AMES NATIONAL CORPORATION Overview
Ames National Corporation (the "Company") is a bank holding company established in 1975 that owns and operates six bank subsidiaries in central, north-central and south-centralIowa (the "Banks"). The following discussion is provided for the consolidated operations of the Company and its Banks,First National Bank ,Ames, Iowa (First National),State Bank & Trust Co. (State Bank ),Boone Bank & Trust Co. (Boone Bank ),Reliance State Bank (Reliance Bank ),United Bank & Trust Co. (United Bank ) andIowa State Savings Bank (Iowa State Bank ). The purpose of this discussion is to focus on significant factors affecting the Company's financial condition and results of operations. The Company does not engage in any material business activities apart from its ownership of the Banks. Products and services offered by the Banks are for commercial and consumer purposes including loans, deposits and wealth management services. Wealth management services includes financial planning and managing trust, agencies, estates and investment brokerage accounts. The Company employs nineteen individuals to assist with financial reporting, human resources, audit, compliance, marketing, technology systems, training, real estate valuation services and the coordination of management activities, in addition to 247 full-time equivalent individuals employed by the Banks. The Company's primary competitive strategy is to utilize seasoned and competent Bank management and local decision making authority to provide customers with faster response times and more flexibility in the products and services offered. This strategy is viewed as providing an opportunity to increase revenues through creating a competitive advantage over other financial institutions. The Company also strives to remain operationally efficient to provide better profitability while enabling the Company to offer more competitive loan and deposit rates. The principal sources of Company revenues and cash flow are: (i) interest and fees earned on loans made by the Company and Banks; (ii) interest on fixed income investments held by the Banks; (iii) fees on wealth management services provided by those Banks exercising trust powers; (iv) service fees on deposit accounts maintained at the Banks; (v) gain on sale of loans; and (vi) merchant and card fees. The Company's principal expenses are: (i) interest expense on deposit accounts and other borrowings; (ii) provision for loan losses; (iii) salaries and employee benefits; (iv) data processing costs associated with maintaining the Banks' loan and deposit functions; (v) occupancy expenses for maintaining the Bank's facilities; and (vi) professional fees. The largest component contributing to the Company's net income is net interest income, which is the difference between interest earned on earning assets (primarily loans and investments) and interest paid on interest-bearing liabilities (primarily deposits and other borrowings). One of management's principal functions is to manage the spread between interest earned on earning assets and interest paid on interest bearing liabilities in an effort to maximize net interest income while maintaining an appropriate level of interest rate risk. The Company had net income of$5.5 million , or$0.62 per share, for the three months endedSeptember 30, 2022 , compared to net income of$6.7 million , or$0.74 per share, for the three months endedSeptember 30, 2021 . The decrease in earnings is primarily the result of lower interest income on loans and higher interest expense on deposits, offset in part by an increase in interest income on taxable securities. The reduction in interest income on loans was primarily due to fewer Paycheck Protection Program ("PPP") fees and interest recognized into income compared to the same period in 2021. Fees recognized from PPP loans during the three months endedSeptember 30, 2022 were$2 thousand as compared to$1.7 million of fees during the three months endedSeptember 30, 2021 . The higher interest expense on deposits is due to an increase in market rates in 2022. The increase in interest income on taxable securities was primarily due to growth in the portfolio. 32
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Net loan charge-offs totaled$3 thousand for the three months endedSeptember 30, 2022 compared to net loan recoveries of$31 thousand for the three months endedSeptember 30, 2021 . A credit for loan losses of$520 thousand was recognized for the three months endedSeptember 30, 2022 as compared to a$94 thousand credit for loan losses for the three months endedSeptember 30, 2021 . The credit for loan losses in 2022 was primarily due to a reduction in specific reserves and an overall improvement in the quality of the loan portfolio.
The following management discussion and analysis will provide a review of important items relating to:
? Challenges
? Key Performance Indicators and Industry Results
? Critical Accounting Policies
? Non-GAAP Financial Measures
? Income Statement Review ? Balance Sheet Review
? Asset Quality Review and Credit Risk Management
? Liquidity and Capital Resources
? Forward-Looking Statements and Business Risks
Challenges Management has identified certain events or circumstances that may negatively impact the Company's financial condition and results of operations in the future and is attempting to position the Company to best respond to those challenges. These challenges are addressed in the Company's most recent Annual Report on Form 10-K filed onMarch 11, 2022 .
