ALERUS FINANCIAL CORP (ALRS) FY 2021 MD&A

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the “Selected Financial Data” and our audited consolidated financial statements and related notes included elsewhere in this report. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Certain risks, uncertainties and other factors, including but not limited to those set forth under “Cautionary Note Regarding Forward-Looking Statements,” “Risk Factors” and elsewhere in this report, may cause actual results to differ materially from those projected in the forward-looking statements. We assume no obligation to update any of these forward-looking statements.

Overview

We are a diversified financial services company headquartered in Grand Forks, North Dakota. Through our subsidiary, Alerus Financial, National Association, we provide innovative and comprehensive financial solutions to businesses and consumers through four distinct business lines—banking, retirement and benefit services, wealth management and mortgage. These solutions are delivered through a relationship-oriented primary point of contact along with responsive and client-friendly technology.

Our primary banking market areas are the states of North Dakota, Minnesota, specifically, the Twin Cities MSA, and Arizona, specifically, the Phoenix MSA. In addition to our offices located in our banking markets, our retirement and benefit services business administers plans in all 50 states through offices located in Michigan, Minnesota and Colorado.

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Our business model produces strong financial performance and a diversified revenue stream, which has helped us establish a brand and culture yielding both a loyal client base and passionate and dedicated employees. We believe our client-first and advice-based philosophy, diversified business model and history of high performance and growth distinguishes us from other financial service providers. We generate a majority of our overall revenue from noninterest income, which is driven primarily by our retirement and benefit services, wealth management and mortgage business lines. The remainder of our revenue consists of net interest income, which we derive from offering our traditional banking products and services.

As of December 31, 2021, we had $3.4 billion of total assets, $1.8 billion of total loans, $2.9 billion of total deposits, $359.4 million of stockholders’ equity, $36.7 billion of AUA/AUM in our retirement and benefit services segment, and $4.0 billion of AUA/AUM in our wealth management segment. For the year ended December 31, 2021, we had $1.8 billion of mortgage originations.

Recent Developments

Impact of COVID-19

As of December 31, 2021, the COVID-19 pandemic remained ongoing, The COVID-19 pandemic has created disruptions in global supply chains, increased rates of unemployment and adversely impacted many industries, including industries related to the collateral underlying certain of our loans, and many of these effects are continuing. In 2021, the U.S. economy began reopening and wider distribution of vaccines encouraged increased economic activity. The progression of the COVID-19 pandemic in the United States did not have an adverse impact on our financial condition and results of operations as of and for the year ended December 31, 2021. Nonetheless, the economic recovery could remain gradual and uneven and could be hindered by persistent or resurgent infection rates, particularly given uncertainty with respect to the disruption and acceptance of the vaccines and their effectiveness with respect to the new variants of the virus.

Effects on Our Market Areas. Our primary banking market areas are the states of North Dakota, Minnesota, and Arizona. Our retirement and benefit services segment serves clients in all 50 states. We offer retirement and benefit services at all of our banking offices located in our three primary market areas. In addition, we operate one retirement and benefits services office in Minnesota, one in Michigan and one in Colorado.

Each of our market areas continues to have different responses to the COVID-19 pandemic due to the availability of the COVID-19 vaccines and varying infection rates. Based on the current environment, it is unclear how the states in our market areas will continue to change policies in response to the COVID-19 pandemic and whether any such changes will negatively impact our customers and regional economies.

Policy and Regulatory Developments. Federal, state and local governments and regulatory authorities have enacted and issued a range of policy responses to the COVID-19 pandemic. Most recently, these have included the following:

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Shareholder Dividend and Stock Repurchases

On January 19, 2022 the Board of Directors of the Company declared a quarterly cash dividend of $0.16 per common share. This dividend is payable on April 8, 2022, to stockholders of record on March 18, 2022.

On February 18, 2021, the Board of Directors of the Company approved a stock repurchase program, or the Program, which authorizes the Company to repurchase up to 770,000 shares of its common stock, subject to certain limitations and conditions. The Program was effective immediately and will continue for a period of 36 months. The Program does not obligate the Company to repurchase any shares of its common stock and there is no assurance that the Company will do so. As of December 31, 2021, no shares had been repurchased under the Program. The Company also repurchases shares to pay withholding taxes on the vesting of restricted stock awards and units.

Net Interest Income

Net interest income represents interest income less interest expense. We generate interest income on interest-earning assets, primarily loans and available-for-sale securities. We incur interest expense on interest-bearing liabilities, primarily interest-bearing deposits and borrowings. To evaluate net interest income, we measure and monitor: (i) yields on loans, available-for-sale securities and other interest-earning assets; (ii) the costs of deposits and other funding sources; (iii) the rates incurred on borrowings and other interest-bearing liabilities; and (iv) the regulatory risk weighting associated with the assets. Interest income is primarily impacted by loan growth and loan repayments, along with changes in interest rates on the loans. Interest expense is primarily impacted by changes in deposit balances along with the volume and type of interest-bearing liabilities. Net interest income is primarily impacted by changes in market interest rates, the slope of the yield curve, and interest we earn on interest-earning assets or pay on interest-bearing liabilities.

