Old Second Bancorp Inc
NASDAQ:OSBC
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Old Second Bancorp Inc
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Good morning, everyone, and thank you for joining us today for Old Second Bancorp, Inc.’s Second Quarter 2023 Earnings Call.
On the call today is Jim Eccher, the Company’s Chairman, President and CEO; Brad Adams, the Company’s CFO; and Gary Collins, the Vice Chairman of our Board.
I will start with a reminder that Old Second’s comments today will contain forward-looking statements about the Company’s business, strategies and prospects, which are based on management’s existing expectations in the current economic environment. These statements are not a guarantee of future performance, and results may differ materially from those projected.
Management would ask you to refer to the Company’s SEC filings for a full discussion of the Company’s risk factors. The Company does not undertake any duty to update such forward-looking statements.
On today’s call, we will also be discussing certain non-GAAP financial measures. These non-GAAP measures are described and reconciled to their GAAP counterparts in our earnings release, which is available on our website at oldsecond.com on the homepage and under the Investor Relations tab.
Now I will turn it over to Mr. Jim Eccher.
Good morning, and thank you for joining us. As customary, I have several prepared opening remarks and will give my overview of the quarter and then turn it over to Brad for additional details. I will then conclude with certain summary comments and thoughts about the future before we open it up for questions.
Net income was $25.6 million or $0.56 per diluted share in the second quarter 2023. Adjusted net income was also $25.6 million, $0.56 per diluted share in the second quarter. This represents our second consecutive quarter of record earnings.
On a same adjusted basis, return on assets was 1.74%. Second quarter 2023 return on average tangible common equity was 25.3% and the tax equivalent efficiency ratio was 46.84%. Second quarter earnings were negatively impacted by a $1.5 million pretax security loss and strategic security sales as well as 362,000 of accelerated senior note issuance cost as we redeemed the $45 million outstanding senior note.
The combined impact of these two items reduced diluted earnings per share by $0.03. Our financial results continue to be favorably impacted by elevated market interest rates with an $18.3 million or 40.5% increase in net interest income in the second quarter compared to the prior like quarter due to manageable funding cost increases along with significant expansion in asset yields across the balance sheet.
The second quarter reflected modest loan growth of $12.2 million over the linked period and $390.5 million or 11% over the same period last year. Loan prepayments accelerated and were stronger in the second quarter compared to the first quarter of 2023, resulting in net origination activity reduction relative to the prior quarter. Activity within loan committee moderated for the majority of the second quarter, although more recently, we have seen activity begin to show signs of significant slowing.
Net interest margin contracted this quarter, largely due to increased funding costs on deposits due to increases in deposit pricing and certain time deposit product specials as well as the accelerated issuance costs associated with the redemption of our senior notes.
Loan yields continued to expand during the quarter, increasing 21 basis points over the linked quarter and 174 basis points year-over-year. The NIM remained strong at 4.64% for the second quarter compared to 4.74% in the -- quarter of 2023. The margin has benefited year-over-year from balance sheet mix improvements, the impact of rising rates on the variable portion of the loan portfolio and continuing loan growth in 2023. The loan-to-deposit ratio is now at 85% compared to 82% last quarter and 68% as of June 30, 2022. As we noted last quarter, our focus now has shifted to balance sheet optimization. And I’ll let Brad talk about that in a moment.
Credit metrics were essentially stable as nonaccrual loans decreased $2.6 million or 4.1% due to upgrades and paydowns on various loans while classified loans ticked up $2.3 million or 1.8% to $127.6 million. Ongoing evaluations of commercial real estate and office have not revealed significant deterioration at this point, and the trends within criticized assets are significantly more favorable this quarter relative to last quarter.
I believe we will have a few recently downgraded credits sufficiently addressed in the third quarter and could see more favorable trends present themselves going forward. Clearly, our focus remains on monitoring potential weakness in commercial real estate and specifically office. We have stressed all maturing credits under renewal rates and believe we don’t see broad-based risk. We have been proactive on refreshing valuations. And as a result, our outlook for credit has not changed.
I think it’s important to remember that half of our commercial real estate exposure is owner-occupied, which we believe is unusual for a bank our size, and our office exposure is only about 5% of the portfolio. We simply don’t have a lot of this year, but we continue to watch it very closely. We recorded net charge-offs of $505,000 in the second quarter compared to $740,000 of net charge-offs in the first quarter.
