HORIZON BANCORP INC /IN/ (HBNC) FY 2021 MD&A

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

Overview

Horizon is a registered bank holding company incorporated in Indiana and headquartered in Michigan City, Indiana. Horizon provides a broad range of banking services in northern and central Indiana and southern and central Michigan through its bank subsidiary, Horizon Bank. Horizon operates as a single segment, which is commercial banking. Horizon’s common stock is traded on the NASDAQ Global Select Market under the symbol HBNC. The Bank was founded in 1873 as a national association, and it remained a national association until its conversion to an Indiana commercial bank effective June 23, 2017. The Bank is a full–service commercial bank offering commercial and retail banking services, corporate and individual trust and agency services, and other services incident to banking.

Fourth Quarter and Fully Year 2021 Highlights

•Net income totaled a record $87.1 million, or $1.98 diluted earnings per share for the year ended December 31, 2021 compared to $68.5 million, or $1.55 diluted earnings per share for the year ended December 31, 2020.

•Net interest income grew to a record $181.7 million for the year ended December 31, 2021, up 6.3% from the year ended December 31, 2020. Reported net interest margin (“NIM”) was 3.13% and adjusted NIM was 3.06%, with reported NIM decreasing by 31 basis points and adjusted NIM decreasing by 32 basis points from the year ended December 31, 2020. (See the “Non–GAAP Reconciliation of Net Interest Margin” table for the definition of this non–GAAP calculation of adjusted NIM.) Approximately 10 basis points of the NIM and adjusted NIM is attributed to Federal Paycheck Protection Program (“PPP”) lending, offset by an estimated 23 basis point compression attributed to excess liquidity during 2021. During 2021, Horizon increased the average balance of its investment portfolio by $805.5 million to leverage capital and focus on increasing net interest income.

•The Company was asset sensitive as of December 31, 2021, resulting from the liquidity on the balance sheet, adjustable rate assets and the low betas on deposit pricing based on expected deposit rates. Based on parallel rate shocks to the balance sheet, at a 100 basis point shock and 200 basis point shock, net interest income would increase approximately $10.0 million and $20.0 million, respectively.

•Commercial loans, excluding PPP and acquired loans, grew by 3.3% during 2021 to a record $2.15 billion, net of PPP and acquired loans, at period end.

•Consumer loans, excluding acquired loans, grew by 2.7% during 2021 to a record $727.3 million at period end, with record production of $397.1 million.

•Residential mortgage loans, excluding acquired loans, declined in–line with expectations by 13.8% during 2021 to $594.4 million at period end, as the addition of new producers and the launch of a new jumbo mortgage product aimed at second home buyers in Horizon's attractive second–home markets began to mitigate the impact of the industry–wide slowdown in mortgage lending from recent historic levels. Mortgage loan revenues only constituted 10.8% of total revenue in 2021.

•Non–interest expense was $139.3 million in 2021, including ongoing operating expenses associated with the Michigan branch acquisition that closed on September 17, 2021. Excluding acquisition–related expenses and non–recurring Employee Stock Ownership Plan (“ESOP”) settlement expense accrual, non–interest expense was $135.5 million, representing 2.08% of average assets for 2021, compared to $131.4 million, or 2.34%, for 2020. Acquisition–related expenses totaled approximately $1.9 million in 2021. (See the “Non–GAAP Reconciliation of Non–Interest Expense” table for the definition of this non–GAAP calculation of adjusted non–interest expense.)

•Horizon accrued $1.9 million of expense in December for a mediation settlement related to a dispute with the U.S. Department of Labor (“DOL”) concerning valuations and sale transactions related to Horizon's ESOP trustee business. Horizon is no longer in the ESOP trustee business and sold all accounts to a third party on September 30, 2021 and recorded a $2.3 million gain on the sale in the third quarter.

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•The efficiency ratio for 2021 was 58.12% compared to 57.01% for 2020. The adjusted efficiency ratio, excluding acquisition–related expense and non–recurring ESOP settlement expense, was 57.46% for 2021 compared to 57.20% for 2020. (See the “Non–GAAP Calculation and Reconciliation of Efficiency Ratio and Adjusted Efficiency Ratio” table below.)

•Horizon's in–market consumer and commercial deposit relationships, including those on–boarded as part of its branch acquisition near the end of the third quarter, combined with strategic pricing moves to manage deposit growth and runoff of higher–priced time deposits, contributed to continued improvement in the cost of interest bearing liabilities, which declined to 0.40% in 2021, compared to 0.87% in 2020.

•Horizon recorded a provision release of $2.1 million in 2021, compared to a provision expense of $20.8 million in 2020, as non–performing loans declined to $19.0 million, or 0.53% of total loans, on December 31, 2021.

•Horizon's book value and tangible book value per share increased to $16.61 and $12.58. (See the “Non–GAAP Reconciliation of Tangible Stockholders' Equity and Tangible Book Value per Share” table below.) Held to Maturity (“HTM”) securities were increased in the fourth quarter through a transfer from Available for Sale (“AFS”) securities and purchases to 57.2% of the investment portfolio. This increase in HTM securities will help manage the impact of unrealized losses to tangible capital in a rising rate environment.

•The integration of 14 branches purchase from TCF National Bank that closed on September 17, 2021 is complete and was very successful. The deposit runoff has stabilized at approximately 8% with the plan to begin to rebuild this runoff as we enter into 2022. The financial impact of this transaction to date is in line with management's projections.

Critical Accounting Policies

The Notes to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10–K for 2021 contain a summary of the Company’s significant accounting policies. Certain of these policies are important to the portrayal of the Company’s financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Management has identified the allowance for loan losses, goodwill and intangible assets, mortgage servicing rights, derivative instruments and valuation measurements as critical accounting policies.

