Old Second Bancorp - 10-Q quarterly report FY

PART I - FINANCIAL INFORMATION

Item 1.                          Financial Statements

Old Second Bancorp, Inc. and Subsidiaries

Consolidated Balance Sheets

(In thousands, except share data)

See accompanying notes to unaudited consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Income

(In thousands, except share data.  Unaudited)

See accompanying notes to unaudited consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

Nine Months Ended September 30, 2006 and 2005

(In thousands, unaudited)

See accompanying notes to unaudited consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Table amounts in thousands, except per share data, unaudited)

Note 1 — Summary of Significant Accounting Policies

The accounting policies followed in the preparation of interim financial statements are consistent with those used in the preparation of annual financial information. The interim financial statements reflect all normal and recurring adjustments, which are necessary, in the opinion of management, for a fair statement of results for the interim periods presented. Results for the periods ended September 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. These interim financial statements should be read in conjunction with the audited financial statements and notes included in Old Second Bancorp, Inc.’s (the “Company”) 2005 Form 10-K.  Unless otherwise indicated, amounts in the tables contained in the notes 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 U.S. generally accepted accounting principles 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 financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the financial statements.

All significant accounting policies are presented in Note A to the consolidated financial statements included in the Company’s annual report on Form 10-K for the year ended December 31, 2005. 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 financial statements and how those values are determined.

In February 2006, the FASB issued Statement 155 (“SFAS 155”), “Accounting for Certain Hybrid Financial Instruments—an amendment of FASB Statements No. 133 and 140.” This Statement is effective for all financial instruments acquired, issued, or subject to a remeasurement event occurring after the beginning of fiscal years beginning after September 15, 2006. Earlier adoption was permitted as of the beginning of 2006, provided an entity had not yet issued financial statements, including financial statements for any interim period, for that fiscal year. The Company did not elect early adoption, and is evaluating the potential impact in future periods.

In March 2006, the FASB issued Statement (“SFAS 156”), “Accounting for Servicing of Financial Assets—an amendment of FASB Statement No. 140.” This Statement is effective as of the beginning of fiscal years beginning after September 15, 2006. Earlier adoption is permitted as of the beginning of an entity’s fiscal year, provided the entity has not yet issued financial statements, including interim financial statements, for any period of that fiscal year. The Company did not elect early adoption, and is evaluating the potential impact in future periods.

In July 2006, the Financial Accounting Standards Board issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, (“FIN 48”). FIN 48 is effective for fiscal years

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beginning after December 15, 2006. FIN 48 applies to all income tax positions subject to Financial Accounting Standards Board Statement No. 109, Accounting for Income Taxes, (“SFAS 109”), including tax positions considered to be routine and those with a high degree of uncertainty. The Company is evaluating the potential impact in future periods.

In September 2006, the Securities Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) 108, which was issued to address diversity in practice in quantifying financial statement misstatements and the potential under current practice for the build up of improper amounts on the balance sheet. The Company is evaluating the potential impact of the standard on future periods.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.”  SFAS No. 157 clarifies the definition of fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years, although earlier application is encouraged. Prospective application of the provisions of SFAS No. 157 is required as of the beginning of the fiscal year in which it is initially applied, except for certain circumstances specified in the Statement that require retrospective application. The Company is in the process of assessing the impact of the adoption of this statement on the Company’s financial statements.

Note 2 — Securities

Securities available for sale were as follows:

Recognition of other than temporary impairment was not necessary in the first nine months of 2006. The unrealized loss in the portfolio was attributed to an increase in rates, which has caused the amortized cost to be more than the current fair value. When interest rates decrease, the individual securities typically will increase in value. The change in value is not related to credit quality deterioration and the Company has the ability and intent to hold all securities until recovery.

