Table of Contents
I
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
☒
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2017
OR
☐
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For transition period from to
Commission File Number 0 -10537
(Exact name of Registrant as specified in its charter)
Delaware
36-3143493
(State or other jurisdiction
(I.R.S. Employer Identification Number)
of incorporation or organization)
37 South River Street, Aurora, Illinois 60507
(Address of principal executive offices) (Zip Code)
(630) 892-0202
(Registrant’s telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of ‘‘large accelerated filer,’’ ‘‘accelerated filer,’’ ‘‘smaller reporting company,’’ and ‘‘emerging growth company’’ in Rule 12b–2 of the Exchange Act.
Large accelerated filer☐Accelerated filer☒
Non-accelerated filer☐Smaller reporting company☐Emerging growth company☐
(Do not check if a smaller reporting company)
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).
Yes ☐ No ☒
As of November 3, 2017, the Registrant had 29,627,086 shares of common stock outstanding at $1.00 par value per share.
OLD SECOND BANCORP, INC.
Form 10-Q Quarterly Report
PART I
Page Number
Item 1.
Financial Statements
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
Item 4.
Controls and Procedures
PART II
Legal Proceedings
Item 1.A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Mine Safety Disclosure
Item 5.
Other Information
Item 6.
Exhibits
Signatures
2
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Old Second Bancorp, Inc. and Subsidiaries
Consolidated Balance Sheets
(In thousands, except share data)
(unaudited)
September 30,
December 31,
2017
2016
Assets
Cash and due from banks
$
32,772
33,805
Interest bearing deposits with financial institutions
14,730
13,529
Cash and cash equivalents
47,502
47,334
Securities available-for-sale, at fair value
533,484
531,838
Federal Home Loan Bank Chicago ("FHLBC") and Federal Reserve Bank Chicago ("FRBC") stock
10,393
7,918
Loans held-for-sale
1,641
4,918
Loans
1,594,191
1,478,809
Less: allowance for loan losses
16,465
16,158
Net loans
1,577,726
1,462,651
Premises and equipment, net
37,971
38,977
Other real estate owned
9,024
11,916
Mortgage servicing rights, net
6,684
6,489
Goodwill and core deposit intangible
8,944
9,018
Bank-owned life insurance ("BOLI")
61,403
60,332
Deferred tax assets, net
42,394
53,464
Other assets
23,241
16,333
Total assets
2,360,407
2,251,188
Liabilities
Deposits:
Noninterest bearing demand
556,874
513,688
Interest bearing:
Savings, NOW, and money market
947,969
950,849
Time
384,272
402,248
Total deposits
1,889,115
1,866,785
Securities sold under repurchase agreements
26,853
25,715
Other short-term borrowings
125,000
70,000
Junior subordinated debentures
57,627
57,591
Senior notes
44,033
43,998
Other liabilities
17,016
11,889
Total liabilities
2,159,644
2,075,978
Stockholders’ Equity
Common stock
34,626
34,534
Additional paid-in capital
117,458
116,653
Retained earnings
145,767
129,005
Accumulated other comprehensive loss
(632)
(8,762)
Treasury stock
(96,456)
(96,220)
Total stockholders’ equity
200,763
175,210
Total liabilities and stockholders’ equity
September 30, 2017
December 31, 2016
Common
Stock
Par value
1.00
Shares authorized
60,000,000
Shares issued
34,625,734
34,534,234
Shares outstanding
29,627,086
29,556,216
Treasury shares
4,998,648
4,978,018
See accompanying notes to consolidated financial statements.
3
Consolidated Statements of Income
(In thousands, except per share data)
Quarters Ended September 30,
Nine Months Ended September 30,
Interest and dividend income
Loans, including fees
18,208
13,496
52,202
39,593
34
48
95
115
Securities:
Taxable
2,424
3,954
7,994
12,547
Tax exempt
1,628
180
4,188
579
Dividends from FHLBC and FRBC stock
94
83
271
251
37
64
91
98
Total interest and dividend income
22,425
17,825
64,841
53,183
Interest expense
Savings, NOW, and money market deposits
239
193
695
577
Time deposits
1,077
931
3,081
2,622
224
23
482
69
930
1,084
3,073
3,251
672
-
2,017
Subordinated debt
245
727
Notes payable and other borrowings
6
Total interest expense
3,142
2,478
9,348
7,252
Net interest and dividend income
19,283
15,347
55,493
45,931
Provision for loan losses
300
1,050
Net interest and dividend income after provision for loan losses
18,983
54,443
Noninterest income
Trust income
1,468
1,403
4,564
4,274
Service charges on deposits
1,722
1,756
4,955
4,961
Secondary mortgage fees
195
322
594
795
Mortgage servicing rights mark to market loss
(194)
(147)
(756)
(1,921)
Mortgage servicing income
451
437
1,330
1,280
Net gain on sales of mortgage loans
1,095
2,177
3,715
5,031
Securities gain (loss), net
102
(1,959)
(165)
(2,020)
Increase in cash surrender value of BOLI
362
383
1,071
987
Debit card interchange income
1,075
1,013
3,131
3,009
Gain (loss) on disposal and transfer of fixed assets, net
10
(1)
Other income
1,567
1,209
3,739
3,751
Total noninterest income
7,843
6,594
22,188
20,146
Noninterest expense
Salaries and employee benefits
10,049
9,014
31,167
26,854
Occupancy, furniture and equipment
1,482
1,500
4,510
4,427
Computer and data processing
1,081
1,105
3,283
3,093
FDIC insurance
199
228
512
793
General bank insurance
246
269
780
839
Amortization of core deposit intangible
24
74
Advertising expense
255
430
1,093
1,212
Debit card interchange expense
285
363
1,033
1,186
Legal fees
162
242
450
Other real estate expense, net
680
426
1,928
2,043
Other expense
2,455
3,005
8,128
8,505
Total noninterest expense
16,918
16,582
52,958
49,546
Income before income taxes
9,908
5,359
23,673
16,531
Provision for income taxes
1,831
1,860
6,023
5,865
Net income
8,077
3,499
17,650
10,666
Basic earnings per share
0.27
0.12
0.60
0.36
Diluted earnings per share
0.59
4
Consolidated Statements of Comprehensive Income
(In thousands)
Net Income
Unrealized holding gains (losses) on available-for-sale securities arising during the period
2,971
(616)
13,798
5,151
Related tax (expense) benefit
(1,191)
237
(5,516)
(2,071)
Holding gains (losses) after tax on available-for-sale securities
1,780
(379)
8,282
3,080
Less: Reclassification adjustment for the net gains (losses) realized during the period
Net realized gains (losses)
Income tax (expense) benefit on net realized gains (losses)
(42)
782
807
Net realized gains (losses) after tax
60
(1,177)
(101)
(1,213)
Other comprehensive income on available-for-sale securities
1,720
798
8,383
4,293
Accretion and reversal of net unrealized holding gains on held-to-maturity securities
5,939
Related tax expense
(2,446)
Other comprehensive income on held-to-maturity securities
3,493
Changes in fair value of derivatives used for cashflow hedges
19
(254)
(445)
(4,278)
Related tax benefit
8
192
1,714
Other comprehensive income (loss) on cashflow hedges
27
(152)
(253)
(2,564)
Total other comprehensive income
1,747
646
8,130
5,222
Total comprehensive income
9,824
4,145
25,780
15,888
5
Consolidated Statements of Cash Flows
Cash flows from operating activities
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation of fixed assets and amortization of leasehold improvements
1,760
1,682
Change in fair value of mortgage servicing rights
756
1,921
Loan loss reserve
Provision for deferred tax expense
5,682
5,476
Originations of loans held-for-sale
(113,077)
(147,187)
Proceeds from sales of loans held-for-sale
119,059
150,247
(3,715)
(5,031)
Net discount accretion of purchase accounting adjustment on loans
(1,115)
Change in current income taxes receivable
111
(1,071)
(987)
Change in accrued interest receivable and other assets
(6,849)
(2,659)
Change in accrued interest payable and other liabilities
4,571
(246)
Net premium amortization/discount (accretion) on securities
1,320
(517)
Securities losses, net
165
2,020
Amortization of core deposit
Amortization of junior subordinated debentures issuance costs
36
Amortization of senior notes issuance costs
77
Stock based compensation
897
Net gain on sale of other real estate owned
(454)
(316)
Provision for other real estate owned losses
1,630
1,305
Net (gain) loss on disposal and transfer of fixed assets
(10)
1
Net cash provided by operating activities
28,547
17,193
Cash flows from investing activities
Proceeds from maturities and calls including pay down of securities available-for-sale
105,327
62,868
Proceeds from sales of securities available-for-sale
152,476
271,374
Purchases of securities available-for-sale
(246,971)
(153,252)
Proceeds from maturities and calls including pay down of securities held-to-maturity
3,372
Net disbursements/proceeds from (purchases) sales of FHLBC stock
(2,475)
600
Net change in loans
(118,711)
(71,600)
Improvements in other real estate owned
(16)
Proceeds from sales of other real estate owned, net of participation purchase
5,512
5,247
Proceeds from disposition of premises and equipment
13
Net purchases of premises and equipment
(852)
(1,163)
Net cash used in (provided by) investing activities
(105,681)
117,430
Cash flows from financing activities
Net change in deposits
22,330
18,296
Net change in securities sold under repurchase agreements
1,138
12,536
Net change in other short-term borrowings
55,000
(15,000)
Payment of senior note issuance costs
Dividends paid on common stock
(888)
(592)
Purchase of treasury stock
(236)
Net cash provided by financing activities
77,302
14,986
Net change in cash and cash equivalents
168
149,609
Cash and cash equivalents at beginning of period
40,338
Cash and cash equivalents at end of period
189,947
Consolidated Statements of Cash Flows - Continued
Supplemental cash flow information
Income taxes paid, net
230
160
Interest paid for deposits
3,802
Interest paid for borrowings
4,890
4,021
Non-cash transfer of loans to other real estate owned
3,701
1,223
Non-cash transfer of premises to other real estate owned
Non-cash transfer of securities held-to-maturity to securities available-for-sale
244,823
7
Consolidated Statements of Changes in
Accumulated
Additional
Other
Total
Paid-In
Retained
Comprehensive
Treasury
Stockholders’
Capital
Earnings
Loss
Equity
Balance, December 31, 2015
34,427
115,918
114,209
(12,659)
(95,966)
155,929
Other comprehensive income, net of tax
Dividends declared and paid
Vesting of restricted stock
106
(106)
Tax effect from vesting of restricted stock
174
Balance, September 30, 2016
34,533
116,468
124,283
(7,437)
171,627
Balance, December 31, 2016
92
(92)
Balance, September 30, 2017
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 the interim consolidated financial statements are consistent with those used in the preparation of the annual financial information. The interim consolidated financial statements reflect all normal and recurring adjustments that are necessary, in the opinion of management, for a fair statement of results for the interim period presented. Results for the period ended September 30, 2017, are not necessarily indicative of the results that may be expected for the year ending December 31, 2017. These interim consolidated financial statements are unaudited and should be read in conjunction with the audited financial statements and notes included in Old Second Bancorp, Inc.’s (the “Company”) annual report on Form 10-K for the year ended December 31, 2016. Unless otherwise indicated, amounts in the tables contained in the notes to the consolidated financial statements are in thousands. Certain items in prior periods have been reclassified to conform to the current presentation.
The Company’s consolidated financial statements are prepared in accordance with United States generally accepted accounting principles (“GAAP”) and follow general practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the consolidated financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the consolidated financial statements.
All significant accounting policies are presented in Note 1 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the consolidated financial statements and how those values are determined.
Recent Accounting Pronouncements
In May 2014, the FASB issued ASU No. 2014-09 "Revenue from Contracts with Customers (Topic 606)." The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. In August 2015, the FASB issued ASU 2015-14 “Revenue from Contracts with Customers (Topic 606) Deferral of the Effective Date.” This accounting standards update defers the effective date of ASU 2014-09 for an additional year. ASU 2015-14 will be effective for annual reporting periods beginning after December 15, 2017. The amendments can be applied retrospectively to each prior reporting period or retrospectively with the cumulative effect of initially applying this update recognized at the date of initial application. Early application is not permitted. In March 2016, the FASB issued ASU 2016-08 “Revenue from Contracts with Customers (TOPIC 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net)” and in April 2016, the FASB issued ASU 2016-10 “Revenue from Contracts with Customers (TOPIC 606): Identifying Performance Obligations and Licensing.” ASU 2016-08 requires the entity to determine if it is acting as a principal with control over the goods or services it is contractually obligated to provide, or an agent with no control over specified goods or services provided by another party to a customer. ASU 2016-10 was issued to further clarify ASU 2014-09 implementation regarding identifying performance obligation materiality, identification of key contract components, and scope. The Company is assessing the impact of ASU 2014-09 and other related ASUs as noted above on its accounting and disclosures within noninterest income, as any interest income impact was not included in the scope of this final ASU pronouncement. Adoption of this ASU is expected to affect the methodology used to record certain recurring revenue streams within trust and asset management fees, but this impact is not anticipated to be significant to the Company’s financial statements. The Company will adopt ASU 2015-14 and related issuances on January 1, 2018, with a cumulative effect adjustment to opening retained earnings, if an adjustment is deemed to be material.
