WESTAMERICA BANCORPORATION (WABC) FY 2021 MD&A

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

The following discussion addresses information pertaining to the financial condition and results of operations of Westamerica Bancorporation and subsidiaries (the “Company”) that may not be otherwise apparent from a review of the consolidated financial statements and related footnotes. It should be read in conjunction with those statements and notes found on pages 51 through 90, as well as with the other information presented throughout this Report.

Critical Accounting Policies

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and follow general practices within the banking industry. Application of these principles requires the Company to make certain estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain accounting policies inherently have a greater reliance on the use of estimates, assumptions and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment writedown or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available.

The most significant accounting policies followed by the Company are presented in Note 1 to the consolidated financial statements. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, Management has identified the allowance for credit losses accounting to be the accounting area requiring the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available. A discussion of the factors affecting accounting for the allowance for credit losses and purchased loans is included in the “Loan Portfolio Credit Risk” discussion below. Certain amounts in prior periods have been reclassified to conform to current presentation.

Financial Overview

Westamerica Bancorporation and subsidiaries’ (collectively, the “Company”) reported net income of $86.5 million or $3.22 diluted earnings per common share in 2021 compared with net income of $80.4 million or $2.98 diluted earnings per common share in 2020. 2021 results included “make-whole” interest income on corporate bonds redeemed prior to maturity of $2.8 million. 2020 results included a provision for credit losses of $4.3 million, which reduced EPS $0.11, representing Management’s estimate of additional reserves needed over the remaining life of its loans due to increased credit-risk from deteriorating economic conditions caused by the COVID-19 pandemic, and $3. 5 million gain on sales of a closed branch building

The Company’s primary and wholly-owned subsidiary, Westamerica Bank (the “Bank”), continued to support its customers during the pandemic. The Bank originated $106 million in loans under the second round of the Paycheck Protection Program (“PPP”) during the first six months of 2021. PPP loans meaningfully increased interest-earning assets and related interest and fee income. The Bank continues to work with loan customers who requested deferral of loan payments due to economic weakness caused by the pandemic. At December 31, 2021, loans granted deferrals under the CARES Act included $84 thousand, all of which were consumer automobile loans.

In response to the pandemic, the Federal Reserve has engaged significant levels of monetary policy to provide liquidity and credit facilities to the financial markets. On March 15, 2020, the Federal Open Market Committee (“FOMC”) reduced the target range for the federal funds rate to 0 to 0.25 percent; relatedly, the FOMC reduced the interest rate paid on deposit balances to 0.10 percent effective March 16, 2020. Effective June 17, 2021, FOMC increased the interest rate paid on excess reserve balances to 0.15%. The Bank maintains deposit balances at the Federal Reserve Bank; the amount that earns interest is identified in the Company’s financial statements as “interest-bearing cash”.

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The extent of the spread of the coronavirus and its ultimate containment are uncertain at this time. The effectiveness of the Federal Reserve Bank’s monetary policies and the federal government’s fiscal policies in stimulating the United States economy is uncertain at this time. Management expects the Company’s net interest margin and non-interest income to decline and credit-related losses to increase for an uncertain period given the decline in economic activity occurring due to the coronavirus. The amount of impact on the Company’s financial results is uncertain.

The Company presents its net interest margin and net interest income on a fully taxable equivalent (“FTE”) basis using the current statutory federal tax rate. Management believes the FTE basis is valuable to the reader because the Company’s loan and investment securities portfolios contain a relatively large portion of municipal loans and securities that are federally tax exempt. The Company’s tax exempt loans and securities composition may not be similar to that of other banks, therefore in order to reflect the impact of the federally tax exempt loans and securities on the net interest margin and net interest income for comparability with other banks, the Company presents its net interest margin and net interest income on an FTE basis.