Allowance for Credit Losses

The allowance for credit losses on loans and leases (“ACL”) replaces the allowance for loan and lease losses as a credit accounting estimate, as of January 1, 2020 with the adoption of ASU 2016–13, Financial Instruments–Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.

The allowance for credit losses represents management’s best estimate of current expected credit losses over the life of the portfolio of loans and leases. Estimating credit losses requires judgment in determining loan specific attributes impacting the borrower’s ability to repay contractual obligations. Other factors such as economic forecasts used to determine a reasonable and supportable forecast, prepayment assumptions, the value of underlying collateral, and changes in size composition and risks within the portfolio are also considered.

The allowance for credit losses is assessed at each balance sheet date and adjustments are recorded in the provision for credit losses. The allowance is estimated based on loan level characteristics using historical loss rates, a reasonable and supportable economic forecast. Loan losses are estimated using the fair value of collateral for collateral–dependent loans, or when the borrower is experiencing financial difficulty such that repayment of the loan is expected to be made through the operation or sale of the collateral. Loan balances considered uncollectible are charged–off against the ACL. Assets purchased with credit deterioration (“PCD”) represent assets that are acquired with evidence of more than insignificant credit quality deterioration since origination at the acquisition date. At acquisition, the allowance for credit losses on PCD assets is booked directly to the ACL. Any subsequent changes in the ACL on PCD assets is recorded through the provision for credit losses. Management believes that the ACL is adequate to absorb the expected life of loan credit losses on the portfolio of loans and leases as of the balance sheet date. Actual losses incurred may differ materially from our estimates. Particularly, the impact of COVID–19 on

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both borrower credit and the greater macroeconomic environment is uncertain and changes in the duration, spread and severity of the virus will affect our loss experience.

Allowance for Credit Losses on Off–Balance Sheet Credit Exposures

The Company estimates expected credit losses over the contractual period in which the Company is exposed to credit risk via a contractual obligation to extend credit, unless that obligation is unconditionally cancellable by the Company. The Company determines the estimated amount of expected credit extensions based on historical usage to calculate the amount of exposure for a loss estimate. After review of the expected credit losses on off–balance sheet exposures, the Company determined the amount not being recorded as immaterial at this time.

Allowance for Credit Losses on Available for Sale Securities

For available for sale debt securities in an unrealized loss position, the Company first assesses whether it intends to sell, or it is more likely than not that it will be required to sell, the security before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the security's amortized cost basis is written down to fair value through income. For debt securities available for sale that do not meet the aforementioned criteria, the Company evaluates whether the decline in fair value has resulted from credit losses or other factors. In making this assessment, management considers the extent to which fair value is less than amortized cost, any changes to the rating of the security by a rating agency, and adverse conditions specifically related to the security, among other factors. If this assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security are compared to the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an ACL is recorded for the credit loss, limited by the amount that the fair value is less than the amortized cost basis. Any impairment that has not been recorded through an ACL is recorded in other comprehensive income.

Changes in the ACL are recorded as provision for, or reversal of, credit loss expense. Losses are charged against the allowance when management believes the uncollectibility of an available for sale security is confirmed or when either of the criteria regarding intent or requirement to sell is met.

Allowance for Credit Losses on Held to Maturity Securities

For held to maturity securities, the Company conducts an assessment of its held to maturity securities at the time of purchase and on at least an annual basis to ensure such investment securities remain within appropriate levels of risk and continue to perform satisfactorily in fulfilling its obligations. The Company considers, among other factors, the nature of the securities and credit ratings or financial condition of the issuer. If available, the Company obtains a credit rating for issuers from the Nationally Recognized Statistical Rating Organization (“NRSRO”) for consideration. If this assessment indicates that a material credit loss exists, the present value of cash flows expected to be collected from the security are compared to the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an ACL is recorded for the credit loss. After completing this assessment, management determined any credit losses as of December 31, 2020 were not material to the consolidated financial statements.

Goodwill and Intangible Assets

Management believes that the accounting for goodwill and other intangible assets also involves a higher degree of judgment than most other significant accounting policies. FASB ASC 350–10 establishes standards for the amortization of acquired intangible assets and impairment assessment of goodwill. At December 31, 2021, Horizon had core deposit intangibles of $20.9 million subject to amortization and $154.6 million of goodwill, which is not subject to amortization. Goodwill arising from business combinations represents the value attributable to unidentifiable intangible assets in the business acquired. Horizon’s goodwill relates to the value inherent in the banking industry and that value is dependent upon the ability of Horizon to provide quality, cost effective banking 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

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to deliver cost effective services over sustained periods can lead to impairment of goodwill that could adversely affect earnings in future periods. FASB ASC 350–10 requires an annual evaluation of goodwill for impairment.

At each reporting date between annual goodwill impairment tests, Horizon considers potential indicators of impairment. Given the current economic uncertainty and volatility surrounding COVID–19, Horizon assessed whether the events and circumstances resulted in it being more likely than not that the fair value of any reporting unit was less than its carrying value. Impairment indicators considered comprised the condition of the economy and banking industry; government intervention and regulatory updates; the impact of recent events to financial performance and cost factors of the reporting unit; performance of the Company's stock and other relevant events. Horizon further considered the amount by which fair value exceeded book value in the most recent quantitative analysis and stress testing performed. At the conclusion of the assessment, the Company determined that as of December 31, 2021, it was more likely than not that the fair value exceeded its carrying value. Horizon will continue to monitor developments regarding the COVID–19 pandemic and measures implemented in response to the pandemic, market capitalization, overall economic conditions and any other triggering events or circumstances that may indicate an impairment of goodwill in the future.

