# PATRIOT NATIONAL BANCORP INC (PNBK) FY 2022 MD&A

Verbatim Item 7 Management's Discussion and Analysis from PATRIOT NATIONAL BANCORP INC's 10-K for fiscal year 2022.

SEC filing source: https://www.sec.gov/Archives/edgar/data/1098146/000162828023009713/pnbk-20221231.htm
Accession: 0001628280-23-009713
Filing date: 2023-03-29
Report date: 2022-12-31
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary.
Confidence: high

Company profile: /company/PNBK/
All MD&A years: /company/PNBK/mda/
Previous year: /company/PNBK/mda/fy2021/ (FY 2021)
Next year: /company/PNBK/mda/fy2023/ (FY 2023)

ITEM 7. Management’s Discussion and Analysis - Financial Condition & Results of Operations

General

Management's Discussion and Analysis of Financial Condition and Results of Operations is intended to assist in understanding the consolidated financial condition and results of operations of the Company. The information contained in this section should be read in conjunction with the consolidated financial statements and accompanying notes thereto included in Item 8 of this Annual Report on Form 10-K.

Critical Accounting Policies

The accounting and reporting policies of Patriot conform to accounting principles generally accepted in the United States of America (“U.S. GAAP”) and to general practices within the financial services industry. A summary of Patriot’s significant accounting policies is included in the Notes to consolidated financial statements that are referenced in Item 8. Financial Statements and Supplementary Data. Although all of Patriot’s policies are integral to understanding its consolidated financial statements, certain accounting policies involve management to exercise judgment, develop assumptions, and make estimates that may have a material impact on the financial information presented in the consolidated financial statements or Notes thereto. The assumptions and estimates are based on historical experience and other factors representing the best available information to management as of the date of the consolidated financial statements, up to and including the date of issuance or availability for issuance. As the basis for the assumptions and estimates incorporated in the consolidated financial statements may change, as new information comes to light, the consolidated financial statements could reflect different assumptions and estimates.

Due to the judgments, assumptions, and estimates inherent in the following policies, management considers such accounting policies critical to an understanding of the Consolidated Financial Statements and Management's Discussion and Analysis of Financial Condition and Results of Operations.

Allowance for Loan and Lease Losses (ALLL)

The Company maintains an ALLL at a level management believes is sufficient to absorb estimated credit losses incurred as of the report date. Management’s determination of the adequacy of the ALLL is based on periodic evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective as it requires significant estimates by management. As applicable, consideration is given to a variety of factors in establishing these estimates including historical losses, peer and industry data, current economic conditions, the size and composition of the loan portfolio, delinquency statistics, criticized and classified assets and impaired loans, results of internal loan reviews, borrowers’ perceived financial and management strengths, the adequacy of underlying collateral, the dependence on collateral, and the strength of the present value of future cash flows and other relevant factors. These factors may be susceptible to significant change.

To the extent actual outcomes differ from management’s estimates, additional provisions for loan losses may be required, which may adversely affect the Company’s results of operations in the future. Subsequent to acquisition of purchased-credit-impaired loans, estimates of cash flows expected to be collected are updated each reporting period based on updated assumptions regarding default rates, loss severity, and other factors that are reflective of current market conditions. Subsequent decreases in expected cash flows will generally result in a provision for loan losses; subsequent increases in expected cash flows may result in a reversal of the provision for loan losses to the extent of prior charges.

The new accounting standard, CECL, effective for the Company as of January 1, 2023. will require the Bank to determine periodic estimates of lifetime expected credit losses on loans, other financial instruments and other commitments to extend credit and provide for the expected credit losses as allowances for credit losses. This will change our current method of providing allowance for loan losses and require us to record an allowance for credit losses as of January 1,2023 materially in excess of our existing allowance for loan losses. CECL will also greatly increase the data we will need to collect and review to determine the appropriate level of the allowance for credit losses and will likely require larger allowances for credit losses going forward than our current methodology.

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Unrealized Gains and Losses on Securities Available-for-sale

The Company receives estimated fair values of debt securities from independent valuation services and brokers. In developing these fair values, the valuation services and brokers use estimates of cash flows based on historical performance of similar instruments in similar rate environments. Available-for-sale debt securities consist primarily of U.S. Government agency debt and mortgage-backed securities issued by the U.S. government, corporate bonds, subordinated notes and SBA loan pools. The Company uses various indicators in determining whether a security is other-than-temporarily impaired including, for debt securities, when it is probable that the contractual interest and principal will not be collected, or for equity securities, whether the market value is below its cost for an extended period of time with low expectation of recovery. The debt securities are monitored for changes in credit ratings because adverse changes in credit ratings could indicate a change in the estimated cash flows of the underlying collateral or issuer. The Company also considers the volatility of a security’s price in comparison to the market as a whole and any recoveries or declines in fair value subsequent to the balance sheet date. If management determines that the impairment is other-than-temporary, the entire amount of the impairment, as of the balance sheet date, is recognized in earnings, even if the decision to sell the security has not been made.

The fair value of the security becomes the new amortized cost basis of the investment and is not adjusted for subsequent recoveries in fair value. Available-for-sale debt securities were not considered to be other-than-temporarily impaired as of December 31, 2022, 2021, or 2020 because the unrealized losses were related to changes in interest rates and did not affect the expected cash flows to be received, or indicate a loss of value on the underlying collateral, or a loss of financial stability on the part of the issuer. Management concluded that the declines in fair value of the investment portfolio as of the reporting dates is temporary and that values would recover by way of increases in market price or positive changes in market interest rates.

Deferred Income Taxes

The Company uses the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on temporary differences between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect on deferred tax assets and liabilities of a change in tax laws is recognized in the consolidated statements of operations in the period that includes the enactment date.

