Old Second Bancorp - 10-Q quarterly report FY

OLD SECOND BANCORP, INC.

Form 10-Q Quarterly Report

Table of Contents

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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 consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Income

(In thousands, except share data)

See accompanying notes to consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

Nine Months Ended September 30, 2005 and 2004

(In thousands)

See accompanying notes to consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(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 period presented.  Results for the periods ended September 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.  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”) 2004 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 for the year ended December 31, 2004. 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.

On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (revised 2004), Share-Based Payment, which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation.”  Statement
123 (R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends FASB Statement No. 95, “Statement of Cash Flows.”  Generally, the approach in Statement 123 (R) is similar to the approach described in Statement 123.  However, Statement 123 (R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values.  Pro forma disclosure is no longer an alternative.  On April 14, 2005, the SEC announced it would provide for a phased-in implementation for the adoption of Statement 123 (R).  Based on this guidance, the Company is now required to adopt Statement 123 (R) on January 1, 2006.

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As permitted by Statement 123, the Company currently accounts for share-based payments to employees using APB No. Opinion 25’s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options.  Accordingly, the adoption of Statement 123 (R)’s fair value method will have a significant impact on results of operations, although it will have no impact on the overall financial position.  The impact of adoption of Statement 123 (R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future.  However, had the Company adopted Statement
123 (R) in prior periods, the impact of that standard would have approximated the impact of Statement 123 as described in the disclosure of pro forma net income and earnings per share in Note A to the consolidated financial statements for the year-ended December 31, 2004.

In May 2005, the Financial Accounting Standards Board ("FASB") issued Statement No. 154, "Accounting Changes and Error Corrections" ("SFAS No. 154").  SFAS No. 154 replaces Accounting Principles Board ("APB") Opinion No. 20 and FASB Statement No. 3 and changes the accounting for and reporting of a change in principle by requiring retrospective application to prior periods' financial statements, rather than by including the cumulative effect of the change in net income in the period of change as previously required under APB 20.  SFAS No. 154 applies to both voluntary and mandated accounting changes, unless the new pronouncement provides other transition requirements.  SFAS No. 154 also requires reporting of a change in depreciation, amortization, or depletion method for long-lived assets as a change in accounting estimate.  SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005; however earlier application is permitted beginning after June 1, 2005.  The Company does not expect the adoption of SFAS No. 154 on January 1, 2006 to have a material impact on its financial condition, results of operations, or liquidity.

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Note 2 – Securities

Securities available for sale are summarized as follows:

Note 3 – Loans

Major classifications of loans were as follows:

Note 4 – Allowance for Loan Losses

Changes in the allowance for loan losses as of September 30, are summarized as follows:

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Note 5 – Deposits

Major classifications of deposits were as follows:

Note 6 – Borrowings

The following table is a summary of borrowings:

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, 2005 and December 31, 2004, and are held in third party pledge accounts.

The Company 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 $1.1 million at December 31, 2004.  The maturity date of the outstanding FHLB advance was March 1, 2005, and they were repaid on that date.

At September 30, 2005 and December 31, 2004, respectively, the period to date average balance of short-term borrowings totaled $158.0 million at a weighted average rate of 3.23% and $108.5 million at a weighted average rate of 1.37%.  The increase in short-term borrowings was primarily the result of asset growth during 2005 that exceeded deposit growth. During 2005, loans and securities grew $234.3 million while deposits grew $148.0 million.

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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. As of September 30, 2005 and December 31, 2004, the TT&L deposits were $1.6 million and $2.0 million, respectively.

The Company has a $20 million line of credit available with Marshall & Ilsley under which there was a $2.7 million outstanding balance as of December 31, 2004 and $3.2 million outstanding balance as September 30, 2005.  A revolving business note dated April 30, 2005 secures the line of credit and is guaranteed by the Company.  The note provides that any outstanding principal will bear interest at the Company’s option, at the rate of either 1% over the previous month average (Federal Reserve targeted rate) federal funds rate or 0.90% over the adjusted interbank rate with a minimum interest rate of 2.20%.  This borrowing is for general corporate purposes, including funding loans held for sale at the Old Second Mortgage Company subsidiary.

Note 7– 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 was sold in July 2003.  The costs associated with the tender offer of the cumulative trust preferred securities are being amortized over 30 years.  Cash distributions on the securities are payable quarterly at an annual rate of 7.80% and are included in interest expense in the consolidated financial statements.

Note 8– 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 are granted for a maximum term of ten years, with vesting occurring over the first three years.

Nonqualified stock options may be granted to directors. 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.

