UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

For the fiscal year ended December 31, 2018

OR

For the transition period from             to             

Commission File Number: 0-024399

 

UNITED COMMUNITY FINANCIAL CORP.

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number: (330) 742-0500

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

(Title of Class)

 

Indicate by checkmark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.      Yes   ☐    No  ☒

Indicate by checkmark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.     Yes   ☐     No  ☒

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒     No  ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).     Yes  ☒     No  ☐

Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this 10-K.  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer or a smaller reporting company or an emerging growth company. See definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act:

 

 

If an emerging growth company, indicate by checkmark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act.).    Yes  ☐    No  ☒

The aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the last reported sale on June 30, 2018 was approximately $527.1 million. (The exclusion from such amount of the market value of the shares owned by any person shall not be deemed an admission by the registrant that such person is an affiliate of the registrant.)

As of March 8, 2019, there were 49,128,875 of the Registrant’s Common Shares outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

Part III of Form 10-K - Portions of the Proxy Statement for the 2019 Annual Meeting of Shareholders

 

 

 

 

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TABLE OF CONTENTS

 

 

 

 

 

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PART I

 

 

DISCUSSION OF FORWARD-LOOKING STATEMENTS

When used in this Form 10-K, the words or phrases “will likely result,” “are expected to,” “will continue,” “is anticipated,” “estimate,” “project” or similar expressions are intended to identify “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to certain risks and uncertainties, including government intervention in the U.S. financial markets, changes in economic conditions in the United Community Financial Corp.’s market area, changes in policies by regulatory agencies, fluctuations in interest rates, demand for loans in our market area, competition and those risks discussed under “Item 1A – Risk Factors” in this Annual Report on Form 10-K, that could cause actual results to differ materially from results presently anticipated or projected. United Community Financial Corp. (United Community, we or our) cautions readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made. We advise readers that the factors listed above could affect United Community’s financial performance and could cause our actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any current statements.

United Community does not undertake, and specifically disclaims, any obligation to release publicly the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

GENERAL

United Community was incorporated in the State of Ohio in February 1998 for the purpose of owning all of the outstanding capital stock of Home Savings Bank (Home Savings or the Bank) issued upon the conversion of Home Savings from a mutual savings association to a permanent capital stock savings association (Conversion). The Conversion was completed on July 8, 1998. On January 31, 2017, United Community completed an acquisition of Ohio Legacy Corp. (OLCB) and merger of United Community’s wholly-owned subsidiary bank with and into Premier Bank & Trust, OLCB’s wholly-owned subsidiary bank (PB&T), with PB&T as the surviving bank following the merger. As a result of this acquisition, United Community became a financial holding company and its surviving subsidiary bank became an Ohio-chartered bank with the name “Home Savings Bank.” The acquisition of OLCB and related merger with PB&T are discussed in further detail below under the heading “Acquisitions.”

In addition to the Bank, United Community also operates through its subsidiaries, HSB Insurance, LLC, HSB Capital, LLC and HSB Insurance, Inc. HSB Capital, LLC was formed as an Ohio limited liability company by United Community during 2016 for the purpose of providing mezzanine funding for customers of the Bank. Mezzanine loans are offered by HSB Capital, LLC to customers in United Community’s market area, as defined below, and are expected to be repaid from the cash flow from operations of the business.  

HSB Insurance, LLC, (d/b/a James & Sons Insurance) is a wholly-owned insurance subsidiary of United Community that was formed on April 6, 2016 to acquire James & Sons Insurance. As a result of this acquisition, HSB Insurance, LLC now offers a variety of insurance products for business and residential customers, including auto, homeowners, life-health, commercial, surety bonds and aviation, within United Community’s market area, as defined below.

HSB Insurance, Inc., was formed on June 1, 2017 as a Delaware-based captive insurance company that is a wholly-owned subsidiary of United Community.  HSB Insurance, Inc. insures against certain risks that are unique to the operations of the Company and its subsidiaries and for which insurance may not be currently available or economically feasible; by pooling resources with several other insurance company subsidiaries of financial institutions to spread a limited amount of risk among themselves.  HSB Insurance, Inc. is subject to regulations of the State of Delaware and undergoes periodic examinations by the Delaware Division of Insurance.

The term “Company” is used in this Annual Report on Form 10-K to refer to United Community and its subsidiaries, collectively.

Our filings with the SEC may be read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. Information on the operation of the Public Reference Room may be obtained by calling 1-800-SEC-0330. These filings are also available on the SEC’s web-site at http://www.sec.gov free of charge as soon as reasonably practicable after we have filed the above referenced reports.

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United Community’s Internet site, ir.ucfconline.com, contains a hyperlink to the Securities and Exchange Commission (SEC) where United Community’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, Section 16 Insider Reports and amendments to those reports that are filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available free of charge, as soon as reasonably practicable after United Community has filed any such report with, or furnished it to, the SEC.  The contents of our website are not incorporated into, or otherwise made a part of, this Annual Report on Form 10-K.  

As a financial holding company, United Community is subject to regulation, supervision and examination by the Board of Governors of the Federal Reserve System (FRB) and the SEC. United Community’s primary activity is holding the common shares of Home Savings. Consequently, the following discussion focuses primarily on the business of Home Savings.

Home Savings was organized as a mutual savings association under Ohio law in 1889. Currently, Home Savings is an Ohio-chartered bank, subject to the supervision and regulation by the Federal Deposit Insurance Corporation (FDIC) and the Division of Financial Institutions (ODFI) of the Ohio Department of Commerce (Ohio Division). Home Savings is a member of the Federal Home Loan Bank of Cincinnati (FHLB) and the deposits of Home Savings are insured up to applicable limits by the FDIC.

Home Savings conducts business from its main office located in Youngstown, Ohio, and through 35 retail banking offices, three wealth management offices and 12 loan production centers located throughout Ohio, western Pennsylvania and West Virginia. The principal business of Home Savings is the origination of mortgage loans, including construction loans, on residential and nonresidential real estate located in Home Savings’ primary market area, which consists of Ashland, Belmont, Columbiana, Cuyahoga, Erie, Franklin, Geauga, Huron, Lake, Lucas, Mahoning, Portage, Richland, Stark, Summit and Trumbull Counties in Ohio, Allegheny and Beaver Counties in Pennsylvania and Monongalia County in West Virginia. In addition to real estate lending, Home Savings originates commercial loans and various types of consumer loans. For liquidity and interest rate risk management purposes, Home Savings invests in various financial instruments as discussed below under the heading “Investment Activities.” Funds for lending and other investment activities are obtained primarily from retail deposits, which are insured up to applicable limits by the FDIC, principal repayments of loans, borrowings from the FHLB, repurchase agreements and maturities of securities.

Interest on loans and other investments is Home Savings’ primary source of income. Home Savings’ principal expenses are interest paid on deposit accounts and other borrowings, as well as salaries and benefits paid to employees. Operating results are dependent to a significant degree on the net interest income of Home Savings, which is the difference between interest earned on loans and other investments and interest paid on deposits and borrowed funds. Like most financial institutions, Home Savings’ interest income and interest expense can be affected significantly by general economic conditions and by the policies of various regulatory authorities.

As of December 31, 2018, the FDIC categorized Home Savings as well capitalized.

ACQUISITIONS

On January 29, 2016, United Community acquired James & Sons Insurance, an insurance agency that offers a variety of insurance products for business and residential customers, which include auto, homeowners, life-health, commercial, surety bonds, and aviation.  James & Sons Insurance was merged into HSB Insurance, LLC, a wholly-owned subsidiary of United Community, with HSB Insurance, LLC as the surviving entity following the merger. This acquisition marked the initial step in the formation of The Home Savings Insurance Group. During fiscal year 2017, United Community completed two additional acquisitions to expand the product offerings and market area of HSB Insurance, LLC.  On February 28, 2017, HSB Insurance, LLC acquired Eich Brothers Insurance, an insurance agency that offers insurance products for business and residential customers, including auto, commercial, homeowners and life-health.  On July 1, 2017, HSB Insurance, LLC acquired Stevens Insurance Agency, which offers insurance products for business and residential customers, including auto, commercial, homeowners and life-health. On July 1, 2018, HSB Insurance, LLC acquired certain assets of Steinhauser Insurance Agency which offers property and casualty insurance for business and personal needs.  Home Savings intends to expand its insurance business via organic growth coupled with a selective acquisition strategy.

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On January 31, 2017, United Community completed its acquisition of OLCB.  Immediately following the acquisition of OLCB, Home Savings was merged into PB&T, and PB&T changed its name to “Home Savings Bank.”  In connection with the acquisition, United Community issued 3,033,604 United Community common shares and paid $19,958,724.19 to OLCB shareholders.   As a result of the acquisition, United Community became a financial holding company and its wholly owned subsidiary became an Ohio-chartered bank.

LENDING ACTIVITIES

General. Home Savings’ principal lending activity is the origination of conventional residential real estate loans, commercial real estate loans, commercial and industrial loans, and various types of consumer loans, including home equity loans and lines of credit, loans secured by deposit accounts and investments, direct and indirect auto lending and unsecured loans, primarily originated in Home Savings’ market area.

 

 

 

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Loan Portfolio Composition. The following table presents certain information regarding the composition of Home Savings’ loan portfolio at the dates indicated:

 

 

 

 

 

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Loan Maturity. The following table sets forth certain information as of December 31, 2018, regarding the dollar amount of construction and commercial loans maturing in Home Savings’ portfolio based on their contractual terms to maturity. Demand and other loans having no stated schedule of repayments or no stated maturity are reported as due in one year or less. Mortgage loans originated by Home Savings always include due-on-sale clauses that provide Home Savings with the contractual right to deem the loan immediately due and payable in the event the borrower transfers the ownership of the property without Home Savings’ consent. The table does not include the effects of possible prepayments.

 

 

The table below sets forth the dollar amount of all loans reported above becoming due after December 31, 2018, which have fixed or adjustable interest rates:

 

 

Commercial Loans:

Multifamily. Home Savings originates loans secured by multifamily properties that contain more than four units. Multifamily loans are offered with adjustable and fixed rates of interest, which adjust according to a specified index, and typically have terms ranging from five to ten years and of the value of the real estate and improvements (LTV) of up to 80%.

Multifamily lending generally is considered to involve a higher degree of risk than one-to-four-family residential lending because the borrower typically depends upon income generated by the subject property to cover operating expenses and debt service. The profitability of a subject property can be affected by economic conditions, government policies and other factors beyond the control of the borrower. Home Savings attempts to mitigate the risk associated with multifamily lending by evaluating the creditworthiness of the borrower and the projected income from the subject property and, in most cases, obtaining personal guarantees on loans made to corporations, limited liability companies and partnerships. Home Savings requires borrowers to submit financial statements annually to enable management to monitor the loan and requires an assignment of rents from borrowers.

At December 31, 2018, loans secured by multifamily properties totaled approximately $134.1 million, or 6.1% of total loans, of which $171,000, or 0.1% of Home Savings’ total multifamily loans, were considered nonperforming. New originations in this loan category totaled $43.2 million in 2018.

Nonresidential. Home Savings originates loans secured by nonresidential real estate, such as retail centers, office buildings, and industrial buildings. Home Savings’ nonresidential real estate loans typically have both fixed and adjustable rates, terms typically ranging from five to ten years and LTVs of up to 80%. The majority of such properties are located within Home Savings’ primary lending area.

Nonresidential real estate lending generally is considered to involve a higher degree of risk than residential lending due to the relatively larger loan amounts and the effects of general economic conditions on the successful operation of income-producing properties. Home Savings has endeavored to reduce such risk by evaluating the credit history of the borrower and their affiliates, the location of the real estate, analyzing the financial condition of the borrower, in most cases obtaining personal guarantees from the borrower or the borrower’s affiliates, and considering the quality and characteristics of the income stream generated by the property and the appraisal supporting the property’s valuation.

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At December 31, 2018, approximately $410.0 million, or 18.7% of Home Savings’ total loans, were secured by mortgages on nonresidential real estate, of which $13,000, or 0.0% of Home Savings’ total nonresidential real estate loans, were considered nonperforming. New originations in this loan category totaled $68.7 million in 2018.

Land. Home Savings also originates a limited number of loans secured by vacant land. Home Savings’ land loans generally are fixed-rate loans for terms of up to five years and require a LTV of 65% or less. At December 31, 2018, approximately $16.8 million, or 0.8%, of Home Savings’ total loans were land loans. None of these loans were nonperforming at December 31, 2018. New originations in this loan category totaled $8.9 million in 2018.

Construction.  Home Savings originates loans for the construction of multifamily properties and nonresidential real estate projects.  Construction loans for multifamily and nonresidential properties typically have LTV at origination of up to 75% based on estimated value at completion, with the value of the land included as part of the owner’s equity.  

Construction loans involve greater underwriting and default risks than loans secured by mortgages on existing properties because construction loans are more difficult to appraise and to monitor.  Loan funds are advanced upon the security of the project under construction.  In the event a default on a construction loan occurs and foreclosure follows, Home Savings may take control of the project and attempt either to arrange for completion of construction or dispose of the unfinished project.  

At December 31, 2018, Home Savings had approximately $141.7 million, or 6.5% of its total loans, invested in commercial construction loans.  None of these loans were nonperforming at December 31, 2018.  New originations for commercial construction loans totaled $96.0 million in 2018.  

Secured and Unsecured. Home Savings makes commercial loans to businesses in its primary market area, including traditional lines of credit, revolving lines of credit and term loans. The collateral coverage ratios for commercial loans depend upon the nature of the underlying collateral. Lines of credit and revolving credits generally are priced on a floating rate basis, which is tied to the prime interest rate or LIBOR. Term loans usually have adjustable rates, but can have fixed rates of interest, and typically have terms of one to five years.

The repayment of commercial loans typically is dependent on the cash flow stream and successful operation of a business, which can be affected by economic conditions. The collateral for commercial term loans often consists of depreciating assets, which are generally matched to the amortization of the underlying loan.

At December 31, 2018, Home Savings had approximately $233.3 million invested in secured commercial loans and $7.0 million in unsecured commercial loans. The majority of these loans are secured by inventory, accounts receivable, equipment, investment property, vehicles or other assets of the borrower. These loans are underwritten based on the creditworthiness of the borrower and the guarantors, where applicable.

Nonperforming secured and unsecured commercial loans at December 31, 2018 amounted to $531,000, or 0.2% of total commercial secured and unsecured loans. New originations of commercial loans totaled $148.6 million in 2018, of which $146.9 million were secured.

Residential Mortgage Loans:

One-to-Four-Family. Home Savings mainly originates conventional loans secured by first mortgages on one-to-four-family residences primarily located within Home Savings’ market area.

Home Savings currently offers fixed-rate mortgage loans and adjustable-rate mortgage loans (ARMs). Although Home Savings’ loan portfolio includes a significant amount of 30-year fixed-rate loans, a considerable portion of fixed rate loans are originated for sale. The interest rate adjustment periods on ARMs are typically one, three, five, seven or ten years. The maximum interest rate adjustment on most of the ARMs is 2.0% on any adjustment date and a total of 6.0% over the life of the loan. The interest rate adjustments on three-year, five-year and ten-year ARMs presently offered by Home Savings are indexed to the weekly average rate on the one-year U.S. Treasury securities. Rate adjustments are computed by adding a stated margin to the index.

FDIC regulations and Ohio law limit the amount that Home Savings may lend in relationship to the appraised value of the real estate and improvements that secure the loan at the time of loan origination. In accordance with such regulations, Home Savings is permitted to make loans up to 100% of the LTV. Home Savings typically requires private mortgage insurance on the portion of the principal amount of the loan that exceeds 80% of the appraised value or sales price of the property (whichever is less) securing the loan.

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Under certain circumstances, Home Savings will offer loans with LTVs exceeding 80% without private mortgage insurance. Customers may borrow up to 80% of the home’s appraised value and obtain a second loan or line of credit from Home Savings for up to 90% of the appraised value without having to purchase mortgage insurance. Home Savings also offers a first-time homebuyers product that permits an LTV of 97% without private mortgage insurance. Such loans involve a higher degree of risk because, in the event of a borrower default, the value of the underlying collateral may not satisfy the principal and interest outstanding on the loan. To reduce this risk, Home Savings underwrites all portfolio loans to Freddie Mac and Fannie Mae underwriting guidelines.

Currently, no interest-only, one-to-four-family loans are contained in the Home Savings’ mortgage loan portfolio.

Home Savings issues loan origination commitments to qualified borrowers primarily for the purchase of single-family residential real estate. Such commitments have specified terms and conditions and are made for periods of up to 60 days, during which time the interest rate is locked in. Home Savings utilizes various hedge strategies to mitigate its interest rate risk during this time period.

At December 31, 2018, Home Savings’ one-to-four-family residential real estate loans held in portfolio totaled approximately $927.3 million, or 42.3% of total loans. At December 31, 2018, $4.2 million, or 0.4%, of Home Savings’ one-to-four-family loans were nonperforming. New originations in this loan category totaled $258.8 million in 2018.

Construction.  Home Savings originates loans for the construction of one-to-four-family residences.  These construction loans to owner-occupants are structured as permanent loans with fixed or adjustable rates of interest and terms of up to 30 years.  During the construction phase, the borrower is required to pay interest only.  These loans have LTVs at origination of up to 95% with appropriate mortgage insurance.  

At December 31, 2018, Home Savings had approximately $141.7 million, or 6.5% of its total loans, invested in one-to-four-family residential construction loans.  All of these loans were performing according to the terms of their agreement as of December 31, 2018.  

New originations for residential mortgage construction loans to owner-occupants totaled $272.4 million in 2018.  The level of new originations exceeded the outstanding balance of these loans as not all funds have been drawn on such loans as of December 31, 2018.

Consumer Loans:

Home Savings originates various types of consumer loans, including home equity loans, home equity lines of credit, vehicle loans, unsecured loans, and cash-secured loans.  Home Savings generally does not originate recreational vehicle loans or marine loans. Consumer loans are made at fixed and variable rates of interest for different terms based on the type of loan.

Home Savings generally makes closed-end home equity loans and lines of credit in an amount that, when added to the prior indebtedness secured by the real estate, does not exceed 90% of the estimated value of the real estate. Home equity loans typically are secured by a second mortgage on the real estate. Home Savings frequently holds the first mortgage, although Home Savings will make home equity loans in cases where it sells the first mortgage or another lender holds the first mortgage. Home Savings also offers home equity lines of credit. Fixed-rate home equity loans typically have terms of ten years. Rate adjustments on adjustable home equity loans change based on the prime interest rate for loans on residences of up to 90% LTV regardless of lien position. At December 31, 2018, approximately $185.7 million, or 8.5%, of Home Savings’ total loan portfolio consisted of home equity loans. Home Savings also makes cash-secured consumer loans and investment-secured loans for up to 100% of the principal balance of the account. These loans generally have fixed rates tied to market conditions.

For new automobiles, loans are originated for up to 115% of the MSRP value of the car with terms of up to 78 months. For used automobiles, loans are made for up to the National Automobile Dealers Association (N.A.D.A.) retail value of the car model and a term of up to 78 months. Most automobile loans are originated indirectly through approved auto dealerships. At December 31, 2018, automobile loans totaled $78.7 million, or 3.6% of Home Savings’ total loan portfolio.

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At December 31, 2018, Home Savings had approximately $277.0 million, or 12.7% of its total loans, invested in consumer loans. Nonperforming consumer loans at December 31, 2018, amounted to $1.7 million, or 0.6% of such loans. New originations of consumer loans totaled $99.7 million in 2018.

Lending Process:

Loan Solicitation and Processing. The lending activities of Home Savings are subject to the written, non-discriminatory underwriting standards and loan origination procedures approved by Home Savings’ Board of Directors (the Board). Loan originations generally are obtained from existing customers and members of the local community and from referrals by real estate brokers, lawyers, accountants, builders and current and former customers. Home Savings also advertises in the local print media, radio television, billboards and online.

Each of Home Savings’ retail banking offices and residential mortgage loan centers have loan personnel who can accept loan applications, which are then forwarded to Home Savings’ Credit Department for processing and approval. In underwriting real estate loans, Home Savings typically obtains a credit report and verification of employment and analyzes the cash flows of the borrower and other documentation concerning the creditworthiness of the borrower. Typically, an appraisal of the fair market value of the real estate that will be given as security for the loan is prepared by an approved independent fee appraiser. For all nonresidential real estate loans, the appraisal is conducted by an outside fee appraiser whose report is reviewed by a third-party appraisal review firm engaged by Home Savings. Upon the completion of the appraisal and the receipt of information on the credit history of the borrower, the loan application is submitted for review to the appropriate persons. Generally, all commercial requests and consumer loan requests of $500,000 or more and residential mortgage loan requests over $800,000 up to and including $5.0 million require the approval of the Officers’ Loan Committee or the appropriate Officer’s Loan Committee member. All loans that would cause the aggregate lending relationship to be greater than $5.0 million require approval from the Executive Officers’ Loan Committee.

Borrowers are required to carry satisfactory fire and casualty insurance and flood insurance, if applicable, and to name Home Savings as an insured mortgagee. Home Savings generally obtains a title guarantee or title insurance on real estate loans.

The procedure for approval of construction loans is the same as for permanent real estate loans, except that an appraiser evaluates the building plans, construction specifications and estimates of construction costs. Home Savings also evaluates the feasibility of the proposed construction project and the experience and record of the builder. Once approved, the construction loan is disbursed in installments based upon periodic inspections of the construction progress and lien releases.

Consumer loans are underwritten based on the borrower’s credit history and an analysis of the borrower’s income and expenses, ability to repay the loan and the value of the collateral, if any.

Loan Originations, Purchases and Sales. Home Savings’ residential loans generally are made on terms and conditions and documented to conform to the secondary market guidelines for sale to Freddie Mac, Fannie Mae and other institutional and private investors in the secondary market. Home Savings originates first mortgage loans insured by the Federal Housing Authority and the Veteran’s Administration with the intention to sell in the secondary market.

Home Savings generally retains the servicing rights on the sale of loans originated in the geographic area surrounding its full-service branches. Home Savings anticipates continued participation in the secondary mortgage loan market to maintain its desired risk profile.

At December 31, 2018, Home Savings had $26.8 million of outstanding commitments to make mortgage loans with the intention to sell in the secondary market, as well as $277.5 million available to borrowers under consumer and commercial lines of credit and $60.3 million available in the OverdraftPrivilege™ program. At December 31, 2018, Home Savings had $128.3 million in funds related to commercial loans in process and $71.4 million related to construction loans in process under existing contractual obligations.

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Loans to One Borrower Limits. Regulations generally limit the aggregate amount that Home Savings may lend to any one borrower to an amount equal to 15.0% of Home Savings’ unimpaired capital and unimpaired surplus (Lending Limit Capital). A bank may lend to one borrower an additional amount not to exceed 10.0% of Lending Limit Capital if the additional amount is fully secured by certain forms of readily marketable collateral. Real estate is not considered readily marketable collateral. In applying this limit, regulations require that loans to certain related or affiliated borrowers be aggregated.

Based on such limits, Home Savings could lend approximately $45.3 million to one borrower at December 31, 2018. The largest amount Home Savings had committed to one borrower at December 31, 2018, was $22.5 million in the form of three loans, of which $8.0 million was outstanding at December 31, 2018. At December 31, 2018, these commercial real estate loans were performing in accordance with their terms.

Delinquent Loans, Nonperforming Assets and Classified Assets. The following table reflects the amount of all loans in a delinquent status as of the dates indicated:

 

 

Home Savings determines the past due status of loans based on the number of payments the loan is past due.

Nonperforming assets include loans past due 90 days and on a nonaccrual status, loans past due 90 days and still accruing, loans less than 90 days past due and on a nonaccrual status, real estate acquired by foreclosure or by deed-in-lieu of foreclosure and repossessed assets. Once a loan becomes 90 days delinquent, it generally is placed on nonaccrual status.

Loans are placed on nonaccrual status when collection in full is considered by management to be in doubt. Interest accrued and unpaid at the time a loan is placed on nonaccrual status is charged against interest income. Subsequent cash payments received, if any, generally are applied to principal unless the remaining recorded investment in the asset (i.e., after charge-off of identified losses, if any) is deemed to be fully collectable. In those cases, subsequent cash payments are applied to principal and interest income in accordance with the original terms of the note.

Home Savings does not extend additional credit to borrowers whose loans are classified — i.e., loans that exhibit a well-defined weakness such that management determines that the loan should be classified as substandard, doubtful or loss — without approval by the applicable loan committee.

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The following table sets forth information with respect to Home Savings’ nonperforming loans and other assets by year at the dates indicated:

 

 

In 2018, net income did not include uncollected interest on nonperforming loans. During 2018, approximately $640,000 in additional interest income would have been recorded had nonaccrual loans been accruing pursuant to contractual terms.

A loan is considered impaired when, based on current information and events, it is probable that Home Savings will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the strength of guarantors (if any). Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all the facts and circumstances surrounding the loans and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis by the fair value of the collateral if the loan is collateral dependent, the present value of expected future cash flows discounted at the loan’s effective interest rate, or the market value of the loan. Home Savings considers all troubled debt restructured loans as impaired.

During 2018, Home Savings experienced a decline in impaired loans of $5.7 million. Home Savings recognized a decrease in nonperforming secured commercial loans of approximately $974,000. Nonperforming residential one-to-four-family and home equity loans declined $3.1 million and $1.1 million, respectively.  Purchased credit impaired loans decreased $1.2 million.

Real estate acquired in settlement of loans is classified separately on the balance sheet at estimated fair value less costs to sell as of the date of acquisition. At foreclosure, the loan is written down to the value of the underlying collateral by a charge to the allowance for loan losses, if necessary. Any subsequent write-downs are charged against operating expenses. Operating expenses of such properties, net of related income or loss on disposition, are included in real estate owned and other repossessed asset expenses. At December 31, 2018, the carrying value of real estate and other repossessed assets acquired in settlement of loans was $1.1 million and consisted primarily of $868,000 in one-to-four-family residential properties, $181,000 secured by one-to-four-family residential construction properties and $39,000 in automobiles and recreational vehicles.

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In addition to the classified loans identified above, other loans may be identified as having potential credit problems as a result of those loans being identified by our internal loan review function. These special mention loans, which have not exhibited the more severe weaknesses generally present in classified loans, amounted to $23.3 million, as of December 31, 2018, compared to $15.8 million as of December 31, 2017.

Allowance for Loan Losses. Management has established a methodology to calculate the allowance for loan losses at a level it believes adequate to absorb probable incurred losses in the loan portfolio. The methodology is reviewed regularly by the Board and is revised as conditions and circumstances within the Bank’s loan portfolio dictate. Management bases its determination of the adequacy of the allowance upon estimates derived from an analysis of individual credits, prior and current loss experience, loan portfolio delinquency levels, overall growth in the loan portfolio, current economic conditions and results of regulatory examinations. Furthermore, in determining the level of the allowance for loan losses, management reviews and evaluates on a monthly basis the necessity of a reserve for individual impaired loans classified by management. The specifically allocated reserve for a classified loan is determined based on management’s estimate of the borrower’s ability to repay the loan given the availability of collateral, market value of collateral, other sources of cash flow and legal options available to Home Savings. Once a review is completed, a specific reserve is determined and allocated to the loan.