Valuation allowances are established when necessary to reduce deferred tax assets to the amounts that are more likely than not expected to be realized based on the weighting of positive and negative evidence. Future realization of deferred tax assets ultimately depends on the existence of sufficient taxable income of the appropriate character (for example, ordinary income or capital gain) within the carryback or carryforward periods available under the applicable tax law. The Company regularly reviews the deferred tax assets for recoverability based on historical taxable income, projected future taxable income, the expected timing of the reversals of existing temporary differences and tax planning strategies. The Company’s judgments regarding future profitability may change due to many factors, including future market conditions and the ability to successfully execute its business plans. Should there be a change in the ability to recover deferred tax assets, the tax provision would increase or decrease in the period in which the assessment is changed.

Goodwill and Other Intangible Assets

Goodwill represents the excess of cost over the identifiable net assets of businesses acquired. Goodwill is recognized as an asset and is to be reviewed for impairment annually and between annual tests when events and circumstances indicate that impairment may have occurred. Impairment is a condition that exists when the carrying amount of goodwill exceeds its implied fair value.

Intangible assets, other than goodwill and indefinite-lived intangible assets, are amortized to expense over their estimated useful lives in a manner consistent with that in which the related benefits are expected to be realized, and are periodically reviewed by management to assess recoverability. Impairment losses on other intangibles are recognized as a charge to expense if carrying amounts exceed fair values.

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Servicing Assets

A servicing asset related to SBA loans is initially recorded when these loans are sold and the servicing rights are retained. The servicing asset is recorded on the balance sheet and included in other assets. Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market-based assumptions. Impairment is evaluated based on stratifying the underlying financial assets by date of origination and term. Any impairment, if temporary, would be reported as a valuation allowance.

Derivatives Instruments and Hedging Activities

The Company enters into interest rate swap agreements as part of the Company’s interest rate risk management strategy. The Company has derivatives not designated as hedges. Derivatives not designated as hedges are not speculative and result from a service the Company provides to certain loan customers. The Company executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies. Those interest rate swaps are simultaneously hedged by offsetting derivatives that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions. The swaps are reported at fair value in other assets or other liabilities. The interest rate swaps qualify as derivatives, but are not designated as hedging instruments, thus any net gain or loss resulting from changes in the fair value is recognized in other noninterest income.

The Company also had derivatives designated as cash flow hedges. Cash flow hedges are used to hedge exposures, or to modify interest rate characteristics, for certain balance sheet accounts under its interest rate risk management strategy. Changes in the fair value of these cash flow hedges are initially recorded in accumulated other comprehensive income and subsequently reclassified into earnings when the forecasted transaction affects earnings. If a hedge relationship were no longer highly effective, hedge accounting would be discontinued.

Further discussion of the derivatives is set forth in Note 1, Note 11, and Note 21 to the consolidated financial statements.

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FINANCIAL CONDITION

Assets

The Company’s total assets increased $94.9 million, or 10.0%, from $948.5 million at December 31, 2021 to $1.0 billion at December 31, 2022, primarily due to an increase in net loans from $729.6 million as of December 31, 2021, to $838.0 million at December 31, 2022.

Cash and cash equivalents

Cash and cash equivalents decreased $8.6 million or 18.2%, from $47.0 million at December 31, 2021 to $38.5 million as of December 31, 2022. The decrease as of December 31, 2022 was primarily attributable to increase in loan origination and purchased loans. The Company’s liquidity position is strong with liquid assets to total assets of 9.3% as of December 31, 2022.

Investment securities

The following table is a summary of the Company’s available-for-sale securities portfolio and other investments at the dates shown:

[[GREPCENT_TABLE]]
[["","December 31,"],["(In thousands, except per share amounts)","2022","","2021","","2020"],["U. S. Government agency and mortgage-backed securities","$","59,046","","","$","66,629","","","$","16,833"],["Corporate bonds","14,655","","","16,921","","","17,290"],["Subordinated notes","4,602","","","4,626","","","9,005"],["SBA loan pools","5,718","","","5,603","","","5,567"],["Municipal bonds","499","","","562","","","567"],["Total available-for-sale securities, at fair value","84,520","","","94,341","","","49,262"],["Other investments, at cost","4,450","","","4,450","","","4,450"],["","$","88,970","","","$","98,791","","","$","53,712"]]
[[/GREPCENT_TABLE]]

Total investments decreased $9.8 million or 9.9%, from $98.8 million at December 31, 2021 to $89.0 million at December 31, 2022. This decrease was primarily attributable to the net unrealized loss of $18.9 million for the available-for-sale securities, associated with rising market interest rates, and $10.3 million in repayments and maturity of principal on available-for-sale securities, which was partially offset by purchases of available-for-sale securities of $19.3 million in 2022. There were no sales of available-for-sales securities during the year ended December 31, 2022 and 2020. During the year ended December 31, 2021, the Bank sold $58.8 million available-for-sale securities and recognized net gain on sale of securities of $76,000.