Noninterest Income

Noninterest income primarily consists of the following:

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Noninterest Expense

Noninterest expense is comprised primarily of the following:

Operating Segments

We measure the overall profitability of business operations based on income before income tax. We allocate costs to our segments, which consist primarily of compensation and overhead expense directly attributable to the products and services within banking, retirement and benefit services, wealth management, and mortgage. We measure the profitability of each segment based on the direct allocations of expense as we believe it better approximates the contribution generated by our reportable operating segments. All indirect overhead allocations and income tax expense is allocated to corporate administration. A description of each segment is provided in Note 22 (Segment Reporting) of the Company’s audited consolidated financial statements included elsewhere in this report.

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Critical Accounting Policies

As a result of the complex and dynamic nature of our business, management must exercise judgment in selecting and applying the most appropriate accounting policies for its various areas of operations. The policy decision process not only ensures compliance with current GAAP, but also reflects management’s discretion with regard to choosing the most suitable methodology for reporting our financial performance. It is management’s opinion that the accounting estimates covering certain aspects of the business have more significance than others due to the relative importance of those areas to overall performance, or the level of subjectivity in the selection process. These estimates affect the reported amounts of assets and liabilities as well as disclosures of revenues and expenses during the reporting period. Actual results could differ from these estimates. The most critical of the accounting policies are discussed below.

Investment securities—Investment securities can be classified as trading, available-for-sale, held-to-maturity and equity. The appropriate classification is based partially on our ability to hold the securities to maturity and largely on management’s intentions with respect to either holding or selling the securities. The classification of investment securities is significant since it directly impacts the accounting for unrealized gains and losses on securities. Unrealized gains and losses on available-for-sale securities are recorded in accumulated other comprehensive income or loss, as a separate component of stockholders’ equity, and do not affect earnings until realized. The fair values of investment securities are generally determined by reference to quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments, or a discounted cash flow model using market estimates of interest rates and volatility. Investment securities with significant declines in fair value are evaluated to determine whether they should be considered other-than-temporarily impaired. An unrealized loss is generally deemed to be other-than-temporary and a credit loss is deemed to exist if the present value of the expected future cash flows is less than the amortized cost basis of the debt security. The credit loss component of an other-than-temporary impairment write-down is recorded in current earnings, while the remaining portion of the impairment loss is recognized in other comprehensive income (loss), provided we do not intend to sell the underlying debt security, and it is not likely that we will be required to sell the debt security prior to recovery of the full value of its amortized cost basis.

Allowance for loan losses—The allowance for loan losses reflects management’s best estimate of probable loan losses in our loan portfolio. Determination of the allowance for loan losses is inherently subjective. It requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, appraisal values of underlying collateral for collateralized loans, and the amount of estimated losses on pools of homogeneous loans which is based on historical loss experience, adjusted for consideration of economic trends, collateral values, trends in past due loans and other factors, all of which may be susceptible to significant change.

Intangible assets—As a result of acquisitions, we carry goodwill and identifiable intangible assets. Goodwill represents the cost of acquired companies in excess of the fair value of net assets at the acquisition date. Goodwill is evaluated at least annually or when business conditions suggest impairment may have occurred. Should impairment occur, goodwill will be reduced to its revised carrying value through a charge to earnings. Core deposits and other identifiable intangible assets are amortized to expense over their estimated useful lives. The determination of whether or not impairment exists is based upon discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows. It also requires them to select a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, required equity market premiums, and company-specific performance and risk metrics, all of which are susceptible to change based on changes in economic and market conditions and other factors. Future events or changes in the estimates used to determine the carrying value of goodwill and identifiable intangible assets could have a material impact on our results of operations.

Income taxes—Income tax expense or benefit is the total of the current year income tax due or refundable 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. 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

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than not” test, no tax benefit is recorded. Interest and penalties related to income tax matters are recognized in income tax expense.

On December 22, 2017, the U.S government enacted Public Law 115-97, commonly known as, the Tax Cuts and Jobs Act, a comprehensive tax legislation, which reduced the federal income tax rate for C corporations from 35% to 21%, effective January 1, 2018. As a result of the reduction in the U.S corporate income tax rate from 35% to 21%, we re-measured our deferred tax assets and recognized $4.8 million of tax expense in the Consolidated Statement of Income for the year ended December 31, 2017. See Note 20 (Income Taxes) of the Company’s audited consolidated financial statements included elsewhere in this report.