The Company’s significant accounting policies (see Note 1 “Summary of Significant Accounting Policies” to the Consolidated Financial Statements below) are fundamental to understanding the Company’s results of operations and financial condition. The Company adopted the following new accounting guidance:

FASB Accounting Standards Update (“ASU”) 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes, was issued December 2019. The ASU is intended to simplify various aspects related to accounting for income taxes, eliminates certain exceptions to the general principles in ASC Topic 740 related to intra-period tax allocation, simplifies when companies recognize deferred taxes in an interim period, and clarifies certain aspects of the current guidance to promote consistent application. This guidance effective for public entities for fiscal years beginning after December 15, 2020, and for interim period within those fiscal years, with early adoption permitted. The Company adopted the ASU provisions on January 1, 2021 and the adoption of the ASU provisions did not have a significant impact on the Company’s consolidated financial statements.

FASB ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, was issued on June 16, 2016. The ASU significantly changed estimates for credit losses related to financial assets measured at amortized cost and certain other contracts. For estimating credit losses, the FASB replaced the incurred loss model with the current expected credit loss (CECL) model, which accelerated recognition of credit losses. Additionally, credit losses relating to debt securities available-for-sale are recorded through an allowance for credit losses under the new standard. The Company is also required to provide additional disclosures related to the financial assets within the scope of the new standard.

The Company adopted the ASU provisions on January 1, 2020. Management evaluated available data, defined portfolio segments of loans with similar attributes, and selected loss estimate models for each identified loan portfolio segment. Management measured historical loss rates for each portfolio segment. Management also segmented debt securities held to maturity, selected methods to estimate losses for each segment, and measured a loss estimate. Agency mortgage-backed securities were assigned no credit loss allowance due to the perceived backing of government sponsored entities. Municipal securities were evaluated for risk of default based on credit rating and remaining term to maturity using Moody’s risk of default factors; Moody’s loss upon default factors were applied to the assumed defaulted principal amounts to estimate the amount for credit loss allowance. The adjustment to the allowance for credit losses was recorded through an offsetting after-tax adjustment to shareholders’ equity. The implementing entry increased allowance for credit losses on loans by $2,017 thousand, reduced allowance for unfunded credit commitments by $2,107 thousand and increased retained earnings by $52 thousand.

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Net Income

Following is a summary of the components of net income for the periods indicated:

Comparing 2021 with 2020, net income increased $6.1 million. Net interest and loan fee (FTE) income increased $6.5 million due to higher average balances of investments, higher average balances of interest-bearing cash and higher yield on PPP loans, partially offset by lower yield on investments, interest-earning cash and loans excluding PPP loans. Results for 2021 included “make-whole” interest income on corporate bonds redeemed prior to maturity of $2.8 million. The Company provided no provision for credit losses in 2021, reflecting Management's evaluation of credit risk over the remaining life of loans and bonds. Results for 2020 included a provision of credit losses of $4.3 million, representing Management’s estimate of additional reserves needed over the remaining life of its loans due to credit-risk from economic weakness caused by the COVID-19 pandemic. Noninterest income decreased $2.3 million in 2021 compared with 2020 primarily because 2020 included $3.5 million in gains on sales of a closed branch building and a $603 thousand recovery on previously charged off loans. Fee income from merchant card processing, debit cards and trust accounts increased in 2021 compared with 2020. In 2021 noninterest expense decreased $760 thousand compared with 2020 due to lower salaries and related benefits, partially offset by higher professional fees and other noninterest expense. The tax rate (FTE) was 27.7% for and 27.2% for 2020.

