FARMERS NATIONAL BANC CORP /OH/ (FMNB) FY 2021 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following presents a discussion and analysis of Farmers’ financial condition and results of operations by its management. The review highlights the principal factors affecting earnings and the significant changes in balance sheet items for the years 2021, 2020 and 2019.  Financial information for prior years is presented when appropriate.  The objective of this financial review is to enhance the reader’s understanding of the accompanying tables and charts, the consolidated financial statements, notes to financial statements and financial statistics appearing elsewhere in this Annual Report on Form 10-K.  Where applicable, this discussion also reflects management’s insights of known events and trends that have or may reasonably be expected to have a material effect on Farmers’ business, financial condition or results of operations.

Cautionary Note Regarding Forward Looking Statements

This Annual Report on Form 10-K contains “forward-looking statements” within the meaning of the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. These forward-looking statements are not statements of historical fact, but rather statements based on Farmers’ current expectations, beliefs and assumptions regarding the future of Farmers’ business, future plans and strategies, projections, anticipated events and trends, its intended results and future performance, the economy and other future conditions.  Forward-looking statements are preceded by terms such as “will,” “would,” “should,” “could,” “may,” “expect,” “estimate,”  “believe,” “anticipate,” “intend,” “plan” “project,” or variations of these words, or similar expressions.  Forward-looking statements are not a guarantee of future performance, and actual future results could differ materially from those contained in forward-looking information. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict and many of which are outside of our control. Numerous uncertainties, risks, and changes could cause or contribute to Farmers’ actual results, performance, and achievements to be materially different from those expressed or implied by the forward-looking statements.  Factors that could cause or contribute to such differences include, without limitation, risks and uncertainties detailed from time to time in Farmers’ filings with the Securities and Exchange Commission, including without limitation the risk factors disclosed in Item 1A, “Risk Factors” of this Annual Report on Form 10-K.

Many of these factors are beyond the Company’s ability to control or predict, and readers are cautioned not to put undue reliance on those forward-looking statements.  The following, which is not intended to be an all-encompassing list, summarizes several factors that could cause the Company’s actual results to differ materially from those anticipated or expected in any forward-looking statement:

Other factors not currently anticipated may also materially and adversely affect the Company’s results of operations, cash flows and financial position.  There can be no assurance that future results will meet expectations.

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While the Company believes that the forward-looking statements in the presentation are reasonable, you should not place undue reliance on any forward-looking statement. In addition, these statements speak only as of the date made.  The Company does not undertake, and expressly disclaims, any obligation to update or alter any statements whether as a result of new information, future events or otherwise, expect as may be required by applicable law.

Results of Operations

Comparison of Operating Results for the Years Ended December 31, 2021 and 2020.

The Company reported net income of $51.8 million for the year ended December 31, 2021, compared to $41.9 million for the year ended December 31, 2020.    On a diluted per common share basis, the Company reported $1.77 in 2021 and $1.47 in 2020.  The results for 2021 include two months of income and expenses from Cortland compared to none in 2020 along with acquisition-related expense and additional provision for credit losses as a result of the merger and the adoption of CECL.

On November 1, 2021, the Company completed its acquisition of Cortland Bancorp (“Cortland”) for consideration consisting of a combination of cash and stock.  Under the terms of the merger agreement, shareholders of Cortland were able to receive either $28 per share in cash or 1.75 shares of the Company’s common stock, subject to an overall limitation of 75% of the shares being exchanged for Company shares and 25% for cash.  The Company issued 5.6 million shares of its common stock along with cash of $29.6 million, which represented a transaction value of approximately $128.5 million based on its closing stock price of $17.82 on October 31, 2021, the closing of the merger.  Goodwill of $48.5 million arising from the acquisition consisted largely of synergies and the cost savings resulting from the combining of the entities.

Net Interest Income

The Company’s net interest income represents the difference between the interest income earned on interest-earning assets and the interest expense paid on interest-bearing liabilities.  Net interest income was $108.0 million for the year ended December 31, 2021, compared to $96.2 million for the year ended December 31, 2020.  The tax-equivalent net interest margin was 3.45% for the year ended December 31, 2021, compared to 3.70% for the year ended December 31, 2020.  The margin declined due to the continued low level of treasury rates and the federal funds rate, both of which has impacted asset yields more negatively than deposit costs.  In addition, the balance of securities available for sale as a percentage of interest earning assets is higher in 2021 than in 2020.  These balances generally have a lower yield than loans, which, in turn, negatively impacts the net interest margin.

Total interest income increased to $116.5 million for the year ended December 31, 2021 compared to $112.3 million for the year ended December 31, 2020.  The increase of $4.2 million was primarily due to an increase in the income on taxable and tax-exempt securities offset by a decline in the interest earned on loans.

The average balance of loans decreased $21.6 million for the year ended December 31, 2021 while the yield on loans declined to 4.66% in 2021 from 4.79% in 2020, which caused interest income on loans to decline $3.6 million in 2021 to $94.8 million.  The decline in average loan balances was primarily due to the payoff of PPP loans along with declines in other loan categories due to high levels of customer liquidity and refinance opportunities offset by the addition of Cortland’s loan balances.