Fair value measurements—Fair value is the price that would be received to sell an asset, or paid to transfer a liability, in the principal or most advantageous market for an asset or liability in an orderly transaction between market participants at the measurement date. The degree of management judgment involved in determining the fair value of a financial instrument is dependent upon the availability of quoted market prices, or observable market inputs. For financial instruments that are traded actively and have quoted market prices or observable market inputs, there is minimal subjectivity involved in measuring fair value. However, when quoted market prices or observable market inputs are not fully available, significant management judgement may be necessary to estimate fair value. In developing our fair value measurements, we maximize the use of observable inputs and minimize the use of unobservable inputs.

Financial assets that are recorded at fair value on a recurring basis include investment securities available-for-sale and derivative financial instruments. As of December 31, 2021, and 2020, $857.0 million or 25.3% and $605.7 million, or 20.1%, respectively, of our total assets consisted of financial assets recorded at fair value on a recurring basis and most of these financial assets consisted of available-for-sale investment securities. The fair value of financial assets on a recurring basis are classified in either Levels 1 or 2 of the fair value hierarchy. Financial liabilities that are recorded at fair value on a recurring basis are comprised of derivative financial instruments. As of December 31, 2021 and 2020, $1.4 million and $2.9 million, respectively represented less than 1% of our total liabilities in those years and were classified as Level 2 of the fair value hierarchy. We have no fair value assets or liabilities classified in Level 3 of the fair value hierarchy.

A further discussion regarding the fair value of assets and liabilities, and the classification of Level 1, 2, and 3 hierarchies, is disclosed in Note 28 (Fair Value of Assets and Liabilities) of the Company’s audited consolidated financial statements included elsewhere in this report.

A summary of the accounting policies used by management is disclosed in Note 1 (Significant Accounting Policies) of the Company’s audited consolidated financial statements included elsewhere in this report.

Selected Financial Data

The following consolidated selected financial data is derived from the Company’s audited consolidated financial statements as of and for the five years ended December 31, 2021.

The consolidated selected financial data presented below contains financial measures that are not presented in accordance with accounting principles generally accepted in the United States and have not been audited. See “Non-GAAP to GAAP Reconciliations and Calculation of Non-GAAP Financial Measures” below.

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Non-GAAP to GAAP Reconciliations and Calculation of Non-GAAP Financial Measures

In addition to the results presented in accordance with GAAP, we routinely supplement our evaluation with an analysis of certain non-GAAP financial measures. These non-GAAP financial measures include the ratio of tangible

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common equity to tangible assets, tangible common equity per share, return on average tangible common equity, net interest margin (tax-equivalent), and the efficiency ratio. Management uses these non-GAAP financial measures in its analysis of its performance, and believes financial analysts and others frequently use these measures, and other similar measures, to evaluate capital adequacy. Management calculates: (i) tangible common equity as total common stockholders’ equity, less goodwill and other intangible assets; (ii) tangible common equity per share as tangible common equity divided by shares of common stock outstanding; (iii) tangible assets as total assets, less goodwill and other intangible assets; (iv) return on average tangible common equity as net income adjusted for intangible amortization net of tax, divided by average tangible common equity; (v) net interest margin (tax-equivalent) as net interest income plus a tax-equivalent adjustment, divided by average earning assets; and (vi) efficiency ratio as noninterest expense less intangible amortization expense, divided by net interest income plus noninterest income plus a tax-equivalent adjustment.

The following tables present these non-GAAP financial measures along with the most directly comparable financial measures calculated in accordance with GAAP for the periods indicated.

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Results of Operations

The following discussion describes the consolidated operations and financial condition of the Company and the Bank. Results of operations for the year ended December 31, 2021 are compared to the results for the year ended December 31, 2020, and the consolidated financial condition of the Company as of December 31, 2021 is compared to December 31, 2020. Results of operations for the year ended December 31, 2020 compared to results for the year ended December 31, 2019, can be found in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations of the Company’s 2020 annual report on Form 10-K filed with the SEC on March 12, 2021.

Summary

Net income for the year ended December 31, 2021, was $52.7 million, an increase of $8.0 million, or 17.9%, compared to $44.7 million for the year ended December 31, 2020. Diluted earnings per common share were $2.97 in 2021, compared to $2.52 in 2020. Return on average total assets was 1.66% in 2021, compared to 1.61% for 2020. The increase in net income was primarily due to a decrease of $14.4 million in provision for loan losses expense and an increase of $3.3 million in net interest income, partially offset by a decrease of $2.0 million in noninterest income and a

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$5.1 million increase in noninterest expense. The decrease in provision for loan losses expense was primarily driven by a $3.5 million reversal of provision expense as well as $826 thousand in net recoveries, a result of improvements in credit quality indicators. Net interest income increased primarily due to a $5.2 million decrease in interest expense paid on deposits and a $5.2 million increase in interest income from investment securities, partially offset by an $8.3 million decrease on interest income from loans. Noninterest income decreased as a result of a $13.1 million decrease in mortgage banking revenue. Noninterest expense increased primarily due to increases of $4.2 million in compensation expense and $2.0 million increase in employee taxes and benefits expense.

