I
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
☒
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2019
OR
☐
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For transition period from to
Commission File Number 0-10537
(Exact name of Registrant as specified in its charter)
Delaware
36-3143493
(State or other jurisdiction
(I.R.S. Employer Identification Number)
of incorporation or organization)
37 South River Street, Aurora, Illinois 60507
(Address of principal executive offices) (Zip Code)
(630) 892-0202
(Registrant’s telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of ‘‘large accelerated filer,’’ ‘‘accelerated filer,’’ ‘‘smaller reporting company,’’ and ‘‘emerging growth company’’ in Rule 12b–2 of the Exchange Act.
Large accelerated filer☐Accelerated filer☒
Non-accelerated filer☐Smaller reporting company☐Emerging growth company☐
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).
Yes ☐ No ☒
Title of each class
Trading Symbol(s)
Name of each exchange on which registered
Common Stock
OSBC
The Nasdaq Stock Market
Preferred Securities of Old Second Capital Trust I
OSBCP
As of August 2, 2019, the Registrant has 29,896,529 shares of common stock outstanding at $1.00 par value per share.
OLD SECOND BANCORP, INC.
Form 10-Q Quarterly Report
Table of Contents
Cautionary Note Regarding Forward Looking Statements
PART I
Page Number
Item 1.
Financial Statements
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
Item 4.
Controls and Procedures
PART II
Legal Proceedings
Item 1.A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Mine Safety Disclosure
Item 5.
Other Information
Item 6.
Exhibits
Signatures
2
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
This report and other publicly available documents of the Company contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act, including with respect to management’s expectations regarding future plans, strategies and financial performance, including regulatory developments, industry and economic trends, and other matters. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company's management and on information currently available to management, can be identified by the inclusion of such qualifications as “expects,” “intends,” “believes,” “may,” “will,” “would,” “could,” “should,” “plan,” “anticipate,” “estimate,” “possible,” “likely” or other indications that the particular statements are not historical facts and refer to future periods. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict and may be outside of the Company’s control. Actual events and results may differ materially from those described in such forward-looking statements due to numerous factors, including:
·
negative economic conditions that adversely affect the economy, real estate values, the job market and other factors nationally and in our market area, in each case that may affect our liquidity and the performance of our loan portfolio;
our ability to achieve anticipated results from our acquisition of Greater Chicago Financial Corp. depends on the state of the economic and financial markets going forward. Specifically, we may incur more credit losses than expected, cost savings may be less than expected, anticipated strategic gains may be significantly harder or take longer to achieve than expected or may not be achieved in their entirety, and customer attrition may be greater than expected;
the financial success and viability of the borrowers of our commercial loans;
changes in U.S. monetary policy, the level and volatility of interest rates, the capital markets and other market conditions that may affect, among other things, our liquidity and the value of our assets and liabilities;
competitive pressures from other financial service businesses and from nontraditional financial technology (“FinTech”) companies;
any negative perception of our reputation or financial strength;
ability to raise additional capital on acceptable terms when needed;
ability to use technology to provide products and services that will satisfy customer demands and create efficiencies in operations;
adverse effects on our information technology systems resulting from failures, human error or cyberattacks;
adverse effects of failures by our vendors to provide agreed upon services in the manner and at the cost agreed, particularly our information technology vendors;
the impact of any claims or legal actions, including any effect on our reputation;
losses incurred in connection with repurchases and indemnification payments related to mortgages;
the soundness of other financial institutions and other counter-party risk;
changes in accounting standards, rules and interpretations and the impact on our financial statements;
our ability to receive dividends from our subsidiaries;
a decrease in our regulatory capital ratios;
adverse federal or state tax assessments;
litigation or government enforcement actions;
legislative or regulatory changes, particularly changes in regulation of financial services companies;
increased costs of compliance, heightened regulatory capital requirements and other risks associated with changes in regulation and the current regulatory environment, including the Dodd-Frank Act; and
each of the factors and risks under the heading “Risk Factors” in our 2018 Annual Report on Form 10-K and in subsequent filings we make with the SEC.
Because the Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain, there can be no assurances that future actual results will correspond to any forward-looking statements and you should not rely on any forward-looking statements. Additionally, all statements in this Form 10-Q, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events, except as required by applicable law.
3
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Old Second Bancorp, Inc. and Subsidiaries
Consolidated Balance Sheets
(In thousands, except share data)
(unaudited)
June 30,
December 31,
2019
2018
Assets
Cash and due from banks
$
38,036
38,599
Interest earning deposits with financial institutions
20,181
16,636
Cash and cash equivalents
58,217
55,235
Securities available-for-sale, at fair value
492,080
541,248
Federal Home Loan Bank Chicago ("FHLBC") and Federal Reserve Bank Chicago ("FRBC") stock
10,608
13,433
Loans held-for-sale
5,142
2,984
Loans
1,902,943
1,897,027
Less: allowance for loan and lease losses
19,372
19,006
Net loans
1,883,571
1,878,021
Premises and equipment, net
42,551
42,439
Other real estate owned
5,668
7,175
Mortgage servicing rights, net
5,818
7,357
Goodwill and core deposit intangible
21,561
21,814
Bank-owned life insurance ("BOLI")
62,322
61,544
Deferred tax assets, net
14,277
21,280
Other assets
21,791
23,473
Total assets
2,623,606
2,676,003
Liabilities
Deposits:
Noninterest bearing demand
632,900
618,830
Interest bearing:
Savings, NOW, and money market
1,023,621
1,040,668
Time
421,253
457,175
Total deposits
2,077,774
2,116,673
Securities sold under repurchase agreements
54,166
46,632
Other short-term borrowings
87,125
149,500
Junior subordinated debentures
57,710
57,686
Senior notes
44,208
44,158
Notes payable and other borrowings
11,035
15,379
Other liabilities
34,324
16,894
Total liabilities
2,366,342
2,446,922
Stockholders’ Equity
Common stock
34,825
34,720
Additional paid-in capital
119,762
119,081
Retained earnings
192,612
175,463
Accumulated other comprehensive income (loss)
6,112
(4,079)
Treasury stock
(96,047)
(96,104)
Total stockholders’ equity
257,264
229,081
Total liabilities and stockholders’ equity
June 30, 2019
December 31, 2018
Common
Stock
Par value
1.00
Shares authorized
60,000,000
Shares issued
34,825,340
34,719,517
Shares outstanding
29,896,529
29,763,078
Treasury shares
4,928,811
4,956,439
See accompanying notes to consolidated financial statements.
4
Consolidated Statements of Income
(In thousands, except per share data)
Three Months Ended June 30,
Six Months Ended June 30,
Interest and dividend income
Loans, including fees
24,924
22,512
49,023
41,248
31
35
53
55
Securities:
Taxable
2,223
2,392
4,637
4,562
Tax exempt
2,141
2,114
4,239
4,175
Dividends from FHLBC and FRBC stock
156
111
305
217
Interest bearing deposits with financial institutions
97
225
146
Total interest and dividend income
29,586
27,261
58,482
50,403
Interest expense
Savings, NOW, and money market deposits
759
501
1,530
845
Time deposits
1,641
1,444
3,259
2,619
147
104
296
183
575
276
1,182
605
931
927
1,858
1,854
672
1,344
107
95
223
Total interest expense
4,832
4,019
9,692
7,545
Net interest and dividend income
24,754
23,242
48,790
42,858
Provision for loan and lease losses
450
1,450
900
728
Net interest and dividend income after provision for loan and lease losses
24,304
21,792
47,890
42,130
Noninterest income
Trust income
1,739
1,645
3,225
3,140
Service charges on deposits
1,959
1,769
3,821
3,361
Secondary mortgage fees
203
195
339
357
Mortgage servicing rights mark to market (loss) gain
(1,137)
(105)
(1,956)
200
Mortgage servicing income
491
627
948
1,079
Net gain on sales of mortgage loans
1,163
1,240
1,925
2,157
Securities gains, net
986
312
1,013
347
Increase in cash surrender value of BOLI
320
351
778
599
Death benefit realized on BOLI
-
1,026
Debit card interchange income
1,166
1,132
2,153
2,144
Other income
1,253
1,366
2,379
2,627
Total noninterest income
8,143
8,532
14,625
17,037
Noninterest expense
Salaries and employee benefits
11,587
12,355
23,199
22,562
Occupancy, furniture and equipment
1,652
3,914
3,210
Computer and data processing
1,524
2,741
2,856
4,085
FDIC insurance
116
165
290
321
General bank insurance
236
299
486
550
Amortization of core deposit intangible
121
253
118
Advertising expense
381
492
615
833
Debit card interchange expense
233
301
380
582
Legal fees
243
286
369
445
Other real estate expense, net
248
429
298
602
Other expense
3,512
3,469
6,660
6,332
Total noninterest expense
20,126
22,286
39,320
39,640
Income before income taxes
12,321
8,038
23,195
19,527
Provision for income taxes
3,043
1,777
5,449
3,777
Net income
9,278
6,261
17,746
15,750
Basic earnings per share
0.31
0.21
0.59
0.53
Diluted earnings per share
0.58
0.52
Dividends declared per share
0.01
0.02
5
Consolidated Statements of Comprehensive Income
(In thousands)
Net Income
Unrealized holding gains (losses) on available-for-sale securities arising during the period
8,645
(1,391)
17,837
(10,199)
Related tax (expense) benefit
(2,432)
392
(5,019)
2,876
Holding gains (losses) after tax on available-for-sale securities
6,213
(999)
12,818
(7,323)
Less: Reclassification adjustment for the net gains realized during the period
Net realized gains
Related tax expense
(276)
(88)
(284)
(98)
Net realized gains after tax
710
224
729
249
Other comprehensive income (loss) on available-for-sale securities
5,503
(1,223)
12,089
(7,572)
Changes in fair value of derivatives used for cash flow hedges
(1,569)
515
(2,642)
1,794
Related tax benefit (expense)
442
(145)
744
(507)
Other comprehensive (loss) income on cash flow hedges
(1,127)
370
(1,898)
1,287
Total other comprehensive income (loss)
4,376
(853)
10,191
(6,285)
Total comprehensive income
13,654
5,408
27,937
9,465
Accumulated
Total
Unrealized Gain
Accumulated Other
(Loss) on Securities
(Loss) on Derivative
Comprehensive
Available-for -Sale
Instruments
Income/(Loss)
For the Three Months Ended
Balance, March 31, 2019
2,548
(812)
1,736
Other comprehensive income (loss), net of tax
Balance, June 30, 2019
8,051
(1,939)
Balance, March 31, 2018
(3,629)
(5)
(3,634)
Other comprehensive (loss) income, net of tax
(1,222)
Balance, June 30, 2018
(4,851)
364
(4,487)
For the Six Months Ended
Balance, December 31, 2018
(4,038)
(41)
Balance, December 31, 2017
2,239
(760)
1,479
Reclassification of stranded tax effects
482
(163)
319
6
Consolidated Statements of Cash Flows
(Unaudited)
Cash flows from operating activities
Adjustments to reconcile net income to net cash provided by operating activities:
Net premium / discount from amortization on securities
1,476
1,388
(1,013)
(347)
Originations of loans held-for-sale
(64,762)
(72,820)
Proceeds from sales of loans held-for-sale
64,181
73,187
Net gains on sales of mortgage loans
(1,925)
(2,157)
Change in fair value of mortgage servicing rights
1,956
(200)
Net discount / premium from accretion on loans
(246)
(776)
(778)
(599)
Net gains on sale of other real estate owned
(150)
(104)
Provision for other real estate owned valuation losses
196
366
Depreciation of fixed assets and amortization of leasehold improvements
1,278
1,142
Net (gains) / losses on disposal and transfer of fixed assets
(3)
Change in current income taxes receivable
2,395
197
Provision for deferred tax expense
3,013
3,468
Change in accrued interest receivable and other assets
(2,570)
(1,075)
Accretion of purchase accounting adjustment on time deposits
(38)
Amortization of purchase accounting adjustment on notes payable and other borrowings
54
Amortization of junior subordinated debentures issuance costs
24
23
Amortization of senior notes issuance costs
50
Change in accrued interest payable and other liabilities
16,575
8,195
Stock based compensation
1,241
1,098
Net cash provided by operating activities
39,853
27,632
Cash flows from investing activities
Proceeds from maturities and calls including pay down of securities available-for-sale
27,863
20,136
Proceeds from sales of securities available-for-sale
120,596
92,746
Purchases of securities available-for-sale
(82,930)
(54,550)
Net proceeds from sales of FHLBC stock
2,825
2,624
Net change in loans
(6,195)
(4,418)
Proceeds from claims on BOLI
1,204
Improvements in other real estate owned
(59)
Proceeds from sales of other real estate owned, net of participation purchase
1,452
2,068
Proceeds from disposition of fixed assets
Net purchases of premises and equipment
(1,390)
(710)
Cash paid for acquisition, net of cash and cash equivalents retained
(35,711)
Net cash provided by investing activities
62,224
23,330
Cash flows from financing activities
Net change in deposits
(38,861)
(9,587)
Net change in securities sold under repurchase agreements
7,534
18,497
Net change in other short-term borrowings
(62,375)
(49,298)
Net change in notes payable and other borrowings
(4,398)
Proceeds from exercise of stock options
32
Dividends paid on common stock
(597)
(594)
Purchase of treasury stock
(430)
(505)
Net cash used in financing activities
(99,095)
(41,487)
Net change in cash and cash equivalents
2,982
9,475
Cash and cash equivalents at beginning of period
55,833
Cash and cash equivalents at end of period
65,308
7
Consolidated Statements of Changes in
Additional
Other
Paid-In
Retained
Treasury
Stockholders’
Capital
Earnings
Income (Loss)
Equity
119,126
183,634
(96,066)
243,255
Other comprehensive income, net of tax
Dividends declared and paid, ($0.01 per share)
(300)
Vesting of restricted stock
(32)
668
(13)
34,717
117,379
151,833
(96,294)
204,001
Other comprehensive loss, net of tax
(298)
703
118,082
157,796
209,814
103
(254)
151
Stock option exercised
Stock warrants exercised
(313)
313
34,626
117,742
142,959
(96,456)
200,350
91
(758)
667
(319)
8
Notes to Consolidated Financial Statements
(Dollar amounts in thousands, except per share data, unaudited)
Note 1 – Summary of Significant Accounting Policies
The accounting policies followed in the preparation of the interim consolidated financial statements are consistent with those used in the preparation of the annual financial information. The interim consolidated financial statements reflect all normal and recurring adjustments that are necessary, in the opinion of management, for a fair statement of results for the interim period presented. Results for the period ended June 30, 2019, are not necessarily indicative of the results that may be expected for the year ending December 31, 2019. These interim consolidated financial statements are unaudited and should be read in conjunction with the audited financial statements and notes included in Old Second Bancorp, Inc.’s (the “Company”) annual report on Form 10-K for the year ended December 31, 2018. Unless otherwise indicated, amounts in the tables contained in the notes to the consolidated financial statements are in thousands. Certain items in prior periods have been reclassified to conform to the current presentation.
The Company’s consolidated financial statements are prepared in accordance with United States generally accepted accounting principles (“GAAP”) and follow general practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the consolidated financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the consolidated financial statements.
Significant accounting policies are presented in Note 1 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the consolidated financial statements and how those values are determined.
Recent Accounting Pronouncements
In February 2016, the FASB issued ASU No. 2016-02 “Leases (Topic 842).” This ASU was issued to increase transparency and comparability among organizations by recognizing lease assets and liabilities on the balance sheet and disclosing key information about leasing arrangements. One key revision from prior guidance was to include operating leases within assets and liabilities recorded; another revision was to create a new model to follow for sale-leaseback transactions. The impact of this pronouncement will primarily affect lessees, as virtually all of their assets will be recognized on the balance sheet, by recording a right of use asset and lease liability. This pronouncement is effective for fiscal years beginning after December 15, 2018. In July 2018, the FASB issued ASU No. 2018-11, “Leases (Topic 842): Targeted Improvements” which provided additional guidance on the transition method, including application as a cumulative-effect adjustment to equity and practical expedients to use when accounting for lease components. The Company adopted this standard as of January 1, 2019, and recorded right of use assets of $817,000 with a like lease liability. As of June 30, 2019, the right of use assets and lessee lease liability both totaled $561,000. As no lease incentives, initial direct costs, or prepayments were present with any of these lease arrangements, the present value of the lessee liabilities was equal to the offsetting right of use assets. The Company also recorded leases receivable related to lessor leases of $174,000 as of January 1, 2019 with a like entry to lease liabilities for the lessor position; these tenant leases receivable balances and lessor lease liabilities both totaled approximately $100,000 as of June 30, 2019. There was no impact to equity for the adoption of this standard on a modified retrospective basis.