Mortgage Servicing Rights

Servicing assets are recognized as separate assets when rights are acquired through purchase or through the sale of financial assets on a servicing–retained basis. Capitalized servicing rights are amortized into non–interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Servicing assets are evaluated regularly for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying servicing rights by predominant characteristics, such as interest rates, original loan terms and whether the loans are fixed or adjustable rate mortgages. Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market–based assumptions. When the book value of an individual stratum exceeds its fair value, an impairment reserve is recognized so that each individual stratum is carried at the lower of its amortized book value or fair value. In periods of falling market interest rates, accelerated loan prepayment can adversely affect the fair value of these mortgage–servicing rights relative to their book value. In the event that the fair value of these assets was to increase in the future, Horizon can recognize the increased fair value to the extent of the impairment allowance but cannot recognize an asset in excess of its amortized book value. Future changes in management’s assessment of the impairment of these servicing assets, as a result of changes in observable market data relating to market interest rates, loan prepayment speeds, and other factors, could impact Horizon’s financial condition and results of operations either positively or negatively.

Generally, when market interest rates decline and other factors favorable to prepayments occur, there is a corresponding increase in prepayments as customers refinance existing mortgages under more favorable interest rate terms. When a mortgage loan is prepaid, the anticipated cash flows associated with servicing that loan are terminated, resulting in a reduction of the fair value of the capitalized mortgage servicing rights. To the extent that actual borrower prepayments do not react as anticipated by the prepayment model (i.e., the historical data observed in the model does not correspond to actual market activity), it is possible that the prepayment model could fail to accurately predict mortgage prepayments and could result in significant earnings volatility. To estimate prepayment speeds, Horizon utilizes a third–party prepayment model, which is based upon statistically derived data linked to certain key principal indicators involving historical borrower prepayment activity associated with mortgage loans in the secondary market, current market interest rates and other factors, including Horizon’s own historical prepayment experience. For purposes of model valuation, estimates are made for each product type within the mortgage servicing rights portfolio on a monthly basis. In addition, on a quarterly basis Horizon engages a third party to independently test the value of its servicing asset.

Derivative Instruments

As part of the Company’s asset/liability management program, Horizon utilizes, from time–to–time, interest rate floors, caps or swaps to reduce the Company’s sensitivity to interest rate fluctuations. These are derivative instruments, which are recorded as assets or liabilities in the consolidated balance sheets at fair value. Changes in

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the fair values of derivatives are reported in the consolidated income statements or other comprehensive income (“OCI”) depending on the use of the derivative and whether the instrument qualifies for hedge accounting. The key criterion for the hedge accounting is that the hedged relationship must be highly effective in achieving offsetting changes in those cash flows that are attributable to the hedged risk, both at inception of the hedge and on an ongoing basis.

Horizon’s accounting policies related to derivatives reflect the guidance in FASB ASC 815–10. Derivatives that qualify for the hedge accounting treatment are designated as either: a hedge of the fair value of the recognized asset or liability or of an unrecognized firm commitment (a fair value hedge) or a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability (a cash flow hedge). For fair value hedges, the cumulative change in fair value of both the hedge instruments and the underlying loans is recorded in non–interest income. For cash flow hedges, changes in the fair values of the derivative instruments are reported in OCI to the extent the hedge is effective. The gains and losses on derivative instruments that are reported in OCI are reflected in the consolidated income statement in the periods in which the results of operations are impacted by the variability of the cash flows of the hedged item. Generally, net interest income is increased or decreased by amounts receivable or payable with respect to the derivatives, which qualify for hedge accounting. At inception of the hedge, Horizon establishes the method it uses for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. The ineffective portion of the hedge, if any, is recognized currently in the consolidated statements of income. Horizon excludes the time value expiration of the hedge when measuring ineffectiveness.

Valuation Measurements

Valuation methodologies often involve a significant degree of judgment, particularly when there are no observable active markets for the items being valued. Investment securities, residential mortgage loans held for sale and derivatives are carried at fair value, as defined in FASB ASC 820, which requires key judgments affecting how fair value for such assets and liabilities is determined. In addition, the outcomes of valuations have a direct bearing on the carrying amounts of goodwill, mortgage servicing rights, and pension and other post–retirement benefit obligations. To determine the values of these assets and liabilities, as well as the extent to which related assets may be impaired, management makes assumptions and estimates related to discount rates, asset returns, prepayment speeds and other factors. The use of different discount rates or other valuation assumptions could produce significantly different results, which could affect Horizon’s results of operations.

Analysis of Financial Condition

Horizon’s total assets were $7.4 billion as of December 31, 2021, an increase of $1.5 billion from December 31, 2020. The increase was primarily in investment securities of $1.4 billion, and cash and due from banks of $343.8 million, offset by decreases in net loans of $257.0 million, and other assets of $12.8 million.

Investment Securities

Investment securities carrying values totaled $2.7 billion at December 31, 2021, and consisted of Treasury and federal agency securities of $311.2 million (11.5%); state and municipal securities of $1.5 billion (55.4%); federal agency mortgage–backed pools of $414.5 million and federal agency collateralized mortgage obligations of $110.1 million (24.2%); private labeled mortgage–backed pools of $131.6 million (4.9%); and corporate securities of $242.5 million (8.9%).