Key Performance Indicators and Industry Results
Certain key performance indicators for the Company and the industry are presented in the following chart. The industry figures are compiled by theFederal Deposit Insurance Corporation (the "FDIC") and are derived from 4,333 community banks and savings institutions insured by theFDIC . Management reviews these indicators on a quarterly basis for purposes of comparing the Company's performance from quarter-to-quarter against the industry as a whole. 33
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Selected Indicators for the Company and the Industry
3 Months 9 Months Years Ended December 31,
Ended Ended 3 Months Ended
September 30, 2022 June 30, 2022 2021 2020
Company Company Industry* Company Industry* Company Industry*
Return on assets 1.05 % 0.93 % 0.77 % 1.10 % 1.15 % 1.25 % 1.01 % 1.09 %
Return on equity 13.65 % 11.15 % 9.78 % 11.49 % 11.43 % 11.61 % 9.48 % 9.72 %
Net interest margin 2.63 % 2.58 % 2.57 % 3.33 % 2.83 % 3.27 % 3.13 % 3.39 %
Efficiency ratio 59.48 % 60.24 % 61.51 % 61.54 % 55.04 % 61.42 % 55.83 % 62.34 %
Capital ratio 7.67 % 8.30 % 7.90 % 10.31 % 10.04 % 10.16 % 10.66 % 10.32 %
*Latest available data
Key performances indicators include:
? Return on Assets This ratio is calculated by dividing net income by average assets. It is used to measure how effectively the assets of the Company are being utilized in generating income. The Company's annualized return on average assets was 1.05% and 1.29% for the three months endedSeptember 30, 2022 and 2021, respectively. This ratio decrease was primarily the result of lower net income. ? Return on Equity This ratio is calculated by dividing net income by average equity. It is used to measure the net income or return the Company generated for the shareholders' equity investment in the Company. The Company's return on average equity was at 13.65% and 12.60% for the three months endedSeptember 30, 2022 and 2021, respectively. This ratio increase was primarily the result of a decrease in the average balance of stockholders' equity due an increase in unrealized losses on securities. ? Net Interest Margin The net interest margin for the three months endedSeptember 30, 2022 and 2021 was 2.63% and 2.97%, respectively. The ratio is calculated by dividing tax equivalent net interest income by average earning assets. Earning assets are primarily made up of loans and investments that earn interest. This ratio is used to measure how well the Company is able to maintain interest rates on earning assets above those of interest-bearing liabilities, which is the interest expense paid on deposits and other borrowings. ? Efficiency Ratio This ratio is calculated by dividing noninterest expense by the sum of net interest income and noninterest income. The ratio is a measure of the Company's ability to manage noninterest expenses. The Company's efficiency ratio was 59.48% and 51.35% for the three months endedSeptember 30, 2022 and 2021, respectively. The efficiency ratio has increased compared to the same quarter last year primarily due to a reduction in net interest income and an increase in noninterest expense. 34
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Table of Contents ? Capital Ratio The average capital ratio is calculated by dividing average total equity capital by average total assets. It measures the level of average assets that are funded by shareholders' equity. Given an equal level of risk in the financial condition of two companies, the higher the capital ratio, generally the more financially sound the company. The Company's capital ratio of 7.67% as ofSeptember 30, 2022 is lower than the industry average of 10.31% as ofJune 30, 2022 primarily due an increase in accumulated other comprehensive losses as interest rates have risen during the third quarter of 2022. Critical Accounting Policies The discussion contained in this Item 2 and other disclosures included within this report are based, in part, on the Company's auditedDecember 31, 2021 consolidated financial statements. These statements have been prepared in accordance with accounting principles generally accepted inthe United States of America . The financial information contained in these statements is, for the most part, based on the financial effects of transactions and events that have already occurred. However, the preparation of these statements requires management to make certain estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. The Company's significant accounting policies are described in the "Notes to Consolidated Financial Statements" accompanying the Company's audited financial statements. Based on its consideration of accounting policies that involve the most complex and subjective estimates and judgments, management has identified the allowance for loan losses, the assessment of other-than-temporary impairment for investment securities and the assessment of goodwill impairment to be the Company's most critical accounting policies. Allowance for Loan Losses The allowance for loan losses is established through a provision for loan losses that is treated as an expense and charged against earnings. Loans are charged against the allowance for loan losses when management believes that collectability of the principal is unlikely. The Company has policies and procedures for evaluating the overall credit quality of its loan portfolio, including timely identification of potential problem loans. On a quarterly basis, management reviews the appropriate level for the allowance for loan losses, incorporating a variety of risk considerations, both quantitative and qualitative. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, known information about individual loans and other factors. Qualitative factors include various considerations regarding the general economic environment in the Company's market area. To the extent actual results differ from forecasts and management's judgment, the allowance for loan losses may be greater or lesser than future charge-offs. Due to potential changes in conditions, including economic disruption, high inflation levels, and rising interest rates, it is at least reasonably possible that changes in estimates will occur in the near term and that such changes could be material to the amounts reported in the Company's financial statements. For further discussion concerning the allowance for loan losses and the process of establishing specific reserves, see the section of the Annual Report on Form 10-K entitled "Asset Quality Review and Credit Risk Management" and "Analysis of the Allowance for Loan Losses". 35
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Fair Value and Other-Than-Temporary Impairment of
The Company's securities available-for-sale portfolio is carried at fair value with "fair value" being defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability is not adjusted for transaction costs. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction. Market participants are buyers and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact, and (iv) willing to transact. Declines in the fair value of available-for-sale securities below their cost that are deemed to be other-than-temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers (1) the intent to sell the investment securities and the more likely than not requirement that the Company will be required to sell the investment securities prior to recovery (2) the length of time and the extent to which the fair value has been less than cost and (3) the financial condition and near-term prospects of the issuer. Due to potential changes in conditions, including economic disruption, high inflation levels, and rising interest rates, it is at least reasonably possible that changes in management's assessment of other-than-temporary impairment will occur in the near term and that such changes could be material to the amounts reported in the Company's financial statements.Goodwill Goodwill arose in connection with four acquisitions consummated in previous periods.Goodwill is tested annually for impairment or more often if conditions indicate a possible impairment. For the purposes of goodwill impairment testing, determination of the fair value of a reporting unit involves the use of significant estimates and assumptions. Impairment would arise if the fair value of a reporting unit is less than its carrying value. AtSeptember 30, 2022 , Company's management has completed the goodwill impairment assessment and determined goodwill was not impaired. Actual future test results may differ from the present evaluation of impairment due to changes in the conditions used in the current evaluation. The effects of economic disruption, high inflation levels, and rising interest rates may negatively impact our net income, fair value and correspondingly goodwill. An impairment of goodwill would decrease the Company's earnings during the period in which the impairment is recorded. 36
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Non-GAAP Financial Measures
This report contains references to financial measures that are not defined in
GAAP. Such non-GAAP financial measures include the Company's presentation of net
interest income and net interest margin on a fully taxable equivalent (FTE)
basis. Management believes these non-GAAP financial measures are widely used in
the financial institutions industry and provide useful information to both
management and investors to analyze and evaluate the Company's financial
performance. Limitations associated with non-GAAP financial measures include the
risks that persons might disagree as to the appropriateness of items included in
these measures and that different companies might calculate these measures
differently. These non-GAAP disclosures should not be considered an alternative
to the Company's GAAP results. The following table reconciles the non-GAAP
financial measures of net interest income and net interest margin on an FTE
basis to GAAP (dollars in thousands).
