NORTHRIM BANCORP INC (NRIM) FY 2021 MD&A

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

We have prepared this Management's Discussion and Analysis as an aid to understanding our financial results. It highlights key information as determined by management but may not contain all of the information that is important to you. It should be read in conjunction with the Company’s audited consolidated financial statements and the notes thereto included in Part II. Item 8 of this report. Discussions of 2019 items and year-to-year comparisons between 2020 and 2019 that are not included in this Form 10-K can be found in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Part II. Item 7 of our Annual Report on Form 10-K for fiscal year ended December 31, 2020.

This annual report contains forward-looking statements that involve risks and uncertainties.  Our actual results may differ materially from those indicated in forward-looking statements.  See “Cautionary Note Regarding Forward-Looking Statements.”

Executive Overview

Net income attributable to the Company increased 14% to $37.5 million or $6.00 per diluted share for the year ended December 31, 2021, from $32.9 million, or $5.11 per diluted share, for the year ended December 31, 2020. The increase in net income is the result of an $11.6 million increase in net income in the Community Banking segment, which was only partially offset by a $7.0 million decrease in net income in the Home Mortgage Lending segment.

Highlights for the year ended December 31, 2021 are as follows:

•Net income in the Community Banking segment increased 74% or $11.6 million, to $27.2 million in 2021 as compared to 2020. This increase was primarily the result of the following:

◦Interest and fee income on PPP loans increased $7.3 million to $15.4 million in 2021 from $8.1 million in 2020. Interest income on PPP loans was $2.9 million and $2.5 million in 2021 and 2020, respectively. Loan fee income on PPP loans was $12.5 million and $5.6 million in 2021 and 2020, respectively. Loan fee income on PPP loans is largely made up of fees fully recognized upon loan forgiveness from the SBA. In 2021, $426.3 million PPP loans were forgiven compared to $65.1 million in 2020. As of December 31, 2021, there is $4.5 million in deferred PPP loan fees, net of deferred costs, remaining to be recognized. Management expects the majority of the remaining deferred fees to be recognized in 2022.

◦The provision for credit losses decreased in 2021 to a benefit of $4.1 million from a provision of $2.4 million in 2020. As of January 1, 2021, the Company implemented ASU 2016-13, Financial Instruments - Credit Losses ("ASU 2016-13" or "CECL"). The provision for 2021 was recorded using the CECL methodology and reflects expected lifetime credit losses on loans and off-balance sheet unfunded loan commitments. The decrease in the provision for credit losses in 2021 compared to 2020 is primarily the result of improvement in economic assumptions used to estimate lifetime credit losses, which have improved but are not yet at pre-pandemic levels. Our nonperforming loans, net of government guarantees, increased to $10.7 million at the end of 2021 compared to $10.0 million at the end of 2020, while total adversely classified loans, net of government guarantees at December 31, 2021 increased to $13.7 million from $12.8 million at December 31, 2020. The Allowance for Credit Losses ("ACL") totaled 0.83% of total portfolio loans at December 31, 2021, compared to 1.46% at December 31, 2020.  The ACL compared to nonperforming loans, net of government guarantees, was 110% at December 31, 2021 compared to 210% at the end of 2020.

◦Interest expense decreased $2.3 million to $3.8 million in 2021 from $6.1 million in 2020 due to lower interest rates.

◦The changes above where partially offset by a $3.8 million increase in tax expense in the Community Banking segment in 2021 primarily due to higher taxable income in 2021 compared to 2020.

•Net income in the Home Mortgage Lending segment decreased 40%, or $7.0 million, to $10.3 million in 2021 from $17.3 million in 2020 primarily due to a decrease in production volume to $1.118 billion in 2021 from $1.295 billion in 2020, as well as a $3.7 million decrease in the change in fair value of the interest rate lock commitments as the loan pipeline decreased at December 31, 2021 compared to December 31, 2020.

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•The net interest margin decreased to 3.58% in 2021 from 4.02% in 2020 mostly due to a decrease in average yields on interest earning assets to 3.74% in 2021 compared to 4.36% in 2020 as a result of lower interest rates. Additionally, the mix of earning assets, specifically an increase in interest-bearing cash, also contributed to the decrease in the net interest margin in 2021 as compared to the prior year.

•The Company continued to maintain strong capital ratios with Tier 1 Capital to Risk Adjusted Assets of 14.08% at December 31, 2021 as compared to 14.20% at December 31, 2020.

•The aggregate cash dividends paid by the Company in 2021 rose 6% to $9.4 million from $8.8 million paid in 2020.

•The Company repurchased 279,276 shares of its common stock in 2021 at an average price of $41.30 per share.

COVID-19 Issues:

•Industry Exposure: Northrim has identified various industries that may be adversely impacted by the COVID-19 pandemic and the volatility in oil prices that has occurred over the last year and a half, though oil prices have rebounded recently. Though the industries affected may change through the progression of the pandemic, the following sectors for which the Company has exposure, as a percent of the total loan portfolio as of December 31, 2021 are being impacted: Healthcare (8%), Tourism (7%), Oil and Gas (4%), Aviation (non-tourism) (4%), Accommodations (4%), Fishing (4%), Restaurants and Breweries (3%) and Retail (2%). The portion of the Company's Allowance that related to the loans with exposure to these industries is estimated at the following amounts as of December 31, 2021:

•Customer Accommodations: The Company has implemented assistance to help customers experiencing financial challenges as a result of COVID-19 in addition to our participation in PPP lending. The provisions of the CARES Act included an election to not apply the guidance on accounting for certain troubled debt restructurings ("TDR") related to COVID-19 and allow certain accommodations to borrowers. These accommodations include interest only and deferral options on loan payments, as well as the waiver of various fees related to loans, deposits and other services. The Company has elected to adopt these provisions of the CARES Act. The outstanding principal balance of loan modifications due to the economic impacts of COVID-19 for the periods below were as follows:

All 17 loan modifications as of December 31, 2021, have entered into more than one modification.

•Branch Operations: All branches have returned to pre-pandemic levels, while a number of customer and employee safety measure continue to be implemented.

•Growth and Paycheck Protection Program:

•Over the last two years, Northrim funded a total of nearly 5,800 PPP loans totaling $612.6 million to both existing and new customers.

•Management estimates that Northrim funded approximately 24% of the number and 32% of the value of all Alaska PPP second round loans.

•As of December 31, 2021, Northrim customers had received forgiveness through the SBA on 4,451 PPP loans totaling $491.4 million.