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Loans held for investment

The following table provides the composition of the Company’s loan held for investment portfolio as of December 31, for each of the years shown:

[[GREPCENT_TABLE]]
[["","December 31,"],["(In thousands)","2022","","2021","","2020"],["","Amount","","%","","Amount","","%","","Amount","","%"],["Loan portfolio segment:"],["Commercial Real Estate","$","437,443","","","51.57","%","","$","365,247","","","49.38","%","","$","282,378","","","38.68","%"],["Residential Real Estate","124,140","","","14.63","%","","158,591","","","21.45","%","","153,851","","","21.07","%"],["Commercial and Industrial","138,787","","","16.36","%","","122,810","","","16.61","%","","144,297","","","19.76","%"],["Consumer and Other","141,091","","","16.63","%","","59,364","","","8.03","%","","67,635","","","9.26","%"],["Construction","4,922","","","0.58","%","","21,781","","","2.95","%","","66,984","","","9.17","%"],["Construction to permanent - CRE","1,933","","","0.23","%","","11,695","","","1.58","%","","15,035","","","2.06","%"],["Loans receivable, gross","848,316","","","100.00","%","","739,488","","","100.00","%","","730,180","","","100.00","%"],["Allowance for loan losses","(10,310)","","","","","(9,905)","","","","","(10,584)"],["Loans receivable, net","$","838,006","","","","","$","729,583","","","","","$","719,596"]]
[[/GREPCENT_TABLE]]

The gross loans receivable increased $108.8 million or 14.7%, from $739.5 million at December 31, 2021 to $848.3 million at December 31, 2022. The increase in loans was primarily attributable to $211.4 million in loan origination and $141.4 million in purchases of loans receivable which was partially offset by a net decrease in loan payoffs of $239.6 million for the year ended December 31, 2022.

Patriot originates SBA 7(a) loans, on which the SBA has historically provided guarantees of 75% of the principal balance. However, during the COVID-19 pandemic in 2021, the SBA temporarily increased the guarantees to 90% and reverted to 75% on October 1, 2021. The guaranteed portion of the Company’s SBA loans is generally sold in the secondary market with the unguaranteed portion held in the portfolio as a loan held for investment.

SBA loans held for investment were included in the commercial real estate loans and commercial and industrial loan classifications above. As of December 31, 2022 and 2021, SBA loans included in the commercial real estate loans were $12.2 million and $9.7 million, respectively. SBA loans included in the commercial and industrial loan were $20.3 million and $17.4 million as of December 31, 2022 and 2021, respectively.

At December 31, 2022, the net loan to deposit ratio was 97.4% and the net loan to total assets ratio was 80.3%. At December 31, 2021, these ratios were 97.0% and 77.0%, respectively.

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Maturities and Sensitivities of Loans to Changes in Interest Rates

The following table presents loans receivable, gross by portfolio segment, by contractual maturity as of December 31, 2022:

[[GREPCENT_TABLE]]
[["","Contractual Maturity of Loan Balance"],["(In thousands)","One year or less","","One through Five Years","","After Five Years","","Total"],["Loan portfolio segment:"],["Commercial Real Estate","$","51,910","","","$","201,391","","","$","184,142","","","$","437,443"],["Residential Real Estate","1,006","","","8,053","","","115,081","","","124,140"],["Commercial and Industrial","17,638","","","59,946","","","61,203","","","138,787"],["Consumer and Other","112","","","72,991","","","67,988","","","141,091"],["Construction","3,885","","","1,037","","","\u2014","","","4,922"],["Construction to permanent - CRE","\u2014","","","\u2014","","","1,933","","","1,933"],["Total","$","74,551","","","$","343,418","","","$","430,347","","","$","848,316"],["Fixed rate loans","$","7,307","","","$","211,974","","","$","148,959","","","$","368,240"],["Variable rate loans","67,244","","","131,444","","","281,388","","","480,076"],["Total","$","74,551","","","$","343,418","","","$","430,347","","","$","848,316"]]
[[/GREPCENT_TABLE]]

All variable rate loans account for 56.59% of the total loan portfolio. Approximately 26.00% of the variable rate loan portfolio reprices with changes in interest rates within three months of the rate change. The balance of the loan portfolio has an initial rate for a fixed period, for example one, three or five years and then reprice annually after the initial fixed period. These repricing characteristics are reflected in the Bank’s aggregate analysis of net interest sensitivity included in Item 7A. of this report.

As a community bank, the Bank is invested in a local economy, which may be subject to the vagaries of general economic conditions. As of December 31, 2022, the investments in Commercial Real Estate and Commercial and Industrial were approximately 67.93% of total loans receivable. These loans generally are collateralized by the underlying real estate and supported by personal guarantees of the borrowers.

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Allowance for loan and lease losses

The allowance for loan and lease losses increased $405,000 from $9.9 million at December 31, 2021 to $10.3 million at December 31, 2022. The increase was primarily attributable to a provision for loan losses of $1.9 million due to increased loan balances and additional specific reserve for one impaired loan, which was partially offset by net charge-offs of $1.5 million for the year ended December 31, 2022.

Based upon the overall assessment and evaluation of the loan portfolio at December 31, 2022 and based upon the prevailing accounting standard (ASC 310-10-35), management believes the allowance for loan and lease losses of $10.3 million, which represents 1.2% of gross loans outstanding, was adequate under prevailing economic conditions to absorb existing losses in the loan portfolio. As of January 1, 2023, the Company adopted ASU 2016-13 to recognize and measure credit losses on financial assets measured at amortized cost as discussed further in the Summary of Significant Accounting Policies.