Three Months Ended September 30, Nine Months Ended September 30,
2022 2021 2022 2021
Reconciliation of net interest income
and annualized net interest margin on an
FTE basis to GAAP:
Net interest income (GAAP) $ 13,663 $ 14,652 $ 40,451 $ 42,488 Tax-equivalent adjustment (1)
170 193 529 636
Net interest income on an FTE basis
(non-GAAP) 13,833 14,845 40,980 43,124
Average interest-earning assets $ 2,105,313 $ 1,999,147 $ 2,114,305 $ 1,989,226
Net interest margin on an FTE basis
(non-GAAP) 2.63 % 2.97 % 2.58 % 2.89 %
(1) Computed on a tax-equivalent basis using an incremental federal income tax rate of
21 percent, adjusted to reflect the effect of the tax-exempt interest income associated
with owning tax-exempt securities and loans.
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Income Statement Review for the Three Months ended
The following highlights a comparative discussion of the major components of net
income and their impact for the three months ended
AVERAGE BALANCES AND INTEREST RATES
The following two tables are used to calculate the Company's non-GAAP net
interest margin on an FTE basis. The first table includes the Company's average
assets and the related income to determine the average yield on earning assets.
The second table includes the average liabilities and related expense to
determine the average rate paid on interest-bearing liabilities. The net
interest margin is equal to interest income less interest expense divided by
average earning assets. Refer to the net interest income discussion following
the tables for additional detail.
AVERAGE BALANCE SHEETS AND INTEREST RATES
Three Months Ended September 30,
2022 2021
Average Revenue/ Yield/ Average Revenue/ Yield/
balance expense rate balance expense rate
ASSETS
(dollars in thousands)
Interest-earning assets
Loans (1)
Commercial $ 72,356 $ 815 4.51 % $ 96,436 $ 2,411 10.00 %
Agricultural 92,853 1,210 5.21 % 98,942 1,014 4.10 %
Real estate 991,574 9,503 3.83 % 934,427 8,936 3.83 %
Consumer and other 16,147 160 3.96 % 15,167 169 4.46 %
Total loans (including
fees) 1,172,930 11,688 3.99 % 1,144,972 12,530 4.38 %
Investment securities
Taxable 762,535 3,226 1.69 % 598,634 2,256 1.51 %
Tax-exempt (2) 132,064 811 2.46 % 146,805 918 2.50 %Total investment securities 894,599 4,037 1.81 %
745,439 3,174 1.70 %
Interest-bearing deposits with banks and federal funds sold 37,784 250 2.65 % 108,736 168 0.62 % Total interest-earning assets 2,105,313$ 15,975 3.04 % 1,999,147$ 15,872 3.18 % Noninterest-earning assets 13,016 76,490 TOTAL ASSETS$ 2,118,329 $ 2,075,637
(1) Average loan balances include nonaccrual loans, if any. Interest income collected on nonaccrual loans has been included. (2) Tax-exempt income has been adjusted to a tax-equivalent basis using an incremental tax rate of 21%.
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AVERAGE BALANCE SHEETS AND INTEREST RATES
Three Months Ended September 30,
2022 2021
Average Revenue/ Yield/ Average Revenue/ Yield/
balance expense rate balance expense rate
LIABILITIES AND
STOCKHOLDERS'
EQUITY
(dollars in
thousands)
Interest-bearing
liabilities
Deposits
Interest-bearing
checking, savings
accounts and moneymarkets$ 1,290,911 $ 1,461 0.45 %$ 1,212,084 $ 467 0.15 % Time deposits 197,731 386 0.78 % 227,760 526 0.92 % Total deposits 1,488,642 1,847 0.50 % 1,439,844 993 0.28 % Other borrowed funds 63,660 295 1.85 % 38,863 34 0.35 % Total interest-bearing liabilities 1,552,302 2,142 0.55 % 1,478,707 1,027 0.28 % Noninterest-bearing liabilities Noninterest-bearing checking 394,845 373,973 Other liabilities 8,687 9,786 Stockholders' equity 162,495 213,171 TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY$ 2,118,329 $ 2,075,637 Net interest income (FTE)(3)$ 13,833 2.63 %$ 14,845 2.97 % Spread Analysis (FTE) Interest income/average assets$ 15,975 3.02 %$ 15,872 3.06 % Interest expense/average assets$ 2,142 0.40 %$ 1,027 0.20 % Net interest income/average assets$ 13,833 2.61 %$ 14,845 2.86 %
(3) Net interest income (FTE) is a non-GAAP financial measure. For further information, refer to the Non-GAAP Financial Measures section of this report.