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Note 3 — Loans

Major loan classifications as of September 30, 2006 and December 31, 2005 were as follows:

Note 4 — Allowance for Loan Losses

Changes in the allowance for loan losses as of September 30 were as follows:

Note 5 — Deposits

Major deposit classifications as of Septmber 30, 2006 and December 31, 2005 were as follows:

Note 6 — Securities Sold Under Repurchase Agreements, Short-Term Borrowings and Note Payable

 Major borrowing classifications as of September 30, 2006 and December 31, 2005 were as follows:

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The Company enters into sales of securities under agreements to repurchase (repurchase agreements). These repurchase agreements are treated as financings. The dollar amounts of securities underlying the agreements remain in the asset accounts. Securities sold under agreements to repurchase consisted of U.S. government agencies at September 30, 2006 and December 31, 2005, and are held in third party pledge accounts.

The Company’s borrowings at the FHLB are limited to the lesser of 35% of total assets or 60% of the book value of certain mortgage loans. In addition, these notes were collateralized by FHLB stock of $7.3 million and loans totaling $61.5 million at December 31, 2005. FHLB stock of $7.7 million and loans totaling $81.5 million were required to be pledged as of September 30, 2006. As of September 30, 2006, FHLB advances of $30 million and $50 million were scheduled to mature on November 6, 2006 and November 28, 2006 respectively.  A new short-term FHLB advance replaced the November 6, 2006 advance that matured.

At September 30, 2006 and December 31, 2005, respectively, the period to date average balance of Federal funds purchased, other short-term borrowings, and securities sold under agreements to repurchase totaled $185.9 million at a weighted average rate of 5.2% and $160.6 million at a weighted average rate of 3.5%.

The Company is a Treasury Tax & Loan (“TT&L”) depository for the Federal Reserve Bank (“FRB”), and as such, it accepts TT&L deposits. The Company is allowed to hold these deposits for the FRB until they are called. The interest rate is the federal funds rate less 25 basis points.  Securities with a face value greater than or equal to the amount borrowed are pledged as a condition of borrowing TT&L deposits.

The Company has a $20 million line of credit available with a correspondent bank under which there was a $3.2 million outstanding balance as of December 31, 2005 and $13.4 million as of September 30, 2006. A revolving business note dated April 30, 2006 secures the line of credit and is guaranteed by the Company. The note provides that any outstanding principal will bear interest at the rate of 0.90% over the British Bankers Association (“BBA”) 1-month LIBOR rate and can change monthly. This borrowing is for general corporate purposes, including common stock repurchases.

Note 7 — Long-Term Incentive Plan

The Long-Term Incentive Plan (the “Incentive Plan”) authorizes the issuance of up to 1,333,000 shares of the Company’s common stock, including the granting of qualified stock options (“Incentive Stock Options”), nonqualified stock options, restricted stock and stock appreciation rights. Stock based awards may be granted to selected directors and officers or employees at the discretion of the board of directors. The Incentive Plan requires the exercise price of any incentive stock option issued to an employee to be at least equal to the fair market value of Company common stock on the date the option is granted. All stock options were granted for a term of ten years. Vesting of stock options granted in 2004 and prior years was accelerated to immediately vest all options as of December 20, 2005. The accelerated vesting eliminated the future compensation expense that the Company would otherwise recognize with respect to these options, in accordance with Statement of Financial Accounting Standards No. 123 (revised 2004) “Share - Based Payment”, (“SFAS No. 123”) issued by the Financial Accounting Standards Board, effective for reporting periods beginning after January 1, 2006. Options granted in 2005 were immediately vested and restricted stock vests three years from the grant date.

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Nonqualified stock options may be granted to directors based upon a formula. These and other awards under the Incentive Plan may be granted subject to a vesting requirement and would become fully vested upon a merger or change in control of the Company. There were no stock options granted in the first nine months of 2006.

A summary of activity in the Incentive Plan and options outstanding is included below:

All options were exercisable at the end of the period. The total intrinsic value of options exercised during the first quarter of 2006 and 2005 was $647,000 and $1,476,000, respectively. There were no exercises in the second quarter of either 2005 or 2006. The total intrinsic value of options exercised during the third quarter of 2006 was $73,000 and there were no options exercised during the third quarter of 2005.

The following pro forma information presents net income and earnings per share had the fair value method of SFAS No. 123 been used to measure compensation cost for stock option plans in 2005.