The increase in income on taxable and tax-exempt securities to $20.9 million in 2021 compared to 2020 was primarily due to an increase in the average balance on these securities of $505.9 million offset by a decline in their yield.  During 2021, the Company continued to invest excess cash balances into securities.

Interest expense declined $7.7 million to $8.5 million in 2021 compared to $16.1 million in 2020.  The decrease was due to a 45 basis point decline in the cost of interest-bearing liabilities offset by an increase in average interest-bearing liabilities of $313.5 million.  The average balance of interest-bearing deposits increased $342.7 million to $2.2 billion at December 31, 2021.  Interest expense related to interest-bearing deposits was $6.8 million in 2021 compared to $14.4 million in 2020.

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Interest on short-term borrowings declined to $7 thousand in 2021 compared to $359 thousand in 2021 as the Company paid off these borrowings in 2021.  Interest on long-term borrowings increased to $1.7 million in 2021 from $1.4 million in 2020.

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Average Balance Sheets and Related Yields and Rates

(Table Dollar Amounts in Thousands except Per Share Data)

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RATE AND VOLUME ANALYSIS

(Table Dollar Amounts in Thousands except Per Share Data)

The following table analyzes by rate and volume the dollar amount of changes in the components of the interest differential:

The amount of change not solely due to rate or volume changes was allocated between the change due to rate and the change due to volume based on the relative size of the rate and volume changes.

Noninterest Income

Total noninterest income increased to $38.2 million for the year ended December 31, 2021 compared to $36.2 million for the year ended December 31, 2020.  The increase in noninterest income is mainly due to increases across many categories of noninterest income offset by declines in the gain on sale of loans.

Bank owned life insurance income increased by $543 thousand in 2021 from 2020 due to the purchase of more insurance at the end of 2020 and the addition of Cortland.

Trust fees increased to $9.4 million in 2021 from $7.6 million in 2020 while investment commissions increased by $746 thousand in 2021 compared to 2020.  Both of these categories benefitted from growth as well as the strong performance of the equity markets in 2021.

Insurance agency commissions increased to $3.5 million in 2021 from $3.1 million in 2020, an increase of 10.6%.  This growth was driven by increased business volume.

Security gains, including fair value changes on equity securities, increased by $624 thousand in 2021 to $1.0 million compared to gains of $380 thousand in 2020.  The Company elected to restructure a portion of its investment portfolio in 2021 that resulted in higher gains.

The net gains on the sale of loans declined by $3.1 million in 2021 to $8.3 million from $11.4 million in 2020.  The decline was due to a decline in margins as well as the volume of loans sold.  The decline was offset somewhat by the recognition of a $239 thousand gain on the sale of the Company’s credit card portfolio in 2021.

Debit card fees increased by $880 thousand in 2021 compared to 2020 due to increased activity along with the addition of Cortland for two months in 2021.

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Noninterest Expenses

Noninterest expense was $79.2 million for the year ended December 31, 2021, compared to $73.0 million in 2020, which was an increase of $6.2 million, or 8.5%.  The increase is primarily due to the merger and merger-related costs.

Salaries and employee benefits declined by $433 thousand to $39.4 million in 2021 compared to $39.8 million in 2020.  This decline was primarily due to the Company having a higher level of unfilled positions in 2021 compared to 2020 due to the continuing labor shortage offset by the addition of Cortland.  In addition, the benefit of deferred salary costs was greater in 2021 than in 2020.

Occupancy and equipment expense increased $1.2 million to $8.5 million in 2021 from $7.3 million in 2020.  The increase was due to Cortland and a higher level of facilities maintenance in 2021 compared to 2020.

Professional fees increased to $4.2 million in 2021 from $2.7 million in 2020.  The increase was due to Cortland and a higher level of consulting expense in 2021.

Merger related costs increased to $7.1 million in 2021 compared to $3.2 million in 2020.  This increase was due to the acquisition of Cortland in 2021, which was a larger acquisition than the acquisition of Maple Leaf in 2020.

State and local taxes increased $139 thousand in 2021 to $2.3 million.  Advertising increased $328 thousand to $1.9 million in 2021 and core processing charges declined by $353 thousand in 2021 to $3.2 million.

Income Taxes

Income tax expense increased to $10.3 million for 2021 compared to $8.4 million in 2020.  The increase was due to an $11.8 million increase in income before income taxes.  Income taxes are computed using the appropriate effective tax rates for each period.  The effective tax rates are less than the statutory tax rate primarily due to nontaxable interest and dividend income.  The effective income tax rate was 16.5% for 2021 and 16.7% for 2020.  The decreased effective tax rate is due to additions to the non-taxable municipal securities portfolio.  Refer to Note 18 to the consolidated financial statements for additional information regarding the effective tax rate.

Comparison of Operating Results for the Years Ended December 31, 2020 and 2019.

The Company’s net income totaled $41.9 million during 2020, compared to $35.8 million for 2019.  On a per share basis, diluted earnings per share were $1.47 as compared to $1.28 diluted earnings per share for 2019.  Return on average assets and return on average equity were 1.46% and 12.80%, respectively, for the year ending December 31, 2020, compared to 1.50% and 12.56% for 2019.