Net Interest Income
For the three months ended
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For the three months endedSeptember 30, 2022 , interest income increased$126 thousand , or 1%, when compared to the same period in 2021. The increase is primarily due to higher interest income on taxable securities and partially offset by fewer PPP fees and interest recognized into income. Taxable securities interest income was$970 thousand higher than the third quarter of 2021 due primarily to increased balances. Fees recognized from PPP loans during the third quarter of 2022 were$2 thousand as compared to$1.7 million of fees during the third quarter of 2021. Interest expense increased$1.1 million , or 109%, for the three months endedSeptember 30, 2022 when compared to the same period in 2021. The higher interest expense for the period is primarily due to an increase in market rates on deposits. In 2022, theFederal Open Market Committee has increased its target for the federal funds interest rate by 3.00%.
Provision (Credit) for Loan Losses
A credit for loan losses of($520) thousand was recognized for the three months endedSeptember 30, 2022 as compared to a credit for loan losses of($94) thousand for the three months endedSeptember 30, 2021 . Net loan charge-offs totaled$3 thousand for the three months endedSeptember 30, 2022 compared to net loan recoveries of$31 thousand for the three months endedSeptember 30, 2021 . The credit for loan losses in 2022 was primarily due to a reduction in specific reserves and an overall improvement in the quality of the loan portfolio.
Noninterest Income and Expense
Noninterest income for the three months endedSeptember 30, 2022 totaled$2.3 million compared to$2.7 million for the three months endedSeptember 30, 2021 , a decrease of 14%. The decrease in noninterest income was primarily due to fewer gains on sale of residential loans held for sale as refinancing volume has slowed as mortgage rates have risen. Noninterest expense for the three months endedSeptember 30, 2022 totaled$9.5 million compared to$8.9 million recorded for the three months endedSeptember 30, 2021 , an increase of 7%. The increase is primarily due to data processing costs as a result of additional investments in technology and normal increases in salaries and benefits. The efficiency ratio was 59.5% for the third quarter of 2022 as compared to 51.4% in the third quarter of 2021. Income Taxes Income tax expense for the three months endedSeptember 30, 2022 totaled$1.4 million compared to$1.8 million recorded for the three months endedSeptember 30, 2021 . The effective tax rate was 21% for the three months endedSeptember 30, 2022 and 2021. The lower than expected tax rate in 2022 and 2021 was due primarily to tax-exempt interest income and New Markets Tax Credits. 40
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Income Statement Review for the Nine Months ended
The following highlights a comparative discussion of the major components of net
income and their impact for the nine months ended
AVERAGE BALANCES AND INTEREST RATES
The following two tables are used to calculate the Company's non-GAAP net
interest margin on an FTE basis. The first table includes the Company's average
assets and the related income to determine the average yield on earning assets.
The second table includes the average liabilities and related expense to
determine the average rate paid on interest-bearing liabilities. The net
interest margin is equal to interest income less interest expense divided by
average earning assets. Refer to the net interest income discussion following
the tables for additional detail.
AVERAGE BALANCE SHEETS AND INTEREST RATES
Nine Months Ended September 30,
2022 2021
Average Revenue/ Yield/ Average Revenue/ Yield/
balance expense rate balance expense rate
ASSETS
(dollars in thousands)
Interest-earning assets
Loans (1)
Commercial $ 71,700 $ 2,438 4.53 % $ 113,448 $ 6,281 7.38 %
Agricultural 93,832 3,141 4.46 % 96,173 2,999 4.16 %
Real estate 973,314 27,173 3.72 % 918,384 26,845 3.90 %
Consumer and other 16,210 477 3.92 % 14,768 516 4.66 %
Total loans (including
fees) 1,155,056 33,229 3.84 % 1,142,773 36,641 4.28 %
Investment securities
Taxable 739,206 8,861 1.60 % 533,161 6,457 1.61 %
Tax-exempt (2) 137,375 2,519 2.45 % 156,969 3,028 2.57 %
Total investment securities 876,581 11,380 1.73 % 690,130 9,485 1.83 %
Interest-bearing deposits with banks and federal funds sold 82,668 675 1.09 % 156,323 515 0.44 % Total interest-earning assets 2,114,305$ 45,284 2.86 % 1,989,226$ 46,641 3.13 % Noninterest-earning assets 30,398 76,434 TOTAL ASSETS$ 2,144,703 $ 2,065,660 (1) Average loan balances include nonaccrual loans, if any. Interest income collected on nonaccrual loans has been included. (2) Tax-exempt income has been adjusted to a tax-equivalent basis using an incremental tax rate of 21%. 41
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AVERAGE BALANCE SHEETS AND INTEREST RATES
Nine Months Ended September 30,
2022 2021
Average Revenue/ Yield/ Average Revenue/ Yield/
balance expense rate balance expense rate
LIABILITIES AND
STOCKHOLDERS'
EQUITY
(dollars in
thousands)
Interest-bearing
liabilities
Deposits
Interest-bearing
checking, savings
accounts and money
markets $ 1,303,599 $ 2,768 0.28 % $ 1,198,914 $ 1,435 0.16 %
Time deposits 206,672 1,153 0.74 % 239,691 1,976 1.10 %
Total deposits 1,510,271 3,921 0.35 % 1,438,605 3,411 0.32 %
Other borrowed
funds 47,412 383 1.08 % 39,927 106 0.35 %
Total
interest-bearing
liabilities 1,557,683 4,304 0.37 % 1,478,532 3,517 0.32 % Noninterest-bearing liabilities Noninterest-bearing checking 400,393 367,698 Other liabilities 8,697 9,880 Stockholders' equity 177,930 209,550 TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY$ 2,144,703 $ 2,065,660 Net interest income (FTE)(3)$ 40,980 2.58 %$ 43,124 2.89 % Spread Analysis (FTE) Interest income/average assets$ 45,284 2.82 %$ 46,641 3.01 % Interest expense/average assets$ 4,304 0.27 %$ 3,517 0.23 % Net interest income/average assets$ 40,980 2.55 %$ 43,124 2.78 %
(3) Net interest income (FTE) is a non-GAAP financial measure. For further information, refer to the Non-GAAP Financial Measures section of this report.
