as hedging instruments to help its commercial customers manage their exposure to interest rate fluctuations. To mitigate the interest rate risk associated with customer contracts, the Company enters into an offsetting derivative contract. The Company manages its credit risk, or potential risk of default by its commercial customers through credit limit approval and monitoring procedures.
The Company has entered into interest rate swap contracts to hedge interest rate exposure on short term liabilities, as well as interest rate swap contracts to hedge interest rate exposure on subordinated debentures. These interest rate swaps are all accounted for as cash flow hedges, with the Company receiving a variable rate of interest and paying a fixed rate of interest.
The Company enters into rate lock commitments and forward loan sales contracts as part of our ongoing efforts to mitigate our interest rate risk exposure inherent in our mortgage pipeline and held for sale portfolio. Under the interest rate lock commitments, interest rates for a mortgage loan are locked in with the client for a period of time, typically 30 days. Once an interest rate lock commitment is entered into with a client, we also enter into a forward commitment to sell the residential mortgage loan to secondary market investors. Forward loan sale contracts are contracts for delayed sale and delivery of mortgage loans to a counter party. We agree to deliver on a specified future date, a specified instrument, at a specified price or yield. The credit risk inherent to us arises from the potential inability of counterparties to meet the terms of their contracts. In the event of non-acceptance by the counterparty, we would be subject to the credit and inherent (or market) risk of the loans retained.
Additionally, the Company enters into forward commitments, options and futures contracts that are not designated as hedging instruments, which serve as economic hedges of the change in fair value of its MSRs.
For more information about our derivative financial instruments, see Note 16, “Derivative Instruments,” in the notes to our consolidated financial statements.
Quarterly Results of Operations
Summarized unaudited quarterly operating results for the Company for the year ending December 31, 2018 and 2017 are as follows:
ITEM 8
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report on Management’s Assessment of Internal Control over Financial Reporting
The management of FB Financial Corporation (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting. The Company's internal control system was designed to provide reasonable assurance to the Company's management and board of directors regarding the preparation and fair presentation of the financial statements. No matter how well designed, internal control over financial reporting has inherent limitations, including the possibility that a control can be circumvented or overridden, and misstatements due to error or fraud may occur and not be detected. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
The Company's management assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2018. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework (2013).
Based on this assessment management has determined that, as of December 31, 2018, the Company's internal control over financial reporting is effective based on the specified criteria.
Report of Independent Registered Public Accounting Firm
Shareholders and the Board of Directors
FB Financial Corporation
Nashville, Tennessee
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheet of FB Financial Corporation (the "Company") as of December 31, 2018, the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for the 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 its operations and its cash flows for the year ended December 31, 2018, in conformity with accounting principles generally accepted in the United States of America.
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 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 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.
Franklin, Tennessee
March 12, 2019
Report of Independent Registered Public Accounting Firm
To the Shareholders and the Board of Directors of FB Financial Corporation:
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheet of FB Financial Corporation and its subsidiaries (the Company) as of December 31, 2017, the related consolidated statements of income, comprehensive income, changes in shareholders' equity and cash flows for each of the two years in the period ended December 31, 2017, and the related notes to the consolidated financial statements (collectively, 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, 2017, and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2017, in conformity with accounting principles generally accepted in the United States of America.
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 audits. 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 U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits 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. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are 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 audits 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 audits 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 audits provide a reasonable basis for our opinion.
/s/ RSM US LLP
We served as the Company's auditor from 2015 to 2017.
Jacksonville, Florida
March 16, 2018
FB Financial Corporation and subsidiaries
Consolidated balance sheets
(Amounts are in thousands except share and per share amounts)
See accompanying notes to consolidated financial statements.
FB Financial Corporation and subsidiaries
Consolidated statements of income
(Amounts are in thousands except share and per share amounts)
See accompanying notes to consolidated financial statements.
FB Financial Corporation and subsidiaries
Consolidated statements of comprehensive income
(Amounts are in thousands)
See accompanying notes to consolidated financial statements.
FB Financial Corporation and subsidiaries
Consolidated statements of changes in shareholders’ equity
(Amounts are in thousands except share and per share amounts)
See accompanying notes to consolidated financial statements.
FB Financial Corporation and subsidiaries
Consolidated statements of cash flows
(Amounts are in thousands)
See accompanying notes to consolidated financial statements.
Note (1)-Basis of presentation:
(A) Organization and Company overview:
FB Financial Corporation (f/k/a First South Bancorp, Inc.) (the “Company”) is a bank holding company headquartered in Nashville, Tennessee. The Company operates through its wholly-owned subsidiary, FirstBank (the "Bank"), with 56 full-service branches throughout Tennessee, north Alabama, and north Georgia, and a national mortgage business with office locations across the Southeast, which primarily originates loans to be sold in the secondary market.
On November 14, 2018, the Bank entered into a Purchase and Assumption Agreement to purchase 11 Tennessee and three Georgia branch locations (the "Branches") from Atlantic Capital Bank, N.A., a national banking association and a wholly owned subsidiary of Atlantic Capital Bancshares, Inc., a Georgia corporation (collectively, “Atlantic Capital”), further increasing market share in existing markets and expanding the Company's footprint into new locations. See Note 2, “Mergers and acquisitions” in the notes to the consolidated financial statements for further details regarding the terms and conditions of this acquisition.
The Bank is subject to competition from other financial services companies and financial institutions. The Company and the Bank are also subject to the regulations of certain federal and state agencies and undergo periodic examinations by those regulatory authorities. See "Supervision and regulation" in part 1, item 1, for more details regarding regulatory oversight.
On June 28, 2016, the Company declared a 100-for-1 stock split, increasing the number of issued and authorized shares from 171,800 to 17,180,000 and 250,000 to 25,000,000, respectively. Additional shares issued as a result of the stock split were distributed immediately upon issuance to the sole shareholder on that date. Share and per share amounts included in the consolidated financial statements and notes thereto reflect the effect of the split for all periods presented. Additionally, in July 2016, the Company increased the authorized shares from 25,000,000 to 75,000,000.
On August 19, 2016, the Company filed a registration statement on Form S-1 with the Securities and Exchange Commission (“SEC”) which was declared effective by the SEC on September 15, 2016. The Company sold and issued 6,764,704 shares of common stock at $19 per share pursuant to that registration statement. Total proceeds received by the Company, net of offering costs, were approximately $115,525. The proceeds were used to fund a $55,000 distribution to the majority shareholder representing undistributed earnings previously taxed to him under subchapter S, and used to repay all $10,075 aggregate principal amount of subordinated notes held by the majority shareholder, plus any accrued and unpaid interest thereon.
The Company terminated its S-Corporation status and became a taxable corporate entity (“C Corporation”) on September 16, 2016 in connection with its initial public offering. Unaudited pro forma amounts for income tax expense, net income, and basic and diluted earnings per share have been presented assuming the Company’s pro forma effective tax rate of 36.75% for the year ended December 31, 2016 as if it had been a C Corporation during that full year.
On May 26, 2017, the Company entered into Securities Purchase Agreements with accredited investors, pursuant to which the Company agreed to sell an aggregate of 4,806,710 shares of the Company’s common stock at a purchase price of $33.00 per share. Total proceeds received from such sale, net of placement agent and other offering costs of $5,901, were approximately $152,721.
Prior to May 31, 2018, the Company was considered a "controlled company" and was controlled by the Company's Executive Chairman and former majority shareholder, James W. Ayers. During the second quarter of 2018, the Company completed a secondary offering of 3,680,000 shares of common stock pursuant to the Company's effective registration statement on Form S-3 whereby James W. Ayers was the seller. As a result of this transaction, the Company ceased to qualify as a "controlled company" as the selling shareholder's ownership was reduced below 50% of the voting power of the Company's issued and outstanding shares of common stock. The Company continues to qualify as an emerging growth company as defined by the "Jumpstart Our Business Startups Act" ("JOBS Act").
(B) Basis of presentation:
The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and general banking industry. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and the reported results of operations for the year then ended.
Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant changes in the near term relate to the determination of the allowance for loan losses, investment securities determination of other-than-temporary impairment (“OTTI”), the determination of fair value in business combinations, the valuation of other
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
real estate owned, and the determination of the fair value of financial instruments, loans held for sale and mortgage servicing rights. See Note 17 for additional information regarding the determination of fair value.
The consolidated financial statements include the accounts of the Company, the Bank, and its’ wholly-owned subsidiaries, FirstBank Insurance, Inc. and Investors Title Company. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain prior period amounts have been reclassified to conform to the current period presentation without any impact on the reported amounts of net income or shareholders’ equity.
(C) Cash flows:
For purposes of reporting consolidated cash flows, cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold and interest earning deposits in other financial institutions with maturities of less than 90 days at the date of purchase. These amounts are reported in the consolidated balance sheets caption “Cash and cash equivalents.” Net cash flows are reported for loans held for investment, deposits and borrowings.
(D) Cash and cash equivalents:
The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash and cash equivalents.
(E) Investment securities:
Debt securities are classified as held to maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity. Debt securities are classified as available-for-sale when they might be sold before maturity. Available-for-sale debt securities are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income, net of applicable taxes.
Beginning as of January 1, 2018, equity securities with readily determinable market values are carried at fair value on the balance sheet with any periodic changes in value made through adjustments to the statement of income. Equity securities without readily determinable market values are carried at cost less impairment and included in other assets on the balance sheet.
Interest income includes the amortization and accretion of purchase premium and discount. Premiums and discounts on securities are amortized on the level-yield method anticipating prepayments based upon the prior three month average monthly prepayments when available. Gains and losses on sales are recorded on the trade date and determined using the specific identification method.
The Company evaluates available-for-sale securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. For securities in an unrealized loss position, consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. In analyzing an issuer’s financial condition, the Company considers whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition.
When OTTI is determined to have occurred, the amount of the OTTI recognized in earnings depends on whether we intend to sell the security or it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis. If we intend to sell the security or it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, the OTTI recognized in earnings is equal to the entire difference between its amortized cost basis and its fair value at the date it was determined to be OTTI. If we do not intend to sell the security and it is not more likely than not that we will be required to sell the security before recovery of its amortized cost basis, the OTTI is separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized as a charge to earnings. The amount of the OTTI related to other factors is recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the investment. During the years ended December 31, 2018, 2017 and 2016, the Company did not record any OTTI on the available-for-sale portfolio; however, during the year ended December 31, 2017, the Company recognized impairment of $945 on one of its equity securities without a readily determinable market value as discussed in Note 4. There were no such impairment charges taken during the years ended December 31, 2018 or 2016.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
(F) Federal Home Loan Bank (FHLB) stock:
The Bank accounts for its investments in FHLB stock in accordance with FASB ASC Topic 942-325 "Financial Services-Depository and Lending-Investments-Other." FHLB stock are equity securities that do not have a readily determinable fair value because its ownership is restricted and lacks a market. FHLB stock is carried at cost and evaluated for impairment.
(G) Loans held for sale:
Loans originated and intended for sale in the secondary market, primarily mortgage loans, are carried at fair value as permitted under the guidance in ASC 825, “Financial Instruments” (“ASC 825”). Net (losses) gains of $(4,539), $9,111, and $(2,289) resulting from fair value changes of these mortgage loans were recorded in income during the years ended December 31, 2018, 2017 and 2016, respectively. The amount does not reflect changes in fair values of related derivative instruments used to hedge exposure to market-related risks associated with these mortgage loans. The change in fair value of both mortgage loans held for sale and the related derivative instruments are recorded in “Mortgage banking income” in the Consolidated Statements of Income. Gains and losses are recognized in Mortgage banking income on the consolidated statements of income at the time the loan is closed. Pass through origination costs and related loan fees are also included in “Mortgage banking income”. Effective December 31, 2017, the Company adopted a change in accounting policy to recognize revenue on Best Efforts deliveries and accrue commissions at the time of the interest rate lock commitment. Management believes this treatment better correlates and streamlines the revenue and expenses of mortgage sale delivery methods.
Periodically, the Bank will transfer mortgage loans originated for sale in the secondary markets into the loan portfolio based on current market conditions, the overall secondary marketability of the loan and the status of the loan. During 2018, 2017, and 2016, the Bank transferred $14,732, $11,706, and $17,963, respectively, of residential mortgage loans into its portfolio. The loans are transferred into the portfolio at fair value at the date of transfer. On occasion, the Bank is able to restructure and sell certain of these mortgage loans previously originated to sell in the secondary market that were included in the Bank's loans held for investment portfolio. At the time of transfer, loans are marked to fair value through adjustment to the allowance for loan losses and reclassified to loans held for sale. During the year ended December 31, 2018, the Company transferred $11,888 of loans held for investment to loans held for sale, resulting in an adjustment to the allowance for loan losses of $349. There were no such transfers during the years ended December 31, 2017 or 2016.