Other loans not reviewed specifically by management are evaluated as a homogenous group of loans (generally single-family residential mortgage loans and all consumer credits except marine loans) using a loss factor applied to the outstanding loan balance to determine the level of reserve required. This loss factor consists of two components, a quantitative and a qualitative component. The quantitative component is based on a historical analysis of all charged-off loans, net of recoveries, looking back 26 quarters as of December 31, 2018.  In determining the qualitative component, consideration is given to such attributes as lending policies, economic conditions, nature and volume of the portfolio, management, loan quality trend, loan review, collateral value, concentrations, economic cycles and other external factors.   The quantitative and qualitative components are combined to arrive at the loss factor, which is applied to the average outstanding balance of homogenous loans.  At December 31, 2017, the Company evaluated 22 quarters of net charge-off history.    

In determining the qualitative factors, consideration is given to such factors as economic conditions, changes in the nature and volume of the portfolio, lending personnel, lending policies, past-due loan trends, and trends in collateral values. Specific reserves on individual loans and historical ratios are reviewed periodically and adjusted as necessary based on subsequent collections, loan upgrades or downgrades, nonperforming trends or actual principal charge-offs. When evaluating the adequacy of the allowance for loan losses, consideration is given to geographic concentrations and the effect that changing economic conditions have on Home Savings. These estimates are particularly susceptible to changes that could result in a material adjustment to results of operations. The provision for loan losses represents a charge against current earnings in order to maintain the allowance for loan losses at an appropriate level.

The following table sets forth an analysis of Home Savings’ allowance for loan losses for the periods indicated:

 

 

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At December 31, 2018, the allowance for loan losses was 0.93% of net loans and 312.6% of total nonperforming loans.

The following table sets forth the allocation of the allowance for loan losses by category. The allocations are based on management’s assessment of the risk characteristics of each of the components of the total loan portfolio and are subject to change when the risk factors of each component change. The allocation is not indicative of either the specific amounts or the loan categories in which future charge-offs may be taken, nor should it be taken as an indicator of future loss trends. The allocation of the allowance to each category is not necessarily indicative of future loss in any particular category and does not restrict the use of the allowance to absorb losses in any category.

 

 

 

INVESTMENT ACTIVITIES

General. Investment securities are classified upon acquisition as available for sale, held to maturity or trading. Securities classified as available for sale are carried at estimated fair value with the unrealized holding gain or loss, net of taxes, reflected in other comprehensive income and as a component of shareholders’ equity. Securities classified as held to maturity are carried at amortized cost. Securities classified as trading are carried at estimated fair value with the unrealized holding gain or loss reflected as a component of income. United Community and Home Savings recognize premiums and discounts in interest on the level yield method without anticipating prepayments and realized gains or losses on the sale of debt securities based on the amortized cost of the specific securities sold.

Home Savings Investment Activities. Federal laws and regulations as well as Ohio law permit Home Savings to invest in various types of marketable securities, including interest-bearing deposits in other financial institutions, federal funds, U.S. Treasury and agency obligations, mortgage-related securities and certain other specified investments. The Board has adopted an investment policy that authorizes management to make investments in U.S. Treasury obligations, U.S. federal agency and federally-sponsored corporation obligations, mortgage-related securities issued or sponsored by Fannie Mae, Freddie Mac and Government National Mortgage Association (GNMA), investment-grade municipal obligations and creditworthy, unrated securities issued by municipalities in which Home Savings is located. Such securities comprised 100% of Home Savings’ investment securities portfolio at December 31, 2018. The investment policy also authorizes management to make investments in securities issued by private issuers, investment-grade corporate debt securities, investment-grade asset-backed securities, certificates of deposit that are fully-insured by the FDIC, bankers’ acceptances, federal funds and money market funds. Home Savings’ investment policy is designed primarily to provide and maintain liquidity within regulatory guidelines, to maintain a balance of high quality investments to minimize risk and to maximize return without sacrificing liquidity.

Home Savings maintains a significant portfolio of mortgage-backed securities and collateralized mortgage obligations that are issued by Fannie Mae, GNMA and Freddie Mac. These securities generally entitle Home Savings to receive a portion of the cash flows from an identified pool of mortgages. Home Savings is exposed to prepayment risk and reinvestment risk to the extent that actual prepayments will differ from those estimated in pricing the security, which may result in adjustments to the net yield on such securities. Mortgage-related securities enable Home Savings to generate positive interest rate spreads with minimal administrative expense and reduce credit risk due to either guarantees provided by the issuer or the high credit rating of the issuer. Mortgage-related securities classified as available for sale also provide Home Savings with an additional source of liquid funds.

United Community Investment Activities. Funds maintained by United Community for general corporate purposes primarily are invested in an account with Home Savings.

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The following table presents the amortized cost, fair value and weighted average yield of securities available for sale at December 31, 2018 by maturity:

 

 

The following table presents the amortized cost, fair value and weighted average yield of securities held to maturity at December 31, 2018 by maturity:

 

 

Yields are calculated on a fully tax equivalent basis.

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SOURCES OF FUNDS

General. Deposits traditionally have been the primary source of Home Savings’ funds for use in lending and other investment activities. In addition to deposits, Home Savings derives funds from interest payments and principal repayments on loans and income on other earning assets. Loan payments are a relatively stable source of funds, while deposit inflows and outflows fluctuate in response to general interest rates and money market conditions. Home Savings also may borrow from the FHLB and other suitable lenders as well as use repurchase agreements as sources of funds.

Deposits. Deposits are attracted principally from within Home Savings’ primary market area through the offering of a selection of deposit instruments, including checking accounts, regular savings accounts, money market accounts, certificates of deposit and individual retirement accounts (IRAs). Interest rates paid, maturity terms, service fees and withdrawal penalties for the various types of accounts are monitored periodically by management. The amount of deposits from outside Home Savings’ primary market area is not significant.

Brokered deposits represent funds, which Home Savings obtained, directly or indirectly, through a deposit broker. A deposit broker places deposits from third parties with insured depository institutions or places deposits with an institution for the purpose of selling interest in those deposits to third parties. Home Savings had $291.0 million in brokered deposits at December 31, 2018 and $156.5 million in brokered deposits at December 31, 2017.

The following table sets forth the dollar amount of deposits in the various types of accounts offered by Home Savings at the dates indicated:

 

 

The following table shows rate and maturity information for Home Savings’ certificates of deposit at December 31, 2018:

 

 

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At December 31, 2018, approximately $663.8 million of Home Savings’ certificates of deposit will mature within one year. Based on past experience and Home Savings’ prevailing pricing strategies, management believes that a substantial percentage of such certificates will be renewed with Home Savings at maturity. If, however, Home Savings is unable to renew the maturing certificates for any reason, borrowings of up to $403.0 million, as of December 31, 2018, were available from the FHLB.

The following table presents the amount of Home Savings’ certificates of deposit of $100,000 or more by the time remaining until maturity at December 31, 2018:

 

 

The following table presents the amount of Home Savings’ certificates of deposit of $250,000 or more, which are included in the table above, by the time remaining until maturity at December 31, 2018:

 

 

The following table sets forth Home Savings’ deposit account balance activity for the periods indicated:

 

 

Borrowings. The FHLB system functions as a central reserve bank providing credit for its member institutions and certain other financial institutions. As a member in good standing of the FHLB, Home Savings is authorized to apply for advances, provided certain standards of creditworthiness have been met December 31, 2018 Home Savings may borrow up to an additional $403.0 million from the FHLB and had $243.0 million in outstanding advances at December 31, 2018. None of the advances outstanding are callable.

COMPETITION

Home Savings faces competition for deposits and loans from other financial institutions, credit unions, online banks and mortgage originators in Home Savings’ primary market area. The primary factors in competition for deposits are customer service, convenience, interest rates and fees. Home Savings competes for loan originations primarily through the interest rates and loan fees it charges and through the efficiency and quality of service it provides to borrowers. Competition is affected by, among other things, the general availability of lendable funds, general and local economic conditions, current interest rate levels and other factors, which are not readily predictable.

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EMPLOYEES

At December 31, 2018, United Community had 504 full-time equivalent employees.  Home Savings believes that relations with its employees are good. Home Savings makes available health, life and disability benefits, access to variable compensation and a 401(k) plan for its employees.

REGULATION

 

The following is a summary of certain statutes and regulations affecting United Community and Home Savings.  The summary is qualified in its entirety by reference to such statutes and regulations. Applicable laws and regulations restrict permissible activities and investments, and require actions to protect loan, deposit, brokerage, fiduciary and other customers, as well as the Federal Deposit Insurance Fund.  

 

Financial Holding Company Regulation

 

United Community is a bank holding company that is qualified and has elected to be a financial holding company.  As a bank holding company, United Community is subject to the Bank Holding Company Act and to the reporting requirements of, and examination and regulation by, the FRB.  The FRB also has extensive enforcement authority over bank holding companies, including, among other things, the ability to assess civil money penalties, issue cease and desist or removal orders, and require that a bank holding company divest subsidiaries (including its bank subsidiaries).  In general, the FRB may initiate enforcement action for violations of laws and regulations and unsafe or unsound practices.

 

A bank holding company is required to serve as a source of financial strength to each subsidiary bank and to commit resources to support those subsidiary banks.  The FRB may require a bank holding company to contribute additional capital to an undercapitalized subsidary bank and may disapprove of the payment of dividends to the shareholders of the bank holding company if the FRB believes the payment would be an unsafe or unsound practice.  The FRB also requires bank holding companies to provide advance notification of planned dividends under certain circumstances.

 

The Bank Holding Company Act requires the prior approval of the FRB in any case where a bank holding company proposes to:

 

 

Financial Holding Company Activities

 

United Community is a financial holding company, permitting it to engage in activities beyond those permitted for traditional bank holding companies.  In order to become a financial holding company, a bank holding company must meet certain capital requirements and be “well managed,” and all of its depository institutions must be “well capitalized” under federal banking regulations, and the depository institutions must have received a Community Reinvestment Act rating of at least satisfactory.

 

Financial holding companies may engage in a wide variety of financial activities, including any activity that the FRB and the Treasury Department consider financial in nature or incidental to financial activities, and any activity that the FRB determines complementary to a financial activity and which does not pose a substantial safety and soundness risk.  These activities include securities underwriting and dealing activities, insurance and underwriting activities and merchant banking/equity investment activities.  Because it has authority to engage in a broad array of financial activities, a financial holding company may have affiliates that are functionally regulated by financial regulators other than the FRB, such as the SEC and state insurance regulators.

 

A financial holding company and its subsidiaries must continue to meet the above described requirements in order to continue to engage in activities that are financial in nature without being subjected to regulatory actions or restrictions, which could include a requirement to divest of the subsidiary or subsidiaries.  If a financial holding company or a subsidiary bank fails to meet the requirements for the holding company to remain a financial holding company, the financial holding company must enter into a written agreement with the FRB to comply with all applicable capital and management requirements.  Until the FRB determines that the holding company and its subsidiary banks meet the requirements, the FRB may impose additional limitations or conditions on the conduct or activities of the financial holding company or any affiliate that the FRB finds to be appropriate or consistent with federal banking laws.  If the deficiencies are not corrected, the financial holding company may be required to divest ownership or control of some or all of its subsidiaries.  If restrictions are imposed on the activities of the holding company, such restrictions may not be made publicly available pursuant to confidentiality regulations of the banking regulators.  

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The Home Savings Insurance Group is supervised and regulated by the State of Ohio Department of Insurance.  The insurance laws and regulations applicable to insurance agencies require education and licensing of individual agents and agencies require reports and impose business conduct rules.  

 

Regulation of Ohio State-Chartered Banks

 

As an Ohio state-chartered bank that is not a member of the Federal Reserve System, Home Savings is supervised and regulated primarily by the ODFI and the FDIC.  Home Savings’ deposits are insured up to applicable limits by the FDIC, and Home Savings is subject to the applicable provisions of the Federal Deposit Insurance Act and other regulations of the FDIC.  Home Savings is also subject to the regulations of the Consumer Financial Protection Bureau (CFPB), which has broad authority to adopt and enforce consumer protection regulations.

 

Various requirements and restrictions under the laws of the United States and the State of Ohio affect the operations of Home Savings, including requirements to maintain reserves against deposits, restrictions on the nature and amount of loans that may be made and the interest that may be charged thereon, restrictions relating to investments and other activities, limitations on credit exposure to correspondent banks, limitations on activities based on capital and surplus, limitations on payment of dividends, limitations on branching and increasingly extensive consumer protection laws and regulations.  

 

Consumer protection laws and regulations include the Equal Credit Opportunity Act and the Fair Housing Act (prohibiting certain types of discriminatory lending practices), the Truth in Lending Act (requiring understandable disclosure of credit terms), the Home Mortgage Dislcosure Act (requiring the collection of data that enables regulatory agencies to determine whether the financial insitutions are serving the housing credit needs of the communities in which they are located), the Real Estate Seteelement Procedures Act (requiring disclosures to borrowers and prohibiting abusive practices that increase borrowers’ costs) and the privacy provisions of the Gramm-Leach-Bliley Act (requiring policies and procedures to restrict unauthorized sharing of non-public customer data with nonaffiliated parties and protecting customer information from unauthorized access).  The banking regulators also use their authority under the Federal Trade Commission Act to take supervisory or enforcement action with respect to unfair or deceptive acts or practices by banks that may not necessarily fall within the scope of specific banking or consumer finance law.

 

In 2017, the State of Ohio completed a substantial re-writing of Ohio’s banking laws that became effective on January 1, 2018.  The law adopted one universal bank charter for depository institutions chartered by the state, rather than having separate types of state depository institution charters with different powers and limitations for banks, savings banks and savings and loan associations.  The result is that all Ohio-chartered depository institutions are now considered to have full commercial bank powers, unless an institution elects to continue to be governed by federal restrictions applicable to federal savings and loan associations and federal savings banks.  While the most substantial changes in the law affect institutions chartered by Ohio as savings banks or savings and loan associations prior to the effectiveness of the new law, some changes also apply to institutions, like Home Savings, that were chartered as commercial banks prior to the change in the law.  The changes for all Ohio-chartered banks include provisions allowing Ohio-chartered banks to exercise the same powers, perform all acts, and provide all services that are permitted for federally chartered depository institutions, with the exception of laws and regulations dealing with interest rates, thereby enhancing opportunities for Ohio-chartered banks to compete with other financial institutions.  Other provisions clarify previous laws addressing, or allow more flexibility with respect to, corporate governance matters, mergers and acquisitions and additional reliance on Ohio corporate law generally.

In addition, in October 2017, Ohio-chartered banks received notices of required assessments to be paid to the ODFI after two years without assessments while the ODFI was funded by State of Ohio excess unclaimed funds allocated to the ODFI by the State of Ohio.   

Economic Growth, Regulatory Relief and Consumer Protection Act

On May 25, 2018, the Economic Growth, Regulatory Relief and Consumer Protection Act (the “Regulatory Relief Act”) was signed into law. The Regulatory Relief Act was designed to provide regulatory relief for banking organizations, particularly for all but the very largest, those with assets in excess of $250 billion. Bank holding companies with assets of less than $100 billion are no longer subject to enhanced prudential standards, and those with assets between $100 billion and $250 billion will be relieved of those requirements in 18 months, unless the FRB takes action to maintain those standards. Certain regulatory requirements applied only to banks with assets in excess of $50 billion and so did not apply to United Community even before the enactment of the Regulatory Relief Act.

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The Regulatory Relief Act also provides that the banking regulators must adopt regulations implementing the provision that banking organizations with assets of less than $10 billion are permitted to satisfy capital standards and be considered “well capitalized” under the prompt corrective action framework if their leverage ratios of tangible assets to average consolidated assets is between 8%and 10%, unless the bank’s federal banking agency determines that the organization’s risk profile warrants a more stringent leverage ratio. The Office of the Comptroller of the Currency (OCC), the FRB and the FDIC have proposed for comment the leverage ratio framework for any banking organization with total consolidated assets of less than $10 billion, limited amounts of certain types of assets and off-balance sheet exposures, and a community bank leverage ratio greater than 9%. The community bank leverage ratio would be calculated as the ratio of tangible equity capital divided by average total consolidated assets. Tangible equity capital would be defined as total bank equity capital or total holding company equity capital, as applicable, prior to including minority interests, and excluding accumulated other comprehensive income, deferred tax assets arising from net operating loss and tax credit carry forwards, goodwill and other intangible assets (other than mortgage servicing assets). Average total assets would be calculated in a manner similar to the current tier 1 leverage ratio denominator in that amounts deducted from the community bank leverage ratio numerator would also be excluded from the community bank leverage ratio denominator.

The OCC, the FRB and the FDIC also adopted a rule providing banking organizations the option to phase in over a three-year period the day-one adverse effects on regulatory capital that may result from the adoption of new current expected credit loss methodology accounting under U. S. generally accepted accounting principles (GAAP).

The Regulatory Relief Act also relieves bank holding companies and banks with assets of less than $100 billion in assets from certain record-keeping, reporting and disclosure requirements.

 

Capital Requirements

 

Financial institutions and their holding companies are required to maintain capital as a way of absorbing losses that can, as well as losses that cannot, be predicted.  The FRB has adopted risk-based capital guidelines for bank holding companies, and the FDIC has adopted risk-based capital guidelines for state banks that are not members of the Federal Reserve System.  The guidelines provide a systematic analytical framework which makes regulatory capital requirements sensitive to differences in risk profiles among banking organizations, takes off-balance sheet exposures expressly into account in evaluating capital adequacy and minimizes disincentives to holding liquid, low-risk assets.  Capital levels as measured by these standards are also used to categorize financial institutions for purposes of certain prompt corrective action regulatory provisions.

The risk-based capital guidelines adopted by the federal banking agencies are based on the “International Convergence of Capital Measurement and Capital Standard” (Basel I), published by the Basel Committee on Banking Supervision (Basel Committee).  New capital rules applicable to smaller banking organizations (Basel III Capital Rules), which also implement certain of the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act), became effective on January 1, 2015.  Compliance with the new minimum capital requirements was required effective on January 1, 2015, whereas a new capital conservation buffer and deductions from common equity capital phased in from January 1, 2016, through January 1, 2019, and most deductions from common equity tier 1 capital have mostly phased in as of January 1, 2019.

The rules include (a) a minimum common equity tier 1 capital ratio of 4.5 percent, (b) a minimum Tier 1 capital ratio of 6.0 percent, (c) a minimum total risk-based capital ratio of 8.0 percent, and (d) a minimum leverage ratio (Tier 1 capital to average assets) of 4%.

Common equity for the common equity tier 1 capital ratio includes common stock (plus related surplus) and retained earnings, plus limited amounts of minority interests in the form of common stock, less the majority of certain regulatory deductions.        

Tier 1 capital includes common equity as defined for the common equity tier 1 capital ratio, plus certain non-cumulative preferred stock and related surplus, cumulative preferred stock and related surplus and trust preferred securities that have been grandfathered (but which are not permitted going forward), and limited amounts of minority interests in the form of additional Tier 1 capital instruments, less certain deductions.

Tier 2 capital, which can be included in the total capital ratio, includes certain capital instruments (such as subordinated debt) and limited amounts of the allowance for loan and lease losses, subject to new eligibility criteria, less applicable deductions.

The deductions from common equity tier 1 capital include goodwill and other intangibles, certain deferred tax assets, mortgage-servicing assets above certain levels, gains on sale in connection with a securitization, investments in a banking organization’s own capital instruments and investments in the capital of unconsolidated financial institutions (above certain levels).  

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Under the guidelines, capital is compared to the relative risk related to the balance sheet.  To derive the risk included in the balance sheet, one of several risk weights is applied to different balance sheet and off-balance sheet assets, primarily based on the relative credit risk of the counterparty.  The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.  

The rules also place restrictions on the payment of capital distributions, including dividends, and certain discretionary bonus payments to executive officers if the company does not hold a capital conservation buffer of greater than 2.5 percent composed of common equity tier 1 capital above its minimum risk-based capital requirements, or if its eligible retained income is negative in that quarter and its capital conservation buffer ratio was less than 2.5 percent at the beginning of the quarter.  The capital conservation buffer phases in starting on January 1, 2016, at .625% and is fully phased in at 2.50%.  The implementation of Basel III is not expected to have a material impact on United Community’s or Home Savings’ capital ratios.

Federal banking regulators have established regulations governing prompt corrective action to resolve capital deficient banks.  Under these regulations, institutions which become undercapitalized become subject to mandatory regulatory scrutiny and limitations, which increase as capital continues to decrease.  Such institutions are also required to file capital plans with their primary federal regulator, and their holding companies must guarantee the capital shortfall up to 5% of the assets of the capital deficient institution at the time it becomes undercapitalized.

Effective January 1, 2015, in order to be “well-capitalized,” a bank must have a common equity tier 1 capital ratio of at least 6.5%, a total risk-based capital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 8% and a leverage ratio of at least 5%, and the bank must not be subject to any written agreement, order, capital directive or prompt corrective action directive to meet and maintain a specific capital level or any capital measure.  United Community’s management believes that Home Savings meets the ratio requirements to be deemed “well-capitalized” under the prompt corrective action regulations.  

A bank with a capital level that might qualify for well-capitalized or adequately-capitalized status may nevertheless be treated as though the bank is in the next lower capital category if the bank’s primary federal banking supervisory authority determines that an unsafe or unsound condition or practice warrants that treatment.  A bank’s operations can be significantly affected by its capital classification under the prompt corrective action rules.  For example, a bank that is not well capitalized generally is prohibited from accepting brokered deposits and offering interest rates on deposits higher than the prevailing rate in its market without advance regulatory approval.  These deposit-funding limitations can have an adverse effect on the bank’s liquidity.  At each successively lower capital category, an insured depository institution is subject to additional restrictions.  Undercapitalized banks are required to take specified actions to increase their capital or otherwise decrease the risks to the federal deposit insurance fund. Bank regulatory agencies generally are required to appoint a receiver or conservator within 90 days after a bank becomes critically undercapitalized, with a leverage ratio of less than 2%.  The Federal Deposit Insurance Act provides that a federal bank regulatory authority may require a bank holding company to divest itself of an undercapitalized bank subsidiary if the agency determines that divestiture will improve the bank’s financial condition and prospects.

Regulations of the FRB require a financial holding company to maintain total risk-based capital of 10.0% and Tier 1 risk-based capital of 6.0%.  

 

Limits on Dividends

The ability of a bank holding company to obtain funds for the payment of dividends and for other cash requirements is largely dependent on the amount of dividends that may be declared by its subsidiary banks and other subsidiaries.  However, the FRB expects a bank holding company to serve as a source of strength to its bank subsidiaries, which may require the holding company to retain capital for further investments in its bank subsidiaries, rather than paying dividends to shareholders of the holding company.  Home Savings may not pay dividends to United Community if, after paying such dividends, it would fail to meet the required capital levels.  Dividends are also subject to limitations if United Community or Home Savings fails to hold the required capital conservation buffer.  Home Savings must have the approval of its regulatory authorities if a dividend in any year would cause the total dividends for that year to exceed the sum of its current year’s net profits and retained net profits for the preceding two years, less required transfers to surplus.  Under Ohio law, Home Savings may pay a dividend from surplus only with the approval of its shareholder United Community and the approval of the Superintendent of Financial Institutions.  Payment of dividends by Home Savings may be restricted at any time at the discretion of its regulatory authorities, if they deem such dividends to constitute an unsafe and/or unsound banking practice or if necessary to maintain adequate capital for Home Savings.  These provisions could have the effect of limiting United Community’s ability to pay dividends on its outstanding common shares.

In addition, FRB policy requires United Community to provide notice to the FRB in advance of the payment of a dividend to United Community’s shareholders under certain circumstances, and states that insured banks and bank holding companies should generally only pay dividends out of current operating earnings.  The FRB may disapprove of such dividend payment if the FRB determines the payment would be an unsafe or unsound practice.

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Deposit Insurance Assessments

The FDIC is an independent federal agency which insures deposits, up to prescribed statutory limits, of federally-insured banks and savings associations and safeguards the safety and soundness of the financial institution industry.  The deposits of Home Savings are insured up to statutorily prescribed limits by the FDIC, generally up to a maximum of $250,000 per separately insured depositor.    

As insurer as well as primary federal regulator of Home Savings, the FDIC is authorized to conduct examinations of and to require reporting by Home Savings, to prohibit Home Savings from engaging in any activity the FDIC determines to pose a threat to the Deposit Insurance Fund, and to take enforcement actions against Home Savings.  The FDIC may terminate insurance of deposits of any institution if it finds that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or other regulatory agency.    

The FDIC assesses a quarterly deposit insurance premium on each insured institution based on risk characteristics of the institution and may also impose special assessments in emergency situations.  The premiums fund the Deposit Insurance Fund (DIF).  Pursuant to the Dodd-Frank Act, the FDIC has established 2.0% as the designated reserve ratio (DRR), which is the amount in the DIF as a percentage of all DIF insured deposits.  In March 2016, the FDIC adopted final rules designed to meet the statutory minimum DRR of 1.35% by September 30, 2020, the deadline imposed by the Dodd-Frank Act.  The Dodd-Frank Act requires the FDIC to offset the effect on institutions with assets of less than $10 billion of the increase in the statutory minimum DRR to 1.35% from the former statutory minimum of 1.15%.  Although the FDIC's new rules reduced assessment rates on all banks, they imposed a surcharge on banks with assets of $10 billion or more to be paid until the DRR reaches 1.35%.  The DRR reached 1.36% at September 30, 2018.  The rules also provide assessment credits to banks with assets of less than $10 billion for the portion of their assessments that contribute to the increase of the DRR to 1.35%.  The rules further changed the method of determining risk-based assessment rates for established banks with less than $10 billion in assets to better ensure that banks taking on greater risks pay more for deposit insurance than banks that take on less risk.  

In addition, all FDIC-insured institutions are required to pay assessments to fund interest payments on bonds issued by the Financing Corporation, which was established by the government to recapitalize a predecessor to the DIF.  These assessments will continue until the Financing Corporation bonds mature in September 2019.  The Financing Corporation has projected that the last assessment will be collected on the March 29, 2019, FDIC invoice.  

Consumer Protection Laws and Regulations

Banks are subject to regular examination to ensure compliance with federal statutes and regulations applicable to their business, including consumer protection statutes and implementing regulations. Potential penalties under these laws include, but are not limited to, fines. The Dodd-Frank Act established the CFPB, which has extensive regulatory and enforcement powers over consumer financial products and services. The CFPB has adopted numerous rules with respect to consumer protection laws, amending some existing regulations and adopting new ones, and has commenced enforcement actions. The following are just some of the consumer protection laws applicable to the Bank:

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The banking regulators also use their authority under the Federal Trade Commission Act to take supervisory or enforcement action with respect to unfair or deceptive acts or practices by banks that may not necessarily fall within the scope of specific banking or consumer finance law.

In October 2017, the CFPB issued a final rule (the “Payday Rule”) with respect to certain consumer loans to be effective on January 16, 2018, although compliance with most sections is required starting on August 19, 2019. The first major part of the rule makes it an unfair and abusive practice for a lender to make short-term and longer-term loans with balloon payments (with certain exceptions) without reasonably determining that the borrower has the ability to repay the loan. The second major part of the rule applies to the same types of loans as well as certain other longer-term loans that are repaid directly from the borrower's account. The rule states that it is an unfair and abusive practice for the lender to withdraw payment from the borrower's account after two consecutive payment attempts have failed, unless the lender obtains the consumer's new and specific authorization to make further withdrawals from the account. The rule also requires lenders to provide certain notices to the borrower before attempting to withdraw payment on a covered loan from the borrower’s account.  