The following table provides detail of activity in the allowance for loan and lease losses:

[[GREPCENT_TABLE]]
[["","Year Ended December 31,"],["(In thousands)","2022","","2021","","2020"],["Balance at beginning of the period","$","9,905","","","$","10,584","","","$","10,115"],["Charge-offs:"],["Commercial Real Estate","\u2014","","","(51)","","","(1,032)"],["Residential Real Estate","\u2014","","","(3)","","","(24)"],["Commercial and Industrial","(70)","","","(212)","","","(677)"],["Consumer and Other","(1,690)","","","(23)","","","(45)"],["Construction","(68)","","","(69)","","","\u2014"],["Total charge-offs","(1,828)","","","(358)","","","(1,778)"],["Recoveries:"],["Commercial Real Estate","154","","","\u2014","","","\u2014"],["Residential Real Estate","4","","","3","","","1"],["Commercial and Industrial","69","","","65","","","70"],["Consumer and Other","121","","","111","","","6"],["Total recoveries","348","","","179","","","77"],["Net charge-offs","(1,480)","","","(179)","","","(1,701)"],["Provision (credit) for loan losses","1,885","","","(500)","","","2,170"],["Balance at end of the period","$","10,310","","","$","9,905","","","$","10,584"],["Ratios:"],["Net charge-offs to average loans","(0.18)","%","","(0.03)","%","","(0.22)","%"],["Allowance for loan losses to total loans","1.22","%","","1.34","%","","1.45","%"]]
[[/GREPCENT_TABLE]]

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The following table provides an allocation of allowance for loan and lease losses by portfolio segment and the percentage of the loans to total loans:

[[GREPCENT_TABLE]]
[["","December 31,"],["(In thousands)","2022","","2021","","2020"],["","Allowance for loan losses","","Percent of loans in each category to total loans","","Allowance for loan losses","","Percent of loans in each category to total loans","","Allowance for loan losses","","Percent of loans in each category to total loans"],["Commercial Real Estate","$","6,966","","","51.57","%","","$","5,063","","","49.38","%","","$","4,485","","","38.68","%"],["Residential Real Estate","665","","","14.63","%","","1,700","","","21.45","%","","1,379","","","21.07","%"],["Commercial and Industrial","1,403","","","16.36","%","","2,532","","","16.61","%","","3,284","","","19.76","%"],["Consumer and Other","1,207","","","16.63","%","","253","","","8.03","%","","295","","","9.26","%"],["Construction","24","","","0.58","%","","78","","","2.95","%","","739","","","9.17","%"],["Construction to permanent - CRE","10","","","0.23","%","","41","","","1.58","%","","162","","","2.06","%"],["Unallocated","35","","","N/A","","238","","","N/A","","240","","","N/A"],["Total Allowance for loan losses","$","10,310","","","100.00","%","","$","9,905","","","100.00","%","","$","10,584","","","100.00","%"]]
[[/GREPCENT_TABLE]]

Nonperforming Assets

The following table presents non-accrual and accruing loans which were past due by over 90 days for the dates indicated:

[[GREPCENT_TABLE]]
[["(In thousands)","December 31,"],["","2022","","2021","","2020"],["Non-accruing loans:"],["Commercial Real Estate","$","11,241","","","$","15,704","","","$","14,534"],["Residential Real Estate","2,470","","","3,148","","","3,854"],["Commercial and Industrial","4,833","","","4,101","","","700"],["Consumer and Other","49","","","142","","","917"],["Construction","\u2014","","","\u2014","","","\u2014"],["Total non-accruing loans","18,593","","","23,095","","","20,005"],["Loans past due over 90 days and still accruing","1,155","","","2","","","16"],["Other real estate owned","\u2014","","","\u2014","","","1,906"],["Total nonperforming assets","$","19,748","","","$","23,097","","","$","21,927"],["Nonperforming assets to total assets","1.89","%","","2.44","%","","2.49","%"],["Nonperforming loans to total loans, net","2.36","%","","3.17","%","","2.78","%"]]
[[/GREPCENT_TABLE]]

Non-accrual loans decreased $4.5 million, from $23.1 million at December 31, 2021 to $18.6 million at December 31, 2022. The $18.6 million of non-accrual loans at December 31, 2022 was comprised of 28 borrowers. Two TDR loans totaling $9.5 million were included in the non-accrual loans. For collateral dependent loans, the Bank has obtained appraisal reports from independent licensed appraisal firms and discounted those values based on the Bank’s experience selling OREO properties and for estimated selling costs to determine estimated impairment. For cash flow dependent loans, the Bank determined the reserve based on the present value of expected future cash flows discounted at the loan's effective interest rate. The Bank evaluated the impaired loans individually and established a specific reserve of $6.0 million as of December 31, 2022.

As of December 31, 2021, the $23.1 million of non-accrual loans was comprised of thirty borrowers, for which a specific reserve of $2.3 million had been established. Three TDR loans of total $9.7 million were included in the non-accrual loans as of December 31, 2021.

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Loans held for sale

Loans held for sale are made up of SBA loans which totaled $5.2 million and $3.1 million at December 31, 2022 and 2021, respectively.

Loans made by the Bank under the SBA 7(a) program generally are made to small businesses to provide working capital or to provide funding for the purchase of businesses, real estate, or equipment. SBA loans are made based primarily on the historical and projected cash flow of the business and secondarily on the underlying collateral provided.

Under the SBA 7(a) program the loans generally carry an SBA guaranty for 75% of the loan. The Bank can sell the guaranteed portion in the secondary market and retain and hold for investment the related unguaranteed portion of these loans, as well as the servicing on such loans, for which it is paid a fee. SBA loans held for investment are included in the commercial real estate loans and commercial and industrial loan classifications. As a result of the COVID-19 pandemic, in 2021, the SBA increased the guaranteed percentage to 90% during one of the rounds of stimulus. As of October 1, 2021, the guaranteed percentage reverted back to 75% of the loan.

Patriot sells the guaranteed portion of SBA loans for liquidity purposes and to generate non-interest income. Loans held for sale represent the guaranteed portion of SBA loans and are reflected at the lower of aggregate cost or market value. Loans held for sale at December 31, 2022 consisted of $3.1 million SBA commercial and industrial loans and $2.1 million SBA commercial real estate, respectively. SBA loans held for sale at December 31, 2021, consisted of $2.6 million SBA commercial and industrial loans and $562,000 SBA commercial real estate, respectively. The Company sold $21.6 million SBA loans during the year ended December 31, 2022, compared to $14.3 million for the year ended December 31, 2021.