Government National Mortgage Association (GNMA) optional repurchase programs allow financial institutions to buy back individual delinquent mortgage loans that meet certain criteria from the securitized loan pool for which the institution provides servicing and was the original transferor. At the servicer’s option and without GNMA’s prior authorization, the servicer may repurchase such a delinquent loan for an amount equal to 100 percent of the remaining principal balance of the loan. Under FASB ASC Topic 860, “Transfers and Servicing,” this buy-back option is considered a conditional option until the delinquency criteria are met, at which time the option becomes unconditional. When the Company is deemed to have regained effective control over these loans under the unconditional buy-back option, the loans can no longer be reported as sold and must be brought back onto the balance sheet as loans held for sale, regardless of whether the Company intends to exercise the buy-back option if the buyback option provides the transferor a more-than-trivial benefit. At December 31, 2018, there were $67,362 of delinquent GNMA loans that had previously been sold; however, the Company determined there was not a "more-than-trivial benefit" based on an analysis of interest rates and an assessment of potential reputational risk associated with these loans. As such, the Company did not rebook the GNMA loans as of December 31, 2018. At December 31, 2017, rebooked GNMA loans held for sale amounted to $43,035 with an offsetting liability included in accrued expenses and other liabilities in the same amount. The fair value option election does not apply to the GNMA optional repurchase loans which do not meet the requirements under FASB ASC Topic 825 to be accounted for under the fair value option.
(H) Loans (excluding purchased credit impaired loans):
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are stated at the principal amount outstanding less any purchase accounting discount net of any accretion recognized to date. Interest on loans is recognized as income by using the simple interest method on daily balances of the principal amount outstanding plus any accretion of purchase accounting discounts.
Loans on which the accrual of interest has been discontinued are designated as nonaccrual loans. Accrual of interest is discontinued on loans past due 90 days or more unless the credit is well secured and in the process of collection. Also, a loan may be placed on nonaccrual status prior to becoming past due 90 days if management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
principal or interest is doubtful. The decision to place a loan on nonaccrual status prior to becoming past due 90 days is based on an evaluation of the borrower’s financial condition, collateral liquidation value, economic and business conditions and other factors that affect the borrower’s ability to pay. When a loan is placed on nonaccrual status, the accrued but unpaid interest is charged against current period operations. Thereafter, interest on nonaccrual loans is recognized only as received if future collection of principal is probable. If the collectability of outstanding principal is doubtful, interest received is applied as a reduction of principal. A loan may be restored to accrual status when principal and interest are no longer past due or it otherwise becomes both well secured and collectability is reasonably assured.
(I) Allowance for loan losses:
The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off.
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 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.
Commercial and commercial real estate loans over $250 are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans, such as consumer, residential real estate loans, commercial and commercial real estate loans less than $250 are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures.
Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings (“TDRs”) and classified as impaired. TDRs are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a TDR is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral.
The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio segment and is based on the actual loss history experienced by the Company over the most recent 5 years. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations.
The following portfolio segments have been identified:
Commercial and industrial loans. The Company provides a mix of variable and fixed rate commercial and industrial loans. Commercial and industrial loans are typically made to small- and medium-sized manufacturing, wholesale, retail and service businesses for working capital and operating needs and business expansions, including the purchase of capital equipment and loans made to farmers relating to their operations. This category also includes loans secured by manufactured housing receivables. Commercial and industrial loans generally include lines of credit and loans with maturities of five years or less. The loans are generally made with operating cash flows as the primary source of repayment, but may also include collateralization by inventory, accounts receivable, equipment and/or personal guarantees. The ability of the borrower to collect accounts receivable, and to turn inventory into sales are risk factors in the repayment of the loan.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Construction loans. Construction loans include commercial construction, land acquisition and land development loans and single-family interim construction loans to small- and medium-sized businesses and individuals. These loans are generally secured by the land or the real property being built and are made based on our assessment of the value of the property on an as-completed basis. We expect to continue to make construction loans at a similar pace so long as demand continues and the market for and values of such properties remain stable or continue to improve in our markets. These loans can carry risk of repayment when projects incur cost overruns, have an increase in the price of building materials, encounter zoning and environmental issues, or encounter other factors that may affect the completion of a project on time and on budget. Additionally, repayment risk may be negatively impacted when the market experiences a deterioration in the value of real estate.
Residential real estate 1-4 family mortgage loans. The Company’s residential real estate 1-4 family mortgage loans are primarily made with respect to and secured by single family homes, which are both owner-occupied and investor owned and include manufactured homes with real estate. The Company intends to continue to make residential 1-4 family housing loans at a similar pace, so long as housing values in our markets do not deteriorate from current prevailing levels and we are able to make such loans consistent with our current credit and underwriting standards. First lien residential 1-4 family mortgages may be affected by unemployment or underemployment and deteriorating market values of real estate.
Residential line of credit loans. The Company’s residential line of credit loans are primarily revolving, open-end lines of credit secured by 1-4 residential properties. The Company intends to continue to make home equity loans if housing values in our markets do not deteriorate from current prevailing levels and we are able to make such loans consistent with our current credit and underwriting standards. Second lien residential 1-4 family mortgages may be affected by unemployment or underemployment and deteriorating market values of real estate.
Multi-family residential loans. The Company’s multi-family residential loans are primarily secured by multi-family properties, such as apartments and condominium buildings. These loans also may be affected by unemployment or underemployment and deteriorating market values of real estate.
Commercial real estate loans. The Company’s commercial real estate owner-occupied loans include loans to finance commercial real estate owner occupied properties for various purposes including use as offices, warehouses, production facilities, health care facilities, retail centers, restaurants, churches and agricultural based facilities. Commercial real estate owner-occupied loans are typically repaid through the ongoing business operations of the borrower, and hence are dependent on the success of the underlying business for repayment and are more exposed to general economic conditions.
Commercial real estate non-owner occupied loans. The Company’s commercial real estate non-owner occupied loans include loans to finance commercial real estate non-owner occupied investment properties for various purposes including use as offices, warehouses, health care facilities, hotels, mixed-use residential/commercial, manufactured housing communities, retail centers, assisted living facilities and agricultural based facilities. Commercial real estate non-owner occupied loans are typically repaid with the funds received from the sale of the completed property or rental proceeds from such property, and are therefore more sensitive to adverse conditions in the real estate market, which can also affected by general economic conditions.
Consumer and other loans. The Company’s consumer and other loans include loans to individuals for personal, family and household purposes, including car, boat and other recreational vehicle loans, manufactured homes without real estate, and personal lines of credit. Consumer loans are generally secured by vehicles and other household goods. The collateral securing consumer loans may depreciate over time. The company seeks to minimize these risks through its underwriting standards. Other loans also include loans to states and political subdivisions in the U.S. These loans are generally subject to the risk that the borrowing municipality or political subdivision may lose a significant portion of its tax base or that the project for which the loan was made may produce inadequate revenue.
(J) Business combinations and accounting for acquired loans with credit deterioration:
Business combinations are accounted for by applying the acquisition method in accordance with ASC 805, “Business Combinations” (“ASC 805”). Under the acquisition method, identifiable assets acquired and liabilities assumed and any non-controlling interest in the acquiree at the acquisition date are measured at their fair values as of that date. Any excess of the purchase price over fair value of net assets acquired is recorded as goodwill. To the extent the fair value of net assets acquired, including any other identifiable intangible assets, exceed the purchase price, a bargain purchase gain is recognized. Results of operations of acquired entities are included in the Consolidated Statements of Income from the date of acquisition.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Loans acquired in business combinations with evidence of credit deterioration since origination and for which it is probable that all contractually required payments will not be collected are considered to be credit-impaired. Purchased credit-impaired loans (“PCI” loans) are accounted for under the accounting guidance for loans and debt securities acquired with deteriorated credit quality, in accordance with ASC 310-30, “Loans and Debt Securities Acquired with Deteriorated Credit Quality” (“ASC 310-30”), and initially measured at fair value, which includes estimated future credit losses expected to be incurred over the life of the loans. Increases in expected cash flows to be collected on these loans are recognized as an adjustment of the loan’s yield over its remaining life, while decreases in expected cash flows are recognized as an impairment. As a result, related discounts are recognized subsequently through accretion based on the expected cash flow of the acquired loans or through adjustment to the allowance for loan loss for any impairment identified subsequent to acquisitions.
(K) Premises and equipment:
Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Provisions for depreciation are computed principally on the straight-line method and are charged to occupancy expense over the estimated useful lives of the assets. Maintenance agreements are amortized to expense over the period of time covered by the agreement. Costs of major additions, replacements or improvements are capitalized while expenditures for maintenance and repairs are charged to expense as incurred.
For financial statement purposes, the estimated useful life for premises is forty years, for furniture and fixtures the estimated useful life is seven to ten years, for leasehold improvements the estimated useful life is the lesser of twenty years or the term of the lease and for equipment the estimated useful life is three to seven years.
(L) Other real estate owned:
Real estate acquired through, or in lieu of, loan foreclosure is initially recorded at fair value less the estimated cost to sell at the date of foreclosure which may establish a new cost basis. Other real estate owned may also include excess facilities held for sale as described in Note 7. Physical possession of residential real estate property collateralizing a consumer mortgage loan occurs when legal title is obtained upon completion of foreclosure or when the borrower conveys all interest in the property to satisfy the loan. After initial measurement, valuations are periodically performed by management and the asset is carried at the lower of carrying amount or fair value less costs to sell. Revenue and expenses from operations are included in other noninterest income and noninterest expenses. Losses due to the valuation of the property are included in (loss) gain on sales or write-downs of other real estate owned.
(M) Mortgage servicing rights:
The Company retains the right to service certain mortgage loans that it sells to secondary market investors. The retained mortgage servicing right is initially recorded at the fair value of future net cash flows expected to be realized for performing servicing activities. Fair value is determined using an income approach with various assumptions including expected cash flows, prepayment speeds, market discount rates, servicing costs, and other factors. These mortgage servicing rights are recognized as a separate asset on the date the corresponding mortgage loan is sold.
In periods prior to 2017, mortgage servicing rights were amortized in proportion to and over the period of estimated net servicing income. These servicing rights were carried at amortized cost less any impairment. Impairment losses on mortgage servicing rights were recognized to the extent by which the unamortized cost exceeded fair value. Impairment losses on mortgage servicing rights of $4,678 was recognized in earnings during the year ended December 31, 2016.
As of January 1, 2017, the Company elected to account for its mortgage servicing rights under the fair value option as permitted under ASC 860-50-35, Transfers and Servicing. The change in accounting policy resulted in a one-time adjustment to retained earnings of $615 for the after-tax increase in fair value above book value at the time of adoption. Subsequent changes in fair value are recorded in earnings in Mortgage banking income.
(N) Transfers of financial assets:
Transfers of financial assets are accounted for as sales, when control over the assets has been relinquished. Control over transferred assets is deemed to be surrendered when the assets have been isolated from the Company, the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
(O) Goodwill and other intangibles:
Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. Goodwill impairment testing is performed annually or more frequently if events or circumstances indicate possible impairment. Goodwill is assigned to the Company’s reporting units, Banking or Mortgage as applicable. See Note 2, “Mergers and acquisitions” for information related to the goodwill recorded in the Bank’s acquisitions of Clayton Bank and Trust and American City Bank. Goodwill is evaluated for impairment by either performing a qualitative evaluation or a two-step quantitative test. The qualitative evaluation is an assessment of factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill. If an entity does a qualitative assessment and determines that it is not more likely than not the fair value of a reporting unit is less than its carrying amount, then goodwill of the reporting unit is not considered impaired, and it is not necessary to continue to the two-step goodwill impairment test. If the estimated implied fair value of goodwill is less than the carrying amount, an impairment loss would be recognized in noninterest expense to reduce the carrying amount to the estimated implied fair value which could be material to our operating results for any particular reporting period. No impairment was identified through the qualitative annual assessments for impairment performed as of December 31, 2018 and 2016. A quantitative assessment was performed for the year ended December 31, 2017 which also indicated no impairment.
Other intangible assets consist of core deposit intangible assets arising from whole bank and branch acquisitions in addition to an operating lease intangible, customer trust intangible and manufactured housing loan servicing intangible recorded in conjunction with the acquisition of the Clayton Banks completed on July 31, 2017 (see Note 2). All intangible assets are initially measured at fair value and then amortized over their estimated useful lives. See Note 8 for additional information on other intangibles.
(P) Income taxes:
Prior to September 16, 2016, the Company was taxed under the provisions of subchapter S of the Internal Revenue Code. Under these provisions, the Company did not pay corporate federal income taxes on its taxable income but was liable for Tennessee corporate income taxes. Instead, the shareholder was liable for individual income taxes on the Company’s taxable income. The Company and the Bank file consolidated federal and state income tax returns.
Unaudited pro forma amounts for income tax expense, net income and basic and diluted earnings per common share have been presented assuming the Company’s pro forma effective tax rate of 36.75% for the year ended December 31, 2016 as if it had been a C corporation during the full year. In addition, the unaudited pro forma results for the year ended December 31, 2016 excludes the effect of recognition of the deferred tax liability attributable to conversion of $13,181 as discussed in Note 13.