In February 2016, the FASB issued ASU No. 2016-02 “Leases (Topic 842).” This ASU was issued to increase transparency and comparability among organizations by recognizing lease assets and liabilities on the balance sheet and disclosing key information about leasing arrangements. One key revision from prior guidance was to include operating leases within assets and liabilities recorded; another revision was included which created a new model to follow for sale-leaseback transactions. The impact of this pronouncement will affect lessees primarily, as virtually all of their assets will be recognized on the balance sheet, by recording a right of use asset and lease liability. This pronouncement is effective for fiscal years beginning after December 15, 2018. The Company is assessing the impact of ASU 2016-02 on its accounting and disclosures.
In March 2016, the FASB issued ASU No. 2016-09 “Stock Compensation - Improvements to Employee Share-Based Payment Accounting (Topic 718).” FASB issued this ASU as part of the Simplification Initiative. This ASU involves several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or
9
liability, and classification on the statement of cash flows. ASU 2016-09 is effective for financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. This standard was adopted by the Company effective January 2017; the adoption of this standard did not have a material effect on the Company’s operating results or financial condition.
In June 2016, the FASB issued ASU No. 2016-13 “Measurement of Credit Losses on Financial Instruments (Topic 326).” ASU 2016-13 was issued to provide financial statement users with more useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date to enhance the decision making process. The new methodology to be used should reflect expected credit losses based on relevant vintage historical information, supported by reasonable forecasts of projected loss given defaults, which will affect the collectability of the reported amounts. This new methodology will also require available-for-sale debt securities to have a credit loss recorded through an allowance rather than write-downs. ASU 2016-13 is effective for financial statements issued for fiscal years beginning after December 15, 2019. The Company is assessing the impact of ASU 2016-13 on its accounting and disclosures, and is in the process of accumulating data and evaluating model options to support future risk assessments.
In March 2017, the FASB issued ASU No. 2017-08 “Receivables-Nonrefundable Fees and Other Costs – Premium Amortization on Purchased Callable Debt Securities (Subtopic 310-20).” This ASU was issued to shorten the amortization period for the premium to the earliest call date on debt securities. This premium is required to be recorded as a reduction to net interest margin during the shorter yield to call period, as compared to prior practice of amortizing the premium as a reduction to net interest margin over the contractual life of the instrument. This ASU does not change the current method of amortizing any discount over the contractual life of the debt security, and this pronouncement is effective for fiscal years beginning after December 15, 2018, with earlier adoption permitted. The Company adopted ASU 2017-08 as a change in accounting principle in the third quarter of 2017 on a modified retrospective basis, which required the Company to reflect its adoption effective January 1, 2017. The effect of amortizing the premium over a shorter period negatively impacted the net interest margin for the first nine months of 2017, and will continue to decrease future quarterly net interest income by approximately 10 basis points a quarter until the premium, which is $25.0 million as of September 30, 2017, is fully amortized. As a result of management’s analysis, the impact of the change in accounting principle as a result of ASU 2017-08 to adjust beginning of year retained earnings was considered insignificant and, accordingly, the impact was adjusted through current period earnings.
In August 2017, the FASB issued ASU 2017-12, “Derivatives and Hedging: Targeted Improvements to Accounting for Hedging Activities”. The purpose of this updated guidance is to better align a company’s financial reporting for hedging activities with the economic objectives of those activities. ASU 2017-12 is effective for public business entities for fiscal years beginning after December 15, 2018, with early adoption, including adoption in an interim period, permitted. The Company plans to adopt ASU 2017-12 on January 1, 2018. ASU 2017-12 requires a modified retrospective transition method in which the Company will recognize the cumulative effect of the change on the opening balance of each affected component of equity in the statement of financial position as of the date of adoption. While the Company continues to assess all potential impacts of the standard, we currently expect adoption to have an immaterial impact on our consolidated financial statements.
Subsequent Events
On October 17, 2017, the Company’s Board of Directors declared a cash dividend of $0.01 per share payable on November 6, 2017, to stockholders of record as of October 27, 2017; dividends of $296,000 were paid to stockholders on November 6, 2017.
Note 2 – Acquisitions
On October 28, 2016, the Bank acquired the Chicago branch of Talmer Bank and Trust, the banking subsidiary of Talmer Bancorp, Inc. (“Talmer”). As a result of this transaction, the Bank recorded assets with a fair value of approximately $230.9 million, including approximately $221.0 million of loans, and assumed deposits with a fair value of approximately $48.9 million. Goodwill of $8.4 million was included within the total assets recorded upon acquisition; net cash of $181.5 million was paid for the purchase.
Note 3 – Securities
Investment Portfolio Management
Our investment portfolio serves the liquidity needs and income objectives of the Company. While the portfolio serves as an important component of the overall liquidity management at the Bank, portions of the portfolio also serve as income producing assets. The size and composition of the portfolio reflects liquidity needs, loan demand and interest income objectives. Portfolio size and composition will be adjusted from time to time. While a significant portion of the portfolio consists of readily marketable securities to address liquidity, other parts of the portfolio may reflect funds invested pending future loan demand or to maximize interest income without undue interest rate risk.
Investments are comprised of debt securities and non-marketable equity investments. Securities available-for-sale are carried at fair value. Unrealized gains and losses, net of tax, on securities available-for-sale are reported as a separate component of equity. This balance sheet component changes as interest rates and market conditions change. Unrealized gains and losses are not included in the calculation of regulatory capital.
FHLBC and FRBC stock are considered nonmarketable equity investments. FHLBC stock was recorded at $5.6 million at September 30, 2017, and $3.1 million at December 31, 2016, and is necessary to maintain access to FHLBC advances, which are utilized as a component to meet the Bank’s daily funding needs. FRBC stock was recorded at $4.8 million at September 30, 2017, and December 31, 2016.
The following table summarizes the amortized cost and fair value of the securities portfolio at September 30, 2017, and December 31, 2016, and the corresponding amounts of gross unrealized gains and losses:
Gross
Amortized
Unrealized
Fair
Cost
Gains
Losses
Value
Securities available-for-sale
U.S. Treasuries
4,001
(11)
3,990
U.S. government agencies
13,475
15
(39)
13,451
U.S. government agencies mortgage-backed
11,131
18
(119)
11,030
States and political subdivisions
224,648
5,173
(789)
229,032
Corporate bonds
10,823
20
(266)
10,577
Collateralized mortgage obligations
81,693
(1,535)
80,386
Asset-backed securities
134,542
865
(3,648)
131,759
Collateralized loan obligations
52,803
505
(49)
53,259
Total securities available-for-sale
533,116
6,824
(6,456)
42,511
(977)
41,534
68,718
258
(273)
68,703
10,957
(336)
10,630
174,352
374
(3,799)
170,927
146,391
341
(8,325)
138,407
102,504
29
(896)
101,637
545,433
1,011
(14,606)
The fair value, amortized cost and weighted average yield of debt securities at September 30, 2017, by contractual maturity, were as follows in the table below. Securities not due at a single maturity date are shown separately.
Weighted
Average
Yield
Due in one year or less
3,400
2.60
%
3,405
Due after one year through five years
5,846
2.74
5,831
Due after five years through ten years
16,105
2.52
16,057
Due after ten years
227,596
2.98
231,757
252,947
2.94
257,050
Mortgage-backed and collateralized mortgage obligations
92,824
2.72
91,416
2.41
4.38
2.91
At September 30, 2017, the Company’s investments include $110.6 million of asset-backed securities that are backed by student loans originated under the Federal Family Education Loan program (“FFEL”). Under the FFEL, private lenders made federally guaranteed student loans to parents and students. While the program was modified several times before elimination in 2010, FFEL securities are generally guaranteed by the U.S Department of Education “DOE”) at not less than 97% of the outstanding principal amount of the loans. The guarantee will reduce to 85% if the DOE receives reimbursement requests in excess of 5% of insured loans; reimbursement
11
will drop to 75% if reimbursement requests exceed 9% of insured loans. In addition to the U.S. Department of Education guarantee, total added credit enhancement in the form of overcollateralization and/or subordination amounted to $12.3 million, or 10.42%, of outstanding principal.
The Company has invested in securities issued from three originators that individually amount to over 10% of the Company’s stockholders equity. Information regarding these three issuers and the value of the securities issued follows:
Issuer
GCO Education Loan Funding Corp
27,555
26,505
Towd Point Mortgage Trust
29,544
29,445
Student Loan Marketing Assocation
25,654
25,803
Securities with unrealized losses at September 30, 2017, and December 31, 2016, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows (in thousands except for number of securities):
Less than 12 months
12 months or more
in an unrealized loss position
Number of
Securities
39
6,701
2,089
4,096
119
6,185
789
24,843
266
10,078
238
21,281
1,297
43,684
12
1,535
64,965
265
3,383
76,725
3,648
81,018
49
7,948
1,404
71,145
5,052
134,583
42
6,456
205,728
957
40,636
898
977
273
35,241
183
4,817
153
5,328
336
10,145
16
3,402
117,752
397
18,109
3,799
135,861
328
17,604
7,997
107,112
8,325
124,716
896
81,613
44
5,143
216,050
9,463
213,060
78
14,606
429,110
Recognition of other-than-temporary impairment was not necessary in the three and nine months ended September 30, 2017 or 2016. The changes in fair value related primarily to interest rate fluctuations. Our review of other-than-temporary impairment determined that there was no credit quality deterioration.
The following table presents net realized gains (losses) on securities available-for-sale for the quarters and nine months ended September 30, 2017 and 2016.
Quarter Ended
Nine Months Ended
Gross realized gains on securities
474
1,380
911
1,518
Gross realized losses on securities
(371)
(3,339)
(1,076)
(3,538)
Securities realized gains (losses), net
103
The majority of the net realized losses in the prior year were incurred to meet the funding needs related to the Talmer branch acquisition in late 2016.
Note 4 – Loans
Major classifications of loans were as follows:
Commercial
257,356
228,113
Leases
69,305
55,451
Real estate - commercial
739,136
736,247
Real estate - construction
94,868
64,720
Real estate - residential
419,583
377,851
Consumer
2,770
3,237
Other1
10,550
11,973
1,593,568
1,477,592
Net deferred loan costs
623
1,217
Total loans
1 The “Other” class includes overdrafts.
It is the policy of the Company to review each prospective credit prior to making a loan in order to determine if an adequate level of security or collateral has been obtained. The type of collateral, when required, will vary from liquid assets to real estate. The Company’s access to collateral, in the event of borrower default, is assured through adherence to lending laws, the Company’s lending standards and credit monitoring procedures. With selected exceptions, the Bank makes loans solely within its market area. There are no significant concentrations of loans where the customers’ ability to honor loan terms is dependent upon a single economic sector, although the real estate related categories listed above represent 78.6% and 79.7% of the portfolio at September 30, 2017, and December 31, 2016, respectively.
