FIRST NATIONAL CORP /VA/ (FXNC) FY 2024 MD&A

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

The following discussion and analysis of the financial condition and results of operations of the Company for the years ended December 31, 2024 and 2023 should be read in conjunction with the consolidated financial statements and related notes to the consolidated financial statements included in Item 8 of this Form 10-K.

Critical Accounting Policies

General

The Company’s consolidated financial statements and related notes are prepared in accordance with GAAP. The financial information contained within the statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset, or relieving a liability. The Bank uses historical losses as one factor in determining the inherent loss that may be present in the loan portfolio. Actual losses could differ significantly from the historical factors used. In addition, GAAP itself may change from one previously acceptable method to another. Although the economics of transactions would be the same, the timing of events that would impact transactions could change.

Presented below is a discussion of those accounting policies that management believes are the most important (Critical Accounting Policies) to the portrayal and understanding of the Company’s financial condition and results of operations. The Critical Accounting Policies require management’s most difficult, subjective, and complex judgments about matters that are inherently uncertain. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.

Allowance for Credit Losses on Loans

The allowance for credit losses on loans (ACLL) is established as losses are estimated to have occurred through a provision for credit losses charged to earnings. Loan losses are charged against the allowance when management determines that the loan balance is uncollectible. Subsequent recoveries, if any, are credited to the allowance. For further information about the Company’s loans and the ACLL, see Notes 1, 4, and 5 to the Consolidated Financial Statements included in this Form 10-K.

The ACLL is evaluated on a quarterly basis by management and is based on a discounted cash flow model to estimate its current expected credit losses. For the purposes of calculating its quantitative reserves, the Company has segmented its loan portfolio based on loans which share similar risk characteristics. Within the quantitative portion of the calculation, the Company utilizes at least one or a combination of loss drivers, which may include unemployment rates, home price indices, and/or gross domestic product (GDP), to adjust its loss rates over a reasonable and supportable forecast period of one year. A straight-line reversion technique is used for the following eight quarters, at which time the Company reverts to historical averages. To further adjust the allowance for credit losses for expected losses not already included within the quantitative component of the calculation, the Company may consider qualitative factors, including but not limited to: variability in the economic forecast, changes in volume and severity of adversity classified loans, changes in concentrations of credit, changes in the nature and volume of the loan segments, factors related to credit administration, and other idiosyncratic risks not embedded in the data used in the model.
This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The Company performs regular credit reviews of the loan portfolio to review credit quality and adherence to underwriting standards. The credit reviews consist of reviews by its internal credit administration department and reviews performed by an independent third party. Upon origination, each loan is assigned a risk rating ranging from one to nine, with loans closer to one having less risk. This risk rating scale is the Company's primary credit quality indicator. The Company has various committees that review and ensure that the allowance for credit losses methodology is in accordance with GAAP and loss factors used appropriately reflect the risk characteristics of the loan portfolio.

The allowance for loan credit losses represents an amount which, in management’s judgement, is adequate to absorb the lifetime expected losses that may be sustained on outstanding loans at the balance sheet date based on the evaluation of the size and current risk characteristics of the loan portfolio, past events, current conditions, reasonable and supportable forecasts of future economic conditions, and prepayment experience. The allowance for loan credit losses is measured and recorded upon the initial recognition of a financial asset. The allowance for loan credit losses is reduced by charge-offs, net of recoveries of previous losses, and is increased or decreased by a provision for (or recovery of) credit losses, which is recorded in the Consolidated Statement of Income. The evaluation also considers the following risk characteristics of each loan portfolio class:

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The ACLL consists of loans individually evaluated and loans collectively evaluated. Loans that do not share risk characteristics are evaluated on an individual basis. The Company designates individually evaluated loans on nonaccrual status as collateral dependent loans, as well as other loans that management of the Company designates as having higher risk and loans for which the repayment is expected to be provided substantially through the operation or sale of the collateral. These loans do not share common risk characteristics and are not included within the collectively evaluated loans for determining the allowance for credit losses. Under CECL, for collateral dependent loans, the Company has adopted the practical expedient to measure the allowance for credit losses based on the fair value of collateral. The allowance for credit losses is calculated on an individual loan basis based on the shortfall between the fair value of the loan’s collateral, which is adjusted for liquidation costs/discounts, and amortized cost. If the fair value of the collateral exceeds the amortized cost, no allowance is required. For further information regarding the ACLL, see Notes 1 and 5 to the Consolidated Financial Statements included in this Form 10-K.

The Company estimates expected credit losses on held-to-maturity securities on an individual basis based on a Probability of Default/Loss Given Default (PD/LGD) methodology primarily using security-level credit ratings. The primary indicators of credit quality for the Company’s held-to-maturity portfolio are security type and credit ratings, which are influenced by a number of factors including obligor cash flow, geography, seniority, among other factors. The Company’s held-to-maturity securities with credit risk are municipal bonds and corporate debt securities. All other held-to-maturity securities are covered by the explicit or implied guarantee of the United States government or one if its agencies.

