OP Bancorp (OPBK) FY 2021 MD&A

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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our historical financial statements and the related notes thereto contained in this Report. Some of the information contained in this discussion and analysis or set forth elsewhere in this Report, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. You should review the sections titled “Cautionary Note Regarding Forward-Looking Statements” and “Risk Factors” for a discussion of forward-looking statements and important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis.

OVERVIEW

We are a bank holding company headquartered in Los Angeles, California. Our commercial community banking activities are operated through Open Bank, our banking subsidiary. We offer commercial banking services to small and medium-sized businesses, their owners and retail customers primarily in the Korean-American community.

Our results of operations depend primarily on our net interest income. We drive our income from interest received on our loan portfolio and the fee income we receive in connection with our deposits and the sale and service of SBA loans. Our major operating expenses are the interest we pay on deposits, the salaries and related benefits we pay our management and staff and the rent we pay on our leased properties. We rely primarily on locally-generated deposits, mostly from the Korean-American market within California, to fund our loan activities. We currently operate seven branches in Los Angeles County and Orange County, one branch in Santa Clara County, and one branch in Carrollton, Texas. We anticipate opening our tenth full service branch in Cerritos, located in Los Angeles County, California, in the first quarter of 2022. We have four loan production offices in Atlanta, Georgia, Aurora, Colorado, and Lynnwood and Seattle, Washington.

As of December 31, 2021, we had total assets of $1.73 billion, gross loans of $1.31 billion, total deposits of $1.53 billion, and total consolidated shareholders’ equity of $165 million. For the years ended December 31, 2021, 2020 and 2019, we recorded net income of $28.8 million, $13.1 million and $16.8 million, respectively.

The following significant items are of note for the year ended December 31, 2021 compared to the year ended December 31, 2020:

•Net income totaled $28.8 million or $1.88 per diluted common share for 2021, compared to $13.1 million or $0.85 per diluted common share

•Net interest income increased to $61.0 million, up 34.5% from $45.4 million

•Total assets of $1.73, a 26.3% increase

•Gross loans of $1.31 billion, a 19.5% increase

•Total deposits of $1.53 billion, a 27.8% increase

•Shareholders’ equity of $165.2 million, a 15.2% increase

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(1)     Represents noninterest expense divided by the sum of net interest income and noninterest income.

COVID-19 Update

The COVID-19 pandemic has caused significant, unprecedented disruption around the world that has affected daily living and negatively impacted the local, state, national and global economies. It has caused significant economic and financial disruption that have adversely affected or otherwise impacted our businesses. The COVID-19 has not yet been globally contained and the number of cases continues to increase in many locations, including in the United States in which we operate. During the course of the continuing pandemic, there have been varying governmental and other responses to slow or control the spread of the COVID-19 and to mitigate the adverse impact of the COVID-19, such as stay at home orders, restrictions on business activities, health and safety guidelines, economic relief for individuals and businesses, and monetary policy measures, such responses have met varying degrees of success, and it remains uncertain whether these actions will be successful in a sustained manner. We cannot predict at this time the scope and duration of the pandemic.

Despite the continuing challenges in recent months, there has been some improvement in the economic environment and resilience in the markets in which we operate. With the seemingly wider availability and distribution of vaccinations and the easing of some restrictions in the United States, we have seen steps towards broader containment. However, there still remains much uncertainty around containment of the pandemic, which will depend on various factors, including but not limited to, the extent and spread of variants of the virus; efficacy of vaccines; and government and other actions to mitigate the spread of COVID-19.

Through the COVID-19 pandemic, the Company was able to react quickly to these changes because of the commitment and flexibility of its workforce coupled with a well-prepared business continuity plan. The Company has taken various steps to help our customers, employees, and communities, while maintaining safe and sound banking operations. The Company has been assisting customers with loan deferrals and the PPP loans and has provided employees remote working environment while maintaining fully functioning operations in all areas.

Loan Payment Deferrals

In early 2020, we began providing payment deferrals of up to 12 months for our commercial and consumer borrowers who had been adversely impacted by the COVID-19 pandemic and had not been delinquent over 30 days on payments at the time of the borrowers’ deferral requests. For the loans modified under this program, in accordance with the provisions of Section 4013 of the CARES Act and the interagency statement issued by bank regulatory agencies, we elected to not apply troubled debt structuring classification who were current as of December 31, 2019. Through December 31, 2021, the Company has processed loan deferments for borrowers across multiple industries representing 226 loan accounts, with an aggregate loan balance of $250.8 million under the interagency guidance and Section 4013 of the CARES Act. As of December 31, 2021, total outstanding balance of remaining in deferment status balance was $5.0 million and represented 0.4% of the total portfolio, down from 2.7% as of December 31, 2020.

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The following tables summarize loan portfolio breakdown by industry and loan deferment as of December 31, 2021:

Paycheck Protection Program

Beginning in April 2020, we accepted applications under the PPP administered by the SBA under the CARES Act, as amended by the Economic Aid Act enacted on December 27, 2020 and have originated loans to qualified small businesses. Under the terms of the program, loans funded through the PPP are eligible to be forgiven if certain requirements are met, including using the funds for certain costs relating to payroll, healthcare and qualifying mortgage interest, rent and utility payments. To the extent not forgiven, loans are subject to terms of the program. Since the PPP’s inception through December 31, 2021, we have funded $154.5 million, and $118.7 million of principal forgiveness has

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been provided on qualifying PPP loans. As of December 31, 2021, there were unamortized net deferred fees and unaccreted discounts of $1.2 million to be recognized over the estimated life of the loan as a yield adjustment on the loans. If a loan is paid off or forgiven by the SBA prior to its projected estimated life, the remaining unamortized deferred fees will be recognized as interest income in that period.