Aged analysis of past due loans by class of loans was as follows:
Recorded
Investment
90 days or
90 Days or
Greater Past
30-59 Days
60-89 Days
Total Past
Due and
Past Due
Due
Current
Nonaccrual
Total Loans
Accruing
89
257,060
207
685
149
834
68,275
196
156
Owner occupied general purpose
253
537
790
154,429
457
155,676
561
Owner occupied special purpose
513
172,866
359
173,738
Non-owner occupied general purpose
649
251,933
1,165
253,747
Non-owner occupied special purpose
248
93,498
93,746
Retail properties
45,149
1,113
46,262
Farm
15,584
15,967
387
Homebuilder
2,644
Land
3,235
Commercial speculative
34,817
All other
63
53,904
205
54,172
Investor
52,361
492
52,853
Multifamily
117,544
4,757
122,301
Owner occupied
40
124,414
4,127
128,581
Revolving and junior liens
732
22
100
854
113,956
1,038
115,848
2,760
11,172
11,173
2,253
1,044
1,169
4,466
1,575,601
14,124
1,207
57
131
227,742
240
286
54,799
366
758
135,599
879
137,236
177,755
385
178,140
667
379
1,046
229,315
1,930
232,291
118,052
119,065
53,474
1,179
54,653
1,353
13,509
14,862
3,883
3,029
22,654
22,728
364
34,509
35,080
54,924
936
56,097
96,502
274
116,900
6,452
123,626
225
405
630
99,374
1,622
101,626
46
3,191
14
13,176
13,190
3,959
1,180
5,139
1,458,387
15,283
1 The “Other” class includes overdrafts and net deferred costs.
Credit Quality Indicators
The Company categorizes loans into credit risk categories based on current financial information, overall debt service coverage, comparison against industry averages, historical payment experience, and current economic trends. This analysis includes loans with outstanding balances or commitments greater than $50,000 and excludes homogeneous loans such as home equity lines of credit and residential mortgages. Loans with a classified risk rating are reviewed quarterly regardless of size or loan type. The Company uses the following definitions for classified risk ratings:
Special Mention. Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan at some future date.
Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Credits that are not covered by the definitions above are pass credits, which are not considered to be adversely rated.
Credit Quality Indicators by class of loans were as follows:
Special
Pass
Mention
Substandard 1
Doubtful
245,603
11,371
382
68,274
1,031
153,039
1,274
1,363
172,216
1,163
250,497
2,085
90,113
3,633
Retail Properties
43,922
1,227
13,472
2,495
52,898
894
380
52,205
648
123,600
563
4,418
113,871
1,977
2,762
1,551,885
18,577
23,729
214,028
11,558
2,527
53,366
976
1,109
135,503
53
1,680
172,353
5,402
229,448
913
114,293
4,772
52,207
1,267
11,840
1,240
1,782
34,696
384
55,001
1,096
115,831
570
7,225
99,286
2,340
3,236
13,165
25
1,430,321
22,004
26,484
1 The substandard credit quality indicator includes both potential problem loans that are currently performing and nonperforming loans.
The Company had $1.2 million and $1.8 million in residential real estate loans in the process of foreclosure as of September 30, 2017, and December 31, 2016, respectively. The Company also had $937,000 and $225,000 in residential real estate included in OREO as of September 30, 2017, and December 31, 2016, respectively.
Impaired loans, which include nonaccrual loans and accruing troubled debt restructurings, by class of loans for the September 30, 2017 periods listed were as follows:
As of September 30, 2017
Unpaid
Interest
Principal
Related
Income
Balance
Allowance
Recognized
With no related allowance recorded
360
123
227
281
Commercial real estate
495
509
372
1,218
1,592
1,481
507
1,199
1,146
Construction
231
206
Residential
1,374
1,627
1,607
4,965
2,379
8,150
9,524
8,987
1,991
2,173
2,237
104
Total impaired loans with no recorded allowance
20,035
22,910
20,636
184
With an allowance recorded
402
51
26
Total impaired loans with a recorded allowance
551
Total impaired loans
20,086
22,961
21,187
186
Impaired loans by class of loans as of December 31, 2016, and for the nine months ended September 30, 2016, were as follows:
As of December 31, 2016
September 30, 2016
388
326
371
1,881
2,131
2,412
66
518
580
1,744
2,010
1,655
1,649
506
1,235
990
636
81
80
221
1,841
2,308
1,864
35
11,391
9,916
120
2,484
3,018
21,238
25,321
21,492
232
595
132
31
803
853
356
1,049
1,448
22,287
26,769
22,005
263
Troubled debt restructurings (“TDRs”) are loans for which the contractual terms have been modified and both of these conditions exist: (1) there is a concession to the borrower and (2) the borrower is experiencing financial difficulties. Loans are restructured on a case-by-case basis during the loan collection process with modifications generally initiated at the request of the borrower. These modifications may include reduction in interest rates, extension of term, deferrals of principal, and other modifications. The Bank participates in the U.S. Department of the Treasury’s (the “Treasury”) Home Affordable Modification Program (“HAMP”) which gives qualifying homeowners an opportunity to refinance into more affordable monthly payments.
17
The specific allocation of the allowance for loan losses for TDRs is determined by calculating the present value of the TDR cash flows by discounting the original payment less an assumption for probability of default at the original note’s issue rate, and adding this amount to the present value of collateral less selling costs. If the resulting amount is less than the recorded book value, the Bank either establishes a valuation allowance (i.e., specific reserve) as a component of the allowance for loan losses or charges off the impaired balance if it determines that such amount is a confirmed loss. This method is used consistently for all segments of the portfolio. The allowance for loan losses also includes an allowance based on a loss migration analysis for each loan category on loans that are not individually evaluated for specific impairment. All loans charged-off, including TDRs charged-off, are factored into this calculation by portfolio segment.
TDRs that were modified during the period are as follows:
TDR Modifications
Quarter Ended September 30, 2017
Nine Months Ended September 30, 2017
# of
Pre-modification
Post-modification
contracts
recorded investment
Troubled debt restructurings
HAMP1
33
Other2
448
418
176
157
575
542
Quarter Ended September 30, 2016
Nine Months Ended September 30, 2016
312
211
235
469
433
70
1,090
949
1 HAMP: Home Affordable Modification Program
2 Other: Change of terms from bankruptcy court
TDRs are classified as being in default on a case-by-case basis when they fail to be in compliance with the modified terms. There was no TDR default activity for the nine months ended September 30, 2017, and September 30, 2016, for loans that were restructured within the 12 month period prior to default.
Note 5 – Allowance for Loan Losses
Changes in the allowance for loan losses by segment of loans based on method of impairment for three and nine months ended September 30, 2017, were as follows:
Real Estate
Allowance for loan losses:
Three months ended September 30, 2017
Beginning balance
2,150
791
8,107
857
2,576
848
15,836
Charge-offs
82
241
Recoveries
43
459
45
(Release) Provision
(104)
(607)
Ending balance
2,039
770
8,633
1,014
2,421
810
778
Nine months ended September 30, 2017
1,629
633
9,547
389
2,692
833
435
215
1,178
262
1,998
124
850
166
1,255
Provision (Release)
417
352
(738)
559
73
330
Ending balance: Individually evaluated for impairment
Ending balance: Collectively evaluated for impairment
2,415
16,459
Loans:
3,147
16,323
257,149
69,109
735,989
94,663
403,260
1,574,105
Changes in the allowance for loan losses by segment of loans based on method of impairment for three and nine months ended September 30, 2016, were as follows:
Three months ended September 30, 2016
1,420
275
8,954
2,933
862
998
15,822
76
792
220
1,197
358
141
71
753
(577)
118
(545)
1,495
346
8,942
470
2,335
937
458
14,983
Nine months ended September 30, 2016
2,041
55
9,013
1,694
1,190
1,965
16,223
1,484
657
250
2,508
718
1,268
(473)
304
1,158
143
(187)
(1,525)
264
514
8,678
14,469
136,819
47,215
617,280
28,786
357,846
3,325
11,581
1,202,852
583
8,426
14,038
23,123
136,236
608,854
28,710
343,808
1,179,729
Note 6 – Other Real Estate Owned
Details related to the activity in the other real estate owned (“OREO”) portfolio, net of valuation reserve, for the periods presented are itemized in the following table:
Quarters Ended
Balance at beginning of period
11,724
16,252
19,141
Property additions
3,796
Property improvements
Less:
Proceeds from property disposals, net of participation purchase and of gains/losses
1,956
2,002
5,058
4,931
Period valuation adjustments
920
365
Balance at end of period
14,144
Activity in the valuation allowance was as follows:
8,304
13,377
9,982
14,127
Provision for unrealized losses
Reductions taken on sales
(421)
(488)
(2,809)
(2,178)
8,803
13,254
Expenses related to OREO, net of lease revenue includes:
Gain on sales, net
(276)
(249)
Operating expenses
361
1,037
Lease revenue
185
163
Net OREO expense
Note 7 – Deposits
Major classifications of deposits were as follows:
Savings
260,268
256,159
NOW accounts
417,054
419,417
Money market accounts
270,647
275,273
Certificates of deposit of less than $100,000
219,152
228,993
Certificates of deposit of $100,000 through $250,000
114,373
110,992
Certificates of deposit of more than $250,000
50,747
62,263
Note 8 – Borrowings
The following table is a summary of borrowings as of September 30, 2017, and December 31, 2016. Junior subordinated debentures are discussed in detail in Note 9:
FHLBC advances1
Total borrowings
253,513
197,304
1 Included in other short-term borrowings on the balance sheet.
The Company enters into deposit sweep transactions where the transaction amounts are secured by pledged securities. These transactions consistently mature overnight from the transaction date and are governed by sweep repurchase agreements. All sweep repurchase agreements are treated as financings secured by U.S. government agencies and collateralized mortgage-backed securities and had a carrying amount of $26.9 million at September 30, 2017, and $25.7 million at December 31, 2016. The fair value of the pledged collateral was $41.5 million at September 30, 2017 and $43.0 million at December 31, 2016. At September 30, 2017, there were no customers with secured balances exceeding 10% of stockholders’ equity.
The Company’s borrowings at the FHLBC require the Bank to be a member and invest in the stock of the FHLBC. Total borrowings are generally limited to the lower of 35% of total assets or 60% of the book value of certain mortgage loans. As of September 30, 2017, the Bank had $125.0 million in advances outstanding under the FHLBC as compared to $70.0 million outstanding as of December 31, 2016. As of September 30, 2017, FHLBC stock held was valued at $5.6 million, and any potential FHLBC advances were collateralized by securities with a fair value of $87.4 million and loans with a principal balance of $251.3 million, which carried a FHLBC calculated combined collateral value of $273.8 million. The Company had excess collateral of $74.5 million available to secure borrowings at September 30, 2017.
The Company completed a debt retirement and simultaneous senior debt offering in the fourth quarter of 2016. Subordinated debt of $45.0 million and $500,000 of senior notes outstanding were paid off with the proceeds of a $45.0 million senior notes issuance and cash on hand. The senior notes mature in ten years, and terms include interest payable semiannually at 5.75% for five years. Beginning December 2021, the senior debt will pay interest at a floating rate, with interest payable quarterly at three month LIBOR plus 385 basis points. The notes are redeemable, in whole or in part, at the option of the Company, beginning with the interest payment date on December 31, 2021, and on any floating rate interest payment date thereafter, at a redemption price equal to 100% of the principal amount of the notes plus accrued and unpaid interest. Debt issuance costs incurred for the senior notes issuance totaled $1.0 million, and are being deferred and recorded to expense over the ten year term of the notes. The unamortized costs are included as a reduction to the balance of the senior notes on the Consolidated Balance Sheet.
Note 9 – Junior Subordinated Debentures
The Company completed the sale of $27.5 million of cumulative trust preferred securities by its unconsolidated subsidiary, Old Second Capital Trust I, in June 2003. An additional $4.1 million of cumulative trust preferred securities were sold in July 2003. The trust preferred securities may remain outstanding for a 30-year term but, subject to regulatory approval, can be called in whole or in part by the Company after June 30, 2008. When not in deferral, distributions on the securities are payable quarterly at an annual rate of 7.80%. The Company issued a new $32.6 million subordinated debenture to Old Second Capital Trust I in return for the aggregate net proceeds of this trust preferred offering. The interest rate and payment frequency on the debenture are equivalent to the cash distribution basis on the trust preferred securities.
The Company issued an additional $25.0 million of cumulative trust preferred securities through a private placement completed by an additional, unconsolidated subsidiary, Old Second Capital Trust II, in April 2007. These trust preferred securities also mature in 30 years, but subject to the aforementioned regulatory approval, can be called in whole or in part on a quarterly basis commencing June 15, 2017. The quarterly cash distributions on the securities were fixed at 6.77% through June 15, 2017, and float at 150 basis points over three-month LIBOR thereafter. The Trust II issuance converted from fixed to floating rate at three month LIBOR plus 150 basis points on June 15, 2017. Upon conversion to a floating rate, a cash flow hedge was initiated which resulted in the total interest rate paid on the debt of 4.30% as of September 30, 2017, compared to the rate paid prior to June 15, 2017 of 6.77%. The Company issued a new $25.8 million subordinated debenture to Old Second Capital Trust II in return for the aggregate net proceeds of this trust preferred offering. The interest rate and payment frequency on the debenture are equivalent to the cash distribution basis on the trust preferred securities. Both of the debentures issued by the Company are disclosed on the Consolidated Balance Sheet as junior subordinated debentures and the related interest expense for each issuance is included in the Consolidated Statements of Income. As of September 30, 2017, and December 31, 2016, unamortized debt issuance costs related to the junior subordinated debentures were
21
$752,000 and $787,000 respectively, and are included as a reduction to the balance of the junior subordinated debentures on the Consolidated Balance Sheet.