Changes in the allowance for credit loss are recorded as provision for (or recovery of) credit losses in the Consolidated Statements of Income. The Company recorded an allowance for credit losses on held-to-maturity securities of $132 thousand upon adoption of ASC 326.

Management evaluates all available-for-sale securities in an unrealized loss position on a quarterly basis, and more frequently when economic or market conditions warrant such evaluation. If the Company has the intent to sell the security or it is more likely than not that the Company will be required to sell the security, the security is written down to fair value and the entire loss is recorded in earnings.

If either of the above criteria is not met, the Company evaluates whether the decline in fair value is the result of credit losses or other factors. In making the assessment, the Company may consider various factors including the extent to which fair value is less than amortized cost, downgrades in the ratings of the security by a rating agency, the failure of the issuer to make scheduled interest or principal payments and adverse conditions specific to the security. If the assessment indicates that a credit loss exists, the present value of cash flows expected to be collected are compared to the amortized cost basis of the security and any deficiency is recorded as an allowance for credit loss, limited by the amount that the fair value is less than the amortized cost basis. Any amount of unrealized loss that has not been recorded through an allowance for credit loss is recognized in other comprehensive income.

Changes in the allowance for credit loss are recorded as a provision for (or recovery of) credit losses in the Consolidated Statements of Income. Losses are charged against the allowance for credit loss when management believes an available-for-sale security is confirmed to be uncollectible or when either of the criteria regarding intent or requirement to sell is met.

Financial Instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit issued to meet customer financing needs. The Company’s exposure to credit losses in the event of nonperformance by the other party to the financial instrument for off-balance sheet loan commitments is represented by the contractual amount of those instruments. Such financial instruments are recorded when they are funded.

The Company records all allowance for credit losses on off-balance sheet credit exposures, unless the commitments to extend credit are unconditionally cancelable, through a charge to provision for (or recovery of) credit losses in the Consolidated Statement of Income. The allowances for credit losses on off-balance sheet credit exposures is estimated by loan segment at each balance sheet date under the current expected credit losses model using the same methodology as the loan portfolio, taking into consideration the likelihood that funding will occur as well as any third-party guarantees. The allowance for unfunded commitments is included in other liabilities on the Company’s consolidated balance sheet.

The loan portfolio includes commercial and industrial loans that were originated by a third-party and were acquired at premiums.  Premiums on performing loans are amortized into interest income and fees on loans over the life of the loans using the effective interest method. Premiums on non-performing loans are not amortized into interest income and fees on loans after loans are placed on non-accrual status and are included in the calculation of specific reserve component of the allowance for credit losses on loans for individually analyzed loans.

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Acquisition Accounting

The Company accounts for mergers and acquisitions that qualify as a business combination under ASC 805,
Business Combinations, which requires the use of the acquisition method of accounting. Under the acquisition method, we record all identifiable assets acquired, including intangible assets and the liabilities assumed at their fair values as of the acquisition date. Determining fair values of net assets acquired often involves estimates based on third-party valuations, such as appraisals or internal valuations based on discounted cash flow analysis or other valuation techniques. These methodologies are inherently subjective and involve significant assumptions, adjustments, and judgement around the selection of assumptions including, among others, discount rates, future expected cash flows, market conditions, and other future events that are highly subjective in nature and subject to change. The determination of the useful lives over which an intangible asset will be amortized is also subjective. While the selected fair values represent our best estimate of fair value as of the acquisition date, these estimates are inherently uncertain. In addition, the acquisition method of accounting allows for a measurement period to adjust acquisition accounting for up to one year after the acquisition date, for new information that existed at the acquisition date but may not have been known or available at that time. For further information, refer to Note 2 “Acquisitions” in Part I, Item 1 of this Annual Report.

Acquired loans are recorded at their fair value at acquisition date without carryover of the acquiree’s previously established ACLL, as credit discounts are included in the determination of fair value. The fair value of the loans is determined using market participant assumptions in estimating the amount and timing of both principal and interest cash flows expected to be collected on the loans and then applying a market-based discount rate to those cash flows. During evaluation upon acquisition, acquired loans are also classified as either PCD or Non-PCD. Acquired loans are subject to the Company’s ACLL policy upon acquisition.

For Non-PCD loans, the difference between the fair value and unpaid principal balance of the loan at acquisition date (premium or discount) is amortized or accreted into interest income over the life of the loans in accordance with ASC 310-20, Receivables – Nonrefundable Fees and Other Costs. If the acquired performing loan has revolving privileges, it is accounted for using the straight-line method; otherwise, the effective interest method is used.

PCD loans are loans that have experienced more-than-insignificant credit deterioration since origination. PCD loans are recorded at the amount paid. An ACLL is determined using the same methodology as other loans held for investment (LHFI). The sum of the loan’s purchase price and ACLL becomes its initial amortized cost basis. The difference between the initial amortized cost basis and the par value of the loan is a noncredit discount or premium, which is amortized into interest income over the life of the loan under ASC 310-20, Receivables – Nonrefundable Fees and Other Costs. If the loan has revolving privileges, the discount/premium is amortized/accreted using the straight-line method; otherwise, the effective interest method is used. Subsequent changes to the ACLL are recorded through provision expense.