Critical Accounting Policies and Estimates

Our accounting and reporting policies conform to accounting principles generally accepted in the United States of America (“GAAP”) and conform to general practices within the industry in which we operate. To prepare financial statements in conformity with GAAP, management makes estimates, assumptions and judgments based on available information. These estimates, assumptions and judgments affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements and, as this information changes, actual results could differ from the estimates, assumptions and judgments reflected in the financial statement. In particular, management has identified several accounting policies that, due to the estimates, assumptions and judgments inherent in those policies, are critical in understanding our financial statements.

The following is a discussion of the critical accounting policies and significant estimates that require us to make complex and subjective judgments. Additional information about these policies can be found in the “Notes to Consolidated Financial Statements, Note 1. Summary of Significant Accounting Policies.”

Allowance for Loan Losses

The allowance for loan losses (“ALL”) is a valuation allowance for probable incurred credit losses. Loan losses are charged against the ALL when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the ALL. Management estimates the ALL balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the ALL may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off.

The ALL is maintained at a level that management believes is appropriate to provide for known and inherent incurred loan losses as of the date of the Consolidated Balance Sheets and we have established methodologies for the determination of its adequacy. The methodologies are set forth in a formal policy and take into consideration the need for an overall general valuation allowance as well as specific allowances that are determined on an individual loan basis.

The evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available. While management uses available information to recognize losses on loans, changes in economic or other conditions may necessitate revision of the estimate in future periods.

RESULTS OF OPERATIONS

Net Income

We reported net income for the year ended December 31, 2021 of $28.8 million, compared to net income of $13.1 million for the year ended December 31, 2020. The increase was primarily due to a $15.7 million increase in net interest income and $5.4 million decrease in provision for loan losses, partially offset by a $6.7 million increase in provision for income taxes.

We reported net income for the year ended December 31, 2020 of $13.1 million, compared to net income of $16.8 million for the year ended December 31, 2019. The decrease was primarily due to a $4.9 million increase in provision for loan losses, offset by a $1.1 million increase in net interest income.

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Net Interest Income

The management of interest income and expense is fundamental to our financial performance. Net interest income, the difference between interest income and interest expense, is the largest component of the Company’s total revenue. Management closely monitors both total net interest income and the net interest margin (net interest income divided by average earning assets). We seek to maximize net interest income without exposing the Company to an excessive level of interest rate risk through our asset and liability policies. Interest rate risk is managed by monitoring the pricing, maturity and repricing options of all classes of interest-bearing assets and liabilities. Our net interest margin is also adversely impacted by the reversal of interest on nonaccrual loans and the reinvestment of loan payoffs into lower yielding investment securities and other short-term investments.

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The following table presents, for the periods indicated, information about: (i) weighted average balances, the total dollar amount of interest income from interest-earning assets and the resultant average yields, (ii) average balances, the total dollar amount of interest expense on interest-bearing liabilities and the resultant average rates, (iii) net interest income, (iv) the interest rate spread, and (v) the net interest margin.

(1)Includes income and average balances for Federal Home Loan Bank (“FHLB”) and Pacific Coast Bankers Bank (“PCBB”) stock, CRA qualified mutual fund, term federal funds, interest-earning time deposits and other miscellaneous interest-earning assets.

(2)    Average loan balances include non-accrual loans and loans held for sale

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(1)Includes income and average balances for FHLB and PCBB stock, CRA qualified mutual fund, term federal funds, interest-earning time deposits and other miscellaneous interest-earning assets.

(2)    Average loan balances include non-accrual loans and loans held for sale

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Increases and decreases in interest income and interest expense result from changes in average balances (volume) of interest-earning assets and interest-bearing liabilities, as well as changes in average interest rates. The following tables set forth the effects of changing rates and volumes on our net interest income during the period shown. Information is provided with respect to (i) effects on interest income attributable to changes in volume (change in volume multiplied by prior rate) and (ii) effects on interest income attributable to changes in rate (changes in rate multiplied by prior volume). Change applicable to both volume and rate have been allocated to volume and rate ratably.

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2021 compared to 2020

Net interest income for the year ended December 31, 2021 was $61.0 million compared to $45.4 million for the year ended December 31, 2020, an increase of $15.7 million, or 34.5%. This increase was primarily due to a $10.5 million increase in interest income from SBA loans, a $155.0 million increase in average SBA loan balance and a $5.2 million decrease in interest expense.

Total interest income was $64.2 million in 2021, compared to $53.7 million in 2020, an increase of $10.5 million, or 19.6%. This increase was primarily due to an increase in interest earned on SBA loans.

Interest and fees on loans was $62.4 million in 2021, compared to $51.8 million in 2020, an increase of $10.6 million, or 20.5%. This increase in interest income on loans was primarily due to a $155.0 million increase in average loan balance resulting from the purchase of loan portfolio from the Hana Small Business Lending, ("Hana") and PPP originations.

Interest income on total investments was $1.7 million in 2021, compared to $1.8 million in 2020. Interest income on securities available for sale decreased $92 thousand, or 7.8%, to $1.1 million in 2021, compared to $1.2 million in 2020. The decrease was primarily due to a 60 basis point decrease in the average yield, partially offset by a 52.0% increase in the average balance of securities available for sale. Interest income on federal funds sold and other investments decreased $25 thousand, or 3.8%, to $625 thousand in 2021 from $650 thousand in 2020, due to a 27 basis point decrease in the average yield on the federal funds sold and other investments, partially offset by a 55.5% increase in the average balance of federal funds sold and other investments held by the Company.