Restricted stock was granted beginning December 20, 2005 under the Incentive Plan. These shares are subject to forfeiture until certain restrictions have lapsed, including employment for a specific period. Restricted stock awards are granted at fair market value. Compensation expense for restricted shares is recognized on a straight-line basis over the three-year vesting period. Included in the determination of net income as reported for the nine-month period ended September 30, 2006, is compensation expense for restricted shares of $152,000, with a related tax benefit of $60,000. As of September 30, 2006, the total compensation cost related to

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nonvested awards not yet recognized was $451,000. The Company expects to recognize this cost over a remaining period of twenty-seven months.

The following table is a summary of restricted stock activity.

Note 8 — Earnings Per Share

Earnings per share is included below as of September 30, (share data not in thousands):

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Note 9 — Other Comprehensive Income (Loss)

Other comprehensive income (loss) is included below:

Note 10 — Retirement Plans

The Company had historically maintained a tax-qualified noncontributory defined benefit retirement plan covering substantially all full-time and regular part-time employees. Benefits were generally based on years of service and compensation. Certain participants in the defined benefit plan were also covered by an unfunded supplemental retirement plan. The purpose of the supplemental retirement plan was to extend full retirement benefits to individuals without regard to statutory limitations under tax-qualified plans.

As of December 31, 2005, the defined benefit and supplemental retirement plans were terminated. Prior to December 31, 2005, all amounts due were paid to participants of the supplemental executive retirement plan (“SERP”). The Company received regulatory approval to distribute accrued benefits to the participants of the defined benefit plan. These distributions began in the third quarter of 2006, and approximately 80% of the distribution payments had been made as of September 30, 2006. As of October 31, 2006, the distribution of the remaining benefit obligation was substantially completed and the remaining liabilities exceeded assets by approximately $163,000. A contribution of that shortfall amount was made as part of the defined benefit plan liquidation process.

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The Company maintains tax-qualified contributory and non-contributory profit sharing plans covering substantially all full-time and regular part-time employees. The expense of these plans was $1,706,000 and $1,059,000 in the first nine months of 2006 and 2005, respectively.

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Item 2.                          Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

Old Second Bancorp, Inc. (the “Company”) is a financial services company with its main headquarters located in Aurora, Illinois. The Company has offices located in Kane, Kendall, DeKalb, DuPage, LaSalle, and Will counties in Illinois. The Company provides financial services through its three subsidiary banks at its thirty banking locations. Old Second Mortgage, which also conducts business as “Maple Park Mortgage”, provides mortgage-banking services at its three offices.  Old Second Financial, Inc. provides insurance products. The Old Second National Bank of Aurora, the Company’s lead subsidiary bank, also engages in trust operations.

Results of Operations

Net income for the third quarter of 2006 was $4.9 million, or $0.37 diluted earnings per share, compared with $7.2 million, or $0.52 diluted earnings per share in the third quarter of 2005. Earnings for the first nine months of 2006 were $1.28 per diluted share, on $17.4 million in net income, compared with $1.46 per diluted share in the first nine months of 2005, on earnings of $19.9 million. The return on equity decreased from 18.67% in the first nine months of 2005, to 15.11% in the first nine months of 2006.

The Company is in the process of distributing the assets of its defined benefit pension plan after terminating the plan in December of 2005. A loss on settlement of the benefit obligations of $1.0 million was recorded in the third quarter of 2006. The loss related to termination of the defined benefit pension plan was $1.4 million for the first nine months of 2006. The liabilities exceeded assets at the time of final distribution of benefits by approximately $163,000. A contribution of that shortfall amount was made in the fourth quarter of 2006 and is discussed in more detail in Note 10.

In comparing the first nine months of 2006 and the first nine months of 2005, several items had an impact on earnings in addition to the termination of the pension plan discussed previously. In the first nine months of 2005, there was a reduction of $340,000 in the estimated accrual for real estate taxes. In the first nine months of 2006, net interest income decreased $1,435,000, and there was a reduction of $1,604,000 in gains on the sale of loans, both of which resulted primarily because of the increase in interest rates. These were offset by an income tax adjustment of $250,000 and securities gains of $418,000 in the first nine months of 2006. At the same time, the provision for loan losses was $1,244,000 in the first nine months of 2006, compared with $813,000 in the first nine months of 2005.