During 2022 and 2021, no loans held for investment were transferred to loans held for sale. In September 2020, one commercial and industrial loan of $5.0 million was reclassified from loans held for investment to loans held for sale. The loan was sold in October 2020 which resulted in proceeds of $5.0 million.

Premises and equipment

As of December 31, 2022 and 2021, Patriot recorded premises and equipment, net, of $30.6 million and $31.5 million, respectively. The decreases in premises and equipment were normal depreciation of the active premises and equipment during the year ended December 31, 2022. In 2021, the Bank sold a building in New Haven, Connecticut, and recognized proceeds from the sale of $1.5 million for the year ended December 31, 2021. The Bank did not sell any property and equipment in 2022.

Management continuously reviews its branch locations and corporate offices evaluating operating efficiencies and market share as well as effective customer service and delivery.

Other Real Estate Owned (“OREO”)

In 2021, Patriot sold the last OREO of $1.9 million and recognized a gain of $2,000. Therefore, no OREO balance was record on the balance sheet as of December 31, 2022 and 2021.

Goodwill

As of December 31, 2022 and 2021, the Company's goodwill was recorded unchanged at $1.1 million, which resulted from the acquisition of Prime Bank in May 2018. The Company performed its annual review of goodwill as of October 31, 2022 and determined that there was no impairment of goodwill.

Core deposit intangible (“CDI”)

Core deposit intangible (“CDI”) was recorded as part of the Prime Bank business combination in May 2018. The CDI is amortized over a 10-year period using the straight-line method. In 2020, an impairment charge of $206,000 was recorded for the year ended December 31, 2020, due to the decline in interest rates in 2020. The Company performed a review of the CDI as of October 31, 2022 and determined that there was no impairment of the CDI as of December 31, 2022. The decrease in CDI of $47,000 from $296,000 at December 31, 2021 to $249,000 at December 31, 2022, was solely due to the amortization of the CDI for the year ended December 31, 2022.

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Deferred Taxes

As of December 31, 2022, Patriot had available approximately $15.8 million of Federal net operating loss carryforwards (“NOL”) that are offset by $15.5 million in Internal Revenue Code §382 limitations. After applying the limitation, at December 31, 2022, Patriot has post-change net operating loss carry-forwards of approximately $0.3 million which do not expire. For the years ended December 31, 2022 and 2021, the Bank did not record any uncertain tax position (“UTP”) related to the utilization of certain federal net operating losses.

Additionally, Patriot has approximately $52.8 million of NOLs available for Connecticut tax purposes at December 31, 2022, which may be used to offset up to 50% of taxable income in any year. The NOLs expire between 2030 and 2040.

As of December 31, 2022, Patriot had a $15.5 million deferred tax asset, comprised of multiple temporary differences, in addition to the previously aforementioned NOLs. The assessment of the potential realizability of the deferred tax assets is based on observation of the condition and future of the Bank, including:

•Cumulative pre-tax profit over the last four years;

•Forecasted taxable income for 2023 and future periods;

•Historical average pre-tax income over the last four years adjusted for a fraud loss and other non-recurring expenses relating to merger and acquisition activity, and a reduced cost of funds now reflected in its most recent results;

•Improvements in operations and cost management; and

•Net operating loss carry-forwards that do not begin to expire until 2030.

Patriot evaluates its ability to realize its net deferred tax assets on a quarterly basis. In doing so, management considers all available evidence, both positive and negative, to determine whether it is more likely than not that the deferred tax assets will be realized. In 2022, management noted improvements in the results of operations, forecasted future period taxable income, the overall quality of the loan portfolio, continued efforts to reduce and control operating expenses, and net operating loss carryforwards that do not begin to expire until the year 2030. Based upon this evidence, management concluded there was no need for a valuation allowance as of December 31, 2022.

Patriot will continue to evaluate its ability to realize its net deferred tax assets. If future evidence suggests that it is more likely than not that a portion of the deferred tax assets will not be realized, a valuation allowance will be established.

Derivatives

As of December 31, 2022, Patriot had entered into four interest rate swaps (“swaps”). Two swaps are with a loan customer to provide a facility to mitigate the fluctuations in the variable rate on the respective loan. The other two swaps are with an outside third party. The customer interest rate swaps are matched in offsetting terms to the third-party interest rate swaps. The swaps are reported at fair value in other assets or other liabilities on the consolidated balance sheets. Patriot’s swaps are derivatives, but are not designated as hedging instruments, thus any net gain or loss resulting from changes in the fair value is recognized in other non-interest income. No gain on the swaps was recognized for the year ended December 31, 2022, 2021 and 2020.

In April 2021, Patriot entered into a receive fixed/pay variable interest rate swap, intended to reduce the Company’s exposure to interest rate movements. This contractual agreement was designated as a cash flow hedge. Under the term of the swap contract, the Company hedged the cash flows associated with a pool of 1-month LIBOR floating rate loans by converting a $50 million portion of that pool of loans into fixed rates with the swap. The Bank received fixed and paid float swap for a 7-year rolling period beginning April 29, 2021. In August 2021, the cash flow hedge interest rate swap contract was terminated.

The Company did not recognize any unrealized and realized gain or loss for the year ended December 31, 2022. During the year ended December 31, 2021, the Company recognized $149,000 of accumulated other comprehensive income that was reclassified into interest income. The interest swap interest income is included in interest and fees on loans on the consolidated statements of operations. A gain of $512,000 was recognized from the termination of the interest rate swap cash flow hedge for the year ended December 31, 2021, which is included in other income on the consolidated statements of operations.