On February 6, 2019, the CFPB issued two proposals with respect to the Payday Rule. First, the CFPB proposed to delay the compliance date for the mandatory underwriting provisions of the Payday Rule to November 19, 2020. It has requested comments on the proposed delay to be made within 30 days. Second, the CFPB proposed to rescind provisions of the Payday Rule that (1) provide that it is an unfair and abusive practice for a lender to make a covered short-term or longer-term balloon-payment loan without reasonably determining that the consumer has the ability to repay the loan according to its terms; (2) prescribe mandatory underwriting requirements for making the ability-to-repay determination; (3) provide exemptions of certain loans from the mandatory underwriting requirements; and (4) provide related definitions, reporting and recordkeeping requirements. The CFPB has requested comments to be made within 90 days on this proposal. These proposals do not change the provisions of the Payday Rule that address lender payment practices with respect to covered loans. The CFPB also stated that it will be considering other changes to the Payday Rule in response to requests received for exemptions of certain types of lenders or loan products and may commence separate additional rulemaking initiatives.  The Payday Rule applies to short-term loans that have terms of 45 days or less, longer-term balloon-payment loans and longer-term loans that have a cost of credit exceeding 36% per annum and for which the lender obtains a leveraged payment mechanism.  Of these loan types, the Company does not offer either short-term loans that have terms of 45 days or less or longer-term balloon-payment loans.  The Company may occasionally offer, on an accommodation basis, vehicle title loans, which qualify as longer-term loans which may have a cost of credit exceeding 36% per annum for which the Company obtains a leveraged payment mechanism.  However, the Rule provides a conditional exemption for accommodation loans provided the lender and its affiliates have made 2,500 or fewer of these loans in the current year and have made 2,500 or fewer of these loans in the preceding calendar year.  Based upon this information, the Payday Rule will have no impact on the Company.

Transactions with Affiliates, Directors, Executive Officers and Shareholders

The Federal Deposit Insurance Act applies to state-chartered non-member banks Section 23A and 23B of the Federal Reserve Act and Regulation W, which restrict transactions by banks and their subsidiaries with their affiliates.  An affiliate of a bank is any company or entity which controls, is controlled by or is under common control with the bank.  Generally, Sections 23A and 23B and Regulation W:  

The term “covered transaction” includes the making of loans to the affiliate, the purchase of assets from the affiliate, the issuance of a guarantee on behalf of the affiliate, the purchase of securities issued by the affiliate, and other similar types of transactions.  

Home Savings’ authority to extend credit to executive officers, directors and greater than 10% shareholders, as well as entities such persons control, is subject to limits established by FDIC regulations, which incorporate by reference most of Sections 22(g) and 22(h) of the Federal Reserve Act and Regulation O promulgated thereunder by the Federal Reserve Board.  Among other restrictions, these loans must be made on terms substantially the same as those offered to unaffiliated individuals or be made as part of a benefit or compensation program and on terms widely available to employees, and must not involve a greater than normal risk of repayment.  In

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addition, the amount of loans a bank may make to these persons is based, in part, on the bank’s capital position, and specified approval procedures must be followed.

Monetary Policy and Economic Conditions

The business of commercial banks is affected not only by general economic conditions, but also by the policies of various governmental regulatory authorities, including the FRB.  The FRB regulates the money and credit conditions and interest rates in order to influence general economic conditions primarily through open market operations in U.S. Government securities, changes in the discount rate on bank borrowings and changes in reserve requirements against bank deposits.  These policies and regulations significantly influence the amount of bank loans and deposits and the interest rates charged and paid thereon, and thus have an effect on earnings.

Patriot Act

The Uniting and Strengthening of America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorist Act of 2001 (Patriot Act) gives the federal government powers to address terrorist threats through domestic security measures, surveillance powers, information sharing and anti-money laundering requirements.  Title III of the Patriot Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies.  Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions.  Among other requirements, Title III and related regulations require regulated financial institutions to establish a program specifying procedures for obtaining identifying information from customers seeking to open new accounts and establish due diligence policies, procedures and controls designed to detect and report suspicious activity.  

Executive and Incentive Compensation

In June 2010, the FRB, the FDIC and the Office of the Comptroller of the Currency issued joint interagency guidance on incentive compensation policies (Joint Guidance) intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking.  This principles-based guidance, which covers all employees who have the ability to affect materially the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should:  (i) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks; (ii) be compatible with effective internal controls and risk management; and (iii) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.  The Joint Guidance made incentive compensation part of the regulatory agencies’ examination process, with the findings of the supervisory initiatives included in reports of examination and enforcement actions possible.

After issuing proposed rules in 2011, in May 2016, the federal bank regulatory agencies approved their second joint notice of proposed rules (Second Proposed Joint Rules) designed to prohibit incentive-based compensation arrangements that encourage inappropriate risks at financial institutions.  The requirements of the Second Proposed Joint Rules would differ for each of three categories of financial institutions:  

Some of the requirements would apply only to Level 1 and Level 2 institutions.  For all covered institutions the Second Proposed Joint Rules would prohibit certain practices and types of incentive compensation and:

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Like all financial companies, United Community’s business and results of operations are subject to a number of risks, many of which are outside of our control. In addition to the other information in this report, readers should carefully consider that the following important factors, among others, could materially impact our business and future results of operations.

United Community and the Bank have an enterprise risk management program. The Board Risk Management Committee provides oversight of the program. The Board also adopted the Corporate Risk Management and Control Policy. The policy provides a framework for risk identification, monitoring and mitigation through a risk assessment process, including reviewing of policies and procedures to enhance the controls and risk management practices at United Community and the Bank. The Officers Risk Management Committee leads this process as part of an ongoing program.

 

Risk Related to Economic, Political and Market Conditions

Economic conditions may adversely affect our results of operations and financial condition.

A reduction in the availability of credit, the lack of confidence in the financial sector, a decrease in consumer confidence, an increase in volatility in the financial markets and reduced business activity could materially and adversely affect our business, financial condition and results of operations. Economic turmoil in Europe and Asia and changes in oil production in the Middle East affect the economy and stock prices in the United States, which can affect United Community’s earnings and capital and the ability of its customers to repay loans.  In addition, the timing and circumstances of the United Kingdom leaving the European Union (Brexit) and their effects on the United States are unknown.  As a result of the challenges presented by economic conditions, we may face the following risks in connection with these events:

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Changes in interest rates could adversely affect our financial condition and results of operations.

Our results of operations depend substantially on our net interest income, which is the difference between the interest earned on loans, securities and other interest-earning assets and the interest paid on deposits and other borrowings. These rates are highly sensitive to many factors beyond our control, including general economic conditions, inflation, recession, unemployment, the money supply and the policies of various governmental and regulatory authorities. While we have taken measures intended to manage the risks of operating in a changing interest rate environment, there can be no assurance that these measures will be effective in avoiding undue interest rate risk.

Increases in interest rates can affect the value of available for sale securities, loans and other assets, including our ability to realize gains on the sale of these assets. We originate loans for sale and for our portfolio. Increasing interest rates may reduce the origination of loans for sale and consequently the fee income we earn on such sales. Further, increasing interest rates may adversely affect the ability of borrowers to pay the principal or interest on loans and leases, resulting in an increase in nonperforming assets and a reduction of income recognized.

In contrast, decreasing interest rates have the effect of causing clients to refinance mortgage loans faster than anticipated. This causes the value of assets related to the servicing rights on loans sold to be lower than originally anticipated. If this happens, we may need to write down our servicing assets faster, which would accelerate our expense and lower our earnings.

Volatility in the economy may negatively impact the fair value of our common shares.

The market price for our common shares has been volatile in the past, and several factors could cause the price to fluctuate substantially in the future, including:

A transition away from LIBOR as a reference rate for financial contracts could negatively affect our income and expenses and the value of various financial contracts.

LIBOR is used extensively in the U.S. and globally as a benchmark for various commercial and financial contracts, including adjustable rate mortgages, corporate debt, interest rate swaps and other derivatives. LIBOR is set based on interest rate information reported by certain banks, which may stop reporting such information after 2021. It is uncertain at this time whether LIBOR will change or cease to exist or the extent to which those entering into financial contracts will transition to any other particular benchmark. Other benchmarks may perform differently than LIBOR or alternative benchmarks have performed in the past or have other consequences that cannot currently be anticipated. It is also uncertain what will happen with instruments that rely on LIBOR for future interest rate adjustments and which remain outstanding if LIBOR ceases to exist.

Adverse changes in the financial markets may adversely impact our results of operations.

The capital and credit markets have been experiencing unprecedented levels of volatility since 2008. While the Company generally invests in securities with limited credit risk, certain investment securities we hold possess higher credit risk since they represent beneficial interests in structured investments collateralized by residential mortgages. Regardless of the level of credit risk, all investment securities are subject to changes in market value due to changing interest rates and implied credit spreads.

Structured investments have at times been subject to significant market volatility due to the uncertainty of credit ratings, deterioration in credit losses occurring within certain types of residential mortgages, changes in prepayments of the underlying collateral and the lack of transparency related to the investment structures and the collateral underlying the structured investment vehicles.

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A default by another larger financial institution could adversely affect financial markets generally.

The commercial soundness of many financial institutions may be closely interrelated as a result of relationships between the institutions. As a result, concerns about, or a default or threatened default by, one institution could lead to significant market-wide liquidity and credit problems, losses or defaults by other institutions.  This “systemic risk” may adversely affect our business.

Risk Related to Our Business

Increases in credit risks could adversely affect our results of operations.

There are inherent risks associated with our lending activities, including credit risk, which is the risk that borrowers may not repay outstanding loans or the value of the collateral securing loans will decrease. We attempt to manage credit risk through a program of underwriting standards, the review of certain credit decisions and an on-going assessment of the quality of the credit already extended. However, conditions such as inflation, recession, unemployment, changes in interest rates, money supply, declines in real estate value and other factors beyond our control may increase our credit risk. Such changes in the economy may have a negative impact on the ability of borrowers to repay their loans. Because we have a significant amount of real estate loans, decreases in real estate values could adversely affect the value of our collateral. In addition, substantial portions of our loans are to individuals and businesses in Ohio. Consequently, any decline in the state’s economy could have a materially adverse effect on our financial condition and results of operations.

A loan is impaired when, based on current information and events, it is probable that Home Savings will be unable to collect both the contractual interest payments and the contractual principal payments, as scheduled in the loan agreement. Construction loans generally involve greater underwriting and default risks than loans secured by mortgages on existing properties because construction loans are more difficult to appraise and to monitor. In the event a default on a construction loan occurs and foreclosure follows, we may need to take control of the project and attempt either to arrange for completion of construction or dispose of the unfinished project.

We operate in an extremely competitive market, and our business will suffer if we are unable to compete effectively.

In our market area, we encounter significant competition from savings and loan associations, banks, credit unions, mortgage-banking firms, securities brokerage firms, asset management firms and insurance companies. Many of our competitors have substantially greater resources and lending limits than we do and may offer services that we do not or cannot provide. In order to compete, Home Savings may need to lower interest rates on its products to match interest rates offered by its competition, which could have a negative impact on net interest margin and earnings.

The preparation of financial statements requires management to make estimates about matters that are inherently uncertain.

Management’s accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. Our management must exercise judgment in selecting and applying many of these accounting policies and methods in order to ensure that they comply with generally accepted accounting principles and reflect management’s judgment as to the most appropriate manner in which to record and report our financial condition and results of operations. Three of the most critical estimates are the level of the allowance for loan losses, the fair value of real estate owned and the valuation of mortgage servicing rights. Due to the inherent nature of these estimates, we cannot provide absolute assurance that we will not significantly increase the allowance for loan losses, sustain loan losses that are significantly higher than the provided allowance or recognize a significant provision for the impairment of mortgage servicing rights. Material additions to the allowance for loan losses and any loan losses that exceed our reserves would materially adversely affect our results of operations and financial condition.

Our allowance for loan losses may prove to be insufficient to absorb probable incurred losses in our loan portfolio.

Lending money is a substantial part of our business. However, every loan we make carries a risk of non-payment. This risk is affected by, among other things: cash flow of the borrower and/or the project being financed; in the case of a collateralized loan, the changes and uncertainties as to the future value of the collateral; the credit history of a particular borrower; changes in economic and industry conditions; and the duration of the loan.

The preparation of consolidated financial statements in conformity with GAAP requires management to make significant estimates that affect the financial statements. One of our most critical estimates is the adequacy of the allowance for loan losses. Due to the inherent nature of these estimates, we cannot provide absolute assurance that we will not be required to charge earnings for significant unexpected loan losses.

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We maintain an allowance for loan losses that we believe is a reasonable estimate of known and probable incurred losses within the loan portfolio. We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of loans. Through a periodic review and consideration of the loan portfolio, management determines the amount of the allowance for loan losses by considering general market conditions, credit quality of the loan portfolio, the collateral supporting the loans and performance of customers relative to their financial obligations with us. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates and real estate values, which may be beyond our control, and these losses may exceed current estimates. We cannot fully predict the amount or timing of losses or whether the loan loss allowance will be adequate in the future.

In addition, bank regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs. Any increase in our allowance for loan losses or loan charge-offs as required by these regulatory authorities might have a material adverse effect on our financial condition and results of operations.

Our financial condition and results of operations could be negatively affected if we fail to manage growth in our effectively.

We may acquire other financial institutions or parts of institutions in the future, open new branches, and consider new lines of business and new products or services. Expansions of its business would involve a number of expenses and risks, including:

 

If our growth involves the acquisition of companies through merger or other acquisition, the success of such merger or acquisition will depend on, among other things, our ability to combine the businesses in a manner that permits growth opportunities and cost efficiencies, and does not cause inconsistencies in standards, controls, procedures and policies that adversely affect the ability of United Community to maintain relationships with customers and employees or to achieve the anticipated benefits of the merger or acquisition.

Failure to manage our growth effectively could have a material adverse effect on its business, future prospects, financial condition or results of operations and could adversely affect United Community’s ability to successfully implement its business strategy.

Our results of operations, financial condition or liquidity may be adversely impacted by potential losses in connection with actual or projected repurchases and indemnification payments related to mortgages sold into the secondary market.

In connection with the origination and sale of residential mortgages into the secondary market, we makes certain representations and warranties, which, if breached, may require it to repurchase such loans, substitute other loans or indemnify the purchasers of such loans for actual losses incurred in respect of such loans. Although we believe that our mortgage documentation and procedures have been appropriate, it is possible that we will receive repurchase requests in the future and we may not be able to reach favorable settlements with respect to such requests. It is therefore possible that we may increase its reserves or may sustain losses associated with such loan repurchases and indemnification payments.

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We may not be able to attract and retain skilled people.

Our success depends in large part on our ability to attract and retain key people. There are a limited number of qualified persons in our market area with the knowledge and experience required to successfully manage our business. The unexpected loss of services of other key personnel could have a material adverse impact on our business because of a loss of their skills, knowledge of our market and years of industry experience. If the Company is not able to promptly recruit qualified personnel, which the Company requires to conduct our operations, our business and our ability to successfully implement our strategic plan could be affected.

We rely, in part, on external financing to fund our operations and the availability of such funds in the future could adversely impact our growth strategy and prospects.

We rely on deposits, advances from the FHLB and other borrowings to fund our banking operations.  Although we consider our sources of funds to be adequate for its current funding needs, we may seek additional debt or equity capital in the future to achieve its long-term business objectives. The sale of equity or convertible debt securities in the future may be dilutive to our shareholders, and debt refinancing arrangements may require us to pledge some of our assets and enter into covenants that would restrict its ability to incur further indebtedness. Additional financing sources, if sought, might be unavailable to the Company or, if available, could be on terms unfavorable to it. If additional financing sources are unavailable, not available on reasonable terms or we are unable to obtain any required regulatory approval for additional debt, our growth strategy and future prospects could be adversely impacted.

Our ability to pay cash dividends is subject to certain regulatory requirements.

United Community is generally dependent upon the earnings of Home Savings for funds to pay dividends on our common shares. The payment of dividends by Home Savings is subject to certain regulatory restrictions. Federal law generally prohibits a depository institution from making any capital distributions (including payment of a dividend) to its parent holding company if the depository institution would be undercapitalized as a result.

U.S. tax laws applicable to Home Savings would cause a taxable recapture of accumulated bad debt reserves of up to $21.1 million to the extent that Home Savings makes a distribution to United Community while Home Savings does not have sufficient tax earnings and profits at the time of such distribution. The income tax liability resulting from such a distribution could be as great as $4.4 million. No deferred tax liability has been recorded for this potential recapture liability. For a further description, refer to Note 14 to the consolidated financial statements.  Accordingly, until Home Savings restores its tax earnings and profits to an amount sufficient to avoid taxable bad debt reserve recapture upon distributions to United Community, we may be unwilling to approve a dividend from Home Savings to United Community even if Home Savings was otherwise permitted or able to make a dividend to United Community. As of December 31, 2018, the deficit in tax earnings and profits was approximately $12.0 million. Tax earnings and profits is generally increased by taxable income and tax-exempt income and decreased by income taxes payable and non-deductible expenses.

As a result, any payment of dividends in the future by United Community will be generally dependent on Home Savings’ earnings, capital requirements, financial condition and other factors.

Changes in the fair value of our investment securities may reduce stockholders’ equity and net income.

As of December 31, 2018, securities available for sale were $241.6 million and the net unrealized losses on those securities were $4.8 million. Stockholders’ equity is increased or decreased by the change in unrealized gain or loss on these securities, through accumulated other comprehensive income (loss) (AOCI). The unrealized gain or loss represents the difference between the estimated fair value and the amortized cost of the securities. A decline in the estimated fair value of the portfolio results in, but is not limited to, a decline in stockholders’ equity, book value per common share, and tangible book value per common share. Potential recovery of a debt security is dependent upon a number of factors as it approaches maturity, including, but not limited to, credit quality and market interest rates. Increases in market interest rates commonly result in declines in the fair value of debt securities. Equity securities have no stated maturity; therefore, declines in fair value may or may not be recovered over time and are subject to market and issuer fundamentals.

We conduct quarterly reviews of our securities portfolio to determine if the declines are other-than-temporary. If we determine that fair value decreases are other-than-temporary, the security is written down to a new cost basis and the resulting loss is charged to earnings as a component of noninterest income.

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We continue to monitor the fair value of our securities portfolio as part of our ongoing other-than-temporary-impairment (OTTI) evaluation process. No assurance can be given that we will not need to recognize OTTI charges in the future. Additional OTTI charges may materially affect our financial condition and earnings. See Note 1 to our consolidated financial statements for a further discussion on OTTI.

Periodic regulatory reviews may affect our operations and financial condition.

The Company is subject to periodic reviews from state and federal regulators, which may impact our operations and our financial condition. As part of the regulatory review, the loan portfolio and the allowance for loan losses are evaluated. As a result, the incurred loss identified on loans or the assigned loan rating could change and may require us to increase our provision for loan losses or loan charge-offs. In addition, any downgrade in loan ratings could impact our level of impaired loans or classified assets. Any increase in our provision for loan losses or loan charge-offs as required by these regulatory authorities could have a material adverse effect on our financial condition and results of operations. Findings of deficiencies in compliance with regulations could result in restrictions on our activities or even a loss in our financial holding company status.

We may be required to repurchase loans it has sold or indemnify loan purchasers under the terms of the sale agreements, which could adversely affect our liquidity, results of operations and financial condition.

When we sell a mortgage loan, it agrees to repurchase or substitute a mortgage loan if it is later found to have breached any representation or warranty the Bank made about the loan or if the borrower is later found to have committed fraud in connection with the origination of the loan. While we have underwriting policies and procedures designed to avoid breaches of representations and warranties as well as borrower fraud, we cannot be sure that no breach or fraud will ever occur. Required repurchases, substitutions or indemnifications could have an adverse effect on the Company’s liquidity, results of operations and financial condition.

We may be a defendant from time to time in the future in a variety of litigation and other actions, which could have a material adverse effect on its business, financial condition, or results of operations.

The Company may be subject to claims or legal action from customers, employees or others. Financial institutions are facing a growing number of significant class actions, including those based on the manner or calculation of interest on loans and the assessments of overdraft fees. Future litigation could include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. Like other financial institutions, the Company and the Bank are also subject to risk from potential employee misconduct, including non-compliance with policies and improper use or disclosure of confidential information.  

The Company’s insurance may not cover all claims that may be asserted against it, and any claims asserted against the Company, regardless of merit or eventual outcome, may harm its reputation. Should the ultimate judgments or settlements in any litigation exceed the Company’s insurance coverage, it could have a material adverse effect on the Company’s business, financial condition, or results of operations. In addition, the Company may not be able to obtain appropriate types or levels of insurance in the future, nor may the Company be able to obtain adequate replacement policies with acceptable terms, if at all.

We are dependent on our information technology and telecommunications systems and third-party servicers, and systems failures or interruptions could have an adverse effect on our financial condition and results of operations.

Our business is highly dependent on the successful and uninterrupted functioning of our information technology and telecommunications systems and third-party servicers. We outsource many of our major systems, such as data processing, loan servicing and deposit processing systems. The failure of these systems, or the termination of a third-party software license or service agreement on which any of these systems is based, could interrupt our operations. Because our information technology and telecommunications systems interface with, and depend on, third-party systems, we could experience service denials if demand for such services exceeds capacity or such third-party systems fail or experience interruptions. If sustained or repeated, a system failure or service denial could result in a deterioration of our ability to process new and renewal loans, gather deposits and provide customer service, compromise our ability to operate effectively, damage our reputation, result in a loss of customer business and/or subject us to additional regulatory scrutiny and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.

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Material breaches in security of our vendors and our systems may have a significant effect on our business.

Financial institutions are under continuous threat of loss due to cyber-attacks especially as we continue to expand customer capabilities to utilize internet and other remote channels to transact business. The most significant cyber–attack risks that we face are e-fraud, denial of service, and loss of sensitive customer data. Loss from e-fraud occurs when cybercriminals breach and extract funds directly from customer or our accounts. Loss can occur as a result of negative customer experience in the event of a successful denial of service attack that disrupts availability of our on-line banking services. The attempts to breach sensitive customer data, such as account numbers and social security numbers, could present significant operational, reputational, legal and/or regulatory costs to us, if successful. The Company has security, backup and recovery systems in place and a comprehensive business continuity plan to ensure the systems will not be inoperable. The Company also has security in place to prevent unauthorized access to the systems. In addition, the Company has a cyber-liability insurance policy to protect against breaches of the Company and vendor systems. Third party service providers also are required to maintain similar controls. However, the Company cannot be certain the measures will be successful to prevent a security breach. Our risk and exposure to these matters remains heightened because of the evolving nature and complexity of these threats from cybercriminals and hackers, our plans to continue to provide internet banking and mobile banking channels, and our plans to develop additional remote connectivity solutions to serve our customers. Security breaches also may increase reputational and legal risks, and the Company could experience an increase in expenses or losses resulting from such breaches.

Potential misuse of funds or information by the Bank’s employees or by third parties could result in damage to our customers for which we could be held liable, subject the Company to regulatory sanctions and otherwise adversely affect our financial condition and results of operations.

Our employees handle a significant amount of funds, as well as financial and personal information. Although the Company has implemented systems to minimize the risk of fraudulent taking or misuse of funds or information, there can be no assurance that such systems will be adequate or that a taking or misuse of funds or information by employees, by third parties who have authorized access to funds or information, or by third parties who are able to access funds or information without authorization will never occur. We could be held liable for such an event and could also be subject to regulatory sanctions.  We could also incur the expense of developing additional controls to prevent future such occurrences. Although the Company has insurance to cover such potential losses, we cannot provide assurance that such insurance will be adequate to meet any liability. In addition, any loss of trust or confidence placed in the Company by our clients could result in a loss of business, which could adversely affect our financial condition and results of operations.

 

Unauthorized disclosure of sensitive or confidential customer information, whether through a breach of our computer systems or otherwise, could result in harm to such customer for which we may be held liable or incur sanctions.

 

Potential misuse of funds or information by Home Savings’ employees or by third parties could result in damage to Home Savings’ customers for which Home Savings could be held liable, subject Home Savings to regulatory sanctions and otherwise adversely affect Home Savings’ financial condition and results of operations.

 

Home Savings’ employees handle a significant amount of funds, as well as financial and personal information. Although Home Savings has implemented systems to minimize the risk of fraudulent taking or misuse of funds or information, there can be no assurance that such systems will be adequate or that a taking or misuse of funds or information by employees, by third parties who have authorized access to funds or information, or by third parties who are able to access funds or information without authorization will never occur. Home Savings could be held liable for such an event and could also be subject to regulatory sanctions. Home Savings could also incur the expense of developing additional controls to prevent future such occurrences. Although Home Savings has insurance to cover such potential losses, Home Savings cannot provide assurance that such insurance will be adequate to meet any liability. In addition, any loss of trust or confidence placed in Home Savings by our customers could result in a loss of business, which could adversely affect our financial condition and results of operations.

 

We could suffer a material adverse impact from interruptions in the effective operation of, or security breaches affecting, our computer systems.

 

Home Savings relies heavily on information systems to conduct our business and to process, record, and monitor transactions. Risks to the system result from a variety of factors, including the potential for bad acts on the part of hackers, criminals, employees and others. As one example, some banks have experienced denial of service attacks in which individuals or organizations flood the bank’s website with extraordinarily high volumes of traffic, with the goal and effect of disrupting the ability of the bank to process transactions. Home Savings is also at risk for the impact of natural disasters, terrorism and international hostilities on its systems or for the effects of outages or other failures involving power or communications systems operated by others. These risks also arise from the same types of threats to businesses with which Home Savings deals.

 

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Risks Related to Legal, Regulatory and Accounting Changes

Legislative, regulatory or accounting changes or actions could adversely impact the financial services industry and/or our business, financial condition or results of operations.

In addition to laws, regulations and actions directed at the operations of banks, proposals to reform the housing finance market could negatively affect our ability to sell loans.

Although it is impossible for the Company to predict at this time what changes in laws and regulations will be implemented and the effect they will have on the Company and the rest of our industry, it is possible that the Company’s revenue could decrease, its interest expense could increase and deposit insurance premiums could change, and steps may need to be taken to increase qualifying capital. The Company’s operating and compliance costs could increase and could adversely affect the Company’s financial condition and results of operations.

Changes in tax laws could adversely affect our financial condition and results of operations.

We are subject to extensive federal, state and local taxes, including income, excise, sales/use, payroll, franchise, withholding and ad valorem taxes. Changes to the Company’s taxes could have a material adverse effect on our results of operations. In addition, the Company’s customers are subject to a wide variety of federal, state and local taxes. Changes in taxes paid by the Company’s customers, including changes in the deductibility of mortgage loan related expenses, may adversely affect their ability to purchase homes or consumer products, which could adversely affect their demand for the Company’s loans and deposit products. In addition, such negative effects on the Company’s customers could result in defaults on the loans the Bank has made and decrease the value of mortgage-backed securities in which the Company has invested.

On December 22, 2017, H.R.1, formally known as the “Tax Cuts and Jobs Act,” was enacted into law. This new tax legislation, among other changes, limits the amount of state, federal and local taxes that taxpayers are permitted to deduct on their individual tax returns and eliminates other deductions in their entirety. Such limits and eliminations may result in customer defaults on loans the Bank has made and decrease the value of mortgage-backed securities in which we have invested.

Increases in FDIC insurance premiums may have a material adverse effect on our earnings.

Increased bank failures for several years commencing in 2008 greatly increased resolution costs of the FDIC and depleted the deposit insurance fund. In order to maintain a strong funding position and restore reserve ratios of the deposit insurance fund, the FDIC took a number of actions, including increasing assessment rates of insured institutions, requiring riskier institutions to pay a larger share of premiums by factoring in rate adjustments based on secured liabilities and unsecured debt levels, changing the assessment base and requiring a prepayment of assessments for over three years.