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•The Company initially utilized the Federal Reserve Bank's Paycheck Protection Program Liquidity Facility (the "PPPLF") to fund PPP loans, but paid those funds back in full during the second quarter of 2020 and has since funded the PPP loans through core deposits and maturity of long-term investments.

Trends in Miscellaneous Financial Data (1)

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1 These unaudited schedules provide selected financial information concerning the Company that should be read in conjunction with Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this report.

2Tangible book value per share is a non-GAAP ratio defined as shareholders’ equity, less intangible assets, divided by common shares outstanding. Management believes that tangible book value is a useful measurement of the value of the Company’s equity because it excludes the effect of intangible assets on the Company’s equity. See reconciliation to book value per share, the most comparable GAAP measurement below.

3Tangible common equity to tangible assets is a non-GAAP ratio that represents total equity less goodwill and intangible assets divided by total assets less goodwill and intangible assets. Management believes this ratio is important as it has received more attention over the past several years from stock analysts and regulators. The most comparable GAAP measure of shareholders' equity to total assets is calculated by dividing total shareholders' equity by total assets. See reconciliation to shareholders' equity to total assets below.

4Tax-equivalent net interest margin is a non-GAAP performance measurement in which interest income on non-taxable investments and loans is presented on a tax-equivalent basis using a combined federal and state statutory rate of 28.43% in 2018 through 2021 and 41.11% in all other years presented.  Management believes that tax-equivalent net interest margin is a useful financial measure because it enables investors to evaluate net interest margin excluding tax expense in order to monitor our effectiveness in growing higher interest yielding assets and

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managing our costs of interest bearing liabilities over time on a fully tax equivalent basis.  See reconciliation to net interest margin, the comparable GAAP measurement below.

5In managing our business, we review the efficiency ratio exclusive of intangible asset amortization, which is a non-GAAP performance measurement. Management believes that this is a useful financial measurement because we believe this presentation provides investors with a more accurate picture of our operating efficiency. The efficiency ratio is calculated by dividing other operating expense, exclusive of intangible asset amortization, by the sum of net interest income and other operating income. Other companies may define or calculate this data differently. For additional information see the "Other Operating Expense" section in Part II. Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this report.  See reconciliation to comparable GAAP measurement below.

6The Company’s 2017 results included the impact of the enactment of the Tax Cuts and Jobs Act, which was signed into law on December 22, 2017. The law includes significant changes to the U.S. corporate tax system, including a Federal corporate rate reduction from 35% to 21%.  In 2017, the Company applied the newly enacted corporate federal income tax rate of 21%, reducing the value of the Company's net deferred tax asset, resulting in approximately a $2.7 million increase in tax expense. In 2018, the Company finalized changes related to the reduction in the federal tax rate which resulted in a $470,000 reduction in tax expense.

7Number of banking offices does not include RML locations. 2021 number of banking offices includes 17 full service branches and 1 loan production office. 2020 number of banking offices includes 16 full service branches and 1 loan production office. 2018 number of banking offices includes 15 full service branches and 1 loan production office.

8FTE includes 321, 312, 311, 320, 314, and 321 Community Banking employees in 2021, 2020, 2019, 2018, 2017 and 2016, respectively. FTE includes 130, 126, 120, 110, 115, and 130 Home Mortgage Lending employees in 2021, 2020, 2019, 2018, 2017 and 2016, respectively.

Reconciliation of Selected Non-GAAP Financial Data to GAAP Financial Measures

These unaudited schedules provide selected financial information concerning the Company that should be read in conjunction with "Part II. Item 7.  Management's Discussion and Analysis of Financial Condition and Results of Operations" of this report.

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Reconciliation of total shareholders' equity to tangible common shareholders’ equity (Non-GAAP) and total assets to tangible assets:

Reconciliation of tangible book value per share (Non-GAAP) to book value per share

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Reconciliation of tax-equivalent net interest margin (Non-GAAP) to net interest margin

Calculation of efficiency ratio

9Amount represents net interest income before provision for loan losses.

Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied, and are not audited.  Although we believe these non-GAAP financial measures are frequently used by stakeholders in the evaluation of the Company, they have limitations as analytical tools and should not be considered in isolation or as a substitute for analysis of results as reported under GAAP.

RESULTS OF OPERATIONS

Income Statement

Net Income

Our results of operations are dependent to a large degree on our net interest income.  We also generate other income primarily through mortgage banking income, purchased receivables products, service charges and fees, and bankcard fees.  Our operating expenses consist in large part of salaries and other personnel costs, data processing, occupancy, marketing, and professional services expenses. Interest income and cost of funds, or interest expense, and mortgage banking income are affected significantly by general economic conditions, particularly changes in market interest rates, by government policies and the actions of regulatory authorities, and by competition in our markets.

We earned net income of $37.5 million in 2021, compared to net income of $32.9 million in 2020.  During these periods, net income per diluted share was $6.00 and $5.11, respectively.  The following sections present discussion of the components that make up net income.

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Net Interest Income / Net Interest Margin

Net interest income is the difference between interest income from loan and investment securities portfolios and interest expense on customer deposits and borrowings. Changes in net interest income result from changes in volume and spread, which in turn affect our margin.  For this purpose, volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities, spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income divided by average interest-earning assets.  Changes in net interest income are influenced by yields and the level and relative mix of interest-earning assets and interest-bearing liabilities.

Net interest income in 2021 was $80.8 million, compared to $70.7 million in 2020.  The increase in 2021 as compared to 2020 was primarily the result of a $7.3 million increase in interest and fee income on PPP loans in 2021 compared to 2020. Interest income on PPP loans was $2.9 million and $2.5 million in 2021 and 2020, respectively. Loan fee income on PPP loans was $12.5 million and $5.6 million in 2021 and 2020, respectively. Loan fee income on PPP loans is largely made up of fees fully recognized upon loan forgiveness from the SBA. Interest income not related to PPP loans also increased $934,000 in 2021 as compared to 2020 due to higher net average interest-earning asset balances that was only partially offset by a decrease in interest rates. Interest expense decreased $2.1 million as a result of lower interest rates. During 2021 and 2020, net interest margins were 3.58% and 4.02%, respectively. The decrease in net interest margin in 2021 as compared to 2020 is the result of decreases in the spread between the average yield on interest-earning assets and the average cost of interest-bearing liabilities which was impacted by a decrease in interest rates, as well as a change in the mix of interest earning-assets. Average loans, the Company's highest yielding interest-earning asset, decreased to 65% of total average interest-earning assets in 2021 from 76% in the 2020. Short-term investments, the Company's lowest yielding interest-earning asset, increased to 14% of total average interest-earning assets in 2021 from 4% in the 2020.

