Old Second Bancorp - 10-Q quarterly report FY

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OLD SECOND BANCORP, INC.

Form 10-Q Quarterly Report

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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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issuance, including prior periods for which financial statements have not been issued.  The provisions of FSP FAS 157-3 did not have an impact on our financial condition or results of operations.

Note 2 – Business Combination

Old Second Acquisition, Inc., was formed as part of the November 5, 2007 Agreement and Plan of Merger between the Company, Old Second Acquisition, Inc., a wholly-owned subsidiary of the Company, and HeritageBanc, Inc. (“Heritage”), located in Chicago Heights.  The parties consummated the merger on February 8, 2008, at which time, Old Second Acquisition, Inc. was merged with and into Heritage with Heritage as the surviving corporation as a wholly-owned subsidiary of the Company.  Additionally, the parties merged Heritage Bank, a wholly-owned subsidiary of Heritage, with and into Old Second National Bank, with Old Second National Bank as the surviving bank.  After the completion of the merger transaction, Heritage was dissolved and is no longer an existing subsidiary.  The purchase price was paid through a combination of cash and approximately 1.6 million shares of the Company’s common stock totaling $86.0 million excluding transaction costs.  The transaction generated approximately $56.9 million in goodwill and $8.9 million in intangible assets subject to amortization.

The business combination was accounted for under the purchase method of accounting.  Accordingly, the results of operations of Heritage have been included in the Company’s results of operations since the date of acquisition.  Under this method of accounting, the purchase price is allocated to the respective assets acquired and liabilities assumed based on their estimated fair values, net of applicable income tax effects.  The excess cost over fair value of net assets acquired is recorded as goodwill.

The purchase accounting for the transaction is preliminary and may be subject to subsequent adjustments.  Under purchase accounting rules, goodwill may fluctuate based on receipt of finalized merger expense amounts as compared to prior estimates.

The following is the unaudited pro forma consolidated results of operations of the Company as though Heritage had been acquired as of the beginning of the periods indicated.

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Included in the pro forma results of operations for the nine months ended September 30, 2008 was one-time pretax merger costs of $3.9 million.

Note 3 – Securities

Securities available for sale are summarized as follows:

Recognition of other than temporary impairment was not necessary in the first nine months of 2008.  The change in value was related primarily to interest rate fluctuations.  An increase in rates will generally cause a decrease in the value of individual securities while a decrease in rates typically results in an increase in value.  Accordingly, based on the Company’s evaluation, management does not believe any individual unrealized loss at September 30, 2008 represents an other-than-temporary impairment as these unrealized losses are primarily attributable to changes in interest rates and the current volatile market conditions, and not credit deterioration.

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The Company has the ability and intent to hold all securities until recovery.

Note 4 – Loans

Major classifications of loans were as follows:

Note 5 – Allowance for Loan Losses

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

Note 6 – Goodwill and Intangibles

The Company added $56.9 million in goodwill and recorded $8.9 million in core deposits and other intangibles due to the Heritage acquisition on February 8, 2008.  Due to adjustments to asset valuation and expected acquisition related expenses, goodwill related to the purchase of Heritage decreased by $25,000 as of September 30, 2008.  The amortization of intangible assets was $797,000 for the first nine months ended September 30, 2008.  At September 30, 2008, the expected amortization of intangible assets is $1.1 million for the year ending December 31, 2008, $1.2 million for the year ending December 31, 2009 and $1.1 million for the year ending December 31, 2010, $847,000 for the year ending December 31, 2011 and $780,000 for the year ending December 31, 2012.

The following table presents the changes in the carrying amount of goodwill and other intangibles during the first nine months ended September 30, 2008 (in thousands):

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Note 7 – Mortgage Servicing Rights

Changes in capitalized mortgage servicing rights as of September 30, summarized as follows:

Note 8 – Deposits

Major classifications of deposits as of September 30, 2008, and December 31, 2007, were as follows:

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Note 9 – Borrowings

The following table is a summary of borrowings as of September 30, 2008, and December 31, 2007:

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 and mortgage-backed securities at September 30, 2008 and December 31, 2007.