Net Interest Income

Net interest income decreased in the first nine months of 2006, to $53.5 million in 2006, from $55.0 million in 2005. Third quarter net interest income declined from $18.8 million in 2005, to $17.3 million in 2006. For both the quarter and year to date periods, growth in earning assets was offset by a lower net interest margin. Average earning assets grew $128.0 million, or 6.14% from the first nine months of 2005 to the first nine months of 2006. In the same period, however, the net interest margin declined from 3.66% in 2005 to 3.37% in 2006.

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On a year to date comparative basis, the average tax-equivalent yield on earning assets increased from 5.73% in 2005 to 6.49% in 2006, which was a 76 basis point increase. During the same nine-month period, however, the cost of funds increased from 2.40% to 3.55%, or 115 basis points. Changes in funding composition had a significant affect on increasing interest costs and lowering the net interest margin. The average balances of lower cost sources of funds such as interest-bearing transaction accounts and savings accounts declined $26.1 million, or 3.2%, from the first nine months of 2005 to the first nine months of 2006. Noninterest-bearing deposits increased by a nominal amount while the aggregate categories of higher-cost sources of funds such as time deposits, repurchase agreements and short-term borrowing increased $170.4 million, or 17.7%.

Management, in order to evaluate and measure performance, uses certain non-GAAP performance measures and ratios. These include taxable-equivalent net interest income (including its individual components) and net interest margin (including its individual components). Management believes that these measures and ratios provide users of the financial information with a more accurate view of the performance of the interest-earning assets and interest-bearing liabilities and of the Company’s operating efficiency for comparison purposes. Other financial holding companies may define or calculate these measures and ratios differently. See the table below for supplemental data and the corresponding reconciliation to GAAP financial measures for the nine months ended September 30, 2006 and 2005.

The following table sets forth certain information relating to the Company’s average consolidated balance sheets and reflects the yield on average earning assets and cost of average liabilities for the periods indicated. The rates are determined by dividing the related interest by the average balance of assets or liabilities. Average balances are derived from daily balances.

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ANALYSIS OF AVERAGE BALANCES,

TAX EQUIVALENT INTEREST AND RATES

Nine Months Ended September 30, 2006 and 2005

(Dollar amounts in thousands- unaudited)

Notes:

(1)             Tax equivalent basis is calculated using a marginal tax rate of 35%.

(2)             Nonaccrual loans are included in the above stated average balances.

(3)             Loan fees, included in interest on loans and loans held for sale, were $2.8 million and $2.3 million in the first nine months of 2006 and 2005, respectively.

Yields on certain asset categories and the net interest margin of the Company and its banking subsidiaries are reviewed on a fully taxable-equivalent basis (“FTE”). In this non-GAAP presentation, net interest income is adjusted to reflect tax-exempt interest income on an equivalent before-tax basis. This measure ensures comparability of net interest income arising from both taxable and tax-exempt sources.

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Provision for Loan Losses

The Company provided an additional $400,000 to the allowance for loan losses in the third quarter of 2006, compared to $450,000 in the third quarter of 2005. The Company provided $1,244,000 in 2006 compared with $813,000 in the first nine months of 2005, an increase of $431,000. Loan portfolio quality remained strong through the third quarter of 2006, and the amount of charge-offs continued at the Company’s historical low level. Management performed quantitative and qualitative analysis of the allowance for loan losses and determined that the amount reported as of September 30, 2006, was appropriate. Despite the general decline in nonperforming assets in 2006, management increased the allowance for loan losses in 2006 to address concerns associated with the commercial real estate market and the large concentration held by the Company. Management has observed slower real estate building and development activity in the Company’s market areas. Although the Company’s borrowers continue to meet their obligations, management believes that the general risk in the sector has increased. The ratio of the allowance for loan losses to nonperforming loans was 363% as of September 30, 2006, compared with 324% as of September 30, 2005. Nonperforming loans were $4.5 million as of September 30, 2006, and $4.9 million as of September 30, 2005. Net charge-offs were $149,000 in the third quarter of 2006 and $136,000 in the third quarter of 2005. On a year to date basis, net charge-offs were $229,000 in the first nine months of 2006 and $469,000 in the first nine months of 2005.