Total interest expense was $3.1 million in 2021, compared to $8.3 million in 2020, a decrease of $5.2 million, or 62.2%. The decrease was primarily due to a 77 basis point decrease in the average rate paid on interest-bearing deposits as a result of the downward adjustments of the Company’s rates paid on interest-bearing deposits in response to the rate decreases by the Federal Reserve. The average balance of interest-bearing liabilities increased $39.0 million to $743.5 million at December 31, 2021 from $704.5 million at December 31, 2020.

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Net interest margins for the years ended December 31, 2021 and 2020 were 4.02% and 3.72%, respectively.

2020 Compared to 2019

Net interest income for the year ended December 31, 2020 was $45.4 million compared to $44.3 million for the year ended December 31, 2019, an increase of $1.1 million, or 2.5%. This increase was primarily due to a $6.2 million decrease in interest expense from a 95 basis point decrease in the average rate paid on interest-bearing liabilities, partially offset by a $5.1 million decrease in interest income from a 105 basis point decrease in the average yield on loans, and a 139 basis point decrease in the average yield on investments. The significant decreases in the average rates were primarily due to the Federal Reserve’s cumulative market rate cuts of 150 basis points through three rate cuts in January and March of 2020.

Total interest income was $53.7 million in 2020, compared to $58.8 million in 2019, a decrease of $5.1 million, or 8.7%. This decrease was primarily due to a decrease in interest earned on our loan portfolio and a decrease in interest earned on federal funds sold.

Interest and fees on loans was $51.8 million in 2020, compared to $55.7 million in 2019, a decrease of $3.9 million, or 7.0%. This decrease in interest income on loans was primarily due to a 105 basis point decrease in the average yield on loans, partially offset by a $119.5 million, or 12.8%, increase in the average balance of loans outstanding.

Interest income on total investments was $1.8 million in 2020, compared to $3.1 million in 2019. Interest income on the securities portfolio decreased $176 thousand, or 13.0%, to $1.2 million in 2020, compared to $1.4 million in 2019. The decrease in interest income on the securities portfolio was primarily due to an 86 basis point decrease in the average yield on the securities portfolio, offset by 33.5% increase in the average balance of securities available for sale held by the Company. Interest income on federal funds sold and other investments decreased $1.1 million, or 61.9%, to $650 thousand in 2020 from $1.7 million in 2019, due to a 183 basis point decrease in the average yield on the federal funds sold and other investments, offset by 35.6% increase in the average balance of federal funds sold and other investments held by the Company.

Total interest expense was $8.3 million in 2020, compared to $14.5 million in 2019, a decrease of $6.2 million, or 42.8%. The decrease was primarily due to decreases in interest expense on deposits as result of the downward adjustments of the Company’s rates paid on interest-bearing deposits in response to the rate decreases by the Federal Reserve. The average balance of interest-bearing liabilities increased $24.2 million to $704.5 million at December 31, 2020 from $680.3 million at December 31, 2019.

Net interest margins for the years ended December 31, 2020 and 2019 were 3.72% and 4.19%, respectively.

Provision for Loan Losses

Credit risk is inherent in the business of making loans. We establish an allowance for loan losses through charges to earnings, which are shown in the statements of operations as the provision for loan losses. Specifically identifiable and quantifiable known losses are promptly charged off against the allowance. The provision for loan losses is determined by conducting a quarterly evaluation of the adequacy of our allowance for loan losses and charging the shortfall or excess, if any, to the current quarter’s expense. This has the effect of creating variability in the amount and frequency of charges to earnings. The provision for loan losses and level of allowance for each period are dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management’s assessment of the quality of the loan portfolio, the valuation of problem loans and the general economic conditions in our market area.

The provision for loan losses was $522 thousand for the year ended December 31, 2021, compared to $6.0 million for the year ended December 31, 2020. Management evaluated the qualitative and quantitative factors on all loan types to reflect the COVID-19 pandemic’s prolonged potential adverse impacts on national, state, and local economic and business conditions. The changes in qualitative factors accounted for a decrease of $1.1 million, and the changes in quantitative factors accounted for an increase of $1.5 million in the provision for loan losses for the year ended December 31, 2021. The changes in quantitative factors included a $439 thousand decrease in the provision for accrued interest receivables on deferred loans.

The allowance for loan losses as a percentage of gross loans was 1.23% at December 31, 2021 and 1.40% at December 31, 2020.

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Noninterest Income

While interest income remains the largest single component of total revenues, noninterest income is also an important component. A portion of our noninterest income is associated with SBA lending activity, consisting of gains on the sale of loans sold in the secondary market and servicing income from loans sold with servicing retained. Other sources of noninterest income include loan servicing fees, service charges and fees, and gains on the sale of securities.

The following table sets forth the various components of our noninterest income for the years ended December 31, 2021 and 2020:

Noninterest income for the year ended December 31, 2021 was $16.0 million, an increase of $5.2 million, or 48.7%, compared to $10.8 million for the year ended December 31, 2020.

Income from service charges on deposit accounts was $1.6 million for 2021, compared to $1.4 million for 2020, an increase of $131 thousand, or 9.2%. The increase was primarily due to higher account analysis charges and wire transaction fees, partially offset by lower overdraft charges in the year ended December 31, 2021, compared to the same period in 2020.

Total gain on sale of loans was $11.3 million in the year ended December 31, 2021, compared to $6.1 million for the same period of 2020, an increase of $5.2 million or 85.7%. Gain on sale of SBA loans totaled $11.0 million in the year ended December 31, 2021, compared to $5.9 million for the same period of 2020. We sold $110.3 million of SBA loans with an average premium of 11.0% in the year ended December 31, 2021, compared to the sale of $85.0 million of SBA loans with an average premium of 8.8% in the same period of 2020. We originated $304.9 million of SBA loans, including $88.1 million of SBA PPP loans, in 2021, compared to $204.1 million of SBA loans, including $66.3 million of SBA PPP loans, in 2020. Gain on sale of other loans for both periods were immaterial.