Goodwill

The Company reviews the carrying value of goodwill at least annually or more frequently if certain impairment indicators exist. In testing goodwill for impairment, the Company first considers qualitative factors to determine whether the existence of events or circumstances lead to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the totality of events and circumstances, the Company concludes that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then no further testing would be required and the goodwill of the reporting unit would not be impaired. If the Company elects to bypass the qualitative assessment or if we conclude that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then the fair value of the reporting unit will be compared with its carrying value to determine whether an impairment exists.  The Company evaluated goodwill as of June 30, 2024 and determined there was no impairment.

Results of Operations

Executive Overview

The Company’s 2024 financial highlights:

Net Income

Net income decreased by $2.6 million to $7.0 million, or $1.00 per diluted share, for the year ended December 31, 2024, compared to $9.6 million, or $1.53 per diluted share, for the same period in 2023. Return on average assets was 0.44% and return on average equity was 5.33% for the year ended December 31, 2024, compared to 0.71% and 8.59%, respectively, for the year ended December 31, 2023.

The $2.6 million decrease in net income resulted from a $8.1 million increase in merger expenses associated with the Touchstone acquisition and a $1.7 million increase in provision for credit losses partially associated with the acquisition. These unfavorable variances were partially offset by a $9.0 million, or 21%, increase in net interest income, a $4.6 million, or 39%, increase in noninterest income, and a $1.1 million decrease in income tax expense.

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The following is selected financial data for the Company for the years ended December 31, 2024 and 2023. This information has been derived from audited financial information included in Item 8 of this Form 10-K (in thousands, except ratios and per share amounts).

For a more detailed discussion of the Company's annual performance, see "Net Interest Income,” “Provision for Credit Losses,” "Noninterest Income," "Noninterest Expense" and "Income Taxes" below.

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Non-GAAP Financial Measures

This report refers to the efficiency ratio, which is computed by dividing noninterest expense, excluding OREO expense, amortization of intangibles, and merger expenses, by the sum of net interest income on a tax-equivalent basis and noninterest income, excluding (gains)/losses on disposal of premises and equipment, and securities gains. This is a non-GAAP financial measure that the Company believes provides investors with important information regarding operational efficiency. Such information is not prepared in accordance with GAAP and should not be construed as such. Management believes, however, such financial information is meaningful to the reader in understanding operating performance, but cautions that such information not be viewed as a substitute for GAAP. The Company, in referring to its net income, is referring to income under GAAP. The components of the efficiency ratio calculation are summarized in the following table (dollars in thousands).

This report also refers to net interest margin, which is calculated by dividing tax equivalent net interest income by total average earning assets. Because a portion of interest income earned by the Company is nontaxable, the tax equivalent net interest income is considered in the calculation of this ratio. Tax equivalent net interest income is calculated by adding the tax benefit realized from interest income that is nontaxable to total interest income then subtracting total interest expense. The tax rate utilized in calculating the tax benefit for both 2024 and 2023 is 21%.  The reconciliation of tax equivalent net interest income, which is not a measurement under GAAP, to net interest income, is reflected in the table below (in thousands).

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Net Interest Income

Net interest income represents the primary source of earnings for the Company. Net interest income equals the amount by which interest income on interest-earning assets, predominantly loans and securities, exceeds interest expense on interest-bearing liabilities, including deposits, other borrowings, subordinated debt, and junior subordinated debt. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, are the components that impact the level of net interest income. The net interest margin is calculated by dividing tax-equivalent net interest income by average earning assets. The provision for credit losses, noninterest income, noninterest expense and income tax expense are the other components that determine net income. Noninterest income and expense primarily consists of income from service charges on deposit accounts, ATM and check card income, wealth management income, income from other customer services, income from bank owned life insurance, and general and administrative expenses.

Net interest income increased $9.0 million, or 21%, to $52.5 million for 2024 compared to the prior year. Total interest income increased by $18.6 million and was partially offset by total interest expense, which increased by $9.6 million.  The net interest margin increased by 10-basis points to 3.51% and average earnings assets increased by $224.0 million, or 17%, offset by a $186.2 million, or 22%, increase in average interest-bearing liabilities, in each case primarily related to the acquisition of Touchstone.

The increase in total interest income was primarily attributable to a $14.2 million, or 29%, increase in interest income and fees on loans. The increase in interest income on loans was attributable to a 52-basis point increase in the yield on loans and a 17% increase in average loan balances compared to the prior year in part due to the acquisition of Touchstone.

The increase in total interest expense was attributable to a $7.3 million increase in interest expense on deposits. The higher interest expense on deposits resulted from a 51-basis point increase in the cost of interest-bearing deposits and a 17% increase in average interest-bearing deposits in part due to the acquisition of Touchstone.  The increase in the cost of deposits was also impacted by a change in the composition of the deposit portfolio as lower cost deposit balances decreased, while higher cost deposit balances increased.