In June 2016, the FASB issued ASU No. 2016-13 “Measurement of Credit Losses on Financial Instruments (Topic 326).” This ASU was issued to provide financial statement users with more useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date to enhance the decision making process. The new methodology to be used should reflect expected credit losses based on relevant vintage historical information, supported by reasonable forecasts of projected loss given defaults, which will affect the collectability of the reported amounts. This new methodology will also require available-for-sale debt securities to have a credit loss recorded through an allowance rather than write-downs. ASU 2016-13 is effective for financial statements issued for fiscal years beginning after December 15, 2019. The Company is assessing the impact of ASU 2016-13 on its accounting and disclosures, and has determined that a combination of loss rate models utilizing weighted average remaining life, migration and vintage analysis will be used for calculation of future expected losses based on data availability and the characteristics of each loan pool being assessed upon the ASU’s adoption in 2020. The Company has accumulated historical data by loan pools and collateral classifications, and is on track to calculate estimates for the last two quarters in 2019 on a parallel test basis to confirm the model processes and determine financial statement impact prior to adoption in 2020. The Company is also developing internal control processes and disclosure documentation related to adoption of this standard.
9
Subsequent Events
On July 16, 2019, the Company’s Board of Directors declared a cash dividend of $0.01 per share payable on August 5, 2019, to stockholders of record as of July 26, 2019; dividends of $299,000 were paid to stockholders on August 5, 2019.
Note 2 – Acquisitions
On April 20, 2018, the Company acquired Greater Chicago Financial Corp. (“GCFC”) and its wholly-owned subsidiary, ABC Bank, which operated four branches in the Chicago metro area. In addition to the acquisition price of $41.1 million, the Company retired the convertible and nonconvertible debentures held by GCFC upon acquisition, which totaled $6.6 million, including interest due. The purchase and the retirement of the debentures were funded with the Company’s cash on hand, and all GCFC common stock was retired and cancelled simultaneous with the close of the transaction. The Company acquired $227.6 million of loans, net of purchase accounting adjustments, and $248.5 million of deposits, net of purchase accounting adjustments for time deposits. Purchase accounting adjustments recorded include a loan valuation mark of $11.2 million, a core deposit intangible of $3.1 million, a fixed asset valuation adjustment of $1.5 million, and goodwill of $10.2 million. In addition, a deferred tax asset of $3.5 million was recorded as of the date of acquisition based on analysis of the fair value of assets acquired, less liabilities assumed. None of the $10.2 million recorded as goodwill is expected to be deductible for tax purposes. No acquisition related costs were incurred in the first quarter of 2019. Acquisition related costs incurred by the Company for the year ended December 31, 2018, totaled $3.5 million, pre-tax, and included $1.1 million of salaries and employee benefits related expenses, and $1.8 million of data processing, computer and ATM related conversion costs. Acquisition costs incurred for the year ending December 31, 2017, related to the merger with GCFC were $65,000, and were expensed as incurred.
The assets and liabilities associated with the acquisition of GCFC were recorded in the Consolidated Balance Sheets at their estimated fair values as of the acquisition date. In many cases the determination of these fair values required management to make estimates about discount rates, future expected cash flows, market conditions and other future events that are highly subjective in nature and subject to change, as noted below. The following table shows the estimated fair value of the assets acquired and liabilities assumed as of April 20, 2018. These fair value estimates were considered final as of March 31, 2019, and no further refinements to the values listed below are anticipated.
The below table summarizes the assets acquired, less the liabilities assumed, related to the GCFC/ABC Bank acquisition. All amounts are listed at their estimated fair values as of date of acquisition, and have been accounted for under the acquisition method of accounting.
GCFC/ABC Bank Acquisition Summary
As of Date of Acquisition
April 20, 2018
6,669
500
72,091
Federal funds sold
4,300
FHLBC stock
1,549
227,594
Premises and equipment
5,339
401
13,280
3,459
1,767
336,949
10
58,005
Savings, NOW and money market
91,494
98,999
248,498
5,623
10,875
23,367
1,406
289,769
Cash consideration paid
47,180
Total Liabilities Assumed and Cash Consideration Paid for Acquisition
Loans acquired in the GCFC acquisition were initially recorded at fair value with no separate allowance for loan losses. The Company reviewed the loans at acquisition to determine which loans should be considered purchased credit impaired (“PCI loans”), defined as impaired loans as those that were either not accruing interest or exhibited credit risk factors consistent with nonperforming loans at the acquisition date, or purchased non-credit impaired loans (“non-PCI loans”), defined as loans acquired that did not show signs of deteriorated credit quality at acquisition.
The following table represents the acquired loans as of date of acquisition and as of June 30, 2019:
ABC Bank Acquired Loans
PCI
Non-PCI
Fair Value
11,360
216,234
11,889
164,645
Contractually required principal and interest payments
19,447
220,308
18,393
166,194
Best estimate of contractual cash flows not expected to be collected
6,537
2,511
5,500
Best estimate of contractual cash flows expected to be collected
12,910
217,797
12,893
165,435
Note 3 – Securities
Investment Portfolio Management
Our investment portfolio serves the liquidity needs and income objectives of the Company. While the portfolio serves as an important component of the overall liquidity management at the Bank, portions of the portfolio also serve as income producing assets. The size and composition of the portfolio reflects liquidity needs, loan demand and interest income objectives. Portfolio size and composition will be adjusted from time to time. While a significant portion of the portfolio consists of readily marketable securities to address liquidity, other parts of the portfolio may reflect funds invested pending future loan demand or to maximize interest income without undue interest rate risk.
Investments are comprised of debt securities and non-marketable equity investments. Securities available-for-sale are carried at fair value. Unrealized gains and losses, net of tax, on securities available-for-sale are reported as a separate component of equity. This balance sheet component changes as interest rates and market conditions change. Unrealized gains and losses are not included in the calculation of regulatory capital.
FHLBC and FRBC stock are considered nonmarketable equity investments. FHLBC stock was recorded at $4.4 million at June 30, 2019, and $7.2 million at December 31, 2018. FRBC stock was recorded at $6.2 million at June 30, 2019, and December 31, 2018.
11
The following tables summarize the amortized cost and fair value of the securities portfolio at June 30, 2019, and December 31, 2018, and the corresponding amounts of gross unrealized gains and losses:
Gross
Amortized
Unrealized
Fair
Cost
Gains
Losses
Value
Securities available-for-sale
U.S. Treasuries
4,008
17
4,025
U.S. government agencies
9,954
(142)
9,812
U.S. government agencies mortgage-backed
16,586
462
(49)
16,999
States and political subdivisions
241,176
11,236
(1,117)
251,295
Collateralized mortgage obligations
64,207
866
(206)
64,867
Asset-backed securities
82,119
888
(282)
82,725
Collateralized loan obligations
62,825
(523)
62,357
Total securities available-for-sale
480,875
13,524
(2,319)
U.S. Treasury
4,006
(83)
3,923
11,112
(161)
10,951
14,407
45
(377)
14,075
277,112
1,916
(4,961)
274,067
66,494
79
(2,144)
64,429
108,574
1,165
(225)
109,514
65,162
(897)
64,289
546,867
3,229
(8,848)
The fair value, amortized cost and weighted average yield of debt securities at June 30, 2019, by contractual maturity, were as follows in the table below. Securities not due at a single maturity date are shown separately.
Weighted
Average
Yield
Due in one year or less
2,489
2.50
%
2,493
Due after one year through five years
4,659
1.88
4,679
Due after five years through ten years
4,658
3.29
4,922
Due after ten years
243,332
3.15
253,038
255,138
3.12
265,132
Mortgage-backed and collateralized mortgage obligations
80,793
3.16
81,866
3.06
4.90
3.35
At June 30, 2019, the Company’s investments included $55.7 million of asset-backed securities that are backed by student loans originated under the Federal Family Education Loan program (“FFEL”). Under the FFEL, private lenders made federally guaranteed student loans to parents and students. While the program was modified several times before elimination in 2010, FFEL securities are generally guaranteed by the U.S Department of Education (“DOE”) at not less than 97% of the outstanding principal amount of the loans. The guarantee will reduce to 85% if the DOE receives reimbursement requests in excess of 5% of insured loans; reimbursement will drop to 75% if reimbursement requests exceed 9% of insured loans. In addition to the DOE guarantee, total added credit enhancement in the form of overcollateralization and/or subordination amounted to $4.7 million, or 8.23% of outstanding principal.
12
The Company has invested in securities issued from three originators that individually amount to over 10% of the Company’s stockholders equity. Information regarding these three issuers and the value of the securities issued follows:
Issuer
GCO Education Loan Funding Corp
27,809
27,593
Towd Point Mortgage Trust
33,927
34,472
Student Loan Marketing Association
25,831
26,091
Securities with unrealized losses at June 30, 2019, and December 31, 2018, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows (in thousands except for number of securities):
Less than 12 months
12 months or more
in an unrealized loss position
Number of
Securities
142
49
4,039
1,117
28,016
206
24,995
1
215
67
3,208
282
30,801
90
17,077
433
24,979
523
42,056
44,670
28
2,014
95,049
2,319
139,719
83
100
7,385
61
3,566
161
377
11,439
126
17,713
33
4,835
110,326
37
4,961
128,039
309
15,211
1,835
43,687
58,898
16,473
721
46,547
176
7,824
897
54,371
16
1,256
86,856
7,592
197,238
77
8,848
284,094
Recognition of other-than-temporary impairment was not necessary as of the three months ended June 30, 2019. The changes in fair value related primarily to interest rate fluctuations. Our review of other-than-temporary impairment determined that there was no credit quality deterioration.
The following table presents net realized gains (losses) on securities available-for-sale for the three and six months ended June 30, 2019 and 2018.
Three Months Ended
Six Months Ended
Proceeds from sales of securities
39,072
90,224
Gross realized gains on securities
1,591
Gross realized losses on securities
—
(578)
Income tax expense on net realized gains
Effective tax rate applied
Securities valued at $324.9 million as of June 30, 2019, an increase from $318.4 million at year-end 2018, were pledged to secure deposits and borrowings, and for other purposes.
13
Note 4 – Loans
Major classifications of loans were as follows:
Commercial
337,848
314,323
Leases
98,379
78,806
Real estate - commercial
825,091
820,941
Real estate - construction
93,079
108,390
Real estate - residential
393,547
407,068
HELOC
128,673
140,442
Other 1
13,533
14,439
Total loans, excluding deferred loan costs and PCI loans
1,890,150
1,884,409
Net deferred loan costs
1,653
Total loans, excluding PCI loans
1,892,109
1,886,062
PCI loans, net of purchase accounting adjustments
10,834
10,965
Total loans
1 The “Other” class includes consumer and overdrafts.
It is the policy of the Company to review each prospective credit prior to making a loan in order to determine if an adequate level of security or collateral has been obtained. The type of collateral, when required, will vary from liquid assets to real estate. The Company’s access to collateral, in the event of borrower default, is assured through adherence to lending laws, the Company’s lending standards and credit monitoring procedures. With selected exceptions, the Bank makes loans solely within its market area. There are no significant concentrations of loans where the customers’ ability to honor loan terms is dependent upon a single economic sector, although the real estate related categories listed above represent 75.7% and 77.9% of the portfolio at June 30, 2019, and December 31, 2018, respectively.
Aged analysis of past due loans by class of loans was as follows:
Recorded
Investment
90 days or
90 Days or
Greater Past
30-59 Days
60-89 Days
Total Past
Due and
Past Due
Due
Current
Nonaccrual
Total Loans
Accruing
337,697
143
98,111
125
Owner occupied general purpose
654
145,155
1,395
147,204
Owner occupied special purpose
828
186,249
499
187,576
Non-owner occupied general purpose
2,241
149
2,390
323,258
568
326,216
Non-owner occupied special purpose
144
97,051
2,960
100,155
Retail properties
604
48,793
1,138
50,535
Farm
1,210
12,195
13,405
Homebuilder
4,370
Land
342
2,625
2,967
Commercial speculative
59,216
All other
26,424
102
26,526
Investor
685
140
825
67,782
383
68,990
Multi-family
69
191,695
191,764
Owner occupied
553
202
755
129,413
132,793
331
138
469
127,085
1,119
15,462
15,492
Total, excluding PCI loans
7,810
629
8,439
1,872,581
11,089
449
7,029
3,356
8,259
8,888
1,879,610
14,445
14
58
352
410
313,913
361
1,768
1,801
160,892
1,579
164,272
36
826
135
961
192,426
395
193,782
2,832
3,035
286,115
4,236
293,386
106,036
3,099
109,135
620
45,968
46,588
13,778
5,102
266
2,478
2,744
350
55,060
55,410
355
45,028
106
45,134
801
957
69,148
353
70,458
545
179
724
195,504
196,228
180
705
1,946
135,360
3,076
140,382
775
138,801
16,000
16,092
9,165
1,824
917
11,906
1,860,415
13,741
935
7,248
2,265
10,617
13,358
1,867,663
16,006
1 The “Other” class includes consumer, overdrafts and net deferred costs.
Credit Quality Indicators
The Company categorizes loans into credit risk categories based on current financial information, overall debt service coverage, comparison to industry averages, historical payment experience, and current economic trends. This analysis includes loans with outstanding balances or commitments greater than $50,000 and excludes homogeneous loans such as home equity lines of credit and residential mortgages. Loans with a classified risk rating are reviewed quarterly regardless of size or loan type. The Company uses the following definitions for classified risk ratings:
Special Mention. Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan at some future date.
Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. The substandard credit quality indicator includes both potential problem loans that are currently performing and nonperforming loans.
Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Credits that are not covered by the definitions above are pass credits, which are not considered to be adversely rated.
15
Credit Quality Indicators by class of loans were as follows:
Special
Pass
Mention
Substandard
Doubtful
326,965
3,179
7,704
98,254
142,385
1,357
3,462
175,763
4,880
6,933
320,735
788
4,693
97,195
Retail Properties
10,977
1,218
26,253
273
67,961
1,029
Multi-Family
191,271
493
128,885
3,773
126,455
2,078
15,468
1,843,913
12,301
35,895
820
1,725
8,289
1,844,733
14,026
44,184
305,993
8,193
137
157,334
1,660
5,278
186,218
3,429
4,135
284,818
8,366
104,526
1,510
44,805
1,783
11,307
1,249
1,222
42,524
2,610
69,242
1,216
195,249
979
135,858
4,524
138,553
1,889
16,061
1,834,550
16,243
35,269
907
2,906
7,152
1,835,457
19,149
42,421
The Company had $519,000 and $448,000 in residential real estate loans in the process of foreclosure as of June 30, 2019, and December 31, 2018, respectively.