Income tax expense is the total of the current year income tax due and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. See Note 13, “Income taxes” for information related to the impact of the Tax Cuts and Jobs Act signed into law on December 22, 2017.
A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.
The Company’s policy is to recognize interest and penalties on uncertain tax positions in “Income tax expense” in the Consolidated Statements of Income. There were no amounts related to interest and penalties recognized for the years ended December 31, 2018, 2017 or 2016.
(Q) Long-lived assets:
Premises and equipment, core deposit intangible assets, and other long-lived assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value. No long-lived assets were deemed to be impaired at December 31, 2018 and 2017.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
(R) Off-balance sheet financial instruments:
Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded, unless considered derivatives.
(S) Derivative financial instruments and hedging activities:
All derivative financial instruments are recorded at their fair values in other assets or other liabilities in the consolidated balance sheets in accordance with ASC 815, “Derivatives and Hedging.” If derivative financial instruments are designated as hedges of fair values, both the change in the fair value of the hedge and the hedged item are included in current earnings. If derivative financial instruments are not designated as hedges, only the change in the fair value of the derivative instrument is included in current earnings.
Cash flow hedges are utilized to mitigate the exposure to variability in expected future cash flows or other types of forecasted transactions. For the Company’s derivatives designated as cash flow hedges, changes in the fair value of cash flow hedges are, to the extent that the hedging relationship is effective, recorded as other comprehensive income and are subsequently recognized in earnings at the same time that the hedged item is recognized in earnings. The ineffective portions of the changes in fair value of the hedging instruments are immediately recognized in earnings. The assessment of the effectiveness of the hedging relationship is evaluated under the hypothetical derivative method.
The Company also utilizes derivative instruments that are not designated as hedging instruments. The Company enters into interest rate cap and/or floor agreements with its customers and then enters into an offsetting derivative contract position with other financial institutions to mitigate the interest rate risk associated with these customer contracts. Because these derivative instruments are not designated as hedging instruments, changes in the fair value of the derivative instruments are recognized currently in earnings.
The Company also enters into commitments to originate loans whereby the interest rate on the loan is determined prior to funding (rate-lock commitments). Rate-lock commitments on mortgage loans that are intended to be sold are considered to be derivatives. Accordingly, such commitments, along with any related fees received from potential borrowers, are recorded at fair value in other assets or liabilities, with changes in fair value recorded in the line item “Mortgage banking income” on the Consolidated Statements of Income. Fair value is based on fees currently charged to enter into similar agreements, and for fixed-rate commitments, the difference between current levels of interest rates and the committed rates is also considered.
The Company utilizes forward loan sale contracts and forward sales of residential mortgage-backed securities to mitigate the interest rate risk inherent in the Company’s mortgage loan pipeline and held-for-sale portfolio. Forward sale contracts are contracts for delayed delivery of mortgage loans or a group of loans pooled as mortgage-backed securities. The Company agrees to deliver on a specified future date, a specified instrument, at a specified price or yield. However, the contract may allow for cash settlement. The credit risk inherent to the Company arises from the potential inability of counterparties to meet the terms of their contracts. In the event of non-acceptance by the counterparty, the Company would be subject to the credit and inherent (or market) risk of the loans retained. Such contracts are accounted for as derivatives and, along with related fees paid to investor are recorded at fair value in derivative assets or liabilities, with changes in fair value recorded in the line item “Mortgage banking income” on the Consolidated Statements of Income. Fair value is based on the estimated amounts that the Company would receive or pay to terminate the commitment at the reporting date.
The Company utilizes two methods to deliver mortgage loans sold to an investor. Under a “best efforts” sales agreement, the Company enters into a sales agreement with an investor in the secondary market to sell the loan when an interest rate-lock commitment is entered into with a customer, as described above. Under a “best efforts” sales agreement, the Company is obligated to sell the mortgage loan to the investor only if the loan is closed and funded. Thus, the Company will not incur any liability to an investor if the mortgage loan commitment in the pipeline fails to close. The Company also utilizes “mandatory delivery” sales agreements. Under a mandatory delivery sales agreement, the Company commits to deliver a certain principal amount of mortgage loans to an investor at a specified price and delivery date. Penalties are paid to the investor should the Company fail to satisfy the contract. Mandatory commitments are recorded at fair value in the Company’s Consolidated Balance Sheets. Gains and losses arising from changes in the valuation of these commitments are recognized currently in earnings and are reflected under the line item “Mortgage banking income” on the Consolidated Statements of Income.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
(T) Lender risk account:
During 2018 the Company began selling qualified mortgage loans to FHLB-Cincinnati via the Mortgage Purchase Program (“MPP”). All mortgage loans purchased from members through the MPP are held on the FHLB’s balance sheet. FHLB does not securitize MPP loans for sale to other investors. They mitigate their credit risk exposure through their underwriting and pool composition requirements and through the establishment of the Lender Risk Account (“LRA”) credit enhancement. The LRA protects the FHLB against possible credit losses by setting aside a portion of the initial purchase price into a performance based escrow account that can be used to offset possible loan losses. The LRA amount is established as a percentage applied to the sum of the initial unpaid principal balance of each mortgage in the aggregated pool at the time of the purchase of the mortgage as determined by the FHLB-Cincinnati and is funded by the deduction from the proceeds of sale of each mortgage in the aggregated pool to the FHLB-Cincinnati. The Company had on deposit with the FHLB-Cincinnati $5,225 at December 31, 2018 in these LRA’s. These accounts are held by the FHLB-Cincinnati and the Company bears the risk of receiving less than 100% of its LRA contribution in the event of losses, either by the Company or other members selling mortgages in the aggregated pool. Any losses will be deducted first from the individual LRA contribution of the institution that sold the mortgage of which the loss was incurred. If losses incurred in the aggregated pool are greater than the member’s LRA contribution, such losses will be deducted from the LRA contribution of other members selling mortgages in that aggregated pool. Any portion of the LRA not used to pay losses will be released over a thirty year period and will not start until the end of five years after the initial fill-up period.
(U) Comprehensive income:
Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses on available-for-sale securities and derivatives designated as cash flow hedges, net of taxes.
(V) Loss contingencies:
Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there are such matters that will have a material effect on the financial statements.
(W) Securities sold under agreements to repurchase:
The Company routinely sells securities to certain customers and then repurchases the securities the next business day. Securities sold under agreements to repurchase are recorded on the consolidated balance sheets at the amount of cash received in connection with each transaction in the line item "Borrowings". These are secured liabilities and are not covered by the Federal Deposit Insurance Corporation. See Note 12, "Borrowings" in the Notes to the consolidated financial statements for additional details regarding securities sold under agreements to repurchase.
(X) Advertising expense:
Advertising costs, including costs related to internet mortgage marketing and related costs, are expensed as incurred. For the years ended December 31, 2018, 2017 and 2016, advertising costs were $13,139, $12,957 and $10,608, respectively.
(Y) Earnings per common share:
Basic earnings per common share ("EPS") excludes dilution and is computed by dividing earnings attributable to common shareholders by the weighted average number of common shares outstanding during the period. Diluted EPS includes the dilutive effect of additional potential common shares issuable under the restricted stock units granted but not yet vested and distributable. DIluted EPS is computed by dividing earnings attributable to common shareholders by the weighted average number of common shares outstanding for the year, plus an incremental number of common-equivalent shares computed using the treasury stock method.
Unvested share-based payment awards, which include the right to receive non-forfeitable dividends or dividend equivalents, are considered to participate with common shareholders in undistributed earnings for purposes of computing EPS. Companies that have such participating securities, including the Company, are required to calculate basic and diluted EPS using the two-class method. Certain restricted stock awards granted by the Company include non-forfeitable dividend equivalents and are considered participating securities. Calculations of EPS under the two-class method (i) exclude from the numerator any dividends paid or owed on participating securities and any undistributed earnings considered to be attributable to participating securities and (ii) exclude from the denominator the dilutive impact of the participating securities.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
The following is a summary of the basic and diluted earnings per common share calculation for each of the periods presented:
(Z) Segment reporting:
The Company’s Mortgage division represents a distinct reportable segment which differs from the Company’s primary business of Banking. Accordingly, a reconciliation of reportable segment revenues, expenses and profit to the Company’s consolidated total has been presented in Note 19.
(AA) Stock-based compensation:
Stock-based compensation expense is recognized in accordance with ASC 718-20, “Compensation - Stock Compensation Awards Classified as Equity”. Expense is recognized based on the fair value of the portion of stock-based payment awards that are ultimately expected to vest, reduced for forfeitures based on grant-date fair value. The restricted stock unit awards and related expense are amortized over the required service period, if any.
(AB) Recently adopted accounting principles:
In May 2014, the FASB issued an update to Accounting Standards Update (“ASU”) No. 2014-9, “Revenue from Contracts with Customers” (FASB Topic 606). The Company adopted this guidance on January 1, 2018 and all subsequent amendments to the ASU (collectively, "ASC 606") which (i) creates a single framework for recognizing revenue from contracts with customers that fall within its scope and (ii) revises when it is appropriate to recognize a gain (loss) from the transfer of nonfinancial assets, such as OREO. The majority of the Company's revenues come from interest income and other sources, including loans, leases, securities, and derivatives that are outside the scope of ASC 606. The Company's services that fall within the scope of ASC 606 are presented within Noninterest income and are recognized as revenue as the Company satisfies its obligation to the customer. Services within the scope of ASC 606 include deposit service charges on deposits, interchange income, investment services and trust income, and the sale of OREO, all within the Banking Segment. The Company has evaluated the effect of this updated on these fee-based income streams and concluded that adoption did not result in a change to the accounting for any of the in-scope revenue streams; as such, no cumulative effect adjustment was recorded.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
The following is a summary of the implementation considerations for the revenue streams that fall within the scope of Topic 606:
•
Service charges on deposits, investment services and trust income, and interchange fees -- Fees from these services are either transaction based, for which the performance obligations are satisfied when the individual transaction is processed, or set periodic service charges, for which the performance obligations are satisfied over the period the service is provided. Transaction based fees are recognized at the time the transaction is processed, and periodic service charges are recognized over the service period. The adoption of Topic 606 had no impact on the Company's revenue recognition practice for these services.
•
Gains on sales of other real estate -- ASU 2014-09 creates Topic 610-20, under which a gain on sale should be recognized when a contract for sale exists and control of the asset has been transferred to the buyer. Topic 606 list several criteria which must exist to conclude that a contract for sale exists, including a determination that the institution will collect substantially all of the consideration to which it is entitled. This presents a key difference between the current and new guidance related to the recognition of the gain when the institution finances the sale of the property. Rather than basing recognition on the amount of the buyer's initial investment, which was the primary consideration under prior guidance, the analysis is now based on various factors including not only the loan to value, but also the credit quality of the borrower, the structure of the loan, and any other factors that may affect collectability. While these differences may affect the decision to recognize or defer gains on sales of other real estate in circumstances where the Company has financed the sale, these amounts have not been material to its financial statements.
In January 2016, the FASB released ASU 2016-1, “Recognition and Measurement of Financial Assets and Liabilities.” The main provisions of the update are to eliminate the available for sale classification of accounting for equity securities and adjust the fair value disclosures for financial instruments carried at amortized cost such that the disclosed fair values represent an exit price as opposed to an entry price. The provisions of this update will require that equity securities be carried at fair market value on the balance sheet and any periodic changes in value will be adjustments to the income statement. A practical expedient is provided for equity securities without a readily determinable fair value such that these securities can be carried at cost less any impairment. Results for reporting periods beginning after January 1, 2018 are presented under this method while prior period disclosures are presented under legacy GAAP. On January 1, 2018, the Company recorded a net loss in beginning retained earnings of $109 in connection with this transition.
In August 2016, the FASB issued ASU 2016-15, "Statement of Cash Flows - Classification of Certain Cash Receipts and Cash Payments (Topic 230)." ASU 2016-15 provides guidance related to certain cash flow issues in order to reduce the current and potential future diversity in practice. This adoption did not have an impact on our financial statements.
In May 2017, the FASB issued ASU 2017-9, “Stock Compensation - Scope of Modification Accounting (Topic 718): Scope of Modification Accounting.” The amendments in this ASU provide guidance on when changes to the terms or conditions of a share-based payment award are to be accounted for as modifications. Under ASU 2017-9, entities are not required to apply modification accounting to a share-based payment award when the award’s fair value, vesting conditions, and classification as an entity or a liability instrument remain the same after the change. ASU 2017-9 is effective for all entities beginning after December 15, 2017 including interim periods within the fiscal year. The adoption of this update on January 1, 2018 did not have a significant impact on the Company's consolidated financial statements.
In August 2017, the FASB issued ASU 2017-12, “Derivatives and Hedging: Targeted Improvements to Accounting for Hedging Activities.” The amendments in this ASU make more financial and non-financial hedging strategies eligible for hedge accounting. It also amends the presentation and disclosure requirements and changes how companies assess effectiveness. The Company elected to early adopt this update effective January 1, 2018. The adoption of this standard did not have a significant impact on our consolidated financial statements.