Net income remained at the same level in 2020 and 2019. Net interest and loan fee (FTE) income increased $6.3 million due to higher average balances of investments and average balances of $151 million of PPP loans, partially offset by lower yield on interest-bearing earning assets and lower average balances of other loans. Results for 2020 include a provision of credit losses of $4.3 million, representing Management estimate of additional reserves needed over the remaining life of its loans due to credit-risk from economic weakness caused by the COVID-19 pandemic. Noninterest income decreased $1.8 million compared with 2019 due to lower income from activity based fees due to reduced economic activity related to the COVID-19 pandemic. Additionally, the results for 2019 included a life insurance gain of $433 thousand. The decrease in noninterest income from 2019 to 2020 was partially offset by $3.5 million in gains on sales of a closed branch building in 2020. In 2020 noninterest expense decreased $420 thousand compared with 2019 due to lower salaries, occupancy and equipment expenses, and lower amortization of intangible assets, and because the results for 2019 included $553 thousand of loss contingency. The decrease was partially offset by higher FDIC assessments (included in “other noninterest expense”) in 2020 because FDIC assessments in 2019 were reduced by application of the Bank’s FDIC assessment credit described in Part 1, Item 1, “Premiums for Deposit Insurance and FDIC Regulation”. The effective tax rate (FTE) was 27.2% for 2020 compared with 26.8% for 2019.

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Net Interest and Loan Fee Income (FTE)

The Company's primary source of revenue is net interest income, or the difference between interest income earned on loans and investment securities and interest expense paid on interest-bearing deposits and other borrowings.

Components of Net Interest and Loan Fee Income (FTE)

Net interest and loan fee income (FTE) increased $6.5 million in 2021 compared with 2020 due to higher average balances of investments (up $431 million), higher average balances of interest-bearing cash (up $486 million) and higher yield on PPP loans (up 0.71%), partially offset by lower yield on investments (down 0.20%), interest-earning cash (down 0.18%) and loans excluding PPP loans. Results for 2021 included “make-whole” interest income on corporate bonds redeemed prior to maturity of $2.8 million.

Net interest and loan fee income (FTE) increased $6.3 million in 2020 compared with 2019 due to higher average balances of investments (up $445 million) and average balances of $151 million of PPP loans, partially offset by lower yield on interest-bearing earning assets (down 0.20%) and lower average balances of other loans (down $74 million).

The net interest margin (FTE) was 2.62% in 2021, 2.91% in 2020 and 3.11% in 2019. The yield on earning assets (FTE) was 2.65% in 2021, 2.94% in 2020 and 3.14% in 2019. Market interest rates declined in 2020 compared with 2019. Additionally, interest-bearing cash balances, which carry lower yield than loans and investments, made up a higher percentage of total earning assets in 2021 than in prior periods. (12.9% in 2021 compared with 6.4% in 2020 and 6.3% in 2019).

The Company’s funding costs were 0.03% in 2021, 2020 and 2019. Average balances of time deposits in 2021 declined $11 million from 2020. Average balances of lower-cost checking and savings deposits grew 16% from 2020 to 2021. Average balances of checking and saving deposits accounted for 97.5% of average total deposits in 2021 compared with 96.9% in 2020 and 96.2% in 2019.

Net Interest Margin (FTE)

The following summarizes the components of the Company's net interest margin (FTE) for the periods indicated.

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Summary of Average Balances, Yields/Rates and Interest Differential

The following tables present information regarding the consolidated average assets, liabilities and shareholders’ equity, the amounts of interest income earned from average interest earning assets and the resulting yields, and the amounts of interest expense incurred on average interest-bearing liabilities and the resulting rates. Average loan balances include nonperforming loans. Interest income includes reversal of previously accrued interest on loans placed on non-accrual status during the period and proceeds from loans on nonaccrual status only to the extent cash payments have been received and applied as interest income and accretion of purchased loan discounts. Yields on tax-exempt securities and loans have been adjusted upward to reflect the effect of income exempt from federal income taxation at the federal statutory tax rate of 21 percent.

Distribution of Assets, Liabilities & Shareholders’ Equity and Yields, Rates & Interest Margin

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Distribution of Assets, Liabilities & Shareholders’ Equity and Yields, Rates & Interest Margin

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Distribution of Assets, Liabilities & Shareholders’ Equity and Yields, Rates & Interest Margin

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Summary of Changes in Interest Income and Expense due to Changes in Average Asset & Liability Balances and Yields Earned & Rates Paid

The following tables set forth a summary of the changes in interest income and interest expense due to changes in average assets and liability balances (volume) and changes in average interest yields/rates for the periods indicated. Changes not solely attributable to volume or yields/rates have been allocated in proportion to the respective volume and yield/rate components.