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The following table sets forth for the periods indicated information with regard to average balances of assets and liabilities, as well as the total dollar amounts of interest income from interest-earning assets and interest expense on interest-bearing liabilities.  Average yields or costs, net interest income, and net interest margin are also presented. Average yields or costs are not calculated on a tax-equivalent basis:

1Interest income includes loan fees.  Loan fees recognized during the period and included in the yield calculation totaled $16.2 million, $8.9 million and $3.3 million for 2021, 2020 and 2019, respectively.

2Nonaccrual loans are included with a zero effective yield.  Average nonaccrual loans included in the computation of the average loans were $12.3 million, $13.8 million, and $16.9 million in 2021, 2020 and 2019, respectively.

3Consists of investment securities available for sale, investment securities held to maturity, marketable equity securities, and investment in Federal Home Loan Bank stock. Taxable long-term investments consist of U.S. treasury and government sponsored entities, corporate bonds, collateral loan obligations, marketable equity securities, and Federal Home Loan Bank stock. Non-taxable long-term investments consist of municipal securities.

4Consists of interest bearing deposits in other banks and domestic CDs.

5The Company does not have any fed funds sold or securities purchased with agreements to resell to disclose as part of its total interest-earning assets in the periods presented.

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The following table sets forth the changes in consolidated net interest income attributable to changes in volume and to changes in interest rates.  Changes attributable to the combined effect of volume and interest rate have been allocated proportionately to the changes due to volume and the changes due to interest rate:

Provision for Credit Losses

The Company adopted ASU 2016-13 effective January 1, 2021. The provision for credit loss expense is the amount of expense that, based on our judgment, is required to maintain the ACL at an appropriate level under CECL. The determination of the amount of the ACL is complex and involves a high degree of judgment and subjectivity. Refer to Note 1 of the notes to Consolidated Financial Statements included in Part II. Item 8 of this report for detailed discussion regarding ACL methodologies for loans, available for sale debt securities, held to maturity securities, loans held for investment, unfunded commitments, and purchased receivables.

The following table presents the major categories of credit loss expense:

As noted above, the provision for credit losses was recorded in accordance with CECL in 2021. The provision for credit losses in 2020, prior to adoption of CECL, was recorded under the incurred loss model. Despite the fact that a different methodology was used in the calculation of the provision for credit losses in 2021 versus 2020, in general the decrease in the provision for credit losses on loans in 2021 as compared to 2020 is primarily the result of improvement in economic assumptions used to estimate credit losses. The ongoing impacts of the CECL methodology will be dependent upon changes in economic conditions and forecasts, as well as loan portfolio composition, quality, and duration.

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See the “Loans and Lending Activity” section under “Financial Condition” and Note 5 of the Notes to Consolidated Financial Statements included in Part II. Item 8 of this report for further discussion of these decreases and changes in the Company’s ACL.

Other Operating Income

The following table details the major components of other operating income for the years ended December 31:

2021 Compared to 2020

The most significant change in other operating income in 2021 was a decrease in mortgage banking income, followed by an increase in bankcard fees and decreases in interest rate swap income and purchased receivable income.

Mortgage banking income consists of gross income from the origination and sale of mortgages as well as mortgage loan servicing fees and is the largest component of other operating income at 81% of total other operating income in 2021 and 83% in 2020. Mortgage banking income decreased in 2021 compared to 2020 mainly due to a decrease in mortgage loans originated and sold as this volume decreased to $1.1 billion in 2021 from $1.3 billion in 2020. The overall decrease in mortgage originations in 2021 as compared to the prior year is primarily the result of the changes in interest rates during the year that led to decreased refinance activity. Additionally, there was a $3.7 million decrease in the fair value of the interest rate lock commitments, which is also included in mortgage banking income, due to a decrease in the loan origination pipeline at December 31, 2021 compared to December 31, 2020.

Interest rate swap income decreased in 2021 as compared to 2020 due to a decrease in the origination of new swap contracts with commercial loan customers. The Company executed new customer swap contracts with a notional value of $15.7 million in 2021 as compared to new customer swap contracts with a notional value of $49.3 million in 2020.

Purchased receivable income decreased in 2021 as compared to 2020 due to customers reportedly using PPP funds instead of selling receivables to fund their operating cash needs.

Bankcard fees and service charges on deposit accounts increased in 2021 due to the cessation of COVID-19 quarantine restrictions, which led to higher transaction volume as compared to 2020, as well as the increase in customers.

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Other Operating Expense

The following table details the major components of other operating expense for the years ended December 31:

2021 Compared to 2020

Other operating expense increased by less than 1% in 2021 as compared to 2020. The largest increases where in data processing expense, occupancy expense, insurance expense, and marketing expense. These increases were only mostly offset by decreases in salary and other personnel expense, professional and outside services, and OREO expense. Data processing expense increased in 2021 compared to 2020 mostly due to increased customer and transaction volume. Occupancy expense, insurance expense, and marketing expense increased in 2021 as compared to 2020 due to miscellaneous repairs and maintenance and tenant improvements at several of the Company's locations, increased FDIC insurance costs associated with asset growth, and increased marketing expense due to higher giving in the form of increased sponsorship and charitable contributions. Decreases in salaries and other personnel expense and professional and outside services in 2021 as compared to 2020 are primarily related to mortgage banking operations, which fluctuate with production volumes. OREO expense decreased in 2021 primarily due to increased gains on sale of OREO properties as compared to 2020.

Income Taxes

The provision for income taxes increased $917,000 or 10%, to $10.5 million in 2021 as compared to 2020.  The increase in 2021 is primarily due to higher pretax income. The Company's effective tax rates were relatively consistent at 21.8% and 22.5% in 2021 and 2020, respectively.

FINANCIAL CONDITION

Investment Securities

The composition of our investment securities portfolio, which includes securities available for sale and marketable equity securities, reflects management’s investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of interest income.  The investment securities portfolio also mitigates interest rate and credit risk inherent in the loan portfolio, while providing a vehicle for the investment of available funds, a source of liquidity (by pledging as collateral or through repurchase agreements), and collateral for certain public funds deposits. Investment securities designated as available for sale comprised 94% of the portfolio as of December 31, 2021 and are available to meet liquidity requirements.