As indicated above, 24.2% of the investment portfolio consists of mortgage–backed securities and collateralized mortgage obligations. These instruments are secured by residential mortgages of varying maturities. Principal and interest payments are received monthly as the underlying mortgages are repaid. These payments also include prepayments of mortgage balances as borrowers either sell their homes or refinance their mortgages. Therefore, mortgage–backed securities and collateralized mortgage obligations have maturities that are stated in terms of average life. The average life is the average amount of time that each dollar of principal is expected to be outstanding. As of December 31, 2021, the mortgage–backed securities and collateralized mortgage obligations in

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the investment portfolio had an average duration of 5.8 years. Securities that have interest rates above current market rates are purchased at a premium.

Available for sale municipal securities are priced by a third party using a pricing grid which estimates prices based on recent sales of similar securities. All municipal securities are investment grade or local non–rated issues. A credit review is performed annually on the municipal securities portfolio.

At December 31, 2021 and 2020, 42.8% and 87.1%, respectively, of investment securities were classified as available for sale. Securities classified as available for sale are carried at their fair value, with both unrealized gains and losses recorded, net of tax, directly to stockholders’ equity. Net appreciation on these securities totaled $7.2 million, which resulted in a balance of $5.7 million, net of tax, included in stockholders’ equity at December 31, 2021. This compared to net appreciation on securities which totaled $34.4 million, net of tax, included in stockholders’ equity at December 31, 2020.

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. A fair value hierarchy is also established which requires an entity to maximize the use of observable and minimize the use of unobservable inputs. There are three levels of inputs that may be used to measure fair value:

Level 1    Quoted prices in active markets for identical assets or liabilities.

Level 2    Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3    Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

When quoted market prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. There are no Level 1 securities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flows. Level 2 securities include U.S. Treasury and Federal agency securities, State and municipal securities, Federal agency collateralized mortgage obligations, Federal agency mortgage-backed pools and corporate notes. For Level 2 securities, Horizon uses a third party service to determine fair value. In performing the valuations, the pricing service relies on models that consider security–specific details as well as relevant industry and economic factors. The most significant of these inputs are quoted market prices, interest rate spreads on relevant benchmark securities and certain prepayment assumptions. To verify the reasonableness of the fair value determination by the service, Horizon has a portion of the Level 2 securities priced by an independent securities broker–dealer.

Unrealized gains and losses on available for sale securities, deemed temporary, are recorded, net of income tax, in a separate component of other comprehensive income on the balance sheet.

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The following is a schedule of maturities of each categories of available for sale and held to maturity debt securities and the related weighted–average yield of such securities as of December 31, 2021:

The weighted–average interest rates are based on coupon rates for securities purchased at par value an on effective interest rates considering amortization or accretion if the securities were purchased at a premium or discount. Yields are not presented on a tax–equivalent basis.

As a member of the Federal Home Loan Bank system, Horizon is required to maintain an investment in the common stock of the Federal Home Loan Bank. The investment in common stock is based on a predetermined formula. At December 31, 2021 and 2020, Horizon had investments in the common stock of the Federal Home Loan Bank totaling $24.4 million and $23.0 million, respectively.

At December 31, 2021, Horizon did not maintain a trading account.

For more information about securities, see Note 4 – Securities to the Consolidated Financial Statements at Item 8.

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Total Loans

Total loans, net of deferred fees/costs, the principal earning asset of the Bank, were $3.6 billion at December 31, 2021. The current level of total loans decreased 6.7% from the December 31, 2020, level of $3.8 billion primarily due to a decrease in mortgage warehouse loans and PPP loans originated during the year. The table below provides comparative detail on the loan categories.

The acceptance and management of credit risk is an integral part of the Bank’s business as a financial intermediary. The Bank has established underwriting standards including a policy that monitors the lending function through strict administrative and reporting requirements as well as an internal loan review of consumer and small business loans. The Bank also uses an independent third-party loan review function that regularly reviews asset quality.

Changes in the mix of the loan portfolio averages are shown in the following table.

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Maturities and Sensitivities of Loans to Changes in Interest Rates

The following table presents the maturity distribution of our loan portfolio as December 31, 2021. The table also presents the portion of loans that have fixed interest rates or variable interest rates that fluctuate over the life of the loans in accordance with changes in an interest rate index.

Commercial Loans

Commercial loans totaled $2.18 billion, or 60.3% of total loans as of December 31, 2021, compared to $2.19 billion, or 56.7% as of December 31, 2020. The decrease during 2021 was primarily due to a decrease in PPP loans of $183.0 million to $25.8 million at December 31, 2021 compared to $208.9 million at December 31, 2020.

Commercial loans consisted of the following types of loans at December 31:

Fixed rate term loans with a book value of $478.8 million and a fair value of $492.4 million have been swapped to a variable rate using derivative instruments. The loans are carried at fair value in the financial statements and the related swap is carried at fair value and is included with other liabilities in the balance sheet. The recognition of the loan and swap fair values are recorded in the income statement and for 2021 equally offset each other. Fair values

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are determined by the counterparty using a proprietary model that uses live market inputs to value interest rate swaps. The model is subject to daily market tests as current and future positions are priced and valued. These are Level 3 inputs under the fair value hierarchy as described above.

At December 31, 2021, the commercial loan portfolio held $321.5 million of adjustable rate loans that had interest rate floors in the terms of the note. Of the commercial loans with interest rate floors, loans totaling $250.6 million were at their floor at December 31, 2021.

Residential Real Estate Loans

Residential real estate loans totaled $594.4 million, or 16.5% of total loans as of December 31, 2021, compared to $624.3 million, or 16.1% of total loans as of December 31, 2020. This category consists of home mortgages that generally require a loan to value of no more than 80%. Some special guaranteed or insured real estate loan programs do permit a higher loan to collateral value ratio. The decrease during 2021 was primarily due to continued refinance activity during the year as a result of historically low interest rates.