Summary of Changes in Interest Income and Expense

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Summary of Changes in Interest Income and Expense

(1) Amounts calculated on an FTE basis using the current statutory federal tax rate.

Provision for Credit Losses

The Company manages credit costs by consistently enforcing conservative underwriting and administration procedures and aggressively pursuing collection efforts with debtors experiencing financial difficulties. The provision for credit losses reflects Management's assessment of credit risk in the loan portfolio and debt securities held to maturity during each of the periods presented.

The Company provided no provision for credit losses in 2021 based on Management’s estimate of reserves needed over the remaining life of its loans and investments. The Company provided a provision for credit losses of $4.3 million recorded in 2020. The 2020 provision represented Management’s estimate of additional reserves needed over the remaining life of its loans and investments due to credit-risk from weakened economic conditions caused by the COVID-19 pandemic. The Company provided no provision for loan losses in 2019 based on Management’s evaluation of credit quality, the level of the provision for loan losses in 2019, and the adequacy of the allowance for loan losses at December 31, 2019. For further information regarding credit risk, net credit losses and the allowance for credit losses, see the “Loan Portfolio Credit Risk” and “Allowance for Credit Losses” sections of this Report.

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Noninterest Income

Components of Noninterest Income

In 2021, noninterest income decreased $2.3 million compared with 2020 primarily because 2020 results included a $3.5 million gain on the sale of a closed branch building, a $603 thousand recovery in excess of previously charged off loan amounts, and higher service charges on deposit accounts. Decreases in 2021 results, compared with 2020, were partially offset by higher transaction volumes from merchant processing services and debit cards, and increases in trust fees.

In 2020, noninterest income decreased $1.8 million compared with 2019 due to lower income from activity based fees due to reduced economic activity related to the COVID-19 pandemic. Additionally, the results for 2019 included a life insurance gain of $433 thousand. The decrease was partially offset by a $3.5 million gain on the sale of a closed branch building in 2020.

Noninterest Expense

Components of Noninterest Expense

In 2021, noninterest expense decreased $760 thousand compared with 2020. The decrease in salaries and related benefits in 2021 compared with 2020 was attributable to attrition. Occupancy and equipment expenses decreased due to lower depreciation expense. These decreases were partially offset by higher professional fees and other noninterest expense.

In 2020, noninterest expense decreased $420 thousand compared with 2019 due to lower salaries, occupancy and equipment expenses, and lower amortization of intangible assets, and because the results for 2019 included $553 thousand of loss contingency. The decrease was partially offset by higher FDIC assessments (included in “other noninterest expense”) in 2020 because FDIC assessments in 2019 were reduced by application of the Bank’s FDIC assessment credit described in Part 1, Item 1, “Premiums for Deposit Insurance and FDIC Regulation”.

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Provision for Income Tax

The Company’s income tax provision (FTE) was $33.2 million in 2021 compared with $30.0 million in 2020 and $29.4 million in 2019. The effective tax rates (FTE) were 27.7% in 2021 compared with 27.2% in 2020 and 26.8% in 2019.

The higher effective tax rates (FTE) in 2021 and 2020 compared with 2019 are due to lower levels of tax-exempt interest income and stock compensation tax deductions in 2020. The tax provisions (FTE) for 2021, 2020 and 2019 include tax benefits of $-0- thousand, $87 thousand and $435 thousand, respectively, for tax deductions from the exercise of employee stock options which exceed related compensation expenses recognized in the financial statements. In 2019, the Company decreased unrecognized tax benefits by $909 thousand related to settlements with taxing authorities. The settlements incorporated amended tax returns for which the Company had recognized a deferred tax asset in the amount of $1,003 thousand.

