HBT Financial, Inc. (HBT) FY 2021 MD&A

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

Unless the context requires otherwise, references in this report to the “Company,” “we,” “us” and “our” refer to HBT Financial, Inc. and its consolidated subsidiaries.

Management’s discussion and analysis should be read in conjunction with the following parts of this Annual Report on Form 10-K: Part I, Item 1 “Business”, Part II, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk”, and Part II, Item 8 “Financial Statements and Supplementary Data”. Detailed discussion and analysis of the financial condition and results of operation for 2021 as compared to 2020 can be found below.

OVERVIEW

HBT Financial, Inc., headquartered in Bloomington, Illinois, is the holding company for Heartland Bank and Trust Company, and has banking roots that can be traced back to 1920. HBT provides a comprehensive suite of business, commercial, wealth management, and retail banking products and services to businesses, families, and local governments throughout Central and Northeastern Illinois and Eastern Iowa. As of December 31, 2021, the Company had total assets of $4.3 billion, loans held for investment of $2.5 billion, and total deposits of $3.7 billion.

Market Area

We currently operate 61 branch locations in Central and Northeastern Illinois and Eastern Iowa. We hold a leading deposit share in many of our markets in Central Illinois, which we define as a top three deposit share rank, providing the foundation for our strong deposit base. The stability provided by this low-cost funding is a key driver of our strong track record of financial performance. Below is a summary of the loan and deposit balances by geographic region.

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NXT Bancorporation, Inc. Acquisition

On October 1, 2021, the Company completed its acquisition of NXT, the holding company for NXT Bank, which was previously announced on June 7, 2021. The acquisition expands the Company’s footprint into Eastern Iowa with four locations that began operating as branches of Heartland Bank following the merger and system conversion of NXT Bank into Heartland Bank in December 2021. After considering business combination accounting adjustments, NXT added total assets of $234 million, total loans of $195 million, and total deposits of $182 million.

Cash consideration of approximately $10.6 million and stock consideration of approximately 1.8 million shares of HBT common stock resulted in aggregate consideration of $39.9 million. Goodwill of $5.7 million was recorded in the acquisition.

The acquisition of NXT provides an opportunity to utilize the Company’s existing excess liquidity to replace NXT’s higher cost funding. Additionally, Heartland Bank’s broader range of products and services and greater ability to meet larger borrowing needs provides an opportunity to expand NXT customer relationships.

The Company incurred the following pre-tax acquisition expenses related to the acquisition of NXT during the year ended December 31, 2021 (dollars in thousands):

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Branch Rationalization Plan

In April 2021, the Company made plans to close or consolidate six branches. One branch was consolidated during the second quarter of 2021, and the remaining five branches were closed during the third quarter of 2021. The Company estimates annual pre-tax cost savings, net of associated revenue impacts, related to the branch rationalization plan to be approximately $1.1 million.

The Company incurred the following pre-tax branch closure costs during the year ended December 31, 2021 (dollars in thousands):

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COVID-19 Response and Impact Overview

The Company has taken a number of steps to support our employees and customers while prioritizing the health and safety of all involved, including, but not limited to:

Paycheck Protection Program Loans

In December 2020, the Paycheck Protection Program (PPP) was extended and allowed eligible borrowers to receive a second PPP loan. During 2021, we funded $104.7 million of PPP loans as part of the second round of the program.

We continue to process forgiveness applications for PPP loans, with $185.3 million of PPP loans originated in round 1 and $75.8 million of PPP loans originated in round 2 receiving full or partial forgiveness by December 31, 2021.

The following table summarizes outstanding PPP loans as of December 31, 2021:

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During the year ended December 31, 2021 and 2020, the deferred origination fees on PPP loans were reduced by direct origination costs of $0.5 million and $0.5 million, respectively, consisting primarily of salaries and benefits costs. Net deferred origination fees on PPP loans of $9.2 million and $3.0 million during the years ended December 31, 2021 and 2020, respectively, were recognized as taxable loan interest income. Recognition of net deferred origination fees is accelerated upon loan forgiveness or repayment prior to contractual maturity.

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Payment Modifications Related to COVID-19

Loan payment modifications were made for borrowers experiencing financial hardship due to COVID-19, with substantially all modifications in the form of a three-month interest-only period or a one-month payment deferral. Consistent with the applicable accounting and regulatory guidance, short-term loan payment modifications such as these are generally not considered to be a troubled debt restructuring.