Net Interest Income—With Nontaxable Income Converted to Fully Taxable Equivalent, or FTE

Net interest income totaled $87.1 million in 2021, an increase of $3.3 million, or 3.9%, from 2020. Net interest margin decreased 32 basis points to 2.90%, in 2021, from the 3.22% reported in 2020. The decrease in net interest margin was primarily a result of a 60 basis point decrease in the average yield on interest earning assets which was partially offset by a corresponding decrease of 43 basis points in the average rate paid on interest-bearing liabilities. These decreases were largely driven by a shift in balance sheet mix as the average balance of interest-bearing deposits with banks increased $60.3 million and the average balance on investment securities increased $439.1 million while the average balance on loans held for investment decreased $86.9 million and the average balance on loans held for sale decreased $13.2 million.

The following table sets forth information related to our average balance sheet, average yields on assets, and average rates of liabilities for the periods indicated. We derived these yields by dividing income or expense by the average balance of the corresponding assets or liabilities. We derived average balances from the daily balances throughout the periods indicated. Average loan balances include loans that have been placed on nonaccrual, while

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interest previously accrued on these loans is reversed against interest income. In these tables, adjustments are made to the yields on tax-exempt assets in order to present tax-exempt income and fully taxable income on a comparable basis.

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Rate/Volume Analysis

The table below presents the effect of volume and rate changes on interest income and expense for the periods indicated. Changes in volume are changes in the average balance multiplied by the previous year’s average rate. Changes in rate are changes in the average rate multiplied by the average balance from the previous year. The net changes attributable to the combined impact of both rate and volume have been allocated proportionately to the changes due to volume and the changes due to rate.

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Provision for Loan Losses

There was a $3.5 million reversal of provision for loan losses for the year ended December 31, 2021, compared to $10.9 million of provision for loan losses for the year ended December 31, 2020. The negative provision for the year was driven by $826 thousand in net recoveries and improvements in credit quality indicators.

The provision for loan losses on off-balance sheet items, a component of “other expense” in our Consolidated Statements of Income, reflects management’s assessment of the adequacy of the allowance for loan losses on lending-related commitments. See “Financial Condition—Allowance for Loan Losses.”

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Noninterest Income

The following table presents noninterest income for the years ended December 31, 2021, 2020, and 2019.

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Total noninterest income decreased by $2.0 million, or 1.3%, to $147.4 million in 2021, from $149.4 million for 2020. The decrease in noninterest income was primarily due to a $13.1 million decrease in mortgage banking revenue and a $2.6 million decrease in gain on the sale of investment securities, partially offset by a $10.8 million increase in retirement and benefit services and a $3.6 million increase in wealth management revenue. The decrease in mortgage banking revenue was primarily due to a $17.3 million decrease in the change in fair value of derivatives. Partially offsetting this decrease was a modest 2 basis point increase in the gain on sale margin and an increase in mortgage originations of $57.1 million, or 3.2%, from 2020. The increase in retirement and benefits services revenue was primarily driven by the December 2020 acquisition of Retirement Planning Services, Inc. and a $2.5 billion, or 7.4%, increase in assets under administration/management. Wealth management revenue increased $3.6 million due to an increase of $701.3 million in wealth management assets under administration/management.

Noninterest income as a percent of total operating revenue, which consists of net interest income plus noninterest income, was 62.9% in 2021, down from 64.1% the prior year. The decrease in 2021 was due to a 1.3% decrease in noninterest income while net interest income increased by 3.9%.

Noninterest Expense

The following table presents noninterest expense for the years ended December 31, 2021, 2020, and 2019.

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Total noninterest expense increased $5.1 million, or 3.1%, to $168.9 million for the year ended December 31, 2021, from $163.8 million for 2020. The increase in noninterest expense was primarily due to increases of $4.2 million in compensation expense, $2.0 million in employee taxes and benefits, $1.5 million in professional fees and assessments and $1.4 million in business services, software and technology expense, partially offset by decreases of $1.9 million in occupancy and equipment expense, $1.5 million in mortgage and lending expenses and $1.2 million in other noninterest expense. The increases in compensation expense and employee taxes and benefits expense were primarily due to the increase in mortgage originations as well as an increase in incentive awards due to the Company’s record financial performance. The increase in professional fees and assessments was primarily due to a $406 thousand increase in legal expenses as a result of a reclassification in expenses from business services, software and technology expense. Business

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services, software and technology increased due to investments in core processing software. Occupancy and equipment expense decreased due to the termination of facility leases and the closure of nine office locations in 2020 as we transitioned to a hybrid work environment. The decrease in mortgage and lending expenses was primarily the result of a $1.5 million decrease in the valuation of mortgage servicing rights. Other noninterest expense decreased, primarily due to a settlement recovery on a previous wire fraud loss accrual.