The Company’s borrowings and letters of credit at the Federal Home Loan Bank of Chicago (“FHLBC”) are limited to the lesser of 35% of total assets or a percentage of the book value of certain mortgage loans as well as a multiple of the amount of FHLBC capital stock owned.  In addition, the advances and letters of credit outstanding, which totaled $31.9 million, were collateralized by FHLBC stock of $11.2 million and loans totaling $324.3 million at September 30, 2008.  FHLBC stock of $7.8 million and loans totaling $278.6 million were pledged as of December 31, 2007.  On September 12, 2008 a 2.20%, daily floating rate FHLBC advance of $175 million was obtained that had a rate of one basis point below the FHLBC federal funds equivalent rate, and on September 26, 2008 a 2.36% rate FHLBC advance of $40.0 million was obtained that had a floating rate of fifteen basis points above the same index.  The $175.0 million advanced matured on October 14, 2008 and was renewed with a November 14, 2008 maturity at a spread of fifteen basis points above the FHLBC federal funds equivalent rate.  Both of these advances can be prepaid without incurring a fee after providing a two-business day notice to the issuer.  As of September 30, 2008, the Company also had $9.0 million in FHLBC advances that were assumed through the Heritage merger.  These advances have fixed rates and $5.0 million of this amount is presented in the notes payable and other borrowings section of the Consolidated Balance Sheets.  The amount and terms of these advances are $2.0 million maturing November 10, 2008 at a rate of 5.08%, $2.0 million maturing May 11, 2009 at a rate of 5.0%, and $5.0 million maturing February 16, 2010 at a rate of 5.09%.

The Company is a Treasury Tax & Loan (“TT&L”) depository for the Federal Reserve Bank and, as such, it accepts TT&L deposits.  The Company is allowed to hold these deposits for the Federal Reserve 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, 2008, and December 31, 2007, the TT&L deposits were $3.7 million and $2.9 million, respectively.

The Company had a $30 million revolving line of credit available with Marshall & Ilsley Bank (“M&I”) which had an outstanding balance of $18.6 million as of December 31, 2007.  On January 31, 2008, the Company entered into a $75.5 million credit facility with LaSalle Bank National Association, (now Bank of America NA), which was comprised of a $30.5 million senior debt facility and $45.0 million of subordinated debt.  The senior debt facility included a $500,000 term loan with a maturity of

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March 31, 2018, and a revolving loan with a maturity of March 31, 2010.  The revolving loan replaced the $30.0 million revolving line of credit facility previously held with M&I.  At September 30, 2008, $16.9 million was outstanding on that line.  Pending approval and negotiations with Bank of America NA, management expects to renew the revolving loan on an annual basis after it matures in 2010.  The subordinated debt matures on March 31, 2018.  The interest rate on the senior debt facility resets quarterly, and is based on, at the Company’s option, either the Bank of America NA prime rate or three-month LIBOR plus 90 basis points.  The interest rate on the subordinated debt resets quarterly, and is equal to three-month LIBOR plus 150 basis points.  The senior debt is secured with all of the issued and outstanding shares of Old Second National Bank.

The above credit facility agreement contains usual and customary provisions regarding acceleration upon the occurrence of an event of default by the Company under the agreement, as described therein.  The agreement also contains certain customary representations and warranties and financial and negative covenants.  At September 30, 2008, the Company did not comply with one of the financial covenants contained within that credit agreement.  The lender subsequently granted the Company a waiver with no additional consideration or change in terms.  The proceeds of the $45.0 million of subordinated debt were primarily used to finance the acquisition of Heritage including transaction costs.  The $30.5 million borrowing facility is for general corporate purposes and was primarily used in the past to repurchase common stock.

Note 10 – 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 $5.1 million of cumulative trust preferred securities was sold in the first week of July 2003.  The costs associated with the tender offer of the cumulative trust preferred securities are being amortized over 30 years.  The trust-preferred securities can remain outstanding for a 30-year term but, subject to regulatory approval, they can be called in whole or in part by the Company.  The stated call period commenced on June 30, 2008 and can be exercised by the Company from time to time hereafter.  Cash distributions on the securities are payable quarterly at an annual rate of 7.80%.