The volume of loan modification requests related to a COVID-19 financial hardship have declined significantly from its height during the second quarter of 2020. As of December 31, 2021 and 2020, the total outstanding balance of loans with an existing payment modification related to a COVID-19 financial hardship were $0.2 million and $28.0 million, respectively.

Industries Adversely Impacted by COVID-19

While many industries have been and may continue to be adversely impacted by the COVID-19 pandemic, the restaurant and hotel industries have been particularly susceptible to significant adverse impacts. While many areas of consumer and business spending have rebounded in recent months, there is uncertainty about the longer lasting impact on the restaurant and hotel industries resulting from the COVID-19 pandemic. Adverse impacts in these and other industries may result in a deterioration of the loan portfolio’s credit quality or an increase in loan losses.

The below table summarizes loan balances within the restaurant and hotel industries, along with risk rating information, as of December 31, 2021:

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As of December 31, 2021, there were no loans within the restaurant and hotel industries that were granted a loan payment modification related to a COVID-19 financial hardship that had not returned to regular payments.

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FACTORS AFFECTING OUR RESULTS OF OPERATIONS

Economic Conditions

The Company’s business and financial performance are affected by economic conditions generally in the United States and more directly in the Illinois and Iowa markets where we primarily operate. The significant economic factors that are most relevant to our business and our financial performance include the general economic conditions in the U.S. and in the Company’s markets, unemployment rates, real estate markets, and interest rates.

COVID-19 Pandemic

Although the Company has had continuous business operations since the beginning of the COVID-19 pandemic, the pandemic has caused significant economic disruption throughout the United States and the communities that we serve. While the economic outlook generally improved in 2021 compared to 2020, uncertainty surrounding potential surges in COVID-19 infections with new virus variants and the longer lasting impact on specific industries remains. As a result, the businesses we serve may continue to be adversely impacted and the ability of our customers to maintain historic deposit levels or to fulfill their contractual obligations to us may deteriorate. This could adversely affect our asset valuations, financial condition, liquidity and results of operations, and the impacts may be material.

During 2020, we experienced the following adverse impacts of the COVID-19 pandemic:

While some of these trends reversed in 2021, and have continued such reversal in the beginning of 2022, sustained improvements are highly dependent upon strengthening economic conditions. The COVID-19 pandemic continues to cause economic uncertainties which may again result in these and other adverse impacts to our financial condition and results of operations.

The Company’s executive management continues to closely monitor the COVID-19 pandemic. As of the date of this filing, we anticipate we will continue to take actions to support our customers in a manner consistent with the current guidance provided by federal banking regulatory authorities.

Interest Rates

Net interest income is our primary source of revenue. Net interest income is equal to the excess of interest income earned on interest earning assets (including discount accretion on purchased loans plus certain loan fees) over interest expense incurred on interest-bearing liabilities. The level of interest rates as well as the volume of interest-earning assets and interest-bearing liabilities both impact net interest income. Net interest income is also influenced by both the pricing and mix of interest-earning assets and interest-bearing liabilities which, in turn, are impacted by external factors such as local economic conditions, competition for loans and deposits, the monetary policy of the Federal Reserve Board and market interest rates.

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The cost of our deposits and short-term wholesale borrowings is largely based on short-term interest rates, which are primarily driven by the Federal Reserve Board’s actions. The yields generated by our loans and securities are typically driven by short-term and long-term interest rates, which are set by the market and, to some degree, by the Federal Reserve Board’s actions. The level of net interest income is therefore influenced by movements in such interest rates and the pace at which such movements occur.

Growth in deposit balances and the forgiveness of PPP loans has resulted in significant cash inflows and excess liquidity. While some excess liquidity was invested into debt securities during 2021, the yields available were lower than existing portfolio yields. Decreases in interest rates, as well as the ongoing economic uncertainty, may decrease our net interest income and net interest margin in future periods, while increases in interest rates are expected to increase our net interest income and net interest margin in future periods.

Credit Trends

We focus on originating loans with appropriate risk / reward profiles. We have a detailed loan policy that guides our overall loan origination philosophy and a well-established loan approval process that requires experienced credit officers to approve larger loan relationships. Although we believe our loan approval process and credit review process are strengths that allow us to maintain a high quality loan portfolio, we recognize that credit trends in the markets in which we operate and in our loan portfolio can materially impact our financial condition and performance and that these trends are primarily driven by the economic conditions and the impact of COVID-19 in our markets.