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Our investment portfolio consists primarily of government sponsored entity securities, corporate securities, collateralized loan obligations, and municipal securities.  Investment securities at December 31, 2021 increased $188.4 million, or 71%, to $455.1 million from $266.7 million at December 31, 2020.  The increase at December 31, 2021 as compared to December 31, 2020 came from an increase in deposits that were not lent out were invested. The average maturity of the investment portfolio was approximately four years at December 31, 2021.

Investment securities may be pledged as collateral to secure public deposits or borrowings.  At December 31, 2021 and 2020, $59.5 million and $77.9 million in securities were pledged for deposits and borrowings, respectively.  Pledged securities decreased at December 31, 2021 as compared to December 31, 2020 primarily due to decreased pledges to the FHLB to support the Company's immediate borrowing capacity at December 31, 2021.

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The following tables set forth the composition of our investment portfolio at December 31 for the years indicated:

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The following table sets forth the market value, maturities, and weighted average pretax yields of our investment portfolio as of December 31, 2021:

(1) Weighted average yields have been calculated on an amortized cost basis and not on a tax-equivalent basis.

The Company’s investment in marketable equity securities does not have a maturity date but it has been included in the over 10 years column above.

Loans and Lending Activities

All of our loans and credit lines are subject to approval procedures and amount limitations.  These limitations apply to the borrower’s total outstanding indebtedness and commitments to us, including the indebtedness of any guarantor. Generally, we are permitted to make loans to one borrower of up to 15% of the unimpaired capital and surplus of the Bank. The legal lending limit for the Bank was $30.2 million at December 31, 2021. At December 31, 2021, the Company had two relationships whose total direct and indirect commitments exceeded $30.2 million; however, no individual direct relationship exceeded the loans-to-one borrower limitation.

The Company's loans have grown significantly in recent history, in part due to PPP loans, but over the last 3 years, non-PPP loans have also increased significantly. Management attributes higher growth in loans, excluding PPP loans, in 2021 and 2020 to our ability to attract new customers through our outreach to the community. The Company's "Land and Expand" program was designed to increase both loans and deposits as we attract a broader customer base and convert new PPP customers into full banking relationships.

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The following table presents growth information for loans and loans excluding PPP loans:

The following table sets forth the composition of our loan portfolio by loan segment as of the dates indicated:

The following table presents the maturity distribution of our loan portfolio and the rate sensitivity of these loans to changes in interest rates as of December 31, 2021:

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Loans Directly Exposed to the Oil and Gas Industry: The Company defines "direct exposure" to the oil and gas industry as companies that it has identified as significantly reliant upon activity related to the oil and gas industry, such as oil producers or drilling and exploration companies, and companies who provide oilfield services, lodging, equipment rental, transportation, and other logistic services specific to the industry. The Company estimates that $63.6 million, or approximately 4% of loans as of December 31, 2021 have direct exposure to the oil and gas industry as compared to $65.1 million, or approximately 4% of loans as of December 31, 2020. The Company's exposure as a percent of the total loan portfolio excluding PPP loans as of December 31, 2021 was 5%. The Company has no loans to oil producers or drilling and exploration companies as of the end of 2021 or 2020, but the $63.6 million outstanding as of December 31, 2021 noted above does include $1.8 million related to the construction of an oil drilling rig. The Company's unfunded commitments to borrowers that have direct exposure to the oil and gas industry were $66.4 million and $63.5 million at December 31, 2021 and 2020, respectively. The portion of the Company's allowance for loan losses that related to the loans with direct exposure to the oil and gas industry was estimated at $684,000 and $1.2 million as of December 31, 2021 and 2020, respectively.

The following table details loan balances by loan segment and class of financing receivable for loans with direct oil and gas exposure as of the dates indicated:

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Credit Quality and Nonperforming Assets

The following table sets forth information regarding our nonperforming loans and total nonperforming assets:

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The Company’s nonperforming loans, net of government guarantees increased in 2021 to $10.7 million as compared to $10.0 million in 2020. This increase was mostly due to several additions to nonaccrual loans which were only partially offset by principal paydowns and charge-offs on nonaccrual loans in 2021. There was interest income of $1.6 million and $924,000 recognized in net income for 2021 and 2020, respectively, related to interest collected on nonaccrual loans whose principal has been paid down to zero. The Company had three relationships that each represented more than 10% of nonaccrual loans as of December 31, 2021.

The Company had $773,000 and $832,000 in loans classified as TDRs, net of government guarantees that were performing as of December 31, 2021 and 2020, respectively.  Additionally, there were $6.5 million and $5.5 million in TDRs included in nonaccrual loans at December 31, 2021 and 2020 for total TDRs, net of government guarantees of $7.3 million and $5.3 million at December 31, 2021 and 2020, respectively.  The increase in TDRs at December 31, 2021 as compared to 2020 was primarily due additions to TDRs that were only partially offset by payoffs and paydowns on loans classified as TDRs in 2021.  See Note 5 of the Notes to Consolidated Financial Statements included in Part II. Item 8 of this report for further discussion of TDRs.

At December 31, 2021, management had identified potential problem loans of $2.1 million as compared to potential problem loans of $6.1 million at December 31, 2020.  Potential problem loans are loans which are currently performing that have developed negative indications that the borrower may not be able to comply with present payment terms and which may later be included in nonaccrual, past due, or impaired loans.  The $4.0 million decrease in potential problem loans at December 31, 2021 from December 31, 2020 was primarily the result of one $3.9 million relationship moving to nonaccrual as well as paydowns and credit risk upgrades to existing potential problem loans that were partially offset by the addition of new potential problem loans in 2021.

The Company acquired a vessel totaling $231,000 in the third quarter of 2019 through foreclosure proceedings related to one lending relationship that was sold in the second quarter of 2021.

The following summarizes OREO activity for the periods indicated:

The Company made a $1.0 million loan in 2021 to facilitate the sale of OREO in 2021, but did not make any loans to facilitate the sale of OREO in 2020.  Our underwriting policies and procedures for loans to facilitate the sale of OREO are no different than our standard loan policies and procedures.

Allowance for Credit Losses

The Company adopted ASU 2016-13 effective January 1, 2021. The determination of the amount of the ACL is complex and involves a high degree of judgment and subjectivity. Refer to Note 1 of the notes to Consolidated Financial

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Statements included in Part II. Item 8 of this report for detailed discussion regarding the ACL methodology for loans and unfunded commitments.

The following tables show the allocation of the ACL and the percent of loans in each category to total loans and the ratio of net loan charge-offs to average loans outstanding by loan segment for the years indicated:

1Represents percentage of this category of loans to total portfolio loans.