The net interest margin was 3.51% for the year ended December 31, 2024, compared to the 3.41% for the prior year as the increase in the yield on earning assets exceeded the increase in cost of funds during 2024. Net accretion income related to acquisition accounting was $408 thousand, or a three-basis point incremental increase to the net interest margin.

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The following table provides information on average interest-earning assets and interest-bearing liabilities for the years ended December 31, 2024 and 2023 as well as amounts and rates of tax equivalent interest earned and interest paid (dollars in thousands). The volume and rate analysis table analyzes the changes in net interest income for the periods broken down by their rate and volume components (in thousands).

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Provision for Credit Losses

Provision for credit losses totaled $7.9 million in 2024, compared to a provision for credit losses of $6.2 million for the prior year. The provision was comprised of a $7.8 million provision for credit losses on loans which includes $3.8 million Day-One provision on Non-PCD loans purchased from Touchstone, a $73 thousand provision for credit losses on unfunded commitments, and a $12 thousand recovery of credit losses on held-to-maturity securities.

For the year ended December 31, 2024, the provision for credit losses on loans of $7.8 million, the allowance for credit losses on acquired PCD loans of $386 thousand, and net charge offs of $3.8 million resulted in a $4.4 million increase in the allowance for credit losses on loans. The $3.8 million of net charge-offs included $2.3 million of loans purchased through a third-party lending program and $1.1 million of related unamortized purchase premiums on the loans.

The general reserve component of the ACLL increased $4.1 million and the specific reserve component of the ACLL increased $374 thousand. The increase in the general reserve was attributable to loan growth. Calculated loss rates were lower as were the inherent risks in the loan portfolio through adjustments to qualitative risk factors. The specific reserve increased by $374 thousand from individually evaluated loan relationships.

For the year ended December 31, 2023, the provision for credit losses on loans of $6.0 million, the adjustment for the adoption of ASU 2016-13 of $2.1 million, and net charge offs of $3.6 million resulted in a $4.5 million increase in the allowance for credit losses on loans. The $3.6 million of net charge-offs included $1.7 million of loans purchased through a third-party lending program and $830 thousand of related unamortized purchase premiums on the loans.

Noninterest Income

Noninterest income totaled $16.4 million for the year, which was a increase of $4.6 million, or 39%, compared to $11.8 million for the prior year. The increase was primarily a result of a bargain purchase gain of $2.9 million related to the Touchstone acquisition and a recovery on a purchased loan of $1.2 million.  Noninterest income categories with moderate increases over the prior year included brokered mortgage fees which increased $133 thousand, or 112%, fees for other customer services which increased $196 thousand, or 25%, wealth management fees which increased $497 thousand, or 16%, and service charges on deposits which increased $342 thousand, or 12%. Categories that decreased over the prior year included gain on sale of other investment which decreased $146 thousand, or 78%, and ATM and check card fees which decreased $144 thousand, or 4%.

Noninterest Expense

Noninterest expense increased $15.7 million, or 42%, for the year ended December 31, 2024, compared to the prior year.  The increase was primarily a result of merger expenses of $8.1 million and core deposit intangible amortization expense of $443 thousand. Categories with moderate increases over the prior year included salaries and employee benefits which increased $4.1 million, or 19%, equipment expense which increased $754 thousand, or 32%, legal and professional expense which increased $346 thousand, or 21%, occupancy expense which increased $419 thousand, or 19%, FDIC assessment increased by $227 thousand, or 36%, and  other operating expense which increased $706 thousand, or 16%. Each of these line items included the operating expenses of Touchstone for the last three months of 2024. Other operating expense increased from higher recruiting expense, directors fees, card cash expense, education and training, loan collection expense, item processing expense, and courier and armored services.

The Company estimates that it will incur additional pre-tax merger related expenses of approximately $4.2 million during the first quarter of 2025.

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Income Taxes

Income tax expense decreased $1.1 million during the year ended
December 31, 2024
compared to the prior year. The Company’s income tax expense differed from the amount of income tax determined by applying the U.S. federal income tax rate to pretax income for the year ended
December 31, 2024
and 2023. The difference was a result of an increase in net permanent tax deductions, primarily comprised of tax-exempt bargain purchase gain, interest income and income from bank owned life insurance. A more detailed discussion of the Company’s tax calculation is contained in Note 12 to the Consolidated Financial Statements included in this Form 10-K.

Financial Condition

General

Total assets increased $591.0 million during the year and totaled $2.0 billion at December 31, 2024. The increase was primarily attributable to a $493.1 million increase in loans, net of allowance, a $68.0 million increase in interest-bearing deposits in banks, and a $11.0 million increase in securities available for sale, which were partially offset by a $38.5 million decrease in securities held to maturity.  The increase in the loan portfolio was impacted by $479.7 million of loans acquired on October 1, 2024, through the acquisition of Touchstone.