Competition

Our profitability and growth are affected by the highly competitive nature of the financial services industry. We compete with community banks in all our markets and, to a lesser extent, with money center banks, primarily in the Chicago MSA. Additionally, we compete with non-bank financial services companies and other financial institutions operating within the areas we serve. We compete by emphasizing personalized service and efficient decision-making tailored to individual needs. We do not rely on any individual, group, or entity for a material portion of our loans or our deposits. We continue to see increased competitive pressures on loan rates and terms which may affect our financial results in the future.

Digital Banking

Throughout the banking industry, in-person branch traffic is expected to continue to decline as more customers turn to digital banking for routine banking transactions. The COVID-19 pandemic has accelerated this transition, and in-person branch traffic is not expected to return to pre-pandemic levels. We plan to continue investing in our digital banking platforms, while maintaining an appropriately sized branch network. An inability to meet evolving customer expectations, with the appropriate level of security, for both digital and in-person banking may adversely affect our financial results in the future.

Regulatory Environment and Trends

We are subject to federal and state regulation and supervision, which continue to evolve as the legal and regulatory framework governing our operations continues to change. The current operating environment includes extensive regulation and supervision in areas such as consumer compliance, the BSA and anti-money laundering compliance, risk management and internal audit. We anticipate that this environment of extensive regulation and supervision will continue for the industry. As a result, changes in the regulatory environment may result in additional costs for additional compliance, risk management and audit personnel or professional fees associated with advisors and consultants.

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FACTORS AFFECTING COMPARABILITY OF FINANCIAL RESULTS

S Corp Status

Prior to October 11, 2019, the Company elected to be taxed under sections of federal and state income tax law as an "S Corporation" which provides that, in lieu of Company income taxes, except for state replacement taxes, the stockholders separately account for their pro rata shares of the Company’s items of income, deductions, losses and credits. As a result of this election, no income taxes, other than state replacement taxes, had been recognized in the accompanying consolidated financial statements prior to October 11, 2019.

Effective October 11, 2019, the Company voluntarily revoked its S Corporation status and became a taxable entity (“C Corporation”). As such, any periods prior to October 11, 2019 will only reflect an effective state replacement tax rate. In connection with the conversion of tax status, the Company recognized a deferred tax asset, and the associated income tax benefit, of $0.5 million.

The following table illustrates the impact of being taxed as a C Corporation:

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N/A  Not applicable.

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The C Corp equivalent effective rates reflect a federal tax rate of 21% and state income tax rate of 9.5%.

Jobs Act Accounting Election

We qualify as an “emerging growth company” under the JOBS Act. The JOBS Act permits us an extended transition period for complying with new or revised accounting standards affecting public companies. We have elected to use the extended transition period until we are no longer an emerging growth company or until we choose to affirmatively and irrevocably opt out of the extended transition period. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements applicable to public companies.

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RESULTS OF OPERATIONS

Overview of Recent Financial Results

The following table presents selected financial results and measures as of and for the year ended December 31.

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N/A  Not applicable.

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Comparison of the Year Ended December 31, 2021 to the Year Ended December 31, 2020

For the year ended December 31, 2021, net income was $56.3 million increasing by $19.4 million, or 52.7%, when compared to net income for the year ended December 31, 2020. Notable changes include the following:

Net Interest Income

Net interest income equals the excess of interest income (including discount accretion on acquired loans) plus fees earned on interest earning assets over interest expense incurred on interest-bearing liabilities. Interest rate spread and net interest margin are utilized to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on interest-earning assets and the rate paid for interest-bearing liabilities that fund those assets. The net interest margin is expressed as the percentage of net interest income to average interest-earning assets. The net interest margin exceeds the interest rate spread because noninterest-bearing sources of funds, principally noninterest-bearing demand deposits and stockholders’ equity, also support interest-earning assets.

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The following tables set forth average balances, average yields and costs, and certain other information for the years ended December 31, 2021, 2020, and 2019. Average balances are daily average balances. Nonaccrual loans are included in the computation of average balances but have been reflected in the table as loans carrying a zero yield. The yields set forth below include the effect of deferred fees and costs, discounts and premiums, and purchase accounting adjustments that are accreted or amortized to interest income or expense.