On January 7, 2020, the Company completed the acquisition of Maple Leaf Financial, Inc. (“Maple Leaf”), the parent company of Geauga Savings Bank, with branches located in Cuyahoga and Geauga Counties in Ohio.  The transaction involved both cash and 1,398,229 shares of stock totaling $43.0 million.  Pursuant to the terms of the Merger Agreement, common shareholders of Maple Leaf had the right to receive $640.00 in cash or 45.5948 common shares, without par value, of the Company, subject to an overall limitation of 50% of the Maple Leaf common shares being exchanged for Farmers common shares and 50% exchanged for cash.  Holders of outstanding and unexercised warrants to purchase Maple Leaf Common Shares received an amount in cash equal to the excess of $640.00 over $370.00, the exercise price of such warrants.  At January 7, 2020, Maple Leaf had total assets of $277.0 million, which included gross loans of $182.1 million, deposits of $183.1 million and equity of $32.1 million.

Net Interest Income

Net interest income, the principal source of the Company’s earnings, represents the difference between interest income on interest-earning assets and interest expense on interest-bearing liabilities.  For 2020, taxable equivalent net interest income increased $14.1 million, or 16.6%, from 2019.  Interest-earning assets averaged $2.664 billion during 2020, increasing $451.3 million compared to 2019.  The Company’s interest-bearing liabilities increased 19.2% from $1.656 billion in 2019 to $1.974 billion in 2020.

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The Company finances its earning assets with a combination of interest-bearing and interest-free funds.  The interest-bearing funds are composed of deposits, short-term borrowings and long-term debt.  Interest paid for the use of these funds is the second factor in the net interest income equation.  Interest-free funds, such as demand deposits and stockholders’ equity, require no interest expense and, therefore, contribute significantly to net interest income.

The profit margin, or spread, on invested funds is a key performance measure.  The Company monitors two key performance indicators - net interest spread and net interest margin.  The net interest spread represents the difference between the average rate earned on interest-earning assets and the average rate paid on interest-bearing liabilities.  The net interest spread in 2020 was 3.49%, decreasing from 3.53% in 2019.  The net interest margin represents the overall profit margin – net interest income as a percentage of total interest-earning assets.  This performance indicator gives effect to interest earned for all investable funds including the substantial volume of interest-free funds.  For 2020, the net interest margin, measured on a fully taxable equivalent basis, decreased to 3.70%, compared to 3.82% in 2019.

The decrease in net interest margin is mainly due to pressure on decreasing rates as the Federal Reserve Bank continued to cut the federal funds interest rate in 2020.  The Federal Reserve Bank cut the target federal funds rate to 0.00% - 0.25%.  Total taxable equivalent interest income was $114.7 million for 2020, which is $10.6 million more than the $104.1 million reported in 2019.  This increase is mainly due to the increase in average earning assets due to organic growth and the acquisition of Maple Leaf.  In comparing the years ending December 31, 2020 and 2019, yields on earning assets decreased 40 basis points while the cost of interest bearing liabilities decreased 36 basis points.  Average loans increased $305.1 million, or 17.4%, in 2020, however, the loan yield decreased 30 basis points to 4.79%.  Tax equated income from securities, federal funds and other increased $1.3 million, or 9.1%, in 2020.  Farmers saw its yields on these assets decrease from 3.22% in 2019 to 2.65% in 2020 and the average balance of investment securities and federal funds sold also increased from $454.5 million in 2019 to $600.7 million in 2020.

The decrease in the federal funds interest rate as mentioned above reduced the cost of short-term borrowings and interest-bearing deposits during 2020.  Total interest expense amounted to $16.1 million for 2020, a 17.7% decrease from $19.6 million reported in 2019.  Interest-bearing deposits increased $334.5 million or 21.8% and decreases in interest rates paid on deposits resulted in a $2.5 million or 14.7% decrease in interest expense on deposit balances.  Other borrowings balances decreased $16.2 million or 13.6% and the interest expense related to these borrowings decreased $1.0 million or 36.1%.  The total cost of interest-bearing deposits and borrowings decreased from 1.18% in 2019 to 0.82% in 2020.

Management will continue to evaluate future changes in interest rates and the shape of the treasury yield curve so that assets and liabilities may be priced accordingly to minimize the impact on the net interest margin.

Noninterest Income

Total noninterest income increased by $8.1 million, or 29.0% in 2020.  The increase in noninterest income is mainly due to net gains on the sale of loans increasing from $3.8 million in 2019 to $11.4 million in 2020 and the increase in debit card and EFT fees increasing from $3.9 million in 2019 to $4.3 million in 2020.  This increase was partially offset by a decrease in income from service charges on deposit accounts of $832 thousand.  The Bank and the Company expect noninterest income to remain steady or decrease slightly during 2021 as management expects the gain on sales of mortgage loans to be reduced in 2021.