Further discussion of the final derivatives is set forth in Note 11 and Note 21 to the consolidated financial statements.

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Deposits

The following table is a summary of the Company’s deposits at the dates shown:

[[GREPCENT_TABLE]]
[["(In thousands)","December 31,"],["","2022","","2021","","2020"],["Non-interest bearing:"],["Non-interest bearing","$","118,541","","","$","140,384","","","$","99,344"],["Prepaid DDA","151,095","","","86,329","","","59,332"],["Total non-interest bearing","269,636","","","226,713","","","158,676"],["Interest bearing:"],["Negotiable order of withdrawal accounts","34,440","","","34,741","","","30,529"],["Savings","71,002","","","109,744","","","98,635"],["Money market","164,827","","","111,957","","","131,378"],["Money market - prepaid deposits","46,173","","","52,561","","","15,011"],["Certificates of deposit, less than $250,000","165,793","","","142,246","","","160,968"],["Certificates of deposit, $250,000 or greater","59,877","","","53,584","","","49,172"],["Brokered deposits","48,698","","","17,016","","","41,287"],["Total Interest bearing","590,810","","","521,849","","","526,980"],["Total Deposits","$","860,446","","","$","748,562","","","$","685,656"]]
[[/GREPCENT_TABLE]]

The Bank has substantially improved its deposit and funding mix over the past year, while reducing its aggregate cost of funds. As of December 31, 2022, total deposits increased $111.9 million, primarily due to growth in prepaid DDA and Money market deposits of $58.4 million and a $61.5 million increase in brokered deposits and certificates of deposits.

Borrowings

As of December 31, 2022 and 2021, total borrowings were $115.2 million and $120.7 million, respectively. Borrowings consist of Federal Home Loan Bank (“FHLB”) advances, senior notes, junior subordinated debentures, and a note payable to the seller from whom the Fairfield branch building was purchased in 2015.

Shareholders’ Equity

Equity decreased $7.8 million from $67.3 million at December 31, 2021 to $59.6 million at December 31, 2022. The decrease was primarily due to $14.0 million unrealized loss in investment portfolio for the year ended December 31, 2022, which was partially offset by $6.2 million of net income for the year ended December 31, 2022.

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The following table presents average balance sheets, interest income, interest expense and the corresponding yields earned, and rates paid for each of the years in the three-year period ended December 31, 2022.

[[GREPCENT_TABLE]]
[["(In thousands)","Year Ended December 31,"],["","2022","","2021","","2020"],["","Average Balance","","Interest","","Yield","","Average Balance","","Interest","","Yield","","Average Balance","","Interest","","Yield"],["ASSETS"],["Interest Earning Assets:"],["Loans","$","831,634","","","$","40,823","","","4.91","%","","$","705,353","","","$","30,115","","","4.27","%","","$","791,626","","","$","35,835","","","4.51","%"],["Investments","96,770","","","2,691","","","2.78","%","","102,466","","","2,147","","","2.10","%","","59,668","","","1,859","","","3.12","%"],["Cash equivalents and other","32,229","","","498","","","1.55","%","","57,753","","","89","","","0.15","%","","49,071","","","209","","","0.42","%"],["Total interest earning assets","960,633","","","44,012","","","4.58","%","","865,572","","","32,351","","","3.74","%","","900,365","","","37,903","","","4.20","%"],["Cash and due from banks","8,091","","","","","","","4,016","","","","","","","2,357"],["Allowance for loan losses","(9,762)","","","","","","","(10,384)","","","","","","","(10,896)"],["OREO","\u2014","","","","","","","893","","","","","","","2,259"],["Other assets","66,440","","","","","","","61,182","","","","","","","62,086"],["Total Assets","$","1,025,402","","","","","","","$","921,279","","","","","","","$","956,171"],["Liabilities"],["Interest bearing liabilities:"],["Deposits","$","572,295","","","$","5,300","","","0.93","%","","$","525,537","","","$","2,243","","","0.43","%","","$","641,981","","","$","9,154","","","1.42","%"],["Borrowings","105,333","","","3,475","","","3.30","%","","94,511","","","2,986","","","3.16","%","","92,469","","","2,671","","","2.88","%"],["Senior notes","12,002","","","866","","","7.22","%","","11,963","","","913","","","7.63","%","","11,888","","","915","","","7.70","%"],["Subordinated debt","17,947","","","1,066","","","5.94","%","","17,910","","","933","","","5.21","%","","17,872","","","991","","","5.53","%"],["Note Payable and other","678","","","46","","","6.78","%","","881","","","15","","","1.70","%","","1,086","","","19","","","1.74","%"],["Total interest bearing liabilities","708,255","","","10,753","","","1.52","%","","650,802","","","7,090","","","1.09","%","","765,296","","","13,750","","","1.79","%"],["Demand deposits","244,128","","","","","","","196,287","","","","","","","116,519"],["Other liabilities","10,610","","","","","","","8,485","","","","","","","8,760"],["Total Liabilities","962,993","","","","","","","855,574","","","","","","","890,575"],["Shareholders' equity","62,409","","","","","","","65,705","","","","","","","65,596"],["Total Liabilities and Shareholders' Equity","$","1,025,402","","","","","","","$","921,279","","","","","","","$","956,171"],["Net interest income","","","$","33,259","","","","","","","$","25,261","","","","","","","$","24,153"],["Interest margin","","","","","3.46","%","","","","","","2.92","%","","","","","","2.68","%"],["Interest spread","","","","","3.06","%","","","","","","2.65","%","","","","","","2.41","%"]]
[[/GREPCENT_TABLE]]

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The following table presents the change in interest-earning assets and interest-bearing liabilities by major category and the related change in the interest income earned and interest expense incurred thereon attributable to the change in transactional volume in the financial instruments and the rates of interest applicable thereto, comparing the years ended December 31, 2022 to 2021 and December 31, 2021 to 2020.