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We are generally unable to control the amount of premiums that the Bank is required to pay for FDIC insurance. If there are additional financial institution failures, the Bank may be required to pay even higher FDIC premiums. Increases in FDIC insurance premiums may materially adversely affect the Company’s results of operations and its ability to continue to pay dividends on our common shares at the current rate or at all. The FDIC has recently adopted rules revising its assessments in a manner benefitting banks with assets totaling less than $10 billion.  There can be no assurance, though, that assessments will not be changed in the future.

Changes in accounting standards, policies, estimates or procedures could impact our reported financial condition or results of operations.

Entities that set generally applicable accounting standards, such as the FASB, the SEC, and other regulatory boards, periodically change the financial accounting and reporting standards that govern the preparation of the Company’s consolidated financial statements. These changes can be difficult to predict and can materially affect how the Company records and reports its financial condition and results of operations. In some cases, the Company could be required to apply a new or revised standard retroactively, which would result in the restatement of the Company’s financial statements for prior periods.

In June 2016, FASB issued a new accounting standard for recognizing current expected credit losses, commonly referred to as CECL. CECL will result in earlier recognition of credit losses and requires consideration of not only past and current events but also reasonable and supportable forecasts that affect collectability. The Company will be required to comply with the new standard in the first quarter of 2020. Upon adoption of CECL, credit loss allowances may increase, which would decrease retained earnings and regulatory capital. The federal banking regulators have adopted a regulation that will allow banks to phase in the day-one impact of CECL on regulatory capital over three years. CECL implementation poses operational risk, including the failure to properly transition internal processes or systems, which could lead to call report errors, financial misstatements, or operational losses.

Management’s accounting policies and methods are fundamental to how the Company records and reports its financial condition and results of operations. The Company’s management must exercise judgment in selecting and applying many of these accounting policies and methods in order to ensure that they comply with GAAP and reflect management’s judgment as to the most appropriate manner in which to record and report our financial condition and results of operations. In some cases, management must select the accounting policy or method to apply from two or more alternatives, any of which might be reasonable under the circumstances yet might result in reporting materially different amounts than would have been reported under a different alternative.

Management has identified several accounting policies that are considered significant to the presentation of our financial condition and results of operations because they require management to make particularly subjective and/or complex judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. Because of the inherent uncertainty of estimates about these matters, no assurance can be given that the application of alternative policies or methods might not result in the Company reporting materially different amounts.

The significant federal and state banking regulations that affect us are described in this Annual Report on Form 10-K under the heading “Regulation.”

 

None.

 

 

Home Savings owns its corporate headquarters building located in Youngstown, Ohio. Of Home Savings’ 35 retail banking offices, 29 are owned and the remaining offices are leased. Loan origination and wealth management offices are leased under long-term lease agreements. The information contained in Note 8 to the consolidated financial statements titled Premises and Equipment is incorporated herein by reference.

 

 

In the normal course of business, United Community and Home Savings are parties, and their respective properties are named or subject, to litigation incidental to their respective businesses. While it is impossible to determine the ultimate resolution of these contingent matters, management believes any resulting liability would not have a material effect upon United Community’s financial statements.

 

 

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Not applicable.

 

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PART II

There were 54,138,910 United Community common shares issued and 48,989,885 shares outstanding and held by approximately 7,400 record holders as of March 8, 2019. United Community’s common shares are traded on The Nasdaq Stock Market^® under the symbol UCFC. Quarterly stock prices and dividends declared are shown in the following table.

 

 

The following table provides information concerning purchases of United Community’s common shares made by United Community during the three months ended December 31, 2018:

 

 

 

 

Restrictions on Dividends.  The ability of a bank holding company to obtain funds for the payment of dividends and for other cash requirements is largely dependent on the amount of dividends that may be declared by its subsidiary banks and other subsidiaries.  However, the FRB expects a bank holding company to serve as a source of strength to its bank subsidiaries, which may require the holding company to retain capital for further investments in its bank subsidiaries, rather than paying dividends to shareholders of the holding company.  Home Savings may not pay dividends to United Community if, after paying such dividends, it would fail to meet the required capital levels.  Dividends are also subject to limitations if United Community or Home Savings fails to hold the required capital conservation buffer.  Payment of dividends by Home Savings may be restricted at any time at the discretion of its regulatory authorities, if they deem such dividends to constitute an unsafe and/or unsound banking practice or if necessary to maintain adequate capital for Home Savings.  These provisions could have the effect of limiting United Community’s ability to pay dividends on its outstanding common shares.  In addition, FRB policy requires United Community to provide notice to the FRB in advance of the payment of a dividend to United Community’s shareholders under certain circumstances, and the FRB may disapprove of such dividend payment if the FRB determines the payment would be an unsafe or unsound practice.

 

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Performance Graph

The following graph compares the cumulative total return on United Community’s common shares since December 31, 2013, with the total return of an index of companies whose shares are traded on The Nasdaq Stock Market and the index of publicly traded bank holding companies. The graph assumes that $100 was invested in United Community shares on December 31, 2013.

 

 

 

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Selected financial condition data:

 

 

Summary of earnings:

 

 

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Selected financial ratios and other data:

 

 

Notes:

 

 

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General

United Community was incorporated in the State of Ohio in February 1998 for the purpose of owning all of the outstanding capital stock of Home Savings issued upon the Conversion, which was completed on July 8, 1998.

The following discussion and analysis of the financial condition and results of operations of United Community and its subsidiary, Home Savings, should be read in conjunction with the consolidated financial statements, and the notes thereto, included in this Annual Report on Form 10-K.

Overview

On January 31, 2017, United Community completed its acquisition of Ohio Legacy Corp (OLCB).  Pursuant to the terms of the Agreement and Plan of Merger, dated September 8, 2016, among United Community, OLCB, Premier Bank & Trust, OLCB’s wholly owned subsidiary bank (PB&T), The Home Savings and Loan Company of Youngstown, Ohio, United Community’s wholly owned subsidiary bank (the Merger Agreement), OLCB was merged with and into United Community (the merger). Immediately following the merger, Home Savings was merged with and into PB&T and the surviving bank changed its name to “Home Savings Bank.”

As a result of the merger and in accordance with the terms of the Merger Agreement, each preferred share of OLCB was deemed to have been converted into OLCB common shares. Each OLCB common share was converted into the right to receive either $18.00 in cash or 2.736 United Community common shares, subject to certain allocation procedures set forth in the Merger Agreement that ensured that 50% of OLCB’s common shares outstanding were converted into United Community common shares, and 50% of OLCB’s common shares outstanding were converted into the right to receive the cash consideration. The Company paid cash in lieu of issuing fractional shares.  This transaction resulted in the addition of approximately $349.3 million in assets and the addition of four branches in Summit, Stark and Belmont counties.  See Note 2 to the consolidated financial statements for additional information regarding this transaction.

In addition to Home Savings, United Community operates through three other wholly-owned subsidiaries: HSB Insurance, LLC, HSB Capital, LLC and HSB Insurance, Inc. HSB Capital, LLC was formed as an Ohio limited liability company by United Community during 2016 for the purpose of providing mezzanine funding for customers of the Bank.  Mezzanine loans are offered by HSB Capital, LLC to customers in United Community’s market area, as defined below, and are expected to be repaid from the cash flow from operations of the business.  

HSB Insurance, LLC, (d/b/a James & Sons Insurance), United Community’s wholly-owned insurance subsidiary, was formed on April 6, 2016 to acquire James & Sons Insurance. As a result of this acquisition, HSB Insurance, LLC now offers a variety of insurance products for business and residential customers, including auto, homeowners, life-health, commercial, surety bonds and aviation, within United Community’s market area. HSB Insurance, LLC completed two additional acquisitions of insurance companies in 2017 and one in 2018 to expand its offerings and market area.

HSB Insurance, Inc., a Delaware-based captive insurance company, was formed by United Community and began operations on June 1, 2017. HSB Insurance, Inc. insures against certain risks unique to the operations of United Community and its subsidiaries and for which insurance may not be currently available or economically feasible in today's insurance marketplace. HSB Insurance, Inc. pools resources with several other similar insurance company subsidiaries of financial institutions to spread a limited amount of risk among themselves.  HSB Insurance, Inc. is subject to regulations of the State of Delaware and undergoes periodic examinations by the Delaware Division of Insurance.

 

Material Changes in Financial Condition

Cash and cash equivalents increased $14.1 million, or 30.1%, to $61.0 million at December 31, 2018, compared to $46.9 million at December 31, 2017. Cash and cash equivalents increased in 2018 primarily as a result of increased fed funds sold on hand at the end of the year.  

Trading securities increased to $364,000 at December 31, 2018.  The Company had no trading securities as of December 31, 2017.  During the fourth quarter of 2018, the Company sold approximately 50% of its Visa Class B shares and the remaining shares were placed into trading securities at fair market value.

 

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Available for sale securities decreased $28.9 million, or 10.7% to $241.6 million at December 31, 2018.  The change in available for sale securities was affected by maturities, pay downs and amortization totaling $12.6 million and sales of $36.6 million.   There was also a decrease in the market value adjustment on the securities totaling $3.7 million.  Partially offsetting this were purchases during 2018 of $24.0 million.  The balance of the unrealized loss position at December 31, 2018 was $4.8 million, pretax, compared to a loss position of $1.1 million, pretax, at December 31, 2017. The unrealized loss position recognized in available for sale securities is primarily driven by market conditions. To that end, the Company expects to receive all principal and interest payments contractually due and has no intent to sell and more than likely will not be required to sell these securities until maturity. The majority of the securities are Government Sponsored Entities (GSE) issued debt, mortgage-backed securities or collateralized mortgage obligations and carry the same rating as the U.S. Government.

The duration of the available for sale securities portfolio was approximately 5.2 years at December 31, 2018. There is risk that longer-term rates could rise, resulting in greater unrealized losses. It is also possible, however, that longer term rates could fall, resulting in the recovery of all of the unrealized losses. Management continues to allow the balance of the portfolio to decline as planned. In addition, the Company may look for opportunities to sell securities and replace them with securities to change the duration characteristics of the portfolio and/or change the mix of the portfolio.  

Held to maturity securities decreased $5.4 million, or 6.5% to $77.5 million at December 31, 2018.  The change in held to maturity securities is the result of maturities, pay downs and amortization offset by the purchase of $3.8 million in securities during the year.  

 

At December 31, 2018, there were no loans held for sale, carried at lower of cost or market, and $91.5 million of loans held for sale, carried at fair value. Loans held for sale, carried at lower of cost or market, were $211,000 and loans held for sale, carried at fair value, were $83.5 million at December 31, 2017.  The increase in loans held for sale, carried at fair value, was primarily attributable to the originations of permanent construction loans during the period.  These loans are not sold until construction of the residence is complete, which is usually within nine to ten months of origination.  Home Savings continues to sell a majority of its newly originated fixed rate mortgage loans into the secondary market as part of its risk management strategy and anticipates continuing to do so in the future.

Net loans increased $177.0 million, or 8.9%, to $2.2 billion at December 31, 2018, compared to $2.0 billion at December 31, 2017.  Total commercial loans increased $120.3 million in 2018 while total residential mortgage loans increased $50.7 million and total consumer loans increased $3.5 million.  The Company continues to focus on growth in commercial real estate and commercial and industrial loans.  See Note 5 to the consolidated financial statements for additional information regarding the composition of net loans.

Allowance for Loan Losses. The allowance for loan losses is a valuation allowance for probable incurred credit losses established through a provision for probable loan losses charged to expense. The allowance for loan losses was $20.4 million at December 31, 2018, compared to $21.2 million at December 31, 2017. The allowance for loan losses as a percentage of loans was 0.93% at December 31, 2018, compared to 1.05% at December 31, 2017. This change is a result of growth in the loan portfolio along with improving credit metrics which lowered the amount of allowance for loan losses. The allowance for loan losses as a percentage of nonperforming loans was 312.6% at December 31, 2018, compared to 181.2% at December 31, 2017. Loan losses are charged against the allowance when the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are added back to the allowance. Home Savings’ allowance for loan loss methodology includes allowance allocations calculated in accordance with ASC Topic 310, “Receivables,” and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies”. Accordingly, the methodology is based on historical loss experience by type of credit plus specific loss allocations and adjustments for current events and conditions. Home Savings’ process for determining the appropriate level of the allowance for probable loan losses is designed to account for credit deterioration as it occurs. The provision for probable loan losses reflects loan quality trends, including the levels of and trends related to nonaccrual loans, past due loans, classified loans and net charge-offs or recoveries, among other factors.

During 2018, the Company recorded a loan loss provision of $699,000.  This recognition was primarily due to the growth of the loan portfolio and, to a lesser extent, net charge-offs, offset by improvements in factors used in calculating the allowance for loan loss reserve.

Impaired Loans. A loan is considered impaired when there is a deterioration of the credit worthiness of the borrower to the extent that there is no longer reasonable assurance of the timely collection of the full amount of principal and interest. The total outstanding balance of all impaired loans was $20.6 million at December 31, 2018 as compared to $26.2 million at December 31, 2017.  The decrease in impaired loans can be largely attributed to the resolution of loans through principal payments, charge-offs, sale of the loan or collateral or by Home Savings taking possession of the collateral.

 

 

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Included in impaired loans above are certain loans Home Savings considers to be troubled debt restructurings (TDR). A loan is considered a TDR if Home Savings grants a concession to a debtor experiencing financial difficulty that it would otherwise not consider. The concession either stems from an agreement between the creditor and the debtor or is imposed by law or a court. If the debtor is not currently experiencing financial difficulties but would probably be in payment default in the future without the modification, then this type of restructure also could be considered a TDR.

A restructured loan that has fallen into nonaccrual status will return to accruing status if either of the following criteria are met: (i) none of the principal and interest is due or unpaid and Home Savings expects repayment of the remaining contractual principal and interest, or (ii) the borrower has resumed paying the full amount of the scheduled contractual interest and principal payments on a loan that is between 30 and 89 days past due and there is reasonable assurance of prepayment established through payment performance over a period of six months. TDR loans aggregated $16.6 million at December 31, 2018 compared to $19.8 million at December 31, 2017. TDR loans that were on nonaccrual status aggregated $1.7 million and $2.4 million at December 31, 2018 and December 31, 2017, respectively. Such loans are considered nonperforming loans. TDR loans that were accruing according to their terms aggregated $14.9 million and $17.9 million at December 31, 2018 and December 31, 2017, respectively.

Nonperforming Loans. Nonperforming loans consist of nonaccrual loans and loans past due 90 days and still accruing. Nonperforming loans were $6.5 million, or 0.30% of total loans, at December 31, 2018, compared to $11.7 million, or 0.59% of total loans, at December 31, 2017.    

Generally, loans are placed on nonaccrual status if principal or interest payments become 90 days past due and/or management deems the collectability of the principal and/or interest to be in question, as well as when required by regulatory guidance. Loans to a customer whose financial condition has deteriorated are considered for nonaccrual status whether or not the loan is 90 or more days past due. Once interest accruals are discontinued, accrued but uncollected interest is charged to current year operations. Subsequent cash receipts on nonaccrual loans are recorded as a reduction of principal. Interest income is recorded only after principal recovery is reasonably assured. Classification of a loan as nonaccrual does not preclude the ultimate collection of loan principal or interest.

Federal Home Loan Bank Stock.  FHLB stock was $19.1 million at December 31, 2018 compared to $19.3 million at December 31, 2017.  The decrease was due to a redemption of stock by the FHLB during 2018.  In 2018, the FHLB paid cash dividends of $1.1 million in lieu of stock dividends to its member banks.

Real Estate Owned and Other Repossessed Assets.  Real estate owned and other repossessed assets decreased $165,000 during the year ended December 31, 2018, as compared to the year ended December 31, 2017. Property acquired in the settlement of loans is recorded at the lower of the loan’s acquisition balance less cost to sell or the fair market value of the property secured less costs to sell. Appraisals are obtained at least annually on properties that exceed $1.0 million in value. Based on current appraisals, a valuation allowance may be established to reflect properly the asset at fair value.

Bank Owned Life Insurance.  Bank Owned Life Insurance (BOLI) is maintained on select officers and employees of Home Savings whereby Home Savings is the beneficiary. BOLI is recorded at its cash surrender value, or the amount currently realizable. Increases in the Home Savings’ policy cash surrender value are tax exempt and death benefit proceeds received by Home Savings are tax-free. Income from these policies and changes in the cash surrender value are recorded in other income. There is no post-termination coverage, split dollar or other benefits provided to participants covered by the BOLI.  Home Savings recognized $1.7 million and $1.6 million as other non-interest income based on the change in cash value of the policies in the twelve months ended December 31, 2018 and 2017, respectively.

 

Other Assets.  Other assets decreased $5.3 million during 2018.  The decrease was driven by declines in various accounts receivable accounts offset by an increase in an investment related to low-income housing aggregating $3.0 million in 2018.  

Total Deposits.  Total deposits increased $256.5 million to $2.2 billion at December 31, 2018, compared to $2.0 billion at December 31, 2017.  Non-interest bearing accounts increased $39.2 million during 2018 to $394.2 million while interest bearing deposits increased $217.2 million to $1.8 billion in 2018.  The Company continues to see increased deposit balances in public funds, business and treasury management along with retail deposits.  Brokered deposits increased $134.5 million for the twelve months ended December 31, 2018 as favorable pricing compared to FHLB advances led the Company to utilize this funding source more often.    

 

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FHLB Advances.  Funds needed in excess of deposit growth are borrowed in the normal course of business, if necessary. Home Savings has an established credit relationship with the FHLB of Cincinnati under which Home Savings could borrow up to an additional $403.0 million as of December 31, 2018.  These borrowings are collateralized by residential mortgage loans.  Of the total borrowing capacity at the FHLB, Home Savings had outstanding short term advances of $243.0 million with a rate of 2.45% at December 31, 2018 compared to a balance of $308,000 at December 31, 2017.  The Company had no long term advances at December 31, 2018 compared to $48.5 million at December 31, 2017.  In December of 2018, the Company elected to terminate the long term advance with the FHLB.  A charge of $936,000 was incurred to terminate this advance.

Shareholders’ Equity.  Shareholders’ equity increased $15.1 million to $309.3 million at December 31, 2018, from $294.3 million at December 31, 2017. The change was primarily driven by net income of $37.2 million offset by cash dividends of $13.0 million, an increase in accumulated other comprehensive loss of $2.8 million and an increase in treasury stock of $6.4 million.  The Company repurchased 811,000 of its shares during 2018 via open market purchases.

Accumulated other comprehensive income increased $2.8 million from December 31, 2017 to December 31, 2018. Unrealized losses on securities included in other comprehensive income have not been recognized in income at December 31, 2018 and December 31, 2017 because the issuer’s securities are of high credit quality (rated AA or higher), management does not intend to sell (and it is likely that management will not be required to sell) the securities prior to their anticipated recovery, and the decline in fair value is largely due to the level of longer-term interest rates in 2018 and 2017. The fair value is expected to recover as the investments approach maturity.

Events beyond management’s control, such as fluctuations in interest rates or a downturn in the economy in areas in which Home Savings’ loans and securities are concentrated, could adversely affect future earnings and consequently Home Savings’ ability to meet its future capital requirements.

Book value per common share as of December 31, 2018 was $6.30 as compared to $5.90 per common share as of December 31, 2017. Book value per share is calculated as total common equity divided by the number of common shares outstanding. Book value was impacted by the overall change in equity as discussed above.

Material Changes in Operating Results for the Years Ended December 31, 2018 and December 31, 2017

Net Income. United Community recognized net income for the twelve months ended December 31, 2018, of $37.2 million, or $0.74 per diluted common share, compared to net income of $21.8 million, or $0.44 per diluted common share.

The significant change in earnings for 2018 was primarily a result of higher pretax income due to growth in earning assets, a lower loan provision and lower noninterest expense.  Net interest income for 2018 increased $7.6 million while the provision for loan losses decreased $3.6 million during the same period. Additionally, non-interest income decreased $1.8 million and noninterest expense decreased $3.2 million primarily due to a decrease of $5.0 million of merger expense.  United Community’s return on average assets and return on average equity were 1.35% and 12.10%, respectively for the twelve months ended December 31, 2018 and 0.85% and 7.63%, respectively, for the twelve months ended December 31, 2017.  Impacting the comparison were three charges that were recognized in 2017.  In the fourth quarter of 2017, a revaluation of net deferred tax assets increased tax expense $1.5 million due to the enactment of the Tax Cuts and Jobs Act on December 22, 2017and an asset write down of $1.5 million, after tax, was prompted by an unfavorable ruling from an Appellate Court. For the year, non-recurring merger related expenses totaling $3.3 million, after tax, were also recognized.  

Net Interest Income. Net interest income was $88.3 million in 2018, up from the $81.3 million recorded in 2017.  Net interest margin increased 2 basis points to 3.43% for the twelve months ended December 31, 2018 compared to 3.41% for the twelve months ended December 31, 2017.

Total interest income increased by $16.5 million in 2018 compared to 2017, to $111.0 million from $94.4 million. The increase is primarily a result of an increase in average net loans and loans held for sale along with an increased yield on loans.  The increased loan yield was due to higher yields being realized on net loans as interest rates rose in 2018.  Average net loans increased $231.1 million in 2018 compared to the same period in 2017 and yields increased 34 basis points to 4.62% for the twelve months ended December 31, 2018 from 4.28% for the same period in 2017. Average loans held for sale increased $14.8 million in 2018 compared to 2017, while yields climbed to 4.49% for the twelve months ended December 31, 2018 from 4.06% for the same period in 2017. Interest income from net loans increased to $96.7 million for the twelve months ended December 31, 2018 compared to $79.8 million for the same period in 2017, and income from loans held for sale increased to $4.3 million for the twelve months ended December 31, 2018 compared to $3.3 million for the same period in 2017.  These increases were partially offset by a decline of $1.8 million in income on available for sale and held to maturity securities.

 

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Interest expense increased by $9.4 million in 2018 to $22.6 million compared to $13.2 million during the same period in 2017. This increase was due to a $114.8 million increase in average interest-bearing liabilities along with a 43 basis point increase in the cost of interest-bearing liabilities in 2018.   The increase in average interest-bearing liabilities was due to growth in deposits offset by a decrease in total borrowed funds.  During 2018, the Company utilized brokered certificates of deposits more often in lieu of short term FHLB advances as the deposits were priced less expensively than the advances.  The increase in the cost of interest-bearing liabilities was driven by increases in yields on both deposits and borrowed funds due to rising interest rates.  Interest expense related to interest-bearing deposits was $17.8 million in 2018 compared to $8.4 million in 2017.  Interest expense on borrowed funds totaled $4.8 million in 2018 compared to $4.7 million in 2017.  

 

Provision for Loan Losses. A provision for loan losses is charged to income to bring the total allowance for loan losses to a level considered by management to be adequate, based on management’s evaluation of such factors as the delinquency status of loans, current economic conditions, the net realizable value of the underlying collateral, changes in the composition of the loan portfolio and prior loan loss experience. The Company recognized a loan loss provision of $700,000 in 2018, compared to $4.3 million in 2017.  The decrease in provision expense during 2018 was driven by lower net charge-offs and the release of reserves due to lower quantitative and qualitative factors offset by strong loan growth.  For the twelve months ended December 31, 2018, net charge-offs to average outstanding loans were 7 basis points.  This compares to 12 basis points for the same period in 2017. 

Noninterest Income. Non-interest income was $23.4 million in 2018 compared to $25.2 million in 2017.    Negatively impacting the comparison was a decline in mortgage banking income of $1.4 million during 2018 along with losses on the sale of available for sale securities of $627,000 compared to gains on the sale of available for sale securities of $566,000 during 2017.  There was also a one-time gain of $595,000 in 2017 for the sale of a building the Company owned that did not reoccur in 2018.  Offsetting these items were increases of $191,000 for insurance agency income, $299,000 for mortgage servicing income, $287,000 for trust fee income and $105,000 for bank owned life insurance.  In addition, the Company sold approximately 50% of the Company’s VISA Class B shares and moved the remainder of the shares into trading securities.  The gain resulting from these two transactions resulted in a gain of $669,000 for 2018.  

 

Noninterest Expense. Non-interest expense was $65.1 million for the twelve months ended December 31, 2018, which represented a decrease of $3.2 million, from the twelve months ended December 31, 2017.  Positively impacting this comparison was merger related expenses totaling $5.0 million in 2017 and the recognition of a $2.3 million asset write down in 2017.  The efficiency ratio decreased to 56.85% for 2018 compared to 64.28% for 2017.

Federal Income Taxes. During the twelve months ended December 31, 2018, the Company recognized tax expense of $8.4 million on pre-tax income of $45.6 million, compared to tax expense of $11.3 million on pre-tax income of $33.1 million for the twelve months ended December 31, 2017.  The primary reason for the variance was the enactment of the Tax Cuts and Jobs Act on December 22, 2017 which lowered the Company’s marginal tax rate from 35% to 21%.  In addition, the Company recognized $1.5 million of additional tax expense in 2017 from the revaluation of its deferred tax assets due to this change in tax law.  

Material Changes in Operating Results for the Years Ended December 31, 2017 and December 31, 2016

Net Income. United Community recognized net income for the twelve months ended December 31, 2017, of $21.8 million, or $0.44 per diluted common share, compared to net income of $18.8 million, or $0.40 per diluted common share as of December 31, 2016.

The significant change in earnings for 2017 was primarily a result of higher pretax income due to the merger and organic growth.  Net interest income for 2017 increased $18.3 million while the provision for loan losses decreased $1.1 million during the same period. Additionally, non-interest income increased $3.2 million and noninterest expense increased $16.2 million with $4.2 million of the increase related to merger costs. United Community’s return on average assets and return on average equity were 0.85% and 7.63%, respectively for the twelve months ended December 31, 2017 and 0.91% and 7.58%, respectively, for the twelve months ended December 31, 2016.  Impacting the comparison were three charges that were recognized. In the fourth quarter, a revaluation of net deferred tax assets increased tax expense $1.5 million and an asset write down of $1.5 million, after tax, was prompted by an unfavorable ruling from an Appellate Court. For the year, non-recurring merger related expenses totaling $3.3 million, after tax, were also recognized.  

 

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Net Interest Income. Net interest income was $81.3 million in 2017, up from the $63.0 million recorded in 2016.  Net interest margin increased 17 basis points to 3.41% for the twelve months ended December 31, 2017 compared to 3.24% for the twelve months ended December 31, 2016.

Total interest income increased by $23.0 million in 2017 compared to 2016, to $94.4 million from $71.4 million. The increase is primarily a result of an increase in average net loans and loans held for sale and along with increased yield on loans and securities.  The increased loan yield was due to the impact of purchase accounting adjustments from the merger along with higher yields being realized on net loans as interest rates rose in 2017.  Average net loans increased $461.2 million in 2017 compared to the same period in 2016 and yields increased 15 basis points to 4.28% for the twelve months ended December 31, 2017 from 4.13% for the same period in 2016. Average loans held for sale increased $35.5 million in 2017 compared to 2016, while yields climbed to 4.06% for the twelve months ended December 31, 2017 from 3.82% for the same period in 2016. Interest income from net loans increased to $79.8 million for the twelve months ended December 31, 2017 compared to $57.9 million for the same period in 2016, and income from loans held for sale increased to $3.3 million for the twelve months ended December 31, 2017 compared to $1.8 million for the same period in 2016.  These increases were partially offset by a decline of $1.1 million in income on available for sale and held to maturity securities.