Note 10 – Equity Compensation Plans
Stock-based awards are outstanding under the Company’s 2008 Equity Incentive Plan (the “2008 Plan”) and the Company’s 2014 Equity Incentive Plan (the “2014 Plan,” and together with the 2008 Plan, the “Plans”). The 2014 Plan was approved at the 2014 annual meeting of stockholders; a maximum of 375,000 shares were authorized to be issued under this plan. Following approval of the 2014 Plan, no further awards will be granted under the 2008 Plan or any other Company equity compensation plan. At the May 2016 annual stockholders meeting, an amendment to the 2014 Plan authorized an additional 600,000 shares to be issued, which resulted in a total of 975,000 shares authorized for issuance under this plan. The 2014 Plan authorizes the granting of qualified stock options, non-qualified stock options, restricted stock, restricted stock units, and stock appreciation rights. Awards may be granted to selected directors and officers or employees under the 2014 Plan at the discretion of the Compensation Committee of the Company’s Board of Directors. As of September 30, 2017, 453,209 shares remained available for issuance under the 2014 Plan.
There were no stock options granted or exercised in the third quarter of 2017 and 2016. All stock options are granted for a term of ten years. There is no unrecognized compensation cost related to unvested stock options as all stock options of the Company’s common stock have fully vested.
A summary of stock option activity in the Plans for the nine months ended September 30, 2017, is as follows:
Weighted-
Remaining
Exercise
Contractual
Aggregate
Shares
Price
Term (years)
Intrinsic Value
Beginning outstanding
94,500
25.82
Canceled
Expired
Exercised
Ending outstanding
0.3
Exercisable at end of period
Generally, restricted stock and restricted stock units granted under the Plans vest three years from the grant date, but the Compensation Committee of the Company’s Board of Directors has discretionary authority to change some terms including the amount of time until the vest date.
Awards under the 2008 Plan will become fully vested upon a merger or change in control of the Company. Under the 2014 Plan, upon a change in control of the Company, if (i) the 2014 Plan is not an obligation of the successor entity following the change in control, or (ii) the 2014 Plan is an obligation of the successor entity following the change in control and the participant incurs an involuntary termination, then the stock options, stock appreciation rights, stock awards and cash incentive awards under the 2014 Plan will become fully exercisable and vested. Performance-based awards generally will vest based upon the level of achievement of the applicable performance measures through the change in control.
The Company granted restricted stock under its equity compensation plans beginning in 2005 and it began granting restricted stock units in February 2009. Restricted stock awards under the Plans generally entitle holders to voting and dividend rights upon grant and are subject to forfeiture until certain restrictions have lapsed including employment for a specific period. Restricted stock units under the Plans are also subject to forfeiture until certain restrictions have lapsed including employment for a specific period, but do not entitle holders to voting rights until the restricted period ends and shares are transferred in connection with the units.
There were 161,500 restricted awards issued under the 2014 Plan during the nine months ended September 30, 2017. There were 130,000 restricted awards issued during the nine months ended September 30, 2016. Compensation expense is recognized over the vesting period of the restricted award based on the market value of the award on the issue date. Total compensation cost that has been recorded for the 2014 Plan was $925,100 and $485,000 in the first nine months of 2017 and 2016, respectively.
A summary of changes in the Company’s unvested restricted awards for the nine months ended September 30, 2017, is as follows:
Restricted
Stock Shares
Grant Date
and Units
Fair Value
Nonvested at January 1
409,000
5.89
Granted
161,500
11.04
Vested
(91,500)
5.07
Forfeited
(14,000)
7.53
Nonvested at September 30
465,000
7.79
Total unrecognized compensation cost of restricted awards was $2.0 million as of September 30, 2017, which is expected to be recognized over a weighted-average period of 2.11 years. Total unrecognized compensation cost of restricted awards was $1.1 million as of September 30, 2016, which was expected to be recognized over a weighted-average period of 1.99 years.
Note 11 – Earnings Per Share
The earnings per share – both basic and diluted – are included below as of September 30 (in thousands except for share and per share data):
Basic earnings per share:
Weighted-average common shares outstanding
29,554,716
29,591,811
29,524,796
Diluted earnings per share:
Dilutive effect of nonvested restricted awards1
473,967
282,228
425,081
303,221
Dilutive effect of stock options
2,556
1,238
2,473
413
Diluted average common shares outstanding
30,103,609
29,838,182
30,019,365
29,828,430
Number of antidilutive options and warrants excluded from the diluted earnings per share calculation
900,839
967,339
977,426
1 Includes the common stock equivalents for restricted share rights that are dilutive.
The above earnings per share calculation did not include a warrant for 815,339 shares of common stock, at an exercise price of $13.43 per share, that was outstanding as of September 30, 2017, and September 30, 2016, because the warrant was anti-dilutive. Of note, the ten year warrant was issued in 2009, and was sold at auction by the Treasury in June 2013 to a third party investor.
Note 12 – Regulatory & Capital Matters
The Bank is subject to the risk-based capital regulatory guidelines, which include the methodology for calculating the risk-weighted Bank assets, developed by the Office of the Comptroller of the Currency (the “OCC”) and the other bank regulatory agencies. In connection with the current economic environment, the Bank’s current level of nonperforming assets and the risk-based capital guidelines, the Bank’s Board of Directors has determined that the Bank should maintain a Tier 1 leverage capital ratio at or above eight percent (8%) and a total risk-based capital ratio at or above twelve percent (12%). At September 30, 2017, the Bank exceeded those thresholds.
At September 30, 2017, the Bank’s Tier 1 capital leverage ratio was 10.63%, an increase of 39 basis point from December 31, 2016, and is well above the 8.00% objective. The Bank’s total capital ratio was 13.52%, an increase of 7 basis points from December 31, 2016, and also modestly above the objective of 12.00%.
Bank holding companies are required to maintain minimum levels of capital in accordance with capital guidelines implemented by the Board of Governors of the Federal Reserve System. The general bank and holding company capital adequacy guidelines are shown in the accompanying table, as are the capital ratios of the Company and the Bank, as of September 30, 2017, and December 31, 2016.
In July 2013, the U.S. federal banking authorities issued final rules (the “Basel III Rules”) establishing more stringent regulatory capital requirements for U.S. banking institutions, which went into effect on January 1, 2015. A detailed discussion of the Basel III Rules is included in Part I, Item 1 of the Company’s Form 10-K for the year ended December 31, 2016, under the heading “Supervision and Regulation.”
At September 30, 2017, and December 31, 2016, the Company, on a consolidated basis, exceeded the minimum thresholds to be considered “well capitalized” under current regulatory defined capital ratios.
Capital levels and industry defined regulatory minimum required levels are as follows:
Minimum Capital
To Be Well Capitalized Under
Adequacy with Capital
Prompt Corrective
Actual
Conservation Buffer if applicable1
Action Provisions2
Amount
Ratio
Common equity tier 1 capital to risk weighted assets
Consolidated
170,622
8.88
110,482
5.750
N/A
Old Second Bank
243,109
12.67
110,330
124,720
6.50
Total capital to risk weighted assets
239,269
12.46
177,627
9.250
259,569
13.52
177,590
191,989
10.00
Tier 1 capital to risk weighted assets
221,579
11.54
139,207
7.250
139,111
153,502
8.00
Tier 1 capital to average assets
9.69
91,467
4.00
10.63
91,480
114,350
5.00
154,537
8.76
90,411
5.125
221,153
12.53
90,456
114,724
216,769
12.29
152,126
8.625
237,306
13.45
152,176
176,436
191,988
10.88
116,904
6.625
116,930
141,199
8.90
86,287
10.24
86,388
107,985
1 As of September 30, 2017, amounts are shown inclusive of a capital conservation buffer of 1.25%; as compared to December 31, 2016, of 0.625%.
2 The Bank exceeded the general minimum regulatory requirements to be considered “well capitalized.”
Dividend Restrictions
In addition to the above requirements, banking regulations and capital guidelines generally limit the amount of dividends that may be paid by a bank without prior regulatory approval. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s profits, combined with the retained profit of the previous two years, subject to the capital requirements described above. Pursuant to the Basel III rules that came into effect January 1, 2015, the Bank must keep a buffer of 0.625% for 2016, 1.25% for 2017, 1.875% for 2018, and 2.5% for 2019 and thereafter of minimum capital requirements in order to avoid additional limitations on capital distributions and certain other payments.
Note 13 – Fair Value Measurements
Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The fair value hierarchy established by the Company also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Three levels of inputs that may be used to measure fair value are:
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the Company has the ability to access as of the measurement date.
Level 2: Significant observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.
Level 3: Significant unobservable inputs that reflect a company’s own view about the assumptions that market participants would use in pricing an asset or liability.
The majority of securities available-for-sale are valued by external pricing services or dealer market participants and are classified in Level 2 of the fair value hierarchy. Both market and income valuation approaches are utilized. Quarterly, the Company evaluates the methodologies used by the external pricing services or dealer market participants to develop the fair values to determine whether the results of the valuations are representative of an exit price in the Company’s principal markets and an appropriate representation of fair value. The Company uses the following methods and significant assumptions to estimate fair value:
·
Government-sponsored agency debt securities are primarily priced using available market information through processes such as benchmark spreads, market valuations of like securities, like securities groupings and matrix pricing.
Other government-sponsored agency securities, MBS and some of the actively traded real estate mortgage investment conduits and collateralized mortgage obligations are priced using available market information including benchmark yields, prepayment speeds, spreads, volatility of similar securities and trade date.
State and political subdivisions are largely grouped by characteristics (e.g., geographical data and source of revenue in trade dissemination systems). Because some securities are not traded daily and due to other grouping limitations, active market quotes are often obtained using benchmarking for like securities.
Auction rate securities are priced using market spreads, cash flows, prepayment speeds, and loss analytics. Therefore, the valuations of auction rate asset-backed securities are considered Level 2 valuations.
Asset-backed collateralized loan obligations were priced using data from a pricing matrix supported by our bond accounting service provider and are therefore considered Level 2 valuations.
Annually every security holding is priced by a pricing service independent of the regular and recurring pricing services used. The independent service provides a measurement to indicate if the price assigned by the regular service is within or outside of a reasonable range. Management reviews this report and applies judgment in adjusting calculations at year end related to securities pricing.
Residential mortgage loans available for sale in the secondary market are carried at fair market value. The fair value of loans held-for-sale is determined using quoted secondary market prices.
Lending related commitments to fund certain residential mortgage loans, e.g., residential mortgage loans with locked interest rates to be sold in the secondary market and forward commitments for the future delivery of mortgage loans to third party investors, as well as forward commitments for future delivery of MBS are considered derivatives. Fair values are estimated based on observable changes in mortgage interest rates including prices for MBS from the date of the commitment and do not typically involve significant judgments by management.
The fair value of mortgage servicing rights is based on a valuation model that calculates the present value of estimated net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income to derive the resultant value. The Company is able to compare the valuation model inputs, such as the discount rate, prepayment speeds, weighted average delinquency and foreclosure/bankruptcy rates to widely available published industry data for reasonableness.
Interest rate swap positions, both assets and liabilities, are based on valuation pricing models using an income approach reflecting readily observable market parameters such as interest rate yield curves.
The fair value of impaired loans with specific allocations of the allowance for loan losses is essentially based on recent real estate appraisals or the fair value of the collateralized asset. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are made in the appraisal process by the appraisers to reflect differences between the available comparable sales and income data. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.
Nonrecurring adjustments to certain commercial and residential real estate properties classified as OREO are measured at the lower of carrying amount or fair value, less costs to sell. Fair values are based on third party appraisals of the property,
resulting in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.