[[GREPCENT_TABLE]]
[["","Year ended December 31,"],["","2022 compared to 2021","","2021 compared to 2020"],["(In thousands)","Increase/(Decrease)","","Increase/(Decrease)"],["","Volume","","Rate","","Total","","Volume","","Rate","","Total"],["Interest Earning Assets:"],["Loans","$","5,063","","","$","5,645","","","$","10,708","","","$","(3,816)","","","$","(1,904)","","","$","(5,720)"],["Investments","(115)","","","659","","","544","","","1,252","","","(964)","","","288"],["Cash equivalents and other","(42)","","","451","","","409","","","36","","","(156)","","","(120)"],["Total interest earning assets","4,906","","","6,755","","","11,661","","","(2,528)","","","(3,024)","","","(5,552)"],["Interest bearing liabilities:"],["Deposit","463","","","2,594","","","3,057","","","(2,762)","","","(4,149)","","","(6,911)"],["Borrowings","342","","","147","","","489","","","58","","","257","","","315"],["Senior notes","3","","","(50)","","","(47)","","","(2)","","","\u2014","","","(2)"],["Subordinated debt","2","","","131","","","133","","","\u2014","","","(58)","","","(58)"],["Note payable and other","31","","","\u2014","","","31","","","(4)","","","\u2014","","","(4)"],["Total interest bearing liabilities","841","","","2,822","","","3,663","","","(2,710)","","","(3,950)","","","(6,660)"],["Net interest income","$","4,065","","","$","3,933","","","$","7,998","","","$","182","","","$","926","","","$","1,108"]]
[[/GREPCENT_TABLE]]

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RESULTS OF OPERATIONS

A discussion regarding the financial condition and results of operations for fiscal 2022 compared to fiscal 2021 is presented below. Discussions of fiscal 2021 items and year-to-year comparisons between fiscal 2021 and fiscal 2020 that are not included in this Form 10-K can be found under Item 7 of Part II of our Annual Report on Form 10-K for the fiscal year ended December 31, 2021, as filed with the SEC on March 24, 2022.

Comparison of Results of Operations for the years 2022 and 2021

For the year ended December 31, 2022, the Company recorded net income of $6.2 million ($1.56 basic and diluted earnings per share) compared to net income of $5.1 million ($1.29 basic and diluted loss per share) for the year ended December 31, 2021.

Pre-tax income was $7.8 million for the year ended December 31, 2022, compared to pre-tax income of $5.0 million for the year ended December 31, 2021. Significant variances are summarized below and discussed in detail subsequently:

•Interest and dividend income increased $11.7 million;

•Interest expense increased $3.7 million;

•Net interest income increased $8.0 million;

•Provision for loan losses increased $2.4 million;

•Non-interest income decreased $818,000; and

•Non-interest expense increased $2.1 million.

Net interest income

Net interest income is the difference between interest income on interest earning assets and interest expense on interest-bearing liabilities. Net interest income depends on the relative amounts of interest earning assets and interest-bearing liabilities and the interest rates earned or paid on them, respectively.

For the year ended December 31, 2022, interest income increased to $44.0 million, as compared to $32.4 million for the year ended December 31, 2021, which was primarily attributable to an increase of $126.3 million in average loan balances, along with an increase in rates earned on loans reflecting the increase in interest rates during 2022.

For the year ended December 31, 2022, total interest expense increased to $10.8 million, as compared to $7.1 million for the year ended December 31, 2021, primarily due to an increase in average deposits balance of $46.8 million. The increase in deposit interest expense reflects higher deposit balances and higher market interest rates.

Net interest income for the years ended December 31, 2022 and 2021 was $33.3 million and $25.3 million, respectively. The Bank’s net interest margin showed improvement, and increased to 3.5% for the year ended December 31, 2022, compared with 2.9% for the year ended December 31, 2021. The higher net interest margin was due to effective monitoring of the Bank’s interest sensitivity position during the rising interest rate environment, higher loan balances and the increase in deposit balances resulting from the addition of $58.4 million of low-cost prepaid deposits in 2022.

Provision (Credit) for loan losses

For the year ended December 31, 2022, the Bank recorded a provision for loan losses of $1.9 million reflecting the increased loan balance and higher charge-offs associated with a purchased consumer loan portfolio. For the year ended December 31, 2021, a credit for loan losses of $500,000 was recorded as a result of improvements in the economy and in classified loan balances.

Non-interest income

For the year ended December 31, 2022, non-interest income decreased to $3.6 million, as compared to $4.4 million in 2021. The decrease was primarily attributable to lower net realized gains on sale of SBA loans as premiums available in the SBA secondary market declined during the year.

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Non-interest expense

For the year ended December 31, 2022, non-interest expense increased to $27.2 million, as compared to $25.2 million for 2021. The increase was primarily attributable to an Employee Retention Credits of $2.9 million recognized in 2021, which was partially offset by a non-recurring project expenses of $1.9 million in connection with the proposed merger transaction with American Challenger in 2021.

Termination of Pending acquisition

On November 14, 2021, the Company and American Challenger entered into a merger agreement, which was subsequently amended on January 28, 2022 and February 28, 2022. On July 18, 2022, the merger agreement was terminated by the parties due to mutual determination that not all closing conditions of the merger agreement could be satisfied. In connection with the proposed merger, the Company has previously recognized expenses of $1.9 million for the full year ended December 31, 2021 and $112,000 for the year ended December 31, 2022.