Other real estate owned reflected a $494,000 decrease in the second quarter to end at 761,000 in total based on three property sales in the quarter, net of one OREO transfer. The allowance for credit losses on loans increased to $55.3 million as of June 30th from $53.4 million at the end of the previous quarter, which is 1.4% of total loans as of June 30, 2023, consistent with the 1.3% total ACL to gross loans as of March 31st.
Unemployment and GDP forecasts used in future loss rate assumptions remained fairly static from last quarter. I think investors should know that we remain confident in the strength of our portfolios and the credits in question are the same ones that we have discussed previously. We continue to watch those closely.
Noninterest income continued to perform well. And excluding losses on security sales discussed earlier, noninterest income increased $745,000 compared to the first quarter, driven by gains on MSR, mark-to-market, adjustments, wealth management income and an increase in credit card related income. Pretax losses of $1.5 million on security sales in the second quarter were incurred related to strategic repositioning within certain security types in our portfolio. Expense discipline continues to be strong, and we believe our efficiency is simply outstanding at this point.
As we look forward, we are continuing on doing more of the same, which is managing liquidity, building commercial loan origination capability for the long term. The goal is obviously to continue to build towards a more stable long-term balance sheet mix featuring more loans and less securities in order to maintain the returns on equity commensurate with our recent performance.
I’ll now turn it over to Brad for more comments.
Thank you, Jim. Net interest income decreased slightly to $63.6 million for the quarter ended relative to the prior quarter of $64.1 million, but increased $18.3 million or 41% from the year ago quarter. Loan yields continued to grow in the second quarter, though at a slower pace than recent periods and securities yields remained relatively flat since last quarter.
Total yield on interest-earning assets increased 20 basis points over the linked quarter to 539 bps, partially mitigated by a 15 basis-point increase in the cost of interest-bearing deposits and a 47 basis-point increase to interest-bearing liabilities in aggregate. The end result was a 10 basis-point decrease in the NIM for the last quarter to 4.64 from 4.74. As noted earlier, we redeemed the outstanding senior debt issuance on June 30th, which resulted in an acceleration of the deferred issuance costs. This had an approximate 3 basis-point negative impact on the margin during the quarter.
Going forward, the senior note redemption net of an assumed 45 basis-point -- or I’m sorry, $45 million dollar for dollar replacement funding costs would add about 3 basis points to the quarter with that being gone. Deposit flows this quarter showed modest leakage on the high end, along with typical seasonal decline that we always see based on tax payments for personal and business customers and commercial customers rolling out new activities in the spring. The nature and character of the declines thus far largely looks and feels like an inverse move of the flows into the Bank, we saw beginning in the latter half of 2020 and continuing through 2021.
Fortunately, we have the liquidity and the balance sheet flexibility to adapt. We’ll continue to remix and optimize rather than chase high beta deposits. We still aren’t lurching at anything, but we have made some fairly significant progress in reducing asset sensitivity over the last year, including reducing variable rate securities from more than a third to just over 20% of the portfolio. There has been some significant earnings and margin give-up associated with doing this, but it’s the right time to return to a more normal duration profile within the portfolio.
With the level of inversion in the curve, we still aren’t in a hurry to place large bets on the path of interest rates. Duration is slowly being added to reduce asset sensitivity in numerous ways. Effective duration on the bond portfolio is now an approximate 3.0 years, up significantly from six months ago. The loan-to-deposit ratio remains low, and our ability to source liquidity from the portfolio has increased relative to the color we gave you last quarter. It seems higher for longer as finally seen its way into the zeitgeist.
I would like to remind you that longer duration portfolios in Old Second’s would have seen relative outperformance to ours given the sharp version from the short end. The mark on the securities portfolio remains high but will be recaptured relatively quickly. The net result is that Old Second should continue to build capital very quickly as evidenced by the 34 basis-point improvement in the TCE ratio over the linked quarter, which combined with the 59 basis points last quarter, that means what we have added 93 basis points of TCE in just six months.
As we sit here today, we have approximately $649 million in undrawn borrowing capacity, an additional $400 million in unpledged securities. In short, liquidity at the Bank remains excellent, and the holding company is in a strong position as well.