In addition to the customary real estate loans described above, the Bank also had outstanding on December 31, 2021, $248.7 million in home equity lines of credit compared to $226.6 million at December 31, 2020. Credit lines normally limit the loan to collateral value to no more than 89%. Home equity credit lines are primarily not combined with a first mortgage and are therefore evaluated in the allowance for loan losses as a separate pool. These loans are classified as consumer loans in the Loans table above and in Note 5 of the Consolidated Financial Statements at Item 8.

Residential real estate lending is a highly competitive business. As of December 31, 2021, the real estate loan portfolio reflected a wide range of interest rates and repayment patterns, but could generally be categorized as follows:

The decrease in adjustable rate residential mortgage loans and increase in fixed rate residential mortgage loans during 2021 was primarily due customers moved to fixed rate products during the low interest rate environment. In addition to the real estate loan portfolio, the Bank originates and sells real estate loans and retains the servicing rights. During 2021 and 2020, approximately $438.1 million and $584.1 million, respectively, of residential mortgages were sold into the secondary market. Loans serviced for others are not included in the consolidated balance sheets. The unpaid principal balances of loans serviced for others totaled approximately $1.5 billion and $1.5 billion at December 31, 2021 and 2020.

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The aggregate fair value of capitalized mortgage servicing rights at December 31, 2021, totaled approximately $15.2 million compared to the carrying value of $15.2 million. Comparable market values and a valuation model that calculates the present value of future cash flows were used to estimate fair value. For purposes of measuring impairment, risk characteristics including product type, investor type and interest rates, were used to stratify the originated mortgage servicing rights.

Mortgage Warehouse Loans

Horizon’s mortgage warehousing lending has specific mortgage companies as customers of Horizon Bank. Individual mortgage loans originated by these mortgage companies are funded as a secured borrowing with a pledge of collateral under Horizon’s agreement with the mortgage company. Each mortgage loan funded by Horizon undergoes an underwriting review by Horizon to the end investor guidelines and is assigned to Horizon until the loan is sold to the secondary market by the mortgage company. In addition, Horizon takes possession of each original note and forwards such note to the end investor once the mortgage company has sold the loan. At the time a loan is transferred to the secondary market, the mortgage company reacquires the loan under its option within the agreement. Due to the reacquire feature contained in the agreement, the transaction does not qualify as a sale and therefore is accounted for as a secured borrowing with a pledge of collateral pursuant to the agreement with the mortgage company. When the individual loan is sold to the end investor by the mortgage company, the proceeds from the sale of the loan are received by Horizon and used to pay off the loan balance with Horizon along with any accrued interest and any related fees. The remaining balance from the sale is forwarded to the mortgage company. These individual loans typically are sold by the mortgage company within 30 days and are seldom held more than 90 days. Interest income is accrued during this period and collected at the time each loan is sold. Fee income for each loan sold is collected when the loan is sold and no costs are deferred due to the term between each loan funding and related payoff, which is typically less than 30 days.

Based on the agreements with each mortgage company, at any time a mortgage company can reacquire from Horizon its outstanding loan balance on an individual mortgage and regain possession of the original note. Horizon also has the option to request that the mortgage company reacquire an individual mortgage. Should this occur, Horizon would return the original note and reassign the assignment of the mortgage to the mortgage company. Also, in the event that the end investor would not be able to honor the purchase commitment and the mortgage company would not be able to reacquire its loan on an individual mortgage, Horizon would be able to exercise its rights under the agreement. The greatest risk related to these loans is transaction and fraud risk. During 2021, Horizon processed approximately $4.9 billion in mortgage warehouse loans.

At December 31, 2021, the mortgage warehouse loan balance was $109.0 million compared to $395.6 million as of December 31, 2020.

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Consumer Loans

Consumer loans totaled $727.3 million, or 20.2% of total loans as of December 31, 2021, compared to $655.2 million, or 16.9% as of December 31, 2020. The increase during 2021 was due to record production during the year of approximately $397.1 million and the loans purchased through the branch acquisition completed during the third quarter of 2021.

Allowance and Provision for Credit Losses

The table below provides an allocation of the year–end allowance for credit losses on loans by loan portfolio segment; however, allocation of a portion of the allowance to one segment does not preclude its availability to absorb losses in other segments.

At December 31, 2021, the allowance for credit losses was $54.3 million, or 1.50% of total loans outstanding, compared to $57.0 million, or 1.47%, at December 31, 2020. During 2021, a release of provision for credit losses was recorded totaling $2.1 million compared to a provision expense of $20.8 million in 2020. The credit loss expense recorded during 2020 reflects our January 2020 implementation of the CECL accounting method and prudent increases in the allocation for the Company's identified stressed portfolios.

Horizon assesses the adequacy of its Allowance for Credit Losses (“ACL”) by regularly reviewing the performance of all of its loan portfolios. As a result of its quarterly reviews, a provision for credit losses is determined to bring the total ACL to a level called for by the analysis. In addition to the adoption of the CECL accounting method, Horizon's reserve build during 2020 includes allocations for potential future loan losses related to economic factors and the nature and characteristics of its loan portfolios, primarily related to the impact on non–essential businesses caused by COVID–19 closures and the slow pace of reopening and economic recovery. Through December 31, 2021, Horizon has not recorded any material specific loan losses attributed to COVID–19 closures.

No assurance can be given that Horizon will not, in any particular period, sustain loan losses that are significant in relation to the amount reserved, or that subsequent evaluations of the loan portfolio, in light of factors then prevailing, including economic conditions and management’s ongoing quarterly assessments of the portfolio, will not require increases in the allowance for credit losses. Horizon considers the allowance for credit losses to be adequate to cover losses inherent in the loan portfolio as of December 31, 2021.

