FS Bancorp (FSBW) Risk Analysis

Our consumer loans accounted for $620.2 million, or 24.5% of our total gross loan portfolio as of December 31, 2024, of which $541.9 million (87.4% of total consumer loans) consisted of indirect home improvement loans (some of which were not secured by a lien on the real property), $74.9 million (12.1% of total consumer loans) consisted of marine loans secured by boats, and $3.3 million (0.5% of total consumer loans) consisted of other consumer loans, which includes personal lines of credit, credit cards, automobile, direct home improvement, loans on deposit, and recreational loans. Generally, we consider these types of loans to involve a higher degree of risk compared to first mortgage loans on owner-occupied, one-to-four-family residential properties. As a result of our large portfolio of consumer loans, it may become necessary to increase the level of provision for credit losses on loans, which would reduce profits. Consumer loans generally entail greater risk than do one-to-four-family residential mortgage loans, particularly in the case of loans that are secured by rapidly depreciable assets, such as automobiles and boats. In these cases, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance. Most of our consumer loans are originated indirectly by or through third parties, which presents greater risk than our direct lending products which involves direct contact between us and the borrower. Unlike a direct loan where the borrower makes an application directly to us, in these loans the dealer, who has a direct financial interest in the loan transaction, assists the borrower in preparing the loan application. Although we disburse the loan proceeds directly to the dealer upon receipt of a "completion certificate" signed by the borrower, because we do not have direct contact with the borrower, these loans may be more susceptible to a material misstatement on the loan application or having the loan proceeds being misused by the borrower or the dealer. In addition, if the work is not properly performed, the borrower may cease payment on the loan until the problem is rectified. Although we file a UCC-2 financing statement to perfect the security interest in the personal property collateral for most fixture loans, there are no guarantees on our ability to collect on that security interest or that the repossessed collateral for a defaulted fixture loan will provide an adequate source of repayment for the outstanding loan given the limited stand-alone value of the collateral.  See "Item 1. Business – Lending Activities – Consumer Lending" and "– Asset Quality."

At December 31, 2024, $617.3 million, excluding loans held for sale of $27.8 million, or 24.4% of our total loan portfolio was secured by first liens on one-to-four-family residential loans.  Additionally, home equity lines of credit and second lien mortgages totaled $75.1 million, or 3.0% of our total loan portfolio at that date. These loans are sensitive to regional and local economic fluctuations, which can significantly impact borrowers' ability to meet payment obligations, making loss levels difficult to predict. A downturn in housing markets, particularly in Washington (and to a lesser extent in Oregon), where a concentration of our loans exists could reduce the value of the collateral securing these loans and increase our risk of loss upon a default by the borrower. Economic decline or reduced real estate sales volumes and prices, coupled with higher unemployment rates, may increase loan delinquencies and asset quality concerns, which could also negatively impact demand for our products and services. Residential loans with higher combined loan-to-value ratios are more vulnerable to property value fluctuations, potentially leading to increased default rates and higher losses, compared to loans with lower loan-to-value ratios. Further, the majority of our home equity lines of credit are second mortgage loans. In the event of defaults on these second mortgage-secured lines of credit, recovering loan proceeds can be challenging unless we cover the first mortgage loan repayment.  This repayment, along with foreclosure costs, must be justified by the property's value. The ongoing Los Angeles wildfires that began in January 2025 present heightened risks to our loan portfolio and the adequacy of our allowance for credit losses. Borrowers impacted by the fires may face financial hardship, leading to increased loan defaults and reduced repayment capacity. Damage to or destruction of properties securing loans may result in collateral value depreciation, further increasing potential losses. Additionally, inadequate insurance coverage or denied claims may limit recovery efforts and contribute to greater uncertainty in estimating credit losses. Local economic disruptions, such as business closures and job losses, may impair borrowers' ability to meet financial obligations, requiring adjustments to our credit loss assumptions. While we had no direct losses related to the Los Angeles wildfires, the concentration of our loan portfolio in fire-prone areas further increases exposure, while the growing frequency and severity of wildfires due to climate change heightens long-term risks. These factors may necessitate increases to our allowance for credit losses to account for elevated credit risks. While we continuously evaluate our allowance to ensure it reflects current and expected risks, there can be no assurance it will be sufficient to cover actual losses, particularly in the context of ongoing and future wildfire-related challenges. These factors may result in elevated rates of delinquencies, defaults, and related losses, which would adversely affect our net income.

