KBRA Affirms Ratings for Heritage Commerce Corp

KBRA affirms the senior unsecured debt rating of BBB+, the subordinated debt rating of BBB, and the short-term debt rating of K2 for San Jose, California-based Heritage Commerce Corp (NASDAQ: HTBK) ("Heritage" or "the company"). In addition, KBRA affirms the deposit and senior unsecured debt ratings of A-, the subordinated debt rating of BBB+, and the short-term deposit and debt ratings of K2 for its subsidiary, Heritage Bank of Commerce. The Outlook for all long-term ratings is Stable.

Key Credit Considerations

The ratings are supported by HTBK’s conservative approach to liquidity and capital management, which has been displayed for a long period of time, with a loan-to-core deposit ratio averaging just below 75% and a CET1 ratio that has averaged 13% over the last five years (13.4% as of 1Q24). The discipline within those respective categories has left the company well positioned entering a more uncertain credit and liquidity environment within the banking industry. Despite being situated in Silicon Valley, Heritage’s deposit base has performed admirably since the bank failures in early 2023, with core balances largely flat since 1Q23, which demonstrates the resilience and strength of the relationships in our view. Moreover, the company has been able to capture some quality deposit and lending relationships from the failed institutions in footprint, which puts HTBK in a solid position for future growth. As of 1Q24, Heritage remains entirely core deposit funded when excluding relationship-based jumbo time deposits (4% of deposits) and subordinated debt, with no reliance on higher-cost brokered deposits or borrowings. With that said, we acknowledge that HTBK reflects a higher level of confidence-sensitive deposits, with uninsured deposits representing 45% of total deposits as of 1Q24. This marks a meaningful decline from 65% entering 2023, which has been reduced from the utilization of the reciprocal network. While this measure remains above peers, it is offset by ample liquidity sources, notably a higher level of cash on-balance sheet ($541 million or 10% of assets). Despite reflecting an asset sensitive balance sheet, which provided benefits at the start of the Fed’s rate hiking regime (NIM grew 111 bps during 2022 and peaked at 4.12% in 4Q22), the company has experienced considerable NIM headwinds throughout 2023/ 2024 due to the acceleration of deposit costs, in part, due to the continued mix shift (NIB down to 28% of total compared to 43% pre-pandemic) as the higher for longer rate environment has persisted. However, HTBK’s deposit beta remains among the lowest in the rating group (total cost of 1.56% during 1Q24). Moving forward, NIM is expected to stabilize around current levels (3.34% for 1Q24) with the potential for expansion later in the year as securities mature and loan growth opportunities arise. Given the reliance on spread revenues (fee income of ~5% of revenues in recent periods) the maintenance of healthy NIM is paramount. Altogether, earnings remain adequate in the context of the rating group, especially on a risk-adjusted basis when factoring in the company's lower risk balance sheet. Credit quality in recent years has been pristine, which we believe is partially attributable to management’s prudent underwriting and robust monitoring, which is illustrated in the investor CRE portfolio, that is slightly above average (nearly 300% of total risk-based capital), with an average LTV and DSCR of 41% and 2.0x, respectively. Heritage's exposure to the investor office sector is higher than peers at 9% of total loans, though the portfolio is granular, largely operated in suburban markets, and also reflects conservative underwriting criteria. Nonetheless, HTBK has consistently held loan loss reserves in excess of peers (1.44% of loans as of 1Q24). In addition to robust reserves, loss absorbing capacity continues to be bolstered by the company's strong core capitalization and sound earnings capacity.

Rating Sensitivities

An upgrade is not expected, though increased scale/market share in the current footprint, combined with a higher level of revenue diversity, while maintaining a conservative stance with capital and liquidity management could facilitate positive rating momentum over time. Conversely, a downgrade is unlikely, though any material deterioration among key financial ratios, specifically credit or liquidity issues, or more aggressive capital management, could potentially pressure the ratings.

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Methodologies

■ Financial Institutions: Bank & Bank Holding Company Global Rating Methodology

■ ESG Global Rating Methodology

Disclosures

A description of all substantially material sources that were used to prepare the credit rating and information on the methodology(ies) (inclusive of any material models and sensitivity analyses of the relevant key rating assumptions, as applicable) used in determining the credit rating is available in the Information Disclosure Form(s) located here.

Information on the meaning of each rating category can be located here.

Further disclosures relating to this rating action are available in the Information Disclosure Form(s) referenced above. Additional information regarding KBRA policies, methodologies, rating scales and disclosures are available at www.kbra.com.

About KBRA

Kroll Bond Rating Agency, LLC (KBRA) is a full-service credit rating agency registered with the U.S. Securities and Exchange Commission as an NRSRO. Kroll Bond Rating Agency Europe Limited is registered as a CRA with the European Securities and Markets Authority. Kroll Bond Rating Agency UK Limited is registered as a CRA with the UK Financial Conduct Authority. In addition, KBRA is designated as a designated rating organization by the Ontario Securities Commission for issuers of asset-backed securities to file a short form prospectus or shelf prospectus. KBRA is also recognized by the National Association of Insurance Commissioners as a Credit Rating Provider.

1 Doc ID: 1004249

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