The following tables set forth the recorded investments, unpaid principal balance and related allowance, excluding purchased credit-impaired loans, by class of loans as of June 30, 2019 and for the three and six months then ended:
As of June 30, 2019
Unpaid
Interest
Principal
Related
Income
Balance
Allowance
Recognized
With no related allowance recorded
63
Commercial real estate
963
1,386
1,311
652
508
447
590
572
853
3,575
1,480
1,159
569
Construction
132
75
Residential
360
368
3,096
4,588
3,354
3,228
21
1,118
1,483
1,039
1,001
Total impaired loans with no recorded allowance
10,842
13,858
10,918
9,343
25
With an allowance recorded
76
114
154
57
664
199
419
530
56
1,512
1,577
29
798
800
803
22
3,363
41
3,402
3,519
80
1,381
1,402
19
1,369
39
20
Total impaired loans with a recorded allowance
6,547
6,610
455
7,688
73
9,531
Total impaired loans
17,389
20,468
18,606
87
18,874
18
Impaired loans by class of loans as of December 31, 2018, and for the three and six months ended June 30, 2018, were as follows:
As of December 31, 2018
June 30, 2018
89
1,659
1,782
645
683
384
40
601
541
459
371
2,362
3,359
4,882
4,696
4,726
884
1,003
933
7,844
9,895
7,325
10,898
396
152
3,098
4,038
139
3,337
1,550
808
819
822
3,676
3,679
46
3,661
3,544
1,232
1,153
12,515
13,936
9,203
60
7,071
119
20,359
23,831
16,528
17,969
141
Troubled debt restructurings (“TDRs”) are loans for which the contractual terms have been modified and both of these conditions exist: (1) there is a concession to the borrower and (2) the borrower is experiencing financial difficulties. Loans are restructured on a case-by-case basis during the loan collection process with modifications generally initiated at the request of the borrower. These modifications may include reduction in interest rates, extension of term, deferrals of principal, and other modifications. The Bank participates in the U.S. Department of the Treasury’s (the “Treasury”) Home Affordable Modification Program (“HAMP”) which gives qualifying homeowners an opportunity to refinance into more affordable monthly payments.
The specific allocation of the allowance for loan and lease losses for TDRs is determined by calculating the present value of the TDR cash flows by discounting the original payment less an assumption for probability of default at the original note’s issue rate, and adding this amount to the present value of collateral less selling costs. If the resulting amount is less than the recorded book value, the Bank either establishes a valuation allowance (i.e., specific reserve) as a component of the allowance for loan and lease losses or charges off the impaired balance if it determines that such amount is a confirmed loss. This method is used consistently for all segments of the portfolio. The allowance for loan and lease losses also includes an allowance based on a loss migration analysis for each loan category on loans and leases that are not individually evaluated for specific impairment. All loans charged-off, including TDRs charged-off, are factored into this calculation by portfolio segment.
TDRs that were modified during the period are as follows:
TDR Modifications
Three Months Ended June 30, 2019
Six Months Ended June 30, 2019
# of
Pre-modification
Post-modification
contracts
recorded investment
Troubled debt restructurings
Investor occupied general purpose
Other1
HAMP2
294
292
399
34
535
Three Months Ended June 30, 2018
Six Months Ended June 30, 2018
110
Rate3
287
503
464
382
706
622
1 Other: Change of terms from bankruptcy court.
2 HAMP: Home Affordable Modification Program.
3 Rate: Refers to interest rate reduction.
TDRs are classified as being in default on a case-by-case basis when they fail to be in compliance with the modified terms. There was no TDR default activity for the periods ended June 30, 2019 and June 30, 2018, for loans that were restructured within the 12 month period prior to default.
The following table details the accretable discount on all of the Company’s purchased loans, both non-PCI loans and PCI loans as of June 30, 2019. The Company’s PCI loans were recorded commensurate with the second quarter 2018 acquisition of ABC Bank; no PCI loans were held prior to that time. Non-PCI loan activity during the first quarter of 2018 stemmed from the Company’s acquisition of the Chicago branch of Talmer Bank and Trust in late 2016. The accretable discount recorded in the second quarter of 2019 totaled $1.1 million; the balance of the non-PCI loan discount was $10.8 million as of June 30, 2018.
Purchased Accounting Accretion
(dollars in thousands)
Accretable Discount- Non-PCI Loans
Accretable Discount- PCI Loans
Non-Accretable Discount- PCI Loans
Beginning balance, April 1, 2019
1,502
1,085
5,969
8,556
Accretion
(286)
(108)
(394)
Charge-offs
(48)
(467)
(515)
Transfer
(2)
7,647
Accretable Discount - Non-PCI Loans
Accretable Discount - PCI Loans
Non-Accretable Discount - PCI Loans
Beginning balance, January 1, 2019
1,867
1,099
8,935
(651)
(122)
(773)
Note 5 – Allowance for Loan and Lease Losses
Changes in the allowance for loan and lease losses by segment of loans based on method of impairment for the three and six months ended June 30, 2019, were as follows:
Real Estate
Allowance for loan and lease losses:
Three months ended June 30, 2019
Beginning balance
3,052
805
10,020
1,325
1,358
19,316
42
279
85
474
Recoveries
Provision (Release)
386
527
(180)
277
(735)
Ending balance
3,377
10,517
1,790
1,335
Six months ended June 30, 2019
734
10,470
969
1,931
1,449
621
169
64
285
588
227
(149)
(187)
Ending balance: Individually evaluated for impairment
113
70
Ending balance: Collectively evaluated for impairment
3,264
949
9,907
1,745
1,265
563
18,513
Ending balance: Acquired and accounted for ASC 310-30
404
Total ending allowance balance
Loans:
Ending balance: Individually evaluated for Impairment
6,848
7,640
2,499
818,243
92,977
385,907
126,174
1,874,720
4,092
674
6,068
Total ending loans balance
829,183
93,753
399,615
Changes in the allowance for loan and lease losses by segment of loans based on method of impairment for three and six months ended June 30, 2018, were as follows:
Three months ended June 30, 2018
2,604
617
9,565
1,143
1,535
870
18,188
504
65
699
92
105
(Release) Provision
1,455
255
(136)
(171)
27
2,676
634
10,537
1,398
1,818
1,390
868
19,321
Six months ended June 30, 2018
2,453
692
9,522
923
1,846
1,446
579
17,461
408
(16)
(55)
201
109
388
1,016
1,806
145
(45)
1,035
456
(1,099)
(102)
338
10,034
1,733
18,733
4,475
193
11,138
15,825
299,536
66,687
803,789
115,293
393,770
127,986
15,062
1,822,123
4,146
1,556
5,509
11,214
Total ending loan balance
299,538
812,410
117,042
410,417
15,082
1,849,162
Note 6 – Other Real Estate Owned
Details related to the activity in the other real estate owned (“OREO”) portfolio, net of valuation reserve, for the periods presented are itemized in the following table:
Balance at beginning of period
6,365
7,063
8,371
Property additions, net of acquisition adjustments
2,812
Property improvements
59
Less:
Proceeds from property disposals, net of participation purchase and of gains/losses
709
1,302
1,964
Period valuation adjustments
254
Other adjustments
Balance at end of period
8,912
Activity in the valuation allowance was as follows:
7,875
8,099
8,027
8,208
Provision for unrealized losses
Reductions taken on sales
(10)
(162)
(226)
8,061
8,348
Expenses related to OREO, net of lease revenue includes:
Gain on sales, net
(77)
(24)
Operating expenses
129
213
257
Lease revenue
Net OREO expense
Note 7 – Deposits
Major classifications of deposits were as follows:
Savings
311,887
304,400
NOW accounts
426,511
425,878
Money market accounts
285,223
310,390
Certificates of deposit of less than $100,000
220,973
230,781
Certificates of deposit of $100,000 through $250,000
144,148
159,953
Certificates of deposit of more than $250,000
56,132
66,441
Note 8 – Borrowings
The following table is a summary of borrowings as of June 30, 2019, and December 31, 2018. Junior subordinated debentures are discussed in detail in Note 9:
Other short-term borrowings 1
Total borrowings
254,244
313,355
1 Includes short-term FHLBC advances for both periods presented as well as the outstanding portion of an operating line of credit as of December 31, 2018, which totaled $4 million.
The Company enters into deposit sweep transactions where the transaction amounts are secured by pledged securities. These transactions consistently mature overnight from the transaction date and are governed by sweep repurchase agreements. All sweep repurchase agreements are treated as financings secured by U.S. government agencies and collateralized mortgage-backed securities and had a carrying amount of $54.2 million at June 30, 2019, and $46.6 million at December 31, 2018. The fair value of the pledged collateral was $73.8 million at June 30, 2019 and $72.8 million at December 31, 2018. At June 30, 2019, there were no customers with secured balances exceeding 10% of stockholders’ equity.
The Company’s borrowings at the FHLBC require the Bank to be a member and invest in the stock of the FHLBC. Total borrowings are generally limited to the lower of 35% of total assets or 60% of the book value of certain mortgage loans. As of June 30, 2019, the Bank had $87.1 million in short-term advances outstanding under the FHLBC compared to $145.5 million outstanding as of December 31, 2018; $65.0 million and $10.0 million of the June 30, 2019, balance was issued at 2.43% and 2.45%, respectively, and the remaining $12.1 million was issued at rates ranging from 1.60% to 2.03%. The additional $4.0 million in other short-term borrowings as of December 31, 2018, was the outstanding portion of a $20.0 million line of credit the Company has with a correspondent bank for short-term funding needs; advances under the line can be outstanding up to 360 days from the date of issuance. This line of credit was repaid with operating cash on hand in late January 2019. The Bank also assumed $23.4 million of long-term FHLBC advances with the ABC Bank acquisition. At June 30, 2019, these advances have a total outstanding balance of $11.0 million and are scheduled to mature over the next seven years with interest rates ranging between 2.19% and 2.83%. FHLBC stock held at June 30, 2019 was valued at $4.4 million, and any potential FHLBC advances were collateralized by securities with a fair value of $78.2 million and loans with a principal balance of $605.9 million, which carried a FHLBC calculated combined collateral value of $489.6 million. The Company had excess collateral of $317.2 million available to secure borrowings at June 30, 2019. The increase of 394.5% since December 2018 is due to the completion of an analysis of FHLB loan collateral eligibility in the first quarter of 2019, which expanded the capacity of funding at the FHLB as additional loan collateral was deemed acceptable.
The Company also has $44.2 million of senior notes outstanding, net of deferred issuance costs, as of June 30, 2019 and December 31, 2018. The senior notes were issued in December 2016 with a ten years maturity, and terms include interest payable semiannually at 5.75% for five years. Beginning December 2021, the senior debt will pay interest at a floating rate, with interest payable quarterly at three month LIBOR plus 385 basis points. The notes are redeemable, in whole or in part, at the option of the Company, beginning with the interest payment date on December 31, 2021, and on any floating rate interest payment date thereafter, at a redemption price equal to 100% of the principal amount of the notes plus accrued and unpaid interest. As of June 30, 2019 and December 31, 2018, unamortized debt issuance costs related to the senior notes were $791,000 and $842,000, respectively, and are included as a reduction of the balance of the senior notes on the Consolidated Balance Sheet. These deferred issuance costs will be amortized to interest expense over the ten year term of the notes and are included in the Consolidated Statements of Income.
Note 9 – Junior Subordinated Debentures
The Company completed the sale of $27.5 million of cumulative trust preferred securities by its unconsolidated subsidiary, Old Second Capital Trust I, in June 2003. An additional $4.1 million of cumulative trust preferred securities were sold in July 2003. The trust preferred securities may remain outstanding for a 30-year term but, subject to regulatory approval, can be called in whole or in part by the Company after June 30, 2008. Distributions on the securities are payable quarterly at an annual rate of 7.80%, unless the Company
elects to defer such interest payments as permitted by the terms of the securities. The Company issued a new $32.6 million subordinated debenture to Old Second Capital Trust I in return for the aggregate net proceeds of this trust preferred offering. The interest rate and payment frequency on the debenture are equivalent to the cash distribution basis on the trust preferred securities.
The Company issued an additional $25.0 million of cumulative trust preferred securities through a private placement completed by an additional, unconsolidated subsidiary, Old Second Capital Trust II, in April 2007. These trust preferred securities also mature in 30 years, but subject to the aforementioned regulatory approval, can be called in whole or in part on a quarterly basis commencing June 15, 2017. The quarterly cash distributions on the securities were fixed at 6.77% through June 15, 2017, and float at 150 basis points over three-month LIBOR thereafter. Upon conversion to a floating rate, a cash flow hedge was initiated which resulted in the total interest rate paid on the debt of 4.40% as of June 30, 2019, compared to the rate paid prior to June 15, 2017 of 6.77%. The Company issued a new $25.8 million subordinated debenture to Old Second Capital Trust II in return for the aggregate net proceeds of this trust preferred offering. The interest rate and payment frequency on the debenture are equivalent to the cash distribution basis on the trust preferred securities.
Both of the debentures issued by the Company are disclosed on the Consolidated Balance Sheet as junior subordinated debentures and the related interest expense for each issuance is included in the Consolidated Statements of Income. As of June 30, 2019, and December 31, 2018, unamortized debt issuance costs related to the junior subordinated debentures were $668,000 and $692,000 respectively, and are included as a reduction to the balance of the junior subordinated debentures on the Consolidated Balance Sheet. These deferred issuance costs will be amortized to interest expense over the 30-year term of the notes and are included in the Consolidated Statements of Income.
Note 10 – Equity Compensation Plans
Stock-based awards are outstanding under the Company’s 2008 Equity Incentive Plan (the “2008 Plan”), the Company’s 2014 Equity Incentive Plan, as amended (the “2014 Plan”), and the Company’s 2019 Equity Incentive Plan (the “2019 Plan” and together with the 2008 Plan and the 2014 Plan, the “Plans”). The 2019 Plan was approved at the May 2019 annual stockholders’ meeting and the number of authorized shares under the 2019 Plan is fixed at 600,000. Following approval of the 2014 Plan, no further awards were to be granted under the 2008 Plan or any other prior Company equity compensation plan, and following the approval of the 2019 Plan, no further awards will be granted under the 2014 Plan. The 2019 Plan authorizes the granting of qualified stock options, non-qualified stock options, restricted stock, restricted stock units, and stock appreciation rights (“SARs”). Awards may be granted to selected directors, officers, employees or eligible service providers under the 2019 Plan at the discretion of the Compensation Committee of the Company’s Board of Directors. As of June 30, 2019, 460,394 shares remained available for issuance under the 2019 Plan.
There were 4,500 stock options exercised and no stock options granted in the six months ended June 30, 2019, and no stock options granted or exercised in the six months ended June 30, 2018. All stock options are granted for a term of ten years. There is no unrecognized compensation cost related to unvested stock options as all stock options of the Company’s common stock have fully vested.
A summary of stock option activity in the Plans for the six months ended June 30, 2019, is as follows:
Weighted-
Remaining
Exercise
Contractual
Aggregate
Shares
per Price
Term (years)
Intrinsic Value
Beginning outstanding
4,500
7.49
0.1
Canceled
Exercised
(4,500)
(27)
Expired
Ending outstanding
Exercisable at end of period
Generally, restricted stock and restricted stock units granted under the Plans vest three years from the grant date, but the Compensation Committee of the Company’s Board of Directors has discretionary authority to change some terms including the amount of time until the vest date.
Under the 2019 Plan, unless otherwise provided in an award agreement, upon the occurrence of a change in control, all stock options and SARs then held by the participant will become fully exercisable immediately if, and all stock awards and cash incentive awards will become fully earned and vested immediately if, (i) the 2019 Plan is not an obligation of the successor entity following a change in control or (ii) the 2019 Plan is an obligation of the successor entity following a change in control and the participant incurs a termination of service without cause or for good reason following the change in control. Notwithstanding the immediately preceding sentence, if the vesting of an award is conditioned upon the achievement of performance measures, then such vesting will generally be subject to the following: if, at the time of the change in control, the performance measures are less than 50% attained (pro rata based upon the time of the period through the change in control), the award will become vested and exercisable on a fractional basis with the numerator being equal to the percentage of attainment and the denominator being 50%; and if, at the time of the change in control, the performance measures are at least 50% attained (pro rata based upon the time of the period through the change in control), the award will become fully earned and vested immediately upon the change in control.
The Company granted restricted stock under its equity compensation plans beginning in 2005 and it began granting restricted stock units in February 2009. Awards of restricted stock under the Plans generally entitle holders to voting and dividend rights upon grant and are subject to forfeiture until certain restrictions have lapsed including employment for a specific period. Awards of restricted stock units under the Plans are also subject to forfeiture until certain restrictions have lapsed including employment for a specific period, but do not entitle holders to voting rights until the restricted period ends and shares are transferred in connection with the units.
There were 139,606 restricted stock units issued under the 2019 Plan during the six months ended June 30, 2019. There were 254,281 restricted stock units issued under the 2014 Plan during the six months ended June 30, 2018. Compensation expense is recognized over the vesting period of the restricted stock unit based on the market value of the award on the issue date. Total compensation cost that has been recorded for the Plans was $1.3 million and $1.1 million in the first six months of 2019 and 2018, respectively.