Investment Securities Portfolio

The Company maintains an investment securities portfolio consisting of securities issued by state and political subdivisions and corporations, collateralized loan obligations, agency and non-agency issued mortgage backed securities, and other securities.

Management managed the investment securities portfolio in response to changes in deposit and loan volumes. The carrying value of the Company’s investment securities portfolio was $4.9 billion at December 31, 2021 and $4.6 billion at December 31, 2020. The following table lists debt securities in the Company’s portfolio by type as of the indicated dates. The Company adopted ASU 2016-13 effective January 1, 2020. Debt securities held to maturity of $306,403 thousand at December 31, 2021 and $515,598 thousand at December 31, 2020, are listed at amortized cost before related reserve for expected credit losses of $7 thousand and $9 thousand, respectively. Debt securities available for sale are listed at fair value.

Management continually evaluates the Company’s investment securities portfolio in response to established asset/liability management objectives, changing market conditions that could affect profitability, liquidity, and the level of interest rate risk to which the Company is exposed. These evaluations may cause Management to change the level of funds the Company deploys into investment securities and change the composition of the Company’s investment securities portfolio.

At December 31, 2021, substantially all of the Company’s investment securities were investment grade as rated by one or more major rating agencies. In addition to monitoring credit rating agency evaluations, Management performs its own evaluations regarding the credit worthiness of the issuer or the securitized assets underlying asset-backed securities. The Company’s procedures for evaluating investments in securities are in accordance with guidance issued by the Board of Governors of the Federal Reserve System, “Investing in Securities without Reliance on Nationally Recognized Statistical Rating Agencies” (SR 12-15) and other regulatory guidance. There have been no significant differences in the Company’s internal analyses compared with the ratings assigned by the third party credit rating agencies.

The Company had no marketable equity securities at December 31, 2021, December 31, 2020 and December 31, 2019. All of the marketable equity securities were sold with no gains or losses from the sale during the third quarter 2019. The market value of the marketable equity securities was $1,747 thousand at December 31, 2018. The Company recognized gross unrealized holding gains of $50 thousand in earnings in 2019.

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The following table shows the fair value carrying amount of the Company’s equity securities and debt securities available for sale as of the dates indicated:

The following table sets forth the relative maturities and contractual yields of the Company’s debt securities available for sale (stated at fair value) at December 31, 2021. Yields on state and political subdivision securities have been calculated on a fully taxable equivalent basis using the current federal statutory rate. Mortgage-backed securities are shown separately because they are typically paid in monthly installments over a number of years.

Debt Securities Available for Sale Maturity Distribution

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The following table shows the amortized cost carrying amount and fair value before related reserve for expected credit losses of $7 thousand at December 31, 2021 and $9 thousand at December 31, 2020, of the Company’s debt securities held to maturity as of the dates indicated:

The following table sets forth the relative maturities and contractual yields of the Company’s debt securities held to maturity at December 31, 2021. Yields on state and political subdivision securities have been calculated on a fully taxable equivalent basis using the current federal statutory rate. Mortgage-backed securities are shown separately because they are typically paid in monthly installments over a number of years.

Debt Securities Held to Maturity Maturity Distribution

The following table summarizes total corporate securities by credit rating:

The Company’s below investment grade corporate bond with a balance of $14.96 million at December 31, 2020 paid off in full at maturity in July 2021.

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The following table summarizes total corporate securities by the industry sector in which the issuing companies operate:

The following table summarizes total consumer, cyclical by sub-sector:

The Company’s $20.5 million (fair value) in corporate bonds to issuers operating in the consumer cyclical – restaurant subsector represent bonds of one company which retails, roasts and provides its own brand of specialty coffee and other complementary products through retail locations worldwide and sells coffee through several distribution channels. The bonds mature in 2023. At December 31, 2021, the bonds were rated BBB and priced with an unrealized gain of $480 thousand.