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Non–performing Loans

Non–performing loans are defined as loans that are greater than 90 days delinquent or have had the accrual of interest discontinued by management. From time to time, the Bank obtains information which may lead management to believe that the collection of payments may be doubtful on a particular loan. In recognition of such, it is management's policy to convert the loan from an “earning asset” to a non–accruing loan. Further, it is management's policy to place a commercial loan on non–accrual status when delinquent in excess of 90 days or management has determined that the borrower's ability to continue to make payments is in doubt. The officer responsible for the loan, Executive Vice President and Chief Commercial Banking Officer and the senior commercial loan workout officer must review all loans placed on non–accrual status. Management continues to work diligently toward returning non–performing loans to an earning asset basis.

Non–performing loans for the previous three years ending December 31 are as follows:

Non–performing loans total 35.0%, 47.0% and 119.9% of the allowance for credit losses at December 31, 2021, 2020 and 2019, respectively. Non–performing loans at December 31, 2021 totaled $19.0 million, a decrease from a balance of $26.8 million as of December 31, 2020 and from a balance of $21.2 million as of December 31, 2019.

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The decrease in non–performing loans in 2021 was primarily due to the upgrade of a two previously non–performing commercial relationships to performing status during the year. Non–performing loans as a percentage of total loans was 0.53% as of December 31, 2021, a decrease from 0.69% as of December 31, 2020 and 0.58% from December 31, 2019.

COVID–19 related loan deferrals decreased to $10.8 million, or 0.3% of total loans at December 31, 2021, compared to $126.7 million, or 3.3% of total loans at December 31, 2020.

Other Real Estate Owned (“OREO”) totaled $3.6 million on December 31, 2021, an increase of $1.7 million from December 31, 2020 and a decrease of $165,000 from December 31, 2019. On December 31, 2021, OREO was comprised of 12 properties, seven of these properties were bank owned properties from branch closures, four properties were residential and one of these properties was commercial real estate.

No mortgage warehouse loans were non–performing or OREO as of December 31, 2021, 2020 or 2019.

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Deferred Tax

Horizon had a net deferred tax asset totaling $3.3 million as of December 31, 2021 and a net deferred tax asset of $188,000 as of December 31, 2020. The following table shows the major components of deferred tax:

Deposits

The primary source of funds for the Bank comes from the acceptance of demand and time deposits. However, at times the Bank will use its ability to borrow funds from the Federal Home Loan Bank and other sources when it can do so at interest rates and terms that are more favorable than those required for deposited funds or loan demand is greater than the ability to grow deposits. Total deposits were $5.8 billion at December 31, 2021, compared to $4.5 billion at December 31, 2020. Average deposits and rates by category for the three years ended December 31 are as follows:

The $838.7 million increase in average deposits during 2021 was primarily due to the acquisition of 14 branches on September 17. The transactional accounts average balances, as the lower cost funding sources, increased $1.0 billion and the average balances for higher cost time deposits decreased $166.5 million. Horizon continually enhances its interest bearing consumer and commercial demand deposit products based on local market conditions and its need for funding to support various types of assets.

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As of December 31, 2021 and 2020, approximately $2.4 billion and $1.9 billion, respectively, or our deposit portfolio was uninsured. The uninsured amounts are estimates based on the methodologies and assumptions used for Horizon Bank's regulatory reporting requirements.

Certificates of deposit of $250,000 or more, which are considered to be rate sensitive and are not considered a part of core deposits, mature as follows as of December 31, 2021:

Interest expense on time certificates of $100,000 or more was approximately $2.4 million, $5.0 million, and $10.7 million for 2021, 2020 and 2019. Interest expense on time certificates of $250,000 or more was approximately $1.4 million, $2.9 million and $7.4 million for 2021, 2020 and 2019.

Off–Balance Sheet Arrangements

As of December 31, 2021, Horizon did not have any off–balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company’s financial condition, change in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors. The term “off–balance sheet arrangement” generally means any transaction, agreement, or other contractual arrangement to which an entity unconsolidated with the Company is a party and under which the Company has (i) any obligation arising under a guarantee contract, derivative instrument or variable interest; or (ii) a retained or contingent interest in assets transferred to such entity or similar arrangement that serves as credit, liquidity or market risk support for such assets.

Capital Resources

Horizon has no material commitments for capital expenditures as of December 31, 2021. Horizon’s sources of funds and liquidity are discussed below in the section captioned “Liquidity” in this Item 7.

Results of Operations

Net Income

Consolidated net income was $87.1 million, or $1.98 per diluted share, in 2021, $68.5 million or $1.55 per diluted share in 2020, and $66.5 million or $1.53 per diluted share in 2019. The increase in net income from the previous year reflects a decrease in credit loss expense of $22.8 million and an increase in net interest income of $10.8 million, offset by an increase in non–interest expense of $7.8 million, an increase in income tax expense of $5.5 million and a decrease in non–interest income of $1.7 million. The increase in diluted earnings per share compared to the previous year reflects an increase in net income and a decrease in diluted shares. Adjusted net income for the year ended December 31, 2021 was $88.6 million, or $2.00 diluted earnings per share, compared to $67.8 million, or $1.53 diluted earnings per share, for the year ended December 31, 2020. (See the “Non–GAAP Reconciliation of Net Income and Diluted Earnings per Share” table under the heading “Use of Non–GAAP Financial Measures” below for the definition of adjusted net income.)