Other income for 2021 were $1.2 million, compared to $1.4 million for 2020, a decrease of $203 thousand, or 14.6%. The decrease was primarily due to a $187 thousand decrease in fair value of equity investment in a mutual fund that the Company invested for CRA purposes.

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The following table sets forth the various components of our noninterest income for the years ended December 31, 2020 and 2019:

Noninterest income for the year ended December 31, 2020 was $10.8 million, a decrease of $655 thousand, or 5.7%, compared to $11.4 million for the year ended December 31, 2019.

Income from service charges on deposit accounts was $1.4 million for 2020, compared to $2.0 million, a decrease of $584 thousand, or 29.0%. This decrease was primarily due to lower overdrafts in the year ended December 31, 2020, compared to the same period in 2019, reflecting higher balances and lower transaction activities on deposit accounts amid the COVID-19 pandemic.

Total gain on sale of loans was $6.1 million in the year ended December 31, 2020, compared to $5.9 million for the same period of 2019, an increase of $187 thousand or 3.2%. Gain on sale of SBA loans totaled $5.9 million in the year ended December 31, 2020, compared to $5.8 million for the same period of 2019. We sold $85.0 million of SBA loans with an average premium of 8.8% in the year ended December 31, 2020, compared to the sale of $85.0 million of SBA loans with an average premium of 8.4% in the same period of 2019. We originated $204.1 million of SBA loans, including $66.3 million of SBA PPP loans, in 2020, compared to $110.5 million of SBA loans in 2019. Gain on sale of other loans for both periods were immaterial.

Loan servicing income, net of amortization, increased by $670 thousand to $1.9 million in 2020, compared to $1.2 million in 2019. The increase in loan servicing income was due to a $323 thousand increase in servicing fees and a $347 thousand decrease in servicing asset amortization expense. Our total SBA loan servicing portfolio was $388.8 million as of December 31, 2020, compared to $347.8 million as of December 31, 2019.

The servicing assets that result from the sales of SBA loans with servicing retained are amortized over the expected term of the loans using a method approximating the interest method. Servicing income generally declines as the respective loans are repaid.

Other income for 2020 were $1.4 million, compared to $2.3 million for 2019, a decrease of $928 thousand, or 40.0%. The decrease was primarily attributable to a one-time gain on company owned life insurance of $1.2 million in the year ended December 31, 2019, partially offset by a gain of $213 thousand from a sale of other property in the year ended December 31, 2020. The Company sold a property that has been used for the Company’s internal use with a gain of $213 thousand during the fourth quarter of 2020.

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Noninterest Expense

Noninterest expense for the year ended December 31, 2021 was $35.9 million, compared to $31.9 million for the year ended December 31, 2020, an increase of $3.9 million, or 12.3%.

The following table sets forth the major components of our noninterest expense for the years ended December 31, 2021 and 2020:

Salaries and employee benefits expense for the year ended December 31, 2021 was $21.3 million, compared to $20.0 million for the year ended December 31, 2020, an increase of $1.2 million, or 6.0%. The increase was primarily due to a $1.3 million increase from an increase in the number of employees to support continued growth and a $1.3 million increase in employee incentives for higher SBA loan originations and sales in 2021, partially offset by a $1.3 million increase in deferred loan origination costs. The average number of full-time equivalent employees was 181.5 in 2021 compared to 171.3 in 2020. The increase in deferred loan costs was primarily attributable to the origination of 1,979 new SBA PPP Loans, in the year ended December 31, 2021, compared to 983 new SBA PPP loans in the year ended December 31, 2020.

Data processing and communication expense for 2021 was $2.0 million, compared to $1.7 million for 2020, an increase of $318 thousand, or 18.9%. This increase was primarily to support balance sheet growth.

Our aggregate donations to the Foundation and other charitable and community contributions for 2021 were $2.9 million, compared to $1.3 million for 2020, an increase of $1.6 million, or 116.5%. The increase was primarily due to higher donation accruals for Open Stewardship Foundation as a result of higher net income.

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The following table sets forth the various components of our noninterest expense for the year ended December 31, 2020 and 2019:

Noninterest expense for the year ended December 31, 2020 was $31.9 million, compared to $32.5 million for the year ended December 31, 2019, a decrease of $580 thousand, or 1.8%.

Salaries and employee benefits expense for the year ended December 31, 2020 was $20.0 million, compared to $20.3 million for the year ended December 31, 2019, a decrease of $226 thousand, or 1.1%. This decrease was attributable to an increase in deferred loan origination cost, partially offset by an increase in the number of employees to support continued growth, annual salary adjustments and increased benefits costs. The increase in deferred loan costs is primarily attributable to the origination of 1,300 new loans, including 983 SBA PPP Loans, in the year ended December 31, 2020, compared to 345 new loans in the year ended December 31, 2019. The average number of full-time equivalent employees was 171.3 in 2020 compared to 166.1 in 2019.

Occupancy and equipment expense for 2020 was $5.0 million, compared to $4.6 million for 2019, an increase of $326 thousand, or 7.0%. This increase was primarily due the annual increase of rent under our office leases and a new branch opened in the second quarter of 2019.

Data processing and communication expense for 2020 was $1.7 million, compared to $1.5 million for 2019, an increase of $152 thousand, or 9.9%. This increase was primarily due to supporting increased online transaction activities and supporting increased users on authentication system along with an increase in number of employees in 2020.

Professional fees for 2020 were $1.1 million, compared to $980 thousand for 2019, an increase of $121 thousand, or 12.3%. The increase was primarily due to an increase in internal audit costs in line with the Company’s growth.