The allowance for loan losses represents management’s estimate of probable incurred credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated statements of condition.

The allowance for loan losses as a percentage of total loans was 0.92% as of September 30, 2006, compared to 0.90% as of December 31, 2005 and 0.95% as of September 30, 2005. In management’s judgment, an adequate allowance for estimated losses has been established; however, there can be no assurance that such losses will not exceed the estimated amounts in the future.

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Past due and nonaccrual loans for the periods ended September 30, 2006 and December 31, 2005 were as follows:

Noninterest Income

Noninterest income was $6.9 million during the third quarter of 2006 and $7.4 million during the third quarter of 2005, a decrease of $500,000, or 6.8%. This decrease was primarily due to a reduction in mortgage banking income, including gains on sales of mortgage loans, secondary market fees, and servicing income, which declined $698,000, or 37.1%, from the third quarter of 2005.  For the year to date, mortgage-banking income in 2006 was down $1,614,000, or 30.9%, from the first nine months of 2005. Higher borrowing costs associated with an increased interest rate environment resulted in a decline in mortgage loan demand and related mortgage banking income. Other income decreased $146,000, or 9.7%, from the third quarter of 2005, to $1.4 million in the third quarter of 2006. Other income increased $80,000, or 1.9%, from the first nine months of 2005 to $4.2 million for the first nine months of 2006.

Trust income was up $127,000, or 8.0%, from the third quarter of 2005 to the third quarter of 2006, to $1.7 million. Trust income was $5.5 million in the first nine months of 2006, an increase of $636,000, or 13.1%, from the first nine months of 2005. Increases in trust income for both the quarter and the year to date period were primarily associated with estate fees. There were no security sales in the third quarter of 2006 or 2005, while securities gains totaled $418,000 in the first nine months of 2006, compared with a $5,000 loss in the first nine months of 2005. Bank owned life insurance (“BOLI”) income increased from $218,000 to $483,000 in the third quarter, and increased from $652,000 to $1,444,000 on a year to date basis, when comparing 2006 and 2005, as a result of BOLI purchases in December of 2005.

Noninterest Expense

Noninterest expense was $17.2 million during the third quarter of 2006, an increase of $2,127,000, or 14.1%, from $15.1 million in the third quarter of 2005. Noninterest expense was $49.0 million during the first nine months of 2006, an increase of $3,513,000, or 7.7%, from $45.5 million in the first nine months of 2005. Salaries and benefits expense was $9.2 million during the third quarter of 2006, an increase of $413,000, or 4.7% from $8.8 million in the third quarter of 2005. In the first nine months of the year, salaries and benefits were $27.3 million in 2006 and $26.9 million in 2005, an increase of $413,000 or 1.5%. The increase in salaries and benefits was primarily due to ordinary increases in salary and benefit costs along with the addition of new employees.

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The Company is in the process of distributing the assets of its defined benefit pension plan after terminating the plan in December of 2005. The liabilities exceeded assets at the time of distribution of all benefits by approximately $163,000. A contribution of that shortfall amount was made in the fourth quarter of 2006. Additional information related to this plan is in Note 10 of this document.

Net occupancy and furniture and equipment expenses increased $204,000 from the third quarter of 2005 to the third quarter of 2006, or 8.5%. Net occupancy and furniture and equipment expenses increased $891,000 from the first nine months of 2005 to the first nine months of 2006, or 13.8%. The increase in the year to date period was due, in part, to a reduction in the estimated accrual for occupancy related expenses in the first nine months of 2005. As the Company has expanded into and developed new markets, related facility expenses have increased. Two new branches opened in the first quarter of 2005, one branch opened in the first quarter of 2006 and two additional branch locations opened in the third quarter of 2006. Other expense increased $496,000, or 15.0%, from the third quarter of 2005, to $3.8 million in the third quarter of 2006. Other expense increased $701,000, or 6.6% from the first nine months of 2005 to $11.3 million in the first nine months of 2006. Increases in other expense for both the quarter and the year to date, when comparing 2006 and 2005, primarily related to loan expenditures, amortization of mortgage servicing rights, and new employee recruitment fees.