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 (the “Trust”) in April 2007.  Although nominal in amount, the costs associated with that issuance are being amortized over 30 years.  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 are fixed at 6.77% through June 15, 2017 and float at 150 basis points over the three-month LIBOR rate thereafter.  The Company issued a new $25.8 million subordinated debenture to the Trust in return for the aggregate net proceeds of this trust preferred offering and to provide the primary source of financing for the common stock tender offer that was completed in May 2007.  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 Old Second Bancorp, Inc. are recorded on the Consolidated Balance Sheets as junior subordinated debentures and the related interest expense for each issuance is included in the Consolidated Statements of Income.

Note 11 – Long-Term Incentive Plan

The Long-Term Incentive Plan (the “Incentive Plan”) authorizes the issuance of up to 1,908,332 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.  Total shares issuable under the plan were 664,277 at September 30, 2008 and 116,531 at December 31, 2007.  Stock based awards may be granted to selected directors and officers or employees at the discretion of the board of directors.  All stock options were granted for a term of ten years.  Restricted stock vests three years

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from the grant date.  Awards under the Incentive Plan become fully vested upon a merger or change in control of the Company.  Compensation expense is recognized over the vesting period of the options based on the fair value of the options at the grant date.

Total compensation cost that has been charged against income for those plans was $255,083 in the third quarter of 2008 and $760,115 in the first nine months of 2008.  The total income tax benefit was $89,279 in the third quarter of 2008 and $266,040 in the first nine months of 2008.  Total compensation cost that has been charged against income for those plans was $174,421 in the third quarter of 2007 and $503,411 in the first nine months of 2007.  The total income tax benefit was $61,047 in the third quarter of 2007 and $176,194 in the first nine months of 2007.

There were 10,500 stock options exercised during the third quarter of 2008.  There were no stock options granted during the third quarter of 2008.  Total unrecognized compensation cost related to nonvested stock options granted under the Incentive Plan is $617,951 as of September 30, 2008, and is expected to be recognized over a weighted-average period of 1.98 years.  Total unrecognized compensation cost related to nonvested stock options granted under the Incentive Plan is $401,803 as of September 30, 2007, and is expected to be recognized over a weighted-average period of 2.25 years.

A summary of stock option activity in the Incentive Plan as of each quarter is as follows:

A summary of changes in the Company’s nonvested options in the Incentive Plan is as follows:

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A summary of stock option activity as of September 30 is as follows:

Restricted stock was granted beginning in 2005 under the Incentive Plan.  No shares were issued during either the third quarter of 2008 or in the third quarter of 2007.  These shares are subject to forfeiture until certain restrictions have lapsed, including employment for a specific period.  These shares vest after a three-year period.  Compensation expense is recognized over the vesting period of the shares based on the market value of the shares at issue date.  Awards under the Incentive Plan become fully vested upon a merger or change in control of the Company.

A summary of changes in the Company’s nonvested shares of restricted stock is as follows:

Total unrecognized compensation cost of restricted shares is $856,985 as of September 30, 2008, which is expected to be recognized over a weighted-average period of 1.92 years.  Total unrecognized compensation cost of restricted shares was $757,615 as of September 30, 2007, which was expected to be recognized over a weighted-average period of 1.94 years.  There were 702 restricted shares vested at September 30, 2008 and none vested at September 30, 2007.

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Note 12 – Earnings Per Share

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

Note 13 – Other Comprehensive Income

The following table summarizes the related income tax effect for the components of Other Comprehensive Income (Loss) as of September 30:

Note 14 – Retirement Plans

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 $1.8 million and $1.4 million in the first nine months of 2008 and 2007, respectively, as the Company had lowered its discretionary profit sharing contribution in 2007.  Management increased the discretionary plan expense in 2008, in part to accommodate the additional permanent employees from Heritage.

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Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis:

We may be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis in accordance with GAAP.  These assets consist of servicing rights, impaired loans and loans held for sale (“LHFS”).  Adjustments to fair value on LHFS primarily result from application of lower-of-cost-or-fair value accounting.  For assets measured at fair value on a nonrecurring basis on hand at September 30, 2008, the following table provides the level of valuation assumptions used to determine each valuation and the carrying value of the related assets:

(1)   Mortgage servicing rights, which are carried at the lower of cost or fair value, were written down to fair value of $2.1 million resulting in a valuation allowance of $1,700.  A net recovery of $85,000 was included in earnings for the first nine months of the year.