Interest expense increased by $4.7 million in 2017 to $13.2 million compared to $8.4 million during the same period in 2016. This increase was due to a $349.1 million increase in average interest-bearing liabilities along with a 14 basis point increase in the cost of interest-bearing liabilities in 2017.   The increase in average interest-bearing liabilities was due to the merger, organic growth in deposits and an increased used of brokered certificates of deposit.  The increase in the cost of interest-bearing liabilities was primarily driven by increases in yields on brokered certificates of deposits and borrowed funds due to rising interest rates.  Interest expense related to interest-bearing deposits was $8.4 million in 2017 compared to $5.9 million in 2016.  Interest expense on borrowed funds totaled $13.2 million in 2017 compared to $8.4 million in 2016.  

 

Provision for Loan Losses. A provision for loan losses is charged to income to bring the total allowance for loan losses to a level considered by management to be adequate, based on management’s evaluation of such factors as the delinquency status of loans, current economic conditions, the net realizable value of the underlying collateral, changes in the composition of the loan portfolio and prior loan loss experience. The Company recognized a loan loss provision of $4.3 million in 2017, compared to $5.4 million in 2016.  The decrease in provision expense during 2017 was driven by lower net charge-offs offset by strong loan growth.  For the twelve months ended December 31, 2017, net charge-offs to average outstanding loans were 12 basis points.  This compares to 29 basis points for the same period in 2016.  The Company recorded a charge-off of $2.5 million during 2016, related to one long-held nonresidential commercial real estate loan which contributed to the higher charge-off ratio. 

Noninterest Income. Non-interest income was $25.2 million in 2017 compared to $22.1 million in 2016.  Positively impacting the comparison was the benefit of trust fee income totaling $1.6 million associated with the merger of OLCB.  Also contributing to the change were increases of $320,000 for insurance agency income, $150,000 for deposit related fees, $274,000 for mortgage banking income, $369,000 for debit/credit card fees and a one-time gain of $595,000 for the sale of a building the Company owned.  Offsetting this was a $123,000 decline in brokerage income and a $96,000 increase in the losses associated with the sale of real estate owned and other repossessed assets.   

 

Noninterest Expense. Non-interest expense was $68.3 million for the twelve months ended December 31, 2017, which represented an increase of $16.2 million, or 31.2%, from the twelve months ended December 31, 2016.  The merger of OLCB and the operating expenses of the acquired branches for the year negatively affected the current comparison along with an increase in merger related expenses.  The merger related expenses totaled $5.0 million in 2017 compared to $787,000 in 2016.  In addition, the Company recognized a $2.3 million asset write down in 2017.  In 2003, Home Savings entered into two development loans on which the borrower subsequently filed bankruptcy, and a court appointed receiver liquidated the collateral. The proceeds from the sale of the collateral have remained in escrow with the court since 2007 as a number of competing claims were made against the proceeds. In 2011, a lower court affirmed Home Savings' priority position in the proceeds, and its lien validity was affirmed by the same court in 2016. However, in December 2017, an appellate court ruled that a portion of the proceeds should be awarded to another claimant. The $2.3 million charge reflects the Appellate court ruling.  The efficiency ratio increased to 64.28% for 2017 compared to 61.01% for 2016 primarily due to the merger expenses and the write down.

Federal Income Taxes. During the twelve months ended December 31, 2017, the Company recognized tax expense of $11.3 million on pre-tax income of $33.1 million, compared to tax expense of $8.1 million on pre-tax income of $27.0 million for the twelve months ended December 31, 2016.  The primary reason for the variance was higher pre-tax income.  In addition, the Company recognized $1.5 million of additional tax expense in 2017 from the revaluation of its deferred tax assets and liabilities due to the enactment of the Tax Cuts and Jobs Act on December 22, 2017.  

 

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Critical Accounting Policies and Estimates

The accounting and reporting policies of United Community comply with accounting principles generally accepted within the United States of America and conform to general practices within the financial services industry. Application of these principles requires management to make estimates, assumptions and judgments that 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. Accordingly, as this information changes, the financial statements could reflect different estimates, assumptions and judgments.

The most significant accounting policies followed by United Community are presented in Note 1 to the consolidated financial statements. Accounting and reporting policies for the allowance for loan losses, income taxes, mortgage servicing rights and other-than-temporary impairment are deemed critical since they involve the use of estimates and require significant management judgments. Application of assumptions different from those used by management could result in material changes in United Community’s financial position or results of operations.

Allowance for Loan Losses. The allowance for loan losses is an amount that management believes will be adequate to absorb probable incurred losses in existing loans taking into consideration such factors as past loss experience, changes in the nature and volume of the portfolio, overall portfolio quality, loan concentrations, specific problem loans, collateral values securing loans and current economic conditions that affect the borrower’s ability to pay. Determination of the allowance inherently is subjective due to the aforementioned reasons. Loan losses are charged-off against the allowance when management believes that the full collectability of the loan is unlikely. Recoveries of amounts previously charged-off are credited to the allowance.

Home Savings maintains a well-documented methodology for maintaining an allowance for loan losses that management believes is compliant with all applicable regulatory guidance and GAAP. The documentation of the adequacy of the allowance for loan losses is reviewed by the board of directors on a quarterly basis.

The allowance is based on management’s evaluation of homogeneous groups of loans (single-family residential mortgage loans and all consumer credit except marine loans) to which loss factors have been applied, as well as an evaluation of individual credits (multi-family, nonresidential mortgage loans, marine loans and commercial loans) based on internal risk ratings, collateral and other unique characteristics of each loan.

Management believes that it uses the best information available to determine the adequacy of the allowance for loan losses. However, future adjustments to the allowance may be necessary and the results of operations could be significantly and adversely affected if circumstances differ substantially from the assumptions used in making the determinations.

Loans Held for Sale. Mortgage loans originated and intended for sale in the secondary market are carried at fair value, as determined by outstanding commitments from investors.  Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings.

Mortgage loans held for sale are generally sold with servicing rights retained.  The carrying value of mortgage loans sold is reduced by the amount allocated to the servicing right.  Gains and losses on sales of mortgage loans are based on the difference between the selling price and the carrying value of the related loan sold.

The fair value of conventional loans held for sale is determined using the current 15 day forward contract price for either 15 or 30 year conventional mortgages and the 60 day forward contract price for either 15 or 30 year Federal Housing Authority mortgages.  Additionally, the fair value of permanent construction loans held for sale is determined using the current 60 day forward contract price for 30 year conventional mortgages which is then adjusted by extrapolating this rate to the estimated time period remaining until construction is complete. The fair value is also adjusted for unobservable market data such as estimated fall out rate and the estimated time from origination to completion of construction.  

Mortgage Servicing Rights. The cost of mortgage loans sold or securitized is allocated between the mortgage servicing rights and the mortgage loans based on the relative fair values of each. The fair value of the mortgage servicing rights is determined by using a discounted cash flow model, which estimates the present value of the future net cash flows of the servicing portfolio, about which management must make assumptions considering future expectations based on various factors, such as servicing costs, expected prepayment speeds and discount rates.

Mortgage servicing rights are amortized in proportion to, and over the period of, estimated net servicing income. Management evaluates mortgage servicing rights for impairment on a quarterly basis by stratifying the loans by original maturity, interest rate and loan type. Impairment is measured by estimating the fair value of each pool, taking into consideration the estimated level of

 

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prepayments based upon current industry expectations. An impairment allowance is recorded for a pool when, and in an amount which, its fair value is less than its carrying value.

The value of mortgage servicing rights is subject to prepayment risk. Future expected net cash flows from servicing a loan will not be realized if the loan pays off earlier than anticipated. Since most of these loans do not contain prepayment penalties, the Company receives no economic benefit if the loan pays off earlier than anticipated.

Income Taxes. We are subject to the income tax laws of the United States, its states and the municipalities in which we operate. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant government taxing authorities. We review income tax expense and the carrying value of deferred tax assets quarterly, and as new information becomes available, the balances are adjusted as appropriate. We assess any uncertain tax positions using a recognition threshold of more-likely-than-not, and a measurement attribute for all tax positions taken or expected to be taken on a tax return, in order for those tax positions to be recognized in the financial statements.

Valuation of Investment Securities. Management evaluates securities for other-than-temporary impairment on at least a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. When an other-than-temporary impairment has occurred, the amount of the other-than-temporary impairment recognized in earnings depends on whether we intend to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss. To determine whether impairment is other-than-temporary, we consider all available information relevant to the collectability of the security, including past events, current conditions, and reasonable and supportable forecasts when developing estimates of cash flows expected to be collected. Factors considered in this assessment include the reasons for the impairment, the severity and duration of the impairment, changes in value subsequent to year-end, forecasted performance of the obligor, and the general market conditions in the geographic area or industry the investee operates in.

If we intend to sell the security or it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the impairment is recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If we do not intend to sell the security and it is not more likely than not that we will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the other-than-temporary impairment is separated, into the amount representing the credit loss and the amount related to all other factors. The amount of the total other-than-temporary impairment related to the credit loss is recognized in earnings. The amount of the total impairment related to other factors is recognized in other comprehensive income.

 

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Yields Earned and Rates Paid

The following table sets forth certain information relating to United Community’s average balance sheet and reflects the average yield on interest earning assets, on a fully tax equivalent basis, and the average cost of interest bearing liabilities for the periods indicated. Such yields and costs are derived by dividing income or expense by the average balances of interest earning assets or interest bearing liabilities, respectively, for the periods presented. Average balances are derived from daily balances. Nonaccruing loans have been included in the table as loans carrying a zero yield. Loan fees are included in interest income. The average balance for securities available for sale is computed using the carrying value, and the average yield on securities available for sale has been computed using the historical amortized cost average balance.

 

 

 

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The table below describes the extent to which changes in interest rates and changes in volume of interest earning assets and interest bearing liabilities have affected United Community’s interest income and interest expense during the periods indicated. For each category of interest earning assets and interest bearing liabilities, information is provided on changes attributable to (i) changes in volume (change in volume multiplied by prior period rate), (ii) changes in rate (change in rate multiplied by prior period volume) and (iii) total changes in rate and volume. The combined effects of changes in both volume and rate, which cannot be separately identified, have been allocated in proportion to the changes due to volume and rate:

 

 

Contractual Obligations, Commitments, Contingent Liabilities and Off-balance Sheet Arrangements

The following table presents, as of December 31, 2018, United Community’s significant fixed and determinable contractual obligations by payment date. The payment amounts represent those amounts contractually due to the recipient and do not include any unamortized premiums, discounts, or other similar carrying value adjustments. Further detail of the nature of each obligation is included in the relevant note to the consolidated financial statements, which is identified following the below table.

 

 

Discussion of loan commitments is included in Note 5 to the consolidated financial statements. In addition, United Community has commitments under benefit plans as described in Note 17 to the consolidated financial statements. Discussion of off-balance sheet arrangements is included in Note 18 to the consolidated financial statements.  

 

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Potential Impact of Changes in Interest Rates

Home Savings’ profitability depends to a large extent on its net interest income, which is the difference between interest income from loans and securities and interest expense on deposits and borrowings. Like most financial institutions, Home Savings’ short-term interest income and interest expense are significantly affected by changes in market interest rates and other economic factors beyond its control. Accordingly, Home Savings’ earnings could be adversely affected during a continued period of low interest rates or a continued period of rising interest rates.

The impact of changes in interest rates is further described in Item 7A in this Annual Report on Form 10-K.

Liquidity and Capital

United Community’s liquidity, primarily represented by cash and cash equivalents, is a result of its operating, investing and financing activities. These activities are summarized below for the years indicated.

 

 

The principal sources of funds for United Community are deposits, loan repayments, maturities of securities, borrowings from financial institutions, repurchase agreements and other funds provided by operations. Home Savings also has the ability to borrow from the FHLB. While scheduled loan repayments and maturing investments are relatively predictable, deposit flows and early loan prepayments are more influenced by interest rates, general economic conditions and competition. Investments in liquid assets maintained by United Community and Home Savings are based upon management’s assessment of (1) the need for funds, (2) expected deposit flows, (3) yields available on short-term liquid assets, and (4) objectives of the asset and liability management program. At December 31, 2018, approximately $663.8 million of Home Savings’ certificates of deposit were expected to mature within one year. Based on past experience and Home Savings’ prevailing pricing strategies, management believes that a substantial percentage of such certificates will be renewed with Home Savings at maturity, although there can be no assurance that this will occur.

Home Savings’ Asset/Liability Committee (ALCO) is responsible for establishing and monitoring liquidity guidelines, policies and procedures. ALCO uses a variety of methods to monitor the liquidity position of Home Savings including a liquidity analysis that measures potential sources and uses of funds over future time periods out to one year. ALCO also performs contingency funding analyses to determine Home Savings’ ability to meet potential liquidity needs under stress scenarios that cover varying time horizons ranging from immediate to long-term.

At December 31, 2018, United Community had total on-hand liquidity, defined as cash and cash equivalents, unencumbered securities and additional FHLB borrowing capacity, of $664.1 million.

Home Savings is subject to certain risk-based capital and leverage ratio requirements adopted by their bank regulatory agencies.   These quantitative calculations are minimums, and the regulatory agencies may determine that either company, based on its size, complexity or risk profile, must maintain a higher level of capital in order to operate in a safe and sound manner.

 

Under the capital rules, Home Savings’ assets, exposures and certain off-balance sheet items are subject to risk weights used to determine the institutions’ risk-weighted assets. These risk-weighted assets are used to calculate the following minimum capital ratios:

 

 

 

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In addition to meeting the minimum capital requirements, Home Savings must also maintain a required capital conservation buffer to avoid becoming subject to restrictions on capital distributions and certain discretionary bonus payments to management.  The capital conservation buffer is calculated as a ratio of CET1 capital to risk-weighted assets, and it effectively increases the required minimum risk-based capital ratios. The capital conservation buffer requirement is being phased in over a three-year period that began on January 1, 2016.  Throughout 2018, the required capital conservation buffer was 1.875%.  Effective, January 1, 2019, the capital conservation buffer requirement is 2.5%.  

 

In addition to the capital adequacy minimums, the prompt corrective action regulations set forth five categories based on the levels of a bank’s capital, the highest of which is “well capitalized.”  Failure to be well capitalized or to meet minimum capital adequacy requirements under the prompt corrective action framework could result in certain mandatory and possible additional discretionary actions by the FRB or the FDIC that, if undertaken, could have a material adverse effect on our operations or financial condition.  

 

The table below sets forth Home Savings’ required regulatory capital ratios as of December 31, 2018, and the actual capital at December 31, 2018 and 2017, calculated using the regulatory capital methodology applicable to us during each of those years.

 

 

 

Qualitative Aspects of Market Risk. The principal market risk affecting United Community is interest rate risk. United Community is subject to interest rate risk to the extent that its interest earning assets reprice differently than its interest bearing liabilities. Interest rate risk is defined as the sensitivity of United Community’s earnings and net asset values to changes in interest rates. As part of its efforts to monitor and manage the interest rate risk, the Board of Directors of Home Savings has adopted an interest rate risk policy that requires the Home Savings Board to review quarterly reports related to interest rate risk and to annually set exposure limits for Home Savings as a guide to management in setting and implementing day to day operating strategies.

Quantitative Aspects of Market Risk. As part of its interest rate risk analysis, Home Savings uses the net portfolio value (NPV) and net interest income methodology. Generally, NPV is the discounted present value of the difference between incoming cash flows on interest earning and other assets and outgoing cash flows on interest bearing and other liabilities. The application of the methodology attempts to quantify interest rate risk as the change in the NPV and net interest income that would result from various levels of theoretical basis point changes in market interest rates.

Home Savings uses an NPV and earnings simulation model prepared internally as its primary method to identify and manage its interest rate risk profile. The model is based on actual cash flows and repricing characteristics for all financial instruments and

 

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incorporates market-based assumptions regarding the impact of changing interest rates on future volumes and the prepayment rate of applicable financial instruments. Assumptions based on the historical behavior of deposit rates and balances in relation to changes in interest rates also are incorporated into the model. These assumptions are inherently uncertain and, as a result, the model cannot precisely measure NPV or net interest income or precisely predict the impact of fluctuations in interest rates on net interest rate changes as well as changes in market conditions and management strategies.

Presented below are analyses of Home Savings’ interest rate risk as measured by changes in NPV and net interest income for instantaneous and sustained parallel shifts of 100 basis point increments in market interest rates. As noted, for the year ended December 31, 2018, the percentage changes fall within the policy limits set by the Board of Directors of Home Savings as the minimum NPV ratio and the maximum change in interest income the Home Savings Board deems advisable in the event of various changes in interest rates. See the table below for Board adopted policy limits.

 

 

As with any method of measuring interest rate risk, certain shortcomings are inherent in the above approach. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market interest rates. In addition, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Further, in the event of a change in interest rates, expected rates of prepayment on loans and early withdrawal levels from certificates of deposit may deviate significantly from those assumed in making risk calculations.

 

 

 

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CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

 

 

See Notes to Consolidated Financial Statements.

 

 

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CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME

 

 

(Continued)

 

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CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (continued)

 

 

See Notes to Consolidated Financial Statements.

 

 

 

 

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CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

 

 

See Notes to Consolidated Financial Statements.

 

 

 

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CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

See Notes to Consolidated Financial Statements

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

 

The accounting policies of United Community Financial Corp. (United Community or the Company) and its subsidiaries, Home Savings Bank (Home Savings or the Bank), HSB Insurance, LLC, HSB Capital, LLC and HSB Insurance, Inc. conform to U.S. Generally Accepted Accounting Principles (GAAP) and prevailing practices within the banking and thrift industries. A summary of the more significant accounting policies follows.

Nature of Operations

The business of Home Savings is providing consumer and business banking service to its market area in Ohio, western Pennsylvania and West Virginia. At the end of 2018, Home Savings was doing business through 35 full service banking branches and 13 loan production centers and three wealth management offices.  Loans and deposits are primarily generated from the areas where banking branches are located. Substantially all loans are secured by specific items of collateral including business assets, consumer assets, and commercial and residential real estate. Commercial loans are expected to be repaid from cash flow from operations of businesses. There are no significant concentrations of loans to any one industry or customer. However, the customers’ ability to repay their loans is dependent on the real estate and general economic conditions in the market area. Home Savings derives its income predominantly from interest on loans, securities, and to a lesser extent, non-interest income. Home Savings’ principal expenses are interest paid on deposits and Federal Home Loan Bank advances, loan loss provisions and normal operating costs.

On January 29, 2016, United Community acquired James & Sons Insurance.  James & Sons Insurance was merged into HSB Insurance, LLC, a wholly-owned subsidiary of United Community.  HSB Insurance, LLC d/b/a James & Sons Insurance is an insurance agency that offers a wide variety of insurance products for business and residential customers, which include auto, homeowners, life-health, commercial, surety bonds and aviation. On February 28, 2017, James & Sons Insurance acquired Eich Brothers Insurance. Eich Brothers Insurance is an insurance agency that offers insurance products for business and residential customers, which include auto, commercial, homeowners and life-health.  On July 1, 2017, James & Sons Insurance acquired Stevens Insurance Agency that offers insurance products for business and residential customers, which include auto, commercial, homeowners and life-health.  On July 1, 2018, James & Sons Insurance acquired Steinhauser Insurance Agency which offers property and casualty insurance.

HSB Capital, LLC was formed by United Community during 2016 for the purpose of providing mezzanine funding for customers.  Mezzanine loans are offered to customers in United Community’s market area and are expected to be repaid from the cash flow from operations of the business.  

HSB Insurance, Inc., a wholly-owned subsidiary of the Company which was formed and began operations on June 1, 2017, is a Delaware-based captive insurance company which insures against certain risks unique to the operations of the Company and its subsidiaries and for which insurance may not be currently available or economically feasible in today’s insurance marketplace.  HSB Insurance, Inc. pools resources with several other insurance company subsidiaries of financial institutions to spread a limited amount of risk among themselves.  HSB Insurance, Inc.  is subject to regulations of the State of Delaware and undergoes periodic examinations by the Delaware Division of Insurance.

Basis of Presentation

The consolidated financial statements include the accounts of United Community and its subsidiaries.  All material inter-company transactions have been eliminated. Certain prior period data has been reclassified to conform to current period presentation. These reclassifications had no effect on prior net income or shareholders’ equity.  

Use of Estimates in the Preparation of Financial Statements

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ.

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Cash Flows

For purposes of the statement of cash flows, United Community considers all highly liquid investments with a term of three months or less to be cash equivalents. Net cash flows are reported for loan and deposit transactions, short-term borrowings and advance payments by borrowers for taxes and insurance.

Securities

Securities are classified as available for sale, held to maturity or trading upon their acquisition. Securities are classified as available for sale when they might be sold before maturity. Securities classified as available for sale are carried at estimated fair value with the unrealized holding gain or loss reported in other comprehensive income, net of tax. Securities classified as held to maturity are carried at amortized cost when management has the positive intent and ability to hold them to maturity. Equity securities are carried at fair value in trading, with changes in fair value reported in net income. Restricted securities such as FHLB stock are carried at cost. Interest income includes amortization of purchase premium or discount on debt securities. Premiums or discounts are amortized on the level-yield method without anticipating prepayments. Gains and losses on sales are recorded on the trade date and are determined using the specific identification method.

Management evaluates securities for other-than-temporary impairment (OTTI) at least quarterly, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) OTTI related to other factors, which is recognized in other comprehensive income. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis.

Loans Held for Sale

Loans held for sale primarily consist of residential mortgage loans originated for sale and other loans that have been identified for sale. If the fair value option has not been elected, the loans are carried at the lower of cost or fair value, determined in the aggregate. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings.  Loans held for sale, for which the fair value option has been elected, are recorded at fair value as of each balance sheet date with the change in fair value recorded in earnings.  The fair value of permanent construction loans held for sale is determined, based on the committed loan amount, using quoted prices for similar assets, adjusted for specific attributes of that loan and other unobservable market data, such as time it takes to complete the project.  The fair value of conventional residential one-to four-family loans held for sale which the fair value option has been elected is determined based on quoted prices for similar loans in active markets.  Since January 1, 2016, the Company elected the fair value option for all loans originated and held for sale.

Mortgage loans held for sale are sold with either servicing rights retained or servicing released. The carrying value of mortgage loans sold is reduced by the amount allocated to the servicing right. Gains and losses on sales of mortgage loans are based on the difference between the selling price and the carrying value of the related loan sold.

Loans

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the outstanding principal balance, net of purchase premiums or discounts, deferred loan fees and costs and an allowance for loan losses. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the level-yield method without anticipating prepayments.

Interest income includes amortization of net deferred loan fees and costs. Loan fees and costs associated with origination of loans are deferred and amortized to interest income over the contractual lives of the loans using the level yield method. Fees received for loan commitments that are expected to be drawn, based on Home Savings’ experience with similar commitments, are deferred and amortized over the lives of the loans using the level-yield method. Fees for other loan commitments are deferred and amortized over the loan commitment period on a straight-line basis. Unamortized deferred loan fees or costs related to loans paid off are included in income. Unamortized net fees or costs on loans sold are included in the basis of the loans in calculating gains and losses. The accrual of interest income and amortization of net deferred fees on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the loan is both well secured and in the process of collection. Consumer loans are typically charged-off no later than 180 days past due. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. Nonaccrual loans and loans past due 90 days

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still accruing include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans.

All interest accrued but not received for a loan placed on nonaccrual is reversed against interest income. Once a loan is on nonaccrual, it will remain on nonaccrual until the loan becomes current and the borrower demonstrates the ability to pay the loan per the contractual terms for a minimum of six months.  Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Under the cost-recovery method, interest income is not recognized until the loan balance is reduced to zero.  Under the cash-basis method, interest income is recorded when the payment is received in cash.  Loans are returned to accrual status when future payments are reasonably assured.

Home Savings determines the past due status of loans based on the number of calendar months the loan is past due. Impaired loans consist of loans that are non-homogenous and in a nonaccrual status; loans considered troubled debt restructurings and loans that have been individually analyzed for impairment.

Residential mortgage loans. Residential mortgage loans are revalued at the time they reach 180 days past due and any portion of the principal that exceeds the fair value is charged-off. Mortgage loans are considered to be homogenous until the loan is individually evaluated at 180 days past due and charged-down to the fair value of the underlying collateral, at which time the loan becomes non-homogenous and is considered impaired. Residential mortgage loans that have been modified and determined to be a troubled debt restructuring (TDR) are revalued based upon the present value of the modified cash flows of the loan to establish a specific reserve on that loan.

Consumer loans. Consumer loans that are secured by residential real estate are revalued once they reach 180 days past due and charged-down to the fair value if necessary. Consumer loans that are not secured by residential real estate are revalued once they reach 120 days past due and are charged-down to the fair value if necessary. Consumer loans are considered to be homogenous until the loan is individually evaluated and charged-down to the fair value of the underlying collateral, at which time the loan becomes non-homogenous and is considered impaired. Consumer loans that have been modified and determined to be a TDR are revalued based upon the present value of the modified cash flows of the loan to establish a specific reserve on that loan.

Commercial loans. A commercial real estate loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. At this time, the loan is charged-down to the fair value.  Commercial and industrial loans are impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. The repayment of commercial loans typically is dependent on the income stream and successful operation of a business. If there is no underlying collateral to value, the company will calculate the present value of expected future cash flows to determine the amount of impairment, if any.

Concentration of Credit Risk

Most of the Company’s business activity is with customers located within Home Savings’ market area. Therefore, the Company’s exposure to credit risk is significantly affected by changes in the economy in Ohio, Western Pennsylvania and Northern West Virginia.

Allowance for Loan Losses

The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required based on an analysis using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations, estimated collateral values, general economic conditions in the market area and other factors. 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 consists of specific and general components. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful. The general component covers non-classified loans and is based on historical loss experience adjusted for current factors.

Other loans not reviewed specifically by management are evaluated as a homogenous group of loans (generally single-family residential mortgage loans and all consumer credits except marine loans) using a loss factor applied to the outstanding loan balance to determine the level of reserve required. This loss factor consists of two components, a quantitative and a qualitative component. The quantitative component is based on a historical analysis of all charged-off loans, net of recoveries, looking back 26 quarters as of December 31, 2018.  In determining the qualitative component, consideration is given to such attributes as lending policies, economic conditions, nature and volume of the portfolio, management, loan quality trend, loan review, collateral value, concentrations,

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economic cycles and other external factors.   The quantitative and qualitative components are combined to arrive at the loss factor, which is applied to the average outstanding balance of homogenous loans.  At December 31, 2017, the Company evaluated 22 quarters of net charge-off history.

A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans are individually evaluated based on the borrower’s ability to repay the loan given the availability of collateral, other sources of cash flow and legal options available to Home Savings. Once a review is completed, a specific reserve is determined and allocated to the loan. These specific reserves on individual loans are reviewed periodically and adjusted as necessary based on subsequent collection, loan upgrades or downgrades, nonperforming trends or actual principal charge-offs.  Loans for which the terms have been modified, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the facts and circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent. Troubled debt restructurings (TDRs) are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a TDR is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For TDRs that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses.

The Bank’s portfolio has the following segments: commercial, which includes commercial real estate secured loans, residential mortgage loans and consumer loans. Residential mortgage loans are made to customers in Home Savings’ market area. These loans are secured by the underlying real estate as collateral. Repayment of these loans is dependent on general economic conditions and unemployment levels in Home Savings’ market area.  To reduce any risk on loans secured by one-to four-family residences, Home Savings underwrites all portfolio loans to Freddie Mac underwriting guidelines.