The $98.7 million (fair value) in corporate bonds in the energy sector are issued by 4 issuers at December 31, 2021. The $217.1 million (fair value) in corporate bonds in the industrial sector are issued by 10 issuers at December 31, 2021.

The Company’s $1.4 billion (fair value) in collateralized loan obligations at December 31, 2021, consist of investments in 157 issues that are within the senior tranches of their respective fund securitization structures. All of the Company’s collateralized loan obligation investments are rated AAA or AA at December 31, 2021.

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The following tables summarize the total general obligation and revenue bonds issued by states and political subdivisions held in the Company’s investment securities portfolios as of the dates indicated, identifying the state in which the issuing government municipality or agency operates.

At December 31, 2021, the Company’s investment securities portfolios included securities issued by 197 state and local government municipalities and agencies located within 33 states. The largest exposure to any one municipality or agency was $7.4 million (fair value) represented by five general obligation bonds.

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At December 31, 2020, the Company’s investment securities portfolios included securities issued by 317 state and local government municipalities and agencies located within 40 states. The largest exposure to any one municipality or agency was $8.2 million (fair value) represented by six general obligation bonds.

At December 31, 2021 and December 31, 2020, the revenue bonds in the Company’s investment securities portfolios were issued by state and local government municipalities and agencies to fund public services such as water utility, sewer utility, recreational and school facilities, and general public and economic improvements. The revenue bonds were payable from 14 revenue sources at December 31, 2021 and 19 revenue sources at December 31, 2020. The revenue sources that represent 5% or more individually of the total revenue bonds are summarized in the following tables.

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See Note 2 to the consolidated financial statements for additional information related to the investment securities.

Loan Portfolio

The Company originates loans with the intent to hold such assets until principal is repaid. Management follows written loan underwriting policies and procedures which are approved by the Bank’s Board of Directors. Loans are underwritten following approved underwriting standards and lending authorities within a formalized organizational structure. The Board of Directors also approves independent real estate appraisers to be used in obtaining estimated values for real property serving as loan collateral. Prevailing economic trends and conditions are also taken into consideration in loan underwriting practices.

All loan applications must be for clearly defined legitimate purposes with a determinable primary source of repayment, and as appropriate, secondary sources of repayment. All loans are supported by appropriate documentation such as current financial statements, tax returns, credit reports, collateral information, guarantor asset verification, title reports, appraisals, and other relevant documentation.

During 2020 and the first six months of 2021, the Bank processed customer PPP loan applications as established by the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”). The United States Small Business Administration guarantees PPP loans; given this guarantee, the PPP loans are not considered to have default risk. PPP loans, net of deferred fees and costs, were $46 million at December 31, 2021 and $187 million at December 31, 2020.

Commercial loans represent term loans used to acquire durable business assets or revolving lines of credit used to finance working capital. Underwriting practices evaluate each borrower’s cash flow as the principal source of loan repayment. Commercial loans are generally secured by the borrower’s business assets as a secondary source of repayment. Commercial loans are evaluated for credit-worthiness based on prior loan performance and borrower financial information including cash flow, borrower net worth and aggregate debt. PPP loans are included in commercial loans.

Commercial real estate loans represent term loans used to acquire or refinance real estate to be operated by the borrower in a commercial capacity. Underwriting practices evaluate each borrower’s global cash flow as the principal source of loan repayment, independent appraisal of value of the property, and other relevant factors. Commercial real estate loans are generally secured by a first lien on the property as a secondary source of repayment.

Real estate construction loans represent the financing of real estate development. Loan principal disbursements are controlled through the use of project budgets, and disbursements are approved based on construction progress, which is validated by project site inspections. A first lien on the real estate serves as collateral to secure the loan.

Residential real estate loans generally represent first lien mortgages used by the borrower to purchase or refinance a principal residence. For interest-rate risk purposes, the Company offers only fully-amortizing, adjustable-rate mortgages. In underwriting first lien mortgages, the Company evaluates each borrower’s ability to repay the loan, an independent appraisal of the value of the property, and other relevant factors. The Company does not offer riskier mortgage products, such as non-amortizing “interest-only” mortgages and “negative amortization” mortgages.