Net Interest Income
For the nine months ended
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For the nine months endedSeptember 30, 2022 , interest income declined$1.3 million , or 3%, when compared to the same period in 2021. The decrease is primarily due to less income recognized from PPP fees and a reduction in the recovery of interest income on nonaccrual loans, partially offset by an increase in income from taxable securities. Fees recognized from PPP loans during the nine months endedSeptember 30, 2022 were$217 thousand as compared to$3.9 million of fees during the same period 2021. Nonaccrual interest income recognized in the nine months endedSeptember 30, 2022 was$76 thousand compared to$355 thousand recognized during the same period of 2021. Taxable securities interest income was$2.4 million higher than 2021 due primarily to increased balances.
Interest expense increased
Provision (Credit) for Loan Losses
A (credit) for loan losses of($706) thousand was recognized for the nine months endedSeptember 30, 2022 as compared to a (credit) for loan losses of($540) thousand for the nine months endedSeptember 30, 2021 . Net loan charge-offs totaled$18 thousand for the nine months endedSeptember 30, 2022 compared to net loan recoveries of$155 thousand for the nine months endedSeptember 30, 2021 . The credit for loan losses in 2022 was primarily due to a reduction in specific reserves and an overall improvement in the quality of the loan portfolio. The credit for loan losses in 2021 was primarily due to loan recoveries and a reduction in a specific reserve.
Noninterest Income and Expense
Noninterest income for the nine months endedSeptember 30, 2022 totaled$7.2 million compared to$7.8 million for the nine months endedSeptember 30, 2021 , a decrease of 8%. The decrease in noninterest income was primarily due to fewer gains on sale of residential loans held for sale as refinancing volume has slowed as mortgage rates have risen. Noninterest expense for the nine months endedSeptember 30, 2022 totaled$28.7 million compared to$27.3 million recorded for the nine months endedSeptember 30, 2021 , an increase of 5%. The increase is primarily due to data processing costs as a result of additional investments in technology and normal increases in salaries and benefits. The efficiency ratio was 60.2% and 54.3% for the nine months endedSeptember 30, 2022 and 2021, respectively. Income Taxes Income tax expense for the nine months endedSeptember 30, 2022 totaled$4.8 million compared to$4.9 million recorded for the nine months endedSeptember 30, 2021 . The effective tax rate was 24% and 21% for the nine months endedSeptember 30, 2022 and 2021, respectively. The increase in the effective tax rate in 2022 was due to a$780 thousand adjustment to deferred taxes for the reduction in futureIowa bank franchise tax rates enacted in the second quarter of 2022. The lower than expected tax rate in 2022 and 2021 was due primarily to tax-exempt interest income and New Markets Tax Credits. 43
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Table of Contents Balance Sheet Review
As of
Investment Portfolio The investment portfolio totaled$784.0 million as ofSeptember 30, 2022 , a decrease of$47.0 million from theDecember 31, 2021 balance of$831.0 million . The decrease in securities available-for-sale is primarily due to a decline in fair value, offset in part by purchases of investments. The decline in fair value occurred as a result of interest rates increasing during 2022. In 2022, theFederal Open Market Committee has increased its target for the federal funds interest rate by 3.00%. On a quarterly basis, the investment portfolio is reviewed for other-than-temporary impairment. As ofSeptember 30, 2022 , gross unrealized losses of$96.5 million , are considered to be temporary in nature due to the interest rate environment and other general economic factors. Certain bonds in the investment portfolio may become other-than-temporarily impaired and could negatively affect the Company's net income. As a result of the Company's favorable liquidity position, the Company does not have the intent to sell securities with an unrealized loss at the present time. In addition, management believes it is more likely than not that the Company will hold these securities until recovery of their fair value to cost basis and expects full principal and interest to be collected. Therefore, the Company does not consider these investments to have other-than-temporary impairment as ofSeptember 30, 2022 . AtSeptember 30, 2022 , the Company's investment securities portfolio included securities issued by 294 government municipalities and agencies located within 29 states with a fair value of$280.5 million . AtDecember 31, 2021 , the Company's investment securities portfolio included securities issued by 298 government municipalities and agencies located within 28 states with a fair value of$292.9 million . No one municipality or agency represents a concentration within this segment of the investment portfolio.Storm Lake, Iowa , general obligation bonds with a fair value of$5.7 million (approximately 2.0% of the fair value of the government municipalities and agencies) represent the largest exposure to any one municipality or agency for the Company as ofSeptember 30, 2022 ; the bonds are repayable from the levy of continuing annual tax on all the taxable property within the territory of the city ofStorm Lake . The Company's procedures for evaluating investments in states, municipalities and political subdivisions include but are not limited to reviewing the offering statement and the most current available financial information, comparing yields to yields of bonds of similar credit quality, confirming capacity to repay, assessing operating and financial performance, evaluating the stability of tax revenues, considering debt profiles and local demographics, and for revenue bonds, assessing the source and strength of revenue structures for municipal authorities. These procedures, as applicable, are utilized for all municipal purchases and are utilized in whole or in part for monitoring the portfolio of municipal holdings. The Company does not utilize third party credit rating agencies as a primary component of determining if the municipal issuer has an adequate capacity to meet the financial commitments under the security for the projected life of the investment, and, therefore, does not compare internal assessments to those of the credit rating agencies. Credit rating downgrades are utilized as an additional indicator of credit weakness and as a reference point for historical default rates. 44