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

The Company accounts for stock options in accordance with APB No. 25, as allowed under SFAS No. 123.  No expense for stock options is recorded, as the grant price equals the market price of the stock at grant date.  There were no stock options granted in 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.

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Note 9 – Earnings Per Share

Earnings per share is included below (share data not in thousands):

Note 10 – Comprehensive Income

Comprehensive income is included below:

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Note 11 – Retirement Plans

The Company has a tax-qualified noncontributory defined benefit retirement plan covering substantially all full-time and regular part-time employees of the Company.  Generally, benefits are based on years of service and compensation. The Board has approved the termination of the defined benefit plan.  All benefits under the defined benefit plan will be distributed after regulatory approval of the termination is received.  Certain participants in the defined benefit plan are also covered by an unfunded supplemental retirement plan. The purpose of the supplemental retirement plan is to extend full retirement benefits to individuals without regard to statutory limitations under tax-qualified plans.  In connection with the termination of the defined benefit plan the Board has approved the termination of the supplemental retirement plan.  All benefits under the supplemental retirement plan will be distributed to plan participants before the end of 2005.

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 $1.1 million and $1.2 million in the first nine months of 2005 and 2004, respectively.

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Item 2.  Managements’ 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 twenty-seven banking locations.  Old Second Mortgage, which also conducts business as “Maple Park Mortgage”, provides mortgage-banking services at its four 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

The Company earned $1.46 diluted earnings per share in the first nine months of 2005, a 10.6% increase over the $1.32 earned in the first nine months of 2004.  Net income was $19.9 million in the first nine months of 2005 compared with $17.9 million in the first nine months of 2004.  This was an 11.5% increase in earnings.  Net income for the third quarter of 2005 was $7.2 million, or $ 0.52 diluted earnings per share, compared with $6.3 million, or $0.46 diluted earnings per share in the third quarter of 2004.  Continued loan growth and an increase in noninterest income contributed to the increase in earnings for the quarter.  The return on equity decreased from 19.29% in the first nine months of 2004, to 18.67% for the same period of 2005.

Net Interest Income

The increase in net income for the first nine months of 2005 was primarily the result of an increase in net interest income.  Net interest income was $55.0 million and $50.8 million during the nine months ended September 30, 2005 and 2004, respectively, an increase of 8.2%.  Net interest income was $18.9 million and $17.1 million during the third quarters of 2005 and 2004, respectively, an increase of $1.8 million or 10.5%.

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, 2005 and 2004.

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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.

ANALYSIS OF AVERAGE BALANCES,

TAX EQUIVALENT INTEREST AND RATES

For periods ended September 30, 2005 and 2004

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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.

Provision for Loan Losses

The Company recorded a $450,000 provision for loan losses in the third quarter of 2005, bringing the total provision to $813,000 for the nine months ended September 30,2005.  The Company did not make a provision for loan losses during the first nine months of 2004, and recorded a negative provision of $2.9 million in the fourth quarter of 2004.  Provisions for loan losses are made to provide for probable and estimable losses inherent in the loan portfolio. The determination by management to reduce the allowance for loan losses in 2004 was based on a comprehensive analysis that considered a number of factors, including the quality of the loan portfolio and favorable loan loss experience. The provision reflects a number of factors, including the size of the loan portfolio, the amount of past due accruing loans (90 days or more), the amount of non-accrual loans and management’s overall view on current credit quality.  Net charge-offs in the first nine months of 2005 increased to $469,000 compared with net charge-offs of $131,000 in the first nine months of 2004.  Total loan charge-offs were $893,000 during the first nine months of 2005, compared with $437,000 during the first nine months of 2004, while recoveries for the same periods were $424,000 and $306,000, respectively.

The allowance for loan losses represents management’s estimate of probable 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 balance sheets.

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One measure of the adequacy of the allowance for loan losses is the ratio of the allowance to total loans. The allowance for loan losses as a percentage of total loans was 0.95% as of September 30, 2005, compared to 1.03% as of December 31, 2004 and 1.25% as of September 30, 2004.  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.

Nonperforming loans of $4.9 million as of September 30, 2005, were down from $5.3 million as of December 31, 2004. Nonperforming loans include loans in nonaccrual status, renegotiated loans, and loans past due ninety days or more and still accruing.  Nonaccrual loans decreased from $5.1 million as of December 31, 2004 to $4.8 million as of September 30, 2005.  The allowance for loan losses as a percentage of nonperforming loans was 324.4% at September 30, 2005 as compared to 295.42% as of December 31, 2004.