Total liabilities increased $540.7 million during the year and totaled $1.8 billion at December 31, 2024.   The increase was attributable to the acquisition of Touchstone, on October 1, 2024, which added total liabilities of $614.6 million, and growth of the Bank's deposit portfolio.  Total deposits increased by $570.1 million, which included $555.4 million in total deposits acquired from Touchstone.   Noninterest-bearing demand deposits increased $140.9 million, savings and interest-bearing deposits increased $261.6 million, and time deposits increased $167.6 million.  Other borrowings decreased $50.0 million as the Company repaid borrowed funds from the Federal Reserve Bank through their Bank Term Funding Program.

Total shareholders' equity increased $50.3 million to $166.5 million at December 31, 2024, compared to $116.3 million at December 31, 2023. The increase was primarily attributable to the issuance of common stock in the amount of $3.3 million and surplus of $43.5 million in the acquisition of Touchstone. Other notable increases include a $2.7 million increase in retained earnings.

Loans

The Bank is an active lender with a loan portfolio that includes commercial and residential real estate loans, commercial loans, consumer loans, construction and land development loans, and home equity loans. The Bank’s lending activity is concentrated on individuals, and small and medium-sized businesses primarily in its market areas. As a provider of community-oriented financial services, the Bank does not typically attempt to further geographically diversify its loan portfolio by undertaking significant lending activity outside its market areas.

The Bank actively participated as a lender in the U.S. Small Business Administration’s (SBA) Paycheck Protection Program (PPP) to support local small businesses and non-profit organizations by providing forgivable loans. Loan fees received from the SBA are accreted by the Bank into income evenly over the life of the loans, net of loan origination costs, through interest and fees on loans. PPP loans totaled $66 thousand and $128 thousand at December 31, 2024 and 2023, respectively; with $66 thousand scheduled to mature in the first and second quarters of 2026. The Company believes these loans will ultimately be forgiven and repaid by the SBA in accordance with the terms of the program. It is the Company’s understanding that loans funded through the PPP program are fully guaranteed by the U.S. government. Should those circumstances change, the Company could be required to establish additional ACLL through additional provision for credit losses charged to earnings.

The loan portfolio includes loans that were acquired through business combinations. Loans acquired through business combinations included unamortized discounts, net of unamortized premiums totaling $14.3 million and $1.9 million, as of December 31, 2024 and 2023, respectively, which are amortized over the life of the loans.

Loans purchased from a third-party that originated and serviced loans to health care professionals totaled $19.0 million as of December 31, 2024, which included unamortized premiums totaling $5.8 million, compared to loans totaling $24.6 million as of December 31, 2023, which included unamortized premiums totaling $7.9 million.

Loans increased $497.6 million to $1.5 billion at December 31, 2024, compared to $969.4 million at December 31, 2023 in large part due to the Touchstone acquisition. Other real estate loans increased by $224.9 million, residential real estate loans increased by $203.2 million, construction and land development loans increased by $31.8 million, commercial, and industrial loans increased by $28.3 million, and consumer and other loans increased by $9.4 million.

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The following table sets forth the maturities of the loan portfolio at December 31, 2024 (in thousands):

Asset Quality

Management classifies non-performing assets as non-accrual loans and OREO. OREO represents real property taken by the Bank when its customers do not meet the contractual obligation of their loans, either through foreclosure or through a deed in lieu thereof from the borrower and properties originally acquired for branch operations or expansion but no longer intended to be used for that purpose. OREO is recorded at the lower of cost or fair value, less estimated selling costs, and is marketed by the Bank through brokerage channels. The Bank had $53 thousand and $0 in assets classified as OREO at December 31, 2024 and 2023, respectively.

Non-performing assets totaled $7.0 million and $6.8 million at December 31, 2024 and 2023, representing approximately 0.35% and 0.48% of total assets, respectively.  Non-performing assets consisted of $7.0 million of non-accrual loans at December 31, 2024.  Non-performing assets consisted of $6.8 million of non-accrual loans at December 31, 2023.

At December 31, 2024, 68% of non-performing assets were commercial and industrial loans, 31% were residential real estate loans, and 1% were construction loans. Non-performing assets could increase due to the deterioration of other loans identified by management as potential problem loans. Other potential problem loans are defined as performing loans that possess certain risks, including the borrower’s ability to pay and the collateral value securing the loan, that management has identified that may result in the loans not being repaid in accordance with their terms. Other potential problem loans totaled $9.1 million and $287 thousand at December 31, 2024 and December 31, 2023, respectively. The amount of other potential problem loans in future periods may be dependent on economic conditions and other factors influencing a customers’ ability to meet their debt requirements.

There were $365 thousand in loans greater than 90 days past due and still accruing at December 31, 2024. There were $524 thousand in loans greater than 90 days past due and still accruing at December 31, 2023.