Noninterest Expenses

Noninterest expense for 2020 was $73.0 million, compared to $64.9 million in 2019, representing an increase of $8.1 million, or 12.5%.  Most of the increase was from salaries and employee benefits, which grew $2.6 million or 7.1%, mainly due to a temporary increase in FTE counts from the acquisition of Maple Leaf, employee bonuses paid as a result of COVID-19 and annual merit increases.  Other operating expenses increased by $1.5 million, or 15.9% as a result of increased captive insurance company losses, as members of the pool made claims for the COVID-19 pandemic.  These increases were slightly offset by a drop in professional fees of $389 thousand, or 12.5%, and litigation settlement expenses of $505 thousand.

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Income Taxes

Income tax expense totaled $8.4 million for 2020 and $7.3 million in 2019.  Income taxes are computed using the appropriate effective tax rates for each period.  The effective tax rates are less than the statutory tax rate primarily due to nontaxable interest and dividend income.  The effective income tax rate was 16.7% for 2020 and 17.0% for 2019.  The decreased effective tax rate is due to additions to the non-taxable municipal securities portfolio.  We anticipate that the effective rate in 2021 will be in the range of 15% to 17%.  Refer to Note 18 to the consolidated financial statements for additional information regarding the effective tax rate.

Loan Portfolio

Maturities and Sensitivities of Loans to Interest Rates

The following schedule shows the composition of loans and the percentage of loans in each category at the dates indicated. Balances include unamortized loan origination fees and costs.

The following schedule sets forth maturities based on remaining scheduled repayments of principal for loans listed above as of December 31, 2021:

The amounts of loans as of December 31, 2021, based on remaining scheduled repayments of principal, are shown in the following table:

Total loans were $2.3 billion at year-end 2021, compared to $2.1 billion at year-end 2020 representing an increase of 12.2%.  Excluding the $482.2 million of loans added from the Cortland acquisition, loans decreased 11.0%.  The decrease in loans can be attributed to the difficult lending environment, the payoff and forgiveness of the PPP loans and the $3.0 million sale of the credit card portfolio.  Loans comprised 64.0% of the Bank’s average earning assets in 2021, compared to 77.5% in 2020.  The product mix in the loan portfolio includes commercial real estate loans 43.3%, commercial loans comprising 13.4%, residential real estate loans 24.9%, consumer loans 8.4% and agricultural loans 10.0% at December 31, 2021, compared with 34.3%, 19.3%, 25.2%, 10.0% and 11.2%, respectively, at December 31, 2020.

Loans contributed 80.0% of total taxable equivalent interest income in 2021 and 86.1% in 2020.  Loan yields were 4.66% in 2021, 94 basis points greater than the average rate for total earning assets.  Management recognizes

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that while the loan portfolio holds some of the Bank’s’ highest yielding assets, it is inherently the most risky portfolio.  Accordingly, management attempts to balance credit risk versus return with conservative credit standards.  Management has developed and maintains comprehensive underwriting guidelines and a loan review function that monitors credits during and after the approval process.  To minimize risks associated with changes in the borrower’s future repayment capacity, the Bank generally requires scheduled periodic principal and interest payments on all types of loans and normally requires collateral. Commercial real estate loans increased from $712.8 million at December 31, 2020 to $1.0 billion at December 31, 2021, an increase of $297.9 million or 41.8%.  $313.7 million coming from the acquisition of Cortland.  The Company’s commercial real estate loan portfolio includes loans for owner occupied and non-owner occupied real estate.  These loans are made to finance properties such as office and industrial buildings, hotels and retail shopping centers.

Residential real estate mortgage loans increased 10.9% to $580.2 million at December 31, 2021, compared to $523.3 million in 2020.  Cortland contributed $86.2 million at the acquisition date.  Farmers originated both fixed rate and adjustable rate mortgages during 2021.  Fixed rate terms are generally limited to fifteen-year terms while adjustable rate products are offered with maturities up to thirty years.

Commercial loans at December 31, 2021 decreased 22.1% from year-end 2020 with outstanding balances of $312.5 million.  The Bank’s commercial loans are granted to customers within the immediate trade area of the Bank.  The mix is diverse, covering a wide range of borrowers, business types and local municipalities.  The Bank monitors and controls concentrations within a particular industry or segment of the economy.  These loans are made for purposes such as equipment purchases, capital and leasehold improvements, the purchase of inventory, general working capital and small business lines of credit.

Agricultural loans increased from $232.0 million in 2020 to $232.3 million in 2021, an increase of $250 thousand.  The Company’s agricultural loan portfolio contains a diverse mix of dairy, crops, land, poultry and cattle loans.

Summary of Credit Loss Experience

The following is an analysis of the allowance for credit losses for 2021.  During 2021 the Company used the CECL methodology while the incurred loss methodology was used in prior years:

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Provisions charged to operations amounted to $4.9 million in 2021, compared to $9.1 million in 2020, a decrease of $4.2 million.  The reduced provision for the current year was mainly a result of current economic conditions resulting from the improvement in the COVID-19 pandemic.