Consumer loans primarily consist of home equity loans and lines of credit. Similar to residential mortgage loans, repayment of consumer loans depends on the general economic conditions and unemployment levels in Home Savings’ market area.  The majority of Home Savings’ consumer loans consist of closed-end home equity loans and lines of credit in an amount that, when added to the prior indebtedness secured by the real estate, does not exceed 90% of the estimated value of the real estate. Other consumer loans, such as automobiles and recreational vehicles, have a higher degree of risk than home equity loans as the collateral depreciates at a faster rate.  

Multifamily and nonresidential real estate loans generally have a higher degree of risk than loans secured by one-to four-family residences. These riskier loans can be affected by economic conditions, operating expenses, debt service and successful operation of income-producing properties. Home Savings tries to reduce this risk by evaluating the credit history of the borrower, location of the real estate, the financial condition of the borrower, obtaining personal guarantees of the principals, the characteristics of the income stream generated by the property and the appraisal supporting the property.

Commercial loans generally entail greater risk than real estate lending. The repayment of commercial loans typically is dependent on the income stream and successful operation of a business, which can be affected by economic conditions. The collateral for commercial loans, if any, often consists of rapidly depreciating assets.

Construction loans involve a higher degree of underwriting and default risk than loans secured by mortgages on existing properties because construction loans are more difficult to appraise and to monitor. Loan funds are advanced based upon the status of the project under construction.  

Servicing Assets

Servicing assets are recognized as separate assets when rights are acquired through the purchase or sale of financial assets. Servicing rights are initially recorded at fair value with the income statement effect recorded in gains on sales of loans. Fair value is based on market prices for comparable mortgage servicing contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses. Capitalized servicing rights are reported in other assets and are amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying assets.

Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to carrying amount. Impairment is determined by stratifying rights into tranches based on predominant risk characteristics, such as original maturity,

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interest rate and loan type. Impairment is recognized through a valuation allowance for an individual tranche. If Home Savings later determines that all or a portion of the impairment no longer exists for a particular tranche, a reduction of the allowance may be recorded as an increase to income.

Servicing fee income is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal, or a fixed amount per loan, and are recorded as income when earned. The amortization of mortgage servicing rights is shown separately in non-interest income.

Transfers of Financial Assets

Transfers of financial assets are accounted for as sales when control over the assets has been relinquished. Control over transferred assets is deemed to be surrendered when the assets have been isolated from the Company, the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.

Real Estate Owned and Other Repossessed Assets

Real estate owned, including property acquired in settlement of foreclosed loans, is initially transferred at fair value less estimated cost to sell after foreclosure, establishing a new cost basis. Physical possession of residential real estate property collateralizing a residential mortgage loan occurs when legal title is obtained upon completion of foreclosure or when the borrower conveys all interest in the property to satisfy the loan through completion of a deed in lieu of foreclosure or through a similar legal agreement.  These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell.  If fair value declines after acquisition, a valuation allowance is recorded through expense. Costs relating to the development and improvement of real estate owned are capitalized, whereas costs relating to holding and maintaining the properties are charged to expense. Other repossessed assets are carried at estimated fair value less estimated cost to sell after acquisition.

Premises and Equipment

Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation and amortization. Buildings and related components are depreciated and amortized using the straight-line method over the useful lives, generally ranging from 20 years to 40 years (or term of the lease, if shorter) of the related assets. Furniture and fixtures are depreciated using the straight-line method with useful lives ranging from three to five years.

Federal Home Loan Bank (FHLB) stock

The Bank is a member of the FHLB system. Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. FHLB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income.

Cash Surrender Value of Life Insurance

Life insurance is carried on the lives of certain employees where Home Savings is the beneficiary. Life insurance is recorded at its cash surrender value, or the amount currently realizable. Increases in the Home Savings’ policy cash surrender value are tax exempt and death benefit proceeds received by Home Savings are tax-free. Income from these policies and changes in the cash surrender value are recorded in other income. The policies contain no split dollar or postretirement benefits for covered employees.

Goodwill and other Intangible Assets

Goodwill is generally determined as the excess of the fair value of the consideration transferred, plus the fair value of any noncontrolling interest in the acquiree, over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually or more frequently if events and circumstances exists that indicate that a goodwill impairment test should be performed.  The Company has selected December 31 as the date to perform the annual impairment test.  Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values.  Goodwill is the only intangible asset with an indefinite life on our balance sheet.

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Other intangible assets consist of core deposit and customer list intangibles.  Core deposit intangible assets arose from whole bank acquisitions. They were initially measured at fair value and are being amortized on an accelerated method over their estimated useful lives.  Customer list intangible arose from the acquisition of James & Sons Insurance in January 2016, Premier Bank and Trust in January 2017, Stevens Insurance Agency in 2017 and Steinhauser Insurance Agency in 2018 and are amortized on an accelerated basis over its estimated useful life of 10 years.

Derivatives

At the inception of a derivative contract, the Company designates the derivative as one of three types based on the Company’s intentions and belief as to likely effectiveness as a hedge. These three types are (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (“fair value hedge”), (2) a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability (“cash flow hedge”), or (3) an instrument with no hedging designation (“stand-alone derivative”). For a fair value hedge, the gain or loss on the derivative, as well as the offsetting loss or gain on the hedged item, are recognized in current earnings as fair values change. For a cash flow hedge, the gain or loss on the derivative is reported in other comprehensive income and is reclassified into earnings in the same periods during which the hedged transaction affects earnings. For both types of hedges, changes in the fair value of derivatives that are not highly effective in hedging the changes in fair value or expected cash flows of the hedged item are recognized immediately in current earnings. Changes in the fair value of derivatives that do not qualify for hedge accounting are reported currently in earnings, as noninterest income.

Net cash settlements on derivatives that qualify for hedge accounting are recorded in interest income or interest expense, based on the item being hedged. Net cash settlements on derivatives that do not qualify for hedge accounting are reported in noninterest income. Cash flows on hedges are classified in the cash flow statement the same as the cash flows of the items being hedged.

The Company formally documents the relationship between derivatives and hedged items, as well as the risk-management objective and the strategy for undertaking hedge transactions at the inception of the hedging relationship. This documentation includes linking fair value or cash flow hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. The Company also formally assesses, both at the hedge’s inception and on an ongoing basis, whether the derivative instruments that are used are highly effective in offsetting changes in fair values or cash flows of the hedged items. The Company discontinues hedge accounting when it determines that the derivative is no longer effective in offsetting changes in the fair value or cash flows of the hedged item, the derivative is settled or terminates, a hedged forecasted transaction is no longer probable, a hedged firm commitment is no longer firm, or treatment of the derivative as a hedge is no longer appropriate or intended.

When hedge accounting is discontinued, subsequent changes in fair value of the derivative are recorded as noninterest income. When a fair value hedge is discontinued, the hedged asset or liability is no longer adjusted for changes in fair value and the existing basis adjustment is amortized or accreted over the remaining life of the asset or liability. When a cash flow hedge is discontinued but the hedged cash flows or forecasted transactions are still expected to occur, gains or losses that were accumulated in other comprehensive income are amortized into earnings over the same periods which the hedged transactions will affect earnings.

Mortgage Banking Derivatives

Commitments to fund mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of these mortgage loans are accounted for as free standing derivatives. Fair values of these mortgage derivatives are estimated based on changes in mortgage interest rates from the date the interest rate on the loan is locked. The Company enters into forward commitments for the future delivery of mortgage loans when interest rate locks are entered into in order to hedge the change in interest rates resulting from its commitments to fund the loans. Changes in the fair values of these derivatives are included in mortgage banking income on the consolidated statements of operations and comprehensive income.

Long-term Assets

Premises and equipment and other long–term assets are reviewed for impairment when events indicate their carrying amounts may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value.

Stock Compensation

Compensation cost is recognized for stock options and restricted stock awards issued to employees and nonemployee directors, based on the fair value of these awards at the date of grant. A Black-Scholes model is utilized to estimate the fair value of stock options, while the market price of the Corporation’s common shares at the date of grant is used for restricted stock awards.

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Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.

Income Taxes

Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax basis of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.

A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.

The Company recognizes interest and/or penalties related to income tax matters in income tax expense.

401(k) Savings Plan

Employee 401(k) and profit sharing plan expense is the amount of matching contributions and administrative costs to administer the plan.

Postretirement Benefit Plans

In addition to Home Savings’ retirement plans, Home Savings sponsored a defined benefit health care plan that was curtailed in 2000 to provide postretirement medical benefits for employees who worked 20 years and attained a minimum age of 60 by September 1, 2000, while in service with Home Savings. That modified plan was further curtailed in 2015, and medical benefits are no longer provided to plan participants as of December 31, 2016 and the plan was terminated and settled.  The plan was unfunded and, as such, had no assets. Furthermore, the plan was contributory and contained minor cost-sharing features such as deductibles and coinsurance. In addition, postretirement life insurance coverage was provided for employees who were participants prior to December 10, 1976. The life insurance plan was non-contributory. Home Savings’ policy was to pay premiums monthly, with no pre-funding. This plan was terminated and settled with participants in 2016.  The benefit obligation was measured annually by a third-party actuary.

Dividend Restriction

Banking regulations require maintaining certain capital levels and may limit the dividends paid by the bank to the holding company or by the holding company to shareholders.

Earnings Per Share

Basic earnings per common share is net income available to common shareholders divided by the weighted average number of common shares outstanding during the period. All outstanding unvested share-based payment awards that contain rights to nonforfeitable dividends are considered participating securities for this calculation. Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable under stock options.

Loss Contingencies

Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. See further discussion at Note 13.

Fair Value of Financial Instruments

Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in Note 18. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.

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Comprehensive Income (Loss)

Comprehensive income (loss) consists of net income and unrealized gains and losses on securities available for sale and changes in unrealized gains and losses on postretirement liabilities, which are also recognized as separate components of equity, net of tax.

Off Balance Sheet Financial Instruments

Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.

New Accounting Standards

 

On January 1, 2018, the Company adopted Accounting Standards Update (ASU) 2014-09 Revenue from Contracts with Customers and all subsequent amendments to the ASU (collectively, ASC 606), which (i) creates a single framework for recognizing revenue from contracts with customers that fall within its scope and (ii) revised when it is appropriate to recognize a gain (loss) from the transfer of nonfinancial assets, such as other real estate owned.  The majority of the Company’s revenues come from interest income and other sources, including loans and securities, which are outside the scope of ASC 606.  The Company’s services that fall within the scope of ASC 606 are presented within noninterest income and are recognized as revenue as the Company satisfies its obligation to the customer.  Services within the scope of ASC 606 include insurance agency income, brokerage income, deposit related fees, debit/credit card income, trust income and the sale of other real estate owned.  Refer to Note 26, Revenue Recognition for further discussion on the Company’s accounting policies for revenue sources within the scope of ASC 606.

The Company adopted ASC 606 using the modified retrospective method applied to all contracts not completed as of January 1, 2018.  Results for reporting periods beginning after January 1, 2018 are presented under ASC 606 while prior period amounts continue to be reported in accordance with legacy GAAP.  The adoption of ASC 606 did not result in a change to the accounting for any of the in-scope revenue streams; as such, no cumulative effect adjustment was recorded.

In January 2016, the FASB issued ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2016-01, among other things, (i) requires equity investments, with certain exceptions, to be measured at fair value with changes in fair value recognized in net income, (ii) simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment, (iii) eliminates the requirement for public business entities to disclose the methods and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet, (iv) requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes, (v) requires an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments, (vi) requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements and (viii) clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities. The new guidance is effective for annual reporting periods and interim reporting periods within those annual periods, beginning after December 15, 2017.  In February 2018, the FASB issued ASU 2018-03, Technical Corrections and Improvements to Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.  The ASU, considered by the Company for adoption, includes amendments that clarify aspect of the guidance issued in ASU 2016-01.  The adoption of this guidance did not have material impact on the Company’s financial statements.  

 

In February 2016, the FASB issued ASU 2016-02 - Leases (Topic 842). The ASU amends existing guidance that requires lessees recognize the following for all leases (with the exception of short–term leases) at the commencement date (1) A lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) A right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term.  Under the new guidance, lessor accounting is largely unchanged.  Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and Topic 606, Revenue from Contracts with Customers.  An entity may adopt the new guidance by either restating prior periods and recording a cumulative effect adjustment at the beginning of the earliest comparative period presented or by recording a cumulative effect adjustment at the beginning of the period of adoption.  The Company plans to use the approach of recording a cumulative effect adjustment at the beginning of the period of adoption.  The new guidance includes a number of optional transition-related practical expedients.  The practical expedients relate to the identification and classification of leases that commenced before the effective date, initial direct costs for leases that commenced before the effective date, and the ability to use hindsight in evaluating lessee options to extend or terminate a lease or to purchase the underlying asset.  An entity that elects to apply these practical expedients will, in effect, continue to account for leases that commence before the effective date in accordance

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with previous GAAP unless the lease is modified, except that lessees are required to recognize a right-of-use asset and a lease liability for all operating leases at each reporting date based on the present value of the remaining minimum rental payments that were tracked and disclosed under previous GAAP.  In 2018, the FASB issued ASU 2018-10, Codification Improvements to Topic 842, Leases, ASU 2018-11, Leases (Topic 842): Targeted Improvements and ASU 2018-20, Leases (Topic 842): Narrow – Scope Improvements for Lessors.  These ASUs amend and clarify guidance in ASU 2016-02 and are being considered by the Company in determining the proper adoption of ASU 2016-02.  The adoption of this guidance on January 1, 2019, resulted in an approximate $5.1 million increase in assets and an approximate $5.4 million increase in liabilities.

In June 2016, the FASB Issued ASU 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (ASU 2016-13).   ASU 2016-13 adds a new Topic 326 to the Accounting Standards Codification (Codification) and removes the thresholds that companies apply to measure credit losses on financial instruments measured at amortized cost, such as loans, receivables, and held-to-maturity debt securities. Under current U.S. GAAP, companies generally recognize credit losses when it is probable that the loss has been incurred. The revised guidance will remove all recognition thresholds and will require companies to recognize an allowance for credit losses for the difference between the amortized cost basis of a financial instrument and the amount of amortized cost that the company expects to collect over the instrument’s contractual life. ASU 2016-13 also amends the credit loss measurement guidance for available-for-sale debt securities and beneficial interests in securitized financial assets. The guidance in ASU 2016-13 is effective for “public business entities,” as defined, that are SEC filers for fiscal years, and for interim periods with those fiscal years, beginning after December 15, 2019.  Early adoption of the guidance is permitted for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Management is currently evaluating the impact of the adoption of this guidance on the Company’s consolidated financial statements.  Management has aggregated and verified the necessary data and addressed any data-archiving improvements necessary for the implementation of this ASU.  In November 2018, the FASB issued ASU 2018-19, Codification Improvements to Topic 326, Financial Instruments – Credit Losses.  The amendment clarifies that receivables arising from operating leases are not within the scope of Subtopic 326-20 and should be accounted for in accordance with Topic 842, Leases.  Management is in the process of evaluating various models to be used.

 

In August 2016, FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230), Classification of Certain Cash Receipts and Cash Payments, which amends the guidance in ASC 230 on the classification of certain cash receipts and payments in the statement of cash flows. The primary purpose of the ASU is to reduce the diversity in practice that has resulted from the lack of consistent principles on this topic. The ASU’s amendments add or clarify guidance on eight cash flow issues:

For public business entities, the guidance in the ASU is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years.  Entities must apply the guidance retrospectively to all periods presented but may apply it prospectively from the earliest date practicable if retrospective application would be impracticable.  The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.  

 

In January 2017, the FASB issued ASU 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. This ASU eliminates Step 2 from the goodwill impairment test. Instead, under the new guidance, an entity is to perform its annual goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An impairment charge would be recognized for the amount by which the carrying amount exceeds the reporting unit's fair value. The new guidance is effective for annual reporting periods, and interim reporting periods within those annual periods, beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The adoption of this guidance is not expected to have an impact on the Company’s consolidated financial statements.

In March 2017, the FASB issued ASU 2017-08, Receivables - Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. This ASU amends the amortization period for certain purchased

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callable debt securities held at a premium. It shortens the amortization period for the premium to the earliest call date. Under current U.S. GAAP, premiums on callable debt securities generally are amortized to the maturity date. The new guidance is effective for annual reporting periods, and interim reporting periods within those annual periods, beginning after December 15, 2018.  The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.

In May 2017, the FASB issued ASU No. 2017-09, Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting. ASU 2017-09 applies to entities that change the terms or conditions of a share-based payment award.  The FASB adopted ASU 2017-09 to provide clarity and reduce diversity in practice as well as cost and complexity when applying the guidance in Topic 718, Compensation—Stock Compensation , to the modification of the terms and conditions of a share-based payment award.

The amendments in ASU 2017-09 include guidance on determining which changes to the terms and conditions of share-based payment awards require an entity to apply modification accounting under Topic 718.

These amendments require the entity to account for the effects of a modification unless all of the following conditions are met:

The fair value (or calculated value or intrinsic value, if such an alternative measurement method is used) of the modified award is the same as the fair value (or value using an alternative measurement method) of the original award immediately before the original award is modified. If the modification does not affect any of the inputs to the valuation technique that the entity uses to value the award, the entity is not required to estimate the value immediately before and after the modification;

The vesting conditions of the modified award are the same as the vesting conditions of the original award immediately before the original award is modified; and

The classification of the modified award as an equity instrument or a liability instrument is the same as the classification of the original award immediately before the original award is modified.

The amendments are effective for all entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2017. Early adoption is permitted, including adoption in any interim period for. The amendments should be applied prospectively to an award modified on or after the adoption date.  The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.

In July 2017, the FASB ASU No. 2017-11, Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); Derivatives and Hedging (Topic 815): (Part I) Accounting for Certain Financial Instruments with Down Round Features, (Part II) Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception.  ASU 2017-11 simplifies the accounting for certain financial instruments with down round features, a provision in an equity-linked financial instrument (or embedded feature) that provides a downward adjustment of the current exercise price based on the price of future equity offerings.

The new ASU will require companies to disregard the down round feature when assessing whether the instrument is indexed to its own stock, for purposes of determining liability or equity classification. Companies that provide earnings per share (EPS) data will adjust their basic EPS calculation for the effect of the feature when triggered (i.e., when the exercise price of the related equity-linked financial instrument is adjusted downward because of the down round feature) and will also recognize the effect of the trigger within equity.

The provisions of the new ASU related to down rounds are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. Early adoption is permitted for all entities.  The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.

In August 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities.  These amendments revise and expand hedge accounting for both financial (e.g., interest rate) and commodity risks.  Its provisions create more transparency around how economic results are presented, both on the face of the financial statements and in the footnotes.  It also makes certain targeted improvements to simplify the application of hedge accounting guidance.  This ASU is effective for public business entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years.  For all other entities, the amendments are effective for fiscal years beginning after December 15, 2019, and interim periods beginning after December 15, 2020.  Early adoption, including adoption in an interim period, is permitted. If an entity early adopts in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period

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(i.e., the initial application date).  The adoption of this guidance did not have an impact on the Company’s consolidated financial statements.

In June 2018, the FASB issued ASU 2018-07, Compensation—Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting (ASU 2018-07).  The FASB issued ASU 2018-07 intending to reduce cost and complexity and to improve financial reporting for nonemployee share-based payments.  ASU 2018-07 expands the scope of Topic 718, Compensation—Stock Compensation (which currently only includes share-based payments to employees) to include share-based payments issued to nonemployees for goods or services. Consequently, the accounting for share-based payments to nonemployees and employees will be substantially aligned. ASU 2018-07 supersedes Subtopic 505-50, Equity—Equity-Based Payments to Non-Employees.  The amendments in ASU 2018-07 are effective for public companies for fiscal years beginning after December 15, 2018, including interim periods within that fiscal year. For all other companies, the amendments are effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. Early adoption is permitted.  The adoption of this guidance did not have an impact on the Company’s consolidated financial statements.

 

 

On January 31, 2017, United Community completed its acquisition of OLCB pursuant to the terms and conditions of the Agreement and Plan of Merger, dated as of September 8, 2016 by and among United Community, the Bank, OLCB and Premier Bank & Trust (the Merger Agreement).  Pursuant to the terms of the Merger Agreement, OLCB was merged with and into United Community. Immediately following the merger, Home Savings was merged with and into Premier Bank & Trust, a wholly-owned subsidiary of OLCB, and changed its name to Home Savings Bank.

 

As a result of the merger and in accordance with the terms of the Merger Agreement, each preferred shareholder of OLCB was deemed to have been converted into OLCB common shares. Each OLCB common share was converted into the right to receive either $18.00 in cash or 2.736 United Community common shares, subject to certain allocation procedures set forth in the Merger Agreement that ensured that 50% of OLCB’s common shares outstanding were converted into United Community common shares and 50% of OLCB’s common shares outstanding received the cash consideration. The Company issued cash in lieu of issuing fractional shares.  

 

After the allocation procedures were applied, the Company issued 3,033,604 United Community common shares and paid $20.4 million to OLCB shareholders as a result of the merger.  Merger related costs aggregating $5.0 million were included in United Community’s Consolidated Statements of Operations for the year ended December 31, 2017.  The fair value of the common shares issued as part of the consideration paid for OLCB was determined on the basis of the closing price of United Community’s commons shares on the date of consummation of the merger (the merger date).

 

The following table summarizes the consideration paid for OLCB.

 

 

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At the merger date, United Community added the following to the Company’s consolidated statements of financial position:

 

 

The fair value of net assets acquired included fair value adjustments to certain receivables that were not considered impaired as of the merger date.  The fair value adjustments were determined using discounted contractual cash flows.  However, the Company believes that all contractual cash flows related to these financial instruments will be collected.  As such, these receivables were not considered impaired at the merger date and were not subject to the guidance relating to purchased credit impaired loans, which have shown evidence of credit deterioration since origination.  The Company has purchased loans, for which there was, at the merger date, evidence of deterioration of credit quality since origination and it was probable, at the merger date, that all contractually required payments would not be collected with a fair value and gross contractual amounts receivable of $1.8 million and $3.3 million, respectively, on the merger date.

 

The following table presents proforma information as if the OLCB merger had occurred at the beginning of 2016.  The proforma information includes adjustments for interest income on loans and securities acquired, amortization of intangibles arising from the transaction, depreciation expense on property acquired, interest expense on deposits acquired, and the related income tax effects.  The proforma financial information is not necessarily indicative of the results of operations that would have occurred had the transaction been effected on the assumed dates.  Net income includes the recognition of $5.0 million in merger related expenses incurred by United Community and $368,000 in merger related expenses for OLCB during the twelve months ended December 31, 2017.  The impact of the acquired insurance agencies is considered immaterial and not included in the table below.  

 

Goodwill is recorded arising from the merger, which consisted largely of synergies and the cost savings resulting from combining the operations of the companies.  No goodwill is expected to be deductible for income tax purposes.  

At the time of the closing, Home Savings’ charter changed to a state chartered commercial bank and United Community became a financial holding company.

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The merger benefits the Company and its shareholders by enabling the Company to further expand into the markets currently served by OLCB and PB&T and strengthening the competitive position of the combined organization. Furthermore, the Company believes its increased asset size after the merger will create additional economies of scale and provide opportunities for asset and earnings growth in an extremely competitive banking environment.  OLCB results of operations were included in the Company’s results beginning January 31, 2017.

On February 28, 2017, HSB Insurance, LLC completed the purchase of an insurance agency engaged in the business of selling insurance including auto, commercial, homeowners and life-health insurance.  Under the purchase agreement, the Company purchased total assets for $722,000, which includes the customer list intangible and goodwill.

On July 1, 2017, HSB Insurance, LLC completed the purchase of an insurance agency engaged in the business of selling insurance including auto, commercial, homeowners and life-health insurance.  Under the purchase agreement, the Company purchased total assets for $81,000, which includes the customer list intangible and goodwill.

On July 1, 2018, HSB Insurance, LLC completed the purchase of an insurance agency engaged in the business of selling property and casualty insurance.  Under the purchase agreement, the Company purchased total assets for $325,000 which includes the customer intangible list.  

 

 

Federal Reserve Board (FRB) regulations require depository institutions to maintain certain non-interest bearing reserve balances. These reserves, which consisted of vault cash at Home Savings, totaled approximately $12.8 million and $12.0 million at December 31, 2018 and 2017, respectively.

 

 

The components of securities available for sale are as follows:

 

 

 

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The components of securities held to maturity are as follows:

 

 

 

Debt securities available for sale by contractual maturity, repricing or expected call date are shown below:

 

Debt securities held to maturity by contractual maturity, repricing or expected call date are shown below:

 

 

Proceeds, gross realized gains, losses and impairment charges of available for sale securities were as follows:

 

 

Income tax expense (benefit) related to net realized gains and losses was $(132,000) for 2018 and $198,000 for 2017 and $211,000 for 2016.

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Securities pledged for public funds were $108.7 million and $129.8 million at December 31, 2018 and 2017, respectively. See further discussion regarding pledged securities in Note 12.

Securities available for sale that have been in an unrealized loss position for less than twelve months or twelve months or more are as follows at December 31, 2018:

 

 

All of the U.S. Treasury and agency securities, obligations of states and municipalities, CMOs and mortgage-backed securities that were temporarily impaired at December 31, 2018, were impaired due to the level of interest rates at that time compared to when securities were purchased. Unrealized losses on these securities have not been recognized into income as of December 31, 2018 because the issuer’s securities are of high credit quality (rated AA or higher), management does not intend to sell, and it is likely that management will not be required to sell, the securities prior to their anticipated recovery, and the decline in fair value is largely due to changes in interest rates and other market conditions.

 

Securities available for sale that have been in an unrealized loss position for less than twelve months or twelve months or more are as follows at December 31, 2017:

 

 

At December 31, 2017, all of the U.S. Treasury and securities, obligations of states and municipalities and mortgage-backed securities that were temporarily impaired were impaired due to the level of interest rates at that time compared to when the securities were purchased.  Unrealized losses on these securities have not been recognized into income as of December 31, 2017 because the issuer’s securities are of high credit quality (rated AA or higher), management does not intend to sell, and it is likely that management will not be required to sell, the securities prior to their anticipated recovery, and the decline in fair value is largely due to changes in interest rates and other market conditions.

 

During the third quarter of 2015, Home Savings transferred mortgage-backed GSE securities with a total amortized cost of $105.3 million with a corresponding fair value of $103.8 million from available for sale to held to maturity.  The net unrealized loss, net of taxes, on these securities at the date of transfer was $999,000.  The fair value at the date of transfer becomes the securities’ new cost basis.  The unrealized holding loss at the time of transfer continues to be reported in accumulated other comprehensive income, net of tax and is amortized over the remaining lives of the securities as an adjustment of the yield.  The amortization of the unamortized holding loss reported in accumulated other comprehensive income will directly offset the effect on interest income from the accretion of the reduced amortized cost for the transferred securities.  The remaining unaccreted unrealized holding loss totaled $876,000 at December 31, 2018 and $1,035,000 at December 31, 2017. Because of this transfer, the total losses less than 12 months and greater than 12 months reported in the table below will not agree to the unrealized losses reported in the inventory of held to maturity securities.  The inventory table reports unrealized gains and losses based upon the transferred securities adjusted cost basis and current fair value.  The reporting of losses less than 12 months and greater than 12 months represents that actual period of time that these securities have been in an unrealized loss position and the securities amortized cost basis as if the transfer did not occur.

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Securities held to maturity that have been in an unrealized loss position for less than twelve months or twelve months or more are as follows at December 31, 2018:

 

 

All of the mortgage-backed securities and obligations of states and municipalities that were temporarily impaired at December 31, 2018, were impaired due to the level of interest rates at that time compared to when the securities were purchased. Unrealized losses on these securities have not been recognized into income as of December 31, 2018 because the issuer’s securities are of high credit quality (rated AA or higher), management does not intend to sell, and it is likely that management will not be required to sell, the securities prior to their anticipated recovery, and the decline in fair value is largely due to changes in interest rates and other market conditions.