Our business depends on the creditworthiness of our customers. As with most financial institutions, we maintain an ACL on loans to reserve for estimated potential losses on loans from defaults and represents management's best estimate of expected credit losses inherent in the loan portfolio. Determining the appropriate level of the ACL on loans involves estimating future losses at the time a loan is originated or acquired, incorporating a broader range of information and future economic scenarios. The determination of the appropriate level of the ACL on loans inherently involves a high degree of subjectivity and requires various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of borrowers and the value of the real estate and other assets serving as collateral for loan repayment.  In determining the amount of the ACL on loans, we review loans, analyze our historical loss and delinquency experience, and evaluate economic conditions. Management also recognizes that significant new growth in loan portfolios, new loan products, and the refinancing of existing loans can result in portfolios comprised of unseasoned loans that may not perform as historical or projected trends suggest, increasing the risk that our ACL may be insufficient to absorb credit losses without significant additional provisions. If our assumptions are incorrect, our ACL on loans may not be sufficient to cover actual losses, resulting in additional provisions for credit losses on loans to replenish the ACL. Deterioration in economic conditions, new information regarding existing loans, identification of additional problem loans or relationships, and other factors, both within and outside of our control, may increase our loan charge-offs and/or otherwise require an increase in our provision for credit losses on loans.  In addition, bank regulatory agencies periodically review our ACL on loans.  Based on their assessment, they may require additional provisions for credit losses or loan charge-offs. Any increase in the provision for credit losses on loans affects net income and could materially impact our financial condition, results of operations, and capital.

At December 31, 2024, we had approved residential warehouse lending lines to three companies in varying amounts from $3.0 million to $9.0 million, for an aggregate amount of $19.5 million. At December 31, 2024, there was $2.2 million outstanding under these residential warehouse lines, compared to $573,000 outstanding at December 31, 2023. This program provides short-term funding to these companies to facilitate the origination of residential mortgage loans for sale in the secondary market.  Our warehouse lending lines are secured by the underlying notes associated with mortgage loans originated by the mortgage banking companies.  In addition, we generally require guarantees from the principal shareholder(s) of each mortgage banking company.  These loans are repaid when the mortgage notes are sold into the secondary market, with the sales proceeds used to pay down the outstanding balance before being disbursed to the mortgage banking company. There are numerous risks associated with residential mortgage warehouse lending, including, but not limited to: (i) potential default by the mortgage bankers who borrow from us; (ii) intentional misrepresentation or fraud by the mortgage banking companies; (iii) changes in the market value of mortgage loans during the warehouse-period, primarily due to interest rate fluctuations, which may affect salability; (iv) unsalable or impaired mortgage loans could lead to decreased collateral value and the failure of a purchaser of the mortgage loan to purchase the loan from the mortgage banker, and (v) the volatility of mortgage loan originations. The underlying collateral risks associated with our residential mortgage warehouse lines are similar to the risks related to our one-to-four-family residential mortgage loans. See also, "Revenue from mortgage banking operations is sensitive to changes in economic conditions, decreased economic activity, a slowdown in the housing market, higher interest rates or new legislation and may adversely impact our financial condition and results of operations."