A summary of changes in the Company’s unvested restricted awards for the six months ended June 30, 2019, is as follows:
Restricted
Stock Shares
Grant Date
and Units
Unvested at January 1
552,281
11.30
Granted
139,606
12.81
Vested
(113,937)
7.40
Forfeited
Unvested at June 30
577,950
12.44
Total unrecognized compensation cost of restricted awards was $3.8 million as of June 30, 2019, which is expected to be recognized over a weighted-average period of 2.07 years.
26
Note 11 – Earnings Per Share
The earnings per share – both basic and diluted – are included below as of June 30:
Basic earnings per share:
Weighted-average common shares outstanding
29,896,231
29,747,078
29,871,081
29,703,508
Diluted earnings per share:
Dilutive effect of unvested restricted awards
493,661
539,166
495,808
506,234
Dilutive effect of stock options and warrants
51,038
43,698
Diluted average common shares outstanding
30,389,892
30,337,282
30,366,889
30,253,440
The above 2018 earnings per share calculation also includes a warrant for 815,339 shares of common stock, at an exercise price of $13.43 per share, that was outstanding as of June 30, 2018, and was considered dilutive. The ten-year warrant was issued in 2009, and was sold at auction by the U.S. Treasury in June 2013 to a third party investor. This warrant was not included as a dilutive factor as of June 30, 2019, due to its cashless exercise on January 16, 2019. As of the date of exercise, the Company’s closing market stock price was $14.23 per share, resulting in 45,836 shares being issued. The cashless warrant exercise resulted in a net $313,000 reduction to treasury stock as these shares were issued from stock held by the Company.
Note 12 – Regulatory & Capital Matters
The Bank is subject to the risk-based capital regulatory guidelines, which include the methodology for calculating the risk-weighted Bank assets, developed by the Office of the Comptroller of the Currency (the “OCC”) and the other bank regulatory agencies. In connection with the current risk-based capital regulatory guidelines, the Bank’s Board of Directors has established an internal guideline requiring the Bank to maintain a Tier 1 leverage capital ratio at or above eight percent (8%) and a total risk-based capital ratio at or above twelve percent (12%). At June 30, 2019, the Bank exceeded those thresholds.
At June 30, 2019, the Bank’s Tier 1 capital leverage ratio was 11.96%, an increase of 60 basis points from December 31, 2018, and is well above the 8.00% objective. The Bank’s total capital ratio was 14.83%, an increase of 69 basis points from December 31, 2018, and also well above the objective of 12.00%.
Bank holding companies are generally required to maintain minimum levels of capital in accordance with capital guidelines implemented by the Board of Governors of the Federal Reserve System. The general bank and holding company capital adequacy guidelines are shown in the accompanying table, as are the capital ratios of the Company and the Bank, as of June 30, 2019 and December 31, 2018.
In July 2013, the U.S. federal banking authorities issued final rules (the “Basel III Rules”) establishing more stringent regulatory capital requirements for U.S. banking institutions, which went into effect on January 1, 2015. The Basel III Rules are applicable to all banking organizations that are subject to minimum capital requirements, including federal and state banks and savings and loan associations, as well as to bank and savings and loan holding companies, other than “small bank holding companies” generally holding companies with consolidated assets of less than $3 billion. The Company is currently considered a “small bank holding company.” A detailed discussion of the Basel III Rules is included in Part I, Item 1 of the Company’s Form 10-K for the year ended December 31, 2018, under the heading “Supervision and Regulation.”
At June 30, 2019, and December 31, 2018, the Company, on a consolidated basis, exceeded the minimum thresholds to be considered “well capitalized” under current regulatory defined capital ratios.
Capital levels and industry defined regulatory minimum required levels are as follows:
Minimum Capital
To Be Well Capitalized Under
Adequacy with Capital
Prompt Corrective
Actual
Conservation Buffer if applicable1
Action Provisions2
Amount
Ratio
Common equity tier 1 capital to risk weighted assets
Consolidated
226,851
10.26
154,772
7.000
N/A
Old Second Bank
311,457
13.96
156,175
145,019
6.50
Total capital to risk weighted assets
302,844
13.70
232,107
10.500
330,825
14.83
234,232
223,078
10.00
Tier 1 capital to risk weighted assets
283,476
12.83
187,806
8.500
189,641
178,485
8.00
Tier 1 capital to average assets
10.85
104,507
4.00
11.96
104,166
130,208
5.00
207,597
9.29
142,444
6.375
295,599
13.29
141,791
144,571
282,126
12.63
220,648
9.875
314,600
14.14
219,637
222,417
263,125
11.78
175,960
7.875
175,153
177,934
10.08
104,415
11.36
104,084
130,105
1 As of June 30, 2019, amounts are shown inclusive of a capital conservation buffer of 2.50%; as compared to December 31, 2018, of 1.875%.
2 The Bank exceeded the general minimum regulatory requirements to be considered “well capitalized.”
Dividend Restrictions
In addition to the above requirements, banking regulations and capital guidelines generally limit the amount of dividends that may be paid by a bank without prior regulatory approval. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s profits, combined with the retained profit of the previous two years, subject to the capital requirements described above. Pursuant to the Basel III rules that came into effect January 1, 2015 and were fully phased in as of January 1, 2019, the Bank must keep a capital conservation buffer of 2.50% above the new regulatory minimum capital requirements, which must consist entirely of Common Equity Tier 1 capital in order to avoid additional limitations on capital distributions and certain other payments.
Note 13 – Fair Value Measurements
Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The fair value hierarchy established by the Company also requires an entity to maximize the use of observable
inputs and minimize the use of unobservable inputs when measuring fair value. Three levels of inputs that may be used to measure fair value are:
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the Company has the ability to access as of the measurement date.
Level 2: Significant observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.
Level 3: Significant unobservable inputs that reflect a company’s own view about the assumptions that market participants would use in pricing an asset or liability.
The majority of securities available-for-sale are valued by external pricing services or dealer market participants and are classified in Level 2 of the fair value hierarchy. Both market and income valuation approaches are utilized. Quarterly, the Company evaluates the methodologies used by the external pricing services or dealer market participants to develop the fair values to determine whether the results of the valuations are representative of an exit price in the Company’s principal markets and an appropriate representation of fair value. The Company uses the following methods and significant assumptions to estimate fair value:
Government-sponsored agency debt securities are primarily priced using available market information through processes such as benchmark spreads, market valuations of like securities, like securities groupings and matrix pricing.
Other government-sponsored agency securities, MBS and some of the actively traded real estate mortgage investment conduits and collateralized mortgage obligations are priced using available market information including benchmark yields, prepayment speeds, spreads, volatility of similar securities and trade date.
State and political subdivisions are largely grouped by characteristics (e.g., geographical data and source of revenue in trade dissemination systems). Because some securities are not traded daily and due to other grouping limitations, active market quotes are often obtained using benchmarking for like securities.
Auction rate securities are priced using market spreads, cash flows, prepayment speeds, and loss analytics. Therefore, the valuations of auction rate asset-backed securities are considered Level 2 valuations.
Asset-backed collateralized loan obligations were priced using data from a pricing matrix supported by our bond accounting service provider and are therefore considered Level 2 valuations.
Annually every security holding is priced by a pricing service independent of the regular and recurring pricing services used. The independent service provides a measurement to indicate if the price assigned by the regular service is within or outside of a reasonable range. Management reviews this report and applies judgment in adjusting calculations at year end related to securities pricing.
Residential mortgage loans available for sale in the secondary market are carried at fair market value. The fair value of loans held-for-sale is determined using quoted secondary market prices.
Lending related commitments to fund certain residential mortgage loans, e.g., residential mortgage loans with locked interest rates to be sold in the secondary market and forward commitments for the future delivery of mortgage loans to third party investors, as well as forward commitments for future delivery of MBS are considered derivatives. Fair values are estimated based on observable changes in mortgage interest rates including prices for MBS from the date of the commitment and do not typically involve significant judgments by management.
The fair value of mortgage servicing rights is based on a valuation model that calculates the present value of estimated net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income to derive the resultant value. The Company is able to compare the valuation model inputs, such as the discount rate, prepayment speeds, weighted average delinquency and foreclosure/bankruptcy rates to widely available published industry data for reasonableness.
Interest rate swap positions, both assets and liabilities, are based on valuation pricing models using an income approach reflecting readily observable market parameters such as interest rate yield curves.
The fair value of impaired loans with specific allocations of the allowance for loan and lease losses is essentially based on recent real estate appraisals or the fair value of the collateralized asset. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are made in the appraisal process by the appraisers to reflect differences between the available comparable sales and income data. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.
Nonrecurring adjustments to certain commercial and residential real estate properties classified as OREO are measured at the lower of carrying amount or fair value, less costs to sell. Fair values are based on third party appraisals of the property,
resulting in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.
Assets and Liabilities Measured at Fair Value on a Recurring Basis:
The tables below present the balance of assets and liabilities at June 30, 2019, and December 31, 2018, respectively, measured by the Company at fair value on a recurring basis:
Level 1
Level 2
Level 3
Assets:
244,120
Mortgage servicing rights
5,819
Interest rate swap agreements
2,695
Mortgage banking derivatives
489,015
12,994
506,034
Liabilities:
Interest rate swap agreements, including risk participation agreements
5,446
265,902
8,165
Corporate bonds
159
532,975
15,522
552,420
756
30
The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are as follows:
Collateralized
States and
Mortgage
Political
Servicing
Obligation
Subdivisions
Rights
Beginning balance January 1, 2019
Transfers into Level 3
Transfers out of Level 3
Total gains or losses
Included in earnings
(17)
(1,701)
Included in other comprehensive income
Purchases, issuances, sales, and settlements
Purchases
17,554
Issuances
417
Settlements
(19,027)
Ending balance June 30, 2019
Beginning balance January 1, 2018
2,268
14,261
6,944
520
(551)
19,934
(554)
(15,195)
(320)
Ending balance June 30, 2018
1,771
18,449
7,812
The following table and commentary presents quantitative and qualitative information about Level 3 fair value measurements as of June 30, 2019:
Measured at fair value
Unobservable
on a recurring basis:
Valuation Methodology
Inputs
Range of Input
of Inputs
Discounted Cash Flow
Discount Rate
8.9% - 22.1%
10.1
Prepayment Speed
7.0 - 69.0%
14.2
The following table and commentary presents quantitative and qualitative information about Level 3 fair value measurements as of December 31, 2018:
10.0 - 229.7%
10.2
7.0 - 68.9%
9.6
In addition to the above, Level 3 fair value measurement included $7.2 million for state and political subdivisions representing various local municipality securities at June 30, 2019. This was classified as securities available-for-sale, and was valued using a discount based on market spreads of similar assets, but the liquidity premium was an unobservable input. The state and political subdivisions securities balance in Level 3 fair value at June 30, 2018, was $18.4 million and collateralized mortgage obligation balance in Level 3 was $1.8 million. Both of these were classified as securities available-for-sale, and were valued using a discount based on market spreads of similar assets, but the liquidity premium was an unobservable input.
Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis:
The Company may be required, from time to time, to measure certain other assets at fair value on a nonrecurring basis in accordance with GAAP. These assets consist of impaired loans and OREO. For assets measured at fair value on a nonrecurring basis at June 30, 2019, and December 31, 2018, respectively, the following tables provide the level of valuation assumptions used to determine each valuation and the carrying value of the related assets:
Impaired loans1
6,092
Other real estate owned, net2
11,760
1 Represents carrying value and related write-downs of loans for which adjustments are substantially based on the appraised value of collateral for collateral-dependent loans; had a carrying amount of $6.5 million and a valuation allowance of $455,000 resulting in an increase of specific allocations within the allowance for loan and lease losses of $103,000 for the six months ended June 30, 2019.
2 OREO is measured at the lower of carrying or fair value less costs to sell, and had a net carrying amount of $5.7 million, which is made up of the outstanding balance of $14.7 million, net of a valuation allowance of $8.1 million and participations of $937,000 at June 30, 2019.
12,163
19,338
1 Represents carrying value and related write-downs of loans for which adjustments are substantially based on the appraised value of collateral for collateral-dependent loans; had a carrying amount of $12.5 million and a valuation allowance of $352,000, resulting in an increase of specific allocations within the allowance for loan and lease losses of $208,000 for the year December 31, 2018.
2 OREO is measured at the lower of carrying or fair value less costs to sell, and had a net carrying amount of $7.2 million, which is made up of the outstanding balance of $16.0 million, net of a valuation allowance of $8.0 million and participations of $900,000, at December 31, 2018.
The Company has estimated the fair values of these assets based primarily on Level 3 inputs. OREO and impaired loans are generally valued using the fair value of collateral provided by third party appraisals. These valuations include assumptions related to cash flow projections, discount rates, and recent comparable sales. The numerical ranges of unobservable inputs for these valuation assumptions are not meaningful.
Note 14 – Fair Values of Financial Instruments
The estimated fair values approximate carrying amount for all items except those described in the following table. Securities available-for-sale fair values are based upon market prices or dealer quotes, and if no such information is available, on the rate and term of the security. The carrying value of FHLBC stock approximates fair value as the stock is nonmarketable and can only be sold to the FHLBC or another member institution at par. FHLBC stock is carried at cost and considered a Level 2 fair value. As of June 30, 2019 and 2018, the fair values of loans and leases are estimated on an exit price basis incorporating discounts for credit, liquidity and marketability factors. The fair value of time deposits is estimated using discounted future cash flows at current rates offered for deposits of similar remaining maturities. The fair values of borrowings were estimated based on interest rates available to the Company for debt with similar terms and remaining maturities. The fair value of off balance sheet volume is not considered material.
The carrying amount and estimated fair values of financial instruments were as follows:
Carrying
Financial assets:
480,880
FHLBC and FRBC stock
1,913,235
Accrued interest receivable
11,096
Financial liabilities:
Noninterest bearing deposits
Interest bearing deposits
1,444,874
1,444,338
42,874
34,284
8,590
45,784
Note payable and other borrowings
2,700
Borrowing interest payable
Deposit interest payable
914
529,160
1,867,594
10,940
1,497,843
1,495,614
47,625
32,989
14,636
45,008
281
973
Note 15 – Derivatives, Hedging Activities and Financial Instruments with Off-Balance Sheet Risk
Risk Management Objective of Using Derivatives
The Company is exposed to certain risk arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, sources, and duration of its assets and liabilities and the use of derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to the Company’s loan portfolio.
Cash Flow Hedges of Interest Rate Risk
The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. During 2019 and 2018, such derivatives were used to hedge the variable cash flows associated with existing variable-rate borrowings.
For derivatives designated and that qualify as cash flow hedges of interest rate risk, the gain or loss on the derivative is recorded in Accumulated Other Comprehensive Income and subsequently reclassified into interest expense in the same period(s) during which the hedged transaction affects earnings. Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are received on the Company’s variable-rate borrowings. During the next twelve months, the Company estimates that an additional $207,000 will be reclassified as an increase to interest expense.
Non-designated Hedges
Derivatives not designated as hedges are not speculative and result from a service the Company provides to certain customers. The Company executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies. Those interest rate swaps are simultaneously hedged by offsetting derivatives that the Company executes with a third party, such that
the Company minimizes its net risk exposure resulting from such transactions. As the interest rate derivatives associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer derivatives and the offsetting derivatives are recognized directly in earnings.
The Company also grants mortgage loan interest rate lock commitments to borrowers, subject to normal loan underwriting standards. The interest rate risk associated with these loan interest rate lock commitments is managed with contracts for future deliveries of loans as well as selling forward mortgage-backed securities contracts. Loan interest rate lock commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Commitments to originate residential mortgage loans held-for-sale and forward commitments to sell residential mortgage loans or forward MBS contracts are considered derivative instruments and changes in the fair value are recorded to mortgage banking revenue. Fair values are estimated based on observable changes in mortgage interest rates including mortgage-backed securities prices from the date of the commitment.