(2)   Represents carrying value and related write-downs of loans for which adjustments are based on the appraised value of collateral for collateral-dependent loans, had a carrying amount of $37.5  million, with a valuation allowance of $4.1 million, resulting in an additional provision for loan losses of $2.3 million for the first nine months of the year.  The carrying value of loans fully charged off is zero.

Note 16 – Interest Rate Swap Derivatives

The Company may occasionally enter into derivative financial instruments as part of our interest rate risk management strategies.  These derivative instruments consist entirely of interest rate swaps and are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates on the balance sheet date.  Since these derivative instruments are not accounted for as hedges, changes in fair value are recognized in noninterest income/expense.  As of September 30, 2008, the notional amount of non-hedging interest rate swaps was $35.6 million whereas there were no interest rate swaps at December 31, 2007.

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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 is the holding company of Old Second National Bank (the “Bank”), a national banking organization headquartered in Aurora, Illinois and provides commercial and retail banking services, as well as trust services.  The Company has offices located in Cook, Kane, Kendall, DeKalb, DuPage, LaSalle and Will counties in Illinois.  On February 8, 2008, the Company completed its acquisition of HeritageBanc, Inc. (“Heritage”) and merged Heritage Bank with and into Old Second National Bank.  As a result of the merger, the Company expanded its franchise into southwestern Cook County and the higher growth markets of the south Chicago suburbs by adding five retail banking locations and one mobile banking operation.  This acquisition provided additional market penetration and allowed the Company to fill in its footprint surrounding the Chicago metropolitan area.  The Company also offers insurance products through Old Second Financial, Inc.

Since the acquisition of Heritage, all major integration initiatives have been completed, and the Company began to realize economic benefits of the transaction in the second quarter of 2008.  The acquired client base provided revenue opportunities for both the corporate and retail business units as the Company’s retail and mortgage services, wealth management and employee benefit services offerings were more expansive than the previous product and services offered to Heritage clientele.  Additionally, access to remote capture services and other treasury management products also became available to complement the traditional commercial deposit and loan products previously offered.  The Company paid consideration of $43.0 million in cash and 1,563,636 shares of the Company’s stock valued at $27.50 per share to consummate the Heritage acquisition.  Details related to the allocation of the purchase price for this business combination are discussed in Note 2.  The terms of the credit facilities that were established to complete the acquisition are detailed in Note 9.

Recent Developments

Recent events in the U.S. and global financial markets, including the deterioration of the worldwide credit markets, have created significant challenges for financial institutions such as the Company.  Dramatic declines in the housing market during the past year, marked by falling home prices and increasing levels of mortgage foreclosures, have resulted in significant write-downs of asset values by many financial institutions, including government-sponsored entities and major commercial and investment banks.  In addition, many lenders and institutional investors have reduced, and in some cases, ceased to provide funding to borrowers, including other financial institutions, as a result of concern about the stability of the financial markets and the strength of counterparties.

In response to the crises affecting the U.S. banking system and financial markets and attempt to bolster the distressed economy and improve consumer confidence in the financial system, on October 3, 2008, the U.S. Congress passed, and the President signed into law, the Emergency Economic Stabilization Act of 2008 (the “Stabilization Act”).  The Stabilization Act authorizes the Secretary of the U.S. Treasury and the Federal Deposit Insurance Corporation (the “FDIC”) to implement various temporary emergency programs designed to strengthen the capital positions of financial institutions and stimulate the availability of credit within the U.S. financial system.  Pursuant to the Stabilization Act, the U.S. Treasury will have the authority to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets.