In February 2018, the FASB issued ASU 2018-02, “Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income.” The amendments in this ASU addressed the income tax accounting treatment of the stranded tax effects within other comprehensive income due to the newly enacted federal corporate tax rate included in the Tax Cuts and Jobs Act issued December 22, 2017. These amendments allow an entity to make a reclassification from other comprehensive income to retained earnings for the difference between the historical corporate income tax rate and the newly enacted corporate income tax rate. The amendments are effective for fiscal years beginning after December 15, 2018, including interim periods within those years. Early adoption is permitted, including adoption in any interim period, for public companies for reporting periods for which financial statements have not yet been issued. The Company elected to early adopt ASU 2018-2 for the year ended December 31, 2017 and, as a result,
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
reclassified $652 from accumulated other comprehensive income to retained earnings resulting from the income tax effect of the Tax Cuts and Jobs Act as of January 1, 2018.
Newly issued not yet effective accounting standards:
In February 2016, the FASB issued ASU 2016-2, “Leases (Topic 842).” The update will require lessees to recognize right-of-use assets and lease liabilities for all leases not considered short term leases. The provisions of the update also include (a) defining direct costs to only include those incremental costs that would not have been incurred if the lease had not been entered into, (b) circumstances under which the transfer contract in a sale-leaseback transaction should be accounted for as the sale of an asset by the seller-lessee and the purchase of an asset by the buyer-lessor, and (c) additional disclosure requirements. The provisions of this update became effective for the Company on January 1, 2019.
In July 2018, the FASB issued ASU 2018-10, “Codification Improvements to Topic 842, Leases” and 2018-11, “Leases (Topic 842): Targeted Improvements”. ASU No. 2018-10 provides improvements related to ASU No. 2016-02 to provide corrections or improvements to a number of areas within FASB ASC Topic 842 and provides additional and optional transition method to adopt the new lease standard. ASU No. 2018-11 allows entities to initially apply the new lease standard at the adoption date and recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. ASU 2018-11 also allows lessors to not separate non-lease components from the associated lease component if certain conditions are met. The amendments in these updates became effective for the Company on January 1, 2019.
FB Financial Corporation elected the optional transition method permitted by ASU 2018-11. Under this method, an entity shall recognize and measure leases that exist at the application date and prior comparative periods are not adjusted. Additionally, the Company elected to adopt the practical expedients allowed under the updates and therefore will not reassess 1) whether any expired or existing contract contain leases, 2) the lease classification for any expired or existing leases, or 3) initial direct costs for any existing leases.
The Company obtained a third-party software application to provide lease contract maintenance and lease accounting under the guidelines of the new standard. Management is currently finalizing the evaluation of the Company’s lease obligations as potential lease assets and liabilities and defined by ASU 2016-02; however, the adoption of ASU 2016-02 is not expected to have a material impact on the Company’s consolidated financial statements. Based on Management’s preliminary analysis of existing lease contracts at December 31, 2018, it is estimated that the adoption of ASU 2016-02 will result in an increase to the Company's consolidated balance sheet to be between 0.4% and 0.8% of total assets. The Company has an immaterial amount of leases in which it is the lessor and does not expect the provisions of these updates to have any material impact on retaining earnings or the Consolidated statements of income. Disclosures required by the amendments of ASU 2016-02 will be presented beginning with the Quarterly Report on From 10-Q for the period ending March 31, 2019.
In June 2016, the FASB issued ASU 2016-13, “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” ASU 2016-13 requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts and requires enhanced disclosures related to the significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an organization’s portfolio. The new model will require institutions to calculate all probable and estimable losses that are expected to be incurred through the financial asset's entire life through a provision for credit losses, including loans obtained as a result of any acquisition not deemed to be purchased credit deteriorated (PCD). CECL also requires the allowance for credit losses for PCD loans to be determined in a manner similar to that of other financial assets measured at amortized cost; however, the initial allowance will be added to the purchase price rather than recorded as provision expense. The disclosure of credit quality indicators related to the amortized cost of financing receivables will be further disaggregated by year of origination (or vintage). Institutions are to apply the changes through a cumulative-effect adjustment to their retained earnings as of the beginning of the first reporting period in which the standard is effective.
ASU 2016-13 will become effective for interim and annual periods beginning after December 15, 2019. Management has established a CECL implementation working group, which includes the appropriate members of management to evaluate the impact the adoption of this ASU will have on the Company's financial statements and disclosures and determine the most appropriate method of implementing the amendments in this ASU. The working group has selected a software vendor and is working on identifying data needs for modeling inputs and identifying appropriate modeling methodologies across our loan segments. During 2019, the Company is focused on model completion and finalizing assumptions with parallel processing of our existing allowance for loan losses model with the CECL model targeted for the second half of 2019, depending on how model completion and validation progresses. Management is also working to establish appropriate accounting policies
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
to address new processes and controls under this update. The Company is currently evaluating the impact of this adoption on it’s financial statements and disclosures and currently expects to record a one-time adjustment to retained earnings to increase the allowance for loan losses, however the magnitude of this adjustment cannot currently be reasonably quantified. Management expects to disclose a range estimate of this impact on Form 10-Q for the quarterly period ended September 30, 2019.
In December 2018, the OCC, the Board of Governors of the Federal Reserve System, and the FDIC approved a final rule to address changes to credit loss accounting under GAAP, including banking organizations’ implementation of CECL. The final rule provides banking organizations the option to phase in over a three-year period the day-one adverse effects on regulatory capital that may result from the adoption of the new accounting standard.
In January 2017, the FASB issued ASU 2017-04, “Intangibles - Goodwill and Other (Topic 350) - Simplifying the Test for Goodwill Impairment.” ASU 2017-04 eliminates step two from the goodwill impairment test. Instead, an entity will perform only step one of its quantitative goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount, and then recognizing an impairment charge for the amount by which the carrying amount exceeds the reporting unit's fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. An entity will still have the option to perform a qualitative assessment for a reporting unit to determine if the quantitative step one impairment test is necessary. ASU 2017-04 will become effective for interim and annual periods beginning after December 15, 2019. Early adoption is permitted, including in an interim period, for impairment tests performed after January 1, 2017. If this standard had been effective for the year ended December 31, 2018, there would have been no impact on our consolidated financial statements.
In March 2017, the FASB issued ASU 2017-08, “Receivables - Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities." The amendments in this ASU shorten the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount, which continue to be amortized to maturity. Public business entities must prospectively apply the amendments in this ASU to annual periods beginning after December 15, 2018, including interim periods. The adoption of this update will not have an impact on the Company's consolidated financial statements.
In June 2018, FASB issued ASU 2018-07, "Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting", which expands the scope of topic 718 to include share-based payment transactions for acquiring goods and services from nonemployees. Consistent with the accounting for employee share-based payment awards, nonemployee share-based payment awards will be measured at grant-date fair value of the equity instruments obligated to be issued when the good has been delivered or the service rendered and any other conditions necessary to earn the right to benefit from the instruments have been satisfied. This ASU is effective for all entities for fiscal years beginnings after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. Early adoption is permitted. The Company does not expect adoption of this standard to have a significant impact on the consolidated financial statements of the company.
In August 2018, the FASB issued "Accounting Standards Update 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework - Changes to the DIsclosure Requirements for Fair Value Measurements." This update is part of the disclosure framework project and eliminates certain disclosure requirements for fair value measurements, requires entities to disclose new information, and modifies existing disclosure requirements. The new disclosure guidance is effective for fiscal years beginning after December 15, 2019. Early adoption is permitted. The Company is currently evaluating the impact this change will have on its consolidated financial statements and disclosures.
Note (2)-Mergers and acquisitions:
Atlantic Capital Bank branch acquisition
On November 14, 2018, the Bank entered into a Purchase and Assumption Agreement (the "Purchase Agreement") to purchase 11 Tennessee and three Georgia branch locations (the "Branches") from Atlantic Capital Bank, N.A., a national banking association and a wholly owned subsidiary of Atlantic Capital Bancshares, Inc., a Georgia corporation (collectively, “Atlantic Capital”). On the terms and subject to conditions set forth in the Purchase Agreement, FirstBank has committed to assume approximately $602,000 in deposits, purchase approximately $381,000 in loans at 99.32% of book value, and pay
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
a deposit premium of 6.25% based on the lower of the actual deposit balance at close or on the average closing deposit balance for the 30 days prior to close.
Upon consumation, the Branches will become FirstBank branches. As such, the Atlantic Capital branch acquistion will be accounted for under ASC 805, "Business Combinations." The Company incurred $401 in merger-related expenses during the year ended December 31, 2018 in connection with this transaction. The acquisition is expected to be completed in the second quarter of 2019. As of the date of this annual report, all regulatory approvals have been received.
Clayton Bank and Trust and American City Bank
On July 31, 2017, FirstBank merged with Clayton Bank and Trust (“CBT”) and American City Bank (“ACB” and together with CBT, the “Clayton Banks”), pursuant to the Stock Purchase Agreement by and among the Company, FirstBank, the Clayton Banks, Clayton HC, Inc., a Tennessee corporation and its majority shareholder, James L. Clayton, dated February 8, 2017, as amended on May 26, 2017, with a purchase price of $236,484. The Company issued 1,521,200 shares of common stock and paid cash of $184,200 to purchase all of the outstanding shares of the Clayton Banks. At closing, the Clayton Banks merged with and into FirstBank, with FirstBank continuing as the surviving banking entity.
Prior to the merger, the Clayton Banks operated 18 banking locations across Tennessee. The merger with the Clayton Banks has allowed the Company to further its strategic initiatives by expanding its geographic footprint in Knoxville and other Tennessee markets and accelerates the growth of the Company’s Banking segment.
Goodwill of $90,323 recorded in connection with the transaction resulted primarily from anticipated synergies arising from the combination of certain operational areas of the Clayton Banks and the Company as well as the purchase premium inherent to buying a complete and successful banking operation. Goodwill is included in the Banking segment as substantially all of the operations resulting from the Clayton Banks merger is included in the Banking segment.
In connection with the transaction, the Company incurred $1,193 and $19,034 in merger and conversion expenses during the years ended December 31, 2018 and 2017, respectively.
For income tax purposes, the merger with the Clayton Banks was treated as an asset purchase. As an asset purchase for income tax purposes, the value of assets and liabilities for the Clayton Banks are the same for both financial reporting and income tax purposes; therefore, no deferred taxes were recorded at the date of acquisition. Additionally, this treatment allows for the deductibility of the goodwill and core deposit intangible for income tax purposes over 15 years.
The Company accounted for the Clayton Banks transaction under the acquisition method under ASC Topic 805. Accordingly, the fair value of the assets acquired and liabilities assumed along with the resulting goodwill was recorded as of the date of the merger. The Company’s operating results include the operating results of the acquired assets and assumed liabilities of the Clayton Banks subsequent to the acquisition date.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
As of December 31, 2017, the Company finalized its valuation of all assets acquired and liabilities assumed, resulting in no material changes to preliminary purchase accounting adjustments. The following tables present the final estimated fair value of net assets acquired as of the July 31, 2017 acquisition date and the consideration paid and an allocation of the purchase price to net assets acquired:
(1)
Amounts include certain reclassifications of opening balances to conform to the Company’s presentation.
(2)
Amount was deposited into an interest-bearing deposit account with the Bank in the name of the Seller as of July, 31, 2017.
The following unaudited pro forma condensed consolidated financial information presents the results of operations for the years ended December 31, 2017 and 2016 as though the merger had been completed as of January 1, 2016. The unaudited estimated pro forma information combines the historical results of the Clayton Banks with the Company’s historical consolidated results and includes certain adjustments reflecting the estimated impact of certain fair value adjustments including loan discount accretion, amortization of core deposit and other intangibles, and amortization of the discount on time deposits for the periods presented. The pro forma information is not indicative of what would have occurred had the acquisition taken place on January 1, 2016 and does not reflect any assumptions regarding cost-savings, revenue enhancements, provision for credit losses or asset dispositions. Actual revenues and earnings of the Clayton Banks since the merger date have not been disclosed as it is not practicable as the Clayton Banks were merged into the Company and separate financial information is not readily available.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Note (3)-Cash and cash equivalents concentrations:
The Bank is required to maintain an average reserve balance with the Federal Reserve Bank or maintain such reserve balance in the form of cash. The required balance at December 31, 2018 was $10,184. The Bank maintains its cash in bank deposit accounts, which, at times, may exceed federally insured limits. The Bank has not experienced any losses in such correspondent accounts and believes it is not exposed to any significant credit risk from cash and cash equivalents.
The Bank had cash in the form of Federal funds sold included in cash and cash equivalents of $31,364 and $66,127 as of December 31, 2018 and 2017, respectively.
Note (4)-Investment securities:
The amortized cost of securities and their fair values at December 31, 2018 and 2017 are shown below:
As of December 31, 2018, the Company also had $3,107 in marketable equity securities recorded at fair value. Net losses of $81 were recognized due to changes in fair value of these securities during the year ended December 31, 2018. As of January 1, 2018, the Company adopted ASU 2016-01 (See Note 1) and reclassified $3,604 of other securities without readily determinable market values to other assets.