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The following table sets forth the components of loan interest income. Loan interest income includes contractual interest on loans, loan fees, accretion of acquired loan discounts and net earnings on cash flow hedges.

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The following table sets forth the components of net interest income. Total interest income consists of contractual interest on loans, contractual interest on securities, contractual interest on interest-bearing deposits in banks, loan fees, accretion of acquired loan discounts, securities amortization, net, and other interest and dividend income. Total interest expense consists of contractual interest on deposits, contractual interest on other interest-bearing liabilities and other interest expense.

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Rate/Volume Analysis

The following table sets forth the dollar amount of changes in interest income and interest expense for the major categories of our interest-earning assets and interest-bearing liabilities. Information is provided for each category of interest-earning assets and interest-bearing liabilities with respect to changes attributable to changes in volume (i.e., changes in average balances multiplied by the prior-period average rate), and changes attributable to rate (i.e., changes in average rate multiplied by prior-period average balances). For purposes of this table, changes attributable to both volume and rate that cannot be segregated have been allocated proportionately to the change due to volume and the change due to rate.

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Comparison of the Year Ended December 31, 2021 to the Year Ended December 31, 2020

Net interest income for the year ended December 31, 2021 increased $4.8 million, or 4.1%, to $122.4 million from $117.6 million for the year ended December 31, 2020. Declines in benchmark interest rates drove lower yields on interest-earnings assets. These declines were more than offset by an increase in PPP loan fees recognized as loan interest income which totaled $9.2 million and $3.0 million during the years ended December 31, 2021 and 2020, respectively. Additionally, a substantial increase in interest-earning asset balances further supported net interest income, driven by the NXT acquisition, PPP loan originations, and federal economic stimulus payments received by our retail customers.

Net interest margin decreased to 3.18% for the year ended December 31, 2021 compared to 3.54% for the year ended December 31, 2020. The decrease was primarily attributable to the decline in the average yield on earning assets and increased balances being held in cash and lower-yielding securities.

Additionally, the $40 million of subordinated notes issued during the third quarter of 2020 added downward pressure to net interest income and net interest margin in subsequent periods. However, the proceeds from the issuance provided additional regulatory capital to buffer against higher than estimated credit losses and support organic and acquisitive growth.

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The quarterly net interest margins were as follows:

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During 2019, overall market interest rates started to decline. The Federal Open Markets Committee lowered Federal Funds target rates for the first time in 11 years on July 31, 2019 and then again in September 2019 and October 2019, for a combined decrease of 75 basis points during 2019. In March 2020, the Federal Open Markets Committee lowered Federal Funds target rates twice, for a combined decrease of 150 basis points in response to the economic downturn related to the COVID-19 pandemic.

These rate cuts, as well as quantitative easing, have resulted in a lower interest rate environment which has put downward pressure on our net interest margin. In general, we believe that potential rate increases will lead to improved net interest margins while rate decreases will result in lower net interest margins.

Provision for Loan Losses

Provisions for loan losses are charged to operations in order to maintain the allowance for loan losses at a level we consider necessary to absorb probable incurred credit losses in the loan portfolio. In determining the level of the allowance for loan losses, management considers past and current loss experience, evaluations of collateral, current economic conditions, volume and type of lending, adverse situations that may affect a borrower’s ability to repay a loan and the levels of nonperforming and other classified loans. The amount of the allowance is based on estimates and the ultimate losses may vary from such estimates as more information becomes available or as events change. We assess the allowance for loan losses on a quarterly basis and make provisions for loan losses in order to maintain the allowance. The provision for loan losses is a function of the allowance for loan loss methodology we use to determine the appropriate level of the allowance for inherent loan losses after accounting for net charge-offs (recoveries).

The deterioration of economic conditions related to the COVID-19 pandemic adversely affected the communities that we serve beginning in 2020. As a result, our allowance for loan losses initially increased at the onset of the COVID-19 pandemic, remained elevated during the remainder of 2020, and then gradually returned to near pre-pandemic levels during 2021 as economic conditions improved.

Comparison of the Year Ended December 31, 2021 to the Year Ended December 31, 2020

The Company recorded a negative provision for loan losses of $8.1 million during the year ended December 31, 2021, compared to a provision for loan losses of $10.5 million during the year ended December 31, 2020. The negative provision was primarily due to a $4.4 million decrease in specific reserves on loans individually evaluated for impairment. Additionally, changes to qualitative factors resulted in a $2.9 million decrease in required reserve, primarily reflecting the shrinking impact of the COVID-19 pandemic on our borrowers, an improved economic environment, and improved asset quality metrics.