Income Taxes

The Company’s provision for Federal and State of Illinois income taxes was $1.6 million and $3.5 million in the third quarters of 2006 and 2005, respectively. Income taxes totaled $7.2 million and $9.7 million in the first nine months of 2006 and 2005, respectively. The average effective income tax rate for the first nine months of 2006 and 2005 was 29.3% and 32.7%, respectively. The reduction in effective tax rate was primarily due to lower pre-tax income, additional tax-exempt BOLI income and the formation of a real estate investment trust during the third quarter of 2006. The real estate investment trust provides us with an alternative vehicle for raising capital should we so desire. The ownership structure of this real estate investment trust is also expected to provide us with certain income tax benefits, which lowered our effective tax rate.

Financial Condition

Assets

Total assets were $2.41 billion as of September 30, 2006, compared with $2.37 billion as of December 31, 2005. Total loans grew $81.0 million during the first nine months of 2006, while cash and cash equivalents and securities available for sale declined $6.2 and $25.0 million respectively.

Loans

The loan category that increased the most in the first nine months of 2006 was commercial real estate, which increased $43.2 million. Construction loans increased $14.2 million and residential loans increased by $30.5 million. The loan portfolio generally reflects the profile of the communities in which the Company operates. Because the Company is located in growing areas, real estate lending (including commercial, residential, and construction) is a

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significant portion of the portfolio. Real estate lending comprised 89.0% of the portfolio as of September 30, 2006 and 88.1% of the portfolio as of December 31, 2005.

Securities and Bank Owned Life insurance

Securities available for sale totaled $445.4 million as of September 30, 2006, a decline of $25.0 million from $470.4 million as of December 31, 2005. Net unrealized losses, net of deferred taxes, in the securities available for sale portfolio decreased from a net unrealized loss of $4.6 million as of December 31, 2005 to a net unrealized loss of $3.3 million as of September 30, 2006. The Company also invests in bank-owned life insurance (“BOLI”). During December 2005, the Company purchased an additional $20.0 million in BOLI, bringing the total to $41.6 million as of December 31, 2005, and $43.1 million as of September 30, 2006.

Deposits and Borrowings

Total deposits increased $82.6 million during the first nine months of 2006, to $2.02 billion as of September 30, 2006. Demand deposits decreased $5.7 million, or 2.2%, to $258.4 million. Savings deposits decreased $11.4 million, or 9.7%, to $106.4 million, while NOW and money market deposit accounts increased $22.5 million, or 9.2%, and $7.5 million, or 1.7%, respectively. Year to date, time deposits increased $69.7 million, or 8.0%, from $876.1 million to $945.8 million.

Pricing and sales strategies targeted the 2006 growth in NOW and money market accounts. Depositors also continued to migrate into term certificates of deposits to lock in rates. Increases in interest-bearing transaction account pricing and the continued shift into certificates of deposit resulted in a higher cost of funds and had a negative impact on the net interest margin. The net interest margin declined from 3.66% in the first nine months of 2005 to 3.37% in the first nine months of 2006. In the same period, the average cost of interest-bearing funds increased 115 basis points.

Securities sold under repurchase agreements, which are typically of short-term duration, decreased from $57.6 million as of December 31, 2005, to $42.5 million as of September 30, 2006. Other short-term borrowings decreased from $171.8 million to $133.7 million. Advances from the Federal Home Loan Bank of Chicago were $80.0 million as of September 30, 2006, while there were no advances as of December 31, 2005. A note payable to a correspondent bank increased $10.2 million, to $13.4 million at September 30, 2006. The proceeds of the note were primarily used to repurchase common stock. The Company is currently maintaining liquid assets and is consistently delivering growth in core deposits to provide funding for loan growth.

