KBRA Downgrades Ratings for First Northwest Bancorp; Outlook Stable

KBRA downgrades the senior unsecured debt rating to BBB- from BBB, downgrades the subordinated debt rating to BB+ from BBB-, and affirms the short-term debt rating of K3 for Port Angeles, Washington-based First Northwest Bancorp. (NASDAQ: FNWB) (“the company”) ("First Northwest"). In addition, KBRA downgrades the deposit and senior unsecured debt ratings to BBB from BBB+, the subordinated debt rating to BBB- from BBB, and the short-term debt and deposit ratings to K3 from K2 for its subsidiary, First Fed Bank ("the bank"). The Outlook for all long-term ratings is Stable.

Key Credit Considerations

The rating downgrade is predicated on FNWB’s weakened earnings profile which has been adversely impacted by funding pressures derived from increased levels of wholesale borrowings and time deposits, accounting for ~50% of total liabilities and resulting in a 66% core deposit to total funding ratio as of 4Q23, much weaker than historic norms. Furthermore, FNWB’s constrained NIM declined by nearly 110 bps from its peak of 3.96% during 4Q22 compared to 2.86% during 4Q23. Given the competitive deposit market dynamics, the total cost of deposits increased (+27 bps) to 2.13% during 4Q23, further pressuring earnings, though directionally consistent with the industry. KBRA expects additional upward repricing within the deposit base over the shorter term given the higher level of time deposits within the funding base and its 99% loan-to-deposit ratio at 4Q23. The company sold nearly $45 million in AFS securities during 4Q23 (~2% of average assets) at a $5.4 million loss in order to provide some relief to the liability sensitive balance sheet over the longer term. In addition, FNWB completed the resolution of its Quin Ventures in 4Q23 at a cost of $1.7 million. The company also announced the sale and leaseback of branches in Jefferson and Clallam County, Washington, which is expected to generate $7.5 million (~25 bps of ROAA) in pre-tax gain expected in 1H24. Absent these nonrecuring items, ROAA would have been approximately 60 bps for 2023, still below many rated peers. To a lesser extent, the downgrade also factors in FNWB's increased levels of nonperforming assets, albeit primarily related to one borrower, which is largely attributable to a $15 million commercial loan that accounts for nearly 70% of classified loan balances as of 4Q23. The company anticipates minimal losses related to the transaction and is believed to be well collateralized. FNWB has not experienced additional material negative credit migration into the special mention/substandard categories outside of the one-time increase in recent periods. We note that First Fed’s risk profile has been trending higher reflected by the growth in its 4 year average RWA density of 75% versus pre-COVID levels of 66%. In addition, the company has also experienced increased NCOs more recently (NCOs of 20 bps in 2023), which can be partially traced to the shift in asset mix to include a higher concentration in commercial real estate lending since demutualizing in 2015 (investor CRE to risk-based capital over 300% at YE23). Positively, the management team has extensive market knowledge within its key geographic footprint, and has further demonstrated success in executing growth through wholesale channels both in asset generation as well as within the funding profile. The company has typically maintained solid regulatory capital, though KBRA expects the company's capital ratios to trend lower given management's expectation of robust growth.

Rating Sensitivities

A rating upgrade is not currently anticipated over the medium term. However, improved profitability metrics defined by stabilized core ROAA highlighted by an improved NIM with a reduced dependence on borrowings and time (retail and brokered) deposits, along with sound credit quality including a resolution of higher NPA levels, and the continued maintenance of capital could result in positive rating momentum over the longer term. Material earnings deterioration through the compression of spread revenues, continued deterioration in asset quality measures resulting in significant credit costs, or aggressive growth that weakens the capital position could pressure ratings.

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