For loans secured by real estate, the Bank requires title insurance to insure the status of its lien and each borrower is obligated to insure the real estate collateral, naming the Company as loss payee, in an amount sufficient to repay the principal amount outstanding in the event of a property casualty loss.

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Consumer installment and other loans are predominantly comprised of indirect automobile loans with underwriting based on credit history and scores, personal income, debt service capacity, and collateral values.

Loan volumes have declined due to payoffs and problem loan workout activities, particularly with purchased loans, and reduced volumes of loan originations. The Company did not take an aggressive posture relative to loan portfolio growth during the post-recession period of historically low interest rates. Management increased investment securities as loan volumes declined.

The following table shows the composition of the loan portfolio of the Company by type of loan and type of borrower, on the dates indicated:

Loan Portfolio

The following table shows the maturity distribution and interest rate sensitivity of loans at December 31, 2021. There were no loans with a remaining maturity of over fifteen years as of December 31, 2021.

Loan Maturity Distribution

Commitments and Letters of Credit

The Company issues formal commitments on lines of credit to well-established and financially responsible commercial enterprises. Such commitments can be either secured or unsecured and are typically in the form of revolving lines of credit for seasonal working capital needs. Occasionally, such commitments are in the form of letters of credit to facilitate the customers’ particular business transactions. Commitment fees are generally charged for commitments and letters of credit. Commitments on lines of credit and letters of credit typically mature within one year. For further information, see the accompanying notes to the consolidated financial statements.

Loan Portfolio Credit Risk

The Company extends loans to commercial and consumer customers which expose the Company to the risk that the borrowers will default, causing loss. The Company’s lending activities are exposed to various qualitative risks. All loan segments are exposed to risks inherent in the economy and market conditions. Significant risk characteristics related to the commercial loan segment include the borrowers’ business performance and financial condition, and the value of collateral for secured loans. Significant risk characteristics related to the commercial real estate segment include the borrowers’ business performance and the value of properties collateralizing the loans. Significant risk characteristics related to the construction loan segment include the borrowers’ performance in successfully developing the real estate into the intended purpose and the value of the property collateralizing the loans. Significant risk characteristics related to the residential real estate segment include the borrowers’ financial wherewithal to service the mortgages and the value of the property collateralizing the loans. Significant risk characteristics related to the consumer loan segment include the financial condition of the borrowers and the value of collateral securing the loans.

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During 2020 and the first six months of 2021, the Bank processed customer PPP loan applications pursuant to the CARES Act. The United States Small Business Administration guarantees PPP loans; given this guarantee, the PPP loans are not considered to have default risk and do not carry an allowance for credit losses. The outstanding balances of PPP loans, net of deferred fees and costs, were $46 million at December 31, 2021.

On April 7, 2020, the U.S. banking agencies issued an Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus (Revised). The statement describes accounting for COVID-19-related loan modifications, including clarifying the interaction between current accounting rules and the temporary relief provided by the CARES Act. The Bank has been actively working with consumer and commercial borrowers requesting deferral of loan payments, granting deferrals of principal and interest payments for 90 days. At December 31, 2021, loans granted loan deferrals totaled $84 thousand, all of which were consumer automobile loans.

The preparation of the financial statements requires Management to estimate the amount of expected losses in the loan portfolio and establish an allowance for credit losses. The allowance for credit losses is maintained by assessing or reversing a provision for credit losses through the Company’s earnings. In estimating credit losses, Management must exercise judgment in evaluating information deemed relevant, such as financial information regarding individual borrowers, overall loss experience, the amount of past due, nonperforming and classified loans, recommendations of regulatory authorities, prevailing economic conditions and other information. The amount of ultimate losses on the loan portfolio can vary from the estimated amounts. Management follows a systematic methodology to estimate loss potential in an effort to reduce the differences between estimated and actual losses.