Securities pledged at December 31, 2018 and 2017 had carrying amounts of $326,215 and $337,604, respectively, and were pledged to secure a Federal Reserve Bank line of credit, public deposits and repurchase agreements.
There were no holdings of securities of any one issuer, other than the U.S. Government and its agencies, in an amount greater than 10% of shareholders' equity at December 31, 2018 and 2017.
Included in available-for-sale securities at December 31, 2018 and 2017 were $2,120 and $348, respectively, in trade date payables that were settled after year end.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
The amortized cost and fair value of debt securities by contractual maturity at December 31, 2018 and 2017 are shown below. Maturities may differ from contractual maturities in mortgage-backed securities because the mortgage underlying the security may be called or repaid without any penalties. Therefore, mortgage-backed securities are not included in the maturity categories in the following maturity summary.
Sales of available-for-sale securities were as follows:
The Company also recognized $1 and $1 on gains related to the early call of available for sale securities during the years ended December 31, 2018 and December 31, 2017, respectively.
The following tables show gross unrealized losses at December 31, 2018 and 2017, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position:
As of December 31, 2018 and 2017, the Company’s securities portfolio consisted of 360 and 294 securities, 174 and 124 of which were in an unrealized loss position, respectively.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
The Company evaluates available-for-sale debt securities with unrealized losses for other-than-temporary impairment (OTTI) on a quarterly basis and recorded no OTTI for the year ended December 31, 2018. During the year ended December 31, 2017, the Company recognized impairment of $945 on one of the equity securities without readily determinable market value. On January 1, 2018, this investment was reclassified to other assets. The Company considers an investment security impaired if the fair value of the security is less than its cost or amortized cost basis. For debt securities, the unrealized losses associated with these investment securities are primarily driven by interest rates and are not due to the credit quality of the securities. The Company currently does not intend to sell those investments with unrealized losses, and it is unlikely that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity.
Note (5)-Loans and allowance for loan losses:
Loans outstanding at December 31, 2018 and 2017, by major lending classification are as follows:
As of December 31, 2018 and 2017, $618,976 and $761,197, respectively, of qualifying residential mortgage loans (including loans held for sale) and $608,735 and $207,370, respectively, of qualifying commercial mortgage loans were pledged to the Federal Home Loan Bank of Cincinnati securing advances against the Bank’s line. As of December 31, 2018 and 2017, $1,336,092 and $737,856, respectively, of qualifying loans were pledged to the Federal Reserve Bank under the Borrower-in-Custody program.
As of December 31, 2018 and 2017, the carrying value of purchased credit impaired loans (“PCI”) loans accounted for under ASC 310-30 Loans and Debt Securities Acquired with Deteriorated Credit Quality, were $68,999 and $88,835, respectively. The following table presents changes in the value of the accretable yield for PCI loans for the periods indicated.
Included in the ending balance of the accretable yield on PCI loans in the table above at December 31, 2018, is a purchase accounting liquidity discount of $2,436. There is also a purchase accounting nonaccretable credit discount of $4,355 related to the PCI loan portfolio at December 31, 2018 and an accretable credit and liquidity discount on non-PCI loans of $7,527 and $2,197, respectively.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Interest revenue, through accretion of the difference between the recorded investment of the loans and the expected cash flows, is being recognized on all PCI loans. Accretion of interest income amounting to $9,010, $5,299 and $2,631 was recognized on purchased credit impaired loans during the years ended December 31, 2018, 2017 and 2016, respectively. This includes both the contractual interest income recognized and the purchase accounting contribution through accretion of the liquidity discount and credit mark for changes in estimated cash flows. The total purchase accounting contribution through accretion excluding contractual interest collected for all purchased loans was $7,608, $5,419 and $3,538 for the years ended December 31, 2018, 2017 and 2016, respectively.
The following provides the allowance for loan losses by portfolio segment and the related investment in loans net of unearned interest for the years December 31, 2018, 2017 and 2016:
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
The following tables provides the allocation of the allowance for loan losses by loan category broken out between loans individually evaluated for impairment, loans collectively evaluated for impairment and loans acquired with deteriorated credit quality as of December 31, 2018, 2017 and 2016:
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
The following tables provides the amount of loans by loan category broken between loans individually evaluated for impairment, loans collectively evaluated for impairment and loans acquired with deteriorated credit quality as of December 31, 2018, 2017 and 2016:
The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. The Company uses the following definitions for risk ratings:
Watch. Loans rated as watch includes loans in which management believes conditions have occurred, or may occur, which could result in the loan being downgraded to a worse rated category. Also included in watch are loans rated as special mention, which have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Substandard. Loans rated as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so rated have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. Also included in this category are loans considered doubtful, which have all the weaknesses previously described and management believes those weaknesses may make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Loans not meeting the criteria above are considered to be pass rated loans.
The following tables show credit quality indicators by portfolio class at December 31, 2018 and 2017:
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Nonperforming loans include loans that are no longer accruing interest (nonaccrual loans) and loans past due ninety or more days and still accruing interest. Nonperforming loans and impaired loans are defined differently. Some loans may be included in both categories, whereas other loans may only be included in one category.
PCI loans are considered past due or delinquent when the contractual principal or interest due in accordance with the terms of the loan agreement remains unpaid after the due date of the scheduled payment. However, these loans are considered to be performing, even though they may be contractually past due, as any non-payment of contractual principal or interest is considered in the periodic re-estimation of expected cash flows and is included in the resulting recognition of current period covered loan loss provision or future period yield adjustments. The accrual of interest is discontinued on PCI loans if management can no longer reliably estimate future cash flows on the loan. No PCI loans were classified as nonaccrual at December 31, 2018 or December 31, 2017 as the carrying value of the respective loan or pool of loans cash flows were considered estimable and probable of collection.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
The following tables provide the period-end amounts of loans that are past due thirty to eighty-nine days, past due ninety or more days and still accruing interest, loans not accruing interest and loans current on payments accruing interest by category at December 31, 2018 and 2017:
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Impaired loans recognized in conformity with ASC 310 at December 31, 2018 and 2017, segregated by class, were as follows:
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
As of December 31, 2018 and 2017, the Company has a recorded investment in troubled debt restructurings of $6,794 and $8,604, respectively. The modifications included extensions of the maturity date and/or a stated rate of interest to one lower than the current market rate. The Company has allocated $63 and $172 of specific reserves for those loans at December 31, 2018 and 2017, respectively, and has committed to lend additional amounts totaling up to $0 and $2, respectively to these customers. Of these loans, $2,703 and $3,205 were classified as non-accrual loans as of December 31, 2018 and 2017, respectively.
The following tables present the financial effect of TDRs recorded during the periods indicated:
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
There were no loans modified as troubled debt restructurings for which there was a payment default within twelve months following the modification during the years ended December 31, 2018, 2017 and 2016.
A loan is considered to be in payment default once it is 90 days contractually past due under the modified terms.
The terms of certain other loans were modified during the years ended December 31, 2018, 2017 and 2016 that did not meet the definition of a troubled debt restructuring. The modification of these loans involved either a modification of the terms of a loan to borrowers who were not experiencing financial difficulties or a delay in a payment that was considered to be insignificant.
In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed under the company’s internal underwriting policy.
Note (6)-Premises and equipment:
Premises and equipment and related accumulated depreciation as of December 31, 2018 and 2017, are as follows:
Depreciation expense was $4,334, $4,316 and $3,995 for the years ended December 31, 2018, 2017 and 2016, respectively.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Note (7)-Other real estate owned:
The amount reported as other real estate owned includes property acquired through foreclosure in addition to excess facilities held for sale and is carried at fair value less estimated cost to sell the property. The following table summarizes the other real estate owned for the years ended December 31, 2018, 2017 and 2016:
Foreclosed residential real estate properties included in the table above totaled $2,101 and $3,631 as of December 31, 2018 and 2017, respectively. The recorded investment in residential mortgage loans secured by residential real estate properties for which foreclosure proceedings are in process totaled $478 and $19 at December 31, 2018 and 2017, respectively.
During the year ended December 31, 2017, the Company acquired $6,888 in other real estate owned through the merger with Clayton Banks, including $4,147 in excess land and facilities held for sale. During the fourth quarter of 2017, the Company consolidated an additional five branch locations and transferred an additional $3,466 of excess land and facilities into other real estate owned as held for sale. At December 31, 2018 and 2017, other real estate owned included excess land and facilities held for sale amounting to $5,381 and $5,895, respectively.
Note (8)-Goodwill and intangible assets:
The balance in goodwill at December 31, 2018 and 2017 was $137,190 and $137,190, respectively.
Goodwill is tested annually, or more often if circumstances warrant, for impairment. If the implied fair value of goodwill is lower than its carrying amount, goodwill impairment is indicated and is written down to its implied fair value. Subsequent increases in goodwill values are not recognized in the financial statements. Goodwill impairment was neither indicated nor recorded during the year ended December 31, 2018 or the year ended December 31, 2017.
On July 31, 2017, the Company recorded $9,060 of core deposit intangibles resulting from the merger with the Clayton Banks, which is being amortized over a weighted average life of approximately 3 years. Additionally, the Company recognized identifiable intangible assets related to favorable lease terms of $587, customer base trust intangible of $1,600, and manufactured housing loan servicing intangible of $1,088 as a result of the Clayton Banks acquisition, which are being amortized over estimated lives of 6.5 years, 10 years, and 5 years respectively.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Core deposit and other intangibles are as follows as of the indicated dates:
Amortization expense for core deposit and other intangibles for the years ended December 31, 2018, 2017 and 2016 was $3,185, $1,995, and $2,132, respectively.
The estimated aggregate amortization expense of core deposit and other intangibles for each of the next five years and thereafter is as follows:
Note (9)-Mortgage servicing rights:
Changes in the Company’s mortgage servicing rights were as follows for years ended December 31, 2018, 2017 and 2016:
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
The following table summarizes servicing income and expense included in mortgage banking income and other noninterest expense within the Mortgage Segment operating results, respectively, for the years ended December 31, 2018, 2017 and 2016, respectively:
Data and key economic assumptions related to the Company’s mortgage servicing rights as of December 31, 2018 and 2017 are as follows:
During the second quarter of 2017, the Company began hedging the mortgage servicing rights portfolio with various derivative instruments to offset changes in the fair value of the related mortgage servicing rights. As of December 31, 2018, the MSR asset was fully hedged with respect to changes in the underlying interest rates (see Note 16).
From time to time, the Company enters agreements to sell certain tranches of mortgage servicing rights. Upon consummation of the sale, occasionally the Company continues to subservice the underlying mortgage loans until they can be transferred to the purchaser. During the years ended December 31, 2018, 2017 and 2016, the Company sold $39,428, $11,686, and $34,118 of mortgage servicing rights on $3,181,483, $1,086,465 and $3,370,395 of serviced mortgage loans, respectively. There was not a material gain or loss recognized during the year ended December 31, 2018 in connection with the sale. As of December 31, 2018 and 2017, there were no loans being serviced that related to bulk sale of mortgage servicing rights. As of December 31, 2018, mortgage escrow deposits amounts to $53,468.
During the fourth quarter of 2018, the Company entered into a letter of intent for the sale of certain mortgage servicing rights on approximately $2,061,175 of serviced mortgage loans. The transaction closed subsequent to the year ended December 31, 2018 during the first quarter of 2019, resulting in the reduction of $29,416 in mortgage servicing rights. The Company is currently subservicing the loans until they can be transferred to the purchaser in 2019. No significant gain or loss is was recognized related to this transaction.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Note (10)-Other assets and other liabilities:
Included in other assets are:
Included in other liabilities are:
Note (11)-Deposits:
The aggregate amount of time deposits with a minimum denomination greater than $250 was $353,134 and $176,837 at December 31, 2018 and 2017, respectively.
At December 31, 2018, the scheduled maturities of time deposits are as follows:
At December 31, 2018 and 2017, the Company had $2,738 and $1,640, respectively, of deposit accounts in overdraft status and thus have been reclassified to loans on the accompanying consolidated balance sheets.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Note (12)-Borrowings:
Borrowings include securities sold under agreements to repurchase, lines of credit, Federal Home Loans Bank advances, and subordinated debt.
Securities sold under agreements to repurchase and federal funds purchased
Securities sold under agreements to repurchase are financing arrangements that mature daily. Securities sold under agreements to repurchase are secured by mortgage-backed securities with a carrying amount of $15,081and $14,293 at December 31, 2018 and 2017, respectively.
Information concerning securities sold under agreements to repurchase is summarized as follows:
The Bank maintains lines with certain correspondent banks that provide borrowing capacity in the form of federal funds purchased in the aggregate amount of $240,000, of which there were no borrowings against as of December 31, 2018.