The Company adopted ASU 2016-13 to calculate the allowance for credit losses (“ACL”) which requires projecting credit losses over the lifetime of the credits.  The ACL is adjusted through the provision for credit losses and reduced by net charge offs of loans.  Although the Company has a diversified loan portfolio, the credit risk in the loan portfolio is largely influenced by general economic conditions and trends of the counties and markets in which the debtors operate, and the resulting impact on the operations of borrowers or on the value of any underlying collateral.

The credit loss estimation process involves procedures that consider the unique characteristics of the Company’s loan portfolio segments.  These segments are disaggregated into the loan pools for monitoring.  A model of risk characteristics, such as loss history and delinquency experience, trends in past due and non-performing loans, as well as existing economic conditions and supportable forecasts used to determine credit loss assumptions.

The Company uses two methodologies to analyze loan pools.  The cohort method (“cohort”) and the probability of default/loss given default (“PD/LGD”).  Cohort relies on the creation of cohorts to capture loans that qualify for a particular segment, as of a point in time. Those loans are then tracked over their remaining lives to determine their loss experience.  The Company aggregates financial assets on the basis of similar risk characteristics when evaluating loans on a collective basis.  Those characteristics include, but aren’t limited to, internal or external credit score, risk ratings, financial asset, loan type, collateral type, size, effective interest rate, term, or geographical location.  The Company uses cohort primarily for consumer loan portfolios.

The probability of default (“PD”) portion of PD/LGD is defined by the Company as 90 days past due, placed on non-accrual, becomes a troubled debt restructuring or is partially, or wholly, charged-off.  Typically, a one-year time period is used to asses PD.  PD can be measured and applied using various risk criteria.  Risk rating is one common way to apply PDs.  Loss given default (“LGD”) is to determine the percentage of loss by facility or collateral type.  LGD estimates can sometimes be driven, or influenced, by product type, industry or geography.  The Company uses PD/LGD primarily for commercial loan portfolios.

Net charge-offs for the year ended December 31, 2021 were $862 thousand, $581 thousand or 40.3% less than net charge-offs for the year ended December 31, 2020.  The allowance for credit losses to total loans increased to 1.26% at December 31, 2021 compared to 1.07% at December 31, 2020.  Nonperforming loans to total loans increased from 0.67% at December 31, 2020 to 0.69% at December 31, 2021.

In accordance with the accounting relief provisions of CARES and subsequent provisions of the Health and Economic Recovery Omnibus Emergency Solutions (HEROES) Acts, the Bank postponed the adoption of the current expected credit losses (“CECL”) accounting standard, in 2020, primarily due to the impact that the COVID-19 pandemic was having on the economy and the lack of reasonable and supportable economic forecasts.  The Company adopted ASU 2016-13 on January 1, 2021.  The Company recorded the one-time adjustment to equity, to comply with the ASU adoption, which increased the allowance for credit losses by $1.9 million, net of tax.

The provision for credit losses charged to operating expense is based on management’s judgment after taking into consideration all factors connected with the collectability of the existing loan portfolio.  Management evaluates the loan portfolio in light of economic conditions, changes in the nature and volume of the loan portfolio, industry standards and other relevant reasonable and supportable forecasts.  Specific factors considered by management in determining the amounts charged to operating expenses include previous charge-off experience, the status of past due interest and principal payments, the quality of financial information supplied by loan customers and the general condition of the industries in the community to which loans have been made.

The allowance for credit losses increased $7.2 million during the year.  The increase is the result of the impact of CECL adoption, day one purchase accounting for the Cortland acquisition and the provision.

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Typically, commercial and commercial real estate loans are identified as collateral dependent when they become ninety days past due, or earlier if management believes it is probable that the Company will not collect all amounts due under the terms of the loan agreement.  When Farmers identifies a loan and concludes that the loan is collateral dependent, Farmers performs an internal collateral valuation as an interim measure.  Farmers typically obtains an external appraisal to validate its internal collateral valuation as soon as is practical and adjusts the associated specific loss reserve, if necessary.

The ratio of the allowance for credit losses to non-performing loans at December 31, 2021 was 181.5%, compared to 160.06% at December 31, 2020.  This was mainly due to the adoption of the new CECL methodology in 2021.  The percentage of non-performing loans to total loans increased slightly from 0.67% in 2020 to 0.69% in 2021.  The balance in the allowance for credit losses also increased in 2021 to $29.4 million from $22.1 million in 2020.  This is mainly due to the adoption of CECL and to the increased loan portfolio size.

The Company has forgone interest income of approximately $473 thousand from nonaccrual loans as of December 31, 2021 that would have been earned, over the life of the loans, if all loans had performed in accordance with their original terms.

The Company offered three-month deferrals upon request by borrowers.  For those borrowers in industries that were greatly impacted by COVID-19, additional deferrals were considered and granted beyond the initial three month period.  The range of the deferred months for subsequent requests were three to twelve months.  The decline in deferred loans and balances is due to borrowers not requesting additional deferments and most continued to pay under the original terms of their loan.

Net charge-offs as a percentage of average loans outstanding increased slightly from 0.04% for 2020 to 0.06% for 2021 as a result of average loans decreasing due to forgiveness and payoffs of PPP loans.  Net charge-offs decreased from $1.4 million in 2020 to $862 thousand in 2021.  A decrease in gross charge-offs was experienced in the consumer loan portfolio of $435 thousand but that was offset by an increase in gross charge-offs in the residential real estate loan portfolio of $125 thousand.

