Security Federal (SFDL) Risk Factors

A t December 31, 2023 , $33.3 million or 5.3% of our total loans were commercial and agricultural business loans. These loans carry distinct risks compared to residential and commercial real estate loans. Unlike real estate lending, which relies on predetermined loan-to-collateral values and views liquidation of the underlying real estate as the primary source of repayment in case of default, our commercial and agricultural business loans are primarily predicated on the borrower's cash flow and secondarily on provided collateral. The borrower's cash flow, often unpredictable, serves as the primary repayment source, supported by collateral such as equipment, inventory, or accounts receivable. However, relying solely on collateral in the event of default may be insufficient due to uncollectible receivables, obsolete inventory, or other factors.

We originate construction loans on single-family residences, multi-family dwellings and projects, and commercial real estate, as well as loans for the acquisition and development and construction of residential subdivisions and commercial projects.  At December 31, 2023, we had $104.5 million of construction loans, representing 16.5% of our total loan portfolio. Construction lending involves inherent risks due to estimating costs in relation to project values. Uncertainties in construction costs, market value, and regulatory impacts make accurately evaluating total project funds and loan-to-value ratios challenging. Factors like shifts in housing demand and unexpected building costs can significantly vary actual results from estimates. Additionally, this type of lending often involves higher principal amounts and might be concentrated among a few builders. A downturn in housing or real estate markets could escalate delinquencies, defaults, foreclosures, and compromise collateral value. Some builders have multiple loans with our institution and also hold residential mortgage loans for rental properties with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss. Moreover, these loans often involve the disbursement of funds with repayment substantially dependent on the success of the ultimate project and the ability of the borrower to sell or lease the property or obtain permanent take-out financing. Thus, repayment depends heavily on project success and the borrower's ability to sell, lease, or secure permanent financing, rather than their ability to repay principal and interest directly.  Misjudging a project's value could leave us with inadequate security and potential losses upon completion. Actively monitoring construction loans, involving cost comparisons and on-site inspections, adds complexity and cost. Market interest rate hikes also might significantly impact construction loans, affecting end-purchaser borrowing costs, potentially reducing demand or the homeowner's ability to finance the completed home. Further, properties under construction are hard to sell and often need completion for successful sales, complicating problem loan resolution. This might require additional funds or engaging another builder, incurring additional costs and market risks. Moreover, speculative construction loans pose additional risks, especially regarding finding end-purchasers for finished projects. Construction loans made by us include those with a sales contract or permanent loan in place for the finished homes and those for which purchasers for the finished homes may not be identified either during or following the construction period, known as speculative construction loans. Speculative construction loans pose additional risks, especially regarding finding end-purchasers for finished projects. Land loans also pose additional risk because of the lack of income being produced by the property and the potential illiquid nature of the collateral. These risks can also be significantly impacted by supply and demand conditions. Construction, acquisition and development ("A&D") loans carry additional risk due to the lack of income being produced by the property and the potential illiquid nature of the collateral. These risks are particularly sensitive to supply and demand dynamics, significantly impacting this lending type. Consequently, such loans often entail substantial fund disbursements, where repayment depends on the project's success and the borrower's capability to develop, sell, or lease the property. This reliance differs from the borrower's or guarantor's independent ability to repay principal and interest. At December 31, 2023, there were no non-performing A&D loans; however, a material increase in non-performing construction and development loans could significantly impact our financial condition and results of operations.

While commercial real estate lending offers the potential for higher returns compare d to single-family residential lending, it is more susceptible to fluctuations in regional and local economic conditions, presenting challenges in predicting potential losses accurately. Evaluating collateral and conducting financial statement analysis for these loans necessitates a more intricate approach during underwriting and continual assessment. At December 31, 2023 , we had $264.8 million of commercial real estate loans, representing 41.7% of our total loan portfolio. Commercial real estate loans typically involve larger principal amounts than other types of lending, and some borrowers hold multiple loans with us. Consequently, adverse developments in a single loan or credit relationship can significantly increase our risk exposure compared to single-family residential loans. Repayment of these loans is dependent on income generated or anticipated from the property securing the loan in amounts sufficient to cover operating expenses and debt service. Economic fluctuations or local market changes can impact this cash flow. For instance, failure to secure or renew leases can impair the borrower's ability to repay the loan. Commercial real estate loans also pose a greater credit risk than one-to-four family residential real estate loans, primarily because the collateral is less liquid. Further, many of these loans include large balloon payments upon maturity, increasing the risk of default as borrowers may need to sell or refinance the property to pay off the loan at maturity. Unlike residential loans, a secondary market for most types of commercial real estate loans is not readily available, limiting our ability to mitigate credit risk by selling our interest. Foreclosing on these loans often entails longer holding periods due to fewer potential purchasers for the collateral. Consequently, charge-offs on commercial real estate loans may be comparatively higher on a per-loan basis than those in our residential or consumer loan portfolios.

We are required by federal regulatory authorities to maintain adequate levels of capital to support our operations. We anticipate that our capital resources will satisfy our capital requirements for the foreseeable future. Nonetheless, we may at some point need to raise additional capital to support continued growth or be required by our regulators to increase our capital resources. Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside our control, and on our financial condition and performance. Accordingly, we may not be able to raise additional capital, if needed, on terms that are acceptable to us. If we cannot raise additional capital when needed, our operations could be materially impaired and our financial condition and liquidity could be materially and adversely affected. In addition, if we are unable to raise additional capital when required by our banking regulators, we may be subject to additional adverse regulatory action.