Federal Home Loan Bank Advances
As a member of the FHLB Cincinnati, the Bank receives advances from the FHLB pursuant to the terms of various agreements that assist in funding its mortgage and loan portfolio production. Under these agreements, the Company pledged qualifying loans of $1,227,711 as collateral securing a line with a total line of credit with a total borrowing capacity of $736,962 as of December 31, 2018. As of December 31, 2017, the Company pledged qualifying loans of $968,567 as collateral securing a line of credit with a total borrowing capacity of $671,461. In 2018, a letter of credit with the FHLB of $100,000 was pledged at December 31, 2018 to secure public funds that required collateral. Additionally, during 2018 a line of $800,000 has been secured with the FHLB for overnight borrowing; however, additional collateral may be needed to draw on the line.
Borrowings against our line totaled $181,765 and $302,372 as of December 31, 2018 and December 31, 2017, respectively. Total borrowings as of December 31, 2018 comprised $1,765 in long term advances, $80,000 in overnight cash management advances (CMAs) and $100,000 in 90 day fixed rate advances borrowed during 2017 as part of a funding strategy for the Clayton Banks merger. During 2017, the Company also entered into three corresponding interest rate swaps to hedge interest rate exposure which mature in 2020, 2021, and 2022 in increments of $30,000, $35,000, and $35,000, respectively. For more information about our derivative financial instruments, see Note 16, “Derivatives.” Total borrowings as of December 31, 2017 comprised $12,372 in long term advances, $190,000 in CMAs and $100,000 in 90 day fixed rate advances. FHLB advances includes both fixed and floating rates ranging from 2.43% to 7.78% at December 31, 2018. The weighted average interest rate on outstanding advances at December 31, 2018 was 1.93%.
Maturities of FHLB advances as of December 31, 2018 are as follows:
The Company maintained a line with the Federal Reserve Bank through the Borrower-in-Custody program in 2018 and 2017. As of December 31, 2018 and 2017, $1,336,092 and $737,856 of qualifying loans and $8,569 and $13,544 of investment securities were pledged to the Federal Reserve Bank through the Borrower-in-Custody program securing a line of credit of $934,745 and $529,547, respectively.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Subordinated Debt
In 2003, two separate trusts formed by the Company issued $9,000 of floating rate trust preferred securities (“Trust I”) and $21,000 of floating rate trust preferred securities (“Trust II”), respectively, as part of a pooled offering of such securities. The Company issued junior subordinated debentures of $9,280, which included proceeds of common securities purchased by the Company of $280, and junior subordinated debentures of $21,650, which included proceeds of common securities of $650. Both issuances were to the trusts in exchange for the proceeds of the securities offerings, which represent the sole asset of the trusts. Trust I pays interest quarterly based upon the 3-month LIBOR plus 3.25%. Trust II pays interest quarterly based upon the 3-month LIBOR plus 3.15%. Rates for the two issues at December 31, 2018, were 5.65% and 5.97%, respectively. Rates for the two issues at December 31, 2017, were 4.59% and 4.82%, respectively. The Company may redeem the first junior subordinated debenture listed, in whole or in part, on any distribution payment date within 120 days of the occurrence of a special event, at the redemption price. The Company may redeem the second junior subordinated debentures listed, in whole or in part, any time after June 26, 2008, on any distribution payment date, at the redemption price. The junior subordinated debentures must be redeemed no later than 2033.
The Company has classified $30,000 of subordinated debt described in the above paragraph as Tier 1 capital. The Federal Reserve Board issued guidance in March 2005 providing more strict quantitative limits on the amount of securities, similar to the junior subordinated debentures issued or assumed by the Company, that are includable in Tier 1 capital. The new guidance, which became effective in March 2009, did not impact the amount of debentures the Company includes in Tier 1 capital. Furthermore, the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act have no effect on the treatment of this subordinated debt as Tier 1 capital while the Company remains below $15,000,000 in assets.
Note (13)-Income taxes:
Allocation of federal and state income taxes between current and deferred portions is as follows:
Federal income tax expense differs from the statutory federal rates of 21% for the year ended December 31, 2018 and 35% for the years ended December 31, 2017 and 2016 due to the following:
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
The components of the net deferred tax liability at December 31, 2018 and 2017, are as follows:
On December 22, 2017, the Tax Cuts and Jobs Act (the “Act”) was signed into law, among other things permanently reduced the corporate tax rate from 35 percent to 21 percent, effective for tax years beginning January 1, 2018. Under the guidance of ASC 740, “Income Taxes” (“ASC 740”), the Company revalued its net deferred tax assets on the date of enactment based on the reduction in the overall future tax benefit expected to be realized at the lower tax rate implemented by the new legislation. After reviewing the Company’s inventory of deferred tax assets and liabilities on the date of enactment and giving consideration to the future impact of the lower corporate tax rates and other provisions of the new legislation, the Company’s revaluation of its net deferred tax liabilities resulted in a $5,894 reduction, which was included in “income taxes” in the Consolidated Statements of Income.
In connection with the initial public offering, as discussed in Note 1, the Company terminated its S-corporation status and became a taxable entity (“C corporation”) on September 16, 2016. The reported income tax expense for the year ended December 31, 2016 reflects the increase in the deferred tax net liability of $13,181 from the conversion in the taxable status. The deferred tax net liability is the result of timing differences in the recognition of income/deductions for generally accepted accounting principles (“GAAP”) and tax purposes. The consolidated statements of income present unaudited pro forma statements of income for the year ended December 31, 2016. Additionally, in recording the impact of the conversion to a C corporation, the Company recorded a deferred income tax expense of $2,955 related to the unrealized gain on available for sale securities through the income statement in accordance with ASC 740-20-45-8; therefore, the amount shown in other comprehensive income has not been reduced by the above expense. This difference will remain in OCI until the underlying securities are sold or mature in accordance with the portfolio approach allowed under ASC 740.
Tax periods for all fiscal years after 2014 remain open to examination by the federal and state taxing jurisdictions to which the Company is subject.
Note (14)-Dividend restrictions:
Due to regulations of the Tennessee Department of Financial Institutions (“TDFI”), the Bank may not declare dividends in any calendar year that exceeds the total of its net income of that year combined with its retained net income of the preceding two years without the prior approval of the TDFI Commissioner. Based upon this regulation, $164,859 and $105,453 was available for payment of dividends without such prior approval at December 31, 2018 and 2017, respectively. In addition, dividends paid by the Bank to the Company would be prohibited if the effect thereof would cause the Bank’s capital to be reduced below applicable minimum capital requirements.
No cash dividends were declared from the Bank to the Company during the years ended December 31, 2018 or 2017.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Note (15)-Commitments and contingencies:
Some financial instruments, such as loan commitments, credit lines, letters of credit, and overdraft protection, are issued to meet customer financing needs. These are agreements to provide credit or to support the credit of others, as long as conditions established in the contract are met, and usually have expiration dates.
Commitments may expire without being used. Off-balance sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated. The same credit policies are used to make such commitments as are used for loans, including obtaining collateral at exercise of the commitment.
Commitments under non-cancelable operating leases were as follows, before considering renewal options that generally are present:
Rent expense for the years ended December 31, 2018, 2017 and 2016, was $4,940, $4,245 and $3,904, respectively.
In connection with the sale of mortgage loans to third party investors, the Bank makes usual and customary representations and warranties as to the propriety of its origination activities. Occasionally, the investors require the Bank to repurchase loans sold to them under the terms of the warranties. When this happens, the loans are recorded at fair value with a corresponding charge to a valuation reserve. The total principal amount of loans repurchased (or indemnified for) was $6,646 and $4,704 and $8,326 for the years ended December 31, 2018, 2017 and 2016, respectively. The Company has established a reserve associated with loan repurchases. This reserve is recorded in accrued expenses and other liabilities on the consolidated balance sheets.
The following table summarizes the activity in the repurchase reserve:
Note (16)-Derivatives:
The Company utilizes derivative financial instruments as part of its ongoing efforts to manage its interest rate risk exposure as well as the exposure for its customers. Derivative financial instruments are included in the Consolidated Balance Sheets line item “Other assets” or “Other liabilities” at fair value in accordance with ASC 815, “Derivatives and Hedging.”
The Company enters into commitments to originate loans whereby the interest rate on the loan is determined prior to funding (rate-lock commitments). Under such commitments, interest rates for mortgage loans are typically locked in for up to forty-five days with the customer. These interest rate lock commitments are recorded at fair value in the Company’s Consolidated Balance Sheets. The Company also enters into best effort or mandatory delivery forward commitments to sell residential mortgage loans to secondary market investors. Gains and losses arising from changes in the valuation of the rate-lock
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
commitments and forward commitments are recognized currently in earnings and are reflected under the line item “Mortgage banking income” on the Consolidated Statements of Income.
The Company enters into forward commitments, futures and options contracts that are not designated as hedging instruments as economic hedges to offset the changes in fair value of MSRs. Gains and losses associated with these instruments are included in earnings and are reflected under the line item “Mortgage banking income” on the Consolidated Statements of Income.
Additionally, the Company enters into derivative instruments that are not designated as hedging instruments to help its commercial customers manage their exposure to interest rate fluctuations. To mitigate the interest rate risk associated with customer contracts, the Company enters into an offsetting derivative contract. The Company manages its credit risk, or potential risk of default by its commercial customers through credit limit approval and monitoring procedures.
In June of 2017, the Company entered into two interest rate swap agreements with notional amounts totaling $30,000 to hedge interest rate exposure on outstanding subordinate debentures included in long-term debt totaling $30,930. See Note 12 “Borrowings” in the notes to the consolidated financial statements for additional details regarding subordinated debentures. Under these agreements, the Company receives a variable rate of interest and pays a fixed rate of interest. The interest rate swap contracts, which mature in June of 2024, are designated as cash flow hedges with the objective of reducing the variability in cash flows resulting from changes in interest rates. As of December 31, 2018 and 2017, the fair value of these contracts was $721 and $305, respectively.
In July of 2017, the Company entered into three interest rate swap contracts on floating rate liabilities at the Bank level with notional amounts of $30,000, $35,000 and $35,000 for a period of three, four and five years, respectively. These interest rate swaps are designated as cash flow hedges with the objective of reducing the variability of cash flows associated with $100,000 of FHLB borrowings obtained in conjunction with the Clayton Banks acquisition. Under these contracts, the Company receives a variable rate of interest and pays a fixed rate of interest. As of December 31, 2017, the fair value of these contracts was $1,127. During the first quarter of 2018, these swaps were canceled, locking in a tax-adjusted gain of $1,564 in other comprehensive income to be accreted over the three, four and five-year terms of the underlying contracts. As of December 31, 2018, there was $1,436 remaining in the other comprehensive income to be accreted into income.
Certain financial instruments, including derivatives, may be eligible for offset in the Consolidated Balance Sheet when the “right of setoff” exists or when the instruments are subject to an enforceable master netting agreement, which includes the right of the non-defaulting party or non-affected party to offset recognized amounts, including collateral posted with the counterparty, to determine a net receivable or net payable upon early termination of the agreement. Certain of the Company’s derivative instruments are subject to master netting agreements. The Company has not elected to offset such financial instruments in the Consolidated Balance Sheets.
Most derivative contracts with clients are secured by collateral. Additionally, in accordance with the interest rate agreements with derivatives dealers, the Company may be required to post margin to these counterparties. At December 31, 2018 the Company had minimum collateral posting thresholds with certain of its derivative counterparties and had collateral posted of $13,904 against its obligations under these agreements. Cash collateral related to derivative contracts is recorded in other assets in the Consolidated Balance Sheets.
The following table provides details on the Company’s derivative financial instruments as of the dates presented:
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Gains (losses) included in the Consolidated Statements of Income related to the Company’s derivative financial instruments
were as follows:
The following discloses the amount included in other comprehensive income (loss), net of tax, for derivative instruments designated as cash flow hedges for the periods presented:
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Note (17)-Fair value of financial instruments:
FASB ASC 820-10 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820-10 also establishes a framework for measuring the fair value of assets and liabilities according to a hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets and liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The hierarchy maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that are derived from assumptions based on management’s estimate of assumptions that market participants would use in pricing the asset or liability based on the best information available under the circumstances.
The hierarchy is broken down into the following three levels, based on the reliability of inputs:
Level 1: Unadjusted quoted prices in active markets for identical assets or liabilities that are accessible at the measurement date.
Level 2: Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active or other inputs that are observable or can be corroborated by observable market data.
Level 3: Significant unobservable inputs for assets or liabilities that are derived from assumptions based on management’s estimate of assumptions that market participants would use in pricing the assets or liabilities.
The Company records the fair values of financial assets and liabilities on a recurring and non-recurring basis using the following methods and assumptions:
During the first quarter of 2018, the Company adopted ASU 2016-01, “Recognition and Measurement of Financial Assets and Liabilities.” The amendments included within this standard, which are applied prospectively, require the Company to disclose fair value of financial instruments measured at amortized cost on the balance sheet to measure the fair value using an exit price notion. Prior to adopting the amendments included in the standard, the Company measured fair value under an entry price notion.