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Noninterest Income

The following table outlines the amount of and changes to the various noninterest income line items as of the dates indicated.

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Comparison of the Year Ended December 31, 2021 to the Year Ended December 31, 2020

Total noninterest income for the year ended December 31, 2021, was $37.3 million, an increase of $2.9 million, or 8.3%, from the year ended December 31, 2020. Notable changes in noninterest income include the following:

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Noninterest Expense

The following table outlines the amount of and changes to the various noninterest expense line items as of the dates indicated.

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Comparison of the Year Ended December 31, 2021 to the Year Ended December 31, 2020

Total noninterest expense for the year ended December 31, 2021, was $91.2 million, a decrease of $0.7 million, or 0.8%, from the year ended December 31, 2020. Notable changes in noninterest expense include following:

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Income Taxes

Prior to October 11, 2019, the Company was taxed under sections of federal and state tax law as an "S corporation" which provides that with the exception of certain state replacement and franchise taxes, current stockholders account separately for their share of the Company’s income, deductions, losses and credits. For additional information, see “Factors Affecting Comparability of Financial Results: S Corp Status”.

Effective October 11, 2019, the Company voluntarily revoked its S Corporation status and became a taxable entity (C Corporation). As such, any periods prior to October 11, 2019 will only reflect an effective state replacement tax rate. In connection with the conversion of tax status, the Company recognized a deferred tax asset, and the associated income tax benefit, of $0.5 million.

Comparison of the Year Ended December 31, 2021 to the Year Ended December 31, 2020

We recorded income tax expense of $20.3 million, or 26.5% effective tax rate, during the year ended December 31, 2021 compared to $12.7 million, or 25.7% effective tax rate during the year ended December 31, 2020. The effective income tax rate was lower than the combined federal and state statutory rate of approximately 28.5% primarily due to tax exempt interest income. The effective income tax rate increased primarily due to tax exempt interest income making up a smaller portion of pre-tax net income during the year ended December 31, 2021 compared to the year ended December 31, 2020. Additionally, the non-deductibility of certain acquisition-related contributed to a higher effective tax rate.

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FINANCIAL CONDITION

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Total assets were $4.3 billion at December 31, 2021, an increase of $648.7 million, or 17.7%, from December 31, 2020. Significant changes in our balance sheet include the following:

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Loan Portfolio

The Company focuses on originating loans with appropriate risk / reward profiles. The Company has a detailed loan policy that guides the overall loan origination philosophy and a well-established loan approval process that requires experienced credit officers to approve larger loan relationships. The Company also has an active credit department that underwrites and prepares annual reviews for larger and more complex loan relationships.

Management monitors credit quality closely with a series of monthly reports and a quarterly Credit Committee meeting where performance and trends within the loan portfolio are reviewed. Portfolio diversification at the borrower, industry, and product levels is actively managed to mitigate concentration risk. In addition, credit risk management includes an independent loan review process that assesses compliance with loan policy, compliance with loan documentation standards, accuracy of the risk rating and overall credit quality of the loan portfolio.

Loans by Category

The following table sets forth the composition of the loan portfolio by category, excluding loans held-for-sale.

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Loans, before allowance for loan losses were $2.50 billion at December 31, 2021, an increase of $252.7 million, or 11.2%, from December 31, 2020. Notable changes include the following:

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The principal categories of our loan portfolio are described below:

Commercial and Industrial: Consists of loans typically granted for working capital, asset acquisition and other business purposes. These loans are underwritten primarily based on the borrower’s cash flow with most loans secondarily supported by collateral. Most commercial and industrial loans are secured by the assets being financed or other business assets, such as accounts receivable, inventory, and equipment, and are typically supported by personal guarantees of the owners. Cash flows and collateral values may fluctuate based on general economic conditions, specific industry conditions and specific borrower circumstances.

Agricultural and Farmland: Consists of loans typically secured by farmland, agricultural operating assets, or a combination of both, and are generally underwritten to existing cash flows of operating agricultural businesses. Debt repayment is provided by business cash flows. Economic trends influenced by unemployment rates and other key economic indicators are not closely correlated to the credit quality of agricultural and farmland loans. The credit quality of these loans is most correlated to changes in prices of corn and soybeans and, to a lesser extent, weather, which has been partially mitigated by federal crop insurance programs.