1Represents percentage of this category of loans to total portfolio loans.

As of December 31, 2021, and 2020, loans acquired in connection with our acquisition of Alaska Pacific on April 1, 2014 are included in the Company's ACL using the same methodology as all other loans as described in Note 1 of the notes to Consolidated Financial Statements included in Part II. Item 8 of this report due to the amount of time that has passed since the loans were purchased. The purchase discount related to acquired credit impaired loans was zero and $328,000 as of December 31, 2021 and 2020, respectively.

The provision for credit losses in 2021 as compared to 2020 decreased $6.5 million to a benefit for credit losses of $4.1 million compared to a provision of $2.4 million in 2020. This decrease is primarily due to improvement in economic assumptions. The Company determined that an ACL of $11.7 million, or 0.83% of portfolio loans, is appropriate as of December 31, 2021 based on our analysis of the current credit quality of the portfolio and current economic conditions. The provision for credit losses in 2020 as compared to 2019 increased $3.6 million to a provision for credit losses of $2.4 million compared to a benefit of $1.2 million in 2019. This increase is primarily due to management's assessment of risk associated with the economic impacts of the COVID-19 pandemic, the reduction in oil prices and a slowing Alaska economy, as well as growth in the unguaranteed portion of the loan portfolio.

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As noted above, the ACL was recorded in accordance with CECL in 2021. The allowance for loan losses in 2020, prior to adoption of CECL, was recorded under the incurred loss model. Despite the fact that a different methodology was used in the calculation of the provision for credit losses in 2021 versus 2020, in general the decrease in the ACL on loans as of December 31, 2021 compared to December 31, 2020 is primarily the result of improvement in economic assumptions used to estimate credit losses following the economy's recovery from the COVID-19 pandemic. The ongoing impacts of the CECL methodology will be dependent upon changes in economic conditions and forecasts, as well as loan portfolio composition, quality, and duration.

The following table sets forth information regarding changes in the ACL for unfunded commitments for the years indicated:

While management believes that it uses the best information available to determine the ACL, unforeseen market conditions and other events could result in an adjustment to the ACL, and net income could be significantly affected if circumstances differed substantially from the assumptions used in making the final determination of the ACL.

Purchased Receivables

Purchased receivable balances decreased at December 31, 2021 to $7.0 million from $13.9 million at December 31, 2020, and year-to-date average purchased receivable balances were $12.4 million and $14.5 million in 2021 and 2020, respectively. Purchased receivable income was $2.3 million and $2.7 million in 2021 and 2020, respectively. Purchased receivable income in 2021 decreased from 2020 due to customers reportedly using PPP loans to fund liquidity needs instead of selling receivables.

The following table sets forth information regarding changes in the purchased receivable ACL for the years indicated:

Deposits

Deposits are our primary source of funds.  Total deposits increased 33% to $2.4 billion at December 31, 2021 from $1.8 billion at December 31, 2020. This increase is primarily due to funding PPP loans, but is also due to new client relationships as a result of the Company's significant PPP efforts during 2021 and 2020. Our deposits generally are expected to fluctuate according to the level of our market share, economic conditions, and normal seasonal trends.

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The following table sets forth the average balances outstanding and average interest rates for each major category of our deposits, for the periods indicated:

The Company's mix of deposits continues to contribute to a low cost of funds with balances in transaction accounts representing 93% of total deposits at December 31, 2021 and 90% at December 31, 2020.

The only deposit category with stated maturity dates is certificates of deposit.  At December 31, 2021, we had $178.0 million in certificates of deposit, of which $118.5 million, or 67%, are scheduled to mature in 2022. The Company’s certificates of deposit increased to $178.0 million during 2021 as compared to $175.6 million at December 31, 2020.  The aggregate amount of certificates of deposit in amounts of $250,000 or more at December 31, 2021 and 2020, was $77.1 million and $83.6 million, respectively.  The following table sets forth the amount outstanding of certificates of deposits in amounts of $250,000 or more by time remaining until maturity and percentage of total deposits as of December 31, 2021:

The Company offers the Certificate of Deposit Account Registry Service® (CDARS®) as a member of Promontory Interfinancial Network, LLCSM (Network). When a Network member places a deposit using CDARS, that certificate of deposit is divided into amounts under the standard FDIC insurance maximum ($250,000) and is allocated among member banks, making the large deposit eligible for FDIC insurance. The Company had $24.0 million CDARS certificates of deposits at December 31, 2021 and $9.4 million CDARS certificates of deposits at December 31, 2020.

Borrowings

FHLB: The Bank is a member of the Federal Home Loan Bank of Des Moines (the "FHLB"). As a member, the Bank is eligible to obtain advances from the FHLB. FHLB advances are dependent on the availability of acceptable collateral such as marketable securities or real estate loans, although all FHLB advances are secured by a blanket pledge of the Company’s assets.  At December 31, 2021, our maximum borrowing line from the FHLB was $1.219 billion, approximately 45% of the Bank’s assets, subject to the FHLB’s collateral requirements. The Company has outstanding advances of $14.5 million as of December 31, 2021 which were originated to match fund low income housing projects that qualify for long term fixed interest

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rates. These advances have original terms of either 18 or 20 years with 30 year amortization periods and fixed interest rates ranging from 1.23% to 3.25%.

Federal Reserve Bank:  The Federal Reserve Bank of San Francisco (the "Federal Reserve Bank") is holding $50.7 million of loans as collateral to secure advances made through the discount window as of December 31, 2021.  There were no discount window advances outstanding at December 31, 2021 or 2020. The Company paid less than $1,000 in interest in 2021 and 2020 on this agreement. The Company utilized the Federal Reserve Bank's PPPLF to fund SBA PPP loans during the second quarter of 2020, but has repaid those funds in full as of June 30, 2020. This advance had an interest rate of 0.35%.

Other Short and Long-term Borrowings:  The Company had no short or long-term borrowings outstanding other than the FHLB advances noted above as of December 31, 2021 or 2020.

The Company is subject to provisions under Alaska state law which generally limit the amount of outstanding debt to 35% of total assets or $948.0 million at December 31, 2021 and 35% of total assets or $736.0 million at December 31, 2020.