Investment securities-Investment securities are recorded at fair value on a recurring basis. Fair values for securities are based on quoted market prices, where available. If quoted prices are not available, fair values are based on quoted market prices of similar instruments or are determined by matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the pricing relationship or correlation among other benchmark quoted securities. Investment securities valued using quoted market prices of similar instruments or that are valued using matrix pricing are classified as Level 2. When significant inputs to the valuation are unobservable, the available-for-sale securities are classified within Level 3 of the fair value hierarchy.
Where no active market exists for a security or other benchmark securities, fair value is estimated by the Company with reference to discount margins for other high-risk securities.
Loans held for sale-Loans held for sale are carried at fair value. Fair value is determined using current secondary market prices for loans with similar characteristics, that is, using Level 2 inputs.
Derivatives-The fair value of the interest rate swaps are based upon fair values provided from entities that engage in interest rate swap activity and is based upon projected future cash flows and interest rates. Fair value of commitments is based on fees currently charged to enter into similar agreements, and for fixed-rate commitments, the difference between current levels of interest rates and the committed rates is also considered. These financial instruments are classified as Level 2.
Other real estate owned-Other real estate owned (“OREO”) is comprised of commercial and residential real estate obtained in partial or total satisfaction of loan obligations and excess land and facilities held for sale. OREO acquired in settlement of indebtedness is recorded at the lower of the carrying amount of the loan or the fair value of the real estate less costs to sell.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Fair value is determined on a nonrecurring basis based on appraisals by qualified licensed appraisers and is adjusted for management’s estimates of costs to sell and holding period discounts. The valuations are classified as Level 3.
Mortgage servicing rights-Servicing rights are carried at fair value. Fair value is determined using an income approach with various assumptions including expected cash flows, market discount rates, prepayment speeds, servicing costs, and other factors. As such, mortgage servicing rights are considered Level 3.
Impaired loans-Loans considered impaired under FASB ASC 310, Receivables, are loans for which, based on current information and events, it is probable that the creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Fair value adjustments for impaired loans are recorded on a non-recurring basis as either partial write downs based on observable market prices or current appraisal of the collateral. Impaired loans are classified as Level 3.
The following table contains the estimated fair values and the related carrying values of the Company's financial instruments. Items which are not financial instruments are not included. Due to the adoption of ASU 2016-01 as of January 1, 2018, the fair value as presented below is measured using the exit price notion in the periods after adoption and may not be comparable with prior periods presented as a result of the change in methodology.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
The balances and levels of the assets measured at fair value on a recurring basis at December 31, 2018 are presented in the following table:
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
The balances and levels of the assets measured at fair value on a non-recurring basis at December 31, 2018 are presented in the following table:
(1) Includes both impaired non-purchased loans and PCI loans.
The balances and levels of the assets measured at fair value on a recurring basis at December 31, 2017 are presented in the following table:
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
The balances and levels of the assets measured at fair value on a non-recurring basis at December 31, 2017 are presented in the following table:
(1) Includes both impaired non-purchased loans and PCI loans.
There were no transfers between Level 1, 2 or 3 during the periods presented.
The following table provides a reconciliation for assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs, or Level 3 inputs, during the year ended December 31, 2018 and 2017:
(1) See Note 1, "Basis of Presentation" in the Notes to the consolidated financial statements for additional details regarding the adoption of ASU 2016-01, Recognition and Measurement of Financial Assets and Liabilities.
As of December 31, 2017, there was no established market for certain other securities, and as such, the Company had estimated that historical costs approximated market value. As of January 1, 2018, the Company adopted ASU 2016-01 (See Note 1) and reclassified $3,604 of these other securities without readily determinable market values to other assets. An impairment of an equity security without a readily determinable fair value was considered to be other-than-temporary and was written down to its fair value resulting in an impairment loss of $945 during the year ended December 31, 2017.
The following table presents information as of December 31, 2018 about significant unobservable inputs (Level 3) used in
the valuation of assets measured at fair value on a nonrecurring basis:
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
(1) Includes both impaired non-purchased loans and PCI loans.
The following table presents information as of December 31, 2017 about significant unobservable inputs (Level 3) used in the valuation of assets measured at fair value on a nonrecurring basis:
(1) Includes both impaired non-purchased loans and PCI loans.
Loans considered impaired are reserved for at the time the loan is identified as impaired taking into account the fair value of the collateral less estimated selling costs. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on changes in market conditions from the time of valuation and management's knowledge of the client and client's business. Other real estate owned acquired in settlement of indebtedness is recorded at fair value of the real estate less estimated costs to sell. Subsequently, it may be necessary to record nonrecurring fair value adjustments for declines in fair value. Any write-downs based on the asset's fair value at the date of foreclosure are charged to the allowance for loan losses. Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by the Company. Once received, a member of the lending administrative department reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with independent data sources such as recent market data or industry wide statistics.
Fair value option
The Company elected to measure all loans originated for sale at fair value under the fair value option as permitted under ASC 825. Electing to measure these assets at fair value reduces certain timing differences and better matches the changes in fair value of the loans with changes in the fair value of derivative instruments used to economically hedge them.
Net (losses) gains of $(4,539) and $9,111 resulting from fair value changes of the mortgage loans were recorded in income during the year ended December 31, 2018 and 2017, respectively. The amount does not reflect changes in fair values of related derivative instruments used to hedge exposure to market-related risks associated with these mortgage loans. The change in fair value of both loans held for sale and the related derivative instruments are recorded in Mortgage Banking Income in the Consolidated Statements of Income. Election of the fair value option allows the Company to reduce the accounting volatility that would otherwise result from the asymmetry created by accounting for the financial instruments at the lower of cost or fair value and the derivatives at fair value. The fair value option election does not apply to the GNMA optional repurchase loans recorded as of December 31, 2017 which do not meet the requirements under FASB ASC Topic 825 to be accounted for under the fair value option. At December 31, 2018, there were $67,362 of delinquent GNMA loans that had previously been sold. The Company determined there not to be a more-than-trivial benefit based on an analysis of interest rates and an assessment of potential reputational risk associated with these loans. As such, the Company had $0 in rebooked GNMA loans included in loans held for sale as of December 31, 2018. GNMA optional repurchase loans totaled $43,035 at December 31, 2017 and are included in loans held for sale on the accompanying Consolidated Balance Sheet. See Note 1, “Basis of presentation” in the Notes to the consolidated financial statements for additional details regarding rebooked GNMA loans.
The Company’s valuation of loans held for sale incorporates an assumption for credit risk; however, given the short-term period that the Company holds these loans, valuation adjustments attributable to instrument-specific credit risk is nominal. Interest income on loans held for sale measured at fair value is accrued as it is earned based on contractual rates and is reflected in loan interest income in the Consolidated Statements of Income.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
The following table summarizes the differences between the fair value and the principal balance for loans held for sale measured at fair value as of December 31, 2018 and 2017:
Note (18)-Parent company only financial statements:
(1) Eliminates in Consolidation
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
(1) Eliminates in Consolidation
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Note (19)-Segment reporting:
The Company and the Bank are engaged in the business of banking and provide a full range of financial services. The Company determines reportable segments based on the significance of the segment’s operating results to the overall Company, the products and services offered, customer characteristics, processes and service delivery of the segments and the regular financial performance review and allocation of resources by the Chief Executive Officer (“CEO”), the Company’s chief operating decision maker. The Company has identified two distinct reportable segments-Banking and Mortgage. The Company’s primary segment is Banking, which provides a full range of deposit and lending products and services to corporate, commercial and consumer customers. The Company offers full-service conforming residential mortgage products, including conforming residential loans and services through the Mortgage segment utilizing mortgage offices outside of the geographic footprint of the Banking operations as well as internet and correspondent delivery channels. Additionally, the Mortgage segment includes the servicing of residential mortgage loans and the packaging and securitization of loans to governmental agencies. The residential mortgage products and services originated in our Banking footprint and related revenues and expenses are included in our Banking segment. The Company’s mortgage division represents a distinct reportable segment which differs from the Company’s primary business of commercial and retail banking.
The financial performance of the Mortgage segment is assessed based on results of operations reflecting direct revenues and expenses and allocated expenses. This approach gives management a better indication of the operating performance of the segment. When assessing the Banking segment’s financial performance the CEO utilizes reports with indirect revenues and expenses including but not limited to the investment portfolio, electronic delivery channels and areas that primarily support the banking segment operations. Therefore these are included in the results of the Banking segment. Other indirect revenue and expenses related to general administrative areas are also included in the internal financial results reports of the Banking segment utilized by the CEO for analysis and are thus included for Banking segment reporting. The Mortgage segment utilizes funding sources from the Banking segment in order to fund mortgage loans that are ultimately sold on the secondary market. The Mortgage segment uses the proceeds from loan sales to repay obligations due to the Banking segment.
During the year ended December 31, 2016, the Company realigned its segment reporting structure to reclassify mortgage banking income and related expenses associated with retail mortgage originations within our Banking geographic footprint from the Mortgage segment to the Banking segment. This change was made to capture all of the product and service offerings for our Banking customer base within our banking geographic footprint into the Banking segment while capturing all of the mortgage banking activities outside of the banking footprint into the Mortgage segment to allow our CEO to better determine resource allocations and operating performance for each segment.
The following tables provides segment financial information for the years ended December 31, 2018, 2017 and 2016 as follows:
(1)
Included in mortgage banking income.
(2)
Included $1,594 in merger and conversion expenses.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
(1)
Included in mortgage banking income.
(2)
Included $19,034 in merger and conversion expenses.
(1)
Included $3,268 in merger and conversion expenses.
Our Banking segment provides our Mortgage segment with a warehouse line of credit that is used to fund mortgage loans held for sale. The warehouse line of credit, which eliminated in consolidation, had a prime interest rate of 5.5%, 4.5% and 3.75% as of December 31, 2018, 2017 and 2016, respectively, and further limited based on interest income earned by the Mortgage segment. The amount of interest paid by our Mortgage segment to our Banking segment under this warehouse line of credit is recorded as interest income to our Banking segment and as interest expense to our Mortgage segment, both of which are included in the calculation of net interest income for each segment. The amount of interest paid by our Mortgage segment to our Banking segment under this warehouse line of credit was $16,057, $16,932 and $12,636 for the December 31, 2018, 2017 and 2016, respectively.
Note (20)-Minimum capital requirements:
Banks and bank holding companies are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Under regulatory guidance for non-advanced approaches institutions, the Bank is required to maintain minimum amounts and ratios of common equity Tier I capital to risk-weighted assets. Additionally, under Basel III rules, the decision was made to opt-out of including accumulated other comprehensive income in regulatory capital. As of December 31, 2018 and 2017, the Bank and Company met all capital adequacy requirements to which it is subject.
Beginning in 2016, an additional conservation buffer was added to the minimum requirements for capital adequacy
purposes, subject to a three year phase-in period. As of December 31, 2018 and 2017, the buffer was 1.88% and 1.25%, respectively. The capital conservative buffer will be fully phased in January 1, 2019 at 2.50%.
Actual and required capital amounts and ratios are presented below at period-end.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Note (21)-Employee benefit plans:
(A)-401(k) plan:
The Bank has a 401(k) Plan (the “Plan”) whereby substantially all employees participate in the Plan. Employees may contribute the maximum amount of their eligible compensation subject to certain limits based on the federal tax laws. The Bank makes matching contributions of 25% of participant contributions not to exceed 6% of an employee’s total compensation. The Bank may also make discretionary Profit Sharing contributions. Matching and profit sharing contributions are vested equally over five years. For the years ended December 31, 2018, 2017 and 2016, the matching portions provided by the Bank to this Plan were $2,211 and $2,344 and $1,379 respectively, which includes the additional discretionary contribution of 25% match contributed in those years.
(B)-Acquired supplemental retirement plans:
In prior years, the Company assumed certain nonqualified supplemental retirement plans for certain former employees of acquired entities. At December 31, 2018 and 2017, other liabilities on the consolidated balance sheet include post-retirement benefits payable of $1,260 and $1,510, respectively, related to these plans. For the years ended December 31, 2018, 2017 and 2016, the Company recorded expense of $4, $4 and $30, respectively, related to these plans and payments to the participants were $191, $191 and $205 in 2018, 2017 and 2016, respectively. The Company also acquired single premium life insurance policies on these individuals. At December 31, 2018 and 2017, other assets on the consolidated balance sheet include $11,115 and $10,873 and reported cash value income (net of related insurance premium expense) of $158, $164 and $181 in 2018, 2017 and 2016, respectively.
(C)-Deferred compensation plans and agreements:
The Bank granted awards (“EBI Units”) to certain employees pursuant to the FirstBank 2010 Equity Based Incentive Plan (the “2010 EBI Plan”), the FirstBank 2012 Equity Based Incentive Plan (the “2012 EBI Plan”) and the FirstBank Preferred Equity Based Incentive Plan (the “Preferred EBI Plan” and, together with the 2010 EBI Plan and the 2012 EBI Plan, the “EBI Plans”). Prior to the initial public offering, awards granted under EBI Plans were settled in cash only. Following the initial public offering, participants in the EBI Plans were given the one-time option to elect, for each EBI Unit vested to such participant, either (i) an amount in cash or (ii) a number of shares of Company common stock determined pursuant to a conversion formula that took into account the effect of the initial public offering. Consistent with the terms of the EBI Plans and approved by the Board of Directors, outstanding EBI Units were adjusted to reflect the 100-for-one stock split that was effectuated prior to the IPO.