Commercial Real Estate - Owner Occupied: Consists of loans secured by commercial real estate that is both owned and occupied by the same or a related borrower. These loans are primarily underwritten based on the cash flow of the business occupying the property. As with commercial and industrial loans, cash flows and collateral values may fluctuate based on general economic conditions, specific industry conditions, and specific borrower circumstances.

Commercial Real Estate - Non-owner Occupied: Consists of loans secured by commercial real estate for which the primary source of repayment is the sale or rental cash flows from the underlying collateral. These loans are underwritten based primarily on the historic or projected cash flow from the underlying collateral. Adverse economic developments or an overbuilt market typically impact commercial real estate projects. Trends in rental and vacancy rates of commercial properties impact the credit quality of these loans.

Multi-family: Consists of loans secured by five or more unit apartment buildings. Multi-family loans may be affected by demographic and population trends, unemployment or underemployment, and deteriorating market values of real estate.

Construction and Land Development: Consists of loans for speculative and pre-sold construction projects for developers intending to either sell upon completion or hold for long term investment, as well as construction of projects to be owner occupied. In addition, loans in this segment generally possess a higher inherent risk of loss than other portfolio segments due to risk of non-completion, changes in budgeted costs, and changes in market forces during the term of the construction period.

One-to-four Family Residential: Consists of loans secured by one-to-four family residences, including both first and junior lien mortgage loans for owner occupied and non-owner occupied properties and home equity lines of credit. The degree of risk in residential mortgage lending depends on the local economy, including the local real estate market and unemployment rates.

Municipal, Consumer and Other: Loans to municipalities include obligations of municipal entities and loans sponsored by municipal entities for the benefit of a private entity where that private entity, rather than the municipal entity, is responsible for repayment of the obligation. Consumer loans include loans to individuals for consumer purposes and typically consist of small balance loans. Economic trends determined by unemployment rates and other key economic indicators are closely correlated to the credit quality of the consumer loans. Loans to other financial institutions, as well as leases, are also included.

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Loan Portfolio Maturities

The following table summarizes the scheduled maturities of the loan portfolio as of December 31, 2021. Demand loans (loans having no stated repayment schedule or maturity) and overdraft loans are reported as being due in one year or less.

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The following table summarizes loans maturing after one year, segregated into variable and fixed interest rates.

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Nonperforming Assets

Nonperforming loans consist of all loans past due 90 days or more or on nonaccrual. Nonperforming assets consist of all nonperforming loans and foreclosed assets. Typically, loans are placed on nonaccrual when they reach 90 days past due, or when, in management’s opinion, there is reasonable doubt regarding the collection of the amounts due through the normal means of the borrower. Interest accrued and unpaid at the time a loan is placed on nonaccrual status is reversed from interest income. Interest payments received on nonaccrual loans are recognized in accordance with our significant accounting policies. Once a loan is placed on nonaccrual status, the borrower must generally demonstrate at least six months of payment performance and we believe that all remaining principal and interest is fully collectible, before the loan is eligible to return to accrual status. Management believes the Company’s lending practices and active approach to managing nonperforming assets has resulted in timely resolution of problem assets.

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Loans acquired with deteriorated credit quality are considered past due or delinquent when the contractual principal or interest due in accordance with the terms of the loan agreement remains unpaid after the due date of the scheduled payment. However, these loans are considered performing, even though they may be contractually past due, as any non-payment of contractual principal or interest is considered in the periodic re-estimation of expected cash flows and is included in the resulting recognition of current period loan loss provision or future period yield adjustments. The accrual of interest is discontinued on loans acquired with deteriorated credit quality if management can no longer estimate future cash flows on the loan. Therefore, interest revenue, through accretion of the difference between the carrying value of the loans and the expected cash flows, is being recognized on all loans acquired with deteriorated credit quality, except those management can no longer estimate future cash flows.

When it appears likely that we will obtain title to real estate collateral, we develop an exit strategy by assessing overall market conditions, the current use and condition of the asset, and its highest and best use. If determined necessary to maximize value, we complete the necessary improvements or tenant stabilization tasks, with the applicable time value discount and improvement expenses incorporated into our estimates of the expected costs to sell. Substantially all foreclosed real estate is valued on an "as-is" basis.