Income Taxes

For the year ended December 31, 2021, we recognized income tax expense of $16.4 million on $69.1 million of pre-tax income resulting in an effective tax rate of 23.7%, a modest change as compared to the same period in 2020, in which we recognized an income tax expense of $13.8 million on $58.5 million of pre-tax income, resulting in an effective tax rate of 23.6%.

Segment Reporting

We determine reportable segments based on the significance of the services offered, the significance of those services to our financial condition and operating results, and our regular review of the operating results of those services. We have four operating segments—banking, retirement and benefit services, wealth management, and mortgage. These segments are components for which financial information is prepared and evaluated regularly by management in deciding how to allocate resources and assess performance.

The selected financial information presented for each segment sets forth net interest income, provision for loan losses, noninterest income, and direct noninterest expense before indirect overhead allocations. Corporate administration includes the indirect overhead and is set forth in the table below along with income tax expense and the consolidated net income. The segment net income before taxes represents direct revenue and expense before indirect allocations and income taxes. Certain reclassification adjustments have been made between corporate administration and the various lines of business for consistency in presentation.

For additional financial information on our segments see Note 22 (Segment Reporting) of the Company’s audited consolidated financial statements included elsewhere in this report.

Banking

The banking segment offers a complete line of loan, deposit, cash management, and treasury services through 14 offices in North Dakota, Minnesota, and Arizona. These products and services are supported through various digital applications. The majority of our assets and liabilities are on the banking segment balance sheet.

The banking segment reported net income before taxes and indirect allocations of $51.6 million for the year ended December 31, 2021, an increase of $14.2 million compared to 2020. The increase was driven primarily by decreases of $14.4 million in provision for loan losses and $1.9 million in noninterest expense as well as a $1.8 million increase in net interest income, partially offset by a $3.9 million decrease in noninterest income.

Retirement and Benefit Services

Retirement and benefit services provides the following services nationally: recordkeeping and administration services to qualified retirement plans; ESOP trustee, recordkeeping and administration; investment fiduciary services to retirement plans; HSA, flex spending account, and government health insurance program recordkeeping and administration services to employers; payroll and human resource information system services for employers. The division services approximately 7,500 retirement plans and more than 376,800 plan participants. In addition, the division employs nearly 300 professionals, and operates within our banking markets as well as Lansing, Michigan, Littleton, Colorado.

The retirement and benefit services segment reported net income before taxes and indirect allocations of $31.5 million for the year ended December 31, 2021, an increase of $5.8 million from $25.7 million for 2020. Revenue of

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$71.7 million, comprised of $27.9 million in asset-based revenue and $43.8 million in participant and transaction revenues, increased $10.8 million or 17.6% primarily due to the acquisition of Retirement Planning Services, Inc.

The following table presents changes in the combined AUA and AUM for our retirement and benefit services segment for the periods presented.

AUA and AUM for the retirement and benefit services segment were $36.7 billion at December 31, 2021, an increase of $2.5 billion, or 7.4%, compared to the total at December 31, 2020. The increase was primarily driven by an increase of $3.0 billion related to market impact, partially offset by outflows outpacing inflows by $420.2 million.

Wealth Management

The wealth management division provides advisory and planning services, investment management, and trust and fiduciary services to clients across our Company’s footprint.

Wealth management reported net income before taxes and indirect allocations of $12.2 million for the year ended December 31, 2021, an increase of $3.0 million, or 33.0%, from 2020. Noninterest income increased $3.6 million, or 20.6%, as compared to 2020, primarily due to an increase in combined AUA and AUM. Wealth management noninterest expense of $8.9 million increased $580 thousand, or 7.0%, from 2020 primarily due to an increase in direct allocation expenses.

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The following table presents changes in the wealth management combined AUA and AUM, disaggregated by product, for the periods presented.

AUA and AUM for the wealth management segment was $3.2 billion, excluding $829.7 million of brokerage assets, at December 31, 2021, an increase of $632.2 million, or 24.5%, compared to the total at December 31, 2020. The increase was driven by a$346.5 million increase as inflows outpaced outflows and a $285.7 million increase related to the market impact.

Mortgage

The mortgage division offers first and second mortgage loans through a centralized mortgage unit in Minneapolis, Minnesota as well as through the banking office locations.

Mortgage reported net income before taxes and indirect allocations of $13.3 million for the year ended December 31, 2021, a decrease of $14.1 million from the $27.4 million reported in 2020. Mortgage noninterest income for 2021 of $48.5 million decreased $13.1 million, or 21.3%, from 2020. The decrease was primarily driven by a decrease in the change in fair value of the secondary market derivatives of $17.3 million, partially offset by a modest 2 basis point increase in the gain on sale margin and an increase of $57.1 million in mortgage originations.