Securities held to maturity that have been in an unrealized loss position for less than twelve months or twelve months or more are as follows at December 31, 2017:

 

 

At December 31, 2017, all of the mortgage-backed securities and obligations of states and municipalities were impaired due to the level of interest rates at that time compared to when the securities were purchased.  Unrealized losses on these securities have not been recognized into income as of December 31, 2017 because the issuer’s securities are of high credit quality (rated AA or higher), management does not intend to sell, and it is likely that management will not be required to sell, the securities prior to their anticipated recovery, and the decline in fair value is largely due to changes in interest rates and other market conditions.

 

 

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Portfolio loans consist of the following:

 

 

Loan commitments are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses, may require payment of a fee and may expire unused. Commitments to extend credit at fixed rates expose The Company to some degree of interest rate risk. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The type or amount of collateral obtained varies and is based on management’s credit evaluation of the potential borrower. Home Savings normally has a number of outstanding commitments to extend credit.  

 

 

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Terms of the commitments in both years extend up to six months, but are generally less than two months. The fixed rate loan commitments have interest rates ranging from 3.75% to 18.00%; and maturities ranging from three months to thirty years. Commitments to fund certain mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of mortgage loans to third party investors are considered derivatives. It is the Company’s practice to enter into forward commitments for the future delivery of residential mortgage loans when interest rate lock commitments are entered into in order to economically hedge the effect of changes in interest rates resulting from its commitments to fund the loans. These mortgage banking derivatives are not designated as hedge relationships.

At December 31, 2018 and 2017, there were $1.0 million and $239,000 of outstanding standby letters of credit, respectively. These are issued to guarantee the performance of a customer to a third party. Standby letters of credit are generally contingent upon the failure of the customer to perform according to the terms of an underlying contract with the third party.

At December 31, 2018 and 2017, there were $60.3 million and $54.4 million in outstanding commitments to fund the OverdraftPrivilege™ Program at Home Savings. With OverdraftPrivilege™, Home Savings pays non-sufficient funds checks and fees on checking accounts up to a preapproved limit.

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The following tables present the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of December 31, 2018 and December 31, 2017 and activity for the years ended December 31, 2018, 2017 and 2016.

 

 

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The unpaid principal balance is the total amount of the loan that is due to the Company. The recorded investment includes the unpaid principal balance less any chargeoffs or partial chargeoffs applied to specific loans. The unpaid principal balance and the recorded investment both exclude accrued interest receivable and deferred loan costs, both of which are immaterial.

The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required based on an analysis using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations, estimated collateral values, general economic conditions in the market area and other factors. 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.

Other loans not reviewed specifically by management are evaluated as a homogenous group of loans (generally single-family residential mortgage loans and all consumer credits except marine loans) using a loss factor applied to the outstanding loan balance to determine the level of reserve required. This loss factor consists of two components, a quantitative and a qualitative component. The quantitative component is based on a historical analysis of all charged-off loans, net of recoveries, looking back 26 quarters as of December 31, 2018.  In determining the qualitative component, consideration is given to such attributes as lending policies, economic conditions, nature and volume of the portfolio, management, loan quality trend, loan review, collateral value, concentrations, economic cycles and other external factors.   The quantitative and qualitative components are combined to arrive at the loss factor, which is applied to the average outstanding balance of homogenous loans.  At December 31, 2017, the Company evaluated 22 quarters of net charge-off history.  

 

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The following table presents loans individually evaluated for impairment by class of loans for the year ended December 31, 2018:

Impaired Loans

(Dollars in thousands)

 

 

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The following table presents loans individually evaluated for impairment by class of loans as of and for the year ended December 31, 2017:

Impaired Loans

(Dollars in thousands)

 

 

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The following table presents loans individually evaluated for impairment by class of loans for the year ended December 31, 2016:

Impaired Loans

(Dollars in thousands)

 

       

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The Company reclassifies a collateralized mortgage loan and consumer loans secured by real estate to real estate owned and other repossessed assets once it has either obtained legal title to the real estate collateral or the borrower voluntarily conveys all interest in the real property to the Bank to satisfy the loan through a deed in lieu of foreclosure or similar legal agreement.  The table below presents loans that are in the process of foreclosure at December 31, 2018 and December 31, 2017, but legal title, deed in lieu of foreclosure or similar legal agreement to the property has not yet been obtained:

 

 

The following tables present the recorded investment in nonaccrual and loans past due over 90 days and still on accrual by class of loans as of December 31, 2018:

Nonaccrual Loans and Loans Past Due Over 90 Days and Still Accruing

As of December 31, 2018

 

 

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The following tables present the recorded investment in nonaccrual and loans past due over 90 days and still on accrual by class of loans as of December 31, 2017:

Nonaccrual Loans and Loans Past Due Over 90 Days and Still Accruing

As of December 31, 2017

 

 

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The following tables present an age analysis of past-due loans, segregated by class of loans as of December 31, 2018:

Past Due Loans

(Dollars in thousands)

 

 

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The following tables present an age analysis of past-due loans, segregated by class of loans as of December 31, 2017:

Past Due Loans

(Dollars in thousands)

 

 

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The following table presents loans by class modified as TDRs that occurred during the year ended December 31, 2018:

 

 

The TDRs described above increased the allowance for loan losses by $3,000, and resulted in no charge-offs during the twelve months ended December 31, 2018.

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The following table presents loans by class modified as TDRs that occurred during the year ended December 31, 2017:

 

 

The TDRs described above increased the allowance for loan losses by $7,000, and resulted in no charge-offs during the twelve months ended December 31, 2017.

 

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The following table presents loans by class modified as TDRs that occurred during the year ended December 31, 2016:

 

 

The TDRs described above increased the allowance for loan losses by $39,000, and resulted in no charge-offs during the twelve months ended December 31, 2016.

During the periods ended December 31, 2018, 2017 and 2016, the terms of certain loans were modified as TDRs. The modification of the terms of such loans included one or a combination of the following: a reduction of the stated interest rate of the loan; an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; or a permanent reduction of the recorded investment in the loan. Modifications involving a reduction of the stated interest rate of a loan were for periods ranging from six months to two years. Modifications involving an extension of the maturity date were for periods ranging from six months to ten years.

As of December 31, 2018 and December 31, 2017, the Company had a recorded investment in TDRs of $16.6 million and $19.8 million, respectively.  The Company allocated $1.1 million of specific reserves to customers whose loan terms were modified in TDRs as of December 31, 2018. The Company allocated $1.6 million of specific reserves to customers whose loan terms were modified in TDRs as of December 31, 2017. The Company committed to lend additional amounts totaling up to $41,000 and $37,000 at December 31, 2018 and December 31, 2017, respectively.  

TDR loans that were on nonaccrual status aggregated $1.7 million and $2.4 million at December 31, 2018 and December 31, 2017, respectively. Such loans are considered nonperforming loans. TDR loans that were accruing according to their terms aggregated $14.9 million and $17.9 million at December 31, 2018 and December 31, 2017, respectively.

There were no loans modified as TDRs for which there was a payment default within twelve months following the modification during the periods ended December 31, 2018 and 2017.  

A TDR is considered to be in payment default once it is 30 days contractually past due under the modified terms.

The terms of certain other loans were modified during the periods ended December 31, 2018 and 2017, but they did not meet the definition of a TDR. The modification of these loans involved either a modification of the terms of a loan to borrowers who were not experiencing financial difficulties or a delay in a payment that was considered to be insignificant.

 

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The following table presents loans by class modified as TDRs for which there was a payment default within twelve months following the modification during the period ended December 31, 2016:

 

 

The TDRs that subsequently defaulted described above resulted in $350,000 in charge-offs during the twelve months ended December 31, 2016 and resulted in $820,000 increase in the provision for loan losses.  2016  

The terms of certain other loans were modified during the period ended December 31, 2016, but they did not meet the definition of a TDR. The modification of these loans involved either a modification of the terms of a loan to borrowers who were not experiencing financial difficulties or a delay in a payment that was considered to be insignificant.

In order to determine whether a borrower is experiencing financial difficulty an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed in accordance with the Company’s internal underwriting policy.

Credit Quality Indicators:

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as current financial information, historical payment experience, credit documentation, public information and current economic trends among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes homogeneous loans past due 90 cumulative days, and all non-homogeneous loans including commercial loans and commercial real estate loans. Smaller balance homogeneous loans are primarily monitored by payment status.

Asset quality ratings are divided into two groups: Pass (unclassified) and Classified. Within the unclassified group, loans that display potential weakness are risk rated as special mention. In addition, there are three classified risk ratings: substandard, doubtful and loss. These specific credit risk categories are defined as follows:

Special Mention. Loans classified as special mention have potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date. Loans may be housed in this category for no longer than 12 months during which time information is obtained to determine if the credit should be downgraded to the substandard category.

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Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable.

Loss. Loans classified as loss are considered uncollectible and of such little value, that continuance as assets is not warranted. Although there may be a chance of recovery on these assets, it is not practical or desirable to defer writing off the asset.

The Company monitors loans on a monthly basis to determine if they should be included in one of the categories listed above. All impaired non-homogeneous credits classified as Substandard, Doubtful or Loss are analyzed on an individual basis for a specific reserve requirement. This analysis is performed on each individual credit at least annually or more frequently if warranted.

As of December 31, 2018 and December 31, 2017, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows:

December 31, 2018

(Dollars in thousands)

 

 

 

 

 

 

 

 

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December 31, 2017

(Dollars in thousands)

 

 

Directors and officers of the Company are loan customers in the ordinary course of business. The following describes loans to officers and/or directors of the Company:

 

 

 

Purchased Credit Impaired Loans:

 

The Company has purchased loans, for which there was, at acquisition, evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected.  The carrying amount of those loans is as follows:

 

 

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Accretable yield, or income expected to be collected, is as follows:  

 

 

For the purchased credit impaired loans disclosed above, there was a decrease of $55,000 in the allowance for loan losses for the year ended December 31, 2018 and there was an increase of $55,000 in the allowance for loan losses for the year ended December 31, 2017.

 

Purchased credit impaired loans purchased during the years ended December 31, 2018 and December 31, 2017 for which it was probable at acquisition that all contractually required payments would not be collected are as follows:

 

 

Income is not recognized on purchased credit impaired loans if the Company cannot reasonable estimate cash flows expected to be collected.  The carrying amounts of such loans are as follows:

 

 

 

Mortgage loans serviced for others, which are not reported in United Community’s assets, totaled $1.4 billion at December 31, 2018 and $1.3 billion as of December 31, 2017. Mortgage banking income is comprised of gains recognized on the sale of loans and changes in fair value of mortgage banking derivatives and changes in fair value of loans held for sale carried at fair value.

Mortgage loans serviced for others are not reported as assets. The principal balance of these loans at year-end are as follows:

 

 

Customer escrow balances in connection with loans serviced for FHLMC and FNMA totaled $16.3 million and $15.3 million at year-end 2018 and 2017.

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Activity for capitalized mortgage servicing rights, included in other assets, was as follows:

 

 

Fair value of mortgage servicing rights was $12.2 million, $10.9 million and $10.2 million at December 31, 2018, 2017, and 2016, respectively.

Activity in the valuation allowance for mortgage servicing rights was as follows:

 

 

Key economic assumptions used in measuring the value of mortgage servicing rights at December 31, 2018 and 2017 were as follows:

 

 

At year-end 2018, the Company had approximately $26.8 million of interest rate lock commitments and $183.0 million of forward commitments for the future delivery of residential mortgage loans, including construction perm loans that are held in available for sale. At year-end 2017, the Company had approximately $40.2 million of interest rate lock commitments and $155.0 million of forward commitments for the future delivery of residential mortgage loans, including construction perm loans that are held in available for sale. The fair value of these mortgage banking derivatives was not material at year-end 2018 or 2017.

 

Home Savings may receive requests for reimbursements from Freddie Mac and Fannie Mae, both of whom in the normal course purchase loans originated by Home Savings, for the purpose of making them whole on certain loans sold in the secondary market. These sold loans may have certain identified weaknesses such that, in the opinion of management, a settlement to the investor might be required. For the twelve months ended December 31, 2018 and 2017, Home Savings recognized no expenses associated with such repurchases. Home Savings had no liability reserve for future make-whole settlements at December 31, 2018 and 2017 because management believed no reserve was necessary given the recent historical losses incurred to date, there were no loans in the pipeline to be repurchased and the probability that future losses will not occur.

 

 

Real estate owned and other repossessed assets at December 31, 2018 and 2017 was as follows:

 

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Activity in the valuation allowance was as follows:

 

 

Expenses related to foreclosed and repossessed assets include:

 

 

 

Premises and equipment consist of the following:

 

 

Depreciation expense was $2.7 million for 2018, $2.7 million for 2017 and $2.3 million for 2016.

Rent expense was $1.0 million for 2018, $790,000 for 2017 and $597,000 for 2016. Rent commitments under noncancelable operating leases for offices were as follows, before considering renewal options that generally are present:

 

 

 

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Goodwill

The change in goodwill during the periods presented is as follows:

 

 

Impairment exists when a reporting unit’s carrying value of goodwill exceeds its fair value.  If the carrying amount of a reporting unit is zero or less than zero, a qualitative analysis of whether it is more likely than not that the reporting unit goodwill is impaired will be performed.  The qualitative assessment indicated that it was more likely than not that the fair value of the reporting unit exceeded its carrying value, resulting in no impairment.  The Company did not have any reporting units with a carrying amount of zero or less than zero at December 31, 2018 or 2017.

Acquired Intangible Assets

 

 

Aggregate amortization expense for 2018 was $502,000, for 2017 was $422,000 and for 2016 was $69,000.  Estimated amortization expense for the next five years is as follows:

 

 

 

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Deposits consist of the following:

 

 

Included in total deposits above are related-party deposits of $7.2 million and $6.1 million at December 31, 2018 and 2017, respectively.

Interest expense on deposits is summarized as follows:

 

 

A summary of certificates of deposit by maturity follows:

 

 

A summary of certificates of deposit with balances greater than $250,000 by maturity is as follows:

 

 

Home Savings had $291.0 million in brokered deposits at December 31, 2018, and $156.5 million in brokered deposits at December 31, 2017.

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Home Savings offered an equity-linked time deposit product (the Power CD) in prior years. The Power CD is a time deposit that provides the purchaser a guaranteed return of principal at maturity plus a potential equity return. Home Savings had $12.6 million in Power CDs that were included in certificates of deposit at December 31, 2018. Home Savings had $12.7 million in Power CDs that were included in certificates of deposit at December 31, 2017.

 

 

The following is a summary of FHLB advances:

 

 

At December 31, 2018, Home Savings had remaining available credit, subject to collateral requirements, with the FHLB of approximately $403.0 million. At December 31, 2017, Home Savings had remaining available credit, subject to collateral requirements, with the FHLB of approximately $256.8 million. All advances must be secured by eligible collateral as specified by the FHLB. Accordingly, Home Savings had a blanket pledge of its one-to four-family mortgages as collateral for the advances outstanding at December 31, 2018 and 2017. The required minimum ratio of collateral to advances is 120% for one-to four-family loans. Additional changes in value can be applied to one-to four-family mortgage collateral based upon characteristics such as loan-to-value ratios and FICO scores.

 

On November 18, 2014, Home Savings modified a $50.0 million fixed-rate term advance with the FHLB.  The modification reduced the weighted average interest rate paid on the debt from 4.20% fixed-rate to a floating rate, and extended the weighted average maturity from 2.0 years to 5.0 years. A $3.9 million prepayment penalty was incurred by Home Savings as part of the modification and has been amortizing using a level yield method over the five-year remaining term as a yield adjustment.  In December of 2018, Home Savings elected to payoff this advance and incurred a $936,000 termination charge which represented the remaining unamortized premium.  FHLB term advances are subject to prepayment penalties.

 

 

The following is a summary of securities sold under an agreement to repurchase and other borrowings:

 

 

 

Securities sold under agreements to repurchase are secured primarily by U.S. agency securities with a fair value of $977,000 at December 31, 2018 and $4.9 million at December 31, 2017.  These securities are held by an independent third party and are for retail customers.  These balances represent an overnight source of funding.

 

 

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United Community and Home Savings are parties to litigation arising in the normal course of business. While it is difficult to determine the ultimate resolution of these matters, management believes any resulting liability would not have a material effect upon United Community’s financial statements.

 

 

 

The income tax expense (benefit) consists of the following components:

 

 

Effective tax rates differ from the statutory federal income tax rate of 21% for 2018, and 35% for 2017 and 2016, due to the following:

 

 

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Significant components of the deferred tax assets and liabilities are as follows:

 

The Company’s ultimate realization of the deferred tax asset is dependent upon the generation of future taxable income during the periods in which temporary differences become deductible. Management considers the nature and amount of projected future taxable income, the scheduled reversal of deferred tax assets and liabilities, and available tax planning strategies in making this assessment. The amount of deferred taxes recognized could be impacted by changes to any of these variables.

Retained earnings at December 31, 2018 included approximately $21.1 million for which no provision for federal income taxes has been made. This amount represents the tax bad debt reserve at December 31, 1987, which is the end of United Community’s base year for purposes of calculating the bad debt deduction for tax purposes. If this portion of retained earnings is used in the future for any purpose other than to absorb bad debts, the amount used will be added to future taxable income. The unrecorded deferred tax liability on the above amount at December 31, 2018 was approximately $4.4 million. At December 31, 2018, Home Savings had approximately $5.7 million deficit in tax earnings and profits. Any distribution from Home Savings to United Community, other than current period earnings, in excess of tax earnings and profits, including any distributions made by Home Savings in direct redemption of stock from United Community, could result in recapture of proportionate amounts of these bad debt reserves and, as a result, recording of the related tax liability.

As of December 31, 2018 and December 31, 2017, United Community had no unrecognized tax benefits or accrued interest and penalties recorded. United Community does not expect the total amount of unrecognized tax benefits to significantly increase within the next twelve months. United Community will record interest and penalties as a component of income tax expense.

United Community and Home Savings are subject to U.S. federal income tax.  United Community and Home Savings are subject to tax in Ohio based upon its net worth. United Community and Home Savings also file state income tax returns in Pennsylvania, Indiana, West Virginia and Florida. United Community is no longer subject to examination by taxing authorities for years prior to 2015.

On December 22, 2017, H.R. 1, commonly known as the Tax Cuts and Jobs Act (the “Act”), was signed into law.  The Act includes several provisions that affected the Company’s federal income tax expense, including reducing the federal income tax rate to 21% effective January 1, 2018.  As a result of the rate reduction, the Company was required to re-measure, through income tax expense in the period of enactment, the deferred tax assets and liabilities using the enacted rate at which these items are expected to be recovered or settled.  The re-measurement of the Company’s net deferred tax asset resulted in additional 2017 income tax expense of $1.5 million.

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United Community’s net operating loss of $1.9 million will be carried forward to use against future taxable income.  The net operating loss carryforwards begin to expire in the year ending December 31, 2029.  This tax benefit is subject to an annual limitation under Internal Revenue Code Section 382; however, United Community and Home Savings expect to utilize the full amount of the benefit.  

 

 

Dividends

United Community’s source of funds for dividends to its shareholders is earnings on its investments and dividends from Home Savings. During the year ended December 31, 2018, United Community paid total cash dividends of $0.26 per common share. While Home Savings’ primary regulator is the FDIC, the FRB has regulations that impose certain restrictions on payments of dividends to United Community as of December 31, 2018.

Home Savings must file an application with, and obtain approval from, the FRB if (i) the proposed distribution would cause total distributions for the calendar year to exceed net income for that year-to-date plus retained net income (as defined) for the preceding two years; (ii) Home Savings would not be at least adequately capitalized following the capital distribution; or (iii) the proposed distribution would violate a prohibition contained in any applicable statute, regulation or agreement between Home Savings and the FRB or the FDIC, or any condition imposed on Home Savings in an FRB-approved application or notice. If Home Savings is not required to file an application, it must file a notice of the proposed capital distribution with the FRB. As of December 31, 2018, Home Savings had $12.4 million in retained earnings that could be distributed based on cumulative dividends and net income over the aforementioned period. Home Savings paid a $29.6 million dividend to United Community from current period earnings during 2018.

Accumulated Other Comprehensive Income (Loss)

Accumulated other comprehensive income (loss) included in the consolidated statements of shareholders’ equity consists of unrealized gains and losses on available for sale securities, unrealized losses on securities transferred from available for sale to held to maturity, accretion of unrealized losses on securities transferred from available for sale to held to maturity, disproportional tax effects and changes in unrealized gains and losses on the postretirement plan. The change includes reclassification of net gains or (losses) on sales of securities of $(627,000), $566,000 and $604,000 for the years ended December 31, 2018, 2017 and 2016.

The following is a summary of accumulated other comprehensive income (loss) to net income balances:

 

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As of June 30, 2014, management concluded it was more likely than not that the Company’s net deferred tax asset would be realized and accordingly determined a full deferred tax valuation allowance was no longer required. Upon reversal of the former full deferred tax valuation allowance as of June 30, 2014, certain disproportionate tax effects are retained in accumulated other comprehensive income (loss) totaling approximately a ($16.6) million loss. Almost the entire disproportionate tax effect is attributable to valuation allowance expense recorded through other comprehensive income (loss) on the tax benefit of losses sustained on the available for sale securities portfolio while the Company was in a full deferred tax valuation allowance. This valuation allowance was appropriately reversed through continuing operations at June 30, 2014, leaving the original expense in accumulated other comprehensive income (loss), where it will remain in accordance with the Company’s election of the “portfolio approach”, until such time as the Company would cease to have an available for sale security portfolio.  During 2016, with the termination and settlement of the postretirement plans, the disproportionate tax effect associated with these plans was reversed and recorded as a tax benefit.

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The following is significant amounts reclassified out of each component of accumulated comprehensive income (loss) to net income for the year ended December 31, 2018:

 

 

The following is significant amounts reclassified out of each component of accumulated comprehensive income (loss) to net income for the year ended December 31, 2017:

 

 

The following is significant amounts reclassified out of each component of accumulated comprehensive income (loss) for the year ended December 31, 2016:

 

 

 

Home Savings is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on Home Savings.  The regulations require Home Savings to meet specific capital adequacy guidelines in keeping with the regulatory framework for prompt corrective action that involve quantitative measures of Home Savings’ assets, liabilities, and certain off balance sheet items as calculated under regulatory accounting practices. Home Savings’ capital classification is also subject to qualitative judgments by the regulators about components of capital, risk weightings, and other factors.

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The Basel III Capital Rules establish a common equity Tier 1 minimum capital requirement (4.5% of risk-weighted assets), a minimum Tier 1 capital to risk-based assets requirement (6% of risk-weighted assets) and assigns a risk weight (150%) to exposures that are more than 90 days past due or are on nonaccrual status and to certain commercial real estate facilities that finance the acquisition, development or construction of real property. The rules also require unrealized gains and losses on certain available-for-sale securities holdings to be included for purposes of calculating regulatory capital requirements unless a one-time opt-in or opt-out is exercised. In connection with the adoption of the Basel III Capital Rules, Home Savings elected to opt-out of the requirement to include most components of accumulated other comprehensive income in Common Equity Tier 1.  The rule limits a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a “capital conservation buffer” consisting of 2.5% of common equity Tier 1 capital risk-based weighted assets in addition to the amount necessary to meeting its minimum risk-based capital requirements.

The capital conservation buffer requirement is being phased in through January 1, 2019, when the full capital conservation buffer requirement will be effective. The capital conservation buffer for 2018 was 1.875% and the capital conservation buffer for 2017 was 1.25%.

Quantitative measures established by regulation for capital adequacy require Home Savings to maintain minimum ratios of Tier 1 (or Core) capital (as defined in the regulations) to average total assets (as defined) and of total risk-based capital (as defined) to risk-weighted assets (as defined).  Home Savings’ Common Equity Tier 1 capital consists of common stock and related paid-in capital, net of treasury stock, and retained earnings. Common Equity Tier 1 for Home Savings is reduced by intangible assets, net of associated deferred tax liabilities and subject to transition provisions. Actual and regulatory required capital ratios without the capital conservation buffer for Home Savings, along with the dollar amount of capital implied by such ratios, are presented below.

 

 

**Tier 1 Leverage Capital Ratio

 

 

**Tier 1 Leverage Capital Ratio

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The components of Home Savings’ regulatory capital are as follows:

 

 

Management believes that as of December 31, 2018 and 2017, Home Savings meets all capital adequacy requirements to which they were subject.  As of December 31, 2018 and 2017, Home Savings was considered well capitalized. Management is not aware of any changes to this classification since that date.

 

 

Postretirement Benefit Plans

In addition to Home Savings’ retirement plans, Home Savings sponsored a defined benefit health care plan that was curtailed in 2000 to provide postretirement medical benefits only for these employees who worked 20 years and attained a minimum age of 60 by September 1, 2000, while in service with Home Savings. That plan was curtailed again in 2015, and medical benefits are no longer provided to plan participants as of December 31, 2016.  The curtailment resulted in a gain of $1.1 million recognized in salaries and employee benefits during 2015 and the recognition of unrealized gains as a reduction of salaries and employee benefits of $1.2 million during 2016.  The plan was unfunded and, as such, had no assets. Furthermore, the plan was contributory and contained minor cost-sharing features such as deductibles and coinsurance. In addition, postretirement life insurance coverage was provided for employees who were participants prior to December 10, 1976. The life insurance plan was non-contributory. Home Savings’ policy was to pay premiums monthly, with no pre-funding. The life insurance portion of the plan was terminated and the plan was settled in the fourth quarter of 2016.  The benefit obligation measurement date was December 31. Information about changes in obligations of the benefit plan follows:

 

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Components of net periodic benefit cost/ (benefit) were as follows:

 

 

401(k) Savings Plan

Home Savings sponsors a defined contribution 401(k) savings plan, which covers substantially all employees. Under the provisions of the plan, Home Savings’ matching contribution is discretionary and may be changed from year to year. For 2018, 2017 and 2016, Home Savings’ match was 50% of pretax contributions up to a maximum of 6%.  Participants become 100% vested in Home Savings contributions upon completion of three years of service. For the years ended 2018, 2017 and 2016, the expense related to this plan was approximately $671,000, $619,000 and $480,000, respectively.

Stock-based Compensation: Stock Options

On April 30, 2015, shareholders approved the United Community Financial Corp. 2015 Long Term Incentive Compensation Plan (the 2015 Plan). The purpose of the 2015 Plan is to provide a means through which United Community may attract and retain employees and non-employee directors, to provide incentives that align their interest with those of United Community’s shareholders and promote the success of United Community’s business.  All employees and non-employee directors are eligible to participate in the 2015 Plan.  The 2015 Plan provides for the issuance of up to 1,200,000 shares that are to be used for awards of stock options, stock awards, stock units, stock appreciation rights, annual bonus awards and long-term incentive awards.

On April 26, 2007, shareholders approved the United Community Financial Corp. 2007 Long-Term Incentive Plan (as amended, the 2007 Plan). The purpose of the 2007 Plan was to promote and advance the interests of United Community and its shareholders by enabling United Community to attract, retain and reward directors, directors emeritus, managerial and other key employees of United Community, including Home Savings, by facilitating their purchase of an ownership interest in United Community. The 2007 Plan was terminated on April 30, 2015 upon the adoption of the 2015 Plan, although the 2007 Plan survives so long as awards issued under the 2007 Plan remain outstanding and exercisable.  The 2007 Plan provided for the issuance of up to 2,000,000 shares that were to be used for awards of restricted stock, stock options, performance awards, stock appreciation rights (SARs), or other forms of stock-based incentive awards.