FDIC insurance and regulatory assessment expense for 2020 was $449 thousand, compared to $259 thousand for 2019, an increase of $190 thousand or 73.4%. The FDIC insurance and regulatory assessments for 2019 was lower due to the small bank assessment credits that was applied to offset the FDIC assessments for the second half of 2019.

Directors’ fees and expenses for 2020 were $700 thousand, compared to $908 thousand for 2019, a decrease of $208 thousand or 22.9%. Directors’ fees and expenses include a monthly retainer fee, reimbursement for travel and other expenses, and stock-based expenses relating to equity awards granted to our directors in prior years under our equity plans. The decrease was primarily due to a decrease in stock-based expenses resulting from the full vesting of the restricted stock units in July 2020. Directors’ stock-based expenses for 2020 and 2019 were $252 thousand and $431 thousand, respectively.

Our aggregate donations to the Foundation and other charitable and community contributions for 2020 were $1.3 million, compared to $1.6 million for 2019, a decrease of $251 thousand, or 15.8%. The decrease was due to decreased donation accruals for Open Stewardship Foundation, which is directly proportionate to our after-tax net income. On an annual basis, we donate 10% of our consolidated net income after taxes to the Foundation.

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Other expenses for 2020 were $1.2 million compared to $1.5 million for 2019, a decrease of $345 thousand, or 22.5%. The decrease was primarily due to Company’s proactive management of overhead expenses amid the COVID-19 pandemic.

Income Tax Expense

Income tax expense was $11.8 million in 2021, compared to $5.1 million in 2020. Effective tax rates were 29.1% and 28.0% in 2021 and 2020, respectively. The increase in the effective tax rate was primarily attributable to less permanent differences as a percentage of pre-tax net income in 2021 compared to 2020. These differences are primarily due to a lower amount of tax benefits resulting from the exercise of non-qualified stock options and the vesting of restricted stock units in 2021.

Some items of income and expense are recognized in different years for tax purposes than when applying GAAP, leading to timing differences between our actual tax liability and the amount accrued for liability based on book income. These temporary differences comprise the “deferred” portion of our tax expense or benefit, which accumulates on our books as a deferred tax asset or deferred tax liability, until such time as they reverse.

Realization of deferred tax assets is primarily dependent upon us generating sufficient future taxable income to obtain benefit from the reversal of net deductible temporary differences, along with the utilization of tax credit carry forwards and the net operating loss carry forwards for Federal and California state income tax purposes. The amount of deferred tax assets considered realizable is subject to adjustment in future periods based on estimates of future taxable income. Under GAAP a valuation allowance is required to be recognized if it is “more likely than not” that the deferred tax assets will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, including forecasts of future income, cumulative losses, applicable tax planning strategies, and assessments of current and future economic and business conditions.

We recognized net deferred tax assets of $8.4 million and $3.2 million as of December 31, 2021, and December 31, 2020, respectively.

After consideration of the matters in the preceding paragraph, we have determined that it is more likely than not that net deferred tax assets as of December 31, 2021 and December 31, 2020 will be fully realized in future years.

FINANCIAL CONDITION

Investment portfolio

The securities portfolio is the second largest component of our interest earning assets, and the structure and composition of this portfolio is important to an analysis of our financial condition. The portfolio serves the following purposes: (i) it provides a source of pledged assets for securing certain deposits and borrowed funds, as may be required by law or by specific agreement with a depositor or lender; (ii) it provides liquidity to even out cash flows from the loan and deposit activities of customers; (iii) it can be used as an interest rate risk management tool, because it provides a large base of assets, the maturity and interest rate characteristics of which can be changed more readily than the loan portfolio to better match changes in the deposit base and our other funding sources; and (iv) it is an alternative interest-earning use of funds when loan demand is weak or when deposits grow more rapidly than loans.

We classify our securities as either available-for-sale or held-to-maturity at the time of purchase. Accounting guidance requires available-for-sale securities to be marked to fair value with an offset to accumulated other comprehensive income (loss), a component of shareholders’ equity. Monthly adjustments are made to reflect changes in the fair value of our available-for-sale securities.

All securities in our investment portfolio were classified as available-for-sale as of December 31, 2021. There were no held-to-maturity or trading securities in our investment portfolio as of December 31, 2021. All available-for-sale securities are carried at fair value and consist of U.S. government agencies or sponsored agency securities.

Securities available-for-sale increased $58.7 million, or 63.9%, to $150.4 million at December 31, 2021 from $91.8 million at December 31, 2020, primarily due to purchases of $98.4 million, partially offset by principal paydowns and maturity of $35.9 million for the year ended December 31, 2021. No issuer of the available-for-sale securities, other

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than U.S. Government and its agencies, comprised more than ten percent of our shareholders’ equity as of December 31, 2021 and 2020.

The following table summarizes the fair value of the available-for-sale securities portfolio as of the dates presented.

Certain securities have fair values less than amortized cost and, therefore, contain unrealized losses. At December 31, 2021, we evaluated the securities which had an unrealized loss for other than temporary impairment (“OTTI”) and determined all decline in value to be temporary. We anticipate full recovery of amortized cost with respect to these securities by maturity, or sooner in the event of a more favorable market interest rate environment. We do not intend to sell these securities and it is not more likely than not that we will be required to sell them before recovery of the amortized cost basis, which may be at maturity.

The following table sets forth certain information regarding contractual maturities and the weighted average yields of our investment securities as of the dates presented. Expected maturities may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties.

We have not used interest rate swaps or other derivative instruments to hedge fixed rate loans or securities to otherwise mitigate interest rate risk.

Loans

Our loans represent the largest portion of our earning assets, substantially greater than the securities portfolio or any other asset category, and the quality and diversification of the loan portfolio is an important consideration when reviewing our financial condition.