We may seek permission to resume stock repurchases this year as well. Margin trends from here are projected to be relatively stable over the remainder of the year with benefits from one more rate hike and continued asset repricing not expected to outpace the increased reliance on overnight borrowings by much.
Provision for credit losses on loans of $2.4 million was recorded during the quarter, and net provision for credit losses was $2 million in the second quarter of 2023 due to a $427,000 reversal of provision on unfunded commitments during the quarter. I would expect loan growth to be roughly consistent with provision growth over the near term, though that could change with significant worsening in the macro environment.
Noninterest expense declined $1.1 million from the previous quarter, driven by lower salaries and employee benefits as well as computer and data processing expenses. I continue to expect quarterly wages and benefits to be between $22 million and $23 million going forward in the near term. Given the revenue performance, employee investment costs have been running high, but we will maintain the ability to dial it back as conditions warrant.
With that, I’d like to turn the call back over to Jim.
Okay. Thanks, Brad.
In closing, we are confident in how we’ve constructed our balance sheet and the opportunities that are ahead for us. We are paying very close attention to credit and expenses. We believe our underwriting has remained disciplined, and our funding position is strong. We have the balance sheet and liquidity flexibility to excel in a higher rate environment. Capital levels should continue to grow and maintain levels above targets, and we will look to be aggressive in adding talent and relationships.
So, that concludes our prepared comments this morning. So, I’ll turn it over to the moderator, and we can open it up to questions.
Thank you. [Operator Instructions] Our first question is coming from Terry McEvoy with Stephens.
Jim, one of your prepared comments you said and as you were talking about the CRE portfolio, there’d be more downgrades in the third quarter, but you expected a favorable outcome. Could you just maybe run through that statement one more time, so I understand exactly what you’re getting at correctly?
Yes. No, just the opposite, Terry, we’re starting to realize some resolutions on some previously downgraded credits and we expect -- and I’ve already seen a few upgrades in this quarter, so -- in the third quarter. So things are trending in the right direction.
Okay. Good. It’s been a long morning already. Maybe, Brad, a question for you, that your interest-bearing deposit costs were really low at just 40 basis points in the second quarter. As you think about the second half of this year and just the competition for deposits, where do you see that trending? And what’s maybe baked into your kind of comments on the margin?
So, I think it will tick up a little bit. I don’t think it will be as big a move as we saw first quarter to second. Most of that -- most of that increase happened in March. We have a big advantage here in that I think most people realize now what -- how granular the deposit base is, it just doesn’t require a lot of movement. I think we will see some uptick. I think that we are exceptionally comfortable at a level under $500 million in borrowing -- overnight borrowing position. If it gets above that, we’ll probably put out more CD pricing.
And consistent with that belief, I just don’t think margin does a whole lot. I would call it plus or minus 5 basis points here. It may be a little bit better in the third with a rate hike or with a little bleeding over into the fourth. But we’re going to continue to sell down the variable portion of that securities portfolio, which is a significant give up. It seems that others have come around to the idea of hire for longer. And so now there is a bid on that, whereas before when we bought it, we were the only ones that wanted it. And as everybody thought, rate cuts were coming this year, nobody wanted to touch it then either. So, our ability to move down that position is markedly better today than it was even a month or two ago, and we’ll continue to do that. So margin upside will probably be given up on just kind of reducing asset sensitivity at this point in the cycle.
And maybe a quick follow-up. What do you need to see or hear to begin repurchasing stock? Brad, you kind of hinted at it, but is it remediation on some of those CRE properties? Is it confidence on funding costs? What are you waiting for or looking at?
No. I mean, we’re building back capital very quickly here. Obviously, I think everybody is aware of how punitive the purchase accounting marks are in an M&A type environment. And it’s just a question of what the best return on marginal capital generation is. There are scenarios whereby M&A can work. There are far more scenarios where it doesn’t. I think people know we’re disciplined on that front and won’t do anything done. But it’s a function of things continuing to look poor in terms of other investment opportunities and the speed at which capital builds. And then also just the overall credit outlook. That feels pretty good. We’ve got a whole heck of a big reserve on office exposures, and we feel pretty good about where we sit.
Thank you. Our next question is coming from Nathan Race with Piper Sandler.