Disclosure of Fair Values of Derivative Instruments on the Balance Sheet
The Company entered into a forward starting interest rate swap on August 18, 2015, with an effective date of June 15, 2017. This transaction had a notional amount totaling $25.8 million as of December 31, 2018, was designated as a cash flow hedge of certain junior subordinated debentures and was determined to be fully effective during the period presented. As such, no amount of ineffectiveness has been included in net income. Therefore, the aggregate fair value of the swap is recorded in other liabilities with changes in fair value recorded in other comprehensive income, net of tax. The amount included in other comprehensive income would be reclassified to current earnings should all or a portion of the hedge no longer be considered effective. The Company expects the hedge to remain fully effective during the remaining term of the swap. The Bank will pay the counterparty a fixed rate and receive a floating rate based on three month LIBOR. The trust preferred securities changed from fixed rate to floating rate in June 15, 2017. The cash flow hedge has a maturity date of June 15, 2037.
The Bank also has interest rate derivative positions to assist with risk management that are not designated as hedging instruments. These derivative positions relate to transactions in which the Bank enters an interest rate swap with a client while at the same time entering into an offsetting interest rate swap with another financial institution. The Bank had $69,000 of cash collateral pledged with one correspondent financial institution to support interest rate swap activity at June 30, 2019; $6.1 million of investment securities were required to be pledged to two correspondent financial institutions. The Bank had $260,000 of cash collateral pledged with one correspondent financial institution to support interest rate swap activity at December 31, 2018; no investment securities were required to be pledged. At June 30, 2019, the notional amount of non-hedging interest rate swaps was $182.0 million with a weighted average maturity of 6.1 years. At December 31, 2018, the notional amount of non-hedging interest rate swaps was $188.9 million with a weighted average maturity of 6.6 years. The Bank offsets derivative assets and liabilities that are subject to a master netting arrangement.
The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the Balance Sheet as of June 30, 2019 and December 31, 2018.
Fair Value of Derivative Instruments
No. of Trans.
Notional Amount $
Balance Sheet Location
Fair Value $
Derivatives designated as hedging instruments
Interest rate swaps
25,774
Other Assets
Other Liabilities
Total derivatives designated as hedging instruments
Derivatives not designated as hedging instruments
Interest rate swaps with commercial loan customers
182,033
Interest rate lock commitments and forward contracts
59,296
Other contracts
18,048
51
Total derivatives not designated as hedging instruments
2,993
2,746
188,931
18,130
18,155
831
698
Disclosure of the Effect of Fair Value and Cash Flow Hedge Accounting
The fair value and cash flow hedge accounting related to derivatives covered under ASC Subtopic 815-20 impacted Accumulated Other Comprehensive Income (“AOCI”) and the Income Statement. The gain recognized in AOCI on derivatives totaled $1.6 million as of June 30, 2019, and a loss in AOCI of $473,000 as of June 30, 2018. The amount of the loss reclassified from AOCI to interest income on the income statement totaled $10,000 and $42,000 for the three months ended June 30, 2019, and June 30, 2018, respectively. The amount of the loss reclassified from AOCI to interest income or interest expense on the income statement totaled $15,000 and $116,000 for the six months ended June 30, 2019, and June 30, 2018, respectively.
Credit-risk-related Contingent Features
For derivative transactions involving counterparties who are lending customers of the Company, the derivative credit exposure is managed through the normal credit review and monitoring process, which may include collateralization, financial covenants and/or financial guarantees of affiliated parties. Agreements with such customers require that losses associated with derivative transactions receive payment priority from any funds recovered should a customer default and ultimate disposition of collateral or guarantees occur.
Credit exposure to broker/dealer counterparties is managed through agreements with each derivative counterparty that require collateralization of fair value gains owed by such counterparties. Some small degree of credit exposure exists due to timing differences between when a gain may occur and the subsequent point in time that collateral is delivered to secure that gain. This is monitored by the Company and procedures are in place to minimize this exposure. Such agreements also require the Company to collateralize counterparties in circumstances wherein the fair value of the derivatives result in loss to the Company.
Other provisions of such agreements include the definition of certain events that may lead to the declaration of default and/or the early termination of the derivative transaction(s):
If the Company either defaults or is capable of being declared in default on any of its indebtedness (exclusive of deposit obligations), then the Company could also be declared in default on its derivative obligations.
If a merger occurs that materially changes the Company's creditworthiness in an adverse manner.
If certain specified adverse regulatory actions occur, such as the issuance of a Cease and Desist Order, or citations for actions considered Unsafe and Unsound or that may lead to the termination of deposit insurance coverage by the Federal Deposit Insurance Corporation.
The Bank also issues letters of credit, which are conditional commitments that guarantee the performance of a customer to a third party. The credit risk involved and collateral obtained in issuing letters of credit are essentially the same as that involved in extending loan commitments to our customers. In addition to customer related commitments, the Company is responsible for letters of credit commitments that relate to properties held in OREO. The following table represents the Company’s contractual commitments due to letters of credit as of June 30, 2019, and December 31, 2018.
The following table is a summary of letter of credit commitments:
Fixed
Variable
Letters of credit:
Borrower:
Financial standby
6,468
6,807
327
7,158
7,485
Commercial standby
1,613
397
Performance standby
251
6,174
6,425
532
6,381
6,913
14,255
14,845
859
14,795
Non-borrower:
Total letters of credit
14,322
14,912
14,003
14,862
Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
The following discussion provides additional information regarding our operations for the three and six months ended June 30, 2019, as compared to June 30, 2018, and our financial condition at June 30, 2019 compared to December 31, 2018. This discussion should be read in conjunction with our consolidated financial statements as well as the financial and statistical data appearing elsewhere in this report and our Form 10-K for the year ended December 31, 2018. The results of operations for the three and six months ended June 30, 2019, are not necessarily indicative of future results (dollar amounts in thousands, except per share data, unaudited).
In this report, unless the context suggests otherwise, references to the “Company,” “we,” “us,” and “our” mean the combined business of Old Second Bancorp, Inc. and its subsidiary bank, Old Second National Bank (the “Bank”).
We have made, and will continue to make, various forward-looking statements with respect to financial and business matters. Comments regarding our business that are not historical facts are considered forward-looking statements that involve inherent risks and uncertainties. Actual results may differ materially from those contained in these forward-looking statements. For additional information regarding our cautionary disclosures, see the “Cautionary Note Regarding Forward-Looking Statements” on page 3 of this report.
Business Overview
The Company is a bank holding company headquartered in Aurora, Illinois. Through our wholly-owned subsidiary bank, Old Second National Bank, a national banking organization also headquartered in Aurora, Illinois, we offer a wide range of financial services through our 29 banking centers located in Cook, DeKalb, DuPage, Kane, Kendall, LaSalle and Will counties in Illinois. These banking centers offer access to a full range of traditional retail and commercial banking services including treasury management operations as well as fiduciary and wealth management services. We focus our business on establishing and maintaining relationships with our clients while maintaining a commitment to provide for the financial services needs of the communities in which we operate. We emphasize relationships with individual customers as well as small to medium-sized businesses throughout our market area. We also have extensive wealth management services, which includes a registered investment advisory platform in addition to trust administration and trust services related to personal and corporate trusts and employee benefit plan administration services.
Financial Overview
Our community-focused banking franchise experienced total asset and overall market growth in the second quarter of 2019, compared to the first quarter of 2019 and the second quarter of 2018, and we believe we are positioned for further growth as we continue to serve our customers’ needs in a competitive economic environment. While industry and regulatory developments in the past few years have made it challenging to attain the levels of profitability and growth reflected prior to the economic recession of 2007-2009, we are continuing to seek to provide value to our customers and the communities in which we operate, by executing on growth opportunities in our local markets and developing new banking relationships. Overall stable market conditions over the past few years are reflected in the financials presented for the reporting period ended June 30, 2019.
The following provides an overview of some of the factors impacting our financial performance for the quarter ending June 30, 2019:
This is the fifth quarter of results of operations that included our acquisition of Greater Chicago Financial Corp., and its wholly-owned subsidiary bank, ABC Bank, which closed on April 20, 2018.
Net income for the second quarter of 2019 was $9.3 million, or $0.31 per diluted share, compared to $6.3 million, or $0.21 per diluted share, for the second quarter of 2018. Net income for the six months ended June 30, 2019, totaled $17.7 million, or $0.58 per diluted share, compared to $15.8 million, or $0.52 per diluted share for the six months ended June 30, 2018.
Net interest and dividend income was $24.8 million for the second quarter of 2019, compared to $23.2 million for the second quarter of 2018. The increase was primarily due to a full period of the increased loan volume resulting from our acquisition of ABC Bank on April 20, 2018, which added $227.6 million in loans, net of purchase accounting adjustments, as well as the increase in interest rates in the year over year period. Net interest and dividend income was $48.8 million for the six months ended June 30, 2019, compared to $42.9 million for the like period in 2018.
Noninterest income was $8.1 million for the second quarter of 2019, compared to $8.5 million for the second quarter of 2018. The reduction was primarily due to a $1.1 million interest rate driven mark to market loss on mortgage servicing rights (“MSR”) recorded in the second quarter of 2019, compared to $105,000 of MSR losses recorded in the second quarter of 2018, which was partially offset by security gains, net, of $986,000 for the second quarter of 2019. Noninterest income was $14.6 million for the six months ended June 30, 2019, which reflected a 14.2% decrease from the like period in 2018, due primarily to a decline of $2.2 million in income related to MSR losses for the six month period.
38
Noninterest expense was $20.1 million for the second quarter of 2019, compared to $22.3 million for the second quarter of 2018, which reflects a decrease of $2.2 million, or 9.7%. The decrease in expense was due to our acquisition of ABC Bank, which resulted in higher costs in the second quarter of 2018 due to data conversion and salary continuation and retention agreements issued to ABC Bank employees. For the six months ended June 30, 2019, noninterest expense totaled $39.3 million, compared to $39.6 million for the like 2018 period, reflecting a decrease of $320,000, or 0.8%.
Income tax expense increased in the second quarter of 2019 period compared to the like 2018 period due primarily to the increase in pretax income of $4.3 million. The effective tax rate for the three months ended June 30, 2019, was 24.7%, compared to 22.1% for the three months ended June 30, 2018. Income tax expense for the six months ended June 30, 2019, totaled $5.4 million, which was $1.7 million, or 44.3%, higher than the income tax expense for the six months ended June 30, 2018, due primarily to the increase in pretax income of $3.7 million.
Asset quality remained consistent; with nonperforming loans as a percent of total loans remaining relatively steady at 0.7% as of June 30, 2019 and 0.8% as of June 30, 2018.
We added $11.4 million of purchase credit impaired loans (“PCI loans”), net of purchase accounting adjustments, in our acquisition of ABC Bank in the second quarter of 2018. As of June 30, 2019, PCI loans, net of purchase accounting adjustments, totaled $10.8 million, and PCI loans to total loans was 0.6%. We had no PCI loans before our acquisition of ABC Bank.
Critical Accounting Policies
Our consolidated financial statements are prepared based on the application of accounting policies in accordance with generally accepted accounting principles (“GAAP”) and follow general practices within the banking industry. These policies require the reliance on estimates and assumptions, which may prove inaccurate or are subject to variations. These estimates, assumptions, and judgments are based on information available as of the date of the consolidated financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the consolidated financial statements. Changes in underlying factors, assumptions, or estimates could have a material impact on our future financial condition and results of operations. The most critical of these significant accounting policies are the policies related to the allowance for loan and lease losses, fair valuation methodologies, income taxes and the accounting related to loans acquired in business combinations. Our significant accounting policies are more fully described in Note 1 to the audited consolidated financial statements contained in our Annual Report on Form 10-K for the year ended December 31, 2018, and the more significant assumptions and estimates made by management are more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies” in our Annual Report on Form 10-K for the year ended December 31, 2018. There have been no material changes to our significant accounting policies or the estimates made pursuant to those policies from those disclosed in our 2018 Annual Report on Form 10-K during the most recent quarter.
Non-GAAP Financial Measures
This report contains references to financial measures that are not defined in GAAP. Such non-GAAP financial measures include the presentation of net interest income and net interest income to interest earning assets on a tax equivalent (“TE”) basis, our adjusted efficiency ratio and our tangible common equity to tangible assets ratio. Management believes that the presentation of these non-GAAP financial measures (a) provides important supplemental information that contributes to a proper understanding of our operating performance, (b) enables a more complete understanding of factors and trends affecting our business, and (c) allows investors to evaluate our performance in a manner similar to management, the financial services industry, bank stock analysts, and bank regulators. Management uses non-GAAP measures as follows: in the preparation of our operating budgets, monthly financial performance reporting, and in our presentation to investors of our performance. However, we acknowledge that these non-GAAP financial measures have a number of limitations. Limitations associated with non-GAAP financial measures include the risk that persons might disagree as to the appropriateness of items comprising these measures and that different companies might calculate these measures differently. These disclosures should not be considered an alternative to our GAAP results. A reconciliation of non-GAAP financial measures to the most directly comparable GAAP financial measures is presented below or alongside the first instance where each non-GAAP financial measure is used.
Results of Operations
Three months ended June 30, 2019 and 2018
Our income before taxes was $12.3 million in the second quarter of 2019, compared to $8.0 million in the second quarter of 2018. The $4.3 million increase in pretax income for the second quarter of 2019, compared to the like 2018 quarter, resulted in an increase to income tax expense of $1.3 million for the second quarter of 2019, compared to the like 2018 quarter. Our net income was $9.3
million, or $0.31 per diluted share, for the second quarter of 2019, compared to net income of $6.3 million, or $0.21 per diluted share, for the second quarter of 2018.
The increase in net income was impacted by a $2.3 million increase in interest and dividend income in the second quarter of 2019, compared to the second quarter of 2018, primarily as a result of higher loan yields in the 2019 period due to rising interest rates, as well as the impact of a full period of the increased loan volume resulting from our ABC Bank acquisition, partially offset by a $813,000 increase in interest expense. In addition, our noninterest expense decreased $2.2 million in the second quarter of 2019, compared to the like quarter in 2018, which was partially offset by a decrease of $389,000 in noninterest income in the second quarter of 2019, compared to the second quarter of 2018.
Management has remained diligent in reviewing our loan portfolio to analyze and determine if charge-offs are required. Average loan growth, including loans held for sale, in the second quarter of 2019 totaled $1.8 million, primarily in commercial loans and leases. Management’s review of the loan portfolio resulted in $450,000 of provision expense in the second quarter of 2019, based on analysis of the allowance and loan portfolio held, a decrease of $1.0 million, compared to $1.5 million in provision expense in the like 2018 quarter. The allowance for loan and lease loss analysis methodology remained consistent, with no material changes incorporated in the second quarter of 2019 from the prior quarter.
Six months ended June 30, 2019 and 2018
Our income before taxes was $23.2 million for the six months ended June 30, 2019, compared to $19.5 million for the six months ended June 30, 2018. Our net income was $17.7 million, or $0.58 per diluted share, for the six months ended June 30, 2019, compared to net income of $15.8 million, or $0.52 per diluted share, for the six months ended June 30, 2018.
The increase in net income was impacted by an $8.1 million increase in interest and dividend income for the six months ended June 30, 2019, compared the like period of 2018, driven by increased average loan volumes due to the ABC Bank acquisition and organic loan growth, as well higher yields on loans due to the rising interest rate environment, partially offset by a $2.1 million increase in interest expense and an additional $228,000 in provision expense. Also impacting net income was a $2.4 million decrease in noninterest income for the six months ended June 30, 2019, compared to the 2018 period, driven primarily by mark to market losses of $2.0 million on MSR’s for the six months ended June 30, 2019, compared to a $200,000 gain on mark to market losses on MSRs in the like 2018 period.
Net Interest Income
Net interest income, which is our primary source of earnings, is the difference between interest income earned on interest-earning assets, such as loans and investment securities, as well as accretion income on purchased loans, and interest incurred on interest-bearing liabilities, such as deposits and borrowings. Net interest income depends upon the relative mix of interest-earning assets and interest-bearing liabilities, the ratio of interest-earning assets to total assets and of interest-bearing liabilities to total funding sources, and movements in market interest rates. Our net interest income can be significantly influenced by a variety of factors, including overall loan demand, economic conditions, credit risk, the amount of nonearning assets including nonperforming loans and OREO, the amounts of and rates at which assets and liabilities reprice, variances in prepayment of loans and securities, early withdrawal of deposits, exercise of call options on borrowings or securities, a general rise or decline in interest rates, changes in the slope of the yield-curve, and balance sheet growth or contraction.