On May 24, 2021, the Company completed the purchase of the Hana’s loan portfolio and paid approximately $97.6 million that included loans of $100.0 million at a fair value discount of $8.9 million, servicing assets of $6.1 million and accrued interest receivable of $398 thousand. The following table summarizes the consideration paid for the loan portfolio and the amounts of assets purchased:

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(1)    Consists of $92.2 million of SBA loans, $6.9 million PPP loans and $919 thousand of real estate loans.

The loan distribution table that follows sets forth our gross loans outstanding, and the percentage distribution in each category as of the dates indicated:

(1)     Includes net deferred loan fees or costs, unamortized premiums and unaccreted discounts of $(7.0) million and $(5.9) million as of December 31, 2021 and 2020, respectively.

Gross loans increased $214.3 million, or 19.5%, to $1.31 billion at December 31, 2021, compared to $1.10 billion as of December 31, 2020. The increase resulted mainly from $100.0 million of the Hana loan purchase and $88.2 million of PPP originations.

The following tables presents the contractual loan maturities by loan category and the contractual distribution of loans to changes in interest rates as of December 31, 2021 and 2020:

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Our loan portfolio is concentrated in commercial real estate with the remaining balances in SBA loans (unguaranteed portion and PPP loans), home mortgage and commercial (primarily manufacturing, wholesale, and services oriented entities). We do not have any material concentrations by industry or group of industries in the loan portfolio. However, 83.3% of our gross loans were secured by real property at December 31, 2021, with no change in percentage from December 31, 2020.

Loans — Commercial Real Estate: We have established concentration limits in the loan portfolio for commercial real estate loans, commercial and industrial loans, and unsecured lending, among others. All loan types are within established limits. We use underwriting guidelines to assess the borrowers’ historical cash flow to determine debt service, and we further stress test the debt service under higher interest rate scenarios. Financial and performance covenants are used in commercial lending agreements to allow us to react to a borrower’s deteriorating financial condition, should that occur.

Commercial real estate loans include owner-occupied and non-occupied commercial real estate. We originate both fixed and adjustable rate loans. Adjustable rate loans are based on the Wall Street Journal prime rate. As of December 31, 2021, approximately 69% of the commercial real estate portfolio consisted of fixed-rate loans. Our policy maximum loan-to-value, or LTV, is 70% for commercial real estate loans. As of December 31, 2021, our average loan to value for commercial real estate loans was 53%. Our commercial real estate loan portfolio totaled $701.5 million at December 31, 2021 compared to $651.7 million at December 31, 2020.

Loans — SBA Loans: We are designated as an SBA Preferred Lender under the SBA Preferred Lender Program. We offer mostly SBA 7(a) variable-rate loans. We generally sell the 75% guaranteed portion of the SBA loans that we originate. Our SBA loans are typically made to small-sized manufacturing, wholesale, retail, hotel/motel and service businesses for working capital needs or business expansions. SBA loans have maturities up to 25 years. Typically, non-real estate secured loans mature in less than 10 years. Collateral may also include inventory, accounts receivable and equipment, and may include personal guarantees. Our unguaranteed SBA loans collateralized by real estate are monitored by collateral type and included in our CRE Concentration Guidance.

As of December 31, 2021, our SBA portfolio totaled $276 million, including $40.6 million of SBA PPP loans, compared to $211.4 million, including $64.9 million of SBA PPP loans, as of December 31, 2020. These increases were primarily due to the Hana loan purchase and continued growth of our SBA loan portfolio. We originated $304.9 million, including $88.1 million of SBA PPP loans, and $204.1 million, including $66.3 million of SBA PPP loans, during the years ended December 31, 2021 and 2020, respectively. We sold $110.3 million and $85.0 million of SBA loans during the years ended December 31, 2021 and 2020, respectively.

From our total SBA loan portfolio, $220.1 million is secured by real estate and $55.8 million is unsecured or secured by business assets at December 31, 2021.

Loans — Commercial and Industrial: Commercial and industrial loans totaled $162.5 million at December 31, 2021, compared to $107.3 million at December 31, 2020, an increase of $55.2 million, or 51.5%. The increase was primarily due to a $36.9 million increase in warehouse line of credits and a $11.7 million increase in commercial term loan purchases in 2021.

Loans - Home Mortgage: We originate mainly non-qualified, alternative documentation single-family home mortgage loans (“home mortgage”) primarily through broker relationships, but also through our branch network. The loan

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product is a five-year or seven-year hybrid adjustable rate mortgage, which reprices after five years to the one-year SOFR plus certain spreads. We originate the non-qualified single-family home mortgage loans held by us for investment.

Home mortgage loans totaled $173.3 million as of December 31, 2021, compared to $128.2 million as of December 31, 2020, an increase of $45.1 million, or 35.2%. The increase was primarily due to a purchase of $48.9 million in home mortgage loans from third party mortgage originators in December 2021. For the year ended December 31, 2021, we originated $57.6 million and sold $4.2 million in home mortgage loans. Payoffs and paydowns for the same period were $40.7 million and $5.9 million, respectively. For the same period in 2020, we originated $48.2 million and sold $9.2 million in home mortgage loans. Payoffs and paydowns for the same period were $26.7 million and $5.5 million, respectively.

Loan Servicing

As of December 31, 2021, 2020, and 2019, we serviced $667.0 million $388.8 million and $347.8 million, respectively, of SBA loans for others. Activity for loan servicing rights was as follows:

Loan servicing rights are reported on our Consolidated Balance Sheets and reported net of amortization.

Allowance for Loan Losses

The allowance for loan losses is an estimate of probable incurred losses in the loan portfolio. Loans are charged-off against the allowance when management believes a loan balance is uncollectible. Subsequent recoveries, if any, are credited to the allowance for loan losses. Management’s methodology for estimating the allowance balance consists of several key elements, which include specific allowances on individual impaired loans and the formula driven allowances on pools of loans with similar risk characteristics. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged-off.