Other financial measures and ratios:

[[GREPCENT_TABLE]]
[["","As of and for the year ended December 31,"],["","2022","","2021","","2020"],["Return on average assets","0.60","%","","0.55","%","","(0.40)","%"],["Return on average equity","9.87","%","","7.75","%","","(5.82)","%"],["Average equity to average assets","6.09","%","","7.13","%","","6.86","%"]]
[[/GREPCENT_TABLE]]

We derived the selected balance sheet measures as of December 31, 2022, 2021 and 2020 and the selected statement of income measures for the years ended December 31, 2022, 2021 and 2020 from our audited consolidated financial statements included elsewhere in this annual report. Average balances have been computed using daily averages.

LIQUIDITY AND CAPITAL RESOURCES

As of December 31, 2022, the Company’s balance sheet liquidity was $97.4 million, which was 9.3% of total assets of $1.0 billion. At December 31, 2021, the balance sheet liquidity was $108.4 million, which was 11.4% of total assets of $948.5 million. Liquidity including readily available off-balance sheet funding sources was 18.0% at December 31, 2022 compared to 21.7% at December 31, 2021.

The following categories of assets are considered balance sheet liquidity: cash and due from banks, federal funds sold (if any), short-term investments (if any), unpledged available-for-sale securities, and loans held for sale. In addition, off-balance sheet funding sources include collateral based borrowing available from the FHLB, correspondent bank borrowing lines, and advised borrowing lines through an interbank borrowing network.

Liquidity is a measure of the Company’s ability to generate adequate cash to meet its financial obligations. The principal cash requirements of a financial institution are to cover downward fluctuations in deposit accounts. Management believes the Company’s liquid assets provide sufficient coverage to satisfy loan demand, cover potential fluctuations in deposit accounts, and to meet other anticipated operational cash requirements for next 12 months and beyond.

The Company is a member of the Federal Home Loan Bank of Boston ("FHLB-B"). At December 31, 2022, the outstanding advances from the FHLB-B aggregated $85.0 million. The additional borrowing capacity available from FHLB-B was $69.2 million, which is comprised of $67.2 million of advances and a $2.0 million overnight line of credit. Additionally, the Bank retains a collateralized borrowing line with the Federal Reserve Bank which totaled $20.4 million at December 31, 2022 and correspondent bank borrowing lines totaling $24.5 million at December 31, 2022.

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As of December 31, 2022, the maturities of Patriot’s contractual obligations are as follows:

[[GREPCENT_TABLE]]
[["(In thousands)","","Contractual Obligations Due"],["Contractual Obligation Category","","Less than One Year","","One to Three Years","","Three to Five Years","","Over Five Years","","Total"],["Certificates of deposit","","$","169,088","","","$","43,876","","","$","12,706","","","$","\u2014","","","$","225,670"],["Brokered deposits","","43,589","","","5,109","","","\u2014","","","\u2014","","","48,698"],["Federal Home Loan Bank borrowings","","55,000","","","30,000","","","\u2014","","","\u2014","","","85,000"],["Senior notes","","\u2014","","","\u2014","","","12,000","","","\u2014","","","12,000"],["Subordinated debt","","\u2014","","","\u2014","","","\u2014","","","10,000","","","10,000"],["Junior subordinated debt","","\u2014","","","\u2014","","","\u2014","","","8,248","","","8,248"],["Note payable","","210","","","375","","","\u2014","","","\u2014","","","585"],["Operating lease obligations","","583","","","775","","","551","","","830","","","2,739"],["Total contractual obligations","","$","268,470","","","$","80,135","","","$","25,257","","","$","19,078","","","$","392,940"]]
[[/GREPCENT_TABLE]]

Management manages its capital resources by seeking to maintain a capital structure that will ensure an adequate level of capital to support anticipated asset growth and absorb potential losses while effectively leveraging capital to enhance profitability and return to shareholders. Due to prior year losses, dividends have not been paid to shareholders over the most recent three-year period but may resume in future periods.

The primary source of liquidity at the Company as a stand-alone parent company is return of capital from the Bank. These capital returns are subject to OCC approval and are needed periodically to provide funds needed to service debt payments at the Company. Return of Capital payments from the Bank to the Company totaled $900,000 for the year ended December 31, 2022, $500,000 for the year ended December 31, 2021, and $2.0 million for the year ended December 31, 2020.

OFF-BALANCE SHEET ARRANGEMENTS

The Bank’s off-balance sheet commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee by the borrower. Since these commitments could expire without being drawn upon or are contingent upon the customer adhering to the terms of the agreements, the total commitment amounts do not necessarily represent future cash requirements. As of December 31, 2022 and 2021, the Bank’s off-balance sheet commitments were $154.3 million and $127.0 million, respectively.

REGULATORY CAPITAL REQUIREMENTS

In September 2019, the community bank leverage ratio (CBLR) framework was jointly issued by the FDIC, OCC and FRB. The final rule gives qualifying community banks the option to use a simplified measure of capital adequacy instead of risk-based capital, beginning with their March 31, 2020 Call Report. Under the final rule a community bank may qualify for the CBLR framework if it has a Tier 1 leverage ratio of greater than 9%, less than $10 billion in total consolidated assets, and limited amounts of off-balance sheet exposures and trading assets and liabilities. In September 2021, the Bank adopted the CBLR framework. The Bank’s Tier 1 leverage ratio as of December 31, 2022 and 2021 was 9.3% and 9.9%, respectively, which is above the well-capitalized required level of 9.0%.

Management continuously assesses the adequacy of the Bank’s capital with the goal to maintain a “well capitalized” classification.

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