Junior Subordinated Debentures

On December 16, 2005, the Company’s subsidiary, NST2, issued trust preferred securities in the principal amount of $10 million.  These securities carry an interest rate of 90-day LIBOR plus 1.37% per annum that was initially set at 5.86% adjusted quarterly.  The securities have a maturity date of March 15, 2036, and are callable by the Company on or after March 15, 2011.  These securities are treated as Tier 1 capital by the Company’s regulators for capital adequacy calculations.  The interest cost to the Company of these securities was $160,000 in 2021.  At December 31, 2021, the securities had an interest rate of 1.57%. The Company entered into an interest rate swap in the third quarter of 2017 to hedge the variability in cash flows arising out of its junior subordinated debentures, by swapping the cash flows with an interest rate swap which receives floating and pays fixed. The Company has designated this interest rate swap as a hedging instrument. The interest rate swap effectively fixes the Company's interest payments on the $10 million of junior subordinated debentures held under NST2 at 3.72% through its maturity date. Net of the impact of the interest rate swap, interest expense on these securities was $382,000 in 2021 and $385,000 in 2020.

Liquidity and Capital Resources

The Company is a single bank holding company and its primary ongoing source of liquidity is from dividends received from the Bank. Such dividends arise from the cash flow and earnings of the Bank. Banking regulations and regulatory authorities may limit the amount of, or require the Bank to obtain certain approvals before paying, dividends to the Company. Given that the Bank currently meets and the Bank anticipates that it will continue to meet, all applicable capital adequacy requirements for a “well-capitalized” institution by regulatory standards, the Company expects to continue to receive dividends from the Bank during 2022. Other available sources of liquidity for the bank holding company include the issuance of debt and the issuance of common or preferred stock. As of December 31, 2021, the Company has 10.0 million authorized shares of common stock, of which 6.0 million are issued and outstanding, leaving 4.0 million shares available for issuance. Additionally, the Company has 2.5 million authorized shares of preferred stock available for issuance.

The Bank manages its liquidity through its Asset and Liability Committee. The Bank's primary source of funds are customer deposits. These funds, together with loan repayments, loan sales, maturity of investment securities, borrowed funds, and retained earnings are used to make loans, to acquire securities and other assets, and to fund deposit flows and continuing operations. The primary sources of demands on our liquidity are customer demands for withdrawal of deposits and borrowers’ demands that we advance funds against unfunded lending commitments.

The Company had cash and cash equivalents of $645.8 million, or 24% of total assets at December 31, 2021 compared to $116.0 million, or 6% of total assets as of December 31, 2020. The increase in cash and cash equivalents is primarily due to a significant increase in deposits. Management expects this elevated level of liquidity to continue through 2022 and potentially into subsequent years. Accordingly, management has invested in slightly longer term investment securities as compared to the last several years. As of December 31, 2021, the weighted average maturity of available for sale securities is 4.1 years compared to 2.6 years at December 31, 2020. At December 31, 2021, $5.0 million in available for sale securities mature in 2022, $15 million mature in 2023, and $116.2 million mature in 2024. Our total unfunded commitments to fund loans, loans held for sale, and letters of credit at December 31, 2021, were $445.9 million.  We do not expect that all of these loans are likely to be fully drawn upon at any one time.  At December 31, 2021, certificates of deposit totaling $118.6 million and $52.6 million, respectively, contractually mature in 2022 and 2023, and may be withdrawn from the Bank. Similar to loans, we do not

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expect that these maturing certificates of deposit, or other non-maturity deposits, to be withdrawn from the Bank in a manner that will strain liquidity; however, unforeseen future circumstances or events may cause higher than anticipated withdrawal of deposits or draws of unfunded commitments to fund new loans. Management believes that cash requirements to fund future non-deposit liabilities, including operating lease liabilities, other liabilities, or borrowings as of December 31, 2021, are not material to the Company's liquidity position as of December 31, 2021.

The Company has other available sources of liquidity to fund unforeseen liquidity needs. These include borrowings available through our correspondent banking relationships and our credit lines with the Federal Reserve Bank and the FHLB.  At December 31, 2021, our liquid assets were $907.9 million and our funds available for borrowing under our existing lines of credit were $1.27 billion. Given these sources of liquidity and our expectations for customer demands for cash and for our operating cash needs, we believe our sources of liquidity to be sufficient in the foreseeable future.

As shown in the Consolidated Statements of Cash Flows included in Part II. Item 8 of this report, net cash provided by operating activities was $112.0 million in 2021 and net cash used by operating activities was $36.5 million in 2020.  The primary source of cash provided by, and used by operating activities for all periods presented was positive net income. In 2021 proceeds from the sale of loans held for sale exceeded proceeds used in originations as refinance activity slowed, and in 2020 the opposite was true. In 2020 the origination of loans held for sale exceeded proceeds from the sale of loans held for sale which is the primary reason that operating cash flow is negative in 2020. Net cash used by investing activities was $159.1 million in 2021 primarily due to purchases of available for sale and held to maturity securities. Net cash used by investing activities was $382.8 million in 2020 primarily due to increases in loans, in particular PPP loans. Financing activities provided cash of $577.0 million in 2021 and $439.8 million in 2020. Financing activities provided cash in both 2021 and 2020 due to increases in deposits that were only partially offset by the payment of cash dividends to shareholders and the repurchase of shares of the Company's common stock.

Throughout our history, the Company has periodically repurchased for cash a portion of its shares of common stock in the open market. The following table presents the amount of common shares repurchased and the weighted average price paid per share for the periods indicated:

At December, 31, 2021, there were 33,724 shares available under the previously announced stock repurchase program. However, on January 28, 2022 the Company announced that its Board of Directors authorized the repurchase of up to an additional 300,000 shares of common stock. The Company intends to continue to repurchase our stock from time-to-time depending upon market conditions, but we can make no assurances that we will continue this program or that we will authorize additional shares for repurchase.

The table below shows the cumulative effect the repurchase of common shares since the inception of the Company on diluted earnings per share:

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Regulatory Capital Requirements: We are subject to minimum capital requirements.  Federal banking agencies have adopted regulations establishing minimum requirements for the capital adequacy of banks and bank holding companies.  The requirements address both risk-based capital and leverage capital.  We believe as of December 31, 2021, that the Company and the Bank met all applicable capital adequacy requirements for a “well-capitalized” institution by regulatory standards.

The table below illustrates the capital requirements in effect in 2021 for the Company and the Bank and the actual capital ratios for each entity that exceed these requirements.  Management intends to maintain capital ratios for the Bank in 2022 exceeding the FDIC’s new requirements for the “well-capitalized” classification.  The capital ratios for the Company exceed those for the Bank primarily because the $10 million trust preferred securities offering is included in the Company’s capital for regulatory purposes, although they are accounted for as a long-term debt in our consolidated financial statements.  The trust preferred securities are not accounted for on the Bank’s financial statements nor are they included in its capital.  As a result, the Company has $10 million more in regulatory capital than the Bank at December 31, 2021 and 2020, respectively, which explains most of the difference in the capital ratios for the two entities.