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The following table summarizes the Company’s allocation of the allowance for credit losses for under CECL for 2021 and the allowance for loan losses for prior years:

The allowance allocated to each of the four loan categories should not be interpreted as an indication that charge-offs in 2021 occurred in the same proportions or that the allocation indicates future charge-off trends.  The allowance allocated to the one-to-four family real estate loan category and the consumer loan category is based upon the Company’s allowance methodology for homogeneous loans, and increases and decreases in the balances of those portfolios.  The consumer loan category represents approximately 8.4% of total loans and in 2021, the gross charge-offs accounted for 54.7% of the losses of the entire loan portfolio.  For the commercial loan category, which represents 15.7% of the total loan portfolio, management relies on the Bank’s internal loan review procedures and allocates accordingly based on loan classifications.  The gross charge-offs in the commercial loan portfolio, was $388 thousand for 2021.

There were no loans other than those identified above, that management has known information about possible credit problems of borrowers and their ability to comply with the loan repayment terms.  Management is actively monitoring certain borrowers’ financial condition and loans which management wants to more closely monitor due to special circumstances.  These loans and their potential loss exposure have been considered in management’s analysis of the adequacy of the allowance for credit losses.

Loan Commitments and Lines of Credit

In the normal course of business, the Bank has extended various commitments for credit. Commitments for mortgages, revolving lines of credit and letters of credit generally are extended for a period of one month up to one year.  Normally, no fees are charged on any unused portion, but an annual fee of two percent is charged for the issuance of a letter of credit.

As of December 31, 2021, there were no concentrations of loans exceeding 10% of total loans that are not disclosed as a category of loans.  As of that date, there were also no other interest-earning assets that are either nonaccrual, past due, restructured or non-performing.

Investment Securities

The investment securities portfolio increased $852.1 million in 2021 to $1.4 billion at December 31, 2021 from $575.6 million at December 31, 2020.  This increase is primarily a result of the Company deploying cash generated from the large inflow of deposits in 2021.  In addition, the Company acquired $130.6 million in investment securities pursuant to the merger with Cortland.  This growth was partially offset by runoff, sales amortization and changes in fair value.  For additional information regarding Farmers’ investment securities see Note 3 to the Consolidated Financial Statements.

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The following table shows the carrying value of investment securities by type of obligation at the dates indicated:

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A summary of debt securities held at December 31, 2021 classified according to maturity and including weighted average yield for each range of maturities is set forth below:

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Premises and Equipment

Premises and equipment increased to $37.5 million at December 31, 2021 compared to $25.6 million at December 31, 2020.  This increase was primarily due to the addition of $12.6 million in fixed assets acquired in the merger offset by depreciation.

Bank Owned Life Insurance

Farmers owns bank owned life insurance policies on the lives of certain members of management.  The purpose of this investment is to help fund the costs of employee benefit plans.  The cash surrender value of these policies was $73.9 million at December 31, 2021, compared to $51.3 million at December 31, 2020.  The increase was primarily due to policies acquired in the current year merger, along with positive changes in the fair value of the policies.

Deposits

Total deposits at December 31, 2021, were $3.5 billion compared to $2.6 billion at December 31, 2020, an increase of $936.4 million, which includes $695.3 million from the merger.  Non-interest bearing deposits increased $307.4 million during 2021 to $916.2 million while interest-bearing deposits increased $660.9 million to $2.6 billion.  In addition to the increase in deposit balances from the merger, the Company saw significant organic growth as customers continued to deposit additional funds to their accounts throughout the year.  The Company has access to the brokered certificate of deposit market and FHLB borrowing capacity if any of this deposit growth should begin to reverse.

Average balances and average rates paid on deposits are as follows:

The following table sets forth the maturities of retail certificates of deposit having principal amounts $250,000 or greater at December 31, 2021 (in thousands):

Uninsured deposits for bank and savings and loan registrants are U.S. federally insured depository institutions as the portion of deposit accounts in U.S. offices that exceed the FDIC insurance limit or similar state deposit insurance regimes and amounts in any other uninsured investment or deposit account that are classified as

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deposits and not subject to any federal or state deposit insurance regimes.  Deposits in amounts in excess of the FDIC insurance limit were $1.16 billion at December 31, 2021.

Short-Term Borrowings

Farmers did not have any short-term borrowings at December 31, 2021 compared to $2.5 million at December 31, 2020.  See Note 12 within Item 8 of this Annual report on Form 10-K for additional detail.