The allowance for loan losses is determined on a quarterly basis and reflects management’s estimate of probable incurred credit losses inherent in the loan portfolio. We also rely on internal and external loan review procedures to further assess individual loans and loan pools, and economic data for overall industry and geographic trends. The computation includes element of judgment and high levels of subjectivity.

A loan is considered impaired when it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans include loans on non-accrual status and performing restructured loans. Income from loans on non-accrual status is recognized to the extent cash is received and when the loan’s principal balance is deemed collectible. Depending on a particular loan’s circumstances, we measure impairment of a loan based upon either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the fair value of the collateral less estimated costs to sell if the loan is collateral dependent. A loan is considered collateral dependent when repayment of the loan is based solely on the liquidation of the collateral. Fair value, where possible, is determined by independent appraisals, typically on an annual basis. Between appraisal periods, the fair value may be adjusted based on specific events, such as if deterioration of quality of the collateral comes to our attention as part of our problem loan monitoring process, or if discussions with the borrower lead us to believe the last appraised value no longer reflects the actual market value for the collateral. The impairment amount on a collateral-dependent loan is charged-off to the allowance if deemed not collectible and the impairment amount on a loan that is not collateral-dependent is set up as a specific reserve.

In cases where a borrower experiences financial difficulties and we make certain concessionary modifications to contractual terms, the loan is classified as a troubled debt restructuring. These concessions may include a reduction of the interest rate, principal or accrued interest, extension of the maturity date or other actions intended to minimize potential

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losses. Loans restructured at a rate equal to or greater than that of a new loan with comparable risk at the time the loan is modified may be excluded from restructured loan disclosures in years subsequent to the restructuring if the loans are in compliance with their modified terms. A restructured loan is considered impaired despite its accrual status and a specific reserve is calculated based on the present value of expected cash flows discounted at the loan’s effective interest rate or the fair value of the collateral less estimated costs to sell if the loan is collateral dependent. Interest income on impaired loans is accrued as earned, unless the loan is placed on non-accrual status.

The allowance for loan losses was $16.1 million at December 31, 2021, compared to $15.4 million at December 31, 2020 and $10.1 million at December 31, 2019. The provision for loan losses was $522 thousand for the year ended December 31, 2021, compared to $6.0 million for the year ended December 31, 2020.

In determining the allowance and the related provision for loan losses, we consider three principal elements: (i) valuation allowances based upon probable losses identified during the review of impaired commercial and industrial, commercial real estate, construction and land development loans; (ii) allocations, by loan classes, on loan portfolios based on historical loan loss experience and qualitative factors; and (iii) review of the credit discounts in relationship to the valuation allowance calculated for purchased loans. Provisions for loan losses are charged to operations to record changes to the total allowance to a level deemed appropriate by us.

It is the policy of management to maintain the allowance for loan losses at a level adequate for risks inherent in the loan portfolio. The FDIC and the DFPI also review the allowance for loan losses as an integral part of their examination process. Based on information currently available, management believes that our allowance for loan losses is adequate. However, the loan portfolio can be adversely affected if California economic conditions and the real estate market in our market area were to weaken. The effect of such events, although uncertain at this time, could result in an increase in the level of nonperforming loans and increased loan losses, which could adversely affect our future growth and profitability. No assurance of the ultimate level of credit losses can be given with any certainty.

Analysis of the Allowance for Loan Losses

The following table provides an analysis of the allowance for loan losses, provision for loan losses and net charge-offs, by category, for the years ended December 31, 2021, 2020 and 2019.

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(1)Excludes (reversal of) provision for uncollectible accrued interest receivable of $205 thousand and $643 thousand for the years ended December 31, 2021, and 2020, respectively. There was no provision for uncollectible accrued interest receivable for the year ended December 31, 2019.

(2)Excludes loans held for sale.

The following table presents an allocation of the allowance for loan losses by portfolio as of December 31, 2021 and December 31, 2020:

Nonperforming Assets

Loans are considered delinquent when principal or interest payments are past due 30 days or more. Delinquent loans may remain on accrual status between 30 days and 90 days past due. Loans on which the accrual of interest has been discontinued are designated as non-accrual loans. Typically, the accrual of interest on loans is discontinued when principal or interest payments are 90 days past due or when, in the opinion of management, there is a reasonable doubt as to

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collectability in the normal course of business. When loans are placed on non-accrual status, all interest previously accrued, but not collected, is reversed against current period interest income. Income on non-accrual loans is subsequently recognized only to the extent that cash is received, and the loan’s principal balance is deemed collectible. Loans are restored to accrual status when loans become well-secured and management believes full collectability of principal and interest is probable.

Nonperforming loans include loans that are 90 days past due and still accruing, loans accounted for on a non-accrual basis and accruing restructured loans. Nonperforming assets consist of nonperforming loans plus OREO.

Nonperforming loans were $3.2 million at December 31, 2021, compared to $985 thousand at December 31, 2020 and $1.5 million at December 31, 2019. The increase in nonperforming loans for the year ended December 31, 2021 was primarily due to SBA loans that were placed on non-accruals in 2021. As of December 31, 2021, $1.0 million of non-accrual loans was the guaranteed portion of SBA loans that are in liquidation.

Real estate we acquire as a result of foreclosure or by deed-in-lieu of foreclosure is classified as OREO until sold, and is initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. We had no OREO as of December 31, 2021, 2020 or 2019.

The following table sets forth the allocation of our nonperforming assets among our different asset categories as of the dates indicated. Nonperforming loans include non-accrual loans, loans past due 90 days or more and still accruing interest, and loans modified under troubled debt restructurings.