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Financial Condition

Overview

Total assets were $3.4 billion at December 31, 2021, an increase of $379.0 million, or 12.6%, compared to $3.0 billion at December 31, 2020. The increase in total assets was primarily due to increases of $613.4 million in investment securities and $69.3 million in cash and cash equivalents, partially offset by decreases of $218.7 million in net loans and $76.0 million in loans held for sale. The increase in investment securities was a result of management’s decision to utilize liquidity and provide for an increase in earning asset yield compared to alternative short-term investments. The decrease in loans held for investment was primarily driven by a $234.9 million decrease in PPP loans as a result of processing SBA loan forgiveness applications. Loans held for sale decreased primarily due to a seasonal decrease in mortgage originations back to normalized levels.

Investment Securities

The following table presents the carrying amount of our investment securities portfolio at the dates indicated:

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The composition of our investment securities portfolio reflects our investment strategy of maintaining an appropriate level of liquidity for normal operations while providing an additional source of revenue. The investment portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet, while providing a vehicle for the investment of available funds, furnishing liquidity, and supplying securities to pledge as collateral. In the second quarter of 2021, we transferred our portfolio of obligations of state and political agencies from available-for-sale to held-to-maturity to protect capital and reduce volatility in other comprehensive income due to market value changes.

At December 31, 2021, total investment securities were $1.2 billion compared to $592.3 million at December 31, 2020. Investment securities as a percentage of total assets were 35.5% and 19.7%, as of December 31, 2021 and December 31, 2020, respectively. The decision to increase investment securities was strategically done to utilize excess liquidity and provide for an increase in earning asset yield compared to alternative short-term investments. Securities with a carrying value of $192.8 million were pledged at December 31, 2021, to secure public deposits and for other purposes required or permitted by law.

The net pre-tax unrealized market value loss on the available-for-sale investment portfolio as of December 31, 2021 was $6.6 million, as compared to a $14.2 million gain as of December 31, 2020. The change from a gain to a loss is indicative of the interest rate environment and changes in the size and composition of the portfolio.

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The investment portfolio is composed of U.S. Treasury debentures, U.S. Agency mortgage-backed pass-throughs, U.S. Agency, Commercial Mortgage Obligations, or CMOs, Corporate bonds and Municipal bonds.

As of December 31, 2021 and December 31, 2020 the Company held 94 tax-exempt state and local municipal securities totaling $49.4 million and held 112 tax-exempt state and local municipal securities totaling $50.1 million, respectively. Other than the aforementioned investments, at December 31, 2021 and December 31, 2020, 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 stockholders’ equity.

As of December 31, 2021 and December 31, 2020, all of the available-for-sale debt securities in an unrealized loss position were investment grade. For the years ended December 31, 2021 and 2020, we evaluated all of our debt securities for credit impairment and determined there were no credit losses evident and we did not record any other-than-temporary impairment. Furthermore, we do not intend to sell and it is more likely than not that we will not be required to sell these debt securities before the anticipated recovery of the amortized cost basis.

Periodic reviews are conducted to identify and evaluate each investment that has an unrealized loss for other-than-temporary impairment. An unrealized loss exists when the current estimated fair value of an individual security is less than its amortized cost basis. Unrealized losses that are determined to be temporary in nature are recorded, net of tax, in accumulated other comprehensive income for available-for-sale securities.

The investment securities presented in the following table are reported at fair value and by contractual maturity as of December 31, 2021. Actual timing may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Additionally, the mortgage backed securities receive monthly principal payments, which are not reflected below. The yields below are calculated on a tax equivalent basis.

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Loans

The loan portfolio represents a broad range of borrowers comprised of commercial and industrial, commercial real estate, residential real estate, and consumer financing loans.

Commercial and industrial loans include financing for commercial purposes in various lines of businesses, including manufacturing, service industry and professional service areas. Commercial and industrial loans are generally secured with the assets of the company and/or the personal guarantee of the business owners.

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Commercial real estate loans consist of term loans secured by a mortgage lien on the real property, such as office and industrial buildings, retail shopping centers and apartment buildings, as well as commercial real estate construction loans that are offered to builders and developers.

Residential real estate loans represent loans to consumers for the purchase or refinance of a residence. These loans are generally financed over a 15- to 30-year term and, in most cases, are extended to borrowers to finance their primary residence with both fixed-rate and adjustable-rate terms. Real estate construction loans are also offered to consumers who wish to build their own homes and are often structured to be converted to permanent loans at the end of the construction phase, which is typically twelve months. Residential real estate loans also include home equity loans and lines of credit that are secured by a first- or second-lien on the borrower’s residence. Home equity lines of credit consist mainly of revolving lines of credit secured by residential real estate.

Consumer loans include loans made to individuals not secured by real estate, including loans secured by automobiles or watercraft, and personal unsecured loans.

Loans outstanding, by type, as of the dates presented are as follows:

Total loans outstanding were $1.8 billion as of December 31, 2021, a decrease of $221.4 million, or 11.2%, from December 31, 2020. The decrease was primarily due to a $255.1 million decrease in the commercial and industrial loan portfolio, primarily attributable to a $234.8 decrease in PPP loans. Excluding PPP loans, total loans increased $13.5 million, or 0.8%. This increase was primarily due to a $47.3 million increase in residential real estate first mortgages and a $35.9 million increase in commercial real estate loans, partially offset by decreases of $27.9 million in consumer revolving and installment loans, a $20.2 million decrease in commercial and industrial loans, and a $17.7 million decrease in residential real estate junior liens.