Assets and Liabilities Measured at Fair Value on a Recurring Basis:
The tables below present the balance of assets and liabilities at September 30, 2017, and December 31, 2016, respectively, measured by the Company at fair value on a recurring basis:
Level 1
Level 2
Level 3
Assets:
U.S. Treasury
216,672
12,360
77,894
2,492
Mortgage servicing rights
Interest rate swap agreements
128
Mortgage banking derivatives
289
516,700
21,536
542,226
Liabilities:
Interest rate swap agreements, including risk participation agreements
1,566
46,477
22,226
167,808
3,119
673
287
512,371
31,834
544,205
1,667
The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are as follows:
Collateralized
States and
Mortgage
Political
Servicing
Obligation
Subdivisions
Rights
Beginning balance January 1, 2017
Total gains or losses
Included in earnings (or changes in net assets)
32
(354)
Included in other comprehensive income
(501)
Purchases, issuances, sales, and settlements
Purchases
10,994
Issuances
951
Settlements
(666)
(20,359)
(402)
Ending balance September 30, 2017
Beginning balance January 1, 2016
5,847
Transfers out of Level 3
(1,394)
1,148
(78)
(526)
Ending balance September 30, 2016
5,075
The following table and commentary presents quantitative and qualitative information about Level 3 fair value measurements as of September 30, 2017:
Measured at fair value
Unobservable
on a recurring basis:
Valuation Methodology
Inputs
Range of Input
of Inputs
Discounted Cash Flow
Discount Rate
10.0 - 1576.2%
10.2
Prepayment Speed
7.0 - 68.3%
10.0
The following table and commentary presents quantitative and qualitative information about Level 3 fair value measurements as of December 31, 2016:
10.0 - 17.0%
6.5 - 77.8%
9.6
In addition to the above, Level 3 fair value measurement included $12.4 million for state and political subdivisions representing various local municipality securities and $2.5 million of collateralized mortgage obligations at September 30, 2017. Both of these were classified as securities available-for-sale, and were valued using a discount based on market spreads of similar assets, but the liquidity premium was an unobservable input. The state and political subdivisions securities balance in Level 3 fair value at September 30, 2016, was zero; the securities were transferred to Level 3 in the fourth quarter of 2016. Given the small dollar amount and size of the municipality involved, this is categorized as Level 3 based on the payment stream received by the Company from the municipality. That payment stream is otherwise an unobservable input.
Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis:
The Company may be required, from time to time, to measure certain other assets at fair value on a nonrecurring basis in accordance with GAAP. These assets consist of impaired loans and OREO. For assets measured at fair value on a nonrecurring basis at September 30, 2017, and December 31, 2016, respectively, the following tables provide the level of valuation assumptions used to determine each valuation and the carrying value of the related assets:
Impaired loans1
Other real estate owned, net2
9,069
1 Represents carrying value and related write-downs of loans for which adjustments are substantially based on the appraised value of collateral for collateral-dependent loans; had a carrying amount of $51,000 and a valuation allowance of $6,000 resulting in a decrease of specific allocations within the allowance for loan losses of $92,000 for the nine months ended September 30, 2017.
2 OREO is measured at the lower of carrying or fair value less costs to sell, and had a net carrying amount of $9.0 million, which is made up of the outstanding balance of $18.7 million, net of a valuation allowance of $8.8 million and participations of $900,000 at September 30, 2017.
1 Represents carrying value and related write-downs of loans for which adjustments are substantially based on the appraised value of collateral for collateral-dependent loans; had a carrying amount and a valuation allowance of $1.0 million, resulting in an increase of specific allocations within the allowance for loan losses of $1.0 million for the year December 31, 2016.
2 OREO is measured at the lower of carrying or fair value less costs to sell, and had a net carrying amount of $11.9 million, which is made up of the outstanding balance of $23.5 million, net of a valuation allowance of $10.0 million and participations of $1.6 million, at December 31, 2016.
The Company has estimated the fair values of these assets based primarily on Level 3 inputs. OREO and impaired loans are generally valued using the fair value of collateral provided by third party appraisals. These valuations include assumptions related to cash flow projections, discount rates, and recent comparable sales. The numerical ranges of unobservable inputs for these valuation assumptions are not meaningful.
Note 14 – Fair Values of Financial Instruments
The estimated fair values approximate carrying amount for all items except those described in the following table. Securities available-for-sale fair values are based upon market prices or dealer quotes, and if no such information is available, on the rate and term of the security. The carrying value of FHLBC stock approximates fair value as the stock is nonmarketable and can only be sold to the FHLBC or another member institution at par. FHLBC stock is carried at cost and considered a Level 2 fair value. Fair values of loans were estimated for portfolios of loans with similar financial characteristics, such as type and fixed or variable interest rate terms. Cash flows were discounted using current rates at which similar loans would be made to borrowers with similar ratings and for similar maturities. The fair value of time deposits is estimated using discounted future cash flows at current rates offered for deposits of similar remaining maturities. The fair values of borrowings were estimated based on interest rates available to the Company for debt with similar terms and remaining maturities. The fair value of off balance sheet volume is not considered material.
28
The carrying amount and estimated fair values of financial instruments were as follows:
Carrying
Financial assets:
514,642
14,852
FHLBC and FRBC Stock
Loans, net
1,568,457
Accrued interest receivable
8,669
Financial liabilities:
Noninterest bearing deposits
Interest bearing deposits
1,332,241
1,329,668
59,524
33,320
26,204
46,958
1,439
Borrowing interest payable
773
Deposit interest payable
573
506,493
25,345
1,453,429
5,928
1,353,097
1,351,000
55,163
32,404
22,759
Subordinated debenture
994
202
599
Note 15 – Financial Instruments with Off-Balance Sheet Risk and Derivative Transactions
To meet the financing needs of its customers, the Bank, as a subsidiary of the Company, is a party to various financial instruments with off-balance-sheet risk in the normal course of business. These off-balance-sheet financial instruments include commitments to originate and sell loans as well as financial standby, performance standby and commercial letters of credit. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The Bank’s exposure to credit loss for loan commitments and letters of credit is represented by the dollar amount of those instruments. Management generally uses the same credit policies and collateral requirements in making commitments and conditional obligations as it does for on-balance-sheet instruments.
Interest Rate Swap Designated as a Cash Flow Hedge
The Company entered into a forward starting interest rate swap on August 18, 2015, with an effective date of June 15, 2017. This transaction had a notional amount totaling $25.8 million as of September 30, 2017, was designated as a cash flow hedge of certain junior subordinated debentures and was determined to be fully effective during the period presented. As such, no amount of ineffectiveness has been included in net income. Therefore, the aggregate fair value of the swap is recorded in other assets with changes in fair value recorded in other comprehensive income. The amount included in other comprehensive income would be reclassified to current earnings should all or a portion of the hedge no longer be considered effective. The Company expects the hedge to remain fully effective during the remaining term of the swap. The Bank will pay the counterparty a fixed rate and receive a floating rate based on three month LIBOR. Management concluded that it would be advantageous to enter this transaction given that the Company has trust preferred securities that changed from fixed rate to floating rate on June 15, 2017. The cash flow hedge has a maturity date of June 15, 2037.
Summary information about the interest rate swap designated as a cash flow hedge is as follows:
As of
Notional amount
25,774
Unrealized loss
(1,439)
(994)
Other Interest Rate Swaps
The Bank also has interest rate derivative positions to assist with risk management that are not designated as hedging instruments. These derivative positions relate to transactions in which the Bank enters an interest rate swap with a client while at the same time entering into an offsetting interest rate swap with another financial institution. Per contractual requirements with the correspondent financial institution, the Bank had $4.2 million in securities available-for-sale pledged to support interest rate swap activity with one correspondent financial institution at September 30, 2017. The Bank had $6.2 million in securities pledged to support interest rate swap activity with one correspondent financial institution at December 31, 2016.
In connection with each transaction, the Bank agreed to pay interest to the client on a notional amount at a variable interest rate and receive interest from the client on the same notional amount at a fixed interest rate. At the same time, the Bank agreed to pay another financial institution the same fixed interest rate on the same notional amount and receive the same variable interest rate on the same notional amount. The transaction allows the client to convert a variable rate loan to a fixed rate loan and is part of the Company’s interest rate risk management strategy. Because the Bank acts as an intermediary for the client, changes in the fair value of the underlying derivative contracts offset each other and do not generally affect the results of operations. Fair value measurements include an assessment of credit risk related to the client’s ability to perform on their contract position, however, and valuation estimates related to that exposure are discussed in Note 13 above. At September 30, 2017, the notional amount of non-hedging interest rate swaps was $349.4 million with a weighted average maturity of 6.7 years. At December 31, 2016, the notional amount of non-hedging interest rate swaps was $85.8 million with a weighted average maturity of 7.3 years. The Bank offsets derivative assets and liabilities that are subject to a master netting arrangement.
The Bank also grants mortgage loan interest rate lock commitments to borrowers, subject to normal loan underwriting standards. The interest rate risk associated with these loan interest rate lock commitments is managed with contracts for future deliveries of loans as well as selling forward mortgage-backed securities contracts. Loan interest rate lock commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Commitments to originate residential mortgage loans held-for-sale and forward commitments to sell residential mortgage loans or forward MBS contracts are considered derivative instruments and changes in the fair value are recorded to mortgage banking revenue. Fair values are estimated based on observable changes in mortgage interest rates including mortgage-backed securities prices from the date of the commitment.
30
The following table presents derivatives not designated as hedging instruments as of September 30, 2017, and periodic changes in the values of the interest rate swaps are reported in other noninterest income. Periodic changes in the value of the forward contracts related to mortgage loan origination are reported in the net gain on sales of mortgage loans.
Asset Derivatives
Liability Derivatives
Notional or
Balance Sheet
Location
Interest rate swap contracts net of credit valuation
349,367
Other Assets
Other Liabilities
Interest rate lock commitments and forward contracts
28,591
The following table presents derivatives not designated as hedging instruments as of December 31, 2016.
85,807
31,980
960
The Bank also issues letters of credit, which are conditional commitments that guarantee the performance of a customer to a third party. The credit risk involved and collateral obtained in issuing letters of credit are essentially the same as that involved in extending loan commitments to our customers. In addition to customer related commitments, the Company is responsible for letters of credit commitments that relate to properties held in OREO. The following table represents the Company’s contractual commitments due to letters of credit as of September 30, 2017, and December 31, 2016.
The following table is a summary of letter of credit commitments (in thousands):
Fixed
Variable
Letters of credit:
Borrower:
Financial standby
177
3,748
3,925
137
4,047
4,184
Commercial standby
122
126
Performance standby
7,912
7,978
8,498
8,581
243
11,782
12,025
12,671
12,891
Non-borrower:
422
525
620
Total letters of credit
12,204
12,447
315
13,196
13,511
Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
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, that provides commercial and retail banking services, as well as a full complement of trust and wealth management services. The Company has offices located in Cook, Kane, Kendall, DeKalb, DuPage, LaSalle and Will counties in Illinois. The following management’s discussion and analysis presents information concerning our financial condition as of September 30, 2017, as compared to December 31, 2016, and the results of operations for the three and nine months September 30, 2017, and September 30, 2016. This discussion and analysis is best read in conjunction with our consolidated financial statements as well as the financial and statistical data appearing elsewhere in this report and our Form 10-K for the year ended December 31, 2016. The results of operations for the quarter September 30, 2017, are not necessarily indicative of future results.
Our community-focused banking franchise has experienced growth in the past year, and is positioned for further success as we continue to serve our customers’ needs in a competitive economic environment. Industry and regulatory developments in the past few years have made it challenging to attain the levels of profitability and growth reflected a decade ago. As we look to provide value to our customers and the communities in which we operate, growth opportunities identified in our local markets are being developed into new banking relationships. We are encouraged by sustained quality in our credit performance as nonperforming loan totals remain at low levels and strong sales efforts have driven loan growth and portfolio diversity. The Company generated increased net interest income in the three month period ended September 30, 2017, as compared to the like period ended September 30, 2016. The Company’s noninterest income growth also contributed to the overall increase in earnings for the third quarter and nine months ended September 30, 2017 as compared to like periods in the prior year. However, the positive earnings impact of the growth in net interest income and noninterest income for the third quarter and nine months of 2017 was partially offset by an increase in noninterest expense. Noninterest expenses were negatively impacted primarily by an increase in employee costs in the year over year periods. Finally, an income tax benefit was recorded in the third quarter of 2017 due to a State of Illinois tax rate increase; this credit had a significantly favorable impact which contributed to the increase in net income in the year over year periods for the quarter and nine months.