Deposits and Other Sources of Funds

We gather deposits primarily through our branch locations. We offer a variety of deposit products including demand deposits accounts, interest-bearing products, savings accounts and certificate of deposits. We dedicate continuing effort into gathering noninterest demand deposits accounts through marketing to our existing and new loan customers, customer referrals, our marketing staff and various involvement with community networks.

The following table show the composition of deposits by type as of the dates indicated:

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The following tables set forth the maturity of time deposits at December 31, 2021:

Other than deposits, we also utilized FHLB advances as a supplementary funding source to finance our operations. The advances from the FHLB are collateralized by residential and commercial real estate loans. As of December 31, 2021, and 2020, we had maximum borrowing capacity from the FHLB of $417.6 million and $394.0 million, respectively. As of December 31, 2021, we had no borrowings from FHLB. At December 31, 2020, we had $5.0 million in borrowings from the FHLB, which has a 0% interest rate under the Zero-Rate Recovery Advance Program, FHLB’s pandemic relief initiatives.

Liquidity and Capital Recourses

Liquidity refers to the measure of our ability to meet the cash flow requirements of depositors and borrowers, while at the same time meeting our operating, capital and strategic cash flow needs, all at a reasonable cost. We continuously monitor our liquidity position to ensure that assets and liabilities are managed in a manner that will meet all short-term and long-term cash requirements. We manage our liquidity position to meet the daily cash flow needs of customers, while maintaining an appropriate balance between assets and liabilities to meet the return on investment objectives of our shareholders. Our short-term and long-term liquidity requirements are primarily met through cash flow from operations, redeployment of prepaying and maturing balances in our loan and investment portfolios, and increases in customer deposits. Other alternative sources of funds will supplement these primary sources to the extent necessary to meet additional liquidity requirements on either a short-term or long-term basis.

Deposits are the primarily funding source for the Bank. Deposits provide a stable source of funding and reduce the Company's reliance on the wholesale funding markets. The following table presents the loan and deposit balances, the loans-to-deposit ratios, and deposits as a percentage of total liabilities as of December 31, 2021 and 2020:

In addition to deposits, the Company has access to various sources of wholesale funding, as well as borrowing capacity at the FHLB, Federal Reserve, and correspondent banks to sustain an adequate liquid asset portfolio, meet daily cash demands and allow management flexibility to execute the business strategy. Economic conditions and the stability of capital markets impact the access to and the cost of wholesale funding. The access to capital markets is also affected by the ratings received from various credit rating agencies.

We had $100.0 million of unsecured federal funds lines with no amounts advanced as of December 31, 2021 and December 31, 2020, respectively, compared to $13.5 million at December 2019. In addition, on such dates we had lines of credit from the Federal Reserve discount window of $141.6 million, $125.7 million and $124.0 million, respectively. The Federal Reserve discount window lines were collateralized by a pool of commercial real estate loans and commercial and industrial loans totaling $240.6 million, $219.1 million and $206.7 million at December 31, 2021, 2020 and 2019, respectively. We did not have any borrowings outstanding with the Federal Reserve at December 31, 2021, 2020 or 2019, and our borrowing capacity is limited only by eligible collateral.

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Based on the values of loans pledged as collateral, we had $350.6 million of additional borrowing availability with the FHLB at December 31, 2021. We also maintain relationships in the capital markets with brokers to issue certificates of deposit and money market accounts.

The Company maintains liquidity in the form of cash and cash equivalents, and unencumbered high-quality and liquid AFS debt securities. The following table presents the Company's liquid assets as of December 31, 2021 and 2020:

The following tables summarizes short- and long-term material cash requirements as of December 31, 2021, which we believe that we will be able to fund these obligations through cash generated from our operations and available alternative sources of funds:

(1)Includes deposits with no defined maturity, such as noninterest-bearing demand, savings and money market.

(2)Deposits and borrowings exclude accrued interest.

In addition to contractual obligations, other commitments of the Company impact liquidity. These include unused commitments to extend credit, standby letters of credit and commercial letters of credit. Since many of these commitments expire without being drawn upon, and each customer must continue to meet the conditions established in the contract, the total amount of these commercial commitments does not necessarily represent the future cash requirements of the Company. The Company's liquidity sources have been, and are expected to be, sufficient to meet the cash requirements of its lending activities, Information about the Company's loan commitments, standby letters of credit and commercial letters of credit is provided in Note 10. Commitments and Contingencies to the Consolidated Financial Statements in this Form 10-K.

Capital Requirements

We are subject to various regulatory capital requirements administered by the federal and state banking regulators. Failure to meet regulatory capital requirements may result in certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for “prompt corrective action”, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting policies. The capital amounts and classifications are subject to qualitative judgments by the federal banking regulators regarding components, risk weightings and other factors. Qualitative measures established by regulation to ensure capital adequacy required us to maintain minimum amounts and various ratios of CET1 capital, Tier 1 capital and total capital to risk-weighted assets and of Tier 1 capital to average consolidated assets, referred to as the “leverage ratio.” For further information, see “Supervision and Regulation.”

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The table below also summarizes the capital requirements applicable to us and the Bank in order to be considered “well-capitalized” from a regulatory perspective, as well as our and the Bank’s capital ratios as of December 31, 2021 and 2020. The Bank exceeded all regulatory capital requirements under the Basel III Capital Rules and were considered to be “well-capitalized” as of the dates reflected in the table below. At December 31, 2021, the FDIC categorized us as well-capitalized under the prompt corrective action framework. There have been no conditions or events since December 31, 2021 that management believes would change this classification.

(1) The capital requirements are only applicable to the Bank, and the Company's ratios are included for comparison purpose.