Brad, I was hoping if you could just expand a little bit on your margin outlook for the back half of this year. I think you spoke to kind of a relatively stable outlook from the 2Q level. And in your prepared remarks, you mentioned the ongoing reliance of the short-term borrowings that are added in the quarter. So, is it fair to assume those remain on balance sheet or I guess, is it more dependent on just how deposit flows trend in the back half of the year, how you guys perhaps map [ph] securities book?
So, the overnight borrowing position is more consistent with the average balance sheet than it is with the period end. I think we mentioned we paid off that senior debt issuance on June 30th, and we had a whole hack of a lot of money moving around that day. So, we borrowed a bit more than we typically would just to make sure the liquidity was there, but that was a one-day thing. We are closer to $400 million than we are to $500 million for the majority of this month so far. So, that feels fine. I think -- some of it is just strategic at this point. Obviously, another rate hike would benefit us. There is no doubt about that. The question is, is the speed at which we would continue to reduce the variable portion of the portfolio.
And that obviously mitigates some of the overnight borrowing levels if we continue to do that because the loan growth -- the loan demand out there is waning significantly these days. That happens, I guess, when cost of funds are above 8%. So, I think that embedded in that kind of margin outlook is that we’ll continue to bring down asset sensitivity, Nate.
Understood. Makes sense. Maybe a question. When you were speaking to earlier just expecting some resolutions or having some resolutions here in the third quarter, are those specifically tied to some of the CRE loans that were moved to classified last quarter?
Yes, they are. We’re seeing sponsors for these credits step up to either inject more capital or providing payment reserves. We’re pleasantly optimistic that we’re going to be able to resolve a couple of our larger ones. This quarter there could be another property sold. So we feel we’ve got our arms around this. And to Brad’s point earlier, we continue to increase our reserve, particularly in office and feel we have an ample reserve particularly against our Chicago office portfolio.
Okay, great. And Brad, I appreciate the guidance in terms of salary costs in the back half of this year, but just kind of any ballpark estimate for the overall run rate for 3Q and 4Q relative to what I thought was a really good quarter of cost controls in 2Q.
I think we’ll see kind of the back office expense for computer and data processing kick back up a little bit. We’re going to add about $300,000 a quarter in terms of occupancy expense, which will come on line in September or October. And that reflects kind of stepping into some new space that takes into account the ongoing needs of the new Old Second post West Suburban acquisition, and it coincides with us basically stepping out of every piece of excess real estate that we got in that acquisition over the last six months, really pleased with both the speed that we’ve gotten out of those real estate positions and also the execution on it. It’s been really well done. And this isn’t my back-ended way of complementing myself. The team did a great job.
Just to put a little color on that, maybe we’ve disposed and closed 16 properties since the beginning of 2022. That includes three branches just in this quarter. And so, we’re well ahead of schedule on cost saves, and we expect to have some lift out of that going forward.
Yes. So, inside two years post deal, it’s really starting to look and feel like one bank. And a lot of the kind of the cultural stuff that we’ve been measuring as well is trending solidly in the right direction. So, hats off to the team on what we’ve been able to accomplish, both from a technical conversion standpoint and also a cultural conversion standpoint, it’s been pretty good.
That’s great to hear. So trying to put all those pieces together, probably like $36 million to $37 million is maybe a good run rate with some of those...
Yes, I think so. I think we’ll be a little better than that in the third quarter and then the fourth that feels about right.
Okay, great. I believe that’s all I had. I’ll step back. Thank you.
Thanks, Nate.
Our next question is coming from Chris McGratty with KBW.
Brad, just going back to the margin for a second. Expectations are obviously for a high -- in the next week or so and then steady for the rest of the year. But then ‘24 has anywhere between 3, 4 cuts. Interested in kind of how you see if that scenario played out, what your downside risk to NIM would be given that you’ve been reducing the rate sensitivity? Like, how much NIM is at risk if we get the forward curve?