Our net interest and dividend income increased by $1.5 million, from $23.2 million for the second quarter of 2018, to $24.8 million for the second quarter of 2019. Our interest and dividend income increased $690,000, or 2.4%, for the second quarter 2019, compared to the first quarter of 2019, and reflected an increase of $2.3 million, or 8.5%, compared to the second quarter of 2018. Tax equivalent interest and dividend income increased by $2.3 million, or 8.4%, from $27.8 million for the second quarter of 2018, to $30.2 million for the second quarter of 2019.
Average earning assets for the second quarter of 2019 were $2.45 billion, reflecting an increase of $8.4 million compared to the first quarter of 2019, and an increase of $55.6 million compared to the second quarter of 2018. Total average loans, including loans held-for-sale, totaled $1.90 billion in the second quarter of 2019, which reflected an increase of $1.8 million compared to the first quarter of 2019, and an increase of $88.2 million compared to the second quarter of 2018. The growth in average balances and resultant interest income in the year over year period was primarily due to $227.6 million of loans acquired, net of purchase accounting adjustments, in our acquisition of ABC Bank on April 20, 2018. Organic loan growth and the rising interest rate environment also drove growth in interest and dividend income. For the second quarter of 2019, yields on average securities increased by 14 basis points and yields on average loans increased by 28 basis points, each compared to the second quarter of 2018, due to the rising interest rate environment.
Average interest bearing liabilities decreased $40.8 million, or 2.3%, in the second quarter of 2019, compared to the first quarter of 2019, and decreased $24.4 million, or 1.4%, compared to second quarter of 2018. The reduction in average interest bearing deposits from the prior quarter and prior year periods was partially offset with growth in noninterest bearing deposits, primarily commercial demand deposits, of $26.8 million for the year over year period. Average other short-term borrowings, which primarily consist of FHLBC advances, decreased $5.0 million in the second quarter of 2019, compared to the first quarter of 2019, and increased $35.2 million, compared to the second quarter of 2018. The average rate paid on short-term FHLBC advances were impacted by the higher interest rate environment resulting in an average rate of 2.47% for the second quarter of 2019, compared to 2.50% for the first quarter of 2019, and 1.90% for the second quarter of 2018. In addition, we acquired notes payable and other borrowings in our acquisition of ABC Bank, consisting solely of long-term FHLBC advances, which resulted in an increase to average interest bearing liabilities of $13.1 million for the second quarter of 2019, an increase of $15.3 million for the first quarter of 2019, and an increase of $19.8 million for the second quarter of 2018. The average cost of funds on these long-term advances was 3.28% for the second quarter of 2019, 3.08% for the first quarter of 2019, and 1.92% for the second quarter of 2018. The rate on our junior subordinated debentures was within a seven basis point range over the past year, reflecting an average rate of 6.47% for the second quarter of 2019, 6.52% for the first quarter of 2019, and 6.45% for the second quarter of 2018.
Our net interest margin, on a tax-equivalent (TE) basis, expressed as a percentage of average earning assets, was 4.15% for the second quarter of 2019, reflecting a six basis point increase from the first quarter of 2019, and an increase of 16 basis points from the second quarter of 2018. The average tax-equivalent yield on earning assets increased to 4.94% for the second quarter of 2019, compared to 4.90% for the first quarter of 2019, and 4.67% for the second quarter of 2018. Increases in net interest margin and yield on average earning assets for the second quarter of 2019, compared to the first quarter of 2019, was attributable to growth in loan volumes and rates, and the increase in net interest margin was also due to growth in noninterest bearing demand accounts, which are a less expensive source of funding. The cost of funds on interest bearing liabilities was 1.13% for the second quarter of 2019, 1.12% for the first quarter of 2019, and 0.92% for the second quarter of 2018. The increase in our cost of funds in each period was driven by the rising interest rate environment, specifically impacting the rates on NOW accounts, newly issued time deposits and FHLBC advances.
Our net interest and dividend income increased by $5.9 million, from $42.9 million for the six months ended June 30, 2018, to $48.8 million for the six months ended June 30, 2019. Our interest and dividend income increased $8.1 million, or 16.0%, for the six months ended June 30, 2019, compared to the six months ended June 30, 2018. Tax equivalent interest and dividend income increased by $8.1 million from $51.5 million for the six months ended June 30, 2018 to $59.6 million for the six months ended June 30, 2019.
Average earning assets for the six months ended June 30, 2019 were $2.44 billion, reflecting an increase of $159.5 million compared to the six months ended June 30, 2018. The yield on average earning assets for the six months ended June 30, 2019 was 4.92%, compared to 4.55% for the six months ended June 30, 2018. Total average loans, including loans held-for-sale, totaled $1.90 billion for the six months ended June 30, 2019, which reflected an increase of $189.8 million compared to the six months ended June 30, 2018. The growth in average loan balances and the resultant interest income was primarily due to $227.6 million of loans acquired, net of purchase accounting adjustments, in our acquisition of ABC Bank on April 20, 2018, organic loan growth and the rising interest rate environment. For the six months ended June 30, 2019, yields on average securities increased by 30 basis points and yields on average loans increased by 37 basis points, each as compared to the six months ended June 30, 2018, due primarily to the rising interest rate environment.
Average interest bearing liabilities increased $76.4 million, or 4.6%, in the six months ended June 30, 2019, compared to the six months ended June 30, 2018. The increase was due primarily to increases in interest bearing deposits of $46.8 million and other short-term borrowings of $23.1 million, which primarily consist of FHLBC advances. The average rate paid on short-term FHLBC advances were impacted by the higher interest rate environment, resulting in an average rate of 2.49% for the six months ended June 30, 2019, compared to 1.68% for the six months ended June 30, 2018. In addition, we acquired notes payable and other borrowings in our acquisition of ABC Bank, consisting solely of long-term FHLBC advances, which resulted in an increase to average interest bearing liabilities of $14.1 million for the six months ended June 30, 2019 and an increase of $10.0 million for the six months ended June 30, 2018. The average cost of funds on these long-term advances was 3.16% for the six months ended June 30, 2019, compared to 1.92% for the six months ended June 30, 2018. The rate on our junior subordinated debentures was 6.49% for both the six months ended June 30, 2019 and 2018.
Our net interest margin (TE) for the six months ended June 30, 2019, was 4.12% compared to 3.88% for the six months ended June 30, 2018, reflecting a 24 basis point increase. The increase in net interest margin for the six months ended June 30, 2019, compared to the six months ended June 30, 2018, was due primarily to the ABC Bank acquisition and organic loan growth, as well as a shift to noninterest bearing deposit accounts, which partially offset increases in cost of funds due to the rising rate environment.
We continue to observe competitive pressure to maintain reduced interest rates on loans retained at renewal. While our loan prices are targeted to achieve certain returns on equity, significant competition for commercial and industrial loans as well as commercial real estate loans has put pressure on loan yields, and our stringent underwriting standards limit our ability to make higher-yielding loans.
The following tables set forth certain information relating to our average consolidated balance sheet and reflect the yield on average earning assets and cost of average interest bearing liabilities for the periods indicated. These yields reflect the related interest, on an annualized basis, divided by the average balance of assets or liabilities over the applicable period. Average balances are derived from daily balances. For purposes of discussion, net interest income and net interest income to total earning assets in the following tables have been adjusted to a non-GAAP tax equivalent (“TE”) basis using a marginal rate of 21% in 2019 and 2018 to more appropriately compare returns on tax-exempt loans and securities to other earning assets.
Analysis of Average Balances,
Tax Equivalent Income / Expense and Rates
Quarters Ended
March 31, 2019
Income /
Rate
Expense
19,053
2.34
18,842
2.45
19,161
2.03
229,263
3.89
236,882
2,414
4.13
268,591
3.57
Non-taxable (TE)2
290,743
2,710
3.74
276,609
2,656
286,611
Total securities
520,006
4,933
3.80
513,491
5,070
555,202
5,068
3.66
Dividends from FHLBC and FRBC
11,317
5.53
11,463
5.27
8,619
5.17
Loans and loans held-for-sale 1, 2
1,897,324
24,958
5.28
1,895,512
24,126
5.16
1,809,077
22,552
Total interest earning assets
2,447,700
30,158
4.94
2,439,308
29,459
2,392,059
27,828
4.67
33,618
33,749
36,720
Allowance for loan and lease losses
(19,435)
(19,235)
(18,494)
Other noninterest bearing assets
174,075
181,767
176,608
2,635,958
2,635,589
2,586,893
Liabilities and Stockholders' Equity
442,430
373
0.34
448,518
379
443,586
238
0.22
288,698
262
0.36
299,305
270
0.37
317,775
0.24
Savings accounts
313,822
124
0.16
307,740
122
298,240
0.09
422,975
1.56
445,076
1,618
1.47
460,909
1.26
1,467,925
2,400
0.66
1,500,639
2,389
0.65
1,520,510
1,945
0.51
1.33
45,157
1.34
44,655
0.93
93,369
2.47
98,328
607
58,199
1.90
57,704
6.47
57,692
6.52
57,657
6.45
44,196
6.10
44,171
6.17
44,096
6.11
13,101
3.28
15,273
3.08
19,795
1.92
Total interest bearing liabilities
1,720,479
1.13
1,761,260
4,860
1.12
1,744,912
0.92
645,580
625,423
618,765
19,586
13,750
15,679
Stockholders' equity
250,313
235,156
207,537
Total liabilities and stockholders' equity
Net interest income (TE) 2
25,326
24,599
23,809
Net interest margin (TE) 2
4.15
4.09
3.99
Interest bearing liabilities to earning assets
70.29
72.20
72.95
1 Interest income from loans is shown on a tax equivalent basis, which is a non-GAAP financial measure, as discussed in the table on page 39, and includes fees of $184,000, $229,000 and $233,000 for the second quarter of 2019, the first quarter of 2019, and the second quarter of 2018, respectively. Nonaccrual loans are included in the above-stated average balances.
2 Tax equivalent basis is calculated using a marginal tax rate of 21% in 2019 and 2018. See the discussion entitled “Non-GAAP Presentations” below and the table on page 45 that provides a reconciliation of each non-GAAP measure to the most comparable GAAP equivalent.
18,948
2.39
16,505
1.78
233,051
4.01
268,959
3.42
283,715
5,366
3.81
283,240
5,285
3.76
516,766
10,003
3.90
552,199
9,847
3.60
11,390
5.40
8,769
4.99
Loans and loans held-for-sale 1 , 2
1,896,422
49,084
5.22
1,706,581
41,319
4.88
2,443,526
59,617
4.92
2,284,054
51,529
4.55
33,683
33,267
(19,335)
(18,379)
177,904
171,585
2,635,778
2,470,527
445,457
752
436,483
414
0.19
293,972
296,672
302
310,798
246
282,390
433,964
1.51
421,882
1.25
1,484,191
4,789
1,437,427
3,464
0.49
44,668
42,477
0.87
95,835
2.49
72,741
1.68
57,698
6.49
57,651
6.13
44,084
6.15
14,181
222
9,952
1,740,757
9,691
1,664,332
0.91
635,557
586,871
16,688
14,829
242,776
204,495
49,926
43,984
4.12
3.88
1 Interest income from loans is shown on a tax equivalent basis, which is a non-GAAP financial measure, as discussed in the table on page 39, and includes fees of $413,000 and $415,000 for the first six months of 2019 and 2018, respectively. Nonaccrual loans are included in the above-stated average balances.
Reconciliation of Tax-Equivalent Non-GAAP Financial Measures
Net interest income (TE) and net interest income (TE) to earning assets are non-GAAP measures that have been adjusted on a TE basis using a marginal rate of 21% for 2019 and 2018 to more appropriately compare returns on tax-exempt loans and securities to other earning assets. The table below provides a reconciliation of each non-GAAP (TE) measure to the GAAP equivalent for the periods indicated:
43
March 31,
Net Interest Margin
Interest income (GAAP)
28,896
Taxable-equivalent adjustment:
558
562
1,127
1,110
Interest income (TE)
Interest expense (GAAP)
Net interest income (TE)
49,925
Net interest income (GAAP)
24,036
Average interest earning assets
Net interest margin (GAAP)
Net interest margin (TE)
Noninterest Income and Expense
The following table details the major components of noninterest income for the periods presented:
2nd Quarter 2019
Noninterest Income
Percent Change From
1,486
17.0
5.7
1,862
5.2
10.7
Residential mortgage banking revenue
136
49.3
4.1
Mortgage servicing rights mark to market (loss)
(819)
(38.8)
(982.9)
457
7.4
(21.7)
762
52.6
(6.2)
Total residential mortgage banking revenue
720
536
1,957
34.3
(63.2)
Securities gain, net
N/M
216.0
458
(30.1)
(8.8)
987
18.1
3.0
1,126
11.3
(8.3)
6,482
25.6
(4.6)
Noninterest income for the second quarter of 2019 increased $1.7 million, or 25.6%, compared to the first quarter of 2019, and decreased $389,000, or 4.6%, compared to the second quarter of 2018.
The increase in noninterest income in the second quarter of 2019, compared to the first quarter of 2019, was driven primarily by a $959,000 increase in securities gain, net, due to select security sales in the second quarter. In addition, increases were reflected in trust income, service charges on deposits, total residential mortgage banking revenue, debit card interchange income, and other income, which resulted in an aggregate $840,000 increase in noninterest income in the second quarter of 2019, compared to the first quarter of 2019. These increases were partially offset by an increase in MSR mark to market losses of $318,000 in the second quarter of 2019, compared to the prior linked quarter, due to interest rate driven valuation reductions and a decrease of $138,000 related to the cash surrender value of BOLI in the second quarter of 2019, compared to the prior linked quarter.
The decrease in noninterest income for the year over year period of $389,000 was primarily driven by a $1.2 million reduction in total residential mortgage banking revenue in the second quarter of 2019, resulting primarily from an increase in MSR mark to market losses of $1.0 million due to interest rate valuation reductions. These reductions were partially offset by aggregate increases of $992,000 resulting from growth in trust income, service charges on deposits, securities gain, net, and debit card interchange income.
44
YTD
Percent
Change
2.7
13.7
(5.0)
(12.1)
(10.8)
3,793
(66.9)
191.9
29.9
(100.0)
0.4
(9.4)
(14.2)
N/M - Not meaningful
Noninterest income for the six months ended June 30, 2019 decreased $2.4 million, or 14.2%, compared to the six months ended June 30, 2018. The decrease in noninterest income for the six months ended June 30, 2019, compared to the prior year period, was primarily driven by a $2.0 million reduction in total residential mortgage banking revenue stemming from rising interest rates and the resultant MSR mark to market valuation losses, and a reduction in other income due to a decline in commercial swap fees. These decreases were partially offset by an increase in service charges on deposits, securities gain, net, and an increase in income due to the change in the cash surrender value of BOLI.
The following table details the major components of noninterest expense for the periods presented:
Noninterest Expense
Salaries
9,004
8,634
9,703
4.3
(7.2)
Officers incentive
893
882
740
1.2
20.7
Benefits and other
1,690
2,096
1,912
(19.4)
(11.6)
Total salaries and employee benefits
11,612
(0.2)
Occupancy, furniture and equipment expense
1,989
(3.2)
16.5
1,332
14.4
(44.4)
174
(33.3)
(29.7)
250
(5.6)
(21.1)
Amortization of core deposit intangible asset
24.7
234
62.8
(22.6)
58.5
92.9
(15.0)
Other real estate owned expense, net
396.0
(42.2)
3,148
11.6
19,194
4.9
(9.7)
Efficiency ratio (GAAP)1
61.91
62.35
69.16
Adjusted efficiency ratio (non-GAAP)2
60.66
60.98
57.88
1 The efficiency ratio shown in the table above is a GAAP financial measure calculated as noninterest expense, excluding OREO expenses and amortization of core deposits, divided by the sum of net interest income and total noninterest income less net gains and
losses on securities and any BOLI death benefit recorded.
2The adjusted efficiency ratio shown in the table above is a non-GAAP financial measure calculated as noninterest expense, excluding OREO expenses, amortization of core deposits and acquisition costs, divided by the sum of net interest income on a fully tax equivalent basis, total noninterest income less net gains and losses on securities and any BOLI death benefit, and includes a tax equivalent adjustment on the increase in cash surrender value of BOLI recorded.