Past due and nonaccrual loans for the periods were as follows:

Noninterest Income

Noninterest income was $7.4 million during the third quarter of 2005 and $6.7 million during the third quarter of 2004, an increase of $698,000, or 10.5%, when compared to the third quarter of 2004.  Noninterest income was $21.0 million during the first nine months of 2005, an increase of $1.6 million, or 8.5% over the $19.3 million of noninterest income for the same period in 2004.  Trust income increased to $4.9 million during the first nine months of 2005, an increase of $536,000 from $4.3 million during the same period in 2004, primarily due to the growth in trust assets under management and higher estate fees.  Service charges on deposits, the largest component of noninterest income, increased from $5.6 million in the first nine months of 2004 to $6.1 million in the first nine months of 2005. Deposit service charges for the period increased as a result of deposit growth and an increase in service charge fees. The purchase of bank owned life insurance (BOLI) during the third quarter of 2004 resulted in noninterest income of $652,000 for the first nine months of 2005 compared to $445,000 for the first nine months of 2004.  Mortgage-related noninterest income, principally gains on sales of mortgage loans, totaled $5.2 million in the first nine months of 2005 compared to $4.9 million in the same period of 2004.

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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 significant portion of the portfolio. These categories comprised 87.5% of the portfolio as of September 30, 2005 and 85.9% of the portfolio as of December 31, 2004.

Securities

Securities totaled $525.7 million as of September 30, 2005, an increase of $72.8 million from $452.9 million as of December 31, 2004.  The net unrealized gains, net of deferred taxes, in the portfolio decreased from a net unrealized gain of $324,000 as of December 31, 2004 to a net unrealized loss of $2.7 million as of September 30, 2005.  The increase in the unrealized loss was attributable to the increase in interest rates, which caused the amortized cost to be more than the current fair value.  If interest rates were to decrease, the individual securities would then increase in value.  The securities affected are primarily issued by FHLB.  The unrealized losses on these securities are not related to credit quality deterioration.  The Company has the ability and intent to hold all securities in an unrealized loss position until maturity or such time that they are no longer in a loss position.

Deposits and Borrowings

Total deposits were $1.95 billion as of September 30, 2005, an increase of $148.0 million, or 8.2%, from $1.80 billion as of December 31, 2004.  Savings deposits increased $76.5 million, or 10.0%, from $763.6 million to $840.2 million.  Time deposits increased $68.2 million from $784.9 million to $853.1 million, or 8.7%. Pricing and sales strategies targeted growth in transactional deposit accounts and customer reinvestment of maturing time deposit balances in longer-term maturities. Successful selling efforts in these areas resulted in an increase in new account relationships and core funding sources.

Securities sold under repurchase agreements, which are typically of short-term duration, increased from $45.2 million as of December 31, 2004, to $56.1 million as of September 30, 2005 or 24.0%.  Other short-term borrowings increased from $75.8 million to $141.7 million primarily due to an increase in federal funds purchased of $92.0 million from $49.0 million as of December 31, 2004, to $141.0 million as of September 30, 2005, offset by a decrease in FHLB advances of  $25.0 million from December 31, 2004.

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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, 2005. The accompanying table shows the capital ratios of the Company and Old Second National Bank, the Company’s lead subsidiary bank, as of September 30, 2005 and December 31, 2004.

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 meet maturing obligations and its existing commitments, 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 $30.2 million in the first nine months of 2005, compared with net cash inflows of $10.3 million in the first nine months of 2004.  Interest received, net of interest paid, was the principal use of operating cash outflows in both periods reported.  The increase in cash outflows for the first nine months of 2004 was primarily a result of the purchase of bank owned life insurance (BOLI) in the third quarter.  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 $249.3 million in the nine months ended September 30, 2005, compared to $168.2 million a year earlier. 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. In the first nine months of 2004, securities transactions accounted for a net outflow of $31.1 million, and net principal disbursed on loans accounted for net outflows of $134.9 million.  Cash outflows for property and equipment were $6.1 million in 2005 compared to $2.9 million for the same period of 2004.

Cash inflows from financing activities in the first nine months of 2005 were $221.2 million, which included an increase in deposits of $148.0 million, an increase in repurchase agreements of $ 10.9 million and an increase of $65.9 million in other short-term borrowings.  This compares with a net cash inflow of $206.4 million in the first nine months of 2004, associated with an increase in deposits of $324.8 million offset by a decrease of $11.7 million in repurchase agreements and a decrease of $104.8 million in other short-term borrowings.

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 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

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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.

Expected Maturity of Interest-Earning Assets and Interest-Bearing Liabilities