Our loan portfolio is highly diversified. The long-term goal of the overall portfolio mix is to retain balance with approximately one third of the portfolio in each of the commercial and industrial, commercial real estate, and residential real estate categories. As of December 31, 2021, approximately 24.8% of loans outstanding were commercial and industrial, while 34.1% of loans outstanding were commercial real estate, and 36.2% of loans outstanding were residential real estate. The commercial lending portfolio is also broadly diversified by industry type as demonstrated by the following distributions at December 31, 2021: real estate (39%), retail trade (10%), healthcare (6%), finance & insurance (6%),wholesale trade (5%), construction (5%), manufacturing (5%), professional services (3%), transportation (3%), agriculture, forestry, fishing and hunting (3%), management of companies (2%), accommodation and food services (1%), educational services (1%), and administrative and support (1%). A variety of other industries with less than a 1% share of the total portfolio comprise the remaining 10%. The loan portfolio is also diversified by market distribution with 52.8% of the portfolio in the Twin Cities MSA, 36.7% in the eastern North Dakota cities of Grand Forks and Fargo, 8.3% in the Phoenix MSA and 2.2% in our national market, as of December 31, 2021.

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We originate both fixed and adjustable rate residential real estate loans conforming to the underwriting guidelines of the Federal National Mortgage Association or the Federal Home Loan Mortgage Corporation, as well as home equity loans and lines of credit that are secured by first or junior liens. Most of our fixed rate residential loans, along with some of our adjustable rate mortgages are sold to other financial institutions with which we have established a correspondent lending relationship.

Our consumer mortgage loans have minimal direct exposure to subprime mortgages as the loans are underwritten to conform to secondary market standards. Volume in this portion of the loan portfolio has been strong over the last few years due to low long-term interest rates and comparatively stable real estate valuations in our primary markets. As of December 31, 2021, our consumer mortgage portfolio was $636.4 million which was a $29.6 million, or 4.9%, increase from $606.8 million as of December 31, 2020. Market interest rates, expected duration, and our overall interest rate sensitivity profile continue to be the most significant factors in determining whether we choose to retain versus sell portions of new consumer mortgage originations.

The combined total of general-purpose business lending to commercial, industrial, non-profit and municipal customers, mortgages on commercial property and dealer floor plan financing is characterized as commercial lending activity. As of December 31, 2021, the commercial loan portfolio was $1.1 billion, a decrease of $223.0 million, or 17.2%, from $1.3 billion as of December 31, 2020. The decrease was primarily due to a $234.8 million decrease in PPP loans. Excluding PPP loans, the commercial loan portfolio increased $11.8, or 1.1%, from 2020. Highly competitive conditions continue to prevail in the small and middle market commercial segments in which we primarily operate. We maintain a commitment to generating growth in our business portfolio in a manner that adheres to our twin goals of maintaining strong asset quality and producing profitable margins. We continue to invest in additional personnel, technology, and business development resources to further strengthen our capabilities in this important product category.

Consistent with regulatory guidance urging banks to work with borrowers during this unprecedented situation, the Company offered a payment deferral program for its lending clients that have been adversely affected by COVID-19. These deferrals were generally no more than 90 days in duration. As of December 31, 2021, most of these payment deferrals have returned to a normal payment status. Of the loans currently in deferral status, 6 loans with a total outstanding principal balance of $3.3 million have been granted additional deferrals, 2 loans with a total outstanding principal balance of $72 thousand remain on the first deferral. In accordance with the Interagency Statement on Loan Modifications and Reporting for Financial Institutions as issued on April 7, 2020, these short-term deferrals were not considered TDRs. See “Note 6 Loans and Allowance for Loan Losses” to the consolidated financial statements for additional information regarding TDRs.

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The following table shows the maturities and sensitivity to interest rates for the loan portfolio as of December 31, 2021:

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The expected life of our loan portfolio will differ from contractual maturities because borrowers may have the right to curtail or prepay their loans with or without penalties. Consequently, the table above includes information limited to contractual maturities of the underlying loans.

Asset Quality

Our strategy for credit risk management includes well-defined, centralized credit policies; uniform underwriting criteria; and ongoing risk monitoring and review processes for all commercial and consumer credit exposures. The strategy also emphasizes diversification on a geographic, industry, and client level; regular credit examinations; and management reviews of loans experiencing deterioration of credit quality. We strive to identify potential problem loans early, take necessary charge-offs promptly, and maintain adequate reserve levels for probable loan losses inherent in the portfolio. Management performs ongoing, internal reviews of any problem credits and continually assesses the adequacy of the allowance. We utilize an internal lending division, Special Credit Services, to develop and implement strategies for the management of individual nonperforming loans.