See the section entitled “Reconciliation of Adjusted Efficiency Ratio Non-GAAP Financial Measures” on page 48 for a reconciliation of this non-GAAP measure to the most comparable GAAP equivalent.
Noninterest expense for the second quarter of 2019 increased $932,000, or 4.9%, compared to the first quarter of 2019, and decreased $2.2 million, or 9.7%, compared to the second quarter of 2018.
The increase in noninterest expense in the second quarter of 2019, compared to the first quarter of 2019, was primarily attributable to a $198,000 increase in other real estate expense, net, due to valuation writedowns, and an increase of $364,000 in other expense due to growth in appraisal and commercial loan related fees, consulting fees, and the timing of audit fees. Computer and data processing also reflected an increase in the second quarter of 2019, compared to the first quarter of 2019, as various projects with software requirements were renewed or enhanced in the current quarter.
The decrease in noninterest expense in the second quarter of 2019, compared to the second quarter of 2018, is primarily attributable to ABC Bank acquisition-related costs recorded in the second quarter of 2018, such as data conversion costs included within computer and data processing, salaries expense stemming from employee continuation and retention accruals, and advertising expense. An increase was reflected in occupancy, furniture and equipment expense of $273,000 for the second quarter of 2019, compared to the second quarter of 2018, which partially offset the overall decrease in noninterest expense in the second quarter of 2019, as we acquired four additional branches with the ABC Bank acquisition, and recorded the commensurate additional costs associated with those branches for a full quarter in the 2019 period.
17,638
17,038
3.5
1,775
1,527
16.2
3,786
3,997
(5.3)
2.8
21.9
114.4
(26.2)
(34.7)
(17.1)
(50.5)
(0.8)
1 The efficiency ratio shown in the table above is a GAAP financial measure calculated as noninterest expense, excluding OREO expenses and amortization of core deposits, divided by the sum of net interest income and total noninterest income less net gains and losses on securities and any BOLI death benefit recorded.
See the section entitled “Reconciliation of Adjusted Efficiency Ratio Non-GAAP Financial Measures” on page 48 for a reconciliation
of this non-GAAP measure to the most comparable GAAP equivalent.
Noninterest expense for the six months ended June 30, 2019, decreased $320,000, or 0.8%, compared to the six months ended June 30, 2018, primarily due to the decrease in computer and data processing costs year over year of $1.2 million. The higher costs in the 2018 period were related to the ABC Bank acquisition data conversion in the second quarter of 2018. In addition, other real estate owned expense, net, decreased $304,000 in the six months ended June 30. 2019, compared to the six months ended June 30, 2018, driven by the decline in other real estate held. Partially offsetting these decreases were increases in occupancy, furniture and equipment expenses of $704,000, amortization of core deposit intangibles of $135,000, and other expenses increased $328,000 due primarily to consulting fees and commercial loan related costs.
Reconciliation of Adjusted Efficiency Ratio Non-GAAP Financial Measures
GAAP
Non-GAAP
Efficiency Ratio / Adjusted Efficiency Ratio
Less amortization of core deposit
Less other real estate expense, net
Less acquisition related costs
3,168
Noninterest expense less adjustments
19,757
19,012
21,760
18,592
Net interest income
Net interest income including adjustments
Less securities gain, net
93
Noninterest income (less) / including adjustments
7,157
6,455
8,220
7,242
6,577
8,313
Net interest income including adjustments plus noninterest income (less) / including adjustments
31,911
30,491
31,462
32,568
31,176
32,122
Efficiency ratio / Adjusted efficiency ratio
Income Taxes
We recorded tax expense of $3.0 million on $12.3 million of pretax income for the second quarter of 2019, compared to income tax expense of $2.4 million in the first quarter of 2019, and $1.8 million of income tax expense in the second quarter of 2018. The effective tax rate for the second quarter of 2019 was 24.7%, compared to 22.1% for the first quarter of 2019, and 22.1% for the second quarter of 2018. The effective tax rate for the second quarter of 2019 was higher than the prior linked quarter due to a tax benefit recorded related to restricted stock awards which vested in the first quarter of 2019, while the effective tax rate for the second quarter of 2019 reflected an increase over the prior year like quarter due to higher levels of taxable income in the second quarter of 2019.
We recorded tax expense of $5.4 million on $23.2 million of pretax income for the six months ended June 30, 2019, compared to income tax expense of $3.8 million on $19.5 million of pretax income for the six months ended June 30, 2018. The effective tax rate for the six months ended June 30, 2019 was 23.5%, which was an increase from the effective tax rate of 19.3% for the six months ended June 30, 2018, due to higher levels of taxable income in the second quarter of 2019, as the 2018 period included $1.0 million of proceeds from a nontaxable BOLI death benefit.
Income tax expense reflected all relevant statutory tax rates and GAAP accounting. There were no significant changes in our ability to utilize the deferred tax assets during the quarter ended June 30, 2019. We had no valuation reserve on the deferred tax assets as of June 30, 2019.
Financial Condition
Total assets decreased $52.4 million from $2.68 billion at December 31, 2018, to $2.62 billion at June 30, 2019, due primarily to a decrease of $49.2 million in securities available-for-sale, as well as a $7.0 million decrease in the deferred tax assets, net. Total loans
47
as of June 30, 2019, increased $5.9 million, or 0.3%, compared to December 31, 2018. Total deposits were $2.08 billion at June 30, 2019, a decrease of $38.9 million from December 31, 2018, primarily due to reductions in time, NOWs and money markets, partially offset by an increase in noninterest bearing demand accounts.
As of
3,876
2.6
3.8
12,216
(10.4)
(19.7)
13,407
20.8
26.8
276,112
(9.0)
700
61,432
0.7
5.6
109,263
(24.5)
(24.3)
66,638
(3.0)
(6.4)
543,644
(9.1)
(9.5)
Available-for-sale security sales during the three months ended June 30, 2019 totaled $32.1 million and consisted of asset-backed securities and state and political subdivisions, whereas purchases during the three month period were primarily tax exempt state and political subdivisions securities. During the second quarter of 2019 security sales resulted in net realized gains of $986,000, compared to $27,000 of security gains, net, for the first quarter of 2019, and security gains, net, of $312,000 for the second quarter of 2018.
Total loans were $1.90 billion as of June 30, 2019, an increase of $5.9 million from December 31, 2018. The increase in total loans for the six month period was due primarily to organic growth in commercial loans, leases, and real estate-commercial loans. Total loans increased $53.8 million from June 30, 2018 to June 30, 2019, due primarily to organic loan growth in commercial, leases, and real estate-commercial, as well as a select HELOC bulk loan purchase of $20.7 million in November 2018.
7.5
12.8
24.8
47.5
808,264
0.5
2.1
115,486
(14.1)
404,908
(3.3)
(2.8)
(8.4)
13,969
(6.3)
(3.1)
1,836,836
0.3
2.9
1,112
18.5
76.2
1,837,948
(1.2)
(3.4)
The quality of our loan portfolio is impacted not only by our credit decisions but also by the economic health of the communities in which we operate. Since we are located in a corridor with significant open space and undeveloped real estate, real estate lending (including commercial, construction, residential, and HELOCs) has been and continues to be a sizeable portion of our portfolio. These categories comprised 75.7% of the portfolio as of June 30, 2019, compared to 77.9% of the portfolio as of December 31, 2018. We continue to oversee and manage our loan portfolio in accordance with interagency guidance on risk management.
Asset Quality
We recorded a $450,000 provision for loan and lease losses for the quarter ended June 30, 2019, compared to a provision of $1.5 million for the quarter ended June 30, 2018. In the second quarter of 2019, we determined provision expense was necessary at a
48
level approximately commensurate with net charge-offs for the quarter, which were $394,000. Runoffs on our acquired loan portfolios are trending with expectations. Management estimates the amount of provision required on a quarterly basis and records the appropriate provision expense, or release of expense, to maintain an adequate reserve for all potential and estimated loan and lease losses.
Nonperforming loans consist of nonaccrual loans, performing restructured accruing loans and loans 90 days or greater past due. We do not consider our PCI loans, which showed evidence of deteriorated credit quality at acquisition, to be nonperforming assets as long as their cash flows and the timing of such cash flows continue to be estimable and probable of collection. Therefore, interest income is recognized through accretion of the difference between the carrying value of these loans and the present value of expected future cash flows. As a result, management has excluded PCI loans from the nonperforming loans in the table below. Remediation work continues in all segments. Nonperforming loans decreased by $3.7 million at June 30, 2019, to $12.7 million from $16.3 million at December 31, 2018. Credit metrics continue to be relatively stable regarding nonperforming loan levels, and management is carefully monitoring loans considered to be in a classified status. Nonperforming loans as a percent of total loans decreased to 0.7% as of June 30, 2019, from 0.9% as of December 31, 2018, and increased slightly from 0.6% as of June 30, 2018. The distribution of our nonperforming loans is shown in the following table.
Nonperforming Loans
(57.1)
Real estate-commercial, nonfarm
6,773
9,738
5,012
(30.4)
35.1
Real estate-construction
635
(77.6)
(83.9)
Real estate-residential:
409
8.5
3,616
4,278
(10.7)
1,873
1,614
16.0
22.9
(29.4)
50.0
Total nonperforming loans
12,659
16,341
11,874
(22.5)
6.6
Loan Charge-offs, net of recoveries
% of
Total1
15.5
(18)
(12.9)
2.5
Owner general purpose
62.1
Owner special purpose
(2.1)
Non-owner general purpose
(12)
(15)
(20)
Non-owner special purpose
99.3
476
150.2
Total real estate-commercial, nonfarm
7.7
208
148.6
483
152.4
Real estate-commercial, farm
(1)
(0.7)
(0.6)
(0.5)
1.4
0.6
Total real estate-construction
Real estate-residential
(7.1)
(63)
(19.9)
(8)
(5.7)
(11)
(3.5)
(14)
(10.0)
(26)
(8.2)
Total real estate-residential
(3.6)
(22.8)
(100)
(31.6)
267
67.8
(46)
(32.9)
Other 2
19.3
9.2
Net charge-offs / (recoveries)
394
100.0
317
1 Represents the percentage of net charge-offs attributable to each category of loans.
2 The “Other” class includes consumer and overdrafts.
Net charge-offs of $394,000 were recorded for the second quarter of 2019, compared to net charge-offs of $140,000 for the first quarter of 2019 and net charge-offs of $317,000 for the second quarter of 2018, reflecting continuing management attention to credit quality and remediation efforts. We have continued our conservative loan valuations and aggressive recovery efforts on prior charge-offs.
The following table shows classified assets by segment for the following periods.
Classified Assets
393
539
(76.8)
19,186
22,661
12,362
(15.3)
55.2
1,248
(1.0)
(89.5)
(25.4)
(15.4)
3,302
(49.6)
(85.1)
5,428
(16.6)
(30.5)
1,633
10.0
27.3
33.3
Total classified loans
26,318
1.8
36.4
(21.0)
(36.4)
Total classified assets, excluding PCI loans
41,563
42,444
35,230
18.0
PCI, net of purchase accounting adjustments
Total classified assets
52,397
53,409
46,444
(1.9)
Classified loans include nonaccrual, performing troubled debt restructurings and all other loans considered substandard. Classified assets include both classified loans and OREO. Loans classified as substandard are inadequately protected by either the current net worth and ability to meet payment obligations of the obligor, or by the collateral pledged to secure the loan, if any. These loans have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt and carry the distinct possibility that we will sustain some loss if deficiencies remain uncorrected.
Total classified loans increased as of June 30, 2019, from the levels at December 31, 2018 and June 30, 2018, primarily due to one large commercial credit which moved to classified status in the first quarter of 2019. Total classified assets reflected a slight decline as of June 30, 2019, from the level at December 31, 2018, and an increase compared to the level one year ago. Management monitors a ratio of classified assets to the sum of Bank Tier 1 capital and the allowance for loan and lease losses as another measure of overall change in loan related asset quality, which is referred to as the “classified assets ratio.” The classified assets ratio was 12.56% for the period ended June 30, 2019, compared to 13.49% as of December 31, 2018 and 12.01% as of June 30, 2018. The decrease in the classified assets ratio for the quarter ended June 30, 2019, compared to December 31, 2018, is due to a $1.5 million decrease in other real estate owned and the continuing accretion of PCI loans, net of purchase accounting adjustments.
Allowance for Loan and Lease Losses
Below is a reconciliation of the activity for loan losses for the periods indicated (in thousands):
Allowance at beginning of period
Charge-offs:
231
84
Total charge-offs
345
Recoveries:
Total recoveries
205
534
(1,132)
Provision (release) for loan and lease losses
Allowance at end of period
Average total loans (exclusive of loans held-for-sale)
1,894,454
1,893,659
1,806,209
1,894,058
1,703,969
Net charge-offs / (recoveries) to average loans
0.03
(0.07)
Allowance at period end to average loans
1.02
1.07
498
19,094
18,823
Net charge-offs for the quarter ended June 30, 2019, totaled $394,000, compared to $140,000 for the quarter ended March 31, 2019, and $317,000 for the quarter ended June 30, 2018. The coverage ratio of the allowance for loan and lease losses to nonperforming loans was 153.0% as of June 30, 2019, which was an increase from the coverage ratio of 129.3% as of March 31, 2019, and a decrease from 162.7% as of June 30, 2018. When measured as a percentage of average loans, our total allowance for loan and lease losses was 1.02% of quarterly average loans as of June 30, 2019 and March 31, 2019 and 1.07% as of June 30, 2018. The total allowance for loan
and lease losses as a percent of total period end loans was 1.05% as of June 30, 2019, excluding the loans acquired in our acquisition of ABC Bank and in our Talmer branch purchase.
In accordance with the accounting guidance for business combinations, there was no allowance brought forward on any of the acquired loans in our acquisition of ABC Bank or our Talmer branch purchase. For purchased non-credit impaired loans (“non-PCI loans”), which refers to loans acquired in our acquisition that did not show signs of credit deterioration at acquisition, credit discounts representing the principal losses expected over the life of the loan are a component of the initial fair value and the discount is accreted to interest income over the life of the loan. Subsequent to the purchase date, the method used to evaluate the sufficiency of the credit discount is similar to organic loans, and if necessary, additional reserves are recognized in the allowance for loan and lease losses. The aggregate non-PCI loans related to our acquisition of ABC Bank and the Talmer branch purchase totaled $227.1 million as of June 30, 2019, net of purchase accounting adjustments of $1.2 million, which included $915,000 of credit discounts. At June 30, 2019, of our $19.4 million allowance for loan and lease losses, $1.5 million related to non-PCI loans. In management’s judgment, an adequate allowance for estimated losses has been established for inherent losses at June 30, 2019, and general changes in lending policy, procedures and staffing, as well as other external factors. However, there can be no assurance that actual losses will not exceed the estimated amounts in the future, based on unforeseen economic events, changes in business climates and the condition of collateral at the time of default and repossession.
We recorded PCI loans, which refers to loans that showed evidence of deteriorated credit quality upon purchase, in our acquisition of ABC Bank. PCI loans totaled $10.8 million, net of purchase accounting adjustments, as of June 30, 2019, and included $5.5 million of credit discounts as of June 30, 2019. We perform re-estimations of cash flows on our PCI loan portfolio on a quarterly basis. Any decline in expected cash flows as a result of these re-estimations, due in any part to a change in credit, is deemed credit impairment, and recorded as provision for loan and lease losses during the period. Any decline in expected cash flows due only to changes in expected timing of cash flows is recognized prospectively as a decrease in yield on the loan and any improvement in expected cash flows, once any previously recorded impairment is recaptured, is recognized prospectively as an adjustment to the yield on the loan.
Other Real Estate Owned
As of June 30, 2019, OREO decreased to $5.7 million, compared to $7.2 million at December 31, 2018, and $8.9 million at June 30, 2018. There were no additions to the OREO portfolio in the second quarter of 2019. Property disposals in the second quarter of 2019 totaled $501,000 due to three property sales. Five valuation write-downs occurred in the second quarter of 2019 with an expense total of $195,000, compared to $254,000 of valuation write-downs recorded in the second quarter of 2018.