Results of Operations
Net income before taxes of $9.9 million in the third quarter of 2017 compares to $5.4 million in the third quarter of 2016. When compared to the third quarter of 2016, the third quarter of 2017 reflected higher levels of net interest and dividend income, a provision for loan loss of $300,000, and increased levels of noninterest income and noninterest expense. Noninterest income in the 2017 period was favorably impacted by net gains recorded on securities portfolio sales as compared to net losses in the like prior year period, as well as an increase in trust revenue due to growth in our customer base. Noninterest expense increased in the third quarter of 2017 when compared to the third quarter of 2016 primarily due to an increase in salaries and employee benefits due to higher insurance costs, as well as an increase in OREO related valuation costs. An income tax benefit of $1.6 million was recorded in the third quarter of 2017 due to a State of Illinois tax rate change; this nonrecurring item increased the Company’s deferred tax asset by a like amount.
Net income before taxes of $23.7 million for the nine months ended September 30, 2017 was favorable as compared to the $16.5 million pretax income for the nine months ended September 30, 2016. Net interest margin was the largest contributor to this favorable variance, as loan growth and securities repositioning have resulted in increased volumes and more favorable yields for the year to date period.
Management has remained diligent with loan portfolio review to analyze loan quality and decide whether charge-offs are required. In the third quarter of 2017, management’s review of the loan portfolio concluded that an additional provision for loan losses should be recorded of $300,000, stemming from third quarter 2017 loan growth and collateral shortfalls on a few credits as a result of updated appraisals. The allowance for loan losses was adequate and appropriate for estimated incurred losses at September 30, 2016; neither a loan loss reserve release nor an additional loan loss provision was deemed necessary for the like 2016 quarter.
Earnings for the third quarter of 2017 were $0.27 per diluted share on $8.1 million of net income as compared to $0.12 per diluted share on net income of $3.5 million for the third quarter of 2016. For the nine month period ended September 30, 2017, earnings were $0.59 per diluted share on $17.7 million of net income, as compared to $0.36 per diluted share on $10.7 million of income for the prior year like period. Earnings growth in the 2017 period, as compared to the like 2016 period, stems from the acquisition of the Chicago branch of Talmer Bank and Trust, which was completed on October 28, 2016. This acquisition resulted in a cash payment of $181.5 million for loans, net of purchased loan discount totaling $221.0 million, deposits of $48.9 million, goodwill of $8.4 million, core deposit intangible of $659,000, and other immaterial assets and liabilities. The performance of the acquired loan portfolio, security portfolio restructuring to higher yielding instruments, and robust organic loan growth in the year over year period were the primary factors driving the earnings increase for the 2017 third quarter and year to date periods.
Net Interest Income
Net interest and dividend income increased by $3.9 million from $15.3 million for the quarter ended September 30, 2016, to $19.3 million for the quarter ended September 30, 2017. Total average loans, including loans held-for-sale, increased by $44.3 million in the third quarter of 2017 as compared to the second quarter of 2017, and $361.9 million as compared to the third quarter of 2016. Average earning assets were $2.12 billion for the third quarter of 2017, which reflected an increase of $6.4 million compared to the second quarter of 2017, and an increase of $212.5 million as compared to the third quarter of 2016. The significant increase in interest and dividend income of $3.9 million, or 25.6%, in the three months ended September 30, 2017 as compared to the like 2016 period, was driven by growth in the loan portfolio primarily due to the Talmer branch acquisition. In addition, the average yield on the securities portfolio increased by 103 basis points in the year over year period due to portfolio repositioning to higher yielding tax exempt securities; the average tax exempt securities portfolio increased by $185.5 million, and earned 138 basis points more in the third quarter of 2017 as compared to the third quarter of 2016.
Quarterly average interest bearing liabilities as of September 30, 2017, decreased $11.9 million, or 0.8%, compared to June 30, 2017, but increased $87.8 million, or 6.0%, when compared to September 30, 2016. Growth from the prior year like period was due to the Talmer branch purchase of $48.9 million of commercial deposits, as well as organic commercial deposit growth. As the deposit growth in the year over year period was driven by commercial demand accounts, the cost of funds did not materially increase from this volume change. However, each quarter presented reflects an increase in the FHLBC borrowing, which is within other short-term borrowings, as this facility was used to fund loan growth. The cost of interest bearing liabilities in the third quarter of 2017 increased to 80 basis points from 67 basis points in the third quarter of 2016, primarily due to the senior note issuance in late 2016. The $45.0 million senior debt issuance, at an average cost of 6.11% in the third quarter of 2017 net of issuance costs, replaced the prior subordinated notes outstanding, which had an average cost of 2.13% in the third quarter of 2016. This issuance resulted in a $430,000 increase to interest expense, which drove the overall higher cost of funds in 2017.
The net interest margin (on a tax-equivalent basis), expressed as a percentage of average earning assets, was 3.77% in the third quarter of 2017, reflecting an increase of 6 basis points from the second quarter of 2017, and growth of 55 basis points from the third quarter of 2016. The average tax-equivalent yield on earning assets increased to 4.32% for the third quarter of 2017, as compared to 3.70% for the third quarter of 2016. Increases in net interest margin and yield on average earning assets for the third quarter of 2017 as compared to prior periods presented was attributable to growth in loan volumes and rates, as well as the securities portfolio repositioning to higher yielding tax exempt holdings, as discussed above. The cost of funds on interest bearing liabilities was 0.80% for the third quarter of 2017 and 0.67% for the third quarter of 2016.
Tax equivalent net interest and dividend income increased by $11.5 million from $46.3 million for the nine months ended September 30, 2016, to $57.8 million for the nine months ended September 30, 2017. Average earning assets for the nine months ended September 30, 2017 increased $188.4 million as compared to the like average period in 2016, and the yield on average earning assets for the nine months of 2017 was 4.22% as compared to 3.69% for the like 2016 period. Average interest bearing liabilities for the nine months ended September 30, 2017, increased $74.5 million, or 5.0%, when compared to like prior year period. Net interest margin for the nine months ended September 30, 2017, was 3.68%, as compared to 3.23% for the nine months ended September 30, 2016, for an increase of 45 basis points.
Management continued to observe competitive pressure to maintain reduced interest rates on loans retained at renewal. While the Bank prices loans to achieve certain return on equity targets, significant competition for both commercial and industrial as well as commercial real estate loans has put pressure on loan yields, and our stringent underwriting standards limit our ability to make higher-yielding loans.
The following tables set forth certain information relating to the Company’s average consolidated balance sheets and reflect the yield on average earning assets and cost of average interest bearing liabilities for the periods indicated. These yields reflect the related interest, on an annualized basis, divided by the average balance of assets or liabilities over the applicable period. Average balances are derived from daily balances. For purposes of discussion, net interest income and net interest income to total earning assets 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.
ANALYSIS OF AVERAGE BALANCES,
TAX EQUIVALENT INTEREST AND RATES
(In thousands - unaudited)
June 30, 2017
Rate
11,685
1.24
11,938
1.03
50,054
0.50
327,892
2.96
361,504
2,607
2.88
624,844
2.53
Non-taxable (TE)
220,540
2,504
4.54
225,182
2,536
4.50
35,046
277
3.16
Total securities
548,432
4,928
3.59
586,686
3.51
659,890
4,231
2.56
Dividends from FHLBC and FRBC
8,339
4.51
7,699
4.78
4.19
Loans and loans held-for-sale1
1,553,473
18,265
4.60
1,509,188
17,445
4.57
1,191,574
13,567
4.46
Total interest earning assets
2,121,929
23,324
4.32
2,115,511
22,711
4.26
1,909,436
17,945
3.70
31,028
39,425
41,344
Allowance for loan losses
(16,478)
(15,779)
(15,767)
Other noninterest bearing assets
185,906
189,928
190,213
2,322,385
2,329,085
2,125,226
Liabilities and Stockholders' Equity
422,913
108
0.10
432,248
107
384,588
0.09
273,440
85
280,482
86
265,135
Savings accounts
262,573
0.07
265,066
257,808
0.06
389,037
1.10
392,779
1,025
401,999
0.92
1,347,963
1,316
0.39
1,370,575
1,258
1,309,530
1,124
0.34
32,800
0.05
35,652
31,892
0.01
72,065
1.19
58,572
146
22,174
57,621
6.46
57,609
1,059
57,573
44,021
6.11
43,995
45,000
2.13
500
1.57
Total interest bearing liabilities
1,554,470
0.80
1,566,403
3,139
1,466,669
0.67
551,768
557,265
472,599
19,395
18,047
15,539
Stockholders' equity
196,752
187,370
170,419
Total liabilities and stockholders' equity
Net interest income (TE)
20,182
19,572
15,467
to total earning assets
3.77
3.71
3.22
Interest bearing liabilities to earning assets
1 Interest income from loans is shown on a TE basis as discussed below and includes fees of $722,000, $573,000 and $700,000 for the third quarter of 2017, the fourth quarter of 2016 and the third quarter of 2016, respectively. Nonaccrual loans are included in the above-stated average balances.
Analysis of Average Balances,
Tax Equivalent Interest and Rates
Nine Months Ended September 30, 2017, and 2016
11,913
1.01
25,960
370,161
682,997
2.45
196,120
6,443
36,340
891
3.27
566,281
14,437
3.40
719,337
13,438
2.49
7,886
4.58
7,955
4.21
1,516,872
52,365
4.55
1,161,312
39,778
2,102,952
67,164
4.22
1,914,564
53,565
3.69
34,670
32,617
(16,184)
(16,145)
189,533
193,443
2,310,971
2,124,479
427,242
316
383,870
261
279,143
254
272,657
198
262,352
125
258,062
392,049
1.05
404,210
0.87
1,360,786
3,776
0.37
1,318,799
3,199
0.32
32,764
0.04
35,022
62,308
472
26,040
0.33
7.11
57,561
2.12
1.58
1,557,465
1,482,922
0.65
544,925
465,094
20,814
13,037
187,767
163,426
57,816
46,313
Net interest income (TE) to total earning assets
3.68
3.23
1 Interest income from loans is shown on a TE basis as discussed below and includes fees of $1.8 million for the first nine months of 2017 and 2016. Nonaccrual loans are included in the above-stated average balances.
Non-GAAP Financial Measures
Management, in order to evaluate and measure performance, uses certain non-GAAP performance measures and ratios. 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 periods ended September 30, 2017, June 30, 2017, and September 30, 2016, and the nine month periods ended September 30, 2017 and 2016.
Net interest income and net interest income to earning assets have been adjusted to a non-GAAP TE basis using a marginal rate of 35% to more appropriately compare returns on tax-exempt loans and securities to other earning assets. The table below provides a reconciliation of each non-GAAP TE measure to the GAAP equivalent for the periods indicated:
June 30,
Net Interest Margin
Interest income (GAAP)
21,800
Taxable-equivalent adjustment:
68
876
888
97
2,255
Interest income (TE)
Interest expense (GAAP)
Net interest income (GAAP)
18,661
Average interest earning assets
Net interest margin (GAAP)
Net interest margin (TE)
Asset Quality
The Company recorded a provision for loan losses expense of $300,000 in the third quarter of 2017. On a quarterly basis, management estimates the amount required and records the appropriate provision or release to maintain an adequate reserve for all potential and estimated loan losses.
Nonperforming loans increased by $270,000 at September 30, 2017, from $16.0 million at December 31, 2016. Credit metrics continue to be relatively stable regarding nonperforming loan levels, and management is carefully monitoring loans considered to be in a classified status. Nonperforming loans as a percent of total loans decreased to 1.0% as of September 30, 2017, from 1.1% as of December 31, 2016, and 1.4% as of September 30, 2016. The distribution of the Company’s nonperforming loans is included in the following table.
Nonperforming Loans
Percent Change From
(in thousands)
Real estate-construction
(27.0)
169.7
Real estate-residential:
1,364
(47.4)
(63.9)
N/M
4,266
6,552
5,755
(34.9)
(25.9)
2,240
2,257
(11.7)
(12.4)
Real estate-commercial, nonfarm
3,631
5,386
7,345
(32.6)
(50.6)
Real estate-commercial, farm
(13.8)
(64.5)
345
(5.7)
Total nonperforming loans
16,271
16,001
17,380
1.7
(6.4)
N/M - Not Meaningful
Nonperforming loans consist of nonaccrual loans, nonperforming restructured accruing loans and loans 90 days or greater past due. Remediation work continues in all segments.