All right. So, you’re firmly in the gut feel territory here. But, -- so I’m probably being overly conservative if we get that rate hike next week in terms of what margin will do, but I think that’s prudent at this point. In terms of rate cuts next year, let’s say, it’s -- let’s say, soft landing lives as an animal that actually exists in nature and assume that it’s kind of 25 basis-point spread over the year. Let me first say that I don’t envision a scenario where we go back to zero. And in a zero rate scenario, Old Second loses its core advantage, which is the deposit base and basically the crappier funding you have, the better you do in that scenario. But in the absolute zero scenario, we probably run to a 3.50 margin from the 4.70 we’re hanging out at today. In a scenario where there are modest and slow cuts, we would trend towards kind of 4 to 4.25 would be my guess, but it would take a while to get there. It would be slow.
Okay. That is reasonable. Thanks for that. And then you mentioned you have a big reserve on the office. Did you -- have you quantified that, or could you quantify what the actual reserve percentage...?
It’s north of 10%.
On Chicago...
At Chicago office, which is where we see the most stress. We only have one suburban office property that is under duress. And we’ve got a pretty good sized reserve on that as well.
And what’s -- that’s a big number. What’s the dollar of Chicago office?
I have that. I think it’s roughly -- that’s $12 million, 8-storey building. We are seeing -- that’s one I commented on last quarter, Chris. We are encouraged to see some leasing activity finally pick up on that. We’ve also got a good sponsor that’s looking to secure new equity to assist with some of the build-out. So, we’re optimistic that this one is trending in the right direction.
But this is -- Jim, this is the one you identified last quarter. This is your -- the 10% is on this specific credit, right? There’s -- what about the rest of Chicago?
The whole office portfolio.
5% of the portfolio is in office, and we have approaching -- and this is aggregate across both downtown and suburban. We’ve got a 5.5% reserve on the entire portfolio.
On the entire office portfolio, over 10 on Chicago office.
On downtown office.
Our next question is coming from Jeff Rulis with D.A. Davidson.
Just wanted to check in on the -- I think you covered kind of rate pretty well, but the deposit runoff, you alluded to that being pretty front-end loaded. I guess, how has that trended, I guess, later in the quarter and into the third quarter and expectations for balances really, not so much rate, but the funding balances on the deposit side.
So, deposits have been more than stable for the better part of 1.5-month. So, half of the second quarter, the latter after the second quarter was entirely stable. The thing that I’d like people to leave with in terms of the character of this is that back when deposits were running in, in second half of 2020 through 2021, I wasn’t able to tell anybody what was happening. It was just kind of coming in over the top across a very granular base.
And the same thing is happening on the outflow. It’s just coming off the top of a very granular base and it’s just a couple of hundred dollars here and there on every account. It’s not any big trend. It’s just kind of leakage and it kind of mirrors both the run-up. And then it also is the mirror image or reverse image of what’s happening in consumer debt overall. So, it just feels like a liquidity burn. But nothing’s really changed in terms of what we’re doing. And we’re fortunate enough that we just have very few depositors that have more than 5 million in the bank. So, we’re just kind of a different duck in that regard.
Got you. And then, if I could, do you have either specific numbers or just the general trend, looking for the monthly margin as you progress through the quarter? Obviously, you had some sort of puts and takes.
Our margin is not doing much, Jeff. That’s what I’m trying to communicate is, is that first quarter given day count is kind of peak margin if nothing else changes on a balance sheet. The delta absent the debt payoff impact in the first quarter was purely unforecastable. I would have said flat. And in all realistic measures of anything, it is entirely stable. If we hadn’t sold the securities, we would have reported an up margin on the quarter.
Got it. Okay. Pretty straightforward. I’ll step back. Thanks.
Thank you. Our next question is coming from David Long with Raymond James.
Just wanted to get a little more color on your appetite to hire and acquire more talent. You’ve got declining loan demand, but obviously some disruption in the market. So, how do you balance the opportunities in the market with -- from a business perspective with the opportunities to bring on talent?
Yes, David, good question. I mean, we tend to try to take the long view. If we find an end market team, we’re going to make that investment because we are obviously making it for the long haul. But you’re right. I mean, loan demand today is certainly pretty tepid. We are seeing some demand in a couple of verticals. But we expect the balance of this year to be pretty muted as far as funding a lot of new business. But we will continue to actively look for new talent.
And when you’re looking for talent, what are the qualities specifically you’re looking for? Do you prefer bankers with a large bank passed or community bank pass, what is the best situation for you guys in that regard?