OREO
6,964
(8.6)
(9.9)
21.0
(29.3)
96
104.2
In management’s judgment, the property valuation allowance as established presents OREO at current estimates of fair value less estimated costs to sell; however, there can be no assurance that additional losses will not be incurred on disposals or upon updates to valuations in the future. Of note, properties valued in total at $4.5 million, or approximately 80.2% of total OREO at June 30, 2019, have been in OREO for five years or more. The appropriate regulatory approval has been obtained for any OREO properties held in excess of five years.
OREO Properties by Type
% of Total
Single family residence
1,137
2,460
Lots (single family and commercial)
4,162
4,310
4,395
Vacant land
440
470
Commercial property
696
1,258
1,587
Total other real estate owned
52
Deposits and Borrowings
Deposits
620,807
2.3
1.9
301,832
3.3
435,514
320,949
(8.1)
(11.1)
249,049
(4.2)
(11.3)
175,174
(17.7)
58,526
(15.5)
(4.1)
2,161,851
(1.8)
(3.9)
Total deposits were $2.08 billion at June 30, 2019, which reflects a $38.9 million decrease from total deposits of $2.12 billion at December 31, 2018, and a decrease of $84.1 million from the $2.16 billion at June 30, 2018. The decrease in deposits at June 30, 2019, compared to December 31, 2018, was due primarily to declines in money market accounts and certificates of deposit, which was partially offset by growth in noninterest bearing demand, savings and NOW accounts. The reduction in deposits in the year over year period reflected an aggregate decrease in NOW, money market and time deposits of $106.2 million or 126.3%, partially offset by aggregate increases in demand deposits and savings accounts of $22.1 million, or 2.6% In addition to total deposit growth experienced related to our ABC Bank acquisition, an increase in noninterest bearing demand deposits in the second quarter of 2019 compared to the first quarter of 2019 and the year over year like period was attributable to strong commercial demand deposit growth stemming from operational fund increases as well as growth in commercial loan clients over the past year.
In addition to deposits, we obtained funding from other sources in all periods presented. Securities sold under repurchase agreements totaled $54.2 million at June 30, 2019, a $7.5 million, or 16.3%, an increase from $46.6 million at December 31, 2018. We also recorded short-term borrowings of $87.1 million from the FHLBC at June 30, 2019, as compared to $149.5 million in short-term borrowings at December 31, 2018. We assumed $23.4 million of long-term FHLBC advances in our ABC Bank acquisition, with maturities scheduled over the next seven years and paying interest at rates of 1.60% to 2.83%. These long-term advances totaled $11.0 million as of June 30, 2019, compared to $15.4 million as of December 31, 2018.
The Company is indebted on senior notes totaling $44.2 million, net of deferred issuance costs, as of June 30, 2019. These notes mature in December 2026, and include interest payable semi-annually at 5.75% for five years. Beginning December 2021, the interest becomes payable quarterly at three month LIBOR plus 385 basis points. The Company is also indebted on $57.7 million, net of deferred issuance costs, of junior subordinated debentures, which are related to the trust preferred securities issued by its two statutory trust subsidiaries, Old Second Capital Trust I and Old Second Capital Trust II (“Trust II”). The Trust II issuance converted from fixed to floating rate at three month LIBOR plus 150 basis points on June 15, 2017. Upon conversion to a floating rate, we initiated a cash flow hedge which resulted in the total interest rate paid on this debt of 4.40% as of June 30, 2019, as compared to 6.77%, which was the rate paid during the period prior to the June 15, 2017 rate reset.
As of June 30, 2019, total stockholders’ equity was $257.3 million, which was an increase of $28.2 million from $229.1 million as of December 31, 2018. This increase is directly attributable to net income of $17.7 million for the first six months of 2019, and a change in accumulated other comprehensive net income (loss), which was a net loss of $4.1 million at December 31, 2018, and a net gain of $6.1 million as of June 30, 2019. In addition, we paid $597,000 of dividends to our common stockholders in the six months ended June 30, 2019.
Our total stockholders’ equity in 2018 included $4.8 million related to the value of a ten-year warrant to purchase shares of our common stock, with an exercise price of $13.43 per share. We issued the warrant in January 2009 as part of our Series B preferred stock issuance. We redeemed all of our Series B preferred stock as of September 30, 2015. The warrant was subsequently sold at auction by the U.S. Treasury in June 2013 to a third party investor. The warrant was exercised on January 16, 2019, in a cashless transaction. As of the date of exercise, our closing market stock price was $14.23 per share, resulting in 45,836 shares being issued, and a net $313,000 reduction to treasury stock.
The following table shows the regulatory capital ratios and the current well capitalized regulatory requirements for the Company and the Bank as of the dates indicated:
Well-Capitalized Plus Capital
Conservation Buffer1
The Company
Common equity tier 1 capital ratio
8.49
Total risk-based capital ratio
11.87
Tier 1 risk-based capital ratio
10.99
Tier 1 leverage ratio
9.37
The Bank
7.00
12.62
10.50
13.51
8.50
10.75
1Represents ratios required to be considered well capitalized under prompt corrective action provisions plus the now fully-phased in capital conservation buffer of 2.5%. The prompt corrective action provisions are only applicable at the Bank level.
As of June 30, 2019, the Company, on a consolidated basis, exceeded the minimum capital ratios to be deemed “well capitalized” and met the now fully phased-in capital conservation buffer requirements. In addition to the above regulatory ratios, our GAAP common equity to total assets ratio, which is used as a performance measurement for capital analysis and peer comparisons, increased from 8.56% at December 31, 2018, to 9.81% at June 30, 2019, due to net income generated for the first six months of 2019, as well as a more favorable position related to unrealized gains on securities available-for-sale. Our GAAP tangible common equity to tangible assets ratio was 9.06% at June 30, 2019, compared to 7.81% as of December 31, 2018. Our non-GAAP tangible common equity to tangible assets ratio, which management also considers a valuable performance measurement for capital analysis, increased from 7.83% at December 31, 2018 to 9.08% at June 30, 2019.
Reconciliation of Tangible Common Equity to Tangible Assets Ratio Non-GAAP Measure
Tangible common equity
Total Equity
Less: Goodwill and intangible assets
Add: Limitation of exclusion of core deposit intangible (80%)
591
642
Adjusted goodwill and intangible assets
20,970
21,172
235,703
236,294
207,267
207,909
Tangible assets
Less: Adjusted goodwill and intangible assets
2,602,045
2,602,636
2,654,189
2,654,831
Common equity to total assets
9.81
8.56
Tangible common equity to tangible assets
9.06
9.08
7.81
7.83
The non-GAAP intangible asset exclusion reflects the 80% core deposit limitation per Basel III guidelines within risk based capital calculations, and is useful for us when reviewing risk based capital ratios and equity performance metrics.
Liquidity
Liquidity is our ability to fund operations, to meet depositor withdrawals, to provide for customers’ credit needs, and to meet maturing obligations and existing commitments. Our liquidity principally depends on our cash flows from operating activities, investment in and maturity of assets, changes in balances of deposits and borrowings, and our ability to borrow funds. We monitor our borrowing capacity at the FHLBC as part of our liquidity management process as supervised by our Asset and Liability Committee (“ALCO”) and reviewed by our Board of Directors.
Net cash inflows from operating activities were $39.9 million during the first six months of 2019, compared with net cash inflows of $27.6 million in the same period of 2018. Proceeds from sales of loans held-for-sale, net of funds used to originate loans held-for-sale,
were a source of outflows for the first six months of 2019 and inflows for the 2018. Interest paid, net of interest received, combined with changes in other assets and liabilities were a source of inflows for the first six months of 2019 and 2018. The management of investing and financing activities, as well as market conditions, determines the level and the stability of net interest cash flows. Management’s policy is to mitigate the impact of changes in market interest rates to the extent possible, as part of the balance sheet management process.
Net cash inflows from investing activities were $62.2 million in the first six months of 2019, compared to net cash inflows of $23.3 million in the same period in 2018. In the first six months of 2019, securities transactions accounted for net inflows of $68.4 million, and the principal change on loans accounted for net outflows of $6.2 million. In the first six months of 2018, securities transactions accounted for net inflows of $61.0 million, and net principal disbursed on loans accounted for net outflows of $4.4 million. Proceeds from claims on BOLI, net of premiums paid, accounted for net inflows of $1.2 million in the second quarter of 2018; there were no BOLI death benefits received in the second quarter of 2019. Proceeds from sales of OREO accounted for $1.5 and $2.1 million in investing cash inflows for the first six months of 2019 and 2018, respectively.
Net cash outflows from financing activities in the first six months of 2019 were $99.1 million, compared with net cash outflows of $41.5 million in the first six months of 2018. Net deposit outflows in the first six months of 2019 were $38.9 million compared to net deposit outflows of $9.6 million in the first six months of 2018. Other short-term borrowings had net cash outflows of $62.4 million in the first six months of 2019 and $49.3 million in the first six months of 2018. Changes in securities sold under repurchase agreements accounted for $7.5 million in net inflows and $18.5 million in net inflows in the first six months of 2019 and 2018, respectively.
Cash and cash equivalents for the six months ended June 30, 2019, totaled $58.2 million, as compared to $65.3 million as of June 30, 2018. In addition to cash and cash equivalents on hand or held as deposits with other financial institutions, we rely on funding sources from customer deposits, cash flows from securities available-for-sale and loans, and a line of credit with the FHLBC to meet potential liquidity needs. These sources of liquidity are immediately available to satisfy any funding requirements due to depositor or borrower demands through the ordinary course of our business. Additional sources of funding include a $20 million undrawn line of credit held by the Company with a third party financial institution, as well as unpledged securities available-for-sale. As of June 30, 2019, our unused borrowing capacity from the FHLBC totaled $317.2 million, and unpledged securities available-for-sale totaled $153.5 million.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Interest Rate Risk
As part of our normal operations, we are subject to interest-rate risk on the assets we invest in (primarily loans and securities) and the liabilities we fund with (primarily customer deposits and borrowed funds). Fluctuations in interest rates may result in changes in the fair market values of our financial instruments, cash flows, and net interest income. Like most financial institutions, we have an exposure to changes in both short-term and long-term interest rates.
In December 2018, the Federal Reserve raised short-term interest rates by 0.25%. There is a current market expectation that the Federal Reserve will reduce short-term interest rates in the latter half of 2019. Generally, Federal Reserve actions have not had a significant impact on long-term rates, although Federal Reserve officials began ending the reinvestment of their securities portfolio cash flow in October 2017 which could result in increases in long-term rates if federal budget deficits continue to increase. We manage interest rate risk within guidelines established by policy which limits are intended to limit our amount of rate exposure. In practice, we seek to manage our interest rate risk exposure well within our guidelines so that such exposure does not pose a material risk to our future earnings.
We manage various market risks in the normal course of our operations, including credit, liquidity risk, and interest-rate risk. Other types of market risk, such as foreign currency exchange risk and commodity price risk, do not arise in the normal course of our business activities and operations. In addition, since we do not hold a trading portfolio, we are not exposed to significant market risk from trading activities. Our interest rate risk exposures at December 31, 2018 and June 30, 2019 are outlined in the table below.
Our net income can be significantly influenced by a variety of external factors, including: overall economic conditions, policies and actions of regulatory authorities, the amounts of and rates at which assets and liabilities reprice, variances in prepayment of loans and securities other than those that are assumed, early withdrawal of deposits, exercise of call options on borrowings or securities, competition, a general rise or decline in interest rates, changes in the slope of the yield-curve, changes in historical relationships between indices (such as LIBOR and prime), and balance sheet growth or contraction. Our ALCO committee seeks to manage interest rate risk under a variety of rate environments by structuring our balance sheet and off-balance sheet positions, which includes interest rate swap derivatives as discussed in Note 15 of the financial statements included in this quarterly report. We seek to monitor and manage interest rate risk within our approved policy guidelines and limits.
We utilize simulation analysis to quantify the impact of various rate scenarios on our net interest income. Specific cash flows, repricing characteristics, and embedded options of the assets and liabilities held by us are incorporated into the simulation model. Earnings at risk are calculated by comparing the net interest income of a stable interest rate environment to the net interest income of a
different interest rate environment in order to determine the percentage change. As of December 31, 2018, we had modest amounts of earnings gains (in both dollars and percentage) should interest rates rise, and limited earnings reductions should interest rates fall. The changes in income across the various interest rate scenarios as of June 2019 were largely unchanged compared to those of December 2018. The general balance sheet composition, both assets and liabilities, did not change appreciably during the quarter, which resulted in little change to our interest rate risk profile. Overall, management considers the current level of interest rate risk to be moderate, but intends to continue closely monitoring changes in that risk in case corrective actions might be needed in the future. The Federal Funds rate and the Bank's prime rate remained unchanged during the quarter at 2.50% and 5.50%, respectively.
The following table summarizes the effect on annual income before income taxes based upon an immediate increase or decrease in interest rates of 0.5%, 1%, and 2% and no change in the slope of the yield curve. Because of declines in market interest rates, it was not possible to calculate a decrease of 2% because many of the market interest rates would fall below zero in that scenario.
Analysis of Net Interest Income Sensitivity
Immediate Changes in Rates
(2.0)
1.0
2.0
Dollar change
(5,329)
(2,037)
2,705
5,149
Percent change
(5.5)
(2.2)
5.4
(12,303)
(5,356)
(2,062)
1,084
2,145
4,178
(12.2)
1.1
4.2
The amounts and assumptions used in the simulation model should not be viewed as indicative of expected actual results. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and management strategies. The above results do not take into account any management action to mitigate potential risk.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
The Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) promulgated under the Securities and Exchange Act of 1934, as amended, as of June 30, 2019. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of June 30, 2019, the Company’s internal controls were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities and Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified.
There were no changes in the Company’s internal controls over financial reporting during the quarter ended June 30, 2019, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
The design of any system of controls and procedures is based in part upon certain assumptions about the likelihood of future events. There can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
The Company and its subsidiaries, from time to time, are involved in collection suits in the ordinary course of business against its debtors and are defendants in legal actions arising from normal business activities. Management, after consultation with legal counsel, believes that the ultimate liabilities, if any, resulting from these actions will not have a material adverse effect on the financial position of the Bank or on the consolidated financial position of the Company.
Item 1.A. Risk Factors
There have been no material changes from the risk factors set forth in Part I, Item 1.A. “Risk Factors,” of the Company’s Form 10-K for the year ended December 31, 2018.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.
Item 3. Defaults Upon Senior Securities
Item 4. Mine Safety Disclosures
Not applicable
Item 5. Other Information
Item 6. Exhibits
Exhibits:
Amendment to Old Second Bancorp, Inc.’s Restated Certificate of Incorporation (incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on May 22, 2019).
Old Second Bancorp, Inc. 2019 Equity Incentive Plan (incorporated by reference to Appendix A to the Company’s definitive proxy statement filed on April 19, 2019).
Form of Employee Time Vesting Restricted Stock Unit Agreement (incorporated by reference to Exhibit 4.8 to the Company’s Form S-8 Registration Statement (333-231807) filed on May 29, 2019).
Form of Director Time Vesting Restricted Stock Unit Agreement (incorporated by reference to Exhibit 4.9 to the Company’s Form S-8 Registration Statement (333-231807) filed on May 29, 2019).
Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a).
Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a).
Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Balance Sheets at March 31, 2019, and December 31, 2018; (ii) Consolidated Statements of Income for the three months ended March 31, 2019 and 2018; (iii) Consolidated Statements of Stockholders’ Equity for the three months ended March 31, 2019 and 2018; (iv) Consolidated Statements of Cash Flows for the three months ended March 31, 2019 and 2018; and (v) Notes to Consolidated Financial Statements, tagged as blocks of text and in detail.*
* As provided in Rule 406T of Regulation S-T, these interactive data files shall not be deemed “filed” for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934 as amended, or otherwise subject to liability under those sections.
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
BY:
/s/ James L. Eccher
James L. Eccher
President and Chief Executive Officer
(principal executive officer)
/s/ Bradley S. Adams
Bradley S. Adams
Executive Vice President and Chief Financial Officer
(principal financial and accounting officer)
DATE: August 7, 2019