On July 12, 1999, shareholders approved the United Community Financial Corp. 1999 Long-Term Incentive Plan (as amended, the 1999 Plan). The purpose of the 1999 Plan was the same as the 2007 Plan. The 1999 Plan terminated on May 20, 2009, although the 1999 Plan survives so long as options issued under the 1999 Plan remain outstanding and exercisable.

The 1999 Plan provided for the grant of either incentive or nonqualified stock options. Options were awarded at exercise prices that were not less than the fair market value of the share at the grant date. The maximum number of common shares that could be issued under the 1999 Plan was 3,569,766. Because the 1999 Plan terminated, no additional options may be issued under it. All of the options awarded became exercisable on the date of grant except that options granted in 2009 became exercisable over three years beginning on December 31, 2009. All options expire 10 years from the date of grant.

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There were 50,000 stock options granted in 2018 and there were no stock options granted in 2017 and 2016. The options must be exercised within 10 years from the date of grant.  Expenses related to stock option grants are included with salaries and employee benefits. All of the Company’s stock options are vested at December 31, 2018 except for the 50,000 granted in 2018 that will vest on February 21, 2019.  The Company recognized $71,000, $1,000 and $9,000, in stock option expense for the twelve months ended December 31, 2018, 2017 and 2016, respectively.  

A summary of activity in the plans is as follows:

 

 

Information related to the stock options granted and exercised during each year follows:

 

 

     

There were no options granted in 2017 and 2016.  The fair value of options granted in 2018 was determined using the following weighted-average assumptions as of the grant date:

 

 

Outstanding stock options have a weighted average remaining life of 3.59 years and may be exercised in the range of $1.20 to $9.14.

Stock-based Compensation: Restricted Stock Awards

The 2015 and 2007 Plans permit the issuance of restricted stock awards to employees and nonemployee directors. Nonvested shares at December 31, 2018 aggregated 210,713, of which 132,532 will vest in 2019, 23,107 will vest in 2020 and 55,074 will vest in 2021.  Expense related to restricted stock awards are charged to salaries and employee benefits and are recognized over the vesting period of the awards based on the market value of the shares at the grant date. The Company recognized approximately $792,000, $951,000 and $970,000 in restricted stock award expenses, including expenses for shares issued under the annual incentive plan, for the twelve months ended December 31, 2018, 2017 and 2016, respectively. The Company expects to recognize additional expenses of approximately $536,000 in 2019, $305,000 in 2020, and $152,000 in 2021.    

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A summary of changes in the Company’s nonvested restricted shares for the year is as follows:

 

 

The total average per share fair value of shares vested during the years ended December 31, 2018, 2017 and 2016 was $9.63, $8.61 and $5.97, respectively.

Annual Incentive Plan

The Annual Incentive Plan (“AIP”) provides incentive compensation awards to certain officers of the Company. The incentive awards are based upon the actual performance of the Company, and personal performance for the twelve months ending December 31, 2018 compared to the actual performance of a peer group and plan during the same twelve month period. The target incentive awards for each year are measured as a percentage of the base salary of participating officers.  Once the awards under the AIP are calculated, they are paid either in cash or 80% cash and 20% restricted stock, depending on the participant. The restricted stock granted vests equally over three years, beginning on the first anniversary of the date the restricted stock is issued.  The Company incurred $369,000, $315,000 and $356,000 in expense for the restricted stock portion of the AIP and $1.6 million, $1.7 million and $1.3 million for the cash portion of the AIP for the twelve months ended December 31, 2018, 2017 and 2016, respectively.   Restricted stock expenses for the AIP are included in the total restricted stock expenses discussed above.      

Long-Term Incentive Plan

The Long-Term Incentive Plan (“LTIP”) provides a long-term incentive compensation opportunity to certain executive officers. Each participant in the LTIP will be granted a target number of Performance Share Units (“PSUs”).  Target PSUs are determined as a percentage of base salary and translated into share units based on the Company’s average stock price at the appropriate measurement date.  The performance period for the annual grant for a given year is from January 1, year 1 through December 31, year 3.   The Company incurred $705,000, $230,000 and $693,000 in expense for the LTIP for the twelve months ended December 31, 2018, 2017 and 2016, respectively.  The increase in expense for 2018 and 2016 was driven by the rise in United Community’s share price during the performance period.  

 

 

Fair value is the exchange price that would be received for an asset if paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair value:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a reporting entity’s own beliefs about the assumptions that market participants would use in pricing an asset or liability.

United Community uses the following methods and significant assumptions to estimate the fair value of each type of financial instrument:

Trading securities: The fair values of trading securities are determined by obtaining quoted prices from a counterparty who makes a market in the securities and materially agrees to an observable price based upon our sale in December 2018 (Level 1 inputs).

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Available for sale securities: The fair values of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2), using matrix pricing.  Matrix pricing is a mathematical technique commonly used to price debt securities that are not actively traded, values debt securities without relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs).

Impaired loans: At the time a loan is considered impaired, it is valued at the lower of cost or fair value. Impaired loans carried at fair value generally receive specific allocations of the allowance for loan losses. For collateral dependent loans, fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.

Other real estate owned: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Real estate owned properties are individually evaluated at least annually for additional impairment and adjusted accordingly.

Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by Home Savings. Once received, a member of the Special Assets Department reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with the independent data sources such as recent market data or industry-wide statistics. On an annual basis, Home Savings compares the actual selling price of collateral that has been sold to the most recent appraised value to determine what additional adjustment should be made to the appraisal value to arrive at fair value. At the time a property is acquired and classified as real estate owned, the fair value is determined utilizing the most appropriate method. A fair value in excess of $250,000 will be supported by an appraisal. After determination of fair value, each property will be recorded at the lower of cost (i.e., recorded investment in the loan) or the estimated net realizable value on the date of transfer to real estate owned. In determining net realizable value, reductions to fair market value may be taken for estimated costs of sale, conditions that must be remedied immediately upon acquisition, and other factors that negatively impact the marketability and prompt sale of the property.

Mortgage servicing rights: On a quarterly basis, loan servicing rights are evaluated for impairment based upon the fair value of the rights as compared to carrying amount. If the carrying amount of an individual tranche exceeds fair value, impairment is recorded on that tranche so that the servicing asset is carried at fair value. Fair value is determined at a tranche level, based on market prices for comparable mortgage servicing contracts (Level 2), when available, or alternatively based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model utilizes assumptions that market participants would use in estimating future net servicing income and that can be validated against available market data (Level 2).

Loans held for sale: Loans held for sale for which the fair value option has not been elected are carried at the lower of cost or fair value, which is evaluated on a pool-level basis. The fair value of loans held for sale is determined using quoted prices for similar assets, adjusted for specific attributes of that loan or other observable market data, such as outstanding commitments from third party investors (Level 2).

Loans held for sale, at fair value:  The Company elected the fair value option for all conventional residential one-to four-family loans held for sale originated after January 1, 2016 and all permanent construction loans held for sale originated after January 1, 2015. The fair value of conventional loans held for sale is determined using the current 15 day forward contract price for either 15 or 30 year conventional mortgages and the 60 day forward contract price for either 15 or 30 year Federal Housing Authority mortgages (Level 2).  

The fair value of permanent construction loans held for sale is determined using the current 60 day forward contract price for 30 year conventional mortgages which is then adjusted by extrapolating this rate to the estimated time period remaining until construction is complete.  The fair value is also adjusted for unobservable market data such as estimated fall out rates and the estimated time from origination to completion of construction (Level 3).

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Purchased and written certificate of deposit option: Home Savings periodically enters into written and purchased option derivative instruments to facilitate the Power CD. The written and purchased options are mirror derivative instruments which are carried at fair value on the consolidated balance sheets. Home Savings uses an independent third party that performs a market valuation analysis for purchased and written certificate of deposit options. (Level 2)

Interest rate swaps: Home Savings periodically enters into interest rate swap agreements with its commercial customers who desire a fixed rate loan term that is longer than Home Savings is willing to extend.  Home Savings then enters into a reciprocal swap agreement with a 3^rd party that offsets the interest rate risk from the interest rate swap extended to the customer.  The interest rate swaps are derivative instruments which are carried at fair value on the consolidated balance sheets. Home Savings uses an independent third party that performs a market valuation analysis for both swap positions. (Level 2)

Assets and Liabilities Measured on a Recurring Basis: Assets and liabilities measured at fair value on a recurring basis are summarized below:

 

 

There were no transfers between Level 1 and Level 2 during 2018 and 2017.

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The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the years ended December 31, 2018 and 2017, in thousands:

 

 

 

There were no transfers between Level 2 and Level 3 during 2018 or 2017.

The following table presents quantitative information about recurring Level 3 fair value measurements at December 31, 2018:

 

 

The following table presents quantitative information about recurring Level 3 fair value measurements at December 31, 2017:

 

 

The significant unobservable inputs used in the fair value measurement of interest rate caps was determined using proprietary models from third-party sources taking into account such factors as size of the transaction, the lack of a quoted market and the custom-tailored nature of the transaction. The fair value is inclusive of interest accruals, as applicable. Significant increases/(decreases) in any of those inputs in isolation would result in a significantly lower/(higher) fair value measurement.

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Assets Measured on a Non-Recurring Basis

Assets measured at fair value on a non-recurring basis are summarized below:

 

 

Impaired loans with specific allocations of the allowance for loan losses, carried at fair value, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a net carrying amount of $967,000 at December 31, 2018, that includes a specific valuation allowance of $69,000. This resulted in an increase of the provision for loan

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losses of $311,000 during the twelve months ended December 31, 2018. Impaired loans with specific allocations of the allowance for loan losses, carried at fair value, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a net carrying amount of $1.7 million at December 31, 2017, that includes a specific valuation allowance of $491,000. This resulted in an increase of the provision for loan losses of $938,000 during the twelve months ended December 31, 2017.

The significant unobservable (Level 3) inputs used in the fair value measurement of collateral for collateral dependent impaired loans included in the above table primarily relate to the adjustment between carrying value versus appraised value. During the reported periods, discounts applied to appraisals for estimated selling costs were 10%.

At December 31, 2018, mortgage servicing rights that were carried at fair value were $3.0 million, resulting in additional expense of $61,000 for the year ended December 31, 2018. At December 31, 2017, mortgage servicing rights that were carried at fair value were $382,000, resulting in additional expense of $9,000 for the year ended December 31, 2017.  Mortgage servicing rights are valued by an independent third party that is active in purchasing and selling these instruments. The value reflects the characteristics of the underlying loans discounted at a market multiple.

At December 31, 2018, other real estate owned, carried at fair value, which is measured for impairment using the fair value of the property less estimated selling costs and had a net carrying amount of $302,000 that includes a valuation allowance of $308,000. This resulted in additional expenses of $109,000 during the twelve months ended December 31, 2018. At December 31, 2017, other real estate owned, carried at fair value, which is measured for impairment using the fair value of the property less estimated selling costs had a net carrying amount of $436,000, with a valuation allowance of $403,000. This resulted in additional expenses of $37,000 during the twelve months ended December 31, 2017.

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a nonrecurring basis at December 31, 2018:

 

 

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Auto and recreational vehicle loans were excluded from the table above as their value is considered immaterial.

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a nonrecurring basis at December 31, 2017:

 

 

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The Company has elected the fair value option for all conventional residential one-to four-family loans originated after January 1, 2016 and all permanent construction loans held for sale an originated after January 1, 2015.  These loans are intended for sale and the Company believes that the fair value is the best indicator of the resolution of these loans.  Interest income is recorded based on the contractual terms of the loan and in accordance with the Company’s policy on loans held for investment.  None of these loans are 90 days or more past due nor on nonaccrual as of December 31, 2018 and 2017.  

As of December 31, 2018 and 2017, the aggregate fair value, contractual balance and gain or loss was as follows:

 

 

The total amount of gains (losses) from changes in fair value included in earnings for the years ended December 31, 2018, 2017 and 2016 were $98,000, $3.9 million, and $(1.8) million, respectively.

The carrying value and estimated fair values of financial instruments at December 31, 2018 and December 31, 2017, were as follows:

 

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Supplemental disclosures of cash flow information are summarized below:

 

 

 

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The Company periodically enters into written and purchased option derivative instruments to facilitate an equity linked time deposit product (the Power CD). The Power CD is a time deposit that provides the purchaser a guaranteed return of principal at maturity plus a potential equity return (a written option), while Home Savings receives a known stream of funds based on the equity return (a purchased option). The written and purchased options are mirror derivative instruments which are carried at fair value on the consolidated statements of financial condition.

Summary information about purchased and written options is as follows:

 

 

Purchased and written options are mirror derivative instruments and as such the changes in fair value are recorded through noninterest income, and offset each other. These options decreased in value $548,000 in 2018 and decreased in value by $79,000 in 2017.

The following table reflects the fair value and location in the consolidated statement of financial condition of interest rate caps, along with purchased and written certificates of deposit options:

Included in other assets:

 

 

Included in other liabilities:

 

 

The Company is subject to counterparty risk. Counterparty risk is the risk to the Company that the counterparty will not live up to its contractual obligations. The ability of the Company to realize the benefit of the derivative contracts is dependent on the creditworthiness of the counterparty, which the Company expects will perform in accordance with the terms of the contracts.

 

Interest Rate Swaps

 

The Company maintains an interest rate protection program for commercial loan customers, which was established in 2018. Under this program, the Company provides a customer with a fixed rate loan while creating a variable rate asset for the Company by the customer entering into an interest rate swap with terms that match the loan.  The Company offsets its risk exposure by entering into an offsetting interest rate swap with an unaffiliated institution.  The Company had interest rate swaps associated with commercial loans with a notional value of $1.2 million and fair value of $56,000 in other assets and $62,000 in other liabilities at December 31, 2018.  The difference in fair value of $6,000 between the asset and liability accounts represents a credit valuation adjustment that flows through noninterest income in 2018.  There were no interest rate swaps outstanding at December 31, 2017.  These interest rate swaps did not have a material impact on the Company’s statements of operation or financial condition

 

 

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Condensed Statements of Financial Condition

 

 

Condensed Statements of Income and Comprehensive Income

 

 

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Condensed Statements of Cash Flows

 

 

 

The Company’s management monitors the revenue streams of the various Company products and services. The identifiable segments are not material, operations are managed, and financial performance is evaluated on a Company-wide basis. All of Home Savings’ financial service operations are considered by management to be aggregated in one reportable operating segment, which is banking services.

 

 

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Earnings per share are computed by dividing net income by the weighted average number of shares outstanding during the period. Diluted earnings per share is computed using the weighted average number of common shares determined for the basic computation plus the dilutive effect of potential common shares that could be issued under outstanding stock options and performance share units.  Stock options for 50,000 shares were anti-dilutive for the year ended December 31, 2018.  There were no stock options that were anti-dilutive for the years ended December 31, 2017 and 2016, respectively.

 

 

 

 

The following table presents summarized quarterly data for each of the years indicated.

 

 

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The Company invests in qualified affordable housing projects.  At December 31, 2018, and 2017, the balance of the investment for qualified affordable housing projects was $9.0 million and $6.0 million, respectively.  These balances are reflected in other assets on the consolidated balance sheet.  Total unfunded commitments related to the investments in qualified affordable housing projects totaled $6.5 million and $5.3 million at December 31, 2018, and 2017, respectively.  The Company expects to fulfill these commitments during the next few years.

 

During the years ended December 31, 2018 and 2017 the Company recognized amortization expense of $444,000 and $156,000 which was included within income tax expense on the consolidated statements of income and the Company recognized $21,000 in amortization expense for the year ended December 31, 2016.

 

Additionally, during the years ended December 31, 2018, 2017, and 2016, the Company recognized tax credits and other benefits from its investment in affordable housing tax credits of $500,000, $191,000, and $26,000, respectively.  During the years ending December 31, 2018, 2017, and 2016, the Company incurred no impairment losses.

 

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The Company recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.  To achieve this result, the following five steps are applied:

 

Step 1: Identify the contract(s) with the customer

Step 2: Identify the performance obligation(s) in the contract

Step 3: Determine the transaction price

Step 4: Allocate the transaction price to the performance obligations in the contract

Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation

 

The new revenue guidance applies to all contracts with customers to provide goods or services in the ordinary course of business, except for loans and securities, which are specifically excluded from the scope.

 

Because loans and securities are outside the scope of the revenue standard, the Company will not use the new standard to account for gains and losses on its investments in securities, loans and derivatives.  The Company also will not use the standard to account for interest and dividend income on financial instruments owned or those included in the Company’s lending activities.  

 

Home Savings’ servicing of loans sold to investors requires Home Savings to provide specific administrative functions for the owner(s) of these assets.  These administrative functions include collecting cash flows from borrowers and remitting them to beneficial interest holders, monitoring delinquencies and executing foreclosures.  Servicing rights that relate to transferred financial assets meet the conditions for sale accounting under ASC 860.  ASC 860 requires the recognition of a servicing asset or liability when the benefits of servicing obtained from the contract are respectively greater than or less than adequate compensation (as defined in ASC 860) for performing the servicing.  While ASC 860 provides initial recognition and subsequent measurement guidance for recognized servicing assets and liabilities, it does not include any explicit guidance for recognizing contractually specified servicing fees when servicing income is equal to adequate compensation.   Therefore, income from servicing financial assets in the scope of ASC 860 is not in the scope of ASC 606, regardless of whether a servicing asset or liability exists. This is because ASC 606 contains an exception to its scope for contracts that fall under ASC 860.

 

Deposit-related fees and charges are in the scope of ASC 606, even though ASC 405 is listed as an exception to the scope of the standard. That is because ASC 405, which the Company applies to determine the appropriate liability accounting for customer deposits, does not provide a model for recognizing fees related to customer deposits (e.g., automated teller machine fees, nonsufficient funds fees, account maintenance or dormancy fees).  When reviewing standard customer agreements, fees are charged as the service is rendered and therefore there are no changes to recognizing income for deposit-related fees.

 

The Company records real estate owned and other repossessed assets (OREO) at fair value less costs to sell upon foreclosure. The objective is to sell OREO within a short period of time because of regulatory and capital requirements. After foreclosure, these assets are carried at the lower of their carrying amount or their fair value less selling costs, so significant gains and losses are uncommon upon sale. OREO is often sold in a transaction that, under the standard, may not be considered a contract with a customer because the sale of the asset is not an output of the entity’s ordinary activities. However, sales of  nonfinancial assets, including in substance nonfinancial assets, should be accounted for using new guidance in ASC 610-20, Other Income — Gains and Losses from the Derecognition of Nonfinancial Assets, which requires entities to apply certain measurement and recognition concepts of ASC 606. Accordingly, the Company recognizes the sale of a real estate property, along with any associated gain or loss, when control of the property transfers to the buyer. For sales of existing real estate properties, this generally will occur at a point in time.

 

Insurance agency income is within the scope of ASC 606.  Approximately 75% of the Company’s insurance agency income is derived from direct-bill customers.  With this arrangement, the customer is billed directly from the insurance carrier.  As a result, the insurance carrier pays a commission to the Company upon completion of the required documentation (policy application or renewal) and recognizes income at that time.  Due to the nature and timing of receipt of these commissions, there will be no change in the manner in which income is recognized.  Agency-billed customers account for approximately 25% of the overall insurance agency income.  Premiums are collected from customers and remitted to the insurance carrier, net of commission, within a short period of time.  At the time the premiums are remitted to the insurance carrier, all work is completed and revenue recognized at that time.  Due to the nature and timing of when the premiums are recognized, there will be no change to the timing of the recognition of insurance agency income.

 

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Debit card fee income is earned as a result of standard interchange fees contractually obligated by Visa to be paid.  Interchange fees are charged to a merchant for the presentment of credit/debit card transactions.  The service is considered complete upon fulfillment of the transaction, which is when the interchange fee is earned and paid.  Credit card fees are paid when earned as a result of an agreement between the bank and a third party provider.  As a result, there is no change to the timing of recognition of this income.

 

Trust fee income is calculated based on assets under management.  Fees are recognized at the end of the month to which the service has been provided for customers billed monthly.  This amounts to approximately 85% of trust fee income recognized, which is collected within a short period of time after the fee is assessed to the customer.  Quarterly and annual fees are accrued and collected based on the contractual agreements with customers.  Fees are assessed to these customers and paid at the end of each quarter.  Due to the nature and timing of when monthly fees are assessed, there will be no change to the way those fees are currently recognized.  Quarterly and annual fees will continue to be recognized over the period when the fees are earned, regardless of when they are assessed to the customer.

 

Brokerage revenue is recognized each month as sales occur.  Brokerage revenue is paid from sales to customers by a third-party.  In a manner similar to that of insurance agency revenue, income is paid directly to the Bank by the third-party once the sale to the customer is complete.  Due to the nature and timing of when the income is earned, there will be no change to timing of when this income is recognized.

 

 

 

 

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Report of Independent Registered Public Accounting Firm

 

Shareholders and the Board of Directors of United Community Financial Corp.

Youngstown, Ohio

 

Opinions on the Financial Statements and Internal Control over Financial Reporting

 

We have audited the accompanying consolidated statements of financial condition of United Community Financial Corp. (the "Company") as of December 31, 2018 and 2017, the related consolidated statements of operations and comprehensive income, shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2018 and the related notes (collectively referred to as the "financial statements"). We also have audited the Company’s internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control – Integrated Framework: (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2018 in conformity with accounting principles generally accepted in the United States of America.  Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control – Integrated Framework: (2013) issued by COSO.

 

Basis for Opinions

 

The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting.  Our responsibility is to express an opinion on the Company’s financial statements and an opinion on the Company’s internal control over financial reporting based on our audits.  We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

 

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.

 

Our audits of the financial statements included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk.  Our audits also included performing such other procedures as we considered necessary in the circumstances.  We believe that our audits provide a reasonable basis for our opinions.

 

Definition and Limitations of Internal Control Over Financial Reporting

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.  A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

 

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Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

 

 

 

 

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MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The management of United Community Financial Corp. (United Community) is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rules 13a-15(f) or 15d-15(f) under the Securities Exchange Act of 1934). United Community’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. United Community’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of United Community; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of United Community are being made only in accordance with authorizations of management and directors of United Community; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of United Community’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management assessed the effectiveness of United Community’s internal control over financial reporting as of December 31, 2018. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in the 2013 Internal Control-Integrated Framework. Based on our assessment and those criteria, management concluded that United Community maintained effective internal control over financial reporting as of December 31, 2018.

United Community’s independent registered public accounting firm has issued its report on the effectiveness of United Community’s internal control over financial reporting as of December 31, 2018, as stated in their report dated March 13, 2019.

 

 

 

 

 

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None.

 

 

Evaluation of Disclosure Controls and Procedures

As of December 31, 2018, United Community’s management, with the participation of the Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of United Community’s disclosure controls and procedures, as defined in Rule 13a-15 under the Exchange Act. Based on this evaluation, United Community’s Chief Executive Officer and Chief Financial Officer concluded that United Community’s disclosure controls and procedures as of December 31, 2018 were effective.

Management’s Report on Internal Control over Financial Reporting

The Management’s Report on Internal Control Over Financial Reporting and the Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting, both of which are contained in Item 8 of this Annual Report on Form 10-K, are incorporated herein by reference.

Changes in Internal Control over Financial Reporting

There were no changes in United Community’s internal control over financial reporting that occurred during the quarter ended December 31, 2018 that have materially affected, or are reasonably likely to materially affect, United Community’s internal control over financial reporting.

 

 

None.

PART III

 

 

Information relating to United Community’s directors, nominees for directorship, executive officers and board committees is provided in, and incorporated by reference from, the proxy statement for the 2019 Annual Meeting of Shareholders of United Community (Proxy Statement) to be filed with the SEC on or about March 22, 2019, under the heading “EXECUTIVE OFFICERS” and under the captions “Nominees for Director,” “Continuing Directors” and “Board Committees” following the heading “PROPOSAL 1 – ELECTION OF DIRECTORS.” Information regarding compliance with Section 16(a) of the Securities Act of 1934 is provided in the Proxy Statement under the heading “SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE” and is incorporated herein by reference. United Community has adopted a code of ethics applicable to all directors, officers and employees of United Community, a copy of which is available under the tab “Corporate Information – Corporate Governance” on our investor relations web page at http://ir.ucfconline.com/govdocs. There have been no material changes to the procedures by which shareholders may recommend nominees to the board of directors.

 

 

Information relating to director compensation is set forth in the Proxy Statement under the caption “Compensation of Non-Employee Directors,” following the heading “PROPOSAL 1—ELECTION OF DIRECTORS,” and information relating to executive compensation is set forth in the Proxy Statement under the headings “COMPENSATION DISCUSSION AND ANALYSIS” and “COMPENSATION OF EXECUTIVE OFFICERS.” Information relating to compensation committee interlocks is set forth in the Proxy Statement under the “Compensation Committee” subsection following the caption “Board Committees” under the heading “PROPOSAL 1 – ELECTION OF DIRECTORS,” and information relating to the compensation committee report is set forth in the Proxy Statement under the heading “COMPENSATION COMMITTEE REPORT." Such information from the Proxy Statement is incorporated herein by reference.

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The information contained in the Proxy Statement under the heading “Security Ownership of Certain Beneficial Owners and Management” is incorporated herein by reference.

United Community maintains the United Community Financial Corp. 1999 Long-Term Incentive Plan (1999 Plan), under which it issued equity securities to its directors, officers and employees in exchange for goods or services. The 1999 Plan was approved by United Community’s shareholders at the 1999 Special Meeting of Shareholders.

On April 26, 2007, shareholders approved the United Community Financial Corp. 2007 Long-Term Incentive Plan (2007 Plan). The purpose of the 2007 Plan is the same as that of the 1999 Plan. The 2007 Plan provided for the issuance of up to 2,000,000 shares and is to be used for awards of restricted stock shares, stock options, performance awards, stock appreciation rights (SARs) or other forms of stock-based incentive awards.

On April 30, 2015, shareholders approved the United Community Financial Corp. 2015 Long Term Incentive Compensation Plan (the 2015 Plan). The purpose of the 2015 Plan is to provide a means through which United Community may attract and retain employees and non-employee directors, to provide incentives that align their interests with those of United Community’s shareholders and to promote the success of United Community’s business.  The 2015 Plan provides for the issuance of up to 1,200,000 shares that are to be used for awards of stock options, stock awards, stock units, stock appreciation rights, annual bonus awards and long-term incentive awards.

Further description of the 1999 Plan, 2007 Plan and 2015 Plan is included in Note 17 to the consolidated financial statements and incorporated herein by reference.

The following table shows, as of December 31, 2018, the number of common shares issuable upon the exercise of outstanding stock options, the weighted average exercise price of those stock options, the number of common shares issued under restricted stock grants, the weighted average share price of those grants and the number of common shares remaining for future issuance under the 2007 Plan, excluding shares issuable upon exercise of outstanding stock options.

Equity Compensation Plan Information

 

 

 

The information contained in the Proxy Statement under the captions “Director Independence,” “Board Committee” and “Related Person Transactions” is incorporated herein by reference.

 

 

The information relating to audit fees and pre-approval of services provided by United Community’s principal accountant in the Proxy Statement under the captions “Audit Fees” and “Audit and Non-Audit Pre-Approval Policy” following the heading “PROPOSAL 4 – RATIFICATION OF THE SELECTION OF OUR INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM” is incorporated herein by reference.

 

 

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PART IV

 

 

 

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None.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

 

 

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