See Note 23 of the Consolidated Financial Statements included in Part II. Item 8 of this report for a detailed discussion of the capital ratios. The requirements for "well-capitalized" come from the Prompt Correction Action rules. See Part I. Item 1 Supervision and Regulation. These rules apply to the Bank but not to the Company. Under the rules of the Federal Reserve Bank, a bank holding company such as the Company is generally defined to be "well capitalized" if its Tier 1 risk-based capital ratio is 8.0% or more and its total risk-based capital ratio is 10.0% or more.

Critical Accounting Policies

The SEC defines "critical accounting policies" as those that require application of management's most difficult, subjective or complex judgments as a result of the need to make "critical accounting estimates", which are estimates that involve estimation uncertainty that has had or is reasonably likely to have a material impact on the Company's financial condition or results of operations. Our significant accounting policies are described in Note 1 in the Notes to Consolidated Financial Statements in Part II. Item 8 of this report. Not all of these significant accounting policies require management to make critical accounting estimates. Management believes that the following accounting policies would be considered critical under the SEC's definition. The following discussion is intended to supplement, but not duplicate, information provided in Note 1 in the Notes to Consolidated Financial Statements in Part II. Item 8 of this report for these policies.

Allowance for Credit Losses Policy: The Company adopted CECL on January 1, 2021. The Company's Executive Loan Management Committee and Asset Liability Committee are both involved in monitoring various aspects of the Company's ACL methodology. The Company's Audit Committee provides board oversight of the ACL process and reviews and approves the ACL methodology on a quarterly basis.

CECL is not prescriptive in the methodology used to determine the expected credit loss estimate. Therefore, management has flexibility in selecting the methodology. However, the expected credit losses must be estimated over a financial asset's contractual term, adjusted for prepayments, utilizing quantitative and qualitative factors. The estimate of current expected credit losses is based on relevant information about past events, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amounts. Historical loss experience is the starting point for estimating expected credit losses. Adjustments are made to historical loss experience to reflect differences in asset-specific risk characteristics, such as underwriting standards, portfolio mix or asset terms, and differences in economic conditions – both current conditions and reasonable and supportable forecasts. When the Company is not able to make or obtain reasonable and supportable forecasts for the entire life of the financial asset it has estimated expected credit losses for the remaining life after the forecasted period using an approach that reverts to historical credit loss information.

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Depending on the nature and size of the pool of financial assets with similar risk characteristics, the Company uses a discounted cash flow (“DCF”) method or a weighted average remaining life method to estimate expected credit losses quantitatively. The Company uses a DCF method for 8 of its 11 loan pools, which represent 97% of the amortized cost basis of total loan pools at December 31, 2021. The weighted average remaining life method is used for the remaining 3 loan pools primarily because loan level data constraints preclude the use of the DCF model.

Under the DCF method, the Company utilizes complex models to obtain reasonable and supportable forecasts to calculate two predictive metrics, the probability of default ("PD") and loss given default ("LGD"). The PD measures the probability that a loan will default within a given time horizon and is an assumption derived from regression models which determine the relationship between historical defaults and certain economic variables. The Company's regression models for PD utilize the Company's actual historical loan level default data. The Company determines a reasonable and supportable forecast and applies that forecast to the regression model to estimate defaults over the forecast period. Management leverages economic projections from a reputable and independent third-party to inform its loss driver forecasts over the Company's four quarter forecast period. Management utilizes and forecasts Alaska unemployment as a loss driver for all of the loans pools that utilize the DCF method. Management also utilizes and forecasts either one-year percentage change in the Alaska home price index or the one-year percentage change in the national commercial real estate price index as a second loss driver depending on the nature of the underlying loan pool and how well that loss driver correlates to expected future losses. Other internal and external indicators of economic forecasts are also considered by management when developing the forecast metrics. Following the forecast period, the economic variables used to calculate PD revert to a historical average at a constant rate over an eight quarter reversion period. Other assumptions relevant to the discounted cash flow model to derive the quantitative allowance include the LGD, which is the estimate of loss for a defaulted loan, prepayment speeds, and the discount rate applied to future cash flows. The DCF method utilizes the effective interest rate of individual assets to discount the expected credit losses over the contractual term of the loan, adjusted for prepayments. The LGD is the expected loss which would be realized presuming a default has occurred and primarily measures the value of the collateral or other secondary source of repayment related to the collateral.

The Company has identified the following pools of financial assets with similar risk characteristics for measuring expected credit losses under CECL as adopted by the Company on January 1, 2021:

Commercial & industrial - Commercial loans are loans for commercial, corporate and business purposes. The Company’s commercial business loan portfolio is comprised of loans for a variety of purposes and across a variety of industries. These loans include general commercial and industrial loans, loans to purchase capital equipment, and other business loans for working capital and operational purposes. Commercial loans are generally secured by accounts receivable, inventory and other business assets. Also included in commercial loans are our PPP loans originated during 2020 and 2021. The Company utilizes the DCF method to quantitatively estimate credit losses for this pool.

Commercial real estate - This category of loans consists of the following loan types:

Owner occupied - This category includes non-farm, non-residential real estate loans for a variety of commercial property types and purposes, including owner occupied commercial real estate loans primarily secured by commercial office or industrial buildings, warehouses or retail buildings where the owner of the building occupies the property. Repayment terms vary considerably, interest rates are fixed or variable, and are structured for full, partial, or no amortization of principal. The Company utilizes the DCF method to quantitatively estimate credit losses for this pool.

Non-owner occupied and multifamily - This category includes non-farm, non-residential real estate loans for a variety of commercial property types and purposes, including investment real estate loans that are primarily secured by office and industrial buildings, warehouses or retail buildings where the owner of the building does not occupy the property, non-owner occupied apartment or multifamily residential buildings, and various special purpose properties. Repayment terms vary considerably, interest rates are fixed or variable, and are structured for full, partial, or no amortization of principal. Generally, these types of loans are thought to involve a greater degree of credit risk than owner occupied commercial real estate as they are more sensitive to adverse economic conditions. The Company utilizes the DCF method to quantitatively estimate credit losses for this pool.

Residential real estate - This category of loans consists of the following loan types:

1-4 family residential properties secured by first liens - This category of loans includes term loans secured by first liens on residential real estate. The Company utilizes the DCF method to quantitatively estimate credit losses for this pool.