Estimates of the net realizable value of real estate collateral also include a deduction for the expected selling costs. For most real estate collateral and foreclosed real estate, we apply a 7.0% deduction to the value of the asset to account for the expected costs to sell the asset. This estimate includes sales commissions and closing costs. Expenses for real estate taxes are accrued and repairs are expensed when incurred.

The following table sets forth information concerning nonperforming loans and nonperforming assets as of each of the dates indicated.

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Comparison of December 31, 2021 to December 31, 2020

Total nonperforming assets were $6.1 million as of December 31, 2021, a decrease of $8.1 million, or 57.1%, from December 31, 2020. Our level of nonperforming assets has remained low in recent years, representing only 0.14% of total assets as of December 31, 2021 and 0.39% of total assets as of December 31, 2020. We believe our continuous credit monitoring and collection efforts have resulted in lower levels of nonperforming assets, while also recognizing that favorable economic conditions prior to the COVID-19 pandemic and substantial federal economic stimulus during the pandemic have also contributed to these lower levels.

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Troubled Debt Restructurings

In general, if the Company grants a troubled debt restructuring (TDR) that involves either the absence of principal amortization or a material extension of an existing loan amortization period in excess of our underwriting standards, the loan will be placed on nonaccrual status. However, if a TDR is well secured by an abundance of collateral and the collectability of both interest and principal is probable, the loan may remain on accrual status. A nonaccrual TDR in full compliance with the payment requirements specified in the loan modification for at least six months may return to accrual status, if the collectability of both principal and interest is probable. All TDRs are individually evaluated for impairment.

The following table presents TDRs by loan category.

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TDRs have remained a small portion of our loan portfolio as loan modifications to borrowers with deteriorating financial condition are generally offered only as a part of an overall workout strategy to minimize losses to the Company. The $5.4 million decrease, or 60.8%, from December 31, 2020 was primarily due to the pay down of one relationship by $3.6 million.

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Risk Classification of Loans

Our policies, consistent with regulatory guidelines, provide for the classification of loans and other assets that are considered to be of lesser quality as pass-watch, substandard, doubtful, or loss.

A pass-watch loan is still considered a "pass" credit and is not a classified or criticized asset, but is a reflection of a borrower who exhibits credit weaknesses or downward trends warranting close attention and increased monitoring. These potential weaknesses may result in deterioration of the repayment prospects for the loan. No loss of principal or interest is expected, and the borrower does not pose sufficient risk to warrant classification.

A substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have a well-defined weakness, or weaknesses, that jeopardize the liquidation of the debt. They are characterized as probable that the borrower will not pay principal and interest in accordance with the contractual terms.

An asset classified as doubtful has all the weaknesses inherent in one classified as substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Assets classified as loss are those considered uncollectible and of such little value that their continuance as assets is not warranted; such balances are promptly charged-off as required by applicable federal regulations.

As of December 31, 2021 and 2020, our risk classifications of loans were as follows:

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Pass-watch loans decreased $60.3 million, or 28.9% from December 31, 2020 to December 31, 2021. Additionally, substandard loans decreased $2.3 million, or 2.8%, from December 31, 2020 to December 31, 2021. These improvements were primarily driven by improving economic conditions, which resulted in both risk rating upgrades and paydowns. Additionally, the transfer of one larger loan to foreclosed assets further contributed to the decrease in substandard loans.

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Net Charge-offs and Recoveries

The following table sets forth activity in the allowance for loan losses.

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The following table summarizes net charge-offs (recoveries) to average loans, before allowance for loan losses by loan category.

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Comparison of the Year Ended December 31, 2021 to the Year Ended December 31, 2020

Net charge-offs (recoveries) to average total loans before allowance for loan losses have remained low for several years, including each of the years ended December 31, 2021 and 2020. We believe our continuous credit monitoring and collection efforts have resulted in lower levels of loan losses, while also recognizing that favorable economic conditions prior to the COVID-19 pandemic and substantial federal economic stimulus during the pandemic have also contributed to reduced loan losses.

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Securities

The Company’s investment policy emphasizes safety of the principal, liquidity needs, expected returns, cash flow targets and consistency with our interest rate risk management strategy. The composition and maturities of the debt securities portfolio as of December 31, 2021 is summarized in the following table. Maturities are based on the final contractual payment dates, and do not reflect the impact of prepayments or early redemptions that may occur. Security yields have not been adjusted to a tax-equivalent basis.

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