Loan Charge-offs, net of recoveries
% of
Total1
(0.2)
(7)
(0.8)
(48)
(7.3)
(2)
(2.4)
(1.7)
(5.0)
Total real estate-construction
(60)
(9.2)
(51)
(6.0)
Real estate-residential
(28)
8.5
(3)
(0.4)
(17)
5.2
129
19.7
(13)
(1.5)
(40)
12.2
723
110.4
(75)
(8.9)
(367)
111.5
(109)
(16.6)
112
13.3
Total real estate-residential
(452)
137.4
111.1
2.5
Owner general purpose
Owner special purpose
(6)
(0.9)
Non-owner general purpose
(43)
13.1
15.7
Non-owner special purpose
75.8
(6.80)
0.6
Total real estate-commercial, nonfarm
(21)
6.3
(6.5)
765
91.1
(2.1)
0.2
7.9
(29.8)
(11.2)
5.1
1.8
(5)
(0.6)
Net (recoveries) / charge-offs
(329)
100.0
655
1 Represents the percentage of net charge-offs attributable to each category of loans.
Net recoveries for the third quarter of 2017 reflected continuing management attention to credit quality. Gross charge-offs for the quarter ended September 30, 2017 were $241,000 compared to $1.2 million for the quarter ended September 30, 2016. Gross recoveries for the quarter ended September 30, 2017 were $570,000 compared to $358,000 for the quarter ended September 30, 2016. In comparison to the linked quarter, the third quarter of 2017 continued to reflect conservative loan valuations and aggressive recovery efforts on prior charge-offs.
Classified Loans
(17.0)
49.6
1,171
(40.9)
(44.7)
6,432
(38.9)
(31.3)
3,078
(15.5)
(35.8)
7,633
9,946
13,220
(23.3)
(42.3)
1,801
40.0
1,519
(84.9)
(74.9)
783
(7.0)
31.7
Total classified loans
28,259
(10.4)
(16.0)
Classified loans include nonaccrual, performing troubled debt restructurings and all other loans considered substandard. Loans classified as substandard are inadequately protected by either the current net worth and ability to meet payment obligations of the obligor, or by the collateral pledged to secure the loan, if any. These loans have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt and carry the distinct possibility that the Company will sustain some loss if deficiencies remain uncorrected.
Classified assets include both classified loans and OREO. Management monitors a ratio of classified assets to the sum of Bank Tier 1 capital and the allowance for loan and lease losses as another measure of overall change in loan related asset quality. This ratio ended at 12.62% for the period ended September 30, 2017.
Allowance for Loan Losses
Below is a reconciliation of the activity for loan losses for the periods indicated (in thousands):
Allowance at beginning of period
15,741
Charge-offs:
Total charge-offs
1,066
Recoveries:
249
Total recoveries
411
743
Loan loss reserve provision
750
Allowance at end of period
Average total loans (exclusive of loans held-for-sale)
1,550,229
1,505,572
1,186,279
1,513,693
1,157,159
Net (recoveries) / charge-offs to average loans
(0.02)
0.11
Allowance at period end to average loans
1.06
1.26
1.09
1.29
15,738
The coverage ratio of the allowance for loan losses to nonperforming loans was 101.2% as of September 30, 2017, which was a minimal reduction from the coverage of 101.4% as of June 30, 2017, but greater than the 86.2% coverage ratio as of September 30, 2016. When measured as a percentage of average loans as of September 30, 2017, total allowance for loan and lease losses increased to 1.06% of total loans from 1.05% as of June 30, 2017, and decreased from 1.26% of average loans at September 30, 2016. The total allowance for loan and lease losses as a percent of total period end loans was 1.15% as of September 30, 2017, excluding the loans acquired from the Talmer branch acquisition, which are effectively “reserved” for potential future losses in the remaining $667,000 credit mark component of the purchase accounting discount recorded. In management’s judgment, an adequate allowance for estimated losses has been established for inherent losses at September 30, 2017, and general changes in lending policy, procedures and staffing, as well as other external factors. However, there can be no assurance that actual losses will not exceed the estimated amounts in the future, based on unforeseen economic events, changes in business climates and the condition of collateral at the time of default and repossession. Loan loss provision for the quarter ended September 30, 2017, increased $300,000 as compared to like quarter of 2016 and decreased $450,000 as compared to second quarter of 2017.
38
Other Real Estate Owned
As of September 30, 2017, OREO ended at $9.0 million. This compares to $11.7 million at June 30, 2017, and $14.1 million at September 30, 2016. New additions to the OREO portfolio of $176,000 in the third quarter of 2017 were minimal. Valuation write-downs continued with an expense of $920,000 in the third quarter of 2017, the majority of which was recorded on three properties, compared to $392,000 in the second quarter of 2017 and $365,000 in the third quarter of 2016. The OREO net book value decreased in the first nine months of 2017 due to 24 property sales, net of a participation purchase. These sales provided $5.5 million in total proceeds, including net gains on OREO sales of $454,000. In addition, net valuation reserve write-downs of $1.6 million on 35 OREO properties were recorded in the first nine months of 2017; both of these reductions were partially offset by 13 property transfers into OREO from nonaccrual or fixed asset status totaling $3.8 million.
OREO
13,481
(13.0)
(27.9)
204
(13.7)
(31.0)
Property disposals
1,569
24.7
(2.3)
392
134.7
152.1
Total other real estate owned
(23.0)
(36.2)
In management’s judgment, the property valuation allowance as established presents OREO at current estimates of fair value less estimated costs to sell; however, there can be no assurance that additional losses will not be incurred on disposals or upon updates to valuations in the future. Of note, properties valued in total at $5.2 million, or approximately 57.5% of total OREO at September 30, 2017, have been in OREO for five years or more. The appropriate regulatory approval has been obtained for any OREO properties held in excess of five years.
OREO Properties by Type
% of Total
Single family residence
Lots (single family and commercial)
5,536
7,322
8,795
Vacant land
628
Multi-family
Commercial property
1,923
3,469
3,231
Total OREO properties
3rd Quarter 2017
Noninterest Income
1,638
4.6
1,615
6.6
(1.9)
Residential mortgage banking revenue
1,547
1,711
2,789
(9.6)
(44.5)
(131)
177.9
105.2
350
3.4
(5.5)
6.1
Gain on disposal and transfer of fixed assets
1,041
50.5
29.6
7,317
7.2
18.9
Of the noninterest income categories, securities gain (loss), net, experienced the largest increases on both a linked quarter and year over year basis, as shown above, primarily due to more favorable investment sales in 2017. The net security losses incurred in 2016 were necessary for liquidity purposes due to funding needs related to the Talmer branch purchase. Mortgage banking revenues have decreased over the last year as the rising rate environment has reduced originations and refinancing; mortgage loans held for sale originations are $34.1 million less year to date 2017 than the prior year to date period. Finally, the favorable variance in other income was driven by growth in commercial loan swap fee income; $547,000 of commercial loan swap fee income was recorded in the third quarter of 2017, as compared to $175,000 in the third quarter of 2016.
Noninterest Expense
Salaries
7,704
7,972
7,205
(3.4)
6.9
Bonus
1,114
521
30.4
113.8
Benefits and other
1,231
1,719
1,288
(28.4)
(4.4)
Total salaries and employee benefits
10,545
(4.7)
11.5
Occupancy, furniture and equipment expense
1,462
1.4
(1.2)
1,112
(2.8)
(2.2)
20.6
(12.7)
(6.8)
(8.6)
Amortization of core deposit intangible asset
(4.0)
452
(43.6)
(40.7)
399
(28.6)
(21.5)
(12.0)
(33.1)
Other real estate owned expense, net
539
26.2
59.6
2,839
(13.5)
(18.3)
17,986
(5.9)
2.0
Efficiency ratio (defined below)
57.66
64.03
66.21
The efficiency ratio shown in the table above is calculated as noninterest expense excluding OREO expenses, amortization of core deposits and acquisition costs, divided by the sum of net interest income on a fully tax equivalent basis, total noninterest income less net gains and losses on securities and includes a tax equivalent adjustment on the increase in cash surrender value of BOLI.
Third quarter 2017 noninterest expense decreased $1.1 million from the second quarter of 2017, and increased $336,000 from the third quarter of 2016. These variances are primarily due to salary and employee benefit related cost fluctuations due to certain one-time costs recorded in 2017, as well as an increase in employee insurance premiums in 2017. The second quarter of 2017 included a one-time cost incurred related to executive relocation and recruitment of $294,000, as well as higher levels of employee insurance costs as compared to the prior year. Although the overall employee count has not significantly increased in the year over year period, the hiring of additional staff in compliance and risk management roles has increased the overall wage base of the Company. A reduction in debit card interchange expense was recorded in the third quarter of 2017 due to reversal of an accrual related to the debit card rewards program. Finally, other expense has declined over the last year due to reductions in loan related expenses, including remediation costs as the loan portfolio quality continues to improve.
Other expenses have minimal fluctuations, as continued efficiencies with operational processes have contributed to maintaining the majority of noninterest expense components with insignificant variation.
Income Taxes
The Company recorded a tax expense of $1.8 million on $9.9 million pre-tax income for the third quarter of 2017. Income tax expense reflected all relevant statutory tax rates and GAAP accounting. The effective tax rate for the third quarter of 2017 was 18.5%, a decrease from 28.9% in the second quarter of 2017 and 34.7% in the third quarter of 2016. A nonrecurring income tax benefit of $1.6 million was recorded in the third quarter of 2017, stemming from the State of Illinois tax rate increase effective July 1, 2017, which increased the Company’s net deferred tax asset by a like amount. In addition, the impact of the tax exempt securities growth in the first and second quarters of 2017 contributed to the tax rate decrease in the third quarter of 2017 as compared to the prior year.
There have been no significant changes in the Company’s ability to utilize the deferred tax assets through September 30, 2017. The Company has no valuation reserve on the deferred tax assets as of September 30, 2017.
Financial Condition
Total assets increased $109.2 million from $2.25 billion as of December 31, 2016, to $2.36 billion at September 30, 2017, due primarily to organic loan growth. Total loans increased $115.4 million, or 7.8%, when compared to December 31, 2016, which was funded by significant deposit growth and FHLBC advances. Securities increased a modest $1.6 million in total, but the securities portfolio experienced select significant shifts in type of investments held year to date.
1,503
43,723
(73.4)
(74.8)
22,254
233.4
929.2
10,730
(0.5)
(1.4)
204,390
(53.0)
(60.7)
140,173
(4.8)
108,284
(47.6)
(50.8)
531,057
0.5
The securities portfolio ended the third quarter of 2017 at $533.5 million, an increase of $1.6 million from $531.8 million at December 31, 2016, and an increase of $2.4 million from September 30, 2016. Available-for-sale purchases during the third quarter of 2017 and year over year periods were primarily tax exempt state and political subdivisions securities; treasuries and government agencies also increased in the period ending September 30, 2017. This portfolio repositioning was performed to enhance overall asset yield due to the rising interest rate environment. During the third quarter of 2017 security sales resulted in net realized gains of $102,000, as compared to net realized losses of $193,000 for the fourth quarter of 2016 and losses of $2.0 million for the third quarter of 2016.
Total loans were $1.59 billion as of September 30, 2017, an increase of $115.4 million from the total as of December 31, 2016, driven by growth in the commercial, real estate-construction and leases portfolios. In addition, a home equity portfolio purchase of $16.7 million from TCF Bank in the second quarter of 2017 contributed to the total residential real estate growth of $41.7 million for the 2017 year to date period. Loan portfolio repositioning continued to drive reductions in commercial real estate concentrations, and to grow commercial and lease financing to diversify the portfolio. Total loans increased $391.7 million from September 30, 2016, due to the organic growth previously discussed as well as $221.0 million of loans from the Talmer branch purchase.
12.8
88.1
25.0
46.8
0.4
46.6
229.6
11.0
17.3
(14.4)
(16.7)
10,517
(11.9)
1,201,788
7.8
32.6
1,064
(48.8)
(41.4)
32.5
The quality of the loan portfolio is impacted by not only Company credit decisions but also the economic health of the communities in which the Company operates. As the Company is located in a corridor with significant open space and undeveloped real estate, real estate lending (including commercial, residential, and construction) has been and continues to be a sizeable portion of the portfolio. These categories comprised 78.6% of the portfolio as of September 30, 2017, compared to 79.7% of the portfolio as of
41
December 31, 2016. The Company continues to oversee and manage its loan portfolio in accordance with interagency guidance on risk management.
Deposits and Borrowings
Deposits
473,477
8.4
17.6
253,454
1.6
2.7
391,188
259,495
4.3
230,748
(4.3)
105,868
3.0
8.0
63,152
(18.5)
(19.6)
1,777,382
1.2
Total deposits were $1.89 billion on September 30, 2017, which reflects a $22.3 million increase from total deposits of $1.87 billion as of December 31, 2016, and a $111.7 million increase from $1.78 billion as of September 30, 2016. Total noninterest bearing demand accounts experienced increases of $43.2 million, or 8.4%, in volumes for the first nine months of 2017, while certificates of deposit reflected a decrease of $18.0 million, or 4.5%, for the same period. Growth in deposits in the third quarter of 2017 was attributed to seasonal tax refunds, as well as strong commercial demand deposit growth stemming from seasonal and operational funds increases as well as growth in commercial loan clients. The total deposit growth of 6.3% in the year over year period is also partially attributable to the $48.9 million of deposits acquired with the Talmer branch purchase in 2016.