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The following table summarizes the total general obligation and revenue bonds in
the Company's investment securities portfolios as of
2022 2021
Estimated Estimated
Amortized Fair Amortized Fair
Cost Value Cost Value
Obligations of states and political
subdivisions:
General Obligation bonds:
Iowa $ 66,206 $ 59,761 $ 72,128 $ 72,830
Texas 29,788 25,963 24,742 24,953
Nebraska 20,166 16,813 19,546 19,486
Oregon 11,064 10,014 4,757 4,864
Washington 10,936 9,767 11,013 11,241
Other (2022: 15 states; 2021: 15 states) 41,361 36,461 36,614 36,753
Total general obligation bonds$ 179,521 $ 158,779 $ 168,800 $ 170,127 Revenue bonds: Iowa$ 57,301 $ 52,057 $ 61,718 $ 62,181 Texas 14,832 12,544 11,898 12,090 Nebraska 9,947 8,344 9,727 9,636 Other (2022: 23 states; 2021: 21 states) 54,931 48,765 38,405 38,825 Total revenue bonds$ 137,011 $ 121,710 $ 121,748 $ 122,732 Total obligations of states and political subdivisions$ 316,532 $ 280,489 $ 290,548 $ 292,859 As ofSeptember 30, 2022 andDecember 31, 2021 , the revenue bonds in the Company's investment securities portfolios were issued by government municipalities and agencies to fund public services such as community school facilities, college and university dormitory facilities, water utilities and electrical utilities. The revenue bonds are to be paid from 5 primary revenue sources. The revenue sources that represent 5% or more, individually, as a percent of the total revenue bonds are summarized in the following table (in thousands): 2022 2021 Estimated Estimated Amortized Fair Amortized Fair Cost Value Cost Value Revenue bonds by revenue source Sales tax$ 31,297 $ 27,883 $ 31,632 $ 31,896 Water 21,884 19,416 22,611 22,924 College and universities, primarily dormitory revenues 19,400 17,028 17,169 17,353 Sewer 13,339 11,484 14,248 14,327 Leases 11,199 10,217 8,788 8,894 Other 39,892 35,682 27,300 27,338
Total revenue bonds by revenue source
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Table of Contents Loan Portfolio The loan portfolio, net of the allowance for loan losses, totaled$1.18 billion and$1.14 billion as ofSeptember 30, 2022 andDecember 31, 2021 , respectively. The increase was primarily due to an increase in the 1-4 family residential loan portfolio, offset in part by a decrease in agricultural operating loans. Deposits Deposits totaled$1.87 billion and$1.88 billion as ofSeptember 30, 2022 andDecember 31, 2021 , respectively. The change in deposits sinceDecember 31, 2021 was due to decreases in noninterest-bearing deposits and time deposits, partially offset by an increase in interest-bearing checking. Deposit balances fluctuate as customers' liquidity needs vary at any given time and could be impacted by prevailing market interest rates, competition, and economic conditions.
Off-Balance Sheet Arrangements
The Company is party to financial instruments with off-balance-sheet risk in the normal course of business. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet. No material changes in the Company's off-balance sheet arrangements have occurred sinceDecember 31, 2021 .
Asset Quality Review and Credit Risk Management
The Company's credit risk is historically centered in the loan portfolio, which totaled$1.18 and$1.14 billion as ofSeptember 30, 2022 andDecember 31, 2021 , respectively. Net loans comprise 56% of total assets as ofSeptember 30, 2022 . The objective in managing loan portfolio risk is to reduce the risk of loss resulting from a customer's failure to perform according to the terms of an agreement and to quantify and manage credit risk on a portfolio basis. The Company's level of problem loans (consisting of nonaccrual loans and loans past due 90 days or more) as a percentage of total loans was 1.28% atSeptember 30, 2022 , as compared to 1.11% atDecember 31, 2021 . The Company's level of problem loans as a percentage of total loans atSeptember 30, 2022 of 1.28% is higher as compared to the Iowa State Average peer group ofFDIC insured institutions as ofJune 30, 2022 , of 0.40%, most recent available. Impaired loans totaled$15.0 million as ofSeptember 30, 2022 and have increased$2.7 million as compared to the impaired loans of$12.3 million as ofDecember 31, 2021 . The increase is primarily due to one borrower with no associated specific reserve. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payment of principal and interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. The Company applies its normal loan review procedures to identify loans that should be evaluated for impairment. The Company had TDRs of$10.8 million as ofSeptember 30, 2022 and$11.3 million as ofDecember 31, 2021 , all of which were included in impaired and nonaccrual loans. 46
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TDRs are monitored and reported on a quarterly basis. Certain TDRs are on nonaccrual status at the time of restructuring. These borrowings are typically returned to accrual status after the following: sustained repayment performance in accordance with the restructuring agreement for a reasonable period of at least nine months; and, management is reasonably assured of future performance. If the TDR meets these performance criteria and the interest rate granted at the modification is equal to or greater than the rate that the Company was willing to accept at the time of the restructuring for a new loan with comparable risk, then the loan will return to performing status. For TDRs that were on nonaccrual status before the modification, a specific reserve may already be recorded. In periods subsequent to modification, the Company will continue to evaluate all TDRs for possible impairment and, as necessary, recognize impairment through the allowance. No additional specific reserve was provided for the three and nine months endedSeptember 30, 2022 and 2021. The Company had no charge-offs for TDRs for the three and nine months endedSeptember 30, 2022 , respectively. The Company had no charge-offs and$262 thousand of recoveries for TDR's for the three and nine months endedSeptember 30, 2021 , respectively. The Company does not have material commitments to lend additional funds to borrowers with loans whose terms have been modified in troubled debt