Our mortgage banking operations provide a meaningful portion of our non-interest income. We generate mortgage revenues primarily from gains on the sale of single-family mortgage loans underwritten pursuant to programs currently offered by Freddie Mac and Fannie Mae. These entities account for a substantial portion of the secondary market in residential mortgage loans. Future changes in their programs, including our eligibility to participate in such programs, the criteria for loans to be accepted, or laws that significantly affect the activity of such entities, could materially adversely affect the success of our mortgage banking operations and, consequently, our results of operations. Changes in economic conditions significantly impact mortgage loan production levels. A slowdown in the housing market, decreased economic activity, or higher interest rates can particularly affect this aspect of our operations. Sustained periods of economic downturn or elevated interest rates have the potential to adversely impact mortgage originations, subsequently affecting income derived from our mortgage lending activities. Our results of operations are also significantly impacted by non-interest expenses related to mortgage banking activities, encompassing salaries, employee benefits, occupancy, equipment, data processing, and other operating costs. Failure to generate an adequate volume of loans for sale may adversely affect our results of operations. In addition, during periods of reduced loan demand, our results of operations may be adversely affected to the extent that we are unable to reduce expenses commensurate with the decline in loan originations. Moreover, deteriorating economic conditions may increase the potential for homebuyers to default on their mortgages. In instances where we have originated loans sold to investors, we may be required to repurchase such loans or provide a financial settlement to investors. Such situations arise if it is proven that borrowers furnished incomplete or inaccurate information on their loan applications, if appraisals are deemed unacceptable, or if loans were not underwritten as per the specified loan program outlined by the investor. If repurchase and indemnity demands increase on loans that we sell from our portfolios, our liquidity, results of operations and financial condition could be adversely affected.

Our earnings and cash flows are largely dependent upon our net interest income. Interest rates are sensitive to many factors that are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies, and particularly, the Federal Reserve. Since March 2022, in response to inflation, the Federal Open Market Committee ("FOMC") of the Federal Reserve has increased the target range for the federal funds rate by 525 basis points, including 225 basis points during 2023, to a range of 5.25% to 5.50% as of December 31, 2023. The FOMC has paused increases to the target federal funds rate but has not ruled out future increases. If the FOMC further increases the targeted federal funds rates, overall interest rates will likely rise, which will negatively impact our net interest income and may negatively impact both the housing market by reducing refinancing activity and new home purchases and the U.S. economy. We principally manage interest rate risk by managing our volume and mix of our earning assets and funding liabilities. In a changing interest rate environment, we may not be able to manage this risk effectively. If we are unable to manage interest rate risk effectively, our business, financial condition and results of operations could be materially affected. Changes in interest rates could also have a negative impact on our results of operations by reducing the ability of borrowers to repay their current loan obligations or by reducing our margins and profitability. Our net interest margin is the difference between the yield we earn on our assets and the interest rate we pay for deposits and our other sources of funding. Changes in interest rates-up or down-could adversely affect our net interest margin and, as a result, our net interest income. Although the yield we earn on our assets and our funding costs tend to move in the same direction in response to changes in interest rates, one can rise or fall faster than the other, causing our net interest margin to expand or contract. Our liabilities tend to be shorter in duration than our assets, so they may adjust faster in response to changes in interest rates. As a result, when interest rates rise, our funding costs may rise faster than the yield we earn on our assets, causing our net interest margin to contract until the yields on interest-earning assets catch up. Changes in the slope of the "yield curve", or the spread between short-term and long-term interest rates-could also reduce our net interest margin. Normally, the yield curve is upward sloping, meaning short-term rates are lower than long-term rates. Because our liabilities tend to be shorter in duration than our assets, when the yield curve flattens or even inverts, we could experience pressure on our net interest margin as our cost of funds increases relative to the yield we can earn on our assets. Also, interest rate decreases can lead to increased prepayments of loans and mortgage-backed securities as borrowers refinance their loans to reduce borrowing costs. Under these circumstances, we are subject to reinvestment risk as we may have to redeploy such repayment proceeds into lower yielding investments, which would likely hurt our income. A sustained increase in market interest rates could adversely affect our earnings. As is the case with many financial institutions, we attempt to increase our proportion of deposits comprising either no or relatively low-interest-bearing accounts, which has been challenging over the last couple years. We would incur a higher cost of funds to retain these deposits in a rising interest rate environment. Our net interest income could be adversely affected if the rates we pay on deposits and borrowings increase more rapidly than the rates we earn on loans and other investments. Changes in interest rates also affect the value of our investment securities portfolio. Generally, the fair value of fixed-rate securities fluctuates inversely with changes in interest rates. Unrealized gains and losses on securities available for sale are reported as a separate component of equity, 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 stockholders' equity. At December 31, 2023, we had an accumulated other comprehensive loss of $35.0 million, which is reflected as a reduction to shareholders' equity. Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on our results of operations, any substantial, unexpected or prolonged change in market interest rates could have a material adverse effect on our financial condition and results of operations. Also, our interest rate risk modeling techniques and assumptions likely may not fully predict or capture the impact of actual interest rate changes on our balance sheet. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management and Market Risk" included in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" of this 2023 Form 10-K.

We obtain updated valuations in the form of appraisals and broker price opinions when a loan has been foreclosed upon and the property taken in as OREO, and at certain other times during the assets holding period. Our net book value in the loan at the time of foreclosure and thereafter is compared to the updated market value of the foreclosed property less estimated selling costs (fair value). A charge-off is recorded for any excess in the asset's net book value over its fair value. If our valuation process is incorrect, or if the property declines in value after foreclosure, the fair value of our investments in OREO may not be sufficient to recover our net book value in such assets, resulting in the need for additional charge-offs. Additional material charge-offs to our investments in OREO could have a material adverse effect on our financial condition and results of operations. In addition, bank regulators periodically review our OREO and may require us to recognize further charge-offs. Significant charge-offs, as required by such regulators, may have a material adverse effect on our financial condition and results of operations.