Our lending activities include extending real estate construction loans to individuals and builders, primarily for residential property development.  As of December 31, 2024, our construction and development loan portfolio totaled $330.7 million, constituting 13.1% of our total gross loan portfolio, excluding $174.1 million in unfunded construction loan commitments.  Of this portfolio, $223.3 million was allocated to speculative residential real estate projects, and $42.0 million was allocated to non-speculative residential custom construction. Additionally, we had three commercial note-secured lines of credit totaling $47.5 million in commitments, directed towards residential construction re-lenders with an outstanding balance of $10.7 million at December 31, 2024. The risks associated with the collateral underlying our commercial construction warehouse lines are similar to those associated with our residential construction and development loans. Construction financing involves a higher degree of credit risk compared to longer-term financing for improved, owner-occupied real estate. These risks include: (i) advanced disbursement of funds based on estimated project costs to achieve future value at completion, making repayment dependent on successful completion; (ii) uncertainty in estimating construction costs and the market value of completed projects; (iii) governmental regulations and changes in housing demand, which can significantly impact project valuations; and (iv) builder concentration as loans are often concentrated among a small group of builders, increasing exposure to individual credit risks.  Market downturns in housing or real estate could result in increased delinquencies, defaults, and foreclosures, significantly impairing the value of collateral and limiting recovery through foreclosure sales. Further, many of our construction loans include interest reserves, allowing borrowers to defer payments by capitalizing interest into the loan principal during the construction phase.  As a result, repayment often depends on the project's success, such as the borrower's ability to sell or lease the property or secure permanent financing. If the appraised value of a completed project is overstated, we may have inadequate collateral to cover the loan, resulting in potential losses.  In addition, monitoring construction loans requires extensive oversight, including cost comparisons and on-site inspections, making these loans more difficult and costly to monitor. Increases in market rates of interest can substantially increase borrowing costs for end-purchasers, potentially reducing the ability of homeowners to finance completed homes or overall demand for projects. Properties under construction are often difficult to sell before completion, which complicates the process to resolve problem construction loans. In some cases, we may need to advance additional funds or hire another builder to complete the project, exposing us to market risks and potential financial losses if sale proceeds fail to cover outstanding loan amounts and associated costs. Furthermore, as of December 31, 2024, our outstanding construction and development loans included $180.4 million in speculative one-to-four-family construction loans and $11.9 million in land acquisition and development loans.  Speculative construction loans involve financing projects without a committed buyer, with repayment relying heavily on market demand upon project completion.  Fluctuating market conditions can significantly impact the salability of such properties and, by extension, loan repayment. The absence of a confirmed buyer during the construction phase increases uncertainty and risk.  Land acquisition loans are often associated with properties lacking income-generating capabilities, with repayment depending on the successful development, sale, or lease of the property. Unlike developed properties, undeveloped land tends to be illiquid and may not readily convert to cash. The lack of income and potential challenges in liquidating the collateral increases the risk of these loans, especially in the event of default.  Given these inherent uncertainties, rigorous monitoring, continuous market evaluations, and proactive management of speculative construction and land acquisition loans are essential to mitigate risks and minimize potential adverse impacts on our loan portfolio and financial performance. At December 31, 2024, $5.0 million in real estate construction and development loans were nonperforming. A substantial increase in nonperforming loans in this segment could significantly affect our financial condition and results of operations.

At December 31, 2024, our commercial business loan portfolio included commercial and industrial loans of $287.0 million, or 11.3%, and warehouse lending of $12.9 million, or 0.4%, of our total gross loan portfolio. Commercial business lending involves risks that are different from those associated with residential and commercial real estate lending. Real estate lending is generally considered to be collateral-based lending with loan amounts based on predetermined loan to collateral values and liquidation of the underlying real estate collateral being viewed as the primary source of repayment in the event of borrower default. Our commercial and industrial business loans are primarily made based on the cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. The borrowers' cash flow may be unpredictable and collateral securing these loans may fluctuate in value. This collateral may consist of equipment, inventory, accounts receivable, or other business assets. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. Other collateral securing these loans may depreciate over time, may be difficult to appraise, may be illiquid, and may fluctuate in value based on the specific type of business and equipment. As a result, the availability of funds for the repayment of commercial and industrial business loans may be substantially dependent on the success of the business itself, which, in turn, is often dependent in part upon general economic conditions and secondarily on the underlying collateral provided by the borrower. For additional information see, "Our residential mortgage warehouse lending and construction warehouse lending programs are subject to various risks that could adversely impact our results of operations and financial condition."