Long-Term Borrowings

Total long-term borrowings increased $11.4 million to $87.8 million at December 31, 2021, from $76.4 million at December 31, 2020.  During 2021, the Company paid off FHLB advances totaling $67.0 million and assumed $4.3 million of junior subordinated debt securities in the merger with Cortland.  In addition, in November 2021, the Company completed the issuance of $75.0 million aggregate principal amount, fixed-to-floating rate subordinated notes due December 15, 2031, in a private offering exempt from the registration requirements under the Securities Act of 1933, as amended.  The notes carry a fixed rate of 3.125% for five years at which time they will convert to a floating rate based on the three-month term secured overnight funding rate, plus a spread of 220 basis points.  The Company may, at its option, beginning December 15, 2026, redeem the notes, in whole or in part, from time to time, subject to certain conditions.  The net proceeds from the sale were approximately $73.8 million, after deducting the offering expenses.  See Note 13 within Item 8 of this Annual report on Form 10-K for additional detail.

Stockholders’ Equity

Total stockholders’ equity increased to $472.4 million at December 31, 2021 from $350.1 million at December 31, 2020.  The increase is due to $98.9 million for the share issuance for the merger with Cortland, net income of $51.8 million and a reduction in treasury stock balances.  This was offset by the dividends paid on common stock during 2021, the cumulative impact of ASU 2016-13 adoption (CECL) and a decline in accumulated comprehensive income.

Contractual Obligations, Commitments, Contingent Liabilities and Off-Balance Sheet Arrangements

The following table presents, as of December 31, 2021, the Company’s significant fixed and determinable contractual obligations by payment date.  The payment amounts represent those amounts contractually due to the recipient and do not include any unamortized premiums or discounts or other similar carrying value adjustments.  Further discussion of the nature of each obligation is included in the referenced note to the consolidated financial statements.

There is also a $7.2 million additional commitment to SBIC investment funds over the next several years.  The payments have no predetermined due dates at year-end 2021.  Note 13 to the consolidated financial statements discusses in greater detail other commitments and contingencies and the various obligations that exists under those agreements.  Examples of these commitments and contingencies include commitments to extend credit and standby letters of credit.

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At December 31, 2021, the Company did not engage in derivatives or hedging contracts that may expose the Company to liabilities greater than the amounts recorded on the consolidated balance sheet.  Management’s policy is to not engage in derivatives contracts for speculative trading purposes.  The Company does utilize interest-rate swaps as a way of helping manage interest rate risk and not as derivatives for trading purposes.  See Note 22 within Item 8 of this Annual report on Form 10-K for additional detail.

Liquidity

The principal sources of funds for the Bank are deposits, loan and security repayments, borrowings from financial institutions, repurchase agreements and other funds provided by operations. The Bank also has the ability to borrow from the FHLB. While scheduled loan repayments and maturing investments are relatively predictable, deposit flows and early loan prepayments are more influenced by interest rates, general economic conditions and competition. Investments in liquid assets maintained by the Company and the Bank are based upon management’s assessment of (1) the need for funds, (2) expected deposit flows, (3) yields available on short-term liquid assets, and (4) objectives of the asset and liability management program.

The Bank’s Asset/Liability Committee (ALCO) is responsible for monitoring liquidity guidelines, policies and procedures. ALCO uses a variety of methods to monitor the liquidity position of the Bank including a liquidity analysis that measures potential sources and uses of funds over future time periods. ALCO also performs contingency funding analyses to determine the Bank’s ability to meet potential liquidity needs under stress scenarios that cover varying time horizons ranging from immediate to long-term.

At December 31, 2021, the Company had total on-hand liquidity, defined as total cash and cash equivalents, unencumbered securities and additional FHLB borrowing capacity, of $1.6 billion.

Capital Resources

The Bank, as a national chartered bank, is subject to the dividend restrictions set forth by the OCC.  The OCC must approve declaration of any dividends in excess of the sum of profits for the current year and retained net profits for the preceding two years (as defined).  Farmers and Farmers Bank are required to maintain minimum amounts of capital to total “risk weighted” assets, as defined by the banking regulators.  At December 31, 2021, under the minimum capital requirements associated with the Basel Committee on capital and liquidity regulation (Basel III), Farmers Bank and Farmers are required to have actual and minimum capital ratios, which are detailed in Note 16 of the Consolidated Financial Statements.  Farmers Bank and Farmers had capital ratios above the minimum levels at December 31, 2021 and 2020.  At year-end 2021 and 2020, the most recent regulatory notifications categorized Farmers Bank as well capitalized under the regulatory framework for prompt corrective action.

During 2013, the Federal banking regulators approved a final rule to implement revised capital adequacy standards of the Basel Committee on Banking Supervision, commonly called Basel III, and to address relevant provisions of the Dodd-Frank Act.  The final rule strengthens the definition of regulatory capital, increases risk-based capital requirements, makes selected changes to the calculation of risk-weighted assets, and adjusts the prompt corrective action thresholds.  The Bank has retained, through a one-time election, the prior treatment for most accumulated other comprehensive income, such that unrealized gains and losses on securities available for sale that did not affect regulatory capital amounts and ratios.  As mentioned in the prior paragraph, the Bank falls within the new regulatory capital ratio guidelines.