The Bank also has a separate deferred compensation agreement with one key executive.
Each plan or agreement is an unfunded general obligation of the Bank. The plans and agreements have varying vesting periods and other terms as follows:
2010 EBI Plan- Pursuant to the terms of the 2010 EBI Plan, each EBI Unit vests ratably over five years, or earlier upon a change of control, death or disability or retirement after age 65. On or shortly following the vesting date, the holder of an EBI Unit will receive an amount in cash (or, if so elected by the participant following the IPO, in stock) equal to the fair market value of a share of common stock on the December 31 immediately preceding the payment date. Prior to the IPO, fair market value was determined by dividing 7.5% of the total assets of the Bank by the total number of outstanding common stock shares of the Company. Following the IPO, EBI Units are valued based upon the Company’s stock price. Units under this plan became fully vested January, 2017.
Preferred EBI Plan-The Preferred EBI Plan has the same terms and conditions as those described above for the 2010 EBI Plan, with the exception of a seven year ratable vesting period. Units under this plan became fully vested January, 2017.
2012 EBI Plan- Pursuant to the terms of the 2012 EBI Plan, each EBI Unit vests and becomes payable following the third anniversary of the date of grant, or earlier upon a change of control, death or disability or retirement after age 65. On or shortly following the vesting date, the holder of an EBI Unit will receive an amount in cash (or, if so elected by the participant following the IPO, in stock) equal to the fair market value of a share of common stock on the December 31 immediately preceding the payment date. Following the IPO, EBI Units are valued based upon the Company’s stock price. Prior to the IPO, fair market value of the Company was determined based upon the average of the sum of (a) 15 times the Company’s after-tax earnings, based on a default tax rate imposed by the Code, and (b) 1.5 times the Company’s tangible book value, defined as the consolidated equity of the Company less unrealized gains (losses) and less goodwill and intangible assets.
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
Following the IPO, EBI Units outstanding under the 2012 EBI Plan were adjusted to prevent dilution of these EBI Units as a result of the IPO pursuant to the following conversion formula: (i) the number of EBI Units outstanding under the 2012 EBI Plan (as adjusted for the stock split), multiplied by (ii) 1.13 (determined by dividing $21.4085, the fair market value per EBI Unit as determined under the 2012 EBI Plan, by $19.00, the IPO price).
Deferred compensation Agreement-Effective December 31, 2014, the Bank entered into an agreement with the Bank’s Chief Executive Officer to reward his prior service, pursuant to which he is entitled to receive a fixed lump sum cash payment equal to $3,000,000 on December 31, 2019 or the earlier occurrence of his separation of service or a change in control of the Company. On August 19, 2016, the Bank entered into an amendment to the deferred compensation agreement, pursuant to which the deferred account is now denominated in 157,895 deferred stock units, determined by dividing $3,000,000 by $19.00 (the IPO price). The deferred stock units are convertible on a 1-for-1 basis into shares of Company common stock on the original payment date described above.
Summary-At December 31, 2018 and 2017, the accompanying consolidated balance sheet include liabilities for cash-settled awards under the EBI Plans amounted to $993 and $2,346, respectively. As of December 31, 2018 and 2017, there were 29,172 and 67,470 units, respectively, in the equity based incentive plan for those employees who elected cash settlement of EBI units. Subsequent to December 31, 2018, these cash-settled awards were fully distributed. For the year ended December 31, 2018 and 2017, the Company incurred expenses related to these plans and agreements totaling $3,787 and $3,685, respectively, which is included in salaries, commissions and employee benefits in the accompanying statement of income. Additionally, payments under the plans totaled $1,818 and $5,163, respectively, for 2018 and 2017.
Note (22)-Stock-Based Compensation
The Company grants restricted stock units under compensation arrangements for the benefit of employees, executive officers, and directors. Restricted stock unit grants are subject to time-based vesting. The total number of restricted stock units granted represents the maximum number of restricted stock units eligible to vest based upon the service conditions set forth in the grant agreements.
Additionally, following the initial public offering, participants in the EBI Plans (see Note 21) were given the option to elect conversion of their outstanding cash-settled units to stock-settled restricted stock units.
The following table summarizes information about vested and unvested restricted stock units, excluding cash-settled EBI units discussed above, outstanding at December 31, 2018:
The total fair value of restricted stock units vested and released, excluding cash-settled EBI units, was $4,562, $2,202 and $2,997 for the years ended December 31, 2018, 2017 and 2016, respectively.
The compensation cost related to stock grants and vesting of restricted stock units, excluding cash-settled EBI units, was $7,436, $8,184 and $4,693 for the years ended December 31, 2018, 2017 and 2016, respectively. This included $645 and $551 paid to Company independent directors during the years ended December 31, 2018 and 2017, respectively, related to independent director grants and compensation elected to be settled in stock. There were no such grants to independent
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
directors during the year ended December 31, 2016. The current period also includes a one-time expense of $249 related to the modification of vesting terms of certain grants
As of December 31, 2018 and 2017, there were $12,371 and $12,950, respectively, of total unrecognized compensation cost related to nonvested stock-settled EBI Units and restricted stock units (excluding cash-settled EBI units discussed above) which is expected to be recognized over a weighted-average period of 2.2 years and 2.8 years, respectively. At December 31, 2018, there was $226 accrued in other liabilities related to dividends declared to be paid upon vesting and distribution of the underlying RSUs.
Employee Stock Purchase Plan:
In 2016, the Company adopted an employee stock purchase plan (“ESPP”) under which employees, through payroll deductions, are able to purchase shares of Company common stock. The purchase price is 95% of the lower of the market price on the first or last day of the offering period. The maximum number of shares issuable during any offering period is 200,000 shares and a participant may not purchase more than 725 shares during any offering period (and, in any event, no more than $25,000 worth of common stock in any calendar year). During the years ended December 31, 2018 and 2017, there were 28,609 shares and 18,658 shares of common stock issued under the ESPP, respectively. As of December 31, 2018 and 2017, there were 2,432,356 and 2,460,965 shares available for issuance under the ESPP, respectively.
Note (23)-Related party transactions:
(A) Loans:
The Bank has made and expects to continue to make loans to the directors, certain management and executive officers of the Company and their affiliates in the ordinary course of business, in compliance with regulatory requirements.
An analysis of loans to executive officers, certain management, and directors of the Bank and their affiliates follows:
Unfunded commitments to certain executive officers, certain management and directors and their associates totaled $15,000 and $4,672 at December 31, 2018 and 2017, respectively.
(B) Deposits:
The Bank held deposits from related parties totaling $287,156 and $110,465 as of December 31, 2018 and 2017, respectively.
(C) Leases:
The Bank leases various office spaces from entities owned by certain directors of the Company under varying terms. The Company had $116 and $137 in unamortized leasehold improvements related to these leases at December 31, 2018 and 2017, respectively. These improvements are being amortized over a term not to exceed the length of the lease. Lease expense for these properties totaled $516, $504 and $522 for the years ended December 31, 2018, 2017 and 2016, respectively.
(D) Investment securities transactions:
The Company holds an investment in a fund that was issued by an entity owned by one of its directors. The balance in the investment was $29 and $200 as of December 31, 2018 and 2017, respectively.
(E) Aviation time sharing agreement:
Effective May 24, 2016, the Company entered an aviation time sharing agreement with an entity owned by certain directors of the Company. This replaces the previous agreement dated December 21, 2012. During the years ended December 31, 2018 and 2017, the Company made payments of $208 and $176, respectively, under these agreements.
(F) Registration rights agreement:
The Company is party to a registration rights agreement with its chairman of the Company’s board of directors (and former majority shareholder) that was entered into in connection with the 2016 IPO, under which the Company is responsible for
FB Financial Corporation and subsidiaries
Notes to consolidated financial statements
(Dollar amounts are in thousands, except share and per share amounts)
payment of expenses (other than underwriting discounts and commissions) relating to sales to the public by the shareholder of shares of the Company’s common stock beneficially owned by him. Such expenses include registration fees, legal and accounting fees, and printing costs payable by the Company and expensed when incurred. During 2018, the Company paid $671 under this agreement related to the secondary offering completed during the second quarter of 2018.
Note (24)-Subsequent event:
The Company has evaluated subsequent events through March 12, 2019, the date these financial statements were available to be issued.
As disclosed in Note 9, "Mortgage servicing rights," the Company closed on the sale of $29,416 of mortgage servicing rights on $2,034,374 of serviced mortgage loans. The Company will continue to service a portion of the loans until they can be transferred to the purchaser. No significant gain or loss was recognized related to this transaction.
There were no other subsequent events, other than what was disclosed above, that occurred after December 31, 2018, but prior to the issuance of these financial statements that would have a material impact on the Company’s consolidated financial statements.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
An evaluation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Act”)) as of December 31, 2018 was carried out under the supervision and with the participation of the Company’s Chief Executive Officer, Chief Financial Officer and other members of the Company’s senior management. The Company’s Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2018, the Company’s disclosure controls and procedures were effective for ensuring that information the Company is required to disclose in reports that it files or submits under the Act, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to the Company’s senior management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Management’s Annual Report on Internal Control over Financial Reporting
The information required to be provided pursuant to this item is set forth under the headings “Report on Management’s Assessment of Internal Control over Financial Reporting” in Item 8, Financial Statements and Supplementary Data.
This Annual Report does not include an attestation report from our registered public accounting firm regarding our internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to rules of the SEC that permit emerging growth companies, which we are, to provide only Management’s Annual Report on Internal Control over Financial Reporting in this Annual Report.
Changes in Internal Controls
There was no change in our internal control over financial reporting that occurred during the fourth quarter ended December 31, 2018 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Limitations on the Effectiveness of Controls
The Company’s management recognizes that a control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues, errors and instances of fraud, if any, within the Company have been detected.
ITEM 9B.
ITEM 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
The information required by this Item will be presented in, and is incorporated herein by reference to, the Company’s definitive proxy statement for the 2019 annual meeting of shareholders which will be filed with the SEC within 120 days of December 31, 2018.
Item 11.
Item 11. Executive Compensation
The information required by this Item will be presented in, and is incorporated herein by reference to, the Company’s definitive proxy statement for the 2019 annual meeting of shareholders which will be filed with the SEC within 120 days of December 31, 2018.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this Item will be presented in, and is incorporated herein by reference to, the Company’s definitive proxy statement for the 2019 annual meeting of shareholders which will be filed with the SEC within 120 days of December 31, 2018.
Item 13.
Item 13. Certain Relationships, Related Transactions and Director Independence
The information required by this Item will be presented in, and is incorporated herein by reference to, the Company’s definitive proxy statement for the 2019 annual meeting of shareholders which will be filed with the SEC within 120 days of December 31, 2018.
Item 14.
Item 14. Principal Accountant Fees and Services
The information required by this Item will be presented in, and is incorporated herein by reference to, the Company’s definitive proxy statement for the 2019 annual meeting of shareholders which will be filed with the SEC within 120 days of December 31, 2018.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) 1. Financial Statements
The following consolidated financial statements of FB Financial Corporation and our subsidiaries and related reports of our independent registered public accounting firm are incorporated in this Item 15. by reference from Part II - Item 8. Financial Statements and Supplementary Data of this Report.
Consolidated balance sheets as of December 31, 2018 and 2017
Consolidated statements of income for the years ended December 31, 2018, 2017 and 2016
Consolidated statements of comprehensive income for the years ended December 31, 2018, 2017 and 2016
Consolidated statements of changes in shareholders’ equity for the years ended December 31, 2018, 2017 and 2016
Consolidated statements of cash flows for the years ended December 31, 2018, 2017 and 2016
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
2. Financial Statement Schedules
None are applicable because the required information has been incorporated in the consolidated financial statements and notes thereto of FB Financial and our subsidiaries which are incorporated in this Annual Report by reference.
3. Exhibits
The following exhibits are filed or furnished herewith or are incorporated herein by reference to other documents previously filed with the SEC.
EXHIBIT INDEX
Exhibit
NumberDescription
*
Filed herewith.
**
Furnished herewith.
†
Represents a management contract or a compensatory plan or arrangement.
ITEM 16. FORM 10-K SUMMARY
None.
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 by the undersigned, thereunto duly authorized.
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Christopher T. Holmes and James R. Gordon and each of them, his or her true and lawful attorney(s)-in-fact and agent(s), with full power of substitution and resubstitution, for him or her and in his or her name, place and stead, in any and all capacities, to sign any or all amendments to this report and to file the same, with all exhibits and schedules thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney(s)-in-fact and agent(s) full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorney(s)-in-fact and agent(s), or their substitute(s), may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.