On October 14, 2008, the U.S. Treasury announced that it will purchase equity stakes in eligible financial institutions that wish to participate.  This program, known as the Capital Purchase Program, allocates $250 billion from the $700 billion authorized by the Stabilization Act to the U.S. Treasury for the purchase of senior preferred shares from qualifying financial institutions.  Eligible institutions will be

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able to sell equity interests to the U.S. Treasury in amounts equal to between 1% and 3% of the institution’s risk-weighted assets.  In conjunction with the purchase of preferred stock, the U.S. Treasury will receive warrants to purchase common stock from the participating institutions with an aggregate market price equal to 15% of the preferred investment.  Participating financial institutions will be required to adopt the U.S. Treasury’s standards for executive compensation and corporate governance for the period during which the U.S. Treasury holds equity issued under the Capital Purchase Program.  Many financial institutions have already announced that they will participate in the Capital Purchase Program.  While the Company’s management is confident that the Company has sufficient capital to support continued growth, the Company has applied to participate in the Capital Purchase Program.

Also on October 14, 2008, using the systemic risk exception to the FDIC Improvement Act of 1991, the U.S. Treasury authorized the FDIC to provide a 100% guarantee of newly-issued senior unsecured debt and deposits in non-interest bearing accounts at FDIC insured institutions.  Initially, all eligible financial institutions will automatically be covered under this program, known as the Temporary Liquidity Guarantee Program, without incurring any fees for a period of 30 days.  Coverage under the Temporary Liquidity Guarantee Program after the initial 30-day period is available to insured financial institutions at a cost of 75 basis points per annum for senior unsecured debt and 10 basis points per annum for non-interest bearing deposits.  After the initial 30-day period, institutions will continue to be covered under the Temporary Liquidity Guarantee Program unless they inform the FDIC that they have decided to opt out of the program.  The Company is assessing its participation in the Temporary Liquidity Guarantee Program and anticipates that it will participate in the insurance program covering the non-interest bearing deposits but not participate in the program to guarantee unsecured senior debt.

Under the Troubled Asset Auction Program, another initiative based on the authority granted by the Stabilization Act, the U.S. Treasury, through a newly-created Office of Financial Stability, will purchase certain troubled mortgage-related assets from financial institutions in a reverse-auction format.  Troubled assets eligible for purchase by the Office of Financial Stability include residential and commercial mortgages originated on or before March 14, 2008, securities or obligations that are based on such mortgages, and any other financial instrument that the Secretary of the U.S. Treasury determines, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, is necessary to promote financial market stability.  The U.S. Treasury has not issued any definitive guidance regarding this program and the Company’s management has not determined whether or not it will participate.

Under the Stabilization Act, the U.S. Treasury is also required to establish a program that will guarantee principal of, and interest on, troubled assets originated or issued prior to March 14, 2008, including mortgage-backed securities.  The program may take any form and may vary by asset class, but it must be voluntary and self-funding.  The U.S. Treasury has the authority to set premiums to reflect the credit risk characteristics of the insured assets.  The U.S. Treasury has solicited requests for comments on how the program should be structured but no program has been implemented to date.  The Stabilization Act also temporarily increases the amount of insurance coverage of deposit accounts held at FDIC-insured depository institutions, including Old Second National Bank, from $100,000 to $250,000.  The increased coverage is effective during the period from October 3, 2008 until December 31, 2009.

It is not clear at this time what impact the Stabilization Act, the Capital Purchase Program, the Temporary Liquidity Guarantee Program, the Troubled Asset Auction Program, other liquidity and funding initiatives of the Federal Reserve and other agencies that have been previously announced, and any additional programs that may be initiated in the future will have on the Company’s future financial condition and results of operations.

The preceding is a summary of recently enacted laws and regulations that could materially impact the Company’s results of operations or financial condition.  This discussion is qualified in its entirety by reference to such laws and regulations and should be read in conjunction with “Supervision and Regulation” discussion contained in ITEM 1: BUSINESS of the Company’s 2007 Form 10-K.

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Results of Operations

Net income for the third quarter of 2008 decreased to $4.1 million, $0.30 diluted earnings per share, compared with $6.1 million, or $0.49 diluted earnings per share, in the third quarter of 2007.  Earnings for the first nine months of 2008 also decreased to $1.25 per diluted share, on $17.0 million in net income, compared with $1.37 per diluted share in the first nine months of 2007, on earnings of $17.6 million.  Earnings in the first nine months of 2008 were primarily affected by the Heritage acquisition, gains on sales of securities as well as an increased provision for loan losses.  The Company’s earnings in 2008 included the contribution of Heritage since its acquisition on February 8, 2008.  Realized losses on securities totaled $20,000 in the third quarter of 2008, which brought the net realized gains total to $1.4 million for the year.  In the third quarter of 2007, there was $11,000 in realized gains from sold securities, which brought the net realized gains total to $493,000 for that year.  The Company recorded a $9.1 million provision for loan losses in the nine months ended September 30, 2008, which included an addition of $6.3 million in the third quarter.  In the same period in 2007, the provision for loan losses was $1.2 million, $600,000 of which was added in the third quarter.  The return on average equity decreased from 15.70% in the first nine months of 2007, to 11.65% for the same period in 2008.