restructurings or whose loans are on nonaccrual. Loans past due 90 days or more that are still accruing interest are reviewed no less frequently than quarterly to determine if there continues to be a strong reason that the credit should not be placed on nonaccrual. As ofSeptember 30, 2022 , nonaccrual loans totaled$15.2 million and there were$12 thousand of loans past due 90 days and still accruing. This compares to nonaccrual loans of$12.7 million and loans past due 90 days and still accruing totaled$169 thousand as ofDecember 31, 2021 . The increase in nonaccrual loans is primarily due to one borrower with no associated specific reserve. There was no real estate owned and$218 thousand as ofSeptember 30, 2022 andDecember 31, 2021 , respectively. The watch and special mention loans classified as agricultural real estate and operating totaled$35.7 million as ofSeptember 30, 2022 as compared to$36.5 million as ofDecember 31, 2021 . The substandard and impaired loans in these categories totaled$5.9 million and$7.4 million as ofSeptember 30, 2022 andDecember 31, 2021 , respectively. The watch and special mention loans classified as commercial real estate totaled$71.7 million as ofSeptember 30, 2022 as compared to$102.2 million as ofDecember 31, 2021 . The substandard and impaired commercial real estate loans totaled$34.6 million and$31.8 million as ofSeptember 30, 2022 andDecember 31, 2021 , respectively. The increase in substandard and impaired commercial real estate loans is due to one borrower with no associated specific reserve. The allowance for loan losses as a percentage of outstanding loans as ofSeptember 30, 2022 was 1.33%, as compared to 1.43% atDecember 31, 2021 . The allowance for loan losses totaled$15.9 million and$16.6 million as ofSeptember 30, 2022 andDecember 31, 2021 , respectively. The decrease in the allowance for loan losses is mainly due to lower specific reserves and improved quality of the loan portfolio, offset in part by loan growth. The allowance for loan losses is management's best estimate of probable losses inherent in the loan portfolio as of the balance sheet date. Factors considered in establishing an appropriate allowance include: an assessment of the financial condition of the borrower, a realistic determination of value and adequacy of underlying collateral, the condition of the local economy and the condition of the specific industry of the borrower, an analysis of the levels and trends of loan categories and a review of delinquent and classified loans. Due to potential changes in conditions, including economic disruption, high inflation levels, and rising interest rates, additional increases in the allowance for loan losses are possible. 47
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Liquidity and Capital Resources
Liquidity management is the process by which the Company, through its Banks' Asset and Liability Committees (ALCO), ensures that adequate liquid funds are available to meet its financial commitments on a timely basis, at a reasonable cost and within acceptable risk tolerances. These commitments include funding credit obligations to borrowers, funding of mortgage originations pending delivery to the secondary market, withdrawals by depositors, maintaining adequate collateral for pledging for public funds, trust deposits and borrowings, paying dividends to shareholders, payment of operating expenses, funding capital expenditures and maintaining deposit reserve requirements. Liquidity is derived primarily from core deposit growth and retention; principal and interest payments on loans; principal and interest payments, sale, maturity and prepayment of securities available-for-sale; net cash provided from operations; and access to other funding sources. Other funding sources include federal funds purchased lines, FHLB advances and other capital market sources. As ofSeptember 30, 2022 , the level of liquidity and capital resources of the Company remain at a satisfactory level. Management believes that the Company's liquidity sources will be sufficient to support its existing operations for the foreseeable future.
The liquidity and capital resources discussion will cover the following topics:
? Review of the Company's Current Liquidity Sources
? Review of Statements of Cash Flows
? Company Only Cash Flows
? Review of Commitments for Capital Expenditures, Cash Flow Uncertainties and
Known Trends in Liquidity and Cash Flows Needs
? Capital Resources
Review of the Company's Current Liquidity Sources
Liquid assets of cash on hand, balances due from other banks and interest-bearing deposits in financial institutions as ofSeptember 30, 2022 andDecember 31, 2021 totaled$29.3 million and$89.1 million , respectively, and management believes these sources provide an adequate level of liquidity given current economic conditions. Other sources of liquidity available to the Banks as ofSeptember 30, 2022 include outstanding lines of credit with the FHLB ofDes Moines, Iowa of$287.2 million , with$23.6 million of outstanding FHLB advances. Federal funds borrowing capacity at correspondent banks was$100.4 million , with no outstanding federal fund purchase balances as ofSeptember 30, 2022 . The Company had securities sold under agreements to repurchase totaling$41.1 million as ofSeptember 30, 2022 . Total investments as ofSeptember 30, 2022 were$784.0 million compared to$831.0 million as ofDecember 31, 2021 . These investments provide the Company with liquidity since all of the investments are classified as available-for-sale as ofSeptember 30, 2022 . The investment portfolio serves an important role in the overall context of balance sheet management in terms of balancing capital utilization and liquidity. The decision to purchase or sell securities is based upon the current assessment of economic and financial conditions, including the interest rate environment, liquidity and credit considerations. The portfolio's scheduled maturities and payments represent a significant source of liquidity. 48
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Review of the Consolidated Statements of Cash Flows
Net cash provided by operating activities for the nine months endedSeptember 30, 2022 totaled$15.0 million compared to$23.7 million for the nine months endedSeptember 30, 2021 . The decrease of$8.7 million in cash provided by operating activities was primarily due to lower net income and fewer net proceeds from loans held for sale.