Yes. So, where we’re seeing significant growth is still from our Chicago market. And so, just by way of metrics, you’re talking about lenders from probably larger banks that are looking for a bank that has the technology and the ability to get deals done. And quite frankly, we’re looking for a different experience than a larger bank. So, that’s typically where we’ve seen the opportunities to hire.
Got it. And is -- are your expectations on hiring? Is that built into your discussions on expense outlook, Brad?
It is, yes.
Our next question is coming from Brian Martin with Janney Montgomery.
Just one question on the clarification on that office, either Jim or Brad. Just the total office exposure in dollars is how much and just the split between Chicago and other, just to make sure I’m clear on what that was?
Yes. We’ve got about $60 million in office exposure in Chicago. So obviously, not very much. Our total office exposure is about $250 million. And of that $60 million, we’ve got about 10% of it reserved in Chicago.
Got you. Okay. All right. So, the other piece is the suburbs. Okay. And then, Brad, your comments about the margin, as far as in terms of additional security sales, I guess, can you give any color on how much you expect further to do on that or just timing or just kind of your outlook there?
Kind of feels like what we’ve done for the last two or three quarters. It’s been slow and steady. I was completely flummoxed and mystified by the whole -- by the shape of the consensus market curve on Fed funds last quarter, and I thought everybody was nuts. And now, I think people are getting a bit carried away on the higher for longer thing. I’d like to believe that rate step down gradually, but I’ve yet to see that animal in real life. So, we’ll see. Our goal is to just return the securities portfolio to what it’s supposed to be, which is kind of more like a 10% variable securities type position before the rug pull. I don’t pretend to know when that is. But typically, a securities portfolio for us is the warehouse for duration, and we’ll get back there, hopefully before the rug pull, but hopefully not too much before the rug pull. So we’ll see.
Okay. And what percent is variable today on that, Brad?
Over -- just over 20%. It peaked out around 35% when nobody thought inflation was a real thing. We were buying the stuff hand over fist.
Yes. Got you. Okay. And then just on your comments on the loan growth being a little bit softer. Jim, you said there were some verticals that were doing better. Maybe just a little comment on that. And then, just what was kind of the payoffs versus production in the quarter? Kind of how did that shake out?
Yes. So we had $12 million in growth, Brian, in the quarter. Payoffs and paydowns were 2x what they were in the first quarter. I think we had over $120 million of paydowns and payoffs. But from here on out, we’re just not expecting a lot of loan demand, as Brad mentioned, with cost of capital over 8 and probably going higher here next week, we’re certainly seeing a lot of our commercial clients just pull back. We’re still seeing pretty good deal activity in sponsored finance and our leasing verticals, but everything else is really slowing down.
Okay. And do you expect the payoffs to slow? I guess -- I hear your comments about production. But just as far as the payoffs, if they were 2x...
Payoffs are hard to predict, Brian. I mean, normally in a rising rate environment, you would expect lower payoffs, right? But we had accelerated payoffs last quarter due to several large property sales. I would expect third quarter paydowns to moderate off second quarter levels.
Got you. Okay. And as far as the potential improvement, I mean, do you expect the improvement in the nonperforming to be material over the next couple of quarters? I don’t know. Certainly, the timing, it sounds like there’s some already occurring...
We wouldn’t mention it if we didn’t. Yes. I think if people consider the move-up last quarter material, it won’t be that fast. I think it will matter to people, yes.
Yes. Okay. And that’s -- okay, second half of the year. And Brad, your comment, Brad, just on the margin, just your comments include that securities reducing the sensitivity incorporates in also the senior debt payoff too, which would give you a benefit. I think you said it was 3 basis points.
Yes. And that 3 basis-point improvement obviously assumes that it’s -- the $45 million is replaced dollar for dollar at Fed fund’s overnight rate. So to the extent that we’re able to do better than that on replacement funding, which I’m hopeful we are, it could be even more substantial than that.
Yes. Okay. But your flat guidance includes that benefit with some give-up on the other stuff. So, okay.
Yes.
Thank you. We have reached the end of our question-and-answer session. So I will now turn back over to Mr. Eccher for any closing remarks.
Okay. Thank you everyone for joining us this morning, and we look forward to speaking with you again next quarter. Goodbye.
Thank you. This concludes today’s conference, and you may disconnect your lines at this time, and we thank you for your participation.