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Net Interest Income

The largest component of net income is net interest income. Net interest income is the difference between interest income, principally from loans and investment securities, and interest expense, principally on deposits and borrowings. Changes in the net interest income are the result of changes in volume and the net interest spread which affects the net interest margin. Volume refers to the average dollar levels of interest earning assets and interest bearing liabilities. Net interest spread refers to the difference between the average yield on interest earning assets and the average cost of interest bearing liabilities. Net interest margin refers to net interest income divided by average interest earning assets and is influenced by the level and relative mix of interest earning assets and interest bearing liabilities.

Net interest income during 2021 was $181.7 million, an increase of $10.8 million, or 6.3%, over the $170.9 million earned in 2020. Yields on the Company’s interest earning assets decreased by 68 basis points to 3.43% during 2021 from 4.11% in 2020. Interest income decreased $5.4 million to $200.0 million for 2021 from $205.4 million in 2020. This decrease was due to the overall decrease in interest rates during 2021 and a decrease in the recognition of interest income from the acquisition–related purchase accounting adjustments of approximately $2.4 million from $6.9 million in 2020 to $4.5 million in 2021, offset by an increase in the average balance of interest earning assets of $901.6 million.

Interest expense decreased $16.1 million from $34.4 million in 2020 to $18.3 million in 2021. This decrease was due to the overall decrease in interest rates during 2021 and $3.8 million in prepayment penalties on borrowings paid during 2020. The prepayment penalties on borrowings were incurred as part of a deleverage strategy in which $83.0 million in FHLB advances with an average cost of 2.61% were paid off during the 4th quarter of 2020. The decrease in rates paid on interest bearing liabilities in addition to the decrease in the yield on the Company’s interest earning assets resulted in a decrease in the net interest margin of 31 basis points from 3.44% for 2020 to 3.13% in 2021. Excluding interest income recognized from acquisition–related purchase accounting adjustments and prepayment penalties on borrowings, the margin would have been 3.06% for 2021 compared to 3.38% for 2020. Management believes that the current level of interest rates is driven by external factors and therefore impacts the results of the Company’s net interest margin.

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The following table presents the average balances of our assets, liabilities, and stockholders' equity, and the related weighted average yields and rates on our interest earning assets and interest bearing liabilities for the periods indicated.

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Net interest income during 2020 was $170.9 million, an increase of $10.1 million, or 6.3%, over the $160.8 million earned in 2019. Yields on the Company’s interest earning assets decreased by 64 basis points to 4.11% during 2020 from 4.75% in 2019. Interest income decreased $3.0 million to $205.4 million for 2020 from $208.3 million in 2019. This decrease was due to the overall decrease in interest rates during 2020, offset by an increase in the recognition of interest income from the acquisition–related purchase accounting adjustments of approximately $1.3 million from $5.6 million in 2019 to $6.9 million in 2020.

Interest expense decreased $13.1 million from $47.5 million in 2019 to $34.4 million in 2020. This decrease was due to the overall decrease in interest rates during 2020 and was partially offset by $3.8 million in prepayment penalties on borrowings. The prepayment penalties on borrowings were incurred as part of a deleverage strategy in $83.0 million in FHLB advances with an average cost of 2.61% were paid off during the 4th quarter of 2020. The decrease in rates paid on interest bearing liabilities in addition to the decrease in the yield on the Company's interest earning assets resulted in a decrease in the net interest margin of 25 basis points from 3.69% for 2019 to 3.44% in 2020. Excluding interest income recognized from acquisition–related purchase accounting adjustments and prepayment penalties on borrowings, the margin would have been 3.38% for 2020 compared to 3.57% for 2019. Management believes that the current level of interest rates is driven by external factors and therefore impacts the results of the Company's net interest margin.

Credit Loss Expense

Horizon assesses the adequacy of its ACL by regularly reviewing the performance of its loan portfolios. Credit loss expense totaled a recovery of $2.1 million in 2021 compared to an expense of $20.8 million in 2020. Total loan net charge–offs were $1.6 million, which included commercial loan net charge–offs of $1.1 million, residential mortgage loan net charge–offs of $9,000 and consumer loan net charge–offs of $533,000 for the year ending December 31, 2021. The higher level of credit loss expense for 2020 was due to the adoption of CECL at the beginning of 2020 increasing credit loss expense for economic factors due to the economic shutdown and exposures to loans with nature and characteristics that have greater loss exposure due to economic uncertainty brought on by COVID–19.

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Credit loss expense totaled $20.8 million in 2020 compared to $2.0 million in 2019. Total loan net charge–offs were $1.9 million, which included commercial loan net charge–offs of $497,000, residential mortgage loan net charge–offs of $167,000 and consumer loan net charge–offs of $1.2 million for the year ending December 31, 2020. The higher level of credit loss expense for 2020 was due to the adoption of CECL at the beginning of 2020 increasing credit loss expense for economic factors due to the economic shutdown and exposures to loans with nature and characteristics that have greater loss exposure due to economic uncertainty brought on by COVID–19.

Additional information related to credit loss expense (recovery) and net charge–offs (recoveries) is presented in the table below. Also see Note 6 – Allowance for Credit and Loan Losses in the accompanying notes to consolidated financial statements included elsewhere in this report.