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1-4 family residential properties secured by junior liens and revolving credit lines secured by 1-4 family first liens - This category of loans includes term loans primarily secured by junior liens on residential real estate and revolving credit lines that are secured by first liens on residential real estate. Home equity revolving lines of credit and home equity term loans are included in this group of loans. The Company utilizes the DCF method to quantitatively estimate credit losses for this pool.

1-4 family residential construction - This category of loans consists of loans to finance the ground up construction, improvement and/or carrying for sale after the completion of construction of 1-4 family residential properties which will secure the loan. These loans may also be secured by tracts or individual parcels of land on which 1-4 family residential properties are being constructed. The repayment of construction loans is generally dependent upon the successful completion of the improvements by the builder for the end user, or sale of the property to a third-party. The Company utilizes the DCF method to quantitatively estimate credit losses for this pool.

Other construction, land development, and raw land - This category of loans consists of loans to finance the ground up construction, improvement and/or carrying for sale after the completion of construction of owner occupied and non-owner occupied commercial properties, and loans secured by raw or improved land. The repayment of construction loans is generally dependent upon the successful completion of the improvements by the builder for the end user, or sale of the property to a third-party. Repayment of land secured loans are dependent upon the successful development and sale of the property, the sale of the land as is, or the outside cash flow of the owners to support the retirement of the debt. The Company utilizes the DCF method to quantitatively estimate credit losses for this pool.

Agricultural production, including commercial fishing - These loans are for the purpose of financing agricultural production, including growing and storing of crops, and for the purpose of financing fisheries and forestries, including loans to commercial fishermen. These loans may be secured or unsecured, but any loans for these purposes that are secured by real estate are included in a real estate category. The Company utilizes the weighted average remaining life method to quantitatively estimate credit losses for this pool.

Consumer - Loans used for personal use, which may be secured or unsecured, and customer overdrafts. The Company utilizes the DCF method to quantitatively estimate credit losses for this pool.

Obligations of states and political subdivisions in the US - This category of loans includes all loans made to states, counties municipalities, school districts, drainage and sewer districts, and Indian tribes in the U.S. These loans maybe be secured by any type of collateral, including real estate. The Company utilizes the weighted average remaining life method to quantitatively estimate credit losses for this pool.

Other - This category of loans includes all other loans that cannot properly be reported in one of the preceding categories. The Company utilizes the weighted average remaining life method to quantitatively estimate credit losses for this pool.

In addition to the quantitative portion of the ACL derived using either the DCF or weighted average remaining life method, the Company also considers the effects of the following qualitative factors in its calculation of expected losses in the loan portfolio:

•Lending strategy, policies, and procedures;

•Quality of internal loan review;

•Lending management and staff;

•Trends in underlying collateral values;

•Competition, legal, and regulatory changes;

•Economic and business conditions including fluctuations in the price of Alaska North slope crude oil;

•Changes in trends, volume and severity of adversely classified loans, nonaccrual loans, and delinquencies;

•Concentration of credit; and

•Changes in the nature and volume of the loan portfolio.

Valuation of goodwill and other intangibles:  Management performs an impairment analysis for the intangible assets with indefinite lives on an annual basis as of December 31. Additionally, goodwill and other intangible assets with indefinite lives are evaluated on an interim basis when events or circumstances indicate impairment potentially exists. The impairment analysis requires management to make subjective judgments. Events and factors that may significantly affect the estimates include, among others, competitive forces, customer behaviors and attrition, changes in revenue growth trends, cost structures, technology, changes in discount rates and specific industry and market conditions. There can be no assurance that changes in circumstances, estimates or assumptions may result in additional impairment of all, or some portion of, goodwill or other intangible assets. The Company performed its annual goodwill impairment testing at December 31, 2021 and 2020 in

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accordance with the policy described in Note 1 to the financial statements included in Part II. Item 8 of this report.  At December 31, 2021, the Company performed its annual impairment test by performing a qualitative assessment. Significant positive inputs to the qualitative assessment included the Company’s increasing net income as compared to historical trends; the Company's increasing market share for deposits in our markets; results of regulatory examinations; peer comparisons of the Company's net interest margin; trends in the Company’s cash flows; improvements in the Alaskan economy in 2021; increases in the volume of mortgage originations in Alaska; increases in the Company's market share of mortgage originations; and increases in the Company's stock price. Significant negative inputs to the qualitative assessment included the muted pace of growth in the Alaska economy. We believe that the positive inputs to the qualitative assessment noted above outweigh the negative inputs for both of the Company's operating segments, and we therefore concluded that it is more likely than not that the fair value of the Company exceeds its carrying value at December 31, 2021 and that no potential impairment existed at that time.

Valuation of OREO:  Other Real Estate Owned ("OREO") represents properties acquired through foreclosure or its equivalent.  Prior to foreclosure, the carrying value is adjusted to the fair value, less cost to sell, of the real estate to be acquired by an adjustment to the allowance for loan loss.  The amount by which the fair value less cost to sell is greater than the carrying amount of the loan plus amounts previously charged off is recognized in earnings.  Any subsequent reduction in the carrying value is charged against earnings. Management's evaluation of fair value is based on appraisals or discounted cash flows of anticipated sales. The amounts ultimately recovered from the sale of OREO may differ from the carrying value of the assets because of market factors beyond the Company's control or due to changes in the Company's strategies for recovering the investment.

Servicing rights:  The Company measures mortgage servicing rights ("MSRs") and commercial servicing rights ("CSRs") at fair value on a recurring basis with changes in fair value going through earnings in the period in which the change occurs. Changes in the fair value of MSRs are recorded in mortgage banking income, and changes in the fair value of CSRs are recorded in commercial servicing revenue. Fair value adjustments encompass market-driven valuation changes and the decrease in value that occurs from the passage of time, which are separately reported. Retained servicing rights are measured at fair value as of the date of sale. Initial and subsequent fair value measurements are determined using a discounted cash flow model. In order to determine the fair value of servicing rights, the present value of expected net future cash flows is estimated. Assumptions used include market discount rates, anticipated prepayment speeds, escrow calculations, delinquency rates and ancillary fee income net of servicing costs. The model assumptions for MSRs are also compared to publicly filed information from several large MSR holders, as available.

Fair Value:   A hierarchical disclosure framework associated with the level of pricing observability is utilized in measuring financial instruments at fair value. The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of pricing observability and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no pricing observability and a higher degree of judgment utilized in measuring fair value. Pricing observability is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established and the characteristics specific to the transaction.