The ACLL represents management’s analysis of the existing loan portfolio and related credit risks. The provision for credit losses is based upon management’s current estimate of the amount required to maintain an adequate ACLL reflective of the risks in the loan portfolio. The allowance for credit losses on loans totaled $16.4 million at
December 31, 2024
and $12.0 million at
December 31, 2023
, representing 1.12% and 1.24% of total loans, respectively. The Company determined that the historical loss analysis and the qualitative adjustment factors that established the collectively evaluated reserve component of the ACLL were appropriate at
December 31, 2024
. The allowance for credit losses on loans as a percentage of total loans decreased to 1.12% at December 31, 2024 compared to 1.24% at December 31, 2023. While the collectively evaluated reserve increased $4.1 million and the individually evaluated reserve component of the ACLL increased $374 thousand, the increased reserve was impacted by an increase in total loans of $497.6 million, or 51.3%, during the same period.

For further discussion regarding the ACLL, see “Provision for Credit Losses” above.

Recoveries of credit losses of $682 thousand and $360 thousand were recorded in the 1-4 family residential and consumer and other loans classes during the year ended December 31, 2024. The recoveries of credit losses resulted primarily from a decrease in the collectively evaluated reserve. These recoveries were offset by provision for credit losses totaling $5.0 million in the construction and land development, other real estate, and commercial and industrial loan classes.  For more detailed information regarding the provision for credit losses on loans, see Note 5 to the Consolidated Financial Statements included in this Form 10-K.

Loans individually evaluated for impairment totaled $7.0 million and $6.8 million at December 31, 2024 and 2023, respectively. The related allowance for credit losses required for these loans totaled $3.1 million and $2.7 million at December 31, 2024 and December 31, 2023, respectively.

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Management believes, based upon its review and analysis, that the Bank has sufficient reserves to cover expected losses inherent within the loan portfolio. For each period presented, the provision for credit losses on loans charged to expense was based on factors that include net charge-offs, asset quality, economic conditions, and loan growth. Changing economic conditions caused by inflation, recession, unemployment, or other factors beyond the Company’s control have a direct correlation with asset quality, net charge-offs, and ultimately the required provision for credit losses. There can be no assurance, however, that an additional provision for credit losses will not be required in the future, including as a result of changes in the qualitative factors underlying management’s estimates and judgments, changes in accounting standards, adverse developments in the economy, on a national basis or in the Company’s market area, loan growth, or changes in the circumstances of particular borrowers. For further discussion regarding the ACLL, see “Critical Accounting Policies” above. The following table shows a detail of loans charged-off, recovered, and the changes in the ACLL (dollars in thousands).

The following table shows the balance of the Bank’s ACLL allocated to each major category of loans and the ratio of related outstanding loan balances to total loans (dollars in thousands).

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The following table provides information on the Bank’s non-performing assets at the dates indicated (dollars in thousands).

The following table summarizes the Company's credit ratios on a consolidated basis as of December 31, 2024 and 2023.

The Company purchased commercial and industrial loans between October 2021 and October 2023 from a third-party finance company that originated and serviced loans to health care professionals. The finance company operated a program that historically provided credit support to the Company through, among other things, the repurchase of their loans and unamortized loan premiums when loans did not pay according to the loan agreements. On December 31, 2024, loans purchased from the finance company totaled $19.0 million, which was comprised of $13.2 million of loan balances and unamortized premiums totaling $5.8 million. The Company determined that $2.6 million of the loans were non-accrual and thus were individually evaluated. Specific reserves on the individually evaluated loans were included in the Company’s allowance for credit losses on loans. The remaining $16.4 million of loans were considered performing and were included in the calculation of the collectively evaluated reserve component of the allowance for credit losses. Premiums are amortized over the life of the loans using the effective interest method. On December 31, 2024 and 2023, there were a total of 155 and 172 loans, respectively, purchased from the finance company included in the Company’s loan portfolio with a weighted average maturity of 7.0 and 7.5 years, respectively.

Securities

Securities totaled $277.3 million at December 31, 2024, a decrease of $25.9 million, or 8.5%, from $303.2 million at the end of 2023. Investment securities are comprised of U.S. agency and mortgage-backed securities, obligations of state and political subdivisions, corporate debt securities, and restricted securities. As of December 31, 2024, neither the Company nor the Bank held any derivative financial instruments in their respective investment security portfolios. Gross unrealized gains in the available for sale portfolio totaled $62 thousand and $61 thousand at December 31, 2024 and 2023, respectively. Gross unrealized losses in the available for sale portfolio totaled $22.1 million and $20.7 million at December 31, 2024 and 2023, respectively.  Gross unrealized gains in the held to maturity portfolio totaled $95 thousand and $107 at December 31, 2024 and 2023, respectively.  Gross unrealized losses in the held to maturity portfolio totaled $11.0 million and $10.8 million at December 31, 2024 and 2023, respectively.  The change in the unrealized gains and losses of investment securities from December 31, 2023 to December 31, 2024 was related to changes in market interest rates and was not related to credit concerns of the issuers.

The Company evaluated securities available for sale in an unrealized loss position for credit related impairment and determined that no allowance for credit losses was necessary at December 31, 2024 and 2023.  At December 31, 2024, the allowance for credit losses on held to maturity securities was $95 thousand.  There was a $107 thousand allowance for credit losses on held to maturity securities at December 31, 2023.