The Company closely monitors the markets in which it conducts its lending operations and follows a strategy to control exposure to loans with high credit risk. The Bank’s organization structure separates the functions of business development and loan underwriting; Management believes this segregation of duties avoids inherent conflicts of combining business development and loan approval functions. In measuring and managing credit risk, the Company adheres to the following practices:

Classified loans with higher levels of credit risk are further designated as “nonaccrual loans.” Management places classified loans on nonaccrual status when full collection of contractual interest and principal payments is in doubt. Uncollected interest previously accrued on loans placed on nonaccrual status is reversed as a charge against interest income. The Company does not accrue interest income on loans following placement on nonaccrual status. Interest payments received on nonaccrual loans are applied to reduce the carrying amount of the loan unless the carrying amount is well secured by loan collateral. “Nonperforming assets” include nonaccrual loans, loans 90 or more days past due and still accruing, and repossessed loan collateral (commonly referred to as “Other Real Estate Owned”).

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Nonperforming Assets

At December 31, 2021, nonaccrual loans consisted of five loans with an average carrying value of $138 thousand.

Management believes the overall credit quality of the loan portfolio is reasonably stable; however, classified and nonperforming assets could fluctuate from period to period. The performance of any individual loan can be affected by external factors such as the interest rate environment, economic conditions, pandemics, and collateral values or factors particular to the borrower. No assurance can be given that additional increases in nonaccrual and delinquent loans will not occur in the future.

Allowance for Credit Losses

Effective January 1, 2020, the Company adopted Accounting Standards Update (ASU) 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments (“CECL”). The following table summarizes allowance for credit losses at the dates indicated:

Allowance for Credit Losses on Debt Securities Held to Maturity

Management segmented debt securities held to maturity, selected methods to estimate losses for each segment, and measured a loss estimate. Agency mortgage-backed securities were assigned no credit loss allowance due to the perceived backing of government sponsored entities. Municipal securities were evaluated for risk of default based on credit rating and remaining term to maturity using Moody’s risk of default factors; Moody’s loss upon default factors were applied to the assumed defaulted principal amounts to estimate the amount for credit loss allowance. The adoption of the ASU resulted in establishment of allowance for credit losses related to debt securities held to maturity of $16 thousand. It was reduced to $7 thousand at December 31, 2021 and $9 thousand at December 31, 2020 to reflect the expected credit losses on debt securities held to maturity.

Allowance for Credit Losses on Loans

The Company’s allowance for credit losses on loans represents Management’s estimate of forecasted credit losses in the loan portfolio based on the CECL model. In evaluating credit risk for loans, Management measures the loss potential of the carrying value of loans. As described above, payments received on nonaccrual loans may be applied against the principal balance of the loans until such time as full collection of the remaining recorded balance is expected.

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The following table summarizes the allowance for credit losses, chargeoffs and recoveries for the periods indicated. The allowance for loan losses for 2017, 2018 and 2019 is shown under legacy GAAP.

The following table summarizes net (chargeoffs) recoveries and the ratio of net (charge-offs) recoveries to average loans for the periods indicated:

The Company's allowance for credit losses on loans is maintained at a level considered adequate to provide for expected losses based on historical loss rates adjusted for current and expected conditions over a forecast period. These include conditions unique to individual borrowers, as well as overall loan loss experience, the amount of past due, nonperforming and classified loans, recommendations of regulatory authorities, prevailing and forecasted economic conditions, or credit protection agreements and other factors. Loans that share common risk characteristics are segregated into pools based on common characteristics, which is primarily determined by loan, borrower, or collateral type. Historical loss rates are determined for each pool. Loans that do not share risk characteristics with other loans in the pools are evaluated individually. See Note 1 to the consolidated financial statements for additional information.

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The following table presents the allocation of the allowance for credit losses as of December 31 for the periods indicated. The allowance for loan losses for 2017, 2018 and 2019 is shown under legacy GAAP.