The transaction charges related to Heritage, net of taxes calculated at a 35% statutory rate, totaled $16,000 in the third quarter of 2008 and $612,000, or $.04 per diluted share in the first nine months of 2008.  Core net income, which is calculated by excluding these transaction costs, was $17.6 million in the first nine months of 2008, which equates to core diluted earnings per share of $1.29 and a core return on average equity of 12.07%.  Management believes that the exclusion of the transaction charges more accurately reflects income from continuing operations, and references to core net income, core diluted earnings per share, and ratios identified as “core” are all non-GAAP measurements.

Net Interest Income

Net interest income increased from $50.8 million in the first nine months of 2007 to $66.1 million in the first nine months of 2008.  Average earning assets grew $360.2 million, or 15.5%, from September 30, 2007 to September 30, 2008, primarily due to organic growth and the Heritage acquisition.  The Company acquired $329.0 million in earning assets through the acquisition, which included $283.6 million in loans and $45.0 million in investments.  Average interest bearing liabilities increased $317.1 million, or 15.4%, from September 30, 2007 and such increase was influenced by these same factors as the asset growth.  Additionally, the Company’s borrowings increased $43.0 million as a result of financing the cash portion of the consideration paid to Heritage shareholders for the acquisition.  The net interest margin (tax equivalent basis), expressed as a percentage of average earning assets, increased from 3.06% in the first nine months of 2007 to 3.41% in the first nine months of 2008.  The average tax-equivalent yield on earning assets decreased from 6.70% in the first nine months of 2007 to 6.02%, or 68 basis points, in the first nine months of 2008.  At the same time, the cost of funds on interest bearing liabilities decreased from 4.18% to 3.03%, or 115 basis points.

Net interest income increased from $17.3 million in the third quarter of 2007 to $23.6 million in the third quarter of 2008.  During the same period, the net interest margin (tax-equivalent basis), expressed as a percentage of average earning assets, increased from 3.01% in 2007 to 3.61% in 2008.  The third quarter 2008 net interest income was enhanced by growth in average earning assets of $306.3 million, or 12.8%, which included the acquisition and organic growth factors discussed above.  The average tax-equivalent yield on earning assets decreased from 6.74% in the third quarter of 2007 to 5.83% in the third quarter of 2008, or 91 basis points.  The cost of interest-bearing liabilities also decreased from 4.23% to 2.57%, or 166 basis points, in the same period.  The general decrease in interest rates lowered interest expense to a greater degree than it reduced interest income, and thereby improved the net interest margin.

Management, in order to evaluate and measure performance, uses certain non-GAAP performance measures and ratios.  In addition to the “core” earnings discussion related to the Heritage acquisition transaction costs found in the results of operation section of the preceding page, management

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has traditionally disclosed other certain non-GAAP ratios to evaluate and measure the Company’s performance.  This includes tax-equivalent net interest income (including its individual components) and net interest margin (including its individual components) to total average interest-earning assets.  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 tables and notes below for supplemental data and the corresponding reconciliations to GAAP financial measures for the three month and nine month periods ended September 30, 2008 and 2007.

The following tables set forth certain information relating to the Company’s average consolidated balance sheets and reflect the yield on average earning assets and cost of average liabilities for the periods indicated.  Dividing the related interest by the average balance of assets or liabilities derives rates.  Average balances are derived from daily balances.  For purposes of discussion, net interest income and net interest income to total earning assets on the following tables have been adjusted to a non-GAAP tax equivalent (“TE”) basis using a marginal rate of 35% to more appropriately compare returns on tax-exempt loans and securities to other earning assets.

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