On September 1, 2022, the Bank transferred 24 securities designated as available for sale with a combined book value of $82.2 million, market value of $74.4 million, and unrealized loss of $7.8 million, to securities designated held to maturity. The unrealized loss is being amortized monthly over the life of the securities with an increase to the carrying value of securities and a decrease to the related accumulated other comprehensive loss, which is included in the shareholders’ equity section of the Company’s balance sheet. The amortization of the unrealized loss on the transferred securities totaled $1.0 million, or $791 thousand net of tax, for the year ended December 31, 2024. The securities selected for transfer had larger potential decreases in their fair market values in higher interest rate environments than most of the other securities in the available for sale portfolio and included U.S. Treasury, agency, municipal and commercial mortgage-backed securities. The securities were transferred to mitigate the potential unfavorable impact that higher market interest rates may have on the carrying value of the securities and on the related accumulated other comprehensive loss. Securities designated as held to maturity are carried on the balance sheet at amortized cost, while securities designated as available for sale are carried at fair market value.

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The following table shows the maturities of debt and restricted securities at amortized cost and market value at December 31, 2024 and approximate weighted average yields of such securities (dollars in thousands). Yields on state and political subdivision securities are shown on a tax equivalent basis, assuming a 21% federal income tax rate. The Company attempts to maintain diversity in its portfolio and maintain credit quality and re-pricing terms that are consistent with its asset/liability management and investment practices and policies. For further information on securities, see Note 3 to the Consolidated Financial Statements included in this Form 10-K.

The above table was prepared using the contractual maturities for all securities with the exception of mortgage-backed securities (MBS) and collateralized mortgage obligations (CMO). Both MBS and CMO securities were recorded using the yield book prepayment model that incorporates four causes of prepayments including home sales, refinancing, defaults, and curtailments/full payoffs.

As of December 31, 2024, the Company did not own securities of any issuer for which the aggregate book value of the securities of such issuer exceeded ten percent of shareholders’ equity.

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Deposits

At December 31, 2024, deposits totaled $1.8 billion, increasing by $570.1 million, from $1.2 billion at December 31, 2023.  At December 31, 2024, noninterest-bearing demand deposits, savings and interest-bearing demand deposits, and time deposits composed 29%, 51%, and 20% of total deposits, respectively, compared to 31%, 54%, and 15% at December 31, 2023.

The following tables include a summary of average deposits and average rates paid (dollars in thousands).

The table above includes brokered deposits greater than $100 thousand.

As of December 31, 2024 the estimated amount of total uninsured deposits was $537.0 million.  Maturities of the estimated amount of uninsured time deposits at December 31, 2024 are presented in the table below.  The estimate of uninsured deposits generally represents the portion of deposit accounts that exceed the FDIC insurance limit of $250,000 and is calculated based on the same methodologies and assumptions used for purposes of the Bank’s regulatory reporting requirements.

Liquidity

Liquidity sources available to the Bank, including interest-bearing deposits in banks, unpledged securities available for sale, at fair value, unpledged securities held-to-maturity, at par, and available lines of credit totaled $758.0 million on December 31, 2024, and $512.7 million on December 31, 2023.  Available lines of credit from other institutions included in the total amount above was $562.5 million on December 31, 2024, and $351.4 million on December 31, 2023. The available lines of credit were comprised of secured and unsecured lines of credit and the Bank had no borrowings on the lines as of December 31, 2024 and December 31, 2023.

The Bank maintains liquidity to fund loan growth and meet the potential demand from its deposit customers, including potential volatile deposits. The estimated amount of uninsured customer deposits totaled $537.0 million on December 31, 2024, and $368.2 million on December 31, 2023. Excluding municipal deposits, the estimated amount of uninsured customer deposits totaled $319.1 million on December 31, 2024, and $286.2 million on December 31, 2023.

Subordinated Debt

See Note 10 to the Consolidated Financial Statements included in this Form 10-K, for discussion of subordinated debt.

Junior Subordinated Debt

See Note 11 to the Consolidated Financial Statements included in this Form 10-K, for discussion of junior subordinated debt.

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Off-Balance Sheet Arrangements

The Company, through the Bank, is a party to credit related financial instruments with risk not reflected in the consolidated financial statements in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit, and commercial letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The Bank’s exposure to credit loss is represented by the contractual amount of these commitments. The Bank follows the same credit policies in making commitments as it does for on-balance sheet instruments.

At December 31, 2024 and 2023, the following financial instruments were outstanding whose contract amounts represent credit risk (in thousands):

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for lines of credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Bank, is based on management’s credit evaluation of the customer.

Unfunded commitments under commercial lines of credit, revolving credit lines, and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines of credit are collateralized as deemed necessary and may or may not be drawn upon to the total extent to which the Bank is committed.

Commercial and standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank generally holds collateral supporting those commitments if deemed necessary.