We employ hedging techniques to mitigate the adverse impacts of rising interest rates on our loans held for sale and interest rate locks provided to customers. Our hedging strategies adapt to varying interest rate levels and market dynamics, utilizing tools such as forward contracts, put and call options on securities, and other mortgage-backed derivatives. However, hedging strategies are not perfect and may not fully shield us from potential losses.  The effectiveness of interest rate hedging could be compromised due to several factors, including but not limited to the following: - Hedging strategies might not entirely align with the specific interest rate risks they aim to mitigate. - The duration of the hedge may not match the underlying liability's duration, impacting its effectiveness. - Risks arise from potential defaults or credit downgrades of counterparties involved in hedging transactions, impacting our ability to execute or assign our side of the hedge. - Changes in fair value adjustments mandated by accounting standards can affect the value of derivatives used for hedging, leading to mark-to-market losses. - Mark-to-market losses could reduce our stockholders' equity. We may enter into derivative financial instruments such as interest rate swaps in order to mitigate our interest rate risks.  These instruments expose us to several risks: - Potential loss due to variations in the spread between the interest rate contract and the hedged item. - Risks related to the counterparty's inability to fulfill obligations. - Exposure to fluctuations and uncertainties in underlying asset prices due to interest rates and market volatility. - Liquidity risk associated with the ease of buying or selling these instruments. Losses on interest rate hedging derivatives could adversely affect our business, financial condition and prospects, leading to decreased net income. We designate interest rate swaps as effective cash flow hedges under Accounting Standards Codification ("ASC") 815, "Derivatives and Hedging." Regular evaluations measure hedge effectiveness, and any ineffectiveness may result from factors such as debt early retirement or counterparty creditworthiness.  Ineffective hedges could materially impact our operations and cash flows, causing volatility in our financial results. Additionally, changes in accounting standards related to these derivatives, particularly ASC 815, could significantly increase earnings volatility.

Our securities portfolio may be impacted by fluctuations in market value, potentially reducing accumulated other comprehensive income and/or earnings. These fluctuations may result from changes in market interest rates, rating agency actions, issuer defaults, issues with underlying securities, lower market prices, or limited investor demand. Our available-for-sale debt securities in an unrealized loss position are evaluated to determine whether the decline in fair value has resulted from credit losses or other factors. If a credit loss is identified, an allowance for credit losses is recorded, resulting in a charge against earnings. Because available-for-sale securities are reported at estimated fair value, changes in interest rates can adversely affect our financial condition.  The fair value of fixed-rate securities generally moves inversely with interest rate changes. Unrealized gains and losses on these securities are reported as a separate component of AOCI, net of tax. Decreases in the fair value of securities available-for-sale resulting from increases in interest rates could have an adverse effect on shareholders' equity.  Additionally, there is no assurance that the declines in market value will not result in credit losses, which would lead to additional provisions for credit losses that could materially affect our net income and capital levels.

We are required by federal regulatory authorities to maintain adequate levels of capital to support our operations.  At some point, we may need to raise additional capital or issue additional debt to support our growth or replenish future losses. Our ability to raise additional capital or issue additional debt depends on conditions in the capital markets, economic conditions, and a number of other factors, including investor perceptions regarding the banking industry, market conditions, and governmental activities, and on our financial condition and performance. Such borrowings or additional capital, if sought, may not be available to us or, if available, may not be on favorable terms. Accordingly, we cannot make assurances that we will be able to raise additional capital or issue additional debt if needed on terms that are acceptable to us, or at all. If we cannot raise additional capital or issue additional debt when needed, our ability to further expand our operations could be materially impaired and our financial condition and liquidity could be materially and adversely affected. In addition, any additional capital we obtain may dilute the interests of existing holders of our common stock. Further, if we are unable to raise additional capital when required by our bank regulators, we may be subject to adverse regulatory action.