Critical Accounting Policies

The Company follows financial accounting and reporting policies that are in accordance with generally accepted accounting principles in the United States of America and conform to general practices within the banking industry.  Some of these accounting policies are considered to be critical accounting policies.  Critical accounting policies are those policies that require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.  The Company has identified three accounting policies that are critical accounting policies and an understanding of these policies is

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necessary to understand the financial statements.  These policies relate to determining the adequacy of the allowance for credit losses, if there is any impairment of goodwill and other intangibles, and estimating the fair value of assets acquired and liabilities assumed in connection with any merger activity.  Additional information regarding these policies is included in the notes to the consolidated financial statements, including Note 1 (Summary of Significant Accounting Policies), Note 4 (Loans) and Note 2 (Business Combinations), and the section above captioned “Loan Portfolio.”  Management believes that the judgments, estimates and assumptions used in the preparation of the consolidated financial statements are appropriate given the factual circumstances at the time.

Farmers maintains an allowance for credit losses.  The allowance for credit losses is presented as a reserve against loans on the balance sheets.  Credit losses are charged off against the allowance for credit losses, while recoveries of amounts previously charged off are credited to the allowance for credit losses.  A provision for credit losses is charged to operations based on management’s periodic evaluation of adequacy of the allowance.  The provision for credit losses provides for probable losses on loans.

The credit loss estimation process involves procedures that consider the unique characteristics of the Company’s loan portfolio segments.  These segments are disaggregated into the loan pools for monitoring.  A model of risk characteristics, such as loss history and delinquency experience, trends in past due and non-performing loans, as well as existing economic conditions and supportable forecasts used to determine credit loss assumptions.

The Company uses two methodologies to analyze loan pools.  The cohort method and the PD/LGD.  Cohort relies on the creation of cohorts to capture loans that qualify for a particular segment, as of a point in time. Those loans are then tracked over their remaining lives to determine their loss experience.  The Company aggregates financial assets on the basis of similar risk characteristics when evaluating loans on a collective basis.  Those characteristics include, but are not limited to, internal or external credit score, risk ratings, financial asset, loan type, collateral type, size, effective interest rate, term, or geographical location.  The Company uses cohort primarily for consumer loan portfolios.

The probability of default (“PD”) portion of PD/LGD is defined by the Company as 90 days past due, placed on non-accrual, becomes a troubled debt restructuring or is partially, or wholly, charged-off.  Typically, a one-year time period is used to asses PD.  PD can be measured and applied using various risk criteria.  Risk rating is one common way to apply PDs.  Loss given default (“LGD”) is to determine the percentage of loss by facility or collateral type.  LGD estimates can sometimes be driven, or influenced, by product type, industry or geography.  The Company uses PD/LGD primarily for commercial loan portfolios.

Management believes that the accounting for goodwill and other intangible assets also involves a higher degree of judgment than most other significant accounting policies.  GAAP establishes standards for the amortization of acquired intangible assets and the impairment assessment of goodwill.  Goodwill arising from business combinations represents the value attributable to unidentifiable intangible assets in the business acquired.  The Company’s goodwill relates to the value inherent in the banking industry and that value is dependent upon the ability of the Company’s subsidiaries to provide quality, cost-effective services in a competitive marketplace.  The goodwill value is supported by revenue that is in part driven by the volume of business transacted.  A decrease in earnings resulting from a decline in the customer base or the inability to deliver cost-effective services over sustained periods can lead to impairment of goodwill that could adversely impact earnings in future periods.  GAAP requires an annual evaluation of goodwill for impairment, or more frequently if events or changes in circumstances indicate that the asset might be impaired.  The fair value of the goodwill is estimated by reviewing the past and projected operating results for the subsidiaries and comparable industry information.  At December 31, 2021, on a consolidated basis, Farmers had intangibles of $8.4 million subject to amortization and $94.2 million in goodwill, which was not subject to periodic amortization.

The Company accounts for acquisitions under Financial Accounting Standards Board (“FASB”) ASC Topic 805, Business Combinations, which requires the use of the acquisition method of accounting.  Assets acquired and liabilities assumed in a business combination are recorded at the estimated fair value on their purchase date.  As provided for under GAAP, management has up to 12 months following the date of the acquisition to finalize the fair values of acquired assets and assumed liabilities, where it was not possible to estimate the acquisition date fair value upon consummation.  Management finalized the fair values of acquired assets and assumed liabilities within this 12-

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month period and management currently considers such values to be the Day 1 Fair Values for the acquisition transactions.  In particular, the valuation of acquired loans involves significant estimates, assumptions and judgment based on information available as of the acquisition date. Loans acquired in a business combination transaction are evaluated either individually or in pools of loans with similar characteristics; including consideration of a credit component.  A number of factors are considered in determining the estimated fair value of purchased loans including, among other things, the remaining life of the acquired loans, estimated prepayments, estimated loss ratios, estimated value of the underlying collateral, estimated holding periods, contractual interest rates compared to market interest rates, and net present value of cash flows expected to be received.

Recent Accounting Pronouncements and Developments

Note 1 to the consolidated financial statements discusses new accounting policies adopted by Farmers during 2021 and 2020 and the expected impact of accounting policies recently issued or proposed but not yet required to be adopted.  To the extent the adoption of new accounting standards materially affects financial condition, results of operations or liquidity, the impacts are discussed in the applicable sections of this financial review and notes to the consolidated financial statements.