At December 31, 2024, the Bank had $2.3 million in locked-rate commitments to originate mortgage loans. Risks arise from the possible inability of counterparties to meet the terms of their contracts. The Bank does not expect any counterparty to fail to meet its obligations.

On April 21, 2020, the Company entered into interest rate swap agreements related to its outstanding junior subordinated debt. The Company uses derivatives to manage exposure to interest rate risk through the use of interest rate swaps. Interest rate swaps involve the exchange of fixed and variable rate interest payments between two parties, based on a common notional principal amount and maturity date with no exchange of underlying principal amounts.

The interest rate swaps qualified and are designated as cash flow hedges. The Company’s cash flow hedges effectively modify the Company’s exposure to interest rate risk by converting variable rates of interest on $9.0 million of the Company’s junior subordinated debt to fixed rates of interest for periods that end between June 2034 and October 2036. The cash flow hedges’ total notional amount is $9.0 million. At December 31, 2024, the cash flow hedges had a fair value of $2.7 million, which is recorded in other assets. The net gain/loss on the cash flow hedges is recognized as a component of other comprehensive income and reclassified into earnings in the same period(s) during which the hedged transactions affect earnings. The Company’s derivative financial instruments are described more fully in Note 25 to the Consolidated Financial Statements included in this Form 10-K.

Capital Resources

The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to the size, composition, and quality of the Company’s asset and liability levels and consistent with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and absorb potential losses. The Company meets eligibility criteria of a small bank holding company in accordance with the Federal Reserve Board’s Small Bank Holding Company Policy Statement issued in February 2015 and is not obligated to report consolidated regulatory capital.

Effective January 1, 2015, the Bank became subject to capital rules adopted by federal bank regulators implementing the Basel III regulatory capital reforms adopted by the Basel Committee on Banking Supervision (the Basel Committee), and certain changes required by the Dodd-Frank Act.

The minimum capital level requirements applicable to the Bank under the final rules are as follows: a new common equity Tier 1 capital ratio of 4.5%; a Tier 1 capital ratio of 6%; a total capital ratio of 8%; and a Tier 1 leverage ratio of 4% for all institutions. The final rules also established a “capital conservation buffer” above the new regulatory minimum capital requirements. The capital conservation buffer was phased-in over four years and, as fully implemented effective January 1, 2019, requires a buffer of 2.5% of risk-weighted assets. This results in the following minimum capital ratios beginning in 2019: a common equity Tier 1 capital ratio of 7.0%, a Tier 1 capital ratio of 8.5%, and a total capital ratio of 10.5%. Under the final rules, institutions are subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions. Management believes, as of December 31, 2024 and December 31, 2023, that the Bank met all capital adequacy requirements to which it is subject, including the capital conservation buffer.

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The following table summarizes the Bank’s regulatory capital and related ratios at December 31, 2024, and 2023 (dollars in thousands).

The prompt corrective action framework is designed to place restrictions on insured depository institutions if their capital levels begin to show signs of weakness. Under the prompt corrective action requirements, which are designed to complement the capital conservation buffer, insured depository institutions are required to meet the following capital level requirements in order to qualify as “well capitalized:” a common equity Tier 1 capital ratio of 6.5%; a Tier 1 capital ratio of 8%; a total capital ratio of 10%; and a Tier 1 leverage ratio of 5%. The Bank met the requirements to qualify as "well capitalized" as of December 31, 2024 and 2023.

On September 17, 2019 the FDIC finalized a rule that introduces an optional simplified measure of capital adequacy for qualifying community banking organizations (i.e., the community bank leverage ratio (CBLR) framework), as required by the Economic Growth Act. The CBLR framework is designed to reduce burden by removing the requirements for calculating and reporting risk-based capital ratios for qualifying community banking organizations that opt into the framework. The Company did not opt into the framework.

The Company did not repurchase any shares during the year ended December 31, 2024.

The Company issued $5.0 million of subordinated debt in June 2020. The purpose of the issuance was primarily to further strengthen holding company liquidity and to remain a source of strength for the Bank in the event of a severe economic downturn. The Company used the proceeds of the issuance for general corporate purposes.  The subordinated debt issued consisted of a 5.50% fixed-to-floating rate subordinated note due 2030 issued to an institutional investor and was structured to qualify as Tier 2 capital under bank regulatory guidelines. The floating rate period for this subordinated note begins July 1, 2025, accordingly the related interest expense could increase during the floating rate period.  The Company assumed two subordinated debt issuances from the acquisition of Touchstone. The subordinated debt assumed consisted of a $8.0 million issuance at a 6.00% fixed-to-floating rate subordinated note callable due 2030.  The floating rate period for this subordinated note begins August 15, 2025, accordingly the related interest expense could increase during the floating rate period. The subordinated debt assumed also consisted of a $10.0 million issuance at a 4.00% fixed-to-floating rate subordinated note due 2032.

First Bank remained well-capitalized at December 31, 2024.

Recent Accounting Pronouncements

See Note 1 to the Consolidated Financial Statements included in this Form 10-K, for discussion of recent accounting pronouncements.

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