In addition to deposits, the Bank obtained funding from other sources in all periods presented. Securities sold under repurchase agreements totaled $26.9 million at September 30, 2017, an increase from $25.7 million at December 31, 2016. The Bank also recorded an advance of $125.0 million from Federal Home Loan Bank of Chicago at September 30, 2017, as compared to $70.0 million at December 31, 2016.
The Company is indebted on senior notes totaling $44.0 million, net of deferred issuance costs, which were issued in the fourth quarter of 2016. These notes mature in December 2026, and include interest payable semiannually at 5.75% for five years. Beginning December 2021, the interest becomes payable quarterly at three month LIBOR plus 385 basis points. The Company is also indebted on $57.6 million, net of deferred issuance costs, of junior subordinated debentures, which are related to the trust preferred securities issued by its two statutory trust subsidiaries, Old Second Capital Trust I and Old Second Capital Trust II (“Trust II”). The Trust II issuance converted from fixed to floating rate at three month LIBOR plus 150 basis points on June 15, 2017. Upon conversion to a floating rate, a cash flow hedge was initiated which resulted in the total interest rate paid on debt of 4.30% as of September 30, 2017, as compared to 6.77%, which was the rate paid during the period prior to the June 15, 2017, rate reset.
As of September 30, 2017, total stockholders’ equity was $200.8 million, which was an increase of $25.6 million from $175.2 million as of December 31, 2016. This increase is directly attributable to nine months of net income in 2017 and a reduction in the accumulated other comprehensive net loss, offset slightly by $888,000 of dividends paid to common shareholders in 2017.
In 2015, the Company redeemed all outstanding shares of the Company’s Series B preferred stock; as of September 30, 2015, no shares of the Series B Stock remained outstanding. After this redemption, the Company’s total stockholders’ equity continues to include $4.8 million to reflect the value of a ten year warrant to purchase shares of its common stock, with an exercise price of $13.43 per share, issued in January 2009 as part of the original Series B issuance. A discussion of the 2009 issuance, including this warrant, is included in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of the Company’s Form 10-K for the year ended December 31, 2016, under the heading “Capital”.
The Company’s non-GAAP tangible common equity to tangible assets ratio was 8.16% at September 30, 2017, compared to 7.41% as of December 31, 2016, and 8.12% at September 30, 2016.
As of September 30,
As of December 31,
Tier 1 capital
Total equity
Tier 1 adjustments:
Trust preferred securities allowed
55,395
47,997
48,728
Cumulative other comprehensive loss
632
8,762
7,437
Disallowed intangible assets
(8,830)
(8,761)
Disallowed deferred tax assets
(26,381)
(31,220)
(32,882)
194,910
Tangible common equity
Total Equity
Less: Intangible assets
8,830
8,761
191,933
166,449
Tangible assets
2,112,751
Less: Goodwill and intangible assets
2,351,577
2,242,427
Liquidity
Liquidity is the Company’s ability to fund operations, to meet depositor withdrawals, to provide for customers’ credit needs, 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. The Company monitors its borrowing capacity at the FHLBC as part of its liquidity management process as supervised by the Asset and Liability Committee (“ALCO”) and reviewed by the Board of Directors.
Net cash inflows from operating activities were $28.5 million during the first nine months of 2017, compared with net cash inflows of $17.2 million in the same period in 2016. Proceeds from sales of loans held-for-sale, net of funds used to originate loans held-for-sale, were a source of inflows for the first nine months of 2017 and 2016. Interest paid, net of interest received, combined with changes in other assets and liabilities were a source of outflows for the first nine months of 2017 and 2016. The management of investing and financing activities, as well as market conditions, determines the level and the stability of net interest cash flows. Management’s policy is to mitigate the impact of changes in market interest rates to the extent possible, as part of the balance sheet management process.
Net cash outflows from investing activities were $105.7 million in the first nine months of 2017, compared to net cash inflows of $117.4 million in the same period in 2016. In the first nine months of 2017, securities transactions accounted for net inflows of $10.8 million, and net principal disbursed on loans accounted for net outflows of $118.7 million. In the first nine months of 2016, securities transactions accounted for net inflows of $184.4 million, and net principal disbursed on loans accounted for net outflows of $71.6 million. Proceeds from sales of OREO accounted for $5.5 million and $5.2 million in investing cash inflows for the first nine months of 2017 and 2016, respectively.
Net cash inflows from financing activities in the first nine months of 2017 were $77.3 million, compared with net cash inflows of $15.0 million in the first nine months of 2016. Net deposit inflows in the first nine months of 2017 were $22.3 million compared to net deposit inflows of $18.3 million in the first nine months of 2016. Other short-term borrowings had net cash inflows related to FHLBC advances of $55.0 million in the first nine months of 2017 and outflows of $15.0 million in the first nine months of 2016. Changes in securities sold under repurchase agreements accounted for $1.1 million and $12.5 million in net inflows in the first nine months of 2017 and 2016, respectively.
Cash and cash equivalents for the nine months ended September 30, 2017, totaled $47.5 million, as compared to $189.9 million as of September 30, 2016. The significantly higher balance at the end of the 2016 period was in anticipation of the $181.5 million paid for the Talmer branch purchase in October 2016.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Interest Rate Risk
As part of its normal operations, the Company is subject to interest-rate risk on the assets it invests in (primarily loans and securities) and the liabilities it funds (primarily customer deposits and borrowed funds), as well as its ability to manage such risk. Fluctuations in interest rates may result in changes in the fair market values of the Company’s financial instruments, cash flows, and net interest income. Like most financial institutions, the Company has an exposure to changes in both short-term and long-term interest rates.
In June 2017, the Federal Reserve raised short-term interest rates by 0.25%. There is a general market expectation that the Federal Reserve will move short-term rates higher in December of 2017. Generally, Federal Reserve actions have not had a significant impact on long-term rates, although Federal Reserve officials have announced a schedule to end reinvestment in their securities portfolio starting October 2017, which could result in increases in long-term rates. The Company manages interest rate risk within guidelines established by a policy which limits the amount of rate exposure. In practice, interest rate risk exposure is maintained well within those guidelines.
The Company manages various market risks in its normal course of operations, including credit, liquidity, and interest-rate risk. Other types of market risk, such as foreign currency exchange risk and commodity price risk, do not arise in the normal course of the Company’s business activities and operations. In addition, since the Company does not hold a trading portfolio, it is not exposed to significant market risk from trading activities. The Company’s interest rate risk exposures estimated at September 30, 2017, and December 31, 2016, are outlined in the table below.
The Company's net income can be significantly influenced by a variety of external factors, including: overall economic conditions, policies and actions of regulatory authorities, the amounts of and rates at which assets and liabilities reprice, variances in prepayment of loans and securities other than those that are assumed, early withdrawal of deposits, exercise of call options on borrowings or securities, competition, a general rise or decline in interest rates, changes in the slope of the yield-curve, changes in historical relationships between indices (such as LIBOR and prime), and balance sheet growth or contraction. The Company's ALCO seeks to manage interest rate risk under a variety of rate environments by structuring the Company's balance sheet and off-balance sheet positions, which include interest rate swap derivatives as discussed in Note 15 of the financial statements included in this quarterly report. The risk is monitored and managed within approved policy limits.
The Company utilizes simulation analysis to quantify the impact of various rate scenarios on net interest income. Specific cash flows, repricing characteristics, and embedded options of the assets and liabilities held by the Company are incorporated into the simulation model. Earnings at risk is calculated by comparing the net interest income of a stable interest rate environment to the net interest income of different interest rate environments in order to determine the percentage change. Significant declines in interest rates that occurred during the first half of 2012 have made it impossible to calculate valid interest rate scenarios for rate declines of 2.0% or more, a situation that continues to date. As of September 30, 2017 and December 31, 2016, the Company’s analyses reflected earnings gains (in both dollars and percentage) should interest rates rise, and earnings reductions should interest rates fall. The changes in income across the various interest rate scenarios as of September 30, 2017 were similar to those increases in Federal Home Loan Bank borrowings. Overall, management considers the current level of interest rate risks to be moderate, but intends to continue closely monitoring changes in that risk in case corrective actions might be needed in the future. Federal funds rate and the Bank’s prime rate remained unchanged at 1.25% and 4.25%, respectively.
The following table summarizes the effect on annual income before income taxes based upon an immediate increase or decrease in interest rates of 0.5% and 1%, and an increase of 2% assuming no change in the slope of the yield curve.
Analysis of Net Interest Income Sensitivity
(dollars in thousands)
Immediate Changes in Rates
(1.0)
1.0
Dollar change
(4,860)
(2,159)
1,175
2,393
4,630
Percent change
(2.9)
3.2
6.2
(4,404)
(2,141)
1,145
2,406
4,866
(6.6)
(3.2)
3.6
7.3
The amounts and assumptions used in the simulation model should not be viewed as indicative of expected actual results. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and management strategies. The above results do not take into account any management action to mitigate potential risk.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
The Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) promulgated under the Securities and Exchange Act of 1934, as amended, as of September 30, 2017. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of September 30, 2017, the Company’s internal controls were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities and Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified.
There were no changes in the Company’s internal controls over financial reporting during the quarter ended September 30, 2017, that have materially affected, or are reasonably likely to affect, the Company’s internal control over financial reporting.
Forward-looking Statements
This document (including information incorporated by reference) contains, and future oral and written statements of the Company and its management may contain, forward-looking statements, within the meaning of such term in the Private Securities Litigation Reform Act of 1995, with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company’s management and on information currently available to management, are generally identifiable by the use of words such as “believe,” “expect,” “anticipate,” “plan,” “intend,” “estimate,” “may,” “will,” “would,” “could,” “should” or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events.
The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. The factors, which could have a material adverse effect on the operations and future prospects of the Company and its subsidiaries, are detailed in the “Risk Factors” section included under Item 1.A. of Part I of the Company’s most recent Annual Report in Form 10-K. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
The Company and its subsidiaries, from time to time, are involved in collection suits in the ordinary course of business against its debtors and are defendants in legal actions arising from normal business activities. Management, after consultation with legal counsel, believes that the ultimate liabilities, if any, resulting from these actions will not have a material adverse effect on the financial position of the Bank or on the consolidated financial position of the Company.
Item 1.A. Risk Factors
There have been no material changes from the risk factors set forth in Part I, Item 1.A. “Risk Factors,” of the Company’s Form 10-K for the year ended December 31, 2016 and the risk factors set forth under the heading “Risk Factors” in the Company’s Registration Statement of Form S-3 (File No. 333-219680), which are incorporated herein by reference. Please refer to those sections of the Company’s Form 10-K and Registration Statement on Form S-3 for disclosures regarding the risks and uncertainties related to the Company’s business.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.
Item 3. Defaults Upon Senior Securities
Item 4. Mine Safety Disclosures
Item 5. Other Information
Item 6. Exhibits
Exhibits:
First Amendment of Old Second Bancorp, Inc. Employment Agreement with James Eccher, dated as of September 1, 2017 (incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K filed on September 1, 2017).
Form of Compensation and Benefits Assurance Agreement (incorporated by reference to Exhibit 10.2 of the Company’s Current Report on Form 8-K filed on September 1, 2017).
Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a).
Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a).
Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Balance Sheets at September 30, 2017, and December 31, 2016; (ii) Consolidated Statements of Income for the nine months ended September 30, 2017 and 2016; (iii) Consolidated Statements of Stockholders’ Equity for the nine months ended September 30, 2017 and 2016; (iv) Consolidated Statements of Cash Flows for the nine months ended September 30, 2017 and 2016; and (v) Notes to Consolidated Financial Statements, tagged as blocks of text and in detail.*
* As provided in Rule 406T of Regulation S-T, these interactive data files shall not be deemed “filed” for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934 as amended, or otherwise subject to liability under those sections.
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
BY:
/s/ James L. Eccher
James L. Eccher
President and Chief Executive Officer
(principal executive officer)
/s/ Bradley S. Adams
Bradley S. Adams
Executive Vice President and Chief Financial Officer
(principal financial and accounting officer)
DATE: November 7, 2017
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