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Nonperforming assets consist of loans 90 days or more past due, nonaccrual loans, foreclosed assets and other real estate owned. We do not consider performing troubled debt restructurings, or TDRs, to be nonperforming assets, but they are included as part of impaired assets. The level of nonaccrual loans is an important element in assessing asset quality. Loans are classified as nonaccrual when principal or interest is in default for 90 days or more, unless in the opinion of management, the loan is well secured and in the process of collection. Exclusive of any delinquency, a loan will be placed in nonaccrual when there is deterioration in the financial condition of the borrower and full payment of principal and interest is not expected.

A loan is categorized as a TDR if a concession is granted, such as to provide for the reduction of either interest or principal due to deterioration in the financial condition of the borrower. Typical concessions include reduction of the interest rate on the loan to a rate considered lower than market and other modification of terms including forgiveness of a portion of the loan balance, extension of the maturity date, and/or modifications from principal and interest payments to interest-only payments for a certain period. Loans are not classified as TDRs when the modification is short-term or results in only an insignificant delay or shortfall in the payments to be received. See “Note 6 Loans and Allowance for Loan Losses” to the consolidated financial statements for additional information regarding TDRs.

Credit Quality Indicators

Loans are categorized 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. A risk rating is assigned to all commercial loans, except pools of homogeneous loans. We periodically perform detailed internal and external reviews of risk rated loans over a certain threshold to identify credit risks and to assess the overall collectability of the portfolio. During the internal reviews, management monitors and analyzes the financial condition of borrowers and guarantors, trends in the industries in which the borrowers operate, and the estimated fair values of collateral securing the loans. These credit quality indicators are used to assign a risk rating to each individual loan. The following definitions are used for risk ratings:

Pass. Higher quality loans that do not fit any of the other categories described below. This category includes loans risk rated with the following ratings: minimal credit risk, modest credit risk, average credit risk, acceptable credit risk, acceptable with risk and management attention.

Special Mention. Loans classified as special mention 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.

Substandard. Loans classified 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 classified 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.

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

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Criticized loans represent loans that are categorized as special mention, substandard, and doubtful. The following table presents criticized loans by type as of December 31, 2021, 2020, and 2019:

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The following table presents information regarding nonperforming assets as of the dates presented:

The allowance for loan losses to nonperforming loans ratio increased 763 basis points from December 31, 2020. The increase was primarily the result of a decrease in nonperforming loans of $2.9 million from December 31, 2020.

Interest income lost on nonaccrual loans approximated $0.3 million, $0.5 million, and $0.4 million for the years ended December 31, 2021, 2020, and 2019, respectively. There was no interest income included in net income related to nonaccrual loans for the years ended December 31, 2021, 2020, and 2019.

Allowance for Loan Losses

The allowance for loan losses is maintained at a level management believes is sufficient to absorb incurred losses in the loan portfolio given the conditions at the time. Management determines the adequacy of the allowance based on periodic evaluations of the loan portfolio and other factors. These evaluations are inherently subjective as they require management to make material estimates, all of which may be susceptible to significant change. The allowance is increased by provisions charged to expense and decreased by actual charge-offs, net of recoveries.

The allowance for loan losses represents management’s assessment of probable credit losses inherent in the loan portfolio. The allowance for loan losses consists of specific components, based on individual evaluation of certain loans, and general components for homogeneous pools of loans with similar risk characteristics.

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Impaired loans include loans placed on nonaccrual status and TDRs. Loans are considered impaired when, based on current information and events, it is probable that all amounts due, in accordance with the original contractual terms of the loan agreement, will not be collected. When determining if all amounts due in accordance with the original contractual terms of the loan agreement will be collected, the borrower’s overall financial condition, resources and payment record, support from guarantors, and the realizable value of any collateral, are taken into consideration. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.

All impaired loans 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 discounted expected future cash flows or at the fair value of collateral if repayment is collateral dependent.

The allowance for non-impaired loans is based on historical losses adjusted for current qualitative factors. The historical loss experience is determined by portfolio segment and is based on the actual loss history over the most recent five years. This actual loss experience is adjusted for 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. These factors are inherently subjective and are driven by the repayment risk associated with each portfolio segment. These portfolio segments include commercial and industrial, real estate construction, commercial real estate, residential real estate first mortgage, residential real estate junior liens, and other revolving and installment.

In the ordinary course of business, we enter into commitments to extend credit, including commitments under credit arrangements, commercial letters of credit, and standby letters of credit. Such financial instruments are recorded when they are funded. A reserve for unfunded commitments is established using historical loss data and utilization assumptions. This reserve is located under accrued expenses and other liabilities on the Consolidated Balance Sheets. The expense for provision for unfunded commitments was $159 thousand for the year ended December 31, 2021 compared to $800 thousand for the year ended December 31, 2020.

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The following table presents, by loan type, the changes in the allowance for loan losses for the periods presented.