Capital

The Company and its three subsidiary banks are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines provide for five classifications, the highest of which is well capitalized. The Company and its subsidiary banks were categorized as well capitalized as of September 30, 2006. The accompanying table shows the capital ratios of the Company and The Old Second National Bank of Aurora, the Company’s lead subsidiary bank, as of September 30, 2006 and December 31, 2005.

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Capital levels and minimum required levels:

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Item 3.                          Quantitative and Qualitative Disclosures about Market Risk

Liquidity and Market Risk

Liquidity is the Company’s ability to fund its operations, to meet depositor withdrawals, to provide for customer’s credit needs, to withstand fluctuations in deposit levels, and to meet maturing obligations and existing commitments. The liquidity of the Company principally depends on cash flows from operating activities, investment in and maturity of assets, changes in balances of deposits and borrowings, and its ability to borrow funds in the money or capital markets.

Net cash inflows from operating activities were $32.7 million in the first nine months of 2006, compared with net cash inflows of $30.2 million in the first nine months of 2005. Proceeds from sale of loans held for sale, net of funds used to originate loans held for sale, were a significant source of inflow for both 2006 and 2005. Interest received, net of interest paid combined with changes in other assets and liabilities were a source of operating cash inflows in 2006, whereas these items were an outflow in 2005. 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, so that balance sheet growth is the principal determinant of growth in net interest cash flows.

Net cash outflows from investing activities were $62.1 million in the nine months ended September 30, 2006, compared to $249.3 million a year earlier. In the first nine months of 2006, securities transactions, including purchases of FHLB stock, accounted for a net inflow of $25.1 million, and net principal disbursed on loans accounted for net outflows of $81.3 million. In the first nine months of 2005, securities transactions accounted for a net outflow of $80.5 million, and net principal disbursed on loans accounted for net outflows of $162.0 million. Cash outflows for premises and equipment were substantially the same for both years.

In the first nine months of 2006, cash inflows from financing activities were $23.2 million, which included an increase in deposits of $82.6 million against a decline in repurchase agreements of $15.1 million and a decline in other short-term borrowings of $38.1 million. Cash outflows for the 2006 treasury stock repurchases used $12.0 million of funds. In the first nine months of 2005, net cash inflows from financing activities were $221.2 million. This 2005 inflow included increases in deposits, repurchase agreements, and other short-term borrowings of $148.0 million, $10.9 million and 65.9 million, respectively.

Interest Rate Risk

The impact of movements in general market interest rates on a financial institution’s financial condition, including capital adequacy, earnings, and liquidity, is known as interest rate risk. Interest rate risk is the Company’s primary market risk. As a financial institution, accepting and managing this risk is an inherent aspect of the Company’s business. However, safe and sound management of interest rate risk requires that it be maintained at prudent levels.

The Company analyzes interest rate risk by examining the extent to which assets and liabilities are interest rate sensitive. The interest sensitivity gap is defined as the difference between the amount of interest earning assets maturing or repricing within a specific time period, and the amount of interest-bearing liabilities maturing or repricing within that time period. A gap

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is considered positive when the amount of interest sensitive assets exceeds the amount of interest sensitive liabilities. A gap is considered negative when the amount of interest sensitive liabilities exceeds the amount of interest sensitive assets. During a period of rising interest rates, a negative gap would tend to result in a decrease in net interest income, while a positive gap would tend to positively affect net interest income. The Company’s policy is to manage the balance sheet so that fluctuations in the net interest margin are minimized, regardless of the level of interest rates.

The accompanying table does not necessarily indicate the future impact of general interest rate movements on the Company’s net interest income, because the repricing of certain assets and liabilities is discretionary, and is subject to competitive and other pressures. As a result, assets and liabilities indicated as repricing within the same period may in fact reprice at different times and at different rate levels. Assets and liabilities are reported in the earliest time frame in which maturity or repricing may occur. Although securities available for sale are reported in the earliest time frame in which maturity or repricing may occur, these securities may be sold in response to changes in interest rates or liquidity needs.