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Non–interest Income

The following is a summary of changes in non–interest income:

During 2021, the Company originated approximately $438.1 million of mortgage loans to be sold on the secondary market, compared to $584.1 million in 2020 as long–term interest rates began to increase during 2021. This decrease in volume in addition to a slight decrease in the percentage earned on the sale of mortgage loans, resulted in a decrease in the overall gain on sale of mortgage loans of $7.6 million compared to the prior year. Gain on the sale of investment securities decreased $3.4 million in 2021 due to the deleverage strategy executed in 2020. Fiduciary activities income decreased $1.7 million during 2021 primarily due to the sale of ESOP trustee accounts which was completed during the third quarter. Mortgage servicing net of impairment increased by $6.1 million during 2021 compared to 2020 primarily due to the recovery net impairment charges of $2.6 million recorded during 2021. Other income increased $2.7 million during 2021 primarily due to the gain on sale of ESOP trustee accounts of $2.3 million. The increase in interchange fee income in 2021 compared to 2020 was the result of organic growth in transactional deposit accounts and volume during 2021.

During 2020, the Company originated approximately $584.1 million of mortgage loans to be sold on the secondary market, compared to $269.7 million in 2019 primarily due to the decrease in long–term interest rates. This increase in volume in addition to an increase in the percentage earned on the sale of mortgage loans, resulted in an increase in the overall gain on sale of mortgage loans of $17.5 million compared to the prior year. Gain on the sale of investment securities increased $4.4 million in 2020 due to the deleverage strategy executed during the year. Mortgage servicing net of impairment decreased by $5.6 million during 2020 compared to 2019 primarily due to net impairment charges of $4.5 million recorded during 2020. The increase in interchange fee income in 2020 compared to 2019 was the result of organic growth in transactional deposit accounts and volume during 2020. The decrease in service charges on deposit accounts income in 2020 was due to an increase in digital transactions and stimulus funds resulting in a decrease in non–sufficient funds fee income.

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Non–interest Expense

The following is a summary of changes in non–interest expense:

For the twelve months ended December 31, 2021, salaries increased $2.4 million reflecting annual merit increases and the additional employees from the branch acquisition completed during the third quarter. Outside services and consultants and other expenses each increased by $1.1 million during 2021. This was partially due to acquisition–related expenses of $671,000 in outside services and consultants and $674,000 in other expenses. Other losses increased $1.1 million primarily due to $1.9 million in ESOP settlement expenses recorded during the fourth quarter of 2021.

For the twelve months ended December 31, 2020, commission and bonuses increased by $3.6 million reflecting record mortgage origination volume and related commission expense. Salaries increased $2.4 million reflecting a full year of additional employees from the Salin acquisition and annual merit increases. Loan expense increased $2.0 million primarily due to the increased volume in commercial and mortgage lending. The increase of $1.6 million in FDIC deposit insurance was due to the assessment credits the Bank received during the third quarter of 2019 as the FDIC reserve was overfunded at that time. Offsetting these increases was a decrease of $1.5 million in other expenses.

Income Taxes

Income tax expense totaled $15.4 million for the year ended December 31, 2021, an increase of $5.5 million when compared to the year ended December 31, 2020. The increase was primarily due to an increase in income before income taxes of $24.1 million in 2021 and fewer tax credits recognized due to delays in projects the Company has invested in offset by an increase in tax exempt municipal investments.

Income tax expense totaled $9.9 million for the year ended December 31, 2020, a decrease of $3.4 million when compared to the year ended December 31, 2019. The decrease was primarily due to the ability to recognize solar tax credits from completed projects the Company has invested in along with an increase in tax exempt municipal investments.

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(Table dollars in thousands except per share data)

Expected Replacement of London Interbank Offered Rate

The ARRC continues its work to the goal of finding suitable replacements for LIBOR. It is expected that a transition away from the widespread use of LIBOR to alternative reference rates and other potential interest rate benchmark reforms will occur beginning potentially in 2022. Although the full impact of such reforms and actions, together with any transition away from LIBOR remains unclear, we are preparing to transition from the LIBOR to an alternative reference rate.

Our transition plan includes a number of key steps, including continued engagement with central bank and industry working groups and regulators, active client engagement, internal operational readiness, and risk management, among other things, to promote the transition to alternative reference rates. We are identifying on-balance sheet and off-balance sheet references to LIBOR, determining appropriate language to replace the LIBOR index language, and determining disclosures necessary for customers, with appropriate procedures and schedules to complete the LIBOR transition.

There remain, however, a number of unknown factors regarding the transition from LIBOR or interest rate benchmark reforms that could impact our business, including, for example, the pace of the transition to replacement or reformed rates, the specific terms and parameters for and market acceptance of the alternative reference rates, prices of and the liquidity of trading markets for products based on the alternative reference rates, and our ability to transition to and develop appropriate systems and analytics for one or more alternative reference rates. For a further discussion of the various risks we face in connection with the expected replacement of LIBOR and reform of interest rate benchmarks on our operations, see “Risk Factors – Risks Related to Our Business.”

Use of Non–GAAP Financial Measures

Certain information set forth in this report on Form 10–K refers to financial measures determined by methods other than in accordance with GAAP. Specifically, we have included non–GAAP financial measures relating to net income, diluted earnings per share, net interest margin, the allowance for credit losses, tangible stockholders’ equity, tangible book value per share, the return on average assets, the return on average common equity and pre–tax pre–provision net income. In each case, we have identified special circumstances that we consider to be adjustments and have excluded them, in order to show the impact of such events as acquisition–related purchase accounting adjustments, prepayment penalties on borrowings and the Tax Cuts and Jobs Act, among other matters we have identified in our reconciliations. Horizon believes these non–GAAP financial measures are helpful to investors and provide a greater understanding of our business without giving effect to the purchase accounting impacts and other adjustments. These measures are not necessarily comparable to similar measures that may be presented by other companies and should not be considered in isolation or as a substitute for the related GAAP measure. See the following tables for reconciliations of the non–GAAP measures identified in this Form 10–K to their most comparable GAAP measures.

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