Net cash used in investing activities for the nine months ended
Net cash provided by financing activities for the nine months endedSeptember 30, 2022 totaled$11.1 million compared to$111.7 million for the nine months endedSeptember 30, 2021 . The decrease in cash provided by financing activities of$100.6 million was primarily due to a decrease in deposits between periods. As ofSeptember 30, 2022 , the Company did not have any external debt financing, off-balance sheet financing arrangements, or derivative instruments linked to its stock.
Review of Company Only Cash Flows
The Company's liquidity on an unconsolidated basis is heavily dependent upon dividends paid to the Company by the Banks. The Banks provide adequate liquidity to pay the Company's expenses and stockholder dividends. Dividends paid by the Banks to the Company amounted to$7.6 million and$7.1 million for the nine months endedSeptember 30, 2022 and 2021, respectively. Various federal and state statutory provisions limit the amounts of dividends banking subsidiaries are permitted to pay to their holding companies without regulatory approval.Federal Reserve policy further limits the circumstances under which bank holding companies may declare dividends. For example, a bank holding company should not continue its existing rate of cash dividends on its common stock unless its net income is sufficient to fully fund each dividend and its prospective rate of earnings retention appears consistent with its capital needs, asset quality and overall financial condition. In addition, theFederal Reserve and theFDIC have issued policy statements, which provide that insured banks and bank holding companies should generally pay dividends only out of current operating earnings. Federal and state banking regulators may also restrict the payment of dividends by order.
The Company, on an unconsolidated basis, has interest-bearing deposits totaling
Review of Commitments for Capital Expenditures, Cash Flow Uncertainties and Known Trends in Liquidity and Cash Flows Needs
OnJune 9, 2022 , the Company entered into a commitment with a contractor to remodel a branch inAmes, Iowa for$3.7 million . The Company has$3.2 million of the commitment remaining atSeptember 30, 2022 . No other material capital expenditures or material changes in the capital resource mix are anticipated at this time. The primary cash flow uncertainty would be a sudden decline in deposits causing the Banks to liquidate securities. Historically, the Banks have maintained an adequate level of short-term marketable investments to fund the temporary declines in deposit balances. There are no known trends in liquidity and cash flow needs as ofSeptember 30, 2022 that are of concern to management. 49
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Table of Contents Capital Resources The Company's total stockholders' equity as ofSeptember 30, 2022 totaled$137.3 million and was$70.5 million less than the$207.8 million recorded as ofDecember 31, 2021 . The decrease in stockholders' equity was primarily the result of an increase in unrealized losses on the investment portfolio and stock repurchases, offset in part by the retention of net income in excess of dividends. AtSeptember 30, 2022 andDecember 31, 2021 , stockholders' equity as a percentage of total assets was 6.6% and 9.7%, respectively. The capital levels of the Company exceed applicable regulatory guidelines as ofSeptember 30, 2022 . Unrealized losses on the investment portfolio are excluded from regulatory capital.
Forward-Looking Statements and Business Risks
The Private Securities Litigation Reform Act of 1995 provides the Company with the opportunity to make cautionary statements regarding forward-looking statements contained in this Quarterly Report, including forward-looking statements concerning the Company's financial performance and asset quality. Forward-looking statements contained in this Quarterly Report are not historical facts and are based on management's current beliefs, assumptions, predictions and expectations of future events, including the Company's future performance, taking into account all information currently available to management. These beliefs, assumptions, predictions and expectations are subject to numerous risks and uncertainties and can change as a result of many possible events or factors, not all of which are known to management and many of which are beyond management's control. If a change occurs, the Company's business, financial condition, liquidity, results of operations, asset quality, plans and objectives may vary materially from those expressed in the forward-looking statements. Accordingly, investors are cautioned not to place undue reliance on such forward-looking statements. These statements are often, but not always, made through the use of words or phrases such as "anticipates," "believes," "can," "could," "may," "predicts," "potential," "should," "will," "estimate," "plans," "projects," "forecasts", "continuing," "ongoing," "expects," "views," "intends" and similar words or phrases. The risks and uncertainties that may affect the Company's future performance and asset quality include, but are not limited to, the following: the substantial negative impact of the continuing COVID-19 pandemic on national, regional and local economies in general and on the Company's customers in particular; competitive products and pricing available in the marketplace; changes in credit and other risks posed by the Company's loan and investment portfolios, including declines in commercial or residential real estate values or changes in the allowance for loan losses resulting from the COVID-19 pandemic or as dictated by new market conditions or regulatory requirements; fiscal and monetary policies of theU.S. government; changes in governmental regulations affecting financial institutions (including regulatory fees and capital requirements); changes in prevailing interest rates; credit risk management and asset/liability management; the financial and securities markets; the availability of and cost associated with sources of liquidity; and other risks and uncertainties inherent in the Company's business, including those discussed under the headings Forward-Looking Statements and Business Risks" and "Risk Factors" in the Company's Annual Report on Form 10-K for the year-endedDecember 31, 2021 . Any forward-looking statements are qualified in their entirety by the foregoing risks and uncertainties and speak only as of the date on which such statements are made. The Company undertakes no obligation to revise or update such forward-looking statements to reflect events or circumstances after the date on which the statements are made